Finance Digest for Week of April 10, 2006

BACK DOOR PLAY ON CHINA’S GROWTH

Centuries ago the silk road was the best trade route to China. Today it is Taiwan, populated by ethnic Chinese who broke away from Beijing in 1949 after the Communists took over. So says Steven R. Champion, an old China hand who two years ago assumed command of the $110 million Taiwan Greater China fund. This closed-end focuses on Taiwanese companies with a large presence on the mainland. Taiwan already produces an enormous amount of the world’s electronic gear (82% of notebook computers, for example), much of this as a subcontractor for Western outfits like Dell, Hewlett-Packard and Apple. Taiwan began setting up plants in China in the late 1980s, as the two longtime antagonists tore down some barriers for their mutual economic benefit. Low-cost Taiwan is taking advantage of the mainland’s even cheaper labor – average monthly manufacturing earnings on the island are $1,200 versus $100 in Guangdong, a key Chinese export hub. Poverty-plagued, growth-loving China is eager for new jobs.

By using Taiwan as a back door to China, investors get the benefit of Taiwan’s better corporate governance and accounting. Taiwanese managers, with their common cultural heritage, know how to operate in China far more adeptly than do other foreigners. 5% of Taiwan’s population has moved to China for work, and island companies have invested $100 billion there, making them among the largest overseas investors in China. An OECD report last December about China’s production showed that its information-technology exports now exceed those of the U.S. Less noticed was that more than half of production comes from Taiwan-owned businesses, according to an estimate by the Market Intelligence Center in Taipei.

A modest and soft-spoken fellow with a flat Midwestern accent, Chicago native Champion moves easily through Chinese and Taiwanese business circles, where a low-key style is prized and brashness is sometimes not. This is the second time he has headed his current fund. He was its manager between 1987 and 1992, when the portfolio was called the Taiwan (ROC) Fund; his predecessor was the celebrated Mark Mobius, lately head of the Templeton Emerging Markets Fund. In those days Taiwan had fast-and-loose accounting standards that rival China’s today. Companies frequently kept two sets of books. At 60, Champion brings a rare sense of Asia’s financial history to his fund. 20 years ago Taiwan was one of Asia’s “four dragons” – Hong Kong, South Korea and Singapore being the others. He had to be very careful then about what he bought. Champion’s 1998 book, The Great Taiwan Bubble, chronicles that era of frenzied day-trading and VIP rooms in the island’s then ubiquitous retail stock shops. As Taiwan prospered and joined the mainstream worldwide economy, though, it cleaned itself up.

The Taiwan Greater China Fund (NYSE: TFC) has logged a 15.7% annual total return over the past three years, slightly trailing the Taiex index of Taiwanese stocks (17.5%). Someone getting into Champion’s fund now can at least tell himself that he is buying on weakness (Taiwanese stocks are off 2.3% this year) and is also getting a modest bargain on the fund’s shares, which go for a 6.6% discount to their net asset value. In another respect the Taiwan Greater China is anything but a bargain. This fund charges its portfolio 2.12% of assets yearly, high even for an international fund.

Champion sorts through Taiwan’s 2,000 companies and throws out those with less than 25% of their revenues from the mainland. Some are available as ADRs; the rest can be bought via a broker on the Taipei exchange. His biggest holding is Hon Hai Precision, which started out as a plasticsmaker in the 1970s and morphed into an electronics manufacturer. It turns out phones for Motorola, iPods for Apple and game consoles for Sony.

PICKING THROUGH LARGE CAP STOCKS

Making money in the stock market is always difficult, but 2005 was one of the easier years in my experience. Investors who avoided large-cap stocks, particularly in drugs or autos, did well. And if they went for Apple Computer and Google, they looked like geniuses. Gratifyingly, 2006 is off to a stronger start than last year and in three months has already achieved a 4.5% total return, half of what most commentators thought would take the entire year. But there is a paradox here. While the overall market is doing fine, no trends have emerged that you can ride.

Stock sectors that would appear to be great bets turn out to be problematical. Energy stocks are a day-to-day thing based on the price of oil – and that, in turn, is affected by geopolitics, weather and Wall Street predictions. Housing stocks are not romping the way they did last year, yet they have not fallen apart, either. Investors jump from one stock to another, hoping to catch a new trend, only to bail out when the trend fails to materialize. One example is Dell Computer, which has been trading in a narrow range of around $30 for some time. When a respected analyst upgraded the stock in mid-February, it gapped up $2 to $31 on heavy volume but has since receded to $30.

As 2006 started, many commentators predicted a recovery in languishing large caps. This would have been good news for Dell, Wal-Mart, Intel, Johnson & Johnson and on and on. These are fine companies with good fundamentals. Things have not worked out for them, though. The reason is the nature of today’s buyers. Stock prices in 2006 are ruled by hedge funds and Wall Street firms trading for their own accounts. The big boys’ program trading, where large numbers of shares are traded when a computer spots the slightest movement, ensures that short-term mentality dominates. For the most part they have little interest in large caps – the GEs and IBMs are likely to move only 10 or 20 cents on the majority of days, giving the hot-money crowd little payoff. These short-term traders remind me of the old joke about the sardine market. The new sardine trader decides one day to eat one and spits it out in disgust. The old trader tells him that the sardines are not for eating, they are for trading.

That is not to say that popular stocks are always bad stocks. In fact, your greatest gains this year are likely to be in stocks of interest to the professional traders. First might be, of all things, a large cap: Google, which I realize (painfully so) is down largely because of some unfortunate management comments. The stock will be back. New Century Financial (NYSE: NEW) is a REIT that handles mortgages, an unloved part of the market. Despite rising rates and plentiful worries about a housing bust, residential real estate never quite seems to crash as it is supposed to. Meanwhile, New Century just raised its dividend for the seventh quarter in a row and pays an astonishing 14% yield. Another dividend play is San Juan Basin Royalty Trust (NYSE: SJT), which owns oil and gas properties. While this stock is tied to natural gas prices, with its monthly dividend it yields 8% today and will benefit if energy prices stabilize or go higher. It costs 13 times trailing earnings.

NEWSPAPER INDUSTRY GETTING A PREMATURE BURIAL

There is a death watch on Wall Street for the newspaper industry. The patient’s condition does not look good, with slumping circulation, anemic ad sales, rising newsprint costs and competition from the Internet for readers’ attention. In reality, newspapers are holding up quite well and have good stocks that are worth owning. Take readership statistics. Gary Pruitt, chief executive of the country’s 8th-largest newspaper company, McClatchy, recently pointed out in a Wall Street Journal editorial that 54% of all adults read a paper every day, and 60% do on Sundays – more people read a Sunday paper than watch the Super Bowl, television’s biggest attraction of the year. Rumor also has it that young people rarely ever read the paper. The truth is, while not at the same high percentages as the broader population, 39% of young adults still read a daily paper. And odds are that more young folks will pick up that habit as they age.

All but a handful of the country’s 1,457 daily newspapers come with an economic moat surrounding them: It is next to impossible for a newcomer to invade the territory of an established paper and gain a foothold. Despite the Internet’s ubiquity, I doubt digital giants like Google and Yahoo can ever replicate the depth of local coverage or level of trust found in a hometown paper. As long as print media control local content, they will distribute it.

Even though I own a number of newspaper stocks, a few are too pricey for me right now. The negative news that has cast a cloud over the industry today may eventually present the chance to acquire shares of great franchises like New York Times, Media General (NYSE: MEG) or Dow Jones. All are wonderful companies that I have had my eye on for years.

These days one of the industry’s hottest headlines is McClatchy’s pending purchase of Knight Ridder, which will propel it into second place for circulation behind Gannett. I think it is a great match. I own McClatchy (NYSE: MNI) in my portfolio because it has a long record of trustworthy journalism and sound judgment – demonstrated by its collection of 13 Pulitzer Prizes over the years and a respectable 12% growth in net income (22% in operating income) over the last five. Skeptics have shaved $2 off McClatchy’s stock price since the buyout announcement. The company now trades at a 32% discount to my estimate of intrinsic worth.

I have held Lee Enterprises (NYSE: LEE) for nine years. The company owns 58 small and midsize dailies, mostly in the Midwest, and last year bulked up with the acquisition of Pulitzer Inc., becoming the nation’s fourth-largest newspaper group. The company sells at a 32% discount to my private market value estimate of $49. Another holding, Journal Register (JRC), has clusters of smallish papers from Michigan to New England. The company recently started paying a quarterly dividend and will continue to repurchase shares. Journal Register trades at a 39% discount to my estimate of its intrinsic value. Trouble stalks Tribune (TRB), another of my holdings. It has been hit with circulation scandals, weak ad sales and ugly ongoing tax litigation from its acquisition of Times Mirror. Wall Street seems to have given up on Tribune, but I have not. The stock changes hands at a 41% discount to my estimate of intrinsic value.

Earnings fall at three U.S. newspaper publishers.

New York Times Co., McClatchy Co. and Tribune Co. on posted sharply lower quarterly earnings on high newsprint costs and depressed advertising sales. The results from the three large publishers underscored the troubles faced by the industry, including circulation declines, high costs and competition for advertising money from the Internet and other new media. First quarter net income fell 14% at McClatchy, 28% at Tribune and 69% at New York Times, which had recognized a big gain in the year-earlier period. Only New York Times, which gave a forecast last month, matched analysts’ expectations. The other two fell short of Wall Street numbers. Shares of newspaper publishers as a group are down about 6% year-to-date.

