Wealth International, Limited

Finance Digest for Week of March 6, 2006

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


Hamilton James is raising one of the largest private equity funds the world has ever seen, a $13 billion whopper for Blackstone Group, renowned kingpin of the buyout business. Suddenly this thriving trade is redefining the terms of power, profit and greed on Wall Street. He waxes rhapsodic on the benefits to the economy. “Good private equity funds improve companies operationally and lower the cost of capital for those that are financed inefficiently,” says James, president of Blackstone and chief of its private equity arm. “If you look at our record, or any good buyout fund’s record, you see consistent outperformance in good times and bad.”

Investors poured $106 billion into leveraged buyout funds last year, double the total of 2004, says Private Equity Analyst. Weary of the wobbly stock market and alarmed by the real estate run-up, they were lured by eye-popping returns of 50% a year (or better) at a few elite funds. Globally, 2,700 funds are raising half a trillion dollars in cash to invest. This will bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put up. Just half a dozen giant firms control half of all private-equity assets.

Egging on the buyout boys: all of Wall Street, which collects marvelous fees from all the buying and selling. There would be no reason to begrudge the financiers their take if they were building enterprises and creating jobs. But they do not make their fortunes by discovering new drugs, writing software or creating retail chains. They are making all this money by trading existing assets. Some buyout firms dabble in deeds that got Wall Street and Big Business in trouble in the post-Enron era – conflicts of interest, inadequate disclosure, questionable accounting, influence-peddling and more. Increasingly the big guys jump into bed with each other.

Moreover, some buyout shops ply rape-and-pillage tactics at their new properties. They exact multimillion-dollar fees advising businesses they just bought. They burden a target company with years of new debt, raised solely to pay out instant cash to the buyout partners. It is akin to letting the Sopranos come in and gut your business to cover your gambling debts. More politely known as a dividend recapitalization, this quick-buck ploy, entirely legal, paid out $18 billion in instant gratification to new owners last year. Now and again corporate carnage follows, as thousands of employees lose their jobs, long-term prospects are diminished and the business files for bankruptcy, stranding minority investors and debtholders. Buyout funds defend brutal tactics by citing their results. They claim to beat the overall market by five percentage points. But in fact they trailed the rise in the S&P 500 from 1980 to 2001, say professors Steven Kaplan of the University of Chicago and Antoinette Schoar of M.I.T.

Worse, their results could be headed for a slump as a huge influx of new money and bidders inflates the prices of properties at a time when interest rates could rise and increase the cost of new debt. Buyout firms are bidding “extraordinary” prices at frenzied corporate auctions, says Michael Gibbons of Brown Gibbons Lang & Co., a Cleveland investment bank doing 25 such deals. “There’s a group of new private equity guys chasing deals for the sake of putting money to work,” says Darrell Butler of Billow Butler & Co., an investment bank in Chicago. “They’re affectionately known as ‘dumb money.’”

Millions of low-rollers – employees and taxpayers – could feel the impact. Pension plans provide 40% of the roughly $600 billion now committed to buyout funds. Many pension plans, both corporate and governmental, are so underfunded they look to private equity to help them close the gap, or at least to tell their actuaries that they can close the gap. Public and private pension funds overall have less than 4% of assets in private equity. But in a cruel coincidence, underfunded pension plans and companies in bad shape rely more heavily on buyout funds than healthy firms do.

But if Darrell Butler is right – if too much dumb money is getting in at the top – the insiders who run funds will still thrive. Private-equity funds typically take a 2% cut of assets annually plus a 20% chunk of everyone else’s profits. This vigorish, common when a $1 billion fund was the norm, has not come down even as buyout funds have grown 10 times as large. These days nearly half the big buyout funds take their 20% slice from the dividend recaps before their investors break even. Previously the funds waited until outside investors (the limited partners) were in the black before collecting their own cut. Private-equity fund managers further cash in by charging their own portfolio firms for everything from negotiating loans to helping run the business. In other instances, buyout shops goose returns with “secondary deals” – selling their holdings to one another. When things go bad limited partners can look to a specialty firm that will buy out what is left of their stakes – but even in this game fraud can happen.

Other buyout firms come under fire for shrewd (or illegal) fundraising tactics. In Illinois a scandal erupted over allegations private equity firms paid hundreds of thousands of dollars in bribes to coax investments out of officials of the state’s teachers pension fund. Corporate retirement funds collectively face a $450 billion pension funding shortfall and are throwing Hail Mary passes to private equity funds to close the chasm. Likewise for public pension plans.

“I can’t think of an industry structure that’s more screwed up,” says one manager of a midsize buyout firm. “The biggest suppliers of capital” – the pension funds – “are the most thinly staffed and underpaid,” he says. State plans with a few employees oversee billion-dollar investments and report to “political entities – their boards – relying on consultants whose business is mostly about marketing and politics,” he says. They are not any match for the buyout guys – who already are anticipating a coming correction and are preparing to profit from it. Some of the biggest names in buyout now are raising “distressed investment funds” (i.e., vulture funds). Feeding on big discounts, they will buy the equity and debt of companies their brethren helped get into trouble.

Link here.


Massive layoffs are usually associated with decaying sectors like Detroit or perennially troubled industries like airlines. But some of the bigger job cuts these days are coming from the high-tech world of pharmaceuticals. Drug companies have announced 70,000 job cuts in the last three years – 17% of the workforce and more than in the entire previous decade. Six out of the top 10 bestselling drugs have stagnant or declining sales. Yes, the drug business remains very profitable, but it is not what it used to be. In the last five years Pfizer, Merck, Bristol-Myers Squibb and Schering-Plough have lost a combined $394 billion in market value, a decline of 54%.

The really bad news: This slump is not likely to end anytime soon. The industry is struggling with an onslaught of generics and an inability of its research labs to replace aging drugs like Lipitor and Prevacid with equivalent blockbusters. But a bigger shift is taking place as well. While the industry has traditionally emphasized mass-market drugs, the hot growth area is expensive treatments for cancer and rare diseases – and that plays into the historic strength of biotech companies. The changes could fuel upheaval in the next decade, perhaps provoking another round of pharma consolidation and new industry leaders as biotech companies like Amgen and Genentech stand to gain ground. European drug companies that invested in smart research could move to the fore.

Link here.


Life is beset with financial hazards. Your new SUV becomes uneconomic when gasoline shoots to $4. The housing bubble collapses just when you are in the middle of a relocation and carrying two houses. A jump in the euro makes your summer vacation unaffordable. Big corporations hedge away financial risks in the futures market on the Chicago Mercantile Exchange, among other trading venues. What is the little investor supposed to do? John Nafeh has an answer: Buy Hedgelets. Nafeh, 63, in late 2004 launched HedgeStreet, a vehicle for making tradable microbets on the prices of things like homes, gold, foreign currencies and oil. And we do mean micro. Most Hedgelets are worth a maximum of $10. You would need to buy a lot of them in order to insure yourself against typical annualized household risks.

HedgeStreet bills its contracts as “small, inexpensive, easy-to-understand” and says they open “markets never before accessible to individual traders.” A nice idea in principle, but it remains to be seen whether HedgeStreet will enable ordinary folk to sleep better. Indeed, the pathetic trading volume, gaping bid/ask spreads and ridiculously short contract maturities (rarely stretching beyond 7 days) are enough to make any intelligent investor’s hair curl. HedgeStreet admits its site right now is best for speculators, but its hedging viability will improve with liquidity. The main problem with Hedgelets is their miserable liquidity. So thin is trading that on some days many contracts trade as few as 20 Hedgelets or none at all. Bid/ask spreads get comically wide at times.

These $10 bets may have some appeal for speculators who want to shoot craps with their lunch money. They are, for the most part, not terribly practical for people concerned about big economic risks in their lives. Here is our advice to people who want to protect against financial risks: Look for some heavily traded stock or stock option to buy. If heating oil or gasoline bills worry you, pick up $20,000 worth of shares in a big oil company and just sit on them. If a real estate collapse is on your mind, wait until April, when the Chicago Merc opens trading in futures keyed to a real estate index in ten cities. Wait until Chicago Merc real estate trading volume tops 500 contracts a day, there is increasing open interest to show it is not just a few day traders, and the bid/ask spread is no worse than 2% of contract value.

What if the Merc home price future never gets off the ground? As a crude (but at least fairly priced) approximation of the insurance you need, you could buy some put options on heavily traded home builder stocks. Yet another option is to do nothing. Better to incur a small risk that the real estate market will go against you than a large risk of getting hosed on bid/ask spreads.

Link here.


The scream of pain and anguish you hear is coming from bondholders. We are suffering from a mania that is sweeping corporate America, benignly called “enhancing shareholder value”. The most common form of this phenomenon is the stock buyback, which if perpetrated on any but the highest-P/E companies has the effect of increasing earnings per share and perhaps the stock price. Unfortunately, at the same time that buybacks enrich shareholders they impoverish bondholders. To pay for the shares the corporate treasurer must either deplete cash reserves or borrow money, and either action hurts a company’s credit rating. Joining buybacks as credit-quality killers are the new zest for acquisitions, which add punishing debt, and spinoffs, where good units depart and big liabilities stay. Whether such moves are strategically wise or not, they frequently have one bad effect: They deplete the balance sheet.

