Finance Digest for Week of April 17, 2006

DEFLATUATION IN SILVER AND GOLD

Other analysts have consistently made the point that inflation and deflation can only be measured in terms of increases or decreases in the quantity of money supply. Although I must agree philosophically, my concern is how much things cost and how little I have left after paying the ever higher costs of rising bills. Rather than argue with others about definitions of inflation and deflation, the Optimist chooses the more productive path of defining the new terms of inflatuation and deflatuation to mean what seems intuitive to him. Note to readers: This is a serious discussion, and the Optimist will not take kindly to odiferous puns about FED inflatuation in handling the nation’s money.

The Optimist confesses that in his youthful and less experienced past, he considered that deflation (which he thought of as paper money buying more essential stuff than it did previously) was possible only if the FED made a decision to push the U.S. economy into a deflationary recession worse than the 1930s. Since the political pressure would increase at least as fast as the nation’s economic pain, the Optimist concluded that our fearless leaders would not be cowered into a deflationary retreat to honest money when they could continue to boldly advance by simply printing more paper at a faster rate. Although that is still the way that he wants to bet, the Optimist has reexamined the terms he has used a little too loosely, and he has come to a new conclusion. The newsletter writers who talk endlessly about deflation are right, sort of, but their projected timing is too far in the future. The correct answer is that the real money gas is exiting financial bubbles now as we speak, and that deflatuation is not only our destiny, but it is our inescapable present as well!

How does one measure costs? What is real money? We are finally beginning to get into meaningful content. The Optimist considers essential items to be food, shelter, energy, medical, clothes, and transportation. The millions of other goods (ranging from computers and electronic toys to expensive imported cars and caviar) and services (from mega store greeter to mud bath massager at exclusive resort spas) are all relevant to the overall price environment, but differ from essentials in one very significant way. People must buy essentials regardless of the price, but people can choose to do without a few of the non-essentials, many of which did not even exist a decade or two ago.

How has the USA measured costs for the last hundred years? The obvious answer is that goods and services have been priced in dollars for more than a century. Well, hopefully those who have previously read the Optimist’s work will not be too surprised to see a different perspective here. The USA has actually used three different currencies during the last century. Until 1933 when FDR confiscated gold, everything was priced in gold and silver. Paper certificates really were as good as gold and silver since paper was freely interchangeable with the real precious metal which backed the value of the paper. Between 1933 and 1971, everything in the USA was priced in a different type of dollar. Although Americans could still exchange the new breed of dollar for silver, only foreigners could get gold for the dollar. After Nixon slammed shut the foreign gold window in 1971, the Federal Reserve Note (FRN) was only a piece of paper which people continued to accept in payment, but only because they had no alternative to doing so.

So what happened to the value of gold during the transition from a dollar that was as good as gold before 1933 to today’s FRN that is just printed paper? The answer is that nothing happened to the value of gold over more than the past two centuries. A ounce of gold in the 1800s was still an ounce of gold in the 1900s. An ounce of gold today continues to be worth an ounce of gold, and it will likely retain that same value for the foreseeable future. Despite the deterioration in the value of paper since 1933, the fact that an ounce of gold is always worth the same precious and desirable ounce of gold is one of the most enduring aspects which makes gold (and silver, for the same reason) real money that preserves purchasing power and truly provides a store of wealth. The price of gold and silver measured in dollars changes substantially but the value remains constant.

We cannot directly compare the dollar prices of gold, silver and all other goods and services over centuries because we are measuring prices the wrong way. Instead of calculating the number of dollars it takes to purchase an ounce of gold or silver, or any good or service, we need to use the stable value of gold to determine the changes in the prices of everything. For example, the current value of an average house is a little less than 400 ounces of gold. The easiest way to see whether we are in inflatuation (so that it takes more gold to buy essential things) or deflatuation (where less gold buys more significant stuff) is to look at charts which show the trends over time of prices measured in the constant value of gold. Since those charts are not readily available, the Optimist created a few example charts by dividing the FRN cost of things by the FRN cost of gold. The charts below show that the price when computed in ounces of gold of houses, stocks, oil, and most other commodities (measured by the CRB Index) may have risen in the past, but are solidly declining now. The currently declining prices (measured in ounces of gold with constant value) across the board demonstrates that we are now in a state of deflatuation, where real prices of essential things are consistently being reduced over time.

Some forecasters who evoke concerns about possible deflation comparable to the sharp price declines during the 1930s at the same time predict that the FRN price of gold will continue to rise. Their view is that gold is not only a great hedge against the obvious price inflation we see now, but that gold will also be a great hedge against the future price deflation they are sure lies ahead. The Optimist concludes that gold and silver FRN prices would suffer just like the FRN prices of everything else, if politicians and the FED made the hard decision to do the right thing and neither spend more than they have nor print additional FRNs. Although there are no certainties, the Optimist can offer his soothing perspective that there is little chance of politicians and the FED converting to the Austrian school of finances, and that there is less chance that politicians and the FED would withstand the extreme political pressures which deflation would generate. America may have been the first in many significant accomplishments through history, but I strongly doubt that we will be the first nation in history to choose to inflict a deflationary depression on its citizens.

So if there will not be deflation in FRN paper prices, but the values of essential items continue to deflate in their real value as measured by gold, what will happen to the FRN price of gold? The answer is that the future will continue to rhyme with the past. From 1980 to 2001, the real prices of stocks, houses and other essential items rose too high as gold was depressed by high real interest rates. For the foreseeable future, the real prices measured in gold of those items will correct back down in a continuing deflatuation of value, even as nominal prices in FRN paper ratchet ever higher for everything. People who use the term deflation inevitably think of the 1930s in America when the dollar gained value through deflation and then the dollar bought more stuff than in the previous decade. Since the dollar in 1930 was convertible to gold and silver, however, the dreaded deflation of the 1930s was really just another example of an increase in the purchasing power of gold. That deflation of 75 years ago was on a larger scale, but otherwise similar to the deflatuation process we see repeating today so that essentials cost less over time when the cost is measured in ounces of gold.