McClatchy Chief Executive Gary Pruitt, one of the most vocal defenders of the industry, disputed criticism that newspaper publishing was obsolete. “Some may see the current slow advertising environment as confirmation of predictions that newspapers and print media are dying,” Pruitt said. “We think that’s wrong.” Another executive, New York Times Chief Financial Officer Leonard Forman, also came to the defense of the industry during a conference call. “These are challenging times,” he said. But “while we operate in a mature industry, the pessimism I hear and read is unwarranted.”

All three publishers highlighted the strength of their own Internet businesses. New York Times said revenue at its About.com site, which it acquired a year ago, rose 98%. Still, new media is only a small part of the newspaper business. At New York Times, the Internet accounted for only 7.5% of total revenue. So for now, publishers must manage high costs for newsprint and an advertising market that over the first quarter was undercut by weak automobile and national ad placements. That trend may not change in the second quarter, Pruitt said. “We expect second-quarter advertising results to be similar to the first quarter.”

FOLLOW NORTH FORK: SELL BANK STOCKS

The marriage of North Fork Bancorp and credit card issuer Capital One Financial may be accurately described as a union made in desperation. Capital One knows that the salad days of the credit card business are over. The business is overcrowded, and the best lending risks have long since been solicited with hordes of new cards. Only subprime risks are left. Issuers say they can slice and dice credit profiles and calculate the delinquency and default risks to control losses – and charge high enough interest to cover both loan losses and the considerable expense of drumming up new business. But interest rates appropriate to cover costs for the subprime customers are already way high. So Capital One has been on an acquisition binge. It has moved into auto lending. Last year it went ahead with its agreement to buy Hibernia even after Hurricane Katrina visited large but unknown damage on that Gulf Coast bank’s portfolio.

Capital One wants North Fork badly, paying a 23% premium over its preannouncement stock price. It is willing to suffer an earnings dilution in the process. With Federal Reserve-led rises in short rates squeezing Capital One’s lending margins, the company sees the deposits of rate-insensitive bank customers as a cheap source of funding. Capital One is not alone in its strategy of blending card issuance with retail banking. That, in fact, is how the card business started out, as a sideline for banks.

Other than North Fork’s three top executives getting a $288 million payday stemming from the sale, that bank has compelling reasons to do the deal. Its 355 branches are in the highly competitive New York City area. With its recent purchase of GreenPoint, a national mortgage lender, North Fork is heavily exposed to the likely collapse of the housing bubble. Outside the mortgage area North Fork is basically a spread lender that borrows short term (mostly via deposits) and lends longer term. But the flat yield curve has slashed the profitability of that activity. So Capital One and North Fork both want to get into each other’s business to water down the poor prospects of their own. Both cannot be right. What should investors do? Steer clear of both. And unless you expect a wave of takeovers of regional banks at big premiums, follow North Fork out the door and sell them. If you are daring, short the Regional Bank Holders Trust (RKH), an ETF.

The Fed’s current interest-rate-raising campaign, like its predecessors, will not stop until something significant happens. That something could be a recession, a collapse in house prices or both. Central bankers aim for soft landings yet usually end up breaking many passengers’ legs since they cannot risk premature ease. They responded weakly to leaping inflation in the late 1970s and had to precipitate two recessions in the early 1980s to regain respect. That is why Fed-controlled short rates will keep rising. And don’t believe the bulls bellowing that the Fed will stop while the economy is still strong.

Meanwhile, long Treasury yields will remain essentially flat, as they have since the Fed started to tighten in June 2004. Globalization, productivity-soaked new tech and other deflationary forces are keeping inflation low, outside of energy. And high petroleum costs are a depressing tax on users, not an inflation generator. In addition, bond investors sense that with high energy costs, Fed tightening and sliding housing prices, the economy is headed for weakness, if not recession and deflation. The current flat yield curve will invert seriously as short rates rise and long rates do not. Bad news for regional banks, brokers, mortgage lenders, consumer finance companies, leveraged realty trusts and other spread lenders. North Fork’s zeal to sell itself is telling you something. Pay attention.

CHINA AND THE GLOBAL LABOR ARBITRAGE

China has come a long way in the 27 years since Deng Xiaoping launched the world’s most populous nation on a path of unprecedented reform. There have been doubters at virtually every point along the way. Yet time and again, China has stayed the course. The latest worry is that the land of surplus labor is rapidly running out of workers – leading to excessive wage inflation and a loss of competitiveness, with profound implications for China and the rest of the world. Such concerns, like those of the past, are vastly overblown, in my view.

A front-page story on mounting Chinese labor shortages in the New York Times sparked a flurry of incoming calls to our various China experts around the world. The anecdotes that form the basis of this report are probably all quite accurate. But the basic conclusion that low-cost Chinese labor is a thing of the past does not stand up well to careful scrutiny. Yes, Chinese wages do appear to be rising at a rapid clip right now. But the increase is coming off such a low level that the cost relatives are still skewed dramatically in favor of China. Moreover, this upsurge of Chinese wage inflation appears to have been accompanied by exceptionally vigorous gains in worker productivity – suggesting that unit labor cost pressures remain under good control. That means China’s competitive advantage remains very much intact. Nor do I buy the equally preposterous notion that China is running short of workers, thereby risking a significant loss of market share to some of its equally low-cost Asian neighbors. There are skill mismatches and other frictional dislocations that arise from time to time in any economy, but the nation has a rural population of some 745 million – by far, the largest pool of surplus labor in the world.

All this underscores the critical role China continues to play in driving the global labor arbitrage – the cross-border migration of production from high-cost to low-cost labor pools. China’s enormous reservoir of low-wage factory workers underscores the enduring potential power of this arbitrage. Nor should the arbitrage be viewed as something that just takes place at the low end of the occupational hierarchy. Currently, about 550,000 newly trained engineers and scientists graduate each year from Chinese universities. In India, the count of such graduates is around 700,000 per year. For China and India, combined, this represent a trebling over the past decade in the entry flow into this segment of their high-skilled talent pool – pushing their combined flow of new graduates in engineering and science to about three times that in the U.S. Courtesy of IT-enabled offshoring, the global labor arbitrage is now at work in this segment of the occupational hierarchy, as well.

I continue to believe that the hyper-speed of IT-enabled globalization is one of the most destabilizing aspects of the global labor arbitrage. Pressures on workers have moved rapidly up the value chain from manufacturing into once nontradable services. Downsizing and wage compression are no longer just a blue-collar phenomenon. Long-sheltered knowledge workers are now being impacted by globalization for the first time ever. With economic recoveries in the high-wage industrial world becoming increasingly jobless, or wageless, or both, the destructive forces of protectionism have reared their ugly head in both the U.S. and Europe. That is hardly an inconsequential development for a world beset with record current account imbalances. The power of the global labor arbitrage has not been diminished by Chinese wage inflation. This could well be a key test of the world’s commitment to globalization.

DOLLAR FACES PUNISHMENT FOR U.S.’S ECONOMIC IMBALANCES

The dollar, that great symbol of American financial hegemony, is facing the risk of a regime change on currency markets. For the past 15 months, these markets have been dominated by interest rate differentials. The dollar has been the winner from this regime as the U.S. Federal Reserve raised benchmark interest rates by 375 basis points to 4.75% from June 2004. In contrast, the eurozone has managed just a meagre 50 points of tightening to 2.5% and Japanese rates have stayed resolutely at virtually zero. From a low of $1.36 to the euro in December 2004, the dollar pushed to a high of $1.167 late last year, as well as hitting 12 month-plus highs against sterling and the yen.

But there is now serious talk that the forex market’s attention may be about to shift and focus once more on structural issues such as current account deficits and central bank reserve diversification. Given the economic imbalances of the U.S., that would put pressure on the dollar. Even if the shift does not happen, most market analysts seem to agree on one thing: the dollar, which last week temporarily hit a 7-month low of $1.233 to the euro, is likely to be deposed from its position of strength.

If interest rate differentials remain the dominant factor, dollar support is seen as waning. The Fed is widely seen to be approaching the end of its cycle of monetary policy tightening with a peak rate of 5 to 5.25% forecast by many analysts. In contrast, the European Central Bank is expected to pull the trigger for a rate rise a further three or four times this year, in spite of last week’s apparent denial by Jean-Claude Trichet, its president, that a May rise is on the cards. Even Japan is seen as joining the rate rise party later in the year.

A shift by markets to focus on structural issues could make matters worse still. Currencies of countries with large current account deficits, such as Iceland and New Zealand, have been punished this year, and the U.S., with a deficit of 7% of GDP, is not immune to the risk of a similar selloff. The wider issue of global imbalances, in which dollar depreciation, against Asian currencies at least, is viewed as part of the solution to the burgeoning U.S. external deficit, is even seen as returning to the agenda of the G7 when it meets in Washington later this month.

Jens Nordvig, currency strategist at Goldman Sachs, sees signs that China, South Korea, Taiwan and Singapore are intervening less in the markets to weaken their currencies, reducing the flow of funds that need to be recycled into dollar assets. Similarly the issue of central bank reserve diversification from the dollar to the euro has returned after a long hibernation. David Bloom, currency analyst at HSBC, still argues that U.S. rates will peak at 5.5%, and believes the market is premature in spying regime change. Yet even he offers no consolation to dollar bulls, eyeing the euro’s return to its highs of $1.35 next year. “The dollar will weaken dramatically,” he says. “All that nonsense about current account deficits not mattering will disappear in a puff of smoke.”

Fed credibility crucial to faith in the dollar, says Fed’s Fisher.