I warned about the deterioration of balance sheets in my December 12, 2005 column. Since then the volume has been turned up, and many high-quality bonds are becoming junky overnight. The rating agencies have been dropping ratings with scary speed. In the first part of this decade they typically waited after an announcement about increased debt to see what the company did with the borrowed money. Now they are lowering the ratings first and looking later. Corporate spending on stock buybacks has exploded. Standard & Poor’s estimates that the companies in the S&P 500 spent $315 billion on share buybacks last year, versus $197 billion in 2004.

Credit quality risk is accelerating, which means it is time for bond buyers to get conservative. Read carefully every bit of news about the high-grade companies you already own. Get out if management makes the wrong move. For your new money I recommend short-term Treasurys. With today’s flat yield curve, 6-month Treasury bills and 2-year notes offer as much yield as 10-year Treasurys, with less risk. Nor is the modest yield gain offered by most corporate bonds worth the risk.

Link here.


Like politics and religion, outsourcing has become a contentious topic. It often translates into lost jobs, and often those jobs migrate to countries where labor is cheap. But not always. Less noticed is that some outsourcing goes on within U.S. borders. Here you see some jobs shift around, yet the end result benefits both corporate bottom lines and general employment levels. With domestic outsourcing, companies get to shed distracting noncore operations so they can focus on what they do best. And employers who take up such cast-off chores do them more efficiently and turn a pretty profit. These are American jobs that, by and large, stay as American jobs. In our portfolios, a key theme is our enthusiasm for businesses competent at minding matters others need but are smart to avoid. We are placing a big bet on outsourcing as demonstrated by a few of my holdings below.

Link here.


The world is running out of oil. Demand in China and other Asian nations is rising rapidly, yet total oil production will soon peak and then decline. As a result, today’s high oil prices, driven by Katrina and Rita, are only a harbinger of even higher prices to come. Such high prices mean an end to life as we know it – life in the suburbs with automobiles, Wal-Marts, and other modern conveniences. Those, at least, are the claims of the peak-oil theorists. Some proponents of peak oil are actually petroleum geologists who have some idea what they are talking about. But many are simply people who hate suburbs and automobiles and are gleeful at the thought that they will soon go away.

Of course, if what they say is true, we should stop building any more low-density suburbs or highways, and instead build New Urban communities and rail transit. The peak-oil theory thereby helps politicians justify intrusive land-use regulations and wasteful transportation projects. Leading the charge in this field is James Howard Kunstler, author of The Geography of Nowhere, which argued that suburbs were “trashy and preposterous”; Home from Nowhere, which advocated New Urbanism as a replacement for traditional suburbs; and now The Long Emergency. As summarized in Rolling Stone, Kunstler’s latest book argues that oil prices are rising to catastrophic levels, and that we will only be saved by building “walkable, human-scale towns.”

Kunstler is no petroleum geologist. As his earlier books show, he simply considers suburbs abominable. If peak oil means an end to the suburbs, then he is all for it. This attitude blinds him to any realistic assessment of his argument. Broken down, Kunstler’s conclusions depend on four separate hypotheses: (1) We are rapidly running out of oil, and fuel prices will soon become unaffordable for ordinary auto drivers. (2) For powering automobiles, there is no substitute for oil. (3) Higher prices will necessarily mean less driving. (4) Less driving will favor New Urbanism over low-density suburbs.

If any one of these four hypotheses are wrong, then Kunstler’s conclusions are unwarranted. All four must be true for there to be any support for the diversion of highway funds to rail transit, or for government regulations or subsidies that favor New Urbanism over low-density suburbs. Let us look at each hypothesis in detail …

Link here.


According to a recent article in Crain’s New York Business, “consumers are rushing to park their money in New York banks” as 12-month CDs hit 5% interest rates for the first time in six years. That suggests we have reached a point, as far as individuals are concerned, where cash has become a viable alternative to other, more risky investments. At the same time, Japanese central bankers are poised to tighten monetary policy following half a decade of “quantitative easing”, while the European Central Bank boosted interest rates this week to 2.5% and indicated further hikes are possible. That suggests we have reached a point where fund managers must take into account a much different global monetary policy environment than they have been used to, which will likely spur a more defensive approach to sector and market weightings.

Link here. Investors on monetary policy watch – link.

New Game

The message from the recent sell-off in global bond markets should not be ignored. The great conundrum of unusually low real long-term interest rates may now be a thing of the past. If so, that could have profound implications for the liquidity cycle and an interest-rate-dependent global economy. I remain convinced that central banks are always in control of the liquidity spigot. And the biggest news in close to a decade is that the Bank of Japan now appears to be on the cusp of abandoning its policy of über accommodation. In doing so, the BoJ would be following the lead of the other two major central banks in the world – the Federal Reserve and the European Central Bank. Each of these institutions abandoned standard operating procedures for extraordinary reasons. One by one, these special circumstances appear to have been overcome – allowing the monetary authorities to remove policies of extraordinary accommodation.

But the biggest move of all has to be the BoJ. On the heels of three consecutive months of positive and accelerating y-o-y inflation in Japan’s core CPI, our crack BoJ watcher, Takehiro Sato, now believes the Japanese central bank may move as early as this week to begin its own normalization campaign. As has been widely advertised, this will be a two-step process – with this week’s likely action entailing the end of “quantitative easing” – the provision of excess reserves to the Japanese banking system. The second shoe to fall – the end of the infamous zero-interest rate policy (ZIRP) that has been in place for 7 years – is still not expected for another year.

Financial markets are impatient beasts. As soon as the broad consensus of investors gets a whiff of a major change brewing in the underlying macro fundamentals, they begin to reprice securities accordingly. With the Japanese economic recovery gathering momentum and with inflation now “breaking out” into positive territory, investors take the old adage very seriously: They move quickly – and ask questions later. That message has not been lost on global bond markets in the past couple of weeks. While yields remain quite low in a broader historical context, the normalization of central bank policies provides good reason to ponder whether we have now seen the secular bottom for long rates. Equally important is the possibility that the BoJ – long the low-cost source of funding in world financial markets – is about to change the rules on the multitude of “carry trades” still popular for yield-hungry investors. If that is the case, a normalization of spreads in what traditionally have been the more risky segments of world financial markets – namely, high-yield corporate credit and emerging market debt – may also be close at hand.

All this takes us to the burning question of the hour: What happens to the world economy if the bond market conundrum is suddenly resolved and real long-term interest rates revert toward historical norms? My guess is that this is not good news for what has been a liquidity-driven, increasingly asset-dependent global economy. I do not think it has been a coincidence that global growth has strengthened in recent years as real long-term interest rates have been trending to the downside. In my view, there can be little doubt that the real interest rate conundrum has paid a handsome dividend to the world economy.

The bearish bond call has been met with repeated frustrations over the past several years. The problem may be traceable to focusing on the wrong issue – inflation – and paying too little attention to the global liquidity cycle. In that latter regard, a key shift has now occurred – the central bank anchor of cheap money has finally been hoisted out of the waters. It was one thing for the Federal Reserve to remove its extraordinary accommodation, but it is another matter altogether for the Bank of Japan to begin implementing its exit strategy. It is a new game for the global liquidity cycle – and possibly a new game as well for real long-term interest rates and an asset-dependent global economy.

Link here. Excess liquidity clinches case for ECB rate rises – link.

World interest rates rising.

The whole world is now at a critical change in the price of money. The implications for this are going to be huge. Here is a typical story headline about the ECB rate hike this week of 0.25% and the rationale for it: “The European Central Bank raised interest rates Thursday for the second time in four months, moving to quell inflation as Europe’s economy begins to improve.” It is my view that the emerging economic strength in Japan, the U.S. and Europe are only late manifestations of the final stage of the great world liquidity bubble Japan started in the early 1990’s. This latest round of rate hikes is going to severely harm the U.S. and world consumer economy. They (the central banks) are late.

Since 1990 or so, the world has had an incredible boost of cheap money. It started with Japan after their stock and real estate busts in the early 90’s. Since then, there was a huge U.S. and world stock bubble, a tech crash here, worldwide housing bubbles which are really speculative finance bubbles. We in the U.S. are now seeing our own housing bubble weaken significantly, and there is speculation that this is only the beginning of a coming collapse in consumer spending here. The fact that the U.S. consumer statistics still show strong gains recently does not mean that the downside of a housing collapse will not result in a severe drop in U.S. consumer habits. I foresee that about Fall of this year, the published consumer statistics will begin to show significant drops of consumer sentiment and spending. This is the pattern that emerged about the housing bubble – the statistics of a slowdown were 3 months behind the real event.

Now, back to world interest rates. There are enough inflationary forces worldwide that, Europe, Japan and the U.S. are now raising rates simultaneously. Japan is growing decently and the BoJ has stated it intends to raise rates in the coming months. That is a huge change from their 10 years of zero cost money. What is emerging is a final chapter of a world liquidity bubble that began in Japan. So much money has now gone into real estate, bonds, securities, derivatives, and so on, that this world liquidity bubble will burst with a great crash. The central banks are going to try to use baby steps, i.e., 0.25% increases, but that will only just allow the asset bubbles to reach there very pinnacle before they implode.