As a final note about real value measured in ounces of gold, consider lowly silver which still does not get enough respect in the financial community. Where houses, stocks, energy, and commodities all show real values which are in deflatuation compared to gold, the real value of silver is in inflatuation. Considering that there is substantially less silver than gold available for industry or investors, and that the continuing deficit in silver production versus consumption continuously reduces the amount of available silver, and that an inevitable recession will further reduce the amount of silver produced as a by-product of base metal mining, the Optimist is happy to reinforce the clear chart message so that all readers can be happy with maximizing the allocation of their investment funds for real physical silver.

What the U.S. government will not reveal about inflation.

There is a great scene in the movie “A Few Good Men” in which a Navy lawyer is grilling a U.S. Marine officer played by Jack Nicholson. “I want the truth,” the lawyer insists. “You can’t handle the truth!” Nicholson’s character barks. I hear this dialogue in my head whenever there is a question on whether the government’s Consumer Price Index is an honest gauge of living costs. I am convinced there is a much more insidious story that needs to be told as the bond and precious-metals markets gyrate daily over perceived inflation threats. If the full impact of consumer-price increases were accounted for, investors would have a lot more to worry about, and you should prepare for a threat that is much greater than Labor Department reports indicate.

The dollar is a swindle.

It is an imposter – pretending to be something of value. But neither Americans nor foreigners can seem to get enough of them. Their faith seems boundless. What are Americans going to do, we wondered, when the Chinese decide to stop taking dollars for their gadgets? And, when the Iranians and Saudis stop exchanging greenbacks for oil? What will Americans do when U.S. householders can no longer refinance their houses to close the gap between expenses and income? And, how will they pay for health care? How will they afford to retire?

This is not a problem for Americans only. The Western world has grown fat and happy in the last half a century. Generations of politicians have made promises that not even geniuses or saints could keep, and the lumps have been living on expectations that only rapid economic growth could meet. Western nations are not run by saints or geniuses, but by lunkheaded sinners. And rapid growth? In America, the average working man has seen no real gain in his disposable income since the Carter administration. Meanwhile, the growth is in the East. Wages are currently rising by 10% per year in both India and China. GDP growth rates are nearly as high.

The tadpoles can stop worrying. American wage earners and retirees can relax, too. Yes, they are losing ground compared to the skinny Asians, but what difference does it make? The dollar is a fraud, and they do not need so many of them anyway. But, we are ranting, aren’t we? What do we know? Nothing. Still, we have a theory! Our theory is that all institutions, bodies, societies, organizations – all things animal, vegetable, mineral – erode, degrade, and degenerate over time. That goes for the consumer economy, too. As time goes by, there are more parasites, leeches, conmen, grifters, anglers, idlers, kibitzers and no-account GS-6s globbing up the system. People begin by buying things they need with money they have saved. Then, they buy things they want with money they earn. Finally, they end up buying things they do not even want with money they do not have and will never earn.

That is what home equity extraction is all about. It is not savings. It is not earnings. It is dream money – money that came in the door while the owner was asleep. The giant swindle is that people think they are getting richer by having access to more dollars. They are suckered into spending and debt, like a lobster into a trap, believing they need more and more. But the promise of spending is as phony as the swindle itself. The more they spend the less they get for it. Before long, the real return on spending – as say, in eating too much, having too much surgery, too many mistresses, or too many soldiers throwing their weight around – is negative.

WHY A (LOOMING) BEAR MARKET CAN SEEM LIKE A BULL MARKET

It sure does not look like the makings of a bear market. Corporate earnings are still growing at a double-digit rate, unemployment is low, consumers are still spending heavily. Yet the stock market in 2005 stubbornly refused to reflect these conditions, with stock appreciation more than ten percentage points below earnings growth, and total returns for last year not much above those on medium-term bonds. There should be plenty of room to catch up in 2006, right? Unfortunately, after the strong start, the second quarter is beginning to feel a bit iffy, with worries about interest rates, oil prices, and global political tensions. Mid-term elections loom ahead. Will the bulls finally be vindicated this year? Or is it possible that the bears could be right and the market averages fall in 2006?

Bulls feel that in almost any given year, there is the potential for double-digit percentage earnings gains. And they would be right, because earnings (on the Dow or the S&P 500) have in fact risen at such rates more years than not since the early 1920s. Bears point out that hopes for a double-digit growth trajectory and corresponding gains in stocks are optimistic – because the average annual rate of earnings growth over the whole span has been only 5.5%. And they would be right, also. Results last year had fodder for both bulls and bears: Corporate earnings growth was in the low teens, but the S&P was up only 3% in price terms (almost 5% counting dividends). So how can both the bulls and bears be right?

The reason for this paradox lies in the fact that corporate earnings take a major tumble, of roughly 20%, every few years, thereby depressing average annual earnings growth. Suppose earnings went up at X% a year for four out of five years, and then fell 20% in year five, how high would X have to be to maintain the average growth rate at 5.50% a year for all five years? The answer is surprisingly high – 13.06%. Although earnings sometimes fall 20% in one year, stocks rarely decline that much. Stocks are not as volatile as earnings on either the upside or downside, which is why single-digit stock market gains are more common than single-digit earnings growth.

The last time that corporate earnings took such a tumble (down 17%) was in 2001. If it happened every five years, we would be looking at a similar event right about now. But it probably will not occur this year. It could have happened in 2004 or 2005, but did not. It can also happen in 2007 or 2008. I am a bear because I believe it will happen soon (in calendar 2007 with the U.S. stock market reflecting this in late 2006). It is optimistic to assume that a recession will not happen until 2010, which would trigger a market anticipation in 2009.

Bulls react strongly to positive reinforcement, because they are right more often than not, but they sometimes underestimate the impact that the occasional bad year can have on the averages. Bears, on the other hand, have a more realistic sense of the long-term averages, but sometimes overlook the fact that the market environment is actually favorable most of the time, even in secular bear markets (when stocks go up slightly more than 50% of the time, rather than almost all the time, as is the case in bull markets). Finding a good balance between optimism and pessimism is key to investment success.

SEEKING COVER IF THE PRICES OF HOMES FALL

You are worried that the law of gravity, as it applies to home prices, has merely been suspended, not repealed. Short of selling the attic (or a few outbuildings, if life has treated you very well), how can you hedge against a decline, if it ever comes? A cheap and practical solution may be on its way. The Chicago Mercantile Exchange expects to begin trading a series of futures and options this month that will allow homeowners and others to bet that indexes of home prices in each of 10 metropolitan areas – Boston, New York, Miami, San Diego, Washington, Chicago, Denver, Las Vegas, San Francisco and Los Angeles – will rise or fall.