The Federal Reserve will do what it takes to maintain its credibility, which is central to preserving the integrity of the U.S. dollar, Dallas Federal Reserve Bank President Richard Fisher said. Alluding to the Fed’s dual role of ensuring inflation does not “raise its ugly head” while still promoting the fastest possible noninflationary growth, Fisher said, “We seek to get it right. And the answer to your question is we will do what gets it right.” Fisher said the U.S. dollar is a “faith-based currency” dependent on the credibility of a central bank. “In addition to a faith-based currency, we are the currency of the world and we must maintain its integrity. As far as my involvement is concerned, I will spend every ounce of energy doing that. I have no doubt that my colleagues will do exactly the same.”

Kohn says Fed risks overshooting on rate hikes.

The Fed is aware it risks going too far on interest-rate rises given that policy moves have a delayed impact on the economy, Fed Board Governor Donald Kohn said. “Overshooting is one of the things we are very aware of as a risk in policy today,” Kohn said in answer to an audience question after a speech to bankers and business leaders. The Fed wants to make sure short-term rates are high enough to contain any potential inflationary pressure, but knows past increases take time to affect the economy, Kohn said.

Since June 2004, the Federal Open Market Committee has raised interest rates in 15 measured steps of a quarter of a percentage point each, bringing the bellwether federal funds rate to its current 4.75% from a low of 1.0%. Kohn, seen as a possible contender to succeed Roger Ferguson as vice chairman of the Fed, said the hikes had so far achieved the central bank’s goal of sustainable non-inflationary growth. On balance, financial markets are expecting two more rises, which would carry the benchmark funds rate to 5.25%. Kohn said the Fed’s attempts to shine a light on policy-making through better communication had likely shortened the lag between rate moves and their impact.

Greenspan calls for stronger Asian currencies.

Alan Greenspan said that current imbalances in the global economy could be corrected if high-growth countries allowed their currencies to strengthen. His remarks were in response to a suggestion on whether Asian countries should consider their own Plaza Accord-style agreement, similar to the one the U.S. reached with Europe and Japan to coordinate intervention in the foreign exchange market to weaken the dollar and reduce the U.S. trade deficit. “The equilibrium is better reached by allowing a number of these countries that show a much higher growth rate than developed countries to allow their currencies to firm,” Mr. Greenspan. “I realize what that does to competitiveness, but that’s the way markets work efficiently. Endeavouring to prevent the exchange rates from moving creates all sorts of distortions.”

Mr. Greenspan also warned of a potential fall in global asset prices, stressing that the ample liquidity currently in the financial system appeared to be an “abnormal situation” and could not last forever. He said the source of this liquidity was the market value of assets worldwide, which had been rising faster than nominal GDP globally due to a decline in real long-term interest rates and a significant fall in real equity premiums. “A good part of this expansion is a direct function of the decline in real equity premiums. That cannot go on indefinitely,” he said. “I don’t know when the liquidity is going to decline but I am reasonably certain that what were looking at is an abnormal situation.”

China economist proposes steps to slow FX reserves.

China should push yuan reforms, let firms hold more foreign currency and raise gold reserves to help slow the rise in foreign exchange reserves, an influential government economist said. China should ideally hold about $700 billion in foreign exchange reserves to ensure debt repayment, finance imports and maintain stability, Xia Bin, head of the financial research institute at the cabinet’s Development Research Centre, said in a research report. The rapid rise in China’s reserves, the world’s largest at $853.6 billion at the end of February, had made it hard for the central bank to control money supply and showed that China had failed to to keep badly needed capital at home, Xia said. A spokesman at the State Administration of Foreign Exchange which manages the reserves, declined to comment on the report.

Japan should worry bond market more than China.

Recently, there was consternation over a report that a Chinese official had urged his government to trim its holdings of U.S. debt and to stop buying dollar bonds. Many people fear that such a move could rattle our financial markets and send yields sharply higher. Yet based on an analysis of Japanese investors’ net purchases and sales of foreign bonds, it seems that we should probably be paying more attention to what that other large Asian nation is up to if we are really worried about where long term U.S. rates are headed.

Over the past five years, whenever we have seen a sharp decline in the 13-week cumulative total of Japanese net investment in medium and long-term foreign bonds, as reported by Japan’s Ministry of Finance, it has been accompanied by a parallel rise in the 5-year U.S. treasury bond yield (among others). Since December 30th, we have seen such a move, with a cumulative measure of net investment falling by ¥8.39 trillion, or more than $70 billion dollars (see chart). That suggests we could be due for even more of a slide in bond prices than we have seen already.

THE (RUDE) AWAKENING

Last week, a friend sent me a link to a Saturday Night Live (SNL) skit, wherein they present a “new consumer credit program”. It is called, “Don’t Buy Stuff You Cannot Afford”. While satire can be useful in pointing out the folly of America’s unprecedented borrowing and spending binge, the remedy will likely be so harsh that it precludes humor. Yet, the aspect of the effects of this credit phenomenon on the average American has long concerned me. So, with your permission, I will continue the story of the couple in the skit, whom I will call Bob and Sally Smith, in my own admittedly dour way. If you are fortunate enough to be reading this article with no credit problems, you still have been, and will be, affected by this historic, reckless expansion of credit. Beyond the effects of inflation, and the probability of deflation, the consequences of our profligacy will not play out in a vacuum and will not be nearly as hygienic as an academic discussion of this problem.

In response to the bursting of the stock market bubble of the late ‘90s, in 2001, the Federal Reserve began slashing interest rates, from 6.5% to 1% by 2003, bringing rates to their lowest levels since the Great Depression. Not surprisingly, as the credit spigot was opened wide, housing prices went parabolic. The unsustainable stock prices of the late ‘90s gave way to the unsustainable real estate prices of today. In 2004 and 2005, thousands of articles warned of a real estate bust, but the bust has yet to occur. Over the last two years, like us, many have cautioned that the stock market is again nearing a significant decline, yet no such decline has unfolded.

So, if things have been “good” for so long (3 years is forever to most Americans), why do we so doggedly hold to the idea that there is a problem and that our current course is not self-sustaining? I think that we are nearing the end of this present course, and while no person can know that this is “the top” (until it is too late to do anything about it), keeping watch for “the top” has never been more crucial. So once again, this time – through the eyes of Mr. and Mrs. Smith, we will look at the line of dominoes, the first of which is teetering and appears to be starting to fall.

WELCOME TO HOUSING HELL

For the past decade, homeowners in the U.S. have been living in “Housing Heaven”. In this heavenly place profits are always made,prices only go up; interest rates only go down; developers keep building, marketing, and selling megabuck, luxurious spa-like residences, that are all sold pre-construction; property speculators always make money, and pyramid their purchases into owning many properties to flip for a quick profit; and, second-homes are not an expensive luxury, but a wise investment for retirement. If you really needed to make ends meet while living in this so-called Housing Heaven, all you had to do was buy a vacation home, rental property, or second-home and proceed to “install your own ATM on the side of your financed house” with your bank’s help, of course. Who needs to work, when you can simply go to the bank and rob your own house? Living this way is fine in Housing Heaven, but not down here on earth. Here is why.

Consumer debt is up to $2 trillion (not including $440 billion of revolving home equity loans and $600 billion of second mortgages). Not only do consumers owe a whopping $9 trillion in mortgage debt, but home equity extraction has reached $600 billion annually. Homeowners have basically received, and spent, in excess of $2 trillion that they never earned. When housing prices are flat or falling, there is no Angel, Tooth Fairy, Easter Bunny or Santa Claus you can call, to refill the ATM machine when it runs out of cash.

Home prices are under horrible pressure. There are probably a few million property owners, including speculators, flippers, and second-home buyers, who are in way over their heads. Demand for over-priced housing is slowing and new buyers are taking their time, being picky, and even renting. Homeownership, as a percentage of the population, is already at a record-high. In 1997, household real estate assets as a percentage of GDP was 105%; today, it is 150%. This level was achieved by using every trick in the mortgage lending book, regardless of income or down payment. It should be no surprise that the affordability index for the first time buyer is at a 20-year low, or that the University of Michigan’s Home Buying Index is approaching an all-time low. Speculative buyers have stopped buying and many potential buyers are canceling orders and leaving deposits on the table.

In many states, property insurance is up 25% to 30%, right up there with soaring heating and air-conditioning costs. The record rise in home prices has helped balance state budgets, but at the expense of property owners who are not capped on their real estate taxes. The Alternative Minimum Tax is also emptying homeowner’s checking accounts! $2 trillion of ARMs were written in 2004 and ‘05 and are scheduled to reset in 2006 and ‘07 to much higher market interest rates, making them much less affordable. On the supply side for housing, sheer panic is beginning. Despite developers’ promotional tactics, last month new home sales still dropped 10% and the supply of new homes for sale hit a new high of 550,000, nearly a 7-month supply. Adding insult to injury, new housing starts are holding up! Housing prices in active real estate markets have gone up so much that the costs associated with owning vs. renting make renting a far more attractive choice now – a true measure of the extent of the housing price bubble.

So, welcome to Housing Hell. Now that buyers are willing to wait one or more years before buying, there are more sellers than buyers. Interest rates, in the meantime, continue going up. With $700 billion of sub-prime mortgages written (of which 10% could default), $2 Trillion of ARMs set to reset, and mortgage delinquencies near 5%, equity to extract is vanishing. As the refinancing game ends and borrowing costs increase, a significant rise in foreclosures could put a few million more homes back on the already-saturated market. The entire structure of housing prices will move lower with these forced sales. With mortgage foreclosures mounting up, it could get unbearably hot in Housing Hell! Our estimate is it will take about six months for sellers – particularly speculators who never intended to live in their properties but whose sole intention was to “flip” them for a profit – to realize they are toast.