The now simultaneous interest rate increases in much of the world are going to start to hamstring liquidity at some point. Already, real estate markets in Shanghai, Britain, Australia, the U.S. and other nations are cooling and are going to break hard. This should occur, in my estimation, by the Fall of this year. At that point, I will be looking for major drops in world stock markets, and for some recovery in good sovereign bond markets.

Link here.

Currency values and interest rates: carried away by the carry trade.

Currency traders have an infatuation with interest rate differentials. Under the prevailing assumption, currencies issued by countries with high interest rates ought to appreciate against currencies issued by countries with low interest rates. This follows the logic of the carry trade, where the currency procured at low rates is exchanged for the currency deployed at high rates. While this temporarily stimulates demand for the high rate currency, it creates an open short position that only accentuates the fundamentally superior value of the low rate currency. This value rests on the axiom that interest rates and credit risk are inversely related. The market assigns rates in line with this axiom, granting the lowest rate to the debt denominated in the most creditworthy currency. Trading against this axiom amounts to trading against the secular trend and runs the risk of being caught flatfooted by sudden realignments of currency value and credit risk.

The carry trade has developed largely because real interest rate differentials are determined on false grounds. The nominal interest rate differential between Japan and the U.S., for example, is 450bps based on their respective overnight lending rates (zero for Japan vs. 4.5% for the U.S.). The real interest rate differential is 250bps in favor of the U.S. when derived by subtracting government estimated CPI rates (0.5% for Japan vs. 2.5% for the U.S.). Borrowing in Japan to lend in the U.S. appears rational and profitable. CPI rates, however, are not an effective proxy for inflation, which is the rate at which the total supply of money and credit in an economy is growing. By this measure, real interest rates are negative in both countries: minus 1.5% in Japan (zero interest less 1.5% inflation) and minus 4.0% in the U.S. (4.5% less 8.5% inflation). The real interest rate differential is 250bps in favor of Japan. The spread widens to 400bps in favor of Japan based on the interest rates of their respective 10-year notes (1.6% for Japan vs. 4.6% for the U.S.). Borrowing in Japan to lend in the U.S., therefore, is actually irrational and highly unlikely to be profitable when positions are closed.

The real interest rate differential between Japan and the U.S. based on money and credit growth, the proper definition of inflation, is consistent with the order of nominal interest rates assigned by the debt market, which also favors Japan. The large buildup of an open short position adds to the yen’s appeal as the currency with the lowest nominal interest rate among irredeemable fiat monies and Japan’s status as the world’s largest creditor state. The eventual covering of this position will temporarily exaggerate the yen’s appreciation against the dollar, with the trigger as likely to be a change in risk premiums demanded on U.S. debt as a narrowing of the nominal interest rate differential between the two countries. Consequently, a devaluation of the dollar against the yen could, in fact, occur in tandem with a widening of the nominal interest rate differential between Japan and the U.S. Currency traders gawking exclusively at rate spreads would not even see what hit them.

Link here.

End of easy money in Japan.

The infamous “carry trade” since 2002 is about to draw to a conclusion this spring as the Bank of Japan raises short-term interest rates for the first time since 1989. And with the end of one of the greatest speculative trades comes the strong likelihood of a hedge fund blowout this spring or summer. The “carry trade” is hedge fund parlance for borrowing in a low yielding currency and investing in a high yielding currency. Over the last four years, some investors have earned a fortune borrowing in yen and investing in emerging market bonds and stocks. That has been one of the hottest trades in the world since 2003 as emerging markets have soared over 200%. At the same time, benchmark Japanese government bond yields have hovered near 1.5%, making cheap credit abundant for speculators. But now traders and investors fear the party will end as monetary officials finally cut-off cheap credit in the face of a rapidly expanding Japanese economy and rising inflation.

Extended periods of cheap credit have historically been followed by massive systemic shocks or mini-panics. Towards the end of the real estate cycle in 1989, the Federal Reserve aggressively raised interest rates, resulting in the worst post-war collapse for commercial and residential properties in 1990 and 1991. The government had to create the Resolution Trust Corporation (RTC) to bailout the bankrupt Savings & Loans in 1991. Once again, rising rates siphoned liquidity in 1994. This time, bond markets were hammered, suffering their worst decline since 1927. Following an extraordinary period of cheap credit from 1991 to 1993, the majority of global fixed income markets tanked in 1994 while Orange County, California, almost went bankrupt because of reckless derivatives tied to the credit cycle. As the era of cheap credit draws to a conclusion in Japan this year, global markets will probably suffer another major correction – now eight years, and counting.

Link here.
Could Japan cause a U.S. house price crash? – link.
Is Japan about to start a sell-off in global financial markets? – link.
Bank of Japan Ends its policy of fighting deflation – link.
Bank of Japan statement on monetary policy – link.

Japan’s problem is high costs, not deflation.

Please excuse my lack of enthusiasm about the end of deflation in Japan. As a resident of this overpriced nation of 127 million, I would not mind experiencing a bit more of the trend. Yes, I have read my Milton Friedman and heard the phrase “scourge of deflation” often enough to fear the phenomenon. It slams financial assets, boosting debt-servicing costs and undermining corporate profits. It erodes business and consumer confidence and lowers tax revenue. It is a “third-rail” to investors, who often avoid economies grappling with it. Still, almost eight years of deflation in the world’s second- biggest economy have offered two positive, yet unappreciated benefits: consumers have gained a bit more purchasing power and a little of the air has leaked out of Japan’s bloat. Economists call that “good deflation”.

I am certainly not hoping Japan’s most promising recovery in 15 years fizzles out. This revival is for real, provided the government or the Bank of Japan do not screw it up. I am rooting for Japan, yet its long-term competitiveness worries me. The fact is that even after years of sliding prices Japanese still arguably pay the world’s highest prices for goods and services. This is still a place where many consumers feel broke if their wallets carry less than $300 cash.

What is lost in the excitement is that deflation has been a symptom, not the cause, of Japan’s “Lost Decade”. While there is a universal sense here that all would be well if only Japan could end deflation, nothing could be further from the truth in age of globalization. All deflation has done – and it has been a very mild bout – is make a wildly expensive country a bit less-wildly expensive. An end to deflation may morph an overpriced, uncompetitive economy where falling prices act as a stealth tax cut to an overpriced, uncompetitive one with rising prices. Will that really leave Japan better off from a global perspective? Japan may be far better off in years ahead if easing prices lower costs to more reasonable levels. Think of it as economic “rightsizing” of the kind that rolled through Corporate America in the 1990s. Japan could use a similar dynamic – not a deflationary spiral, but a steady and orderly decline.

That is a contrarian view. Yet when was the last time Economics 101 applied to Asia’s biggest economy? Amid strong GDP growth and a trade surplus, the yen is surging? Wrong. The world’s biggest public debt ratio – 151% of GDP – is skyrocketing bond yields? Wrong. Expectations for rising inflation are slamming the Nikkei 225 Stock Average? Wrong. Ever wonder why deflation scares Japan Inc. so much? Because it is a force the country’s best and brightest cannot control, and that could bring fundamental changes to the economy. For these reasons and more, declining prices may do more good than harm.

Link here.


For the past several years there has been an ongoing debate among bears about how numerous U.S. imbalances would be resolved: debts, deficits, under-saving, over-consumption, and asset bubbles. The deflationists argue that bubbles always burst and when they do, debtors default. Inflationists make the case that in a social democracy the government will do everything in its power to bail out the debtor class, even run the printing presses. Cynics point out the obvious: a central bank will always try to mitigate the pain of its banking constituents. Their contentions all have merit.

Four years ago deflation fears were rampant. The tech bubble was bursting, the economy slipping into recession, and the Fed seemed impotent to stem the slide. The Fed responded with a massive dose of ultra-cheap credit which at first had little effect, but eventually made its way into the next asset bubble: real estate. Today inflation – particularly “asset inflation” – is the toast of the town. Speculators are binging on stocks, real estate, and commodities. Professionals are reaching for yield with exotic debt instruments. And the Fed chairmanship has returned to rock star status. Meanwhile, expectations for consumer price inflation remain guarded. U.S. economists predict a 2.4% rise in the CPI this year and inflation-indexed bond investors expect the CPI to average 2.5% over the next 10 years.

The inflationary side of the boat has clearly gotten crowded. What will cause it to capsize? Dr. Marc Faber, editor of The Gloom, Boom & Doom Report, offers two possible scenarios: a crash in asset prices or an accelerating consumer price inflation in which asset prices decline in real terms, though not necessarily in absolute terms. After throwing the inflation switch on full throttle, the Fed has backed off somewhat with 14 “measured” rate increases over the past 20 months. Why? Perhaps they no longer believe their own sales literature. As the accompanying table below shows, the official inflation measures are grossly understated. Over the last five years, prices for practically everything have exceeded the CPI, driven by rapid growth in money and credit.

Are investors overestimating the Fed’s ability and will to inflate? For at least the short- to intermediate-term, we believe that to be the case. The Fed appears to be in a box. They have allowed the inflation genie out of the bottle, leaving asset bubbles, a declining dollar, and rising consumer prices in their wake. An aggressive easing – at least at this point – would surely exacerbate the situation, and appears highly unlikely. Meanwhile, the air is slowly leaving the housing bubble. Its deflation appears to have plenty of room, perhaps for the next six months, to gain momentum. By the time the Fed reacts to declining home prices and rising defaults, it will be too late.