Housing futures and options have the potential to help individuals manage the risk of homeownership, investment advisers say. They caution, however, that for that potential to become reality, sizable markets in the contracts, to ensure fair pricing, will have to be established first. When derivative contracts are listed, they are not necessarily traded – at least not in adequate quantity to make them effective hedging tools. Glenn Mueller, a real estate strategist at the Dividend Capital Group in Denver, is skeptical and is waiting to see how those markets develop. The idea underlying the contracts “obviously makes sense,” Mr. Mueller said. “When you’re trying to hedge risk and you can get someone to take the other side, you do it.” But he wonders who will take the other side, speculating on home prices to rise. One answer is portfolio managers looking to diversify into real estate without having to come around every month to collect rent checks and fix plumbing.

Many more constituencies would have reason to bet on a decline: mortgage lenders guarding against defaults and the prospect of holding foreclosed properties, builders concerned that their homes may fetch lower prices once they are on the market, as well as individual owners. Such lopsided interest could distort pricing, he warned, and furnish windfalls to professionals. Mr. Mueller advised homeowners to hold off “until there has been at least a year of trading and you can see there’s liquidity.” Christopher J. Cordaro, a financial planner in New Jersey, is hoping that institutional investors will take to the new vehicles and then “individuals can piggyback on it.” But he counseled against using them to gamble. “I really hope folks will stay away from that. You can lose a lot of money speculating. Leave that to the pros.”

“Buy and Hold” vs. “Market Timing” in real estate?

After the dot-com bubble blew up in 2000, “buy and hold” vs. “market timing” provoked a lot of debate among investors, though the argument always had to do with the stock market. Interestingly, the past two years failed to produce a similar discussion about real estate. But questions over buy and hold vs. market timing in that market now look a lot more relevant, given the number of people who imagined that they could “flip” an overpriced 3-bedroom home as easily as they qualified for the interest-only mortgage.

There is no point in trying to compare common stocks and real estate as investments – apples and oranges, etc. Still, I am sure that more than a few would-be real estate entrepreneurs told themselves that, unlike stock assets, they could at least rent the properties they could not flip within three weeks of closing. And they were right, as explained by an article in the Wall Street Journal. The story describes an investor who “bought a three-bedroom house in Stuart, Florida, for about $318,000 in late 2005.” He planned “to quickly flip the property by selling it for as high as $425,000,” only to discover that the market had gone soft. Thus the home has “been on the market since early January with no takers,” which brings us to the Plan B: He rents “his investment house out for $1,000 a month, while paying a $2,045 monthly mortgage and a $108 monthly homeowner’s association fee.”

Mortgage lending rates are rising, as is the number of unsold homes on the market. Existing home sales are falling, as is the median price of a single family home. The WSJ article quotes a real estate broker who used to have “2-6 showings a day,” yet who now laments that “we went three days this week with not a single showing. That’s incredible.” But there is nothing “incredible” about the early stages of this trend. The facts are more than credible. The question is not the direction of the trend, but how to stay ahead of where it is going.

Housing market: Up in ARMs?

Which one of the following does NOT belong? a.) Terrorism, b.) a stock market crash, c.) a soaring energy market, and d.) the resetting of interest rate payments on exotic mortgages. Well, according to a Chicago Tribune, ALL of the items on the list above fit together perfectly, as they aptly describe the four greatest obstacles to setback the American consumer since the start of 2000 – with “d” being the “next” hurdle to overcome.

Correct us if we are wrong but nobody we know signed the bottom line of some bank-authorized contract reading: “Yes, I agree in a few years time to pay the emotional and financial price of a deadly attack on American soil by Islamic extremists, the longest bear market since the Great Depression, and record-high oil prices.” Which means one thing: While the terms and conditions of these non-traditional loans have not changed, the attitude towards them has – especially now that PAYBACK time is here. These “exotic” mortgages allowed borrowers to enjoy a 3-5 year long “freeze"”period with rates locked in at 50-year lows. Enter spring thaw and the prevailing rates (currently at 31-month highs) are now owed – in addition to any principal withheld over that period for “interest only” loans. According to the Tribune piece, rate caps will expire on $300 billion worth of hybrid ARMs in 2006 and nearly $1 trillion in 2007, swiping $40 billion from consumer spending power. A grim scenario vividly described by one Associated Press piece as the big “Sting”, the ultimate “sticker shock”, and the “ticking time bomb”.

OK. We will give the mainstream a conservative handicap of loan sharks and scam artists who hoodwinked “innocent victims” into taking on these low-down, no-down mortgages. But the fact remains: Interest-only and hybrid adjustable rate mortgages (ARMs) made up 42% of home financing in 2005, versus 1.9% in 2001. For the most part, lending institutions have been giving borrowers exactly what they asked for: buy now, pay BIG later – a perfect set-up for a public who believes such risks will be rewarded by ever-rising home values, pay wages, and economic growth.

The problem comes when mass social mood turns down AND the same optimism which once saw sub-prime loans as the key to the American Dream will suddenly regard them as financial nightmares. This time, there is no mistaking who the Enron’s of the next phase in social mood will be. They will be the firms now peddling adjustable-rate, no-interest, nothing down and assorted other types of “sub-prime” mortgages. Today, we have just that – a “tidal wave shift away from” easy lending and laissez-fare TO the long-arm of the law; from don’t ask, don’t tell TO due diligence and a December 2005 mandate by the Office of the Comptroller Of Currency limiting the ability of banks to issue riskier loans.

DANGERS OF THE HOUSING MARKET DELUSION

Do higher house prices make a country richer? The answer is simply “no”. If the market value of the stock is raised, those who own it are made better off by as much as those who will buy their houses from them are made worse off. Higher prices merely redistribute income among residents, principally from the young to the old. So why do fast-growing economies tend to have soaring house prices and slow-growing ones the opposite? The answer is not that higher house prices make a country richer, but the opposite – the wealthier the country, the more expensive its housing. Of nine countries looked at, seven enjoyed relatively strong rises in real house prices over the past decade. But in two key cases – Germany and Japan – prices fell.