Over the past 30 years, the United States has seen a Housing Hell scenario a number of times – in 1980-82, the early ‘90s, and 1996. The housing markets that suffered the most (particularly the Northeast and California), took almost 10 years to recover from the downturn. Homeowners lost money every month and were forced to rent out their properties at a loss because they could not sell them. Based on history, those who rent for a few years, rather than buy, will be rewarded the most (even though rents should increase with general inflation). The day will come again when it will, indeed, cost less to buy than it does to rent. That will signify the return, once again, of Housing Heaven.

Adjustable rate mortgages explode in Bay Area.

In the Bay Area, almost 75% of mortgage loans taken out last year allowed borrowers to delay the payment of principal and, in some cases, interest, according to data from San Francisco research firm LoanPerformance. Nearly 43% of new mortgages – including those to purchase or refinance a home – were interest-only loans, which are adjustable-rate mortgages that require no principal payments for a set number of years. That is roughly the same percentage as in 2004, but double the percentage as in 2003.

More surprising was that so-called option ARMs jumped to 29% of the Bay Area mortgage market from less than 10% in 2004. These are adjustable-rate loans that let the borrower choose from a variety of payments each month. The smallest payment includes no principal and less than 100% of the interest due. The unpaid interest gets tacked onto the principal, creating “negative amortization”, which is why these are also known as “neg-am” loans. Both types of loans essentially let borrowers trade lower payments today for higher payments later. The growth in these so-called nontraditional mortgages reflects a variety of trends: soaring home prices, more-flexible lending standards and a greater willingness by consumers to finance their lifestyle by borrowing against their home equity.

Interest-only and option ARMs are often called “affordability products”, because they often let people buy a more expensive house than they could with a conventional fixed-rate mortgage. But many people also choose them when refinancing an existing mortgage. In the Bay Area, 53.2% of purchasers and 35.3% of refinancers chose interest-only loans last year, while 22.5% of purchasers and 33.9% of refinancers chose option ARMs, according to LoanPerformance. Nationally, the same pattern holds true, but on a smaller scale. Last year, 34.2% of purchasers and 20.7% of refinancers chose interest-only loans, while 7.7% of purchasers and 11.4% of refinancers chose option ARMs.

Bob Visini, a spokesman for LoanPerformance, says he has “no explanation” for why so many refinancers, who already own a house they presumably can afford, are choosing these alternative loans. “I’d be willing to bet the vast majority are cash-out refis,” and that people are taking alternative loans so they can take out more cash. Between 1987 and 1991, Congress phased out the tax deduction on auto, credit card and other consumer loans, but not on home mortgage interest. As a result, many people today use their homes to finance cars, college tuitions, home improvements and other purchases. “The government almost forced people to do this when they took away the deduction for interest other than mortgage,” Visini says.

Regulators are taking a harder look at nontraditional loans to see what risks they pose to lenders, the financial system and to the borrowers themselves, who may not understand these complicated products. Both types of loan have the potential for payment shock when the interest rate adjusts and when principal payments must begin. In late December, the five agencies that regulate lenders issued proposed guidance on nontraditional mortgages. The regulators would like to see lenders using more-conservative assumptions when they determine a borrower's ability to repay a loan and do a better job of explaining the products and disclosing risks to customers. Although the new guidance is not final yet (the regulators are now considering comments submitted by the public and lenders) some think it will make alternative loans harder to get.

INFLATION IS MORE A GLOBAL CALL THAN EVER BEFORE

The momentum of liquidity-driven markets always lasts longer than you think. Now it is getting ridiculous. Markets have taken on an almost impervious aura. That continues to be the message from low volatility in equities, generally stable currencies, and historically tight spreads in risky assets such as emerging market and high-yield debt. And so once again, the humble practitioner of orthodox macro is faced with a profound question: Do the markets know something we don’t, or is something about to give?

I suspect we will have an answer to this question sooner rather than later. As I see it, the verdict hinges critically on the inflation call. So far, inflationary pressures have remained generally quiescent around the world – even in the face of an oil shock and a sharp upsurge in non-oil commodity prices. But now, with the global growth cycle on the upswing, there are worries in some quarters that inflation may be about to take a turn for the worse. While the Federal Reserve, the European Central Bank, and even the Bank of Japan continue to express concern over such a possibility, the markets remain skeptical. That is certainly the inference that can be drawn from a decomposition of the recent back-up in long-term interest rates. The so-called break-even inflation gauge – the difference between nominal and real interest rates and, therefore, a good proxy for market-based measures of inflationary expectations – remains confined to the relatively tight range that has prevailed over the past couple of years. Most bond bears argue that the upsurge in growth means that the pressure on long rates is about to shift from the real interest rate component to the inflationary premium.

I am not in that camp – at least, insofar as the inflation call is concerned. To me, inflation is more a global call than ever before. Such a conclusion is very much at odds with the country-specific assessment of inflation risks that still dominates the thinking of central banks. There is persuasive statistical evidence in support of the emergence of a global price rule. Interestingly enough, researchers from the Bank for International Settlements have led the charge in presenting this evidence. As such, this self-described “bank for central banks” finds itself very much at odds with its biggest clients. BIS researchers have recently extended their analysis, arguing that a “globe-centric” framework now does a much better job in explaining inflation than does the traditional “country-centric” approach. To the extent that there is slack in the global economy, inflationary pressures could well remain in check – even for those nations that have run out of spare capacity in labor and product markets at home.

This is a powerful and perfectly sensible conclusion, in my view – but one that has been generally ignored by the macro establishment. It is particularly relevant in the context of the current upturn in the global economy. The BIS researchers’ broadest measure of the global output gap paints a picture of good balance between worldwide supply and demand in 2005. Consequently, with the global price rule still flashing an all-clear sign, the bond market may have a very difficult time pushing nominal long-term interest rates much above current levels. Moreover, in the event of a downside surprise in global growth – still a distinct possibility, by my reckoning – bond markets actually could rally quite sharply.

Still, I would be the first to concede that there may be a good deal more to the bond market call than just focusing on inflation risks. The pyrotechnics of a disruptive U.S. current account adjustment are especially worrisome in that regard – particularly as Washington now ups the ante on protectionism. The risk of a sharp decline in the US dollar can hardly be ruled out in a normal global rebalancing scenario, let alone in one that is accompanied by increased frictions on the free flow of trade and capital. In the event the dollar starts to slide sharply, America’s foreign creditors – be they private or official – could demand to be compensated for taking currency risk. Given that the bulk of recent foreign capital inflows into the U.S. have gone into fixed income instruments, that compensation would probably take the form of wider spreads on longer-term U.S. real interest rates relative to those elsewhere in the world.

It may be that given the extraordinary accommodation of major central banks in recent years, long rates simply may have been pinned down by the mother of all liquidity cycles. But now, for the first time in 15 years, the world’s major central banks are all on the same side of the policy equation. That may be “all” it takes to push normalization out to the long end of the yield curve. What worries me most about such a scenario is the possibility of discontinuous adjustments – with simmering pressures at the long end suddenly vented by a sharp upward movement in real long-term rates. That implies that there could be important nonlinear threshold effects that stem from shifts in the liquidity cycle – sharp adjustments that exact considerable collateral damage on other asset markets. Given the extraordinary compressions in spread markets, those risks can hardly be taken lightly.

Perhaps the biggest risk in all this is that central banks do not fully understand how to set monetary policy in an era of globalization. If they do not appreciate the power of new structural constraints on inflation, they run the risk of unleashing what the BIS calls “undesirable side effects, such as & the build-up of financial imbalances, notably excessive credit and asset price increases that could raise material risks for the economy further down the road.” Interesting advice from the bank for central banks! I would take that critique one step further: If monetary authorities tighten when inflation is well-contained, they run the risk of taking real interest rates up to onerous levels that could take a surprisingly severe toll on the global economy. In an era of globalization, I suspect it will pay to heed the global price rule.

Or not …

In a speech last week – “A New Perspective for Policy” – Fed Bank of Dallas President Richard W. Fisher, noted a finding from recent globalization research conducted by the BIS. “…[F]or some countries, including – and to my mind especially – the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.” Mr. Fisher also noted “the realization of the importance of global economic conditions for making monetary policy decisions is becoming more widespread.” Reminiscent of the late-‘90s view that extraordinary productivity gains had empowered the Greenspan Fed to let the economy (and financial markets!) run hotter, today it is “globalization” that supposedly keeps “inflation” in check, thereby bestowing the Federal Reserve and global central bankers greater latitude for accommodation.

There is great irony in the fact that U.S. led global credit inflation and attendant asset bubbles of unprecedented dimensions are fostering (over)investment in global goods-producing capacity, a backdrop that is perceived by the New Paradigmers as ensuring ongoing “slack” and quiescent “inflation”. This is dangerously flawed analysis, and I find it at this point rather ridiculous that policymakers cling to such a narrow (“core-CPI”) view of “inflation”. I suggest Mr. Fisher, Dr. Bernanke, Dr. Poole and others read (or, perhaps, reread) the classic, Banking and the Business Cycle – A Study of the Great Depression in the United States, by C.A. Phillips, T.F. McManus, and R.W. Nelson, 1937.

The authors brought a (refreshing) degree of invaluable clarity to complex – and pertinent – economic issues that are today simply omitted from the discourse. In particular, I much appreciate the use of the terminology “Investment Credit Inflation”. It is, after all, the creation of new financial claims (credit) that augments purchasing power, and analysts must be vigilant observers of the sources and uses of this additional spending. The key is to recognize the nature of the processes of credit creation and dissemination, especially when marketable securities, leveraged speculation, and asset inflation are key facets of the boom. And just as the popular proxy index for the general price level utterly failed during the 1920s to indicate the prevailing massive credit inflation, the Fed’s favored (narrow) price level indicators today only work to palliate and mislead. But it is better to just let the timeless insights from “Banking and the Business Cycle” “speak” for themselves. …

The authors’ delved into considerable detail and analysis elucidating the various factors and mechanisms that supported “a much larger superstructure of credit than was previously possible.” Certainly at the top of the list was the expansion of the Federal Reserve System, along with various factors and avenues that significantly reduced bank reserve-to-deposit requirements and financial innovation generally. To be sure, however, the “hyper-elasticity of the Federal Reserve System” and the fractional-reserve banking apparatus from the ‘20s is inflationary child’s play in comparison to the virtually unchecked securities-based credit systems of our day.