At some point we would expect the debtor class to beg for inflation, and for the Fed to give it to them. The Fed will probably be forced to rely less on banks and other intermediaries and more on monetization – purchasing various assets and paying for them with money created out of thin air. It would be a radical departure from Fed procedure, and if it does happen will come far too late to prevent the housing and consumption balloon from popping.

Some in the inflation camp are convinced we are on the road to hyperinflation. While we don’t necessarily disagree, the path may take more twists and turns than they expect. Mr. Market tends to follow the course that inflicts the maximum amount of pain. A relative decline in asset values would bail out the speculator, whereas an absolute decline would take him and his creditor out to the woodshed. The investing crowd would then likely react to the new deflationary reality by selling off assets, paying down debt, and actually saving … just in time to get smashed by a new wave of inflation. Under either scenario – a real or absolute decline in asset values – gold will almost certainly outperform real estate and the shares of mortgage lenders.

Link here.

Does the U.S. have a handle on inflation?

Over on RealMoney, Barry Ritholtz opined that the U.S. government is probably underestimating inflation because it is focusing on the wrong type of inflation. I would agree with that, having identified no less than five different types of inflation: commodity inflation, wage inflation, monetary inflation, fiscal inflation, and foreign exchange inflation. Before discussing “inflation”, it helps to identify which form of inflation is being talked about. Failure to do so may have caused some of the confusion that often surrounds this topic.

Link here.


Should you have a lottery ticket in your 401(k)? The question came to mind as I completed an examination of the 3,438 publicly traded companies with 10-year records in the Morningstar database. If you worked for a winning company – one that had stunning stock market returns over the last 10 years – you could be wealthy already. If you worked for a losing company – one that had poor stock market returns over the same period – your employer’s contribution has either gone nowhere or disappeared. Your retirement hangs on the difference.

This is serious stuff. In the rapidly fading world of broad employee benefits, a 401(k) plan to which the employer contributed company stock made some sense. As a worker, you had the combination of Social Security, a corporate pension, your own savings in a 401(k) plan, and your employer’s stock contribution to the 401(k) plan. The company stock may have been a lottery ticket, but it was a “free” lottery ticket. You had a lot of other things to rely on. You could take the risk.

Now, as The Great Reneging builds momentum, younger workers face frozen pensions or no pension at all. Corporate managements are shrinking the entire structure of employee benefits. Young workers also face uncertain Social Security benefits. Worse, they face the possibility that their employment taxes will increase even as their future Social Security benefits decrease. Result? A lot of retirement security – too much – is riding on your corporate lottery ticket.

Link here.


Billed as the great equalizer between the rich and the poor, globalization has been anything but. An increasingly integrated global economy is facing the strains of widening income disparities – within countries and across countries. This has given rise to a new and rapidly expanding underclass that is redefining the political landscape. The growing risks of protectionism are an outgrowth of this ominous trend.

It was not supposed to be this way. Globalization has long been portrayed as the rising tide that lifts all boats. The surprise is in the tide – a rapid surge of IT-enabled connectivity that has pushed the global labor arbitrage quickly up the value chain. Only the elite at the upper end of the occupational hierarchy have been spared the pressures of an increasingly brutal wage compression. The rich are, indeed, getting richer but the rest of the workforce is not. This spells mounting disparities in the income distribution – for developed and developing countries, alike. The U.S. and China exemplify the full range of pressures bearing down on the income distribution. With per capita income of $38,000 and $1,700, respectively, the U.S. and China are at opposite ends of the global income spectrum. Yet both countries have extreme disparities in the internal mix of their respective income distributions.

While the U.S. and China suffer from similar degrees of income inequality, they have arrived at this point through very different means. America’s Gini coefficient – one measure of income inequality – has been on the rise for over 35 years. What is new is how America’s income distribution has become more unequal in a period of rapidly rising productivity growth – a development that has been accompanied by an extraordinary bout of real wage stagnation over the past four years. Economics teaches us that in truly competitive labor markets, workers are paid in accordance with their marginal productivity contribution. Yet that has not been the case for quite some time in the U.S. I do not think it is a coincidence that the relationship between productivity growth and worker compensation has broken down as the forces of globalization have intensified.

Courtesy of the hyper-speed of sharply accelerating Internet penetration, the global labor arbitrage has pushed into areas that historically have been unaccustomed to wage competition. In earlier research I found that the disconnect between compensation and productivity growth during the current economic expansion has been much greater in services than in manufacturing. This once nontradable segment of the U.S. economy is now feeling the increasingly powerful forces of the global labor arbitrage for the first time ever. The Internet has forever changed the competitive climate for most white-collar knowledge workers. Courtesy of near-ubiquitous connectivity, the output of the knowledge worker can now be e-mailed to a desktop from anywhere in the world. That brings low-cost, well-trained, highly-educated workers in Bangalore, Shanghai, and Eastern and Central Europe into the global knowledge-worker pool. That is now true of software programmers, engineers, designers, as well as a broad array of professionals toiling in legal, accounting, medical, actuarial, consulting, and financial-analyst positions. As a result, real wage compression in open economies like the U.S. has moved rapidly up the value chain – sparing an increasingly small portion of those at the very top of the occupational hierarchy. Washington’s penchant for cutting taxes of the wealthy probably has not helped matters either.

In China, it is a different story altogether. China remains very much a tale of two economies – a booming development model at work in the increasingly urbanized coastal part of the nation in stark juxtaposition with relatively stagnant economic conditions persisting in the rural central and western portions of the country. While fully 560 million urban Chinese are now participating in the economy’s rapid development dynamic, that still leaves a rural population of some 745 million on the outside looking in. Interestingly enough, the accelerating trend of rural-to-urban migration has done little to arrest the inequalities of the Chinese income distribution over the past 15 years, reflecting the impacts of an ever-widening income disparity between coastal China and the rest of the nation, and also a function of the increased divergence in the distribution of urban incomes.

Significantly, Chinese income disparities in the Internet age may well have a very different connotation than in the past. With increased IT connectivity in western and central China – mainly in the form of the village kiosk – the rural poor now have real-time access to the “outside world”. This gives them a very vivid picture of the prosperity they are missing. In that vein, the Internet has the potential to spark resentment and social instability in China’s two-track development model – the very last thing the government wants. The Chinese leadership is very focused on the income distribution issue, and is expected to make this a major topic of debate and policy action at the upcoming National People’s Congress.

As different as the problems are in the U.S. and China, there is no economic issue in either country that hits the political hot button like income disparities. And with both countries suffering from relatively high degrees of inequality, neither can be expected to backtrack insofar as the political response is concerned. Given the mounting bilateral trade tensions between the two nations, this poses a worrisome problem. America’s increasingly populist politicians have responded to the income distribution problem by turning protectionist – portraying China as the culprit for the pressures bearing down on middle-income U.S. workers. China, on the other hand, continues to cling to an export- and investment-led growth dynamic that not only fuels political resentment in the U.S. but also seems to have a natural bias toward widening disparities in its income distribution. Yet this same approach drives the vigorous employment growth that is absolutely vital in order to provide China with the scope to keep dismantling its inefficient state-owned economy.

Inequalities of the income distribution have long been the Achilles’ heel of economic growth and development. In an era of IT-enabled globalization, that seems more the case than ever. History tells us that the pressures of widening income disparities are often vented in the political arena. The steady drumbeat of protectionism is a very worrisome manifestation of that lesson. To the extent the risks of protectionist actions come into play, the U.S. dollar and real interest rates would probably bear the brunt of the financial market response.

Link here.


The two major players in the global economy, the US and China, are operating at opposite ends of the saving spectrum. Thrifty Chinese have taken saving to excess, while profligate Americans have spent their way into debt. Neither of these trends is sustainable – they lead to destabilizing economic and political developments for both nations – and a better balance must be struck. China needs to convert excess saving into consumption, while the U.S. needs to end its buying binge and rediscover the art of saving. The numbers leave little doubt as to the extraordinary contrast between the two economies. Last year China saved about half of its GDP, or some $1.1 trillion. At the same time, the U.S. saved only 13% of its national income, or $1.6 trillion. That is right, the U.S., whose economy is six times the size of China’s, cannot manage to save twice as much money.

And that is just looking at national averages that include saving by consumers, businesses, and governments. The contrast is even starker at the household level – a personal saving rate in China of about 30% of household income, compared with a U.S. rate that dipped into negative territory last year (-0.4% of after-tax household income). These are extreme readings by any standard. Similar extremes show up in the consumption shares of the two economies – the mirror image of trends in personal saving rates. U.S. consumption has held at a record 71% of GDP since early 2002, while Chinese consumption appears to have slipped to a record low of about 50% of GDP in 2005.

In China’s case, relatively weak consumption means its growth dynamic is skewed heavily toward exports and fixed investment. These two sectors account for more than 75% of Chinese GDP and are growing by more than 25% a year. If China stays with this growth mix, any further increase on the export side would be a recipe for trade friction and protectionist responses. That is certainly the direction Washington is heading in these days. Moreover, a continued burst of Chinese investment could lead to excess capacity and deflation at home. The U.S. saving shortfall is equally stressful. American consumers have mistaken bubble-like appreciation of their homes for saving. Facing anemic growth in labor incomes they have turned to debt-financed equity extraction from their homes in order to keep consuming.