It is no surprise that the laggards have also been two of the worst performing high-income economies over this period, while Australia, France, Ireland, New Zealand, Spain, the UK and the U.S. have shown better economic performance. Why then should faster-growing economies experience strong rises in the price of housing? Scarce land increases in value as economic activity rises. More important, richer people spend more on better located housing. Disproportionate increases in prices are needed to ration the slowly adjusting supply in response to higher demand.

A risk also exists of self-sustaining upward (and on the opposite side of the cycle, downward) spirals: higher house prices lead to more borrowing and spending, faster economic expansion, still higher house prices, and so forth. When prices fall, however, declining housing equity, shrinking borrowing and spending and widespread defaults may generate a contraction in economic activity and in house prices. A big question therefore is whether house prices have overshot equilibrium levels. Where prices have risen far faster than underlying incomes, only two possibilities exist. Either prices have moved to a higher equilibrium level, in which case future purchasers will have to save more and consume less. That would itself have significant economic implications. Or they have reached an unsustainable level, in which case they will fall in real terms. That would have far more significant economic implications. The future will tell us which and where – possibly quite soon.

Real estate insiders go bearish in blogs.

If the secret worries of real estate professionals are any indication, home prices could be heading for a swoon. When Brad Inman of Inman News, which tracks the real estate industry and is widely read by industry insiders, recently gave real estate agents the opportunity to blog about market conditions, they almost uniformly described them as bad – and getting worse. “Normally, brokers and agents tend to sugarcoat the news; they don’t want to affect consumer confidence,” says Inman. “By letting them post anonymously, we gave them a way to really share their thoughts.” Most responded with tales of high inventories, slow sales and languishing prices. Usually, comments from posters tend to be very diverse, with no clear consensus. “This round of blogging,” he says, “has been conclusive; no one said the markets are great.” Inman sums up his blog-induced sentiments rather succinctly. “It scares me.”

ICELAND COOLS, RAISING WORRY OF WIDER CHILL

This tiny windswept island nation of 300,000 people has undergone one of the fastest, fizziest economic transformations in the world in recent years – one that is on par with the expansion enjoyed by many of the world’s fastest-growing emerging markets. Thanks to the opening of its financial markets and a flow of money from international investors lured by its high interest rates, Iceland has quickly morphed into a European mini-titan, with large business interests throughout Scandinavia, a red-hot housing market and a crop of young, wealthy entrepreneurs. The local stock market, only created in 1985, has been the best-performing Western market for four years in a row. Downtown Reykjavik is home to boutiques selling Dior eye shadow and Gucci handbags, snuggled next to ones peddling knit mittens and ceramics created by local artists.

But Iceland’s ascent has hit a speed bump in the past several months. Concerned that the economy has overheated, or reacting to macroeconomic changes in other countries, some global investors, including hedge funds, have withdrawn money from Icelandic markets. This pullback has caused the main stock index, the ICEX15, to fall 18%, and the currency, the krona, to weaken. These declines, some analysts say, run the risk of driving other investors away, creating a downward spiral that could have global repercussions. If nothing else, the analysts say, Iceland’s own economy could be in for a rough patch, serving as a cautionary tale for other emerging markets.

With a population on a par with a midsize city and a gross domestic product of around $10.3 billion, or just below that of Rwanda, Iceland would not seem to be on the radar screen of many financial experts. But analysts from Merrill Lynch, Danske Bank, Fitch, Standard & Poor’s and Moody’s Investors Service and economists around the world have weighed in, some expressing concern, others saying fears of an Icelandic meltdown are overblown.

Nicolas Bouzou, the chief economist of Institut Xerfi, a research concern in Paris, feels that Iceland could be the “butterfly’s wing” that sets off serious problems in capital markets around the world. That is because “many countries have the same macroeconomic configuration of Iceland,” Bouzou said recently, a “real estate bubble, very strong credit expansion and a very high commercial deficit.” The same could be said of New Zealand, Australia and even the U.S., he added. If investors lose money in Iceland, they will pull out of other countries with similar economic structures, he said. It is always a small event, Bouzou said, that triggers what he called “systematic crashes”. In this case, he said, the event could be a further decline in Iceland’s currency or stock market, or the country’s inability to pay off some of its debt – which some critics believe could be a possibility.

For Icelandic policy makers new to the global economic stage and unaccustomed to being the focus of international criticism over their finances, the negative attention is prompting a mixture of soul-searching and defiance. Still, the state of Iceland’s economy is better than it appears, said Thordur Fridjonsson, chief executive of Iceland’s stock exchange.

Various countries around the world are experiencing similar adjustment pains, as institutional investors comb new markets for high yields, pumping liquidity into areas that have rarely if ever been the destination of outside money. One particular set of investors is stepping back – those who have taken advantage of Iceland’s high interest rates by borrowing money in low-rate environments like Japan and purchasing higher-yielding Icelandic bonds. Their debt buying has helped Iceland’s total corporate and household debt to double since 1990 to 350% of GDP.

JAPAN’S GIANT SUCKING SOUND

On March 9, the central Bank of Japan (BoJ) signaled that the era of free money, known as “quantitative easing”, would soon begin to wind down. This change has spurred broad international commentary focused mainly on the timing of Japan’s return to normal interest-rate-directed monetary policy and the broad implications of this return for both Japan’s economy and the global economy. Much more significant, the end of quantitative easing will pull an enormous amount of liquidity from Asian and U.S. stocks and bonds, prompting widespread asset price depreciation and yen revaluation.

The BoJ first implemented quantitative easing in March 2001. At that time, nominal official interest rates had in effect reached 0%. This left the BoJ no scope to reduce official interest rates further to thwart the spread of deflation and a building liquidity crisis in Japan’s financial system. Because interest rates had become zero-bound, the BoJ began to pump liquidity into the economy and banking system by selling yen in the foreign-exchange market, by buying Japanese government securities and, most interesting, by funneling cash directly to Japan’s commercial banks via their reserve accounts at the central bank.