JAPAN CENTRAL BANK ENDS EASY MONEY POLICY

Imagine a bank that doles out loans but charges no interest. For five years, that is what Japan has been for the world economy – an all-purpose lender with next-to-nothing borrowing costs thanks to the central bank’s zero interest rate policy. The trend helped pump up economies, stocks and foreign currencies from America to Australia. But concerns are mounting it could all unravel on a global scale with the Bank of Japan’s decision last month to finally tighten the taps on all the easy money.

At risk is a flow of funds known as the carry trade, an investment strategy that has lured people to Japan to borrow money on the cheap and invest it overseas for higher returns. No one is sure how much money is at stake, but economists say stopping the flow could prompt global investors to sell their holdings of stocks, bonds and other assets outside Japan, particularly in the U.S. That could weaken the dollar, push up yields on U.S. Treasury bonds and boost interest rates in the U.S. and Europe. “When it starts to reverse, it could lead to some real shock waves in the market,” warned Kenneth S. Courtis, the Asia vice chairman of Goldman Sachs Ltd. in Tokyo.

In an attempt to bail the world’s second-largest economy out of more than a decade of doldrums, the BoJ implemented a super loose monetary policy 5 years ago to make it easy for companies to borrow funds. Not only did the central hold interest rates close to 0%, it flooded commercial banks with about ¥35 trillion ($295 billion) in daily liquidity – nearly six times the amount banks actually needed, by many economists’ estimates. It did not take long for global investors to start exploiting all this 0% cash sloshing around. They borrowed money from Japanese banks and invested it overseas for higher returns. In the 12-nation euro zone, the key interest rate is 2.5%, while the U.S. benchmark rates are now 4.75%. Other popular destinations have been New Zealand, where the key interest rate is 7.25%, and Iceland, where the central bank recently hiked rates to 11.5%.

On March 9, however, the BoJ declared Japan’s economy is back on track and soon ready for higher interest rates – a trend that will squeeze the profit margin, or spread, on carry trades, making them riskier and less attractive. It is hard to know to what degree – and where – investors will move their money, but many experts believe that U.S. markets could suffer as a result. “What everyone is worried about is the whole regime will disappear,” said David Bloom, a currency analyst at HSBC in London. “At some point this whole carry trade situation will end. The point is whether this is the catalyst. That’s why it’s such an important and seminal moment for financial markets.”

In a sign that investors are already reacting to the shift, the yield on Japan’s 10-year government bond has climbed to around 1.9% from 1.6% since the BoJ’s announcement last month. The dollar has so far held steady in a range of 115 yen to 120 yen, but it could drop as low as 105 yen by year’s end as the BoJ gradually siphons off extra liquidity, according to Marc Ostwald, a strategist at Monument Securities in London. Big change may still be some time down the road because the gap between Japanese and U.S. rates is still big and likely to remain that way. Most expect the BoJ to wait until summer or later to raise rates, and then only bump them to 0.25%. At the same time, the Fed and the ECB are also expected to keep lifting rates, which would keep the gap steady. BoJ Gov. Toshihiko Fukui has pledged to make Japan’s transition gradual so as not to rattle markets. But analysts say clear communication from the BoJ about the next step will be crucial.

OIL-BACKED ETF MAKES U.S. DEBUT

The first fund to be listed in the U.S. to track the price of oil made its market debut on the American Stock Exchange. The U.S. Oil Fund, an oil-backed exchange traded fund, will aim to tap into the growing appetite for commodity investments. ETFs are designed to provide a cheap and direct alternative to investing directly into the underlying commodity. Instead of buying the physical oil, investors buy units in the ETF which represent an underlying barrel of oil. The U.S. Oil Fund tracks the price of the West Texas Intermediate, which is a premium crude oil traded on the New York Mercantile Exchange. The unit price of the fund opened and continued to trade at a discount to the benchmark WTI futures contract. The U.S. Oil fund was quoted at $67.80 a unit with each unit representing a barrel of oil. On Nymex, WTI was trading 81 cents higher at $68.20 a barrel in early afternoon New York trade. A distortion in the price can reflect a lack of liquidity.

The most popular commodity-backed ETF, the StreetTRACKS gold ETF, is listed on the New York Stock Exchange. Barclays Investors plans to launch its iShares Silver Trust, a silver-backed ETF on the ASE this year after the SEC allowed the ASE to change its listing rules. In spite of investor interest in the oil markets, which has seen oil futures trading volumes soar to record levels in recent months, oil-backed ETFs have not taken off with investors. The Brent oil ETF launched on the London Stock Exchange last year is in the process of being overhauled in order to widen its investment appeal after a sluggish start.

THE DONALD ESTABLISHES A MORTGAGE COMPANY

Donald J. Trump, already a developer of apartment towers and casinos and star of a television show, is starting a company to offer home and commercial mortgages. Trump Mortgage LLC, based in New York, plans to complete $3 billion in loans this year and has a goal of issuing $100 billion in loans annually in the next five to 10 years, said E.J. Ridings, 42, the new company’s chief executive officer. Trump Mortgage will offer loans ranging from $30,000 home equity lines of credit to $300-million commercial mortgages, he said.

The founding marks an expansion into consumer loans for Trump, 59, when rising interest rates have hurt home sales. The average rate on a 30-year mortgage is about 6.35%, close to a 2½-year high, according to mortgage buyer Freddie Mac. “The way we look at it, it’s the most exciting time because we think the best players will remain,” Ridings said. “It’s still a huge industry.” Initially, Trump Mortgage will serve as a broker for mortgages. The company already is working with 60 to 70 banks and more are being added, Ridings said. Eventually Trump Mortgage plans to be its own banker for residential loans. Trump Mortgage is the billionaire’s first excursion into the consumer-loan business.

THE SECRET OIL SANDS PLAY

Everyone is telling you these days that the Canadian oil sands are the place to invest. Some commentators are talking about how the oil sands could produce more crude than Saudi Arabia, warning you not to miss the boat because investment dollars worldwide are about to flood to the region, making a fortune for all involved. Most analysts will then go on to recommend stocks like Suncor Energy, Canadian Oil Sands Trust or UTS Energy as ways to cash in on the oil sands mania. The problem? These three stocks – darlings of so many pundits – have a combined market cap of roughly $60 billion. There had better be a lot of investment money coming, because it is going to take a tidal wave of dollars to move the share prices of these large-caps. True, if you had invested in these companies a year ago, you would have doubled and perhaps even tripled your money. Not a bad return. But with these stocks having already gained so much, so fast, it is now going to take a double or triple of last year’s investment influx to achieve the same returns. As an investor in these companies you are pushing a rock up a hill that is growing steeper by the day.

That said, I am a believer in the oil sands sector. Simply put, political problems are looming in almost every major oil-producing nation around the globe. Iraq is a mess, with production still below the levels prior to the U.S. invasion. Iran looks like it may be next on Bush’s hit list. Nigeria has 420,000 barrels of oil production shut in because of attacks on pipelines and platforms. Russia is a Jekyll-and-Hyde game, one day happy to share its petro-riches with the world, the next turning off the taps to its neighbors. The Venezuelan government recently seized control of numerous oil fields, effectively evicting major companies from the country. With all this going on, the Canadian oil sands may be the only significant oil reserve on “friendly” soil. As such, I am not surprised to see the region getting a lot of attention. If I was U.S. energy secretary, I would be shopping for a good townhouse in Fort McMurray.

But as a speculator, I am always looking for ways to maximize my profits. Even though I see the oil sands as a sector whose time has come, I have a hard time sinking my money into a multi-billion-dollar company that is on the lips of every Wall Street lackey. When everyone’s talking about something, you should look elsewhere. But where? As speculators, I believe our best bet is to look for companies that are working oil sands plays in new areas that have not been recognized by the street. Go beyond the boundaries of the Suncors of the world to find the next big thing. For instance, with attention focused on Alberta’s oil sands, few analysts have noted that development abruptly ends at the province’s eastern border with Saskatchewan. Do the rocks suddenly disappear? Unlikely. In fact, looking deeper we found historical evidence that Saskatchewan hosts rich oil sands – perhaps even richer than Alberta’s. The problem is politics. The Saskatchewan government has been all but closed to development, meaning that almost no companies have pursued projects here.

I say “almost none” because it turns out there is one little-known oil sands developer working in Saskatchewan. A company it just so happens holds a land package larger than all Alberta’s oil sands projects combined, with management that has already built one oil sands company into a billion-dollar player. But despite these glaring positives, the company has gotten little love from the market. So much so that when we came upon it, it was trading at a $200 million market cap – tiny by oil sands standards. In December 2005, we jumped on the huge potential here and within three months saw gains as high as 315%. Despite this run, the stock is still less than half the market cap of the smallest Alberta oil sands company – with potential for reserves that dwarf those of most Alberta players. To mention the name here would be unfair to Casey Energy Speculator subscribers – but rest assured this is a story that will be receiving a great deal of mention in the pages of our letter. But the bottom line stands: Uncover opportunities that are beyond most investors radar at the moment, but which have the ability to benefit from the rising tide once they do break.