There is a more insidious connection between the saving postures of China and the U.S.: Chinese savers are, in effect, subsidizing the spending binge of American consumers. In order to fuel its export-led economic growth, China has decided to keep its currency relatively cheap and tightly pegged to the dollar. To do so, it must constantly recycle a large portion of its saving into dollar-denominated financial assets – an investment strategy that helps keep U.S. interest rates low and an interest-rate-sensitive American housing market in a perpetual state of froth. That is dangerous for the U.S., but it is also an increasingly risky proposition for China because it bloats that country’s money supply. This excess liquidity then spills over into the Chinese financial system, leading to asset bubbles such as those in its coastal property markets.

It is in neither country’s best interest to stay the present course. Instead, there must be a role reversal: China’s savers must be turned into consumers, and the excesses of U.S. consumption must be converted into saving. This will not be an easy task for either nation, but it sure beats the increasingly treacherous alternatives. In the U.S., it will take nothing short of a major campaign to boost national saving. That will require a reduction of public-sector dissaving (i.e., outsized federal budget deficits) and the enactment of some form of consumption tax. Sadly, there is little reason to be optimistic that Washington is about to embrace a pro-saving policy agenda. In China, it will also take major policy initiatives to spark consumption-led growth. The good news is that the Chinese leadership is focused on shifting its growth mix toward private consumption.

China’s determination stands in sharp contrast to Washington’s inattentiveness to saving initiatives. That could spell trouble. As Chinese saving is converted into consumption, it will have less surplus capital that can be used to fund America’s saving shortfall. That means China will be reducing its support for the American consumer. And that would raise the odds of a hard landing for the dollar and the U.S. economy, with dire consequences for a still U.S.-centric global economy. The U.S. and China need to get their saving agendas in order before it is too late for them – and for the rest of the world.

Link here.


In his annual letter to Berkshire Hathaway shareholders contained in its 2005 annual report (PDF file), released this past weekend, billionaire investor Warren Buffett said he made few changes to the company’s stock holdings but cautioned investors that the portfolio’s returns may be modest over the next several years. Buffett said while the company stands by its major holdings – all “strong, highly-profitable businesses” – current valuations are not cheap. He said the group may double in value over the next 10 years with average annual per-share earnings gains of between 6% and 8%. Stock values, he said, will likely match that growth.

As for the overall stock market, Buffett braces investors for more modest returns to come, citing increased “frictional” costs – related to trading, advice and money management – that eat away at performance. “These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have,” writes Buffett (see essay beginning on page 18 of the annual report, which we have put in easy-to-read format here).

Berkshire Hathaway added Wal-Mart and Anheuser-Busch to its portfolio and increased its holdings in Wells Fargo, a company that Wells Fargo chief executive Dick Kovacevich “runs brilliantly,” Buffett said. Also new to the company’s list of top holdings are Ameriprise Financial, a spin-off of American Express, and Procter & Gamble, which merged with former-holding Gillette last year.

Looking ahead at Berkshire’s insurance business, Buffett was cautious about the outlook for increasingly severe hurricanes in the coming years after the company lost $3.4 billion in 2005 as a result of Hurricanes Katrina, Rita and Wilma. To insulate the company from further losses, Buffett said Berkshire Hathaway will “now write mega-(catastrophe) policies only at prices far higher than prevailed last year and then only with an aggregate exposure that would not cause distress” if unusually strong hurricanes continue to hammer the region. That move has been echoed in the wider insurance industry by large players such as Allstate.

Another tricky area for the company is its exposure to General Re’s derivatives business. In the last year, the company’s pullout from the business cost Berkshire Hathaway $104 million pre-tax, bringing the company’s aggregate losses from exiting the derivatives operations to $404 million. “The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operations,” he wrote to investors. “I failed in my attempt to exit painlessly and in the meantime more trades were put on the books. Fault me for dithering.” He said derivatives in some circumstances could cause markets to become “chaotic” and Berkshire’s experience with the business should be used as an instructional tool for managers, auditors and regulators.

Buffett also sounded off on the increasing abuses surrounding executive compensation, but defended Gillette’s former chief executive Jim Kilts’s hefty compensation package – worth over $150 million – after the company sold itself to Procter & Gamble in a deal valued at $57 billion. Buffett was less kind about the overall state of executive compensation in the U.S., saying it was “ridiculously out of line with performance,” a fact that is unlikely to change in the current environment. He said corporations should pay their CEOs relative to performance but added that CEOs today can receive a bigger payout for being fired than “an American worker earns in a lifetime of cleaning toilets.”

Forthrightly as usual, Buffett addressed the issue of his advancing age: “As owners, you are naturally concerned about whether I will insist on continuing as CEO after I begin to fade and, if so, how the board will handle that problem. You also want to know what happens if I should die tonight.” He responded that the subsidiary operations would not miss a beat upon his death, and that they have three managers at Berkshire who are reasonably young and fully capable of being CEO. “Any of the three would be much better at certain management aspects of my job than I. On the minus side, none has my crossover experience that allows me to be comfortable making decisions in either the business arena or in investments. … Berkshire’s board has fully discussed each of the three CEO candidates and has unanimously agreed on the person who should succeed me if a replacement were needed today. … The important point is that the directors know now – and will always know in the future – exactly what they will do when the need arises.”

And further: “The other question that must be addressed is whether the Board will be prepared to make a change if that need should arise not from my death but rather from my decay, particularly if this decay is accompanied by my delusionally thinking that I am reaching new peaks of managerial brilliance. … When [managers’] abilities ebb, so usually do their powers of self-assessment. Someone else often needs to blow the whistle. When that time comes for me, our board will have to step up to the job. From a financial standpoint, its members are unusually motivated to do so. I know of no other board in the country in which the financial interests of directors are so completely aligned with those of shareholders. Few boards even come close. On a personal level, however, it is extraordinarily difficult for most people to tell someone, particularly a friend, that he or she is no longer capable. If I become a candidate for that message, however, our board will be doing me a favor by delivering it. … And while we are on the subject, I feel terrific.”

Link here.
Buffett: “How to Minimize Investment Returns” – link.
2005 Berkshire Hathaway annual report here (PDF file).


If you buy an ounce of gold today, you might regret it tomorrow. But if you do not buy an ounce of gold today, you might regret it two years from now, if not sooner. According to a freshly minted research report by Chevereux analyst, Paul Mylchreest, the gold price is in the process of moving higher. Much higher. The confluence of several potent trends, says Mylchreest, will lift the gold price to at least $1,000 an ounce by 2008. If the Chevereux analyst is on target, today’s gold investors need not be overly concerned whether they pay $550 or $600 for an ounce off gold.

All major sources of supply are declining, says Mylchreest, at the very same moment that many major sources of demand are rising, and will continue to rise. To make things even more interesting, the global gold market already faces an annual supply shortage of about 600 tonnes. Even though the gold price has doubled over the last few years, Mylchreest believes it will double yet again over the next few years, if not quadruple to a “super spike” price of $2000 an ounce. We are persuaded by his bullish arguments.

First, let us take a peek at the waning sources of supply. World mine production has failed to increase since the end of the 1990s, and actually fell by 5% in 2004, according to the World Gold Counsel. “[Once] exploration has been sharply cut,” Newmont Mining’s CEO, Pierre Lassonde, explains, “it takes at least seven to eight years for a rise in price to generate not just exploration, but the subsequent exploitation of the results …” In other words, the global gold mining industry will not be ramping up supplies any time soon. Meanwhile, Western central banks appear to be curtailing both “official” and “unofficial” sales of gold. In the name of “reserve diversification”, these banks have been unloading tonnes of gold from their vaults every year. Now it appears that Western central banks are reducing their direct official sales, while also restraining their gold-lending activities. The global gold mining industry is also reducing its gold-selling activities. Chevreux estimates that global gold producers have trimmed their forward sales by about 42% – a drop from 2,271 tonnes to 1,323 tonnes.

All the while that the above-cited sources of supply are drying up, demand is soaring. The central banks of China and Russsia, for example, have been boosting their gold holdings, while promising to buy even more. Several Eastern central banks hold grotesquely large positions in U.S. Treasury securities, alongside curiously petite holdings of gold. Perhaps that is part of the reason that individual investors are also piling into the gold market. Individual investors are snapping up everything from numismatic coins to gold stock mutual funds. But still, gold and gold stocks represent a surprisingly small portion of most investment portfolios. The market capitalization of the world’s 10 largest gold stocks totals less than $100 billion, which is less than one third of the market cap of General Electric. The market for physical gold is also relatively small. “The value of all the gold on the planet is $2.7 trillion, based on a $550 price per ounce,” Chevreux calculates. By comparison, the total value of the U.S. stock and bond markets exceeds $35 trillion.

“At some point, both central banks and private institutions will have their fill of dollars,” former Fed chairman, Paul Volcker, remarked one year ago. “I don’t know whether change will come with a bank or with a whimper, whether sooner or later. … It is more likely that it will be financial crisis rather than policy foresight that will force the change.” At some point, in other words, gold will flirt with a four-digit price tag. That point may be fast-approaching.