Quantitative easing initially had no discernable impact on Japan’s economy. Deflation became increasingly acute, the economy remained very weak and the accumulation of bad loans by Japan’s banks accelerated. After the spectacular failures of several corporations and financial institutions, the BoJ ramped up its quantitative-easing program in 2003 under the guidance of a new governor, Toshihiko Fukui. Fukui greatly increased the BoJ’s intervention in the foreign-exchange and government-securities markets (yen sales and purchases of Japanese government bonds). He used much of the excess liquidity generated by this intervention to funnel more money into the reserve accounts of Japan’s commercial banks. By the end of 2003, balances in these accounts increased from about ¥6 trillion ($51 billion) to more than ¥30 trillion ($256 billion), where they stayed until late 2005.

The flood of liquidity greatly improved balance sheets across Japan’s financial system. This was important because the size of problem loans in the financial system had become enormous, prompting foreign banks to shun Japanese banks because of very high counterparty risk (risk of bank failure). Unfortunately, this liquidity had no impact on bank lending, and domestic credit in Japan continued to contract, as demand for domestic credit remained very weak. The flood of cash into Japan’s financial system did not go anywhere in 2003 and 2004. Starting in 2005, foreign banks borrowed huge amounts of yen at very low interest rates in 2005 using a Japanese bank as a counterparty. This yen was swapped for foreign currencies and invested in other Asian countries as well as in the U.S.

Such swaps are generally conducted off-balance-sheet, meaning they are neither directly monitored nor controlled by the BoJ. However, exchange-rate movements between the yen and other currencies during 2005 offer some insight into the magnitude of these swaps. In 2005, the yen depreciated by 16% against the South Korean won, 13% against the Malaysian ringgit, 11% against the Indian rupee, 10% against the Indonesian rupiah, 9% against the Thai baht and 20% against the U.S. dollar. This broad depreciation of the yen was not driven by trade flows – Japan had a current-account surplus of ¥18 trillion in 2005. Nor was it driven by the net outflow of domestic investment into other countries. The net outflow of investment from Japan was only 7 trillion yen ($60 billion). Subtracting this from the ¥18 trillion current-account surplus leaves a combined trade and investment surplus in Japan of ¥11 trillion ($94 billion) in 2005. Under normal circumstances, this surplus should have produced yen appreciation.

Because the BoJ has not intervened in the foreign-exchange markets since the first quarter of 2004, off-balance-sheet Japanese swaps offer the only explanation for the depreciation of the yen last year. These swaps must have exceeded Japan’s combined trade and investment surplus of ¥11 trillion by at least ¥15 trillion, possibly ¥25 trillion. In other words, foreign entities borrowed between ¥25 and ¥35 trillion ($214 to $300 billion) from Japan’s banks in 2005 to invest in other countries. Much of this money probably found its way into equity markets across Asia. Likely candidates are South Korea, India, the Philippines and Singapore, where the stock markets jumped 59%, 36%, 25% and 17% higher, respectively, last year despite generally deteriorating political and economic fundamentals. Excess Japanese liquidity probably also found its way into Turkish and Brazilian equities and fixed-income securities, which also performed spectacularly in 2005 despite broadly deteriorating investment fundamentals.

Another likely place where excess Japanese liquidity roosted in 2005 is the U.S. bond market. U.S. bond yields remained remarkably low in the face of rapidly rising short-term interest rates last year. This performance has defied explanation by policymakers at the U.S. Federal Reserve, including both former chairman Alan Greenspan and current chairman Ben Bernanke.

The fountain of liquidity that supported stellar stock- and bond-market performances in many countries in 2005 will soon be shut off. BoJ governor Fukui emphasized that outright purchases of Japanese government securities by the central bank would continue and that official short-term interest rates would not change much this year. Fukui also mentioned that the BoJ had already begun to reduce the banking system’s excess reserves and that these reserves would decline from ¥30 trillion to about ¥6 trillion by the end of June. Because these reserves were never used to fund credit growth in Japan, their reduction will have little impact on the Japanese economy. However, the heavy use of these reserves to fund investments in other countries implies that their rapid reduction will have significant negative consequences for asset markets worldwide.

As Japan’s excess liquidity is mopped up, investors that borrowed Japanese yen to fund investments in other countries will find it impossible to renew their swaps. Because international currency and interest-rate swap liquidity is very concentrated in tenors of one year or less (the life of a swap is called its “tenor”), the majority of these swaps will mature this year. Consequently, investors will be forced to sell the equity and fixed-income assets that these swaps financed. In addition, these investors will have to buy yen to repay their yen loans. The end of quantitative easing is another factor that will propel a sharp correction in global investment asset values this year. It will also produce substantial yen appreciation against most currencies.

BULLS ARE RUNNING TO INDIA, RAISING FEARS OF A BUBBLE

Shashibhushana Reddy, a 28-year-old software professional with the local division of the Intel Corporation, has invested a quarter of his earnings in India’s equity markets for the last three years. Mainly choosing media, pharmaceutical and manufacturing stocks, he has seen his investments triple as he rides a boom in the country’s equity markets. Now Mr. Reddy is preparing to get even more aggressive. “Indian companies are doing extremely well,” he said, “and I plan to soon start investing half my earnings in the stock market.” Thanks to investors like Mr. Reddy, the bellwether Sensex stock market index in Mumbai soared 45% in 2005, and it has already risen 20% in the first three months of this year. The impressive gains have been spurred by India’s surging economy, which posted a growth rate of 7.5% last year.

At the same time, the country has attracted more overseas investors, who poured $10.7 billion into Indian equities in 2005, and $4.13 billion in just the first quarter of this year. But analysts and fund managers are cautioning that the stock market pendulum may have swung too far, and they warn that some companies are highly overvalued. “India has never had this kind of sustained economic growth; therefore, price-to-earnings ratios of companies are in uncharted territory right now,” said Satish V. Betadpur, president and chief investment officer of Anagha Capital Management, where he manages $120 million in global hedge fund money. So buoyant is the sentiment that an initial public offering by Reliance Petroleum – the largest in India so far this year – sold out in minutes last week.

FISTFULS OF DOLLARS

Large gains are piling up in commodities markets and prices are surpassing levels that are well beyond those dictated by demand and supply calculations. Some commentators and journalists have even raised the “B” word (bubble) with respect to these gains. The largest gains have accrued to industrial and precious metals with copper, zinc, aluminum, silver and gold that have each marked multi-decade high levels. Increasingly, the stock explanation of “soaring demand from China and India” can no longer explain the surge in the prices of these commodities. We believe that something larger and potentially more troubling is afoot.