SOMETHING HAS GOTTA GIVE (FOR STOCKS)

Forget Goldilocks. Pollyanna has been running up and down Wall Street lately, annoying bears and bulls alike, and she does not seem to be getting tired – yet. Oil is back near $70 a barrel, gold is flirting with $600, a 25-year high, and the 10-year Treasury yield is back up near 5%, its highest in almost four years – all classic signs that some investors think inflation is about to make a comeback. Yet stocks are doing just fine, considering, posting modest declines at most over the past few sessions. In fact, the major gauges remain near multi-year highs and the Russell 2000 index of small-cap stocks is near its all-time high.

Why is that? It may be that the factors lifting oil, gold and interest rates are also lifting stocks, said Stephen Leeb, president of Leeb Capital Management. “The rise in commodities, interest rates, all of this is a reflection of worldwide growth,” Leeb said. “That’s why the stock market is not crashing.” The surge in gold prices – traditionally seen as a hedge against inflation - could also be a reflection of broader demand for the commodity around the world, said Douglas Altabef, managing director at Matrix Asset Advisors. As long as all of these other markets can keep rising, that should help support stocks, Leeb said. “The risk is if one of these markets became explosive,” he said, that could upset the balance.

So are stock investors just delaying the inevitable, or are there enough factors in place to keep stocks from sinking? Surging oil prices, gold above $600 an ounce and rising rates could add up to a nasty environment for stocks, said Paul Mendelsohn, chief investment strategist at Windham Financial Services. And the market could be especially vulnerable if oil, gold and interest rates surge further, he said, noting that such an environment would be somewhat the opposite of what happened in 1982, the start of what the Stock Trader’s Almanac calls the “super bull cycle” that stretched on and off until 2000. Inflationary pressures similar to now were in play in 1982, Mendelsohn noted, but receded gradually the next few years, enabling stocks to rise. “If inflation doesn’t accelerate much from here, and the Fed just raises rates a little more, we might see something like the end of the 1990s again,” said Stephen Stanley, chief economist at RBS Greenwich Capital. “But if the Fed has to really ramp up to fight inflation, it’s going to be a much worse environment than investors realize.”

“Why all the gloom?” asked Peter Brodie, director of investments at Bryn Mawr Trust Wealth Management, noting that yes, the stock market is vulnerable, but nevertheless remains well supported since corporate earnings growth has managed to stay strong. Stocks are also getting some support as money that had been going into real estate is starting to flow back into stocks, Brodie said. There have been numerous signs in recent months that the real estate market is cooling – and what is bad for the goose is sometimes good for the gander. And the rally in long-term yields has also helped return bond market rates to a more normal pattern, which is a plus for stocks, Mendelsohn said. Finally, the bulls may be able to hang on longer simply because they have been hanging on so long. Stocks have more or less been in an uptrend since bottoming in October of 2002. “The stock market tends to rise,” Mendelsohn said. “And once it has been in an uptrend, you really need something big to get it to move substantially lower.”

READY FOR $262 A BARREL OIL?

Be afraid. Be very afraid. That is the message from two of the world’s most successful investors on the topic of high oil prices. One of them, Hermitage Capital’s Bill Browder, has outlined six scenarios that could take oil up to a downright terrifying $262 a barrel. The other, billionaire investor George Soros, would not make any specific predictions about prices. But as a legendary commodities player, it is worth paying heed to his words. “I’m very worried about the supply-demand balance, which is very tight,” Soros says. “U.S. power and influence has declined precipitously because of Iraq and the war on terror and that creates an incentive for anyone who wants to make trouble to go ahead and make it.” As an example, Soros pointed to the regime in Iran, which is heading towards a confrontation with the West over its nuclear power program and does not show any signs of compromising.

Another emboldened troublemaker is Russian president Vladimir Putin, Soros said, citing Putin’s recent decision to briefly shut the supply of natural gas to Ukraine. The only bit of optimism Soros could offer was that the next 12 months would be most dangerous in terms of any price shocks, because beginning in 2007 he predicts new oil supplies will come online. Hermitage’s Bill Browder does not yet have the stature of George Soros. But his $4 billion Moscow-based Hermitage fund rose 81.5% last year and is up a whopping 1780% since its inception a decade ago. A veteran of Salomon Bros. and Boston Consulting Group, the 41-year old Browder has been especially successful because of his contrarian take. For example, he continued to invest in Russia when others fled following the Kremlin’s assault on Yukos.

To come up with some likely scenarios in the event of an international crisis, his team performed a “regression analysis”, extrapolating the numbers from past oil shocks and then using them to calculate what might happen when the supply from an oil-producing country was cut off in six different situations. The fall of the House of Saud – the one that generates that $262 a barrel – seems the most far-fetched of the six possibilities. More realistic – and therefore more chilling – would be the scenario where Iran declares an oil embargo a la OPEC in 1973, which Browder thinks could cause oil to double to $131 a barrel. Other outcomes include an embargo by Venezuelan strongman Hugo Chavez ($111 a barrel), civil war in Nigeria ($98 a barrel), unrest and violence in Algeria ($79 a barrel) and major attacks on infrastructure by the insurgency in Iraq ($88 a barrel). Regressions analysis is an art, not a science, and some of these scenarios are quite dubious, like Venezuela shutting the spigot.

Although there are long-term answers like ethanol, what is needed is a crash conservation effort in the United States. This does not have to be command-and-control style. Moral suasion counts for a lot. It has been done it before. For all the cracks about Jimmy Carter in a cardigan and his malaise speech, America did reduce its use of oil following the price shocks of the 1970s, and laid the groundwork for low energy prices in the 1980s and 1990s. But it would require spending political capital, and offending traditional White House allies … something this president does not seem to want to do.

$6 Gasoline

Hurricanes, Terrorism, Hugo Chavez or Murphy’s Law. One way or another gasoline prices are heading much higher this summer. $6 a gallon is not out of the question in some parts of the U.S. So it might be a good time to buy call options on gasoline or to sell your Escalade … or both. Last year’s hurricane season was the most destructive one in recorded history, with 27 named storms and 14 hurricanes. These powerful and relentless storms, including the infamous Katrina, knocked out a huge portion of the nation’s hydrocarbon production and refining infrastructure. Many natural gas platforms in the Gulf remain shut-in. Forecasters expect another busy Atlantic hurricane season this year, with 17 named storms but not as many intense storms striking land as last year.

This year’s hurricane season, which runs from June 1 to November 30, is likely to have nine hurricanes, five of them intense, according to William Gray, a hurricane researcher at Colorado State University. “Even though we expect to see the current active period of Atlantic major hurricane activity to continue for another 15-20 years,” says Gray, “it is unlikely the seasons that follow will have the number of major hurricane U.S. landfall events as we have seen in 2004-2005.” Even so, Gray’s team places an 81% chance on the probability that at least one major hurricane will make landfall along the U.S. coastline in 2006, and a 47% probability a major hurricane will hit the Gulf Coast between the Florida Panhandle and Brownsville, Texas.

I do not trust these hurricane predictions very much, but ANY disruption to gasoline production could cause prices to soar. Hurricanes are just one of the many threats to our nation’s supply of gasoline. Terrorism and Venezuela pose an ever-present threat to the supply of imported gasoline. Gasoline supplies are already tight, which is why I expect to see unleaded rally hard this week, especially if EIA’s inventory numbers show large drawdowns. Last Friday the CEO of Yellow Roadway shocked me by saying he is not concerned about energy prices. WHAT? If he is not he should be. Waste Management, the big garbage-hauling company, has one of the biggest fleets of trucks in the world. Because of soaring fuel costs, Waste Management just reported its first quarterly loss ever. It is so frightening to listen to some of these people who are just so deep in denial about where the commodities are going. I weep for their complacency.

If gasoline demand ramps up this summer and we get hit with even one major hurricane in the Gulf coast, we are going to see at least $3.50 for regular unleaded gasoline, and in some states, maybe $4.50. And that is before any potential problems out of Venezuela, Iran, Iraq, Nigeria or elsewhere. Gasoline is already $3.04 for premium right down the street from my house. Do individuals really believe that if we have a devastating hurricane in the Gulf, or if Hugo Chavez suddenly pulls the easy gasoline off the market and sends it to China, that gas will only go up another 40 cents? In the financial markets, denial is a very expensive character trait. Sell the Escalade … buy call options on gasoline.

“REVOLUTIONARY” FED STUDY HAS ECONOMISTS RETHINKING LONG-TERM FORECASTS

A new Federal Reserve study has shaken economists’ forecasts by suggesting the U.S. economy will decelerate much more over the next decade than most now expect. The study, to be published in July, finds that the retirement of the Baby Boom generation will force far-reaching adjustments in the way the economy works. Forecasts for everything from growth and employment to corporate profits and interest rates will have to be recast. The Fed’s report “is such a revolutionary shot,” said Ian Morris, chief U.S. economist at HSBC Securities USA Inc. in New York. “Something like this is going to take time to digest.”

The study projects a slower pace of workforce growth than most economists now forecast, suggesting the economy cannot keep growing at the present-day pace without generating pressure for higher wages and inflation. To prevent that, the Fed will have to enforce a lower speed limit on the economy by pushing up interest rates. The study suggests that growth over the next 10 years will average less than 3%, instead of the 3.3% of the last decade, economists said. A 0.3 percentage point difference in growth in the $12 trillion U.S. economy translates into $360 billion over 10 years, equal to the size of Switzerland’s economy. Payroll gains, which averaged 200,000 a month in the 1990s, may be half that. “This is a very big story,” said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor. “It makes the challenge for the Fed a little greater.”