Link here.


As a profession that has spent decades establishing itself in the midst of one of the greatest bull markets in history, it is understandably difficult for financial planners to conceive of the possibility that the markets of the future might be fundamentally different from those of the past. Although we all have repeated the ubiquitous phrase, “past performance is not an indicator of future results,” we produce financial plans that are predicated on historical average market returns, and then try to design portfolios that will be most likely to match those long-term averages.

However, since March of 2000, it is probable that most financial planners have delivered a level of investment performance that is far below the assumptions made in their clients’ financial plans at that time, even if the planner had used “reasonable” historical averages rather than the remarkable returns of the 1990s. Many in the industry would answer that although portfolios have underperformed in the short term, clients realize that their balanced portfolios have significantly outperformed the absolute losses of the stock markets, especially the Nasdaq. Many advisors believe that while clients may be trailing their original assumptions, most clients are grateful that their capital has been reasonably preserved over this period with their diversified strategic portfolios. While this may be true, the numbers are appalling. Unless the planner had the ability to achieve superior returns through either excellent security or manager selection, or other active management strategies, the portfolio performance of clients is probably considerably lagging the planner’s initial real-return projections.

This article proposes that strategic asset allocation is not the most desirable strategy for portfolio management during secular bear markets. During these periods of long-term market returns that underperform historical averages, the traditional passive strategic “rules” for managing client portfolios must be reconsidered. The authors will present evidence that suggests long-term market cycles do, in fact, exist. The article will then present four alternative active management strategies that are currently considered to be “high risk” strategies by the planning community (often because they “risk” substantially underperforming their relative benchmark), but may actually deliver significantly better returns for clients in difficult markets. Finally, the authors will discuss the phobic response to active management strategies in the advisor community and consider the financial planning and business implications of a secular bear market.

Link here.


As retirement nears, millions of Baby Boomers are scrambling for deck chairs on the Titanic. For about 30 years now I have been watching a major financial disaster developing. Its contributing factors include the shaky financial foundations of Social Security and Medicare, compounded by most Americans’ lack of financial education and entitlement mentality. As a result, my investment strategy is to get out of anything that is “paper with ink on it.” I explain what this means and what investments I favor later in this article.

But first, let me discuss the iceberg known as Financial Excess, which I believe lies before the SS U.S.A. In the last three decades, we as a nation have only increased our excesses, accelerated our mistakes, and mismanaged America’s wealth. Turning the ship’s wheel at this time – hard left or hard right – will do no good. It is too late. So it is not a good time to be captain of SS U.S.A., or the skipper of SS Big Mutual Fund or SS Pension Plan. In the coming years, I believe big will not be better.

Instead, for many of us, it is better to be a small, disciplined investor. I believe speed, financial education, and maneuverability will prove to be better than size. It will be far better to be in a well-stocked lifeboat than be treading water with millions of pensioners and laid-off workers, many with their party hats still on. Why so pessimistic? Well, I would rather be known as a realist. People know there is a problem, yet they continue to do the same things. Today millions of people have trillions of dollars riding in the stock market, their homes, savings plans, and bonds – financial assets that worked in the past but probably will not work when the SS U.S.A. hits the iceberg.

As an investor, I am investing against the U.S. dollar. Let me be clear: I am not investing against the U.S. – America is a rich, productive country. But our dollar is toast. In my opinion, that means getting out of anything else that is “paper with ink on it” – anything backed by the full faith and confidence of the SS U.S.A. That means I am very suspicious of stocks, bonds, savings, and mutual funds, especially if they are U.S. dependent. Although I love real estate, I am suspicious of any piece of property that does not generate cash flow today. I do not invest in future appreciation of real estate – not today, at least. Today, I invest in assets with tangible value, especially assets that go up in price as the dollar’s purchasing power sinks. Today, I have large positions in gold, silver, and oil.

For the small investor, I believe buying silver coins is a safe bet. As the dollar drops, silver will hold its value or go up. I do not recommend buying coins for numismatic value (rarity).

Link here.


When I was one of the lone voices talking up commodities and China heading into the new millennium, I ran into much skepticism among the press. The writers, reporters, and anchors around the world, the so-called business media who ought to have known better, were more likely to raise an eyebrow or even turn hostile when I wanted to talk about oil, lead, and sugar more than about the “next big thing” in stocks. Occasionally, I like to tease these media types. During one breakfast interview in a Paris hotel, a congenial writer from a French business magazine who was much more eager to discuss the falling dollar and the surging euro – for obvious reasons (Vive la France!) – asked me what I would recommend for an ordinary investor like her. I plucked a wrapped sugar cube from the bowl on the table and handed it to her. She looked at me as if I had gone mad. “Put this in your pocket and take it home,” I advised, “because the price of sugar is going to go up five times in the next decade.”

She laughed, eyeing her sugar with skepticism. I told her that the price of sugar that day was 5.5 cents per pound, so cheap that no one in the world was even paying attention to the sugar business. I reminded her that when sugar prices last made their all-time record run-soaring more than 45 times, from 1.4 cents in 1966 to 66.5 cents in 1974 – her countrymen were planting sugar all over France. She nodded – “Supply and demand,” she said – and pocketed her sugar. But I suspect that she has not put any of her money where her mouth – or her pocket – is. No one had for years, which, of course, was my point. Sugar prices were so low for so long that it was the last business enterprising souls around the world would be likely to enter in the 1990s and early 2000s. If you are an ambitious young farmer in Brazil (or Germany or Australia or Thailand, also major sugar producing nations), do you choose to produce sugar at 5.5 cents a pound or soybeans, which closed 2003 near $8 a bushel, a 6-year high? Even in the U.S., which has its own protected domestic sugar market at two to three times the world price, only the most efficient producers are surviving.

Sugar has had its boom times in the past – that 1974 record, and another spike in 1981 during the last bull market in commodities. And if I am right and we are in another long-term bull market in commodities, we are likely to see another sugar high. Historically, nearly everything goes up in every kind of bull market, whether it is company shares, commodities, or apartments on Park Avenue. And with world sugar prices at 85% or so below their all-time high, the chances of moving higher are strong. To those of us who have been here before, it is promising to note that similar supply and demand imbalances are shaping up that could push sugar prices upward over the next decade.

The 1973-74 sugar season began with extremely tight supply conditions worldwide. Demand continued to rise. There was evidence that some big industry users were stockpiling sugar in anticipation of higher prices. Soon people were grabbing sugar off the shelves in armloads to offset rising prices. Others were grabbing cubes off restaurant tables for home use. Dinner guests were arriving with 5-pound bags of sugar instead of the traditional bottle of wine or bouquet of flowers. Even people who had never given the sugar futures markets a moment’s thought knew something was up when they walked into the local coffee shop and noticed that the sugar had vanished from the table. Quite simply, global demand for sugar had exceeded supply, and before long the price of sugar headed for the roof. Significant, too, was the fact that Americans had come to see cheap sugar as a birthright.

U.S. consumption did not slow down much until September 1974, when the reality of high prices finally kicked in. By December 1976 and January 1977, world sugar prices were ranging between 7 and 9 cents a pound – figures that were, according to the CRB Commodity Yearbook report at the time, “below their reported cost of production in some countries.” And many, many Johnny-come-lately sugar speculators lost their money – proving, once again, the perils of rushing into a market where prices are rising 45 times, whether it is sugar or dot-coms. The forces of supply and demand put hysteria in its place, once again.

For the next 20 years – during a bear market in commodities – sugar remained plentiful, with bearish prices zigging and zagging at the low end with a few minor spikes, as typically happens in bear as well as bull markets. Gradually, sugar had gone from a respectable commodity that fed the world and supported entire economies to a victim of changing fashions in diet and health: sugar was bad for you, it made you fat, it made kids hyper, and it rotted their teeth. Meanwhile, in labs all over the world chemists were looking for substitutes, preferably noncarcinogens. In 1981, the U.S. Food and Drug Administration approved the artificial sweetener aspartame, and in a flash this newcomer replaced sugar in cookies, cakes, and other favorite snacks sold around the world. In 1983 the major soft-drink companies started using literally millions of tons of high-fructose corn syrup to sweeten their beverages. Bad for sugar (but good for corn).

By 1985, the price of sugar had made it all the way down to 2.5 cents. No one wanted to be in the sugar business. They were giving away seats on the sugar exchange at the New York Board of Trade. Sugar prices stayed in a bear market for the next 19 years, and were still bearish that day in early 2004 when I was teaching the French business writer about her future as a sugar baroness. World production of raw sugar had reached a record level in the 2002-03 season, and the next season produced almost as much. Brazilian exports were also at a record high. That French writer had reason to be skeptical. Most prognosticators were bearish. So why was I confidently telling someone to buy sugar? Supply and demand. Of course, I was already a firm believer in the fact that a bull market in commodities was under way, and if, as I have noted, the history of past bull markets tells us that nearly everything makes a new all-time high, why not sugar?

Link here (scroll down to piece by Jim Rogers).