As we search for explanations we find little in the last quarter century by which to compare the current commodities boom and its implications for contemporary financial markets. However, this much we do know, investors can put away the market handbook of the last financial era, which ended in 2000. This handbook in hindsight can be summarized in two lines: “Buy the dips in U.S. stock and bond markets. Hold and never sell.” Following these two guidelines over the last bull market has minted millions of millionaires in the U.S. who have by skill (few) or by chance (most) invested their money in stocks and long duration bonds. This largely accidental achievement has inured both professional and amateur investors to easy success and a belief that these markets always go up. They are not aware that the handbook’s two line rule is not a coda. The context and circumstance that made following the handbook’s rules so profitable no longer exist: disinflation, declining interest rates, a rising dollar and declining real costs for raw materials (i.e., commodities). Investors still betting on a “buy the dips” strategy are in for a surprise.

After a bear market, and a cyclical bull market, the factors that converged to bring about the greatest bull market in history are now reversing, permanently. Without manipulation of government statistics, inflation would be rising steeply. Interest rates of all maturities are now rising. Commodity and raw material prices have been rising for 5 years now. Critically, the dollar, after a year’s hiatus is declining again. This is a unpleasant concoction for U.S. financial markets. The predicament of the dollar in particular has malevolent implications that will define the next epoch in financial history. However, after screaming about the dollar and imbalances (the twin deficits) and interest rate conundrums, critics of the dollar and U.S. finances have grown subdued. This has emboldened the dollar’s apologists to make their case.

Our view is that the U.S. dollar is a diseased currency, afflicted by the widely known but largely undiscounted twin (budget and current account) deficits and its economy dominated by speculation and debt driven consumption. We think that the precipitous rise of industrial and precious metals are leading indicators of wider price increases in all dollar denominated commodities that will lift inflation and interest rates in the U.S. This view is still filed under “crank and crackpot theories” by most financial analysts and commentators. After years of predicting a dollar crisis without success, cranks and crackpots predicting the currency’s demise deserve their notoriety. Yet, even a casual observer can see that the current environment is ripe to catalyze a crisis. Alan Greenspan, the man responsible for the dollar’s sad predicament, thinks a devaluation of the dollar is both “unlikely” and “probably ill advised.” Thanks Al. We will check back with you after the housing prices have collapsed and the dollar broken by soaring inflation.

The U.S.’s reserve currency status does allow it more options than a country like Argentina. It can choose to “break the bank”, i.e., maintain the value of the dollar or “break the dollar”, i.e., save the economy. By this we mean that the Fed could raise interest rates precipitously to defend the dollar but will not. Instead they will allow the dollar to sink by keeping interest rates low. Congress pandering to a suddenly pathologically insecure electorate is readying protectionist legislation and a pork filled 2007 budget, that could precipitate a “break the dollar” event.

As we wrote earlier, recent history is a poor guide for what is occurring today in financial markets. However, history does provide a central lesson: times change, human behavior does not. The real fundamentals in financial markets now and forever are fear, greed and fairness. Using such an analytic framework we can begin to construct a vision of what lies ahead for investors. Extrapolating the lessons of the last bull market that ended in March 2000 to the contemporary period is a strategy for maximizing losses and minimizing gains.

A BULL MARKET GOODBYE FROM DUBAI?

Ever wondered if the tallest buildings around the world are significant beyond their awesome engineering? Our analysts remind us that the Skyscraper Indicator was devised in the 1940s to show the relationship of the tallest buildings to price tops in financial markets. How big is this peak? The closest precedent is what happened in the late 1920s. At the tail end of the 1920s Americans experienced an unprecedented level of prosperity with no apparent end in sight. Though the Great Depression would soon wipe out many of those gains, three landmark buildings on the New York City skyline – the Chrysler Building, the Empire State Building, and the Manhattan Company Building [40 Wall Street] – remain as tangible reminders of the enormous ambition and exuberance that characterized the era. All three buildings were conceived in the bull market and built through the peak, only to open for business amidst the worst market for office space for decades on either side. That great race to be the worl’qs tallest is the building frenzy Edward R. Dewey used to identify the “Skyscraper Indicator” back in the 1940s.

The latest “race to the sky” also features three contenders, in Malaysia, Taiwan and Dubai. But this time, the first two skyscrapers actually held the title of world’s tallest for only a few years, eventually exceeded by an even taller monument to another regions’ euphoric surge in social mood. Dewey originally observed that the “world’s tallest” sell signal for stocks is given when a tower is conceived because construction takes a while to complete. A new world’s tallest building is invariably occupied only in the aftermath of the bull market that gave rise to its creation. All three of the new ones fit this profile, as the Malaysian market doubled-topped in 1994 and 1997, before the completion of the Petronas Towers; Taiwan peaked in 2000 ahead of the 2004 completion of the Taipei 101 building. Now, the Burj Dubai is being built through the wreckage of a crashing Dubai Stock Index. At 800 meters, the Burj will be close to half a mile high, more than doubling the Empire State Building’s 381-meter height.

WHY BULL MARKETS GO UP FOREVER

The following piece documents the remarkably similar reasons why the bull markets of 1929 and 2000 were unique and should run forever. Despite this reasoning and with remarkable fidelity, they both lasted for 116 months. That is from the top of the last business cycle with the old era of inflation to the euphoric climax of speculation. The enthusiasms in projecting most new financial eras seem to naturally group into four main reasons. The first is the new era itself, followed by the political shift from left to center as CPI inflation diminishes with rejuvenation in Europe and opening of new consumer markets. Other points are the celebration of high technology and cost-cutting which were prompted by intense price competition in a disinflationary period. The end of the old era of inflation also provided the appearance of new found discipline in monetary policy.

“SELL STOCKS” ADVICE REVISITED … AND REITERATED

On March 20th, I issued an unequivocal sell recommendation on stocks. If you wish, you may categorize the missive at hand as an unequivocal reaffirmation of the March 20th recommendation. After the close yesterday (April 18), I posted the following on the GRA website: “Can +195 points on the DJIA be a bearish development? I think it can, and I will do my best overnight to explain why. I was hoping to use the time to catch up on some other research material, but something like today, occurring when it did and for the stated reasons, simply cannot pass without comment. The piece will be short, and I will try to have it out before the open tomorrow.” Here goes.