While economists have known for years that the coming retirement of the baby boomers would be a drain on the labor force, the Fed study suggests that the U.S. is already feeling the effects and the impact in the next decade may be much bigger than previously thought. The study projects what the authors call a “conservative” 3 percentage-point decline over the next 10 years in the labor force participation rate – the percentage of people who are either working or looking for work. Much of that drop is driven by the retirement of the baby boomers, the 78 million Americans born between 1946 and 1964. The projected drop in the participation rate would “reduce the sustainable rate of economic growth relative to the robust pace experienced over the past decade or so,” said the Fed report.

Not everyone is won over by the conclusions of the study. “We have a lot of experience in that area,” said Stephen Goss, chief actuary at the Social Security Administration in Baltimore, whose participation rate forecasts are central to estimating revenue and expenditure streams for the nation’s retirement fund. “We don’t see the rate declining as much as they do.”

SHADOW STATISTICS

Ben Bernanke, Fed chairman, recently delivered an upbeat view of the U.S. economy. It was cheerful, optimistic … and delusional. The official government statistics hide many warts on the face of the U.S. economy. Like makeup dabbed on an aging film star, they are an attempt to cover the wrinkles and present a veneer of youth. To most people, this is no revelation. Like plastic surgery and tummy tucks, it is what stars do to keep up appearances. However, few know the extent of the deceit. What if you learned that inflation were closer to 7% than to the official 3%? What if unemployment were closer to 12%, rather than the official 5%? What if the economy were actually contracting, as opposed to growing? What follows is a partial peek at the economy – sans makeup. And, more importantly, what it means for you and your hard-earned dough.

It was the genius of writer George Orwell that he chose to build his dystopia on the foundations of language and information – how it is used to deceive, manipulate and control. His chilling novel 1984 stands out precisely because it is only a distortion of things that are happening now and that have always happened. Orwell’s dystopia is a mirror in a funhouse, as you see enough of your own world in this disturbing reflection. Thankfully, there are still some people doing the important work of getting at the truth behind the official statistics – piercing the veil of Newspeak, sweeping away the cobwebs of sham. John Williams is an economist dedicated to doing just that. His Shadow Government Statistics reveals the extensive rot under the floorboards of the U.S. economy.

Let us take the official inflation rate, tracked using the consumer price index, or CPI. The idea behind the CPI is to have a fixed basket of goods and track how the prices of these things change from year to year. It only gained prominence after World War II, as a way to adjust autoworkers’ labor contracts, a practice that soon spread. Over time, its importance grew and more people looked to it as a gauge of general price inflation – and, hence, to get a feel for the health of the economy.

The thing is, the way the CPI is calculated changed dramatically over the years. Politicians have figured out that these statistics are useful in winning elections. Ergo, nearly every administration has altered the calculation. And always, the changes made the CPI lower. Every effort to change the CPI, by design, aims to make the economy look “better” than it looked before the changes. The accumulation of these changes creates a huge difference over time. The rate of inflation using only the pre-Clinton era CPI would be closer to 7%! But it is about more than just making the economy look better. For example, since increases in Social Security payments link to the CPI, a lower CPI also saves the government money. According to Williams, if you used the CPI when Jimmy Carter was president, you would get Social Security checks 70% higher than today’s levels! The government also duped all those people who thought it was such a great idea to buy TIPS (Treasury inflation-protected securities). Changes in the CPI determine the interest paid on these bonds. Given the government manipulates the CPI, you can be sure the interest rate paid will not keep pace with inflation – nor has it ever.

The manipulation of the CPI explains the great disconnect between what the man in the street feels when he pays his bills and what the confident, well-dressed Fed chiefs and politicians try to tell him. The cost of living is rising a lot more than they want you to believe. At a 7% annual rate of inflation, the cost of living would double in about 10 years. Looked at differently, the purchasing power of your dollar will fall in half.

What about unemployment? The government, since the time of the Kennedy administration, has been changing the definition of “unemployed”. Again, many small changes over time lead to dramatic end results. According to Williams, if you back out the changes, you get an unemployment number closer to 12%!

The federal deficit – basically, the amount of money the government is losing every year – was officially $319 billion in 2005. However, this excludes unfunded Social Security and Medicare obligations. Throw them into the mix and calculate the deficit the way a business does in its financial statements – and you get an annual deficit around $3.5 trillion … more than 10 times the so-called “official” deficit. By Williams’s calculations, you could raise the tax rate to 100% – dump everyone’s salaries into the U.S. Treasury – and still have a deficit. Years of such deficits have created a mountain of obligations for the U.S. government. As Williams says, “The fiscal 2005 statement shows that total federal obligations at the end of September were $51 trillion; over four times the level of GDP.” These debts are unsustainable. The bills must go unpaid. If the U.S. government were a private corporation, its bankruptcy would be beyond dispute. This is why Social Security and Medicare are not going to exist in the not-too-distant future.

Williams believes GDP is contracting now. The government reported only a 1.1% increase in the fourth quarter. Even in an election year, and despite the government’s best efforts to paint a pretty face, all it could muster was a measly 1.1%. More likely, the economy actually contracted 2% in the fourth quarter. This means we are in a recession NOW. This is not conspiracy-theory stuff. As Williams points out, it is all disclosed in the footnotes in the government’s reports. All he is doing is backing out many of the changes to more realistically compare these numbers with the numbers of the past.

Oddly enough, these insights do not change our approach. In fact, Williams’ work reinforces several things we have already covered in past letters. To wit: (1) Yields on real estate investment trusts (REITs) and utilities – to say nothing about the bond market – appear even more pathetic against an inflation rate of 7%. The yield for risks taken is simply not adequate. If the slumbering bond market awoke to the reality of a 7% inflation rate, there would be a sell-off the likes of which this country has never seen. And (2) The U.S. dollar is a doomed currency over the long haul. Bernanke, the self-professed student of the Great Depression, accepts the mainstream view that the Fed’s great mistake then was not to flood the system with dollars. He will not make that “mistake” again. Expect the printing presses to run day and night at full capacity when the trouble starts.

Trying to pin down the economy in precise numbers is futile anyway. It is too big, too complex. All macro statistics are severely flawed. This is why I seldom write about them. Investing using macro statistics is like trying to find the nearest post office with a globe. They are so vague as to be useless. The basic idea I want to leave you with is that the economy is far weaker than generally portrayed. Most investors ignore the rat’s nest of risks and invest indiscriminately in stocks – without proper due diligence. As investors, we need to stick to our fundamentals more carefully than ever.

GOLD KNOWS WHAT NO ONE KNOWS, PUTS THE LIE TO CENTRAL BANKERS’ CLAIMS

April Fools day usually arrives on April 1st, but the day for the European Central Bank chief Jean “Tricky” Trichet to play dirty tricks came on April 6th, and left overzealous euro bulls licking their wounds. Expectations of an ECB rate hike to 2.75% on May 4th, seems like a slam dunk, with the Euro M3 money supply exploding at an annualized rate of 8% in February, way above the ECB’s 4.5% reference level for stable inflation, and European bank loans to the private sector expanding at a 10.3% clip, the fastest rate in over six years. Such a potent cocktail is fueling takeover mania across Europe, where mergers and buyouts doubled to $454 billion in the first quarter from the same period a year earlier, after a whopping $1.03 trillion of deals in 2005. “Tricky” Trichet and his cohorts at the ECB are holding down borrowing costs in the Eurozone by expanding the money supply to meet strong loan demand, in a brazen effort to lift European stock and real estate markets higher.

With demand for cheap long-term credit rising strongly in Germany, questions must be asked about whether the low level of global interest rates are appropriate, said the future ECB chief economist Juergen Stark on March 28th. “We are dealing with a global wave of liquidity today. One must ask oneself whether key interest rates are sending the correct signal here. This development is unsustainable,” he said. Other ECB policymakers were barking loudly last week whipping the euro bulls into a buying frenzy. But when the moment of truth arrived for the ECB to walk the talk on April 6th, “Tricky” Trichet pulled the rug from under the euro, and in the process, created a lot of ill will towards the 12-nation common currency.

But the gold market remained defiant, hovering just below €500 per ounce, even after global bond yields moved swiftly higher. Euro traders are learning the hard way, what gold traders have known to be true for quite some time. Central bankers can not be trusted to preserve the purchasing power of paper money. Gold knows what no one knows!

Trichet’s endless brainwashing about his self-proclaimed vigilance against inflation falls on deaf ears in the gold market these days. “We are still, and will continue to be credible, as we were at the first day,” he told leading bankers at the Institute of International Finance on March 30th. But Trichet’s audience is the investment banking community which is reaping huge profits from merger mania in Europe, which in turn, needs the daily injection of cheap money to keep business executives in the mood to buy other companies. European exporters prefer a weaker Euro, so the ECB is aiming for a sweet spot of $1.20, which can keep foreign sales buoyant to the Far East and the U.S., yet help to hold down the cost of dollar denominated raw material and crude oil imports.

European gold traders were a bit slow to recognize Trichet’s strategy, but finally saw through the smokescreens in September 2005, when the Euro M3 money supply expanded at an 8.5% clip, without a protest from the “vigilant” Trichet. Jawboning and stepped up gold sales in the fourth quarter of 2005 failed to keep the yellow metal under sedation, cornering “Tricky” Trichet, and forcing the ECB into two baby step rate hikes to 2.50%. Now, the ECB faces a dilemma, because the gold market in Europe has become more sophisticated, and is pegging the gold price to the performance of leading Euro equity markets. So unless the ECB steps up to the plate to tighten its monetary policy, neither gold nor EuroStoxx blue chips are likely to give up much ground.