One of the most frequent questions from U.S.-based investors we get here at Casey Research is, “How do I buy Canadian stocks?” Approximately 80% of the world’s expenditures on mineral exploration are made by Canadian companies. It only follows that the Toronto Stock Exchange (TSX) and the TSX Venture Exchange (TSX-V) are home to most of the companies we follow here at Casey Research. Less frequently, we also follow stocks listed in London (AIM) or Australia (ASX), both markets being home to numerous mineral exploration companies. So our answer is always that a U.S.-based investor who is serious about making serious money should hire a full service broker with substantial experience trading directly on Canadian and other foreign exchanges.

However, there is a growing trend for Canadian companies to “migrate” to U.S. and other non-Canadian exchanges. That is, they retain their Canadian listings, but obtain a second listing in the U.S. (or even a third listing elsewhere, such as in Germany). Why? For starters, a U.S. listing exposes the company to the many U.S. institutions that otherwise would not be allowed to invest, no matter how attractive the stock might be. The desirability of a U.S. listing is a no-brainer based on simple demographics: the U.S. has 10 times the population of Canada and perhaps 1/10 as many publicly traded mining companies. Access to that many more investors in a market with so few competitors has obvious advantages … but it has costs as well.

Challenges and costs aside, the results achieved by companies that have migrated to the U.S. market are hard to argue with. Companies that have made solid technical progress but are not tapping into the U.S. market have not generated nearly the same trading volumes nor had similar price appreciation as companies accomplishing similar things who have listed in the U.S. The logic is clear: expose a good company with good news to 10 times more investors … and magic can happen. To us, the case for entering the U.S. market is quite compelling – but that is not the only market a Canadian company might migrate to. With gold rising against most currencies, including the euro, interest in gold stocks is increasing around the world.

Once the millions of U.S. investors with online trading accounts get serious about building gold stock portfolios – just as they once did with dot-com stocks – it will be like trying to squeeze the contents of the Hoover dam through a garden hose. The implications are clear. Get positioned in quality Canadian juniors now, then urge management to list in the U.S. If a Canadian company tells you it is seeking a U.S. listing – or even announces that it has been approved for one and soon will start trading in the U.S. – that alone might be a reason to buy. Also, be sure that quality companies already listed in the U.S. make up a sizable portion of your speculation portfolio, perhaps between 30% and 50%. While they may already be running ahead in terms of valuation, they will receive the most buying pressure when the big rush into junior resource stocks begins.

Link here.


Last month, my fellow columnist John Dorfman published a tongue-halfway-in-cheek dictionary of stock market terms. In a similar vein, here is a suggested lexicon for the bond market.

Alpha: The amount of excess return promised by a hedge fund manager to justify his pocketing 2% of your capital and 20% of any profit. It seems there are only two ways to generate alpha. The first is to sell General Motors Corp. bonds and simultaneously buy those of its finance unit, GMAC. The second is to go long GMAC debt while being short GM securities. Anyone who cannot see the difference between these two trades clearly is not as bright as the hedge fund guys. They are displaying their individuality by making identical bets on GMAC regaining its investment-grade rating while GM slides further toward filing for bankruptcy protection.

Credit-default swap: (a) A way to insure your bond investments against non-payment by the borrower. (b) A security that lets traders bet against a company’s creditworthiness, in sizes several times bigger than the company’s outstanding debt, without filling in any pesky paperwork to settle the trades. (c) A derivative that allows fund managers to dodge the restrictions placed on their investment strategies by their trusty trustees.

Default: In the dim and distant past, issuers other than automakers would occasionally be unable to make their interest payments. Airlines, or telecommunications companies, for example. Even governments. Post-traumatic amnesia has allowed many investors to erase these painful memories, and default now applies solely to the auto industry, and is of no concern anywhere else. Russian bonds, Argentina’s bills? Ship ‘em in.

Derivatives: (a) Innovative financial instruments that allow different types of risk to be sliced, diced and transferred efficiently around the global capital markets, according to market regulators. (b) “Weapons of financial mass destruction” that, when you try to unravel them, become the equivalent of trying to carry “a cat home by its tail,” according to Warren Buffett.

Hedge fund manager: The guy wearing an open-necked shirt under an Italian suit who drives that Bentley sports car you have been lusting after. His unique investment strategy, developed using his years of experience in the capital markets and honed by proprietary mathematical models running on expensive supercomputers, uses a short/long position to … (see Alpha entry).

Leverage: In previous dictionaries, this was a Bad Thing, since it applied to a company that had lots of debt, thus undermining the value of the debt owned by you. Under current definitions, it is a Good Thing, since it keeps those private equity buyers and their debt-financed takeovers at bay.

Pension fund manager: Anyone who thinks it makes sense to lend to the U.K. for 50 years at 3.75%, to the U.S. for 30 years at 4.7%, or to Poland for 50 years at 4.5%; the buyer of last resort for overpriced bonds.

Link here.


A lot of people would like to dismiss Mahmoud Ahmadinejad as a lunatic, as if that saves us the trouble of having to figure out what to do with the current president of Iran and his seemingly unstoppable nuclear program. Ahmadinejad has certainly said the type of things that circumspect world leaders try to avoid – namely that Israel should be wiped off the map or moved to Alaska and that the Holocaust may not have happened and that Iran could choose to use oil as a weapon if the West tries to impose sanctions. Is he crazy? Or is it just crazy talk? I do not know. He has claimed that for 28 minutes during a speech delivered at the U.N. in September, he was surrounded by a halo of light and that no one in the audience blinked while he spoke. Later in November, speaking to a group of clerics in Tehran, Ahmadinejad claimed that the main purpose of his government is to pave a path for the return of Islam’s 12th Imam, Mahdi. Shia Muslims, from what I can gather, claim that the 12th Imam disappeared in 941 and upon his return will rule the Earth for 7 years before a final last judgment of humanity.

What do we have here, then? The leader of a nation determined to pursue its nuclear program and who believes he is helping to usher in the end times is scary stuff, or so it would appear. It is scary enough that it provoked French President Jacques Chirac to make one of the most remarkable statements in the last 50 years of public diplomacy. What the comments meant is quite clear: France would consider a nuclear attack against a state sponsor of terror – like Iran – that aided or abetted an attack on French soil. Remember those riots outside Paris last year? Do you think all of that discontent just went away? It would not surprise me if an outside party, like Iran, calmly and quietly moved into France in an attempt to organize the French rioters into a genuine and very dangerous French intifada. Knowledge of an attempt to do so seems like the sort of thing that would prompt a man like Jacques Chirac, whose country has billions invested in Iran, to publicly threaten a nuclear strike. More crazy talk?

If you feel like things are rumbling out of control and that something big and important is happening, well, then, you are not alone. But what does all of it mean for gold, for the dollar, for oil, for America? In fact, is there more at stake than just the price of oil? Are the social and economic structures that have defined the world since the end of World War II about to collapse? What will replace them?

When I got back from my excursion to the Far East in late 2004 and sat down to write up the story, I emphasized three major trends that would create danger and opportunity for investors. (1) The bull market in energy (oil, gas, electric, nuclear) was going to be one of the longest and strongest you and I would see in our investment lifetimes. (2) The general rise of Asia into the developed world was causing huge demographic and economic dislocations – and creating enormous investment opportunities as Asian economies began to consume as well as produce, to spend as well as save. (3) The rise of the East was accompanied by the simultaneous collapse of the ruling currency regime of the last 30 years, the dollar standard.

This last point is still so inconceivable to many people that they refuse to entertain the possibility. Too much would have to change. Too much wealth would be destroyed. Too many vacations would have to be canceled. Yet the inexorable rise of gold shows that this revolution in money is slowly but surely eroding the dollar’s status. The current situation with Iran does not change any of those three main trends. But it could accelerate them.

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

Crazy Talk, Part II

If Paul Kennedy is correct, America is in trouble. Paul Kennedy authored a book entitled, The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500-2000. Kennedy’s analysis of “great powers” provides a disturbing context for America’s own rise to power, and her eventual fall. “The triumph of any one Great Power … or the collapse of another, has usually been the consequence of lengthy fighting by its armed forces; but it has also been the consequence of the more or less efficient utilization of the state’s productive economic resources in wartime, and, further in the background, of the way in which that state’s economy has been rising or falling relative to the other leading nations, in the decades preceding the actual conflict. For that reason, how a Great Power’s position steadily alters in peacetime is as important to this study as how it fights in wartime.”

If you date the war on terror to its beginnings, you could conceivably go back to the Iranian hostage crisis of 1979-80. But let us use Sept. 11 as our start date. Since that time, how efficiently has the United States been using its productive economic resources? Not very, would be the short answer. Debt has driven a boom in American consumption right alongside a costly, open-ended police-action in Iraq.

Throughout the 20th century, America benefited disproportionately from innumerable technological breakthroughs, not the least of these being nuclear weaponry. Not surprisingly, the U.S. economy flourished throughout most of the century. “It sounds crudely mercantilistic to express it this way, but wealth is usually needed to underpin military power, and military power is usually needed to acquire and protect wealth. … If, however, too large a portion of the state’s resources is diverted from wealth creation and allocated instead to military purposes, then that is likely to lead to a weakening of national power over the longer term,” says Kennedy. You might add that if states’ resources and capital and their creative energies are diverted and devoted to buying and selling houses and filling them with trinkets bought on eBay, national power is weakened. The consumption lifestyle to which America has grown addicted does not produce capital. It does not produce wealth. It does not produce power.