Several months ago, I observed that two of the three U.S. financial, markets – debt and currency – might very well have tougher sledding in a climate in which there was uncertainty about what the Fed was going to do on a forward basis, versus the one we have been in. The climate we have been in has been one of relatively high certainty about the succession of rate hikes that commenced in June 2004. At the time, the above view was expressed in response to what was yet another attempt, albeit another premature attempt, by Wall Street bulls to promote into higher stock prices “the Fed is almost finished” mantra. Yesterday, the bulls believe they finally got what they have been so arduously hoping for. In the process, they may also wind up getting some fallout for which they had not been hoping nor will they especially enjoy.

What they did want and get came in the minutes of the FOMC’s March policy meeting, released yesterday afternoon: “In the Committee's discussion of monetary policy for the intermeeting period, all members favored raising the target federal funds rate 25 basis points to 4.75 percent at this meeting … Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy.” The bullish camp placed inordinate emphasis on the above passage. Inordinate in that there was plenty of other material you easily could construe as being in conflict with it. A major portion of the minutes appears in the excerpt at the conclusion of this missive, but I implore people to read the document in its entire context.

Now that the Fed has wended its way through a succession of 15 rate increases over almost the last two years, I think there is a growing list of criticisms you can lodge against how this was handled and what it has accomplished. Start with the fact the Federal Funds Rate never should have been taken to a trough of 1% to begin with. How that came about and what took place afterwards can be laid squarely on the shoulders of Alan Greenspan and his practice of end-justifies-means leadership. This variety of governance has now infected and corrupted, at least on an intellectual level, most of Washington. In my view, it poses a huge threat to the well-being of the Republic! And has the 375 basis points in a higher Federal Funds Rate really accomplished much more than simply making everyone’s cost of money a good deal more expensive? Using money measures M2 and M3 as guides, we have more expensive money with no serious contraction in its availability.

Of course, in the Greenspan/Bernanke New World Order of Fed governance, we are no longer allowed to have M3. The “official” reasons provided by the Fed were moronic nonsense! M3 is the broader, far better gauge of liquidity creation. If you were the Fed and wanted to foster long-term trendline growth of around 3.5%, give or take, in real GDP, there is no way you would be permitting M3 to grow at the 2/2006 vs. 2/2005 rate of 8%. Unless, of course, your motives were different than the ones publicly stated. And something else that bothers me – a lot – is that a variety of communications strongly suggest that a majority of the FOMC’s members are making monetary policy on the basis of actually believing the government’s shoddy data, the inflation data in particular.

What I want to emphasize here is that Fed’s monetary policy of years standing has created such a mess that an intended result in one area presents the major risk of unintended consequences in others. And now that the Fed clearly is signaling its desire to throttle back on rate increases, the likely unintended consequences, at least in my opinion, will be seen in the behavior of the dollar’s exchange-rate value and of open-market, longer-dated interest rates. In my view, the behavior, on balance, will be of the negative variety. (The possible policy shift that has been signaled is not likely to hurt the rise in prices of many commodities, though.) As to the dollar and bond prices, the negative behavior already has begun.

On the other hand, yesterday’s release of FOMC minutes certainly gave the Fed what it wanted in stock prices. However, I think yesterday’s rally, along with its probable follow-through into at least a portion of today if not a bit beyond, merely represents “an absolutely wonderful gift for people who have been dragging their feet in raising cash!”

For stocks, is this as good as it gets?

Awfully nice rally on Tuesday. But there is something awfully familiar about it. In fact, it feels like the major gauges were at the levels they hit Tuesday just a few weeks ago. Not to mention a few weeks before that. This could speak to the resilience of the stock market, or it could suggest that the market is in the process of “topping out” – in other words, the recent rally may be over.

“Markets don’t make a top and then slide, topping is a process,” said Barry Ritholtz, chief market strategist at Ritholtz Research. “Typically markets make an initial top, back off, try to surpass it, and can’t do it.” This process repeats itself a number of times until the market stops trying to surpass that earlier high. That high may have been hit near the end of March or early April, which would mean that this current advance is as good as it is going to get for the major gauges for a while. Technical and seasonal factors suggest the market has peaked.

“There’s long-term resistance for the S&P 500 around 1310,” said Katie Townshend, chief market technician at MKM Partners. “It certainly feels like we’ve topped out.” Why is that? First and foremost is the age of the bull market, she said, which dates to when the major gauges hit bottom in October 2002. At 3½, the current bull is one of the oldest on record. In fact there are only five in history that have lasted longer than the current one, according to the Stock Trader’s Almanac. As the bull has gotten more mature, it has lost steam. “The most recent push to new highs was with far less momentum than what we saw earlier in the advance,” Townshend said. The most recent leg of the rally has also seen retail investors jumping in at the strongest pace in several years. And while that would seem to be a plus for stocks, it often means the best of the run is over. The S&P 500 could easily flip-flop, retesting the recent highs a few more times. But beyond the short term, a big correction looks to be brewing, Townshend said.

ROGERS SAYS GOLD TO REACH $1,000 AS COMMODITIES SOAR

Jim Rogers, the former George Soros partner who foresaw the start of a commodity rally in 1999, said the boom in energy and raw material prices will drive gold to a record $1,000 an ounce. “The shortest bull market for commodities lasted 15 years, the longest 23 years,” Rogers, 63, said in an interview. So if history is any guide, “they’ve got a long way to go.” Crude oil, copper and zinc prices are at records as hedge funds and other speculators seek greater returns than from stocks and bonds. Supplies have been curbed by low investment and output disruptions, making it harder to meet demand led by China, the fastest growing major economy. The Goldman Sachs index of 24 commodities has more than tripled in seven years.