Across the English Channel, the bankers on Thread-Needle Street make the ECB look like monetary hawks. The Bank of England became the first disciple of former Fed chief Alan Greenspan’s “Asset Targeting” policy in 2001, when it slashed its base rate to 3.50%, in a desperate effort to cushion the decline of the Footsie-100. Either by design or fanciful luck, the BOE succeeded in doubling UK home prices, helping the British economy to avoid a recession that gripped the Euro zone and the U.S. The Bank of England has opened wide the money spigots, fueling asset inflation in the UK equities markets and in gold. Housing prices have begun to percolate again, rising for six consecutive months to stand 5.3% higher from a year ago. With its manufacturing base moving overseas and dwindling oil supplies from the North Sea, the UK economy hinges on asset inflation, much like the U.S. economy. British traders turned to gold after the BOE lowered its base rate to 4.50% in August 2005, when it became obvious that the BOE’s jawboning about fighting inflation was just empty words.

The Bank of England has never really understood the psychology of the gold market. The BOE dumped two-thirds of its gold, or 415 tons, between 1999 and 2001 at an average price below $300 per ounce. But what is more surprising, the gnomes of Zurich, stationed at the Swiss National Bank made the same blunder, by selling half of the Swiss gold reserves, or 1300 tons, between May 2000 and May 2005. Overall, the SNB gold sales amounted to SF21.1 billion, at an average selling price of $351.40 per ounce. Soon after the SNB’s final gold sale in May 2005, the price of gold climbed by nearly 50% over the next eleven months to SF760 francs per ounce, to reflect a 50% loss of gold behind the Swiss currency. The collapse of the Swiss franc in relation to gold, puts into question the psychological status of the Swiss franc as a safe haven currency.

The SNB is following the lead of ECB, with both banks sticking to three month intervals between rate hikes, to keep the euro/Swiss franc exchange rate in a stable range. The SNB will tighten rates gradually, said SNB member Philipp Hildebrand on March 23rd. “The fact is that from today’s point of view we are in a situation to conduct a cautious approximation of rates towards neutrality, thanks to a favorable inflationary development and still well-anchored inflationary expectations,” said Hildebrand, attempting to brainwash the financial media while ignoring the 50% devaluation of the Swiss franc versus gold. The Swiss franc will remain a low interest rate currency that hedge funds can utilize for funding operations in gold, silver, crude oil, copper, and zinc, the premier leaders of the “Commodity Super Cycle”.

In the Far East, the Bank of Japan announced on March 9th that is would begin to dismantle ultra easy money policy, by draining ¥26 trillion ($220 billion) from the Tokyo money markets in the months ahead. But nobody knows for sure what time frame the BoJ has planned to lift its overnight loan rate above zero percent. Instead, BoJ chief Fukui has gone out of his way to assure Japan’s financial warlords of the ruling LDP party, that BoJ policy would remain accommodative. While the BoJ is draining yen by refusing to rollover maturing short-term debt, it is also pumping ¥1.2 trillion into the banking system each month through JGB purchases. The BoJ remains under heavy political pressure to go slow with its tightening campaign, and to keep yen plentiful and cheap, insulating the Japanese economy and Nikkei-225 stock index from record high oil prices. Japanese gold traders understand the scheme that LDP financial warlords are pursuing, and are pegging the price of gold to the Nikkei-225, both rivals for investment funds seeking a safe haven from BoJ monetary inflation.

After hiking the fed funds rate to 4.75% on March 28th, the Federal Reserve acknowledged that the “Commodity Super Cycle” might be signaling higher inflation. Engaging in a battle with the “Commodity Super Cycle” would represent a 180º turn in Bernanke’s thinking on commodity prices and inflation. But the Fed is almost out of ammunition in its 21-month old battle against gold, silver, copper, zinc, and crude oil. At the current sales pace, there were enough new homes on the market to satisfy demand for the next 6.3 months, the largest amount in more than a decade. The median selling price of a new home last month was $230,400, down from $243,900 in October. The Fed is not about to pull any nasty tricks like Trichet, and should follow through on its widely telegraphed quarter-point rate hike to 5.0% on May 10th. But beyond 5.0%, the Fed would risk killing the goose that lays the golden eggs for the U.S. economy, the housing bubble, and that might be a red line that Bernanke & Co. cannot cross.

If so, which central bank would assume the mantle of fighting the commodities rallies with a tighter monetary policy? European and Japanese central banks are playing a double game, tightening monetary policy at a snail’s pace, but leaving plenty of euros and yen floating in the banking system at negative real interest rates, in an effort to keep their equity markets afloat. The Federal Reserve announced on November 10th, 2005, that it would no longer disclose to Americans what it is doing with the U.S. M3 money supply. Since then, gold has soared $110 per ounce, bumping against the psychological $600 level.

While the Dow Jones Industrials rally to 5-year high might look impressive in U.S. dollar terms, the DJI is in a raging bear market in hard money terms. Last week, the DJIA fell below 19 ounces of gold, or 30% lower than two years ago. While gold is matching the performances of European and Japanese equity benchmarks, and blowing away the Dow Industrials, the yellow metal is still in a four year bear market against the crude oil market. Gold has rebounded from as low as 6.5 barrel of crude oil per ounce, but meeting resistance at 9.25 barrels this year. Gold might outperform crude oil, if Arab oil kingdoms in the Persian Gulf decide to allocate more Petro-dollars to gold, in a flight to safety from the Ayatollah of Iran.

Pension funds poured money into crude oil, base and precious metals in March, putting the “Commodity Super Cycle” back on track after a period of consolidation in February. There are about 10,000 hedge funds managing up to $1.5 trillion in assets around the world, and institutional investment in commodity index funds has topped $80 billion. Former Fed chief “Easy” Al Greenspan, was quoted in January, saying gold’s rally did not reflect heightened inflation expectations, but rather geo-political tensions around the world. With the yellow metal bumping up against $600 per ounce level, its highest in 25-years, perhaps Gold knows what no one knows!

Wading into gold.

If a stock market correction is coming soon in the U.S., one subscriber recently inquired, will foreign stocks also suffer badly? And how will the stocks of natural resource companies fare?

I cannot know the unknowable, of course. But I can hazard a couple of guesses and offer a couple of suggestions. First off: I too believe there is a correction coming – and potentially much more than a correction. While nothing is guaranteed, we could be lining up for a 1987-style market crash, with all that entails. If we see such an event, I doubt foreign stocks will be spared in the short term. Here and now, the bulls are practically baying at the moon. Everything seems to be going up and up (except government inflation numbers). Bears have gotten trampled. There is talk of global slowdown, but the reality has not taken hold just yet. Copper, otherwise known as “Dr. Copper” or “the metal with a Ph.D. in economics,” is rolling along at historic highs. Steel stocks, sensitive to industrial demand, are carving out new highs too. Liquidity channelers like Goldman Sachs are at the absolute peak of their earnings cycle – making more in the most recent quarter than in the entire 2002.

Ominous signs are also building. Protectionist sentiment is on the rise, even more so in Europe than in the U.S. The housing bubble has not popped, but it is clearly hissing. The consumer-spending gas gauge is moving closer to “E”, even before adjustable-rate mortgages begin adjusting much higher. Long bonds are breaking down. The Middle East situation is fraying badly at the edges (and Middle Eastern stock markets have already crashed, by the way). Emerging markets in general look vulnerable.

The bulls are still in control, but the bears are not vanquished yet. At some point, the credit-driven liquidity boom has to end, and it will likely end badly. Still, it could be six days, six weeks or six months before things come apart at the seams. Our markets could be even higher at that point – much higher. And who knows how energy and metals will respond to stepped-up global turmoil? Depending on the circumstances, it could help as much as hurt, even with the walls falling down all around. So what do we do in these turbulent times?

First, work from a long-term thesis. Second, work out a plan and stick to it. The thesis regarding precious metals – which we have reiterated many times over the past year – can be summed up in one phrase: All roads lead to inflation. If the government continues to fudge the statistics and run the printing presses, gold and silver will continue to rise in secular bull market fashion. Alternatively, if liquidity dries up and a deflationary spiral sets in, the Fed will eventually be forced to “inflate or die”, pulling out all the stops to avoid a Great Depression scenario.

The thesis regarding energy and infrastructure is a bit more complex, but still fairly simple. Between the ramifications of Peak Oil and the long-term implications of developing world growth, we are in the early stages of an energy bull market that could last another 5 to 15 years or more. Furthermore, we have barely begun to address the world’s 21st-century infrastructure needs. There are many years’ worth of work to be done.

So if one is mostly on the sidelines, better to jump in now or wait? The problem with waiting is you do not know how far things will go before the big downdraft comes. It might be a long way off yet. And it might be smaller than you expect when it comes. No two ways about it, the ride is going to be wild at times. So do not plunge in all at once. I suggest putting cash to work a little bit at a time. The investor’s key trait is patience, defined by some as “the art of waiting without tiring of waiting.” This includes waiting out the pains of corrections, resisting the urge to cut and run when the chips are down. A good investor can handle a sharp setback, because he or she is focused on long-term objectives.

The trader’s key trait, on the other hand, is flexibility. If you want to use tight stops and take profits on run-ups, that is excellent – as long as you are willing to monitor things closely, make consistent decisions and re-establish positions at the appropriate time. The trader has more active responsibility than the investor, and willingly embraces that responsibility. It is not a question of which mentality is better, but rather which mentality better suits you personally.

Already this year, most oil and metals stocks have subjected investors to gut-wrenching volatility. Expect more of the same. The energy and metals markets are likely to get even wilder, making a solid plan that much more critical. I expect the bull market in gold, silver, oil and most other natural resources to last another 5 to 15 years, but I also expect harrowing price drops along the way. In other words, think of the resource stock sector as shallow pool: “No Diving or Jumping.” Wade into the water slowly and enjoy the refreshing long-term gains.