About the only thing preventing a complete migration of wealth and power from the West to the East is the dollar standard. This convenient currency regime allows America to fund its consumption – and its wars – with a depreciating currency. It is a tremendous advantage Kennedy does not ignore. The modern warfare state is simply not possible without “an advanced system of banking and credit,” and that, for now, is exactly what is keeping America afloat. The world still wants our bonds. But how long will this advantage last? I suspect a lot will have to do with the price of oil. As oil rises in dollar terms the run on the dollar will grow. Hard assets like gold will not just be fashionable. They will be indispensable to wealth preservation.

The truth is, we have no idea how sturdy the current social, economic, and geopolitical order is. We only know that it is changing at lightning speed and that America seems to be on the wrong side of many important and powerful changes. Unfortunately, currencies do not have the option of retiring gracefully, like Alan Greenspan. They self-immolate, with a little help from central bankers willing to stoke the fire with ever more amounts of paper.

It does not sound very good, does it? Crazy talk? Maybe. But I doubt it. There is not much you or I can do about great matters. But we can manage our money. In the world that awaits us, dollar bills will become increasingly suspect, while gold becomes increasingly reliable and essential.

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


Alan Greenspan had only been on the job a few days when he was put to his first test. The crash of 1987 came as a shock to world stock markets. It came as a shock to Alan Greenspan, too. The man had run an economic forecasting business – notoriously badly. If economic forecasting were driving an automobile, you would not have wanted to climb into the car with the maestro. He drove blind – into financial potholes, stock crashes, bubbles, busts and head-on into recessions. Now, Ben Bernanke comes into the same job. He sits in the driver’s seat in the same office, in the same country as his predecessor. But, he has stepped into a different world.

When Alan Greenspan came into the Fed, the Dow was under 2,000 and a conventional 30-year mortgage was over 11%. When we looked yesterday, the Dow was nearly 11,000 and mortgage rates had just hit a three-year high of 6.24%, after dipping down to a low near 6%. Where exactly the trend toward lower rates ended, we do not know – probably in 2003 or 2004. Some people think it has not ended yet, but even if rates fall further, it is unlikely they will do so for the same pleasant reasons, or with the same beneficent results that greeted Alan Greenspan.

The wind has changed. The investors who were worried and skittish in 1987 are complacent and confident 20 years later. Those who panicked when the Dow hit 2,500 are now serene with it at 11,000. The credit derivatives market that barely existed in 1987 is now worth $12 trillion. And homeowners who wondered how they were going to pay off their $50,000 mortgages in the ‘80s now borrow $200,000 with no intention of ever paying it off.

Bernanke’s test is coming. He, too, will have his opportunity to blunder. Will the stock market crash? We do not know, but if it does, it has a lot more room to fall than it did in 1987. Will the derivatives market melt down? Who can say? But if it does, there will be hell to pay. Is the dollar likely to buckle … or the bond market fall to its knees? Don’t ask us. We only notice that whatever risks and dangers Alan Greenspan faced in 1987 have been multiplied many times for Ben Bernanke. On his first day on the job, he had about $15 trillion more in debt to worry about, savings rates that had not been seen since 1933, mortgage rates from the Kennedy era and 200 fewer basis points to cut.

He does not seem to notice. Above, the clouds are thickening and hurricane winds are whipping up all around. The Bank of Japan is raising rates. House prices are stabilizing or falling. Ben Bernanke might want to get out an umbrella.

Link here (scroll down to piece by Bill Bonner).


A mutual fund’s past performance, which is the first feature that investors consider when choosing a fund, doesn’t predict future performance. Funds buy expensive ads in newspapers and magazines to tout their performances over the past one, three, five, and ten years. The mutual fund industry irresponsibly promotes this ‘culture of performance,’ even though it knows perfectly well that it misleads investors. When it comes to mutual funds, the past is not prologue.” ~~ Former SEC Chairman, Arthur Levitt

In the fall of 2004 I had just completed a talk for a group of accountants and attorneys who work with several foundations. I told them, prior to my presentation, that the material would not be comforting, but that since there were substantial implications to those who depended on their leadership, we needed to address these dilemmas. When I finished, one gentleman said something interesting to me. He said, “The institutional consultant we work with today reviews hundreds of managers and tons of information. They look at market information through historical averages, and operate from the premise that we can’t know what will happen in the future. It always feels like they’re trying to drive down the highway, looking in the rearview mirror. But your presentation was different. It’s like you are saying,‘look dead ahead.’”

Perhaps he had heard the same bromide that Robert Prechter refers to: “‘Economic Forecasting’ goes the old joke, ‘is like trying to drive a car blind-folded and following directions given by a person who is looking out the back window.’ With socionomics, we are no longer looking out the back window; we are facing forward. With the Wave Principle, we are no longer driving blind. We can see enough about the road ahead to negotiate the car.” While some may dismiss the study of socionomics and wave principles, we can hardly deny that our investments decisions are affected by our emotions.

Undoubtedly, we are all familiar with the right-brain, left-brain concept of an emotional and a logical side of our minds. From the highest paid CEOs and the most powerful politicians to the lowest paid fast food workers and the smallest children, we observe both emotional and logical actions and reactions. Indeed, we see the same thing in our own every-day behaviors. Yet, when it comes to investing, the vast majority of investors fail to recognize the power and influence our emotions exert on our decisions.

The hindrances to logical, or unemotional, investing would be difficult to overstate. In short, the basal ganglia and limbic system are the parts of the brain that guide the behaviors that are required for self-preservation, and since money is something we need to survive, these emotional and instinctual forces exert a very strong influence on our investment decisions. To make matters worse, research shows that these two parts of the brain do not learn from experience. Also, since flocking or herding is part of the self-preservation dynamic in mammals, going against the crowd is completely unnatural. This is why it is easy to intellectually agree with Buffet’s or Templeton’s admonitions to invest oppositely of the crowd, and so extremely difficult to actually do it. In other words, whether we are professional or retail investors, we are hard-wired to fail.

When it comes to investing, if we never stop and ponder how our emotional and instinctual tendencies affect us, we will eventually fail. We ride the wave of current success, drawing comfort from the fact that so many others agree with us. Many of us are so averse to the negative feelings, of anxiety and fear that the consideration of a crash conjures, that we avoid even thinking about the possibility, much less preparing for it ahead of time. Now in some ways, not wanting to consider a severe downturn makes sense. We all want our jobs and futures to be secure and successful. It is inherent that only a few would suggest it could be otherwise, and since it is only a few, it is much more comforting to rationalize that the masses supporting our optimistic view must be right. Yet, this is the reason that millions of investors will lose substantial amounts of funds in the years ahead. And, to me, that does not make sense.

Contrary to popular belief, investing opposite of the crowd is even harder for professional managers, because their livelihoods are contingent on their short-term performance. Avoiding the noise of the crowd is a rigorous test of any money manager’s skills. But, someone will note, “If the rare nonherding professional fund manager acts counter to the market’s trend, then his customers leave in droves. Rationality, to most managers, means getting rich giving customers what they want, not losing most of them with prudent investing. Regardless of the market outlook of any specific fund manager, then, the herding majority remains in complete control of the bulk of professionally managed money.” And, now we see why Excellent Managers (PDF) are such a rarity.

Now, let us change gears and see how this has played out over the last several months in the real world of the stock market. We will start with the January 30th announcement that our nation’s GDP grew an abysmal 1.1% during the last quarter of 2005 – 75% lower than the previous quarter. It has little, if any, effect on the markets, and two days later is a distant memory. Or, immediately following the most destructive hurricane to ever hit an American coast - Katrina, the Dow rallied over the next two weeks. Does this move in the Dow reflect investors who were rationally and efficiently adjusting their positions as reports of this event continued to dominate our news channels? The chart below shows that there have only been eight weeks since 2000, where there were more bears than bulls. That means that while the Dow was crashing, from 2000 to 2002, there were only eight weeks when investors were bearish about the future direction of the market. In the same chart, we can also see that bulls have outnumbered bears every week since late 2002. This 173-week run of more bulls than bears is an all-time record.

Most of us are convinced, by the rhetoric, that the last 3 years have “proven” that the markets can overcome anything. And, why not? The Dow lost 201 points on January 20. Outside of that, the Dow has not seen a move of more than 2% in almost 3 years. In this type of environment, it is easy to forget 2000 to 2002 and to be lulled into thinking that the last three years are the norm. We are all pretty comfortable. This chart shows that the volatility index is trending near a 15-year low. We do not realize that comfort can be very deceiving. For your own benefit, I implore you to shake off the lethargy these last few years created, and to rigorously pursue actions to safeguard your capital. We cannot count on an extrapolation of the past three years.

I leave you with this. The statement below was made less than 18 months before the onslaught of 2000 to 2002. Many of us were fortunate enough to recoup some of our losses from that time. Are we foolish enough to let our financial futures ride on the roulette wheel again? “This expansion will run forever. We will not see a recession for years to come … as we have the tools to keep the current expansion going. Policy levers and our policy team … will keep it from happening.

Link here.
Previous Finance Digest Home Next
Back to top