“Supply and demand is terribly out of balance for nearly all commodities right now,” Rogers said in Singapore April 17. “This is not a bubble.” Bullion for immediate delivery reached a 25-year high of $624.80 an ounce today, still below an all-time peak of $850 for spot gold in 1980. Crude oil rose to a record $71.60 a barrel in New York yesterday and copper gained the most in nine years. “Gold at $1,000 is attainable, but to achieve it we’ll have to see a further deterioration in the macro-economic environment leading to a decline in the dollar,” said Hong Kong-based Alastair McIntyre, head of marketing at ScotiaMocatta, the bullion unit of the Bank of Nova Scotia. “Jim Rogers is a respected figure as he saw the move in commodity prices before it happened.”

The Goldman Sachs Commodity Index has increased 13% this year, compared with a 4.8% gain in the S&P 500 stock index. Benchmark U.S. Treasuries have lost about 1.6%, according to Merrill Lynch indexes. “Nearly everything makes a new all-time high in a bull market,” said Rogers. He did not predict when gold would reach $1,000 an ounce.

“Nobody has discovered a major oilfield in over 35 years,” Rogers said. “All the major oilfields are in decline. Unless someone does something quickly, the price of oil is going to go a lot higher over the next decade.” He depicted a similar scenario for metals. “Nobody has opened any major mines anywhere in the world for many years and it takes a long time to bring new mines on stream,” he said. “All the old mines are in the process of being depleted and demand is continuing to grow.” Agricultural commodities may offer new investment opportunities. “That’s where prices have moved least.” Cotton prices are more than 50% below their all-time high; soybeans are 60% below their peak and sugar 80%, Rogers said. “These agricultural commodities are very cheap on any historical basis.” The commodity index fund he started in late 1998 has more than tripled.

Why metals stocks have not peaked.

Is it too late to buy into the boom in metals stocks – everything from gold to silver to copper to iron to zinc? After all, flashy gold stock Goldcorp (GG: NYSE) is up 130% or so in the last 52 weeks, and plodding copper stock Phelps Dodge (PD: NYSE) is not far behind, with a 90% return. Or does the current boom in metals have longer to run, making this a good time to buy despite gains like these?

Investors looking to answer such questions should take a clue from the boom in oil prices, particularly from a theory called Peak Oil. The analogy is not perfect – the commodity markets for metals are much smaller and much more speculative than the market for crude oil. But applying a theory that I am calling “Peak Metal” argues that while short-run risks have risen recently, the boom in the prices of metals and metal stocks is a long, long way from over. Over the long term, the only thing likely to derail it, in fact, is a big slowdown in the global economy – and therefore in global demand. And that does not look likely in either 2006 or 2007.

Peak Oil is a controversial theory that argues that, sometime soon, global oil production is due to hit a peak. After that point, no matter how much money oil companies spend on exploring for new oil and developing new reserves, global oil production will not go up. After a period of stagnant production, global production will indeed start to decline. Most of the controversy about Peak Oil involves shouting matches about when – if ever – this peak will occur. Estimates range from now to 2008 to 2020 to never. To me, predicting the date for peak production is an interesting parlor game. Given the immense ignorance we have about the true levels of production and reserves in major oil producers such as Saudi Arabia and Russia, I simply do not think it is possible to come up with a specific year.

But I find the mechanisms that Peak Oil theory has developed to explain the direction of oil prices and the operation of the oil market immediately applicable to the metals sector. As oil production moves toward the peak, oil also becomes harder to find. Discoveries are smaller and in less-accessible regions or geologic formations. And it costs more to produce the crude from these discoveries. Producing oil from existing fields also gets more expensive. Recovering the marginal barrel of oil requires more technology, more equipment and more dollars than recovering the first barrel. As oil prices rise, it does become profitable to exploit alternative oil deposits, such as Canada’s huge oil sands reserves. These new sources and substitutes are more expensive to produce than oil used to be. If they were not, they would have been put into production during the days of cheap oil.

Similar Peak Metal factors make me want to rush out and add more metals stocks to my portfolio. It is becoming harder and harder to find significant new deposits of everything from gold to copper. When new deposits are discovered, they are in politically riskier countries. Production costs are higher in newly discovered deposits. Mining companies are even more conservative about adding new production than oil companies – scarred by the boom-and-bust cycle of an industry that is even more cyclical than oil, are so far sticking by their pre-boom projections for the prices of their commodities. And nothing comparable to the alternative supplies in the oil sector – such as oil sands and oil shale – has occurred in the metals sector.

But one difference between the markets for oil and metals gives me pause: The commodity markets for metals are so much smaller than the commodity market for oil that it is much, much easier for speculative demand to drive up the price of gold, silver, copper, etc., than it is to drive up the price of oil. Not that the price of oil has not moved up and down as speculative cash has flooded in and out of the oil market. But it took the anticipation of two huge hurricanes – and then the passing of those storms – plus the prospects of major geopolitical upheaval to produce a 10% to 15% swing in oil this year and last. In the much smaller gold and silver markets, all it takes is the launching of an ETF or two. Gold and silver have been driven higher on the projected launch of funds that let retail investors buy the commodities. The launch of gold ETFs pushed gold prices up 12% in the 90 days before the ETFs were actually launched. (Prices fell 10% in the 90 days after trading in the ETFs began.) Silver is now going through the same process. Barclays Global Investors, the backer of the silver ETF, estimates that demand for its ETF will require it to buy 130 million ounces of silver, or 12% of global silver demand.

So where do I come down? Yes, in the long term I believe the metals boom will run for the rest of the decade – or until a downturn in the global economy puts the kibosh on demand for all commodities. And, yes, in the short term, I believe that flows of speculative cash have pushed the prices of all the metals, but especially silver and copper, to heights where they have become unglued from the positive long-term fundamentals. (Gold, the first choice of investors in any crisis, is, as always, a special case.) In the jargon of Wall Street, they are ahead of themselves. I would not sell positions in this sector that I own, but I would not add new positions just yet. For that I would wait for a sharp little correction. Nothing too big, mind you. But enough to take gold and silver off the front page of The Wall Street Journal for a while.

Copper Prices: Brewski-High

According to a Pittsburgh Post Gazette article, for many in the business of making money Kappa Kappa Gamma’s next slamm’n, bamm’n beer bash is just the place to be – at least AFTER the kegs have been tapped that is. Turns out, thanks to the intoxicating winning streak in copper prices to record highs, the tanks used for brewing beer (typically lined with the red metal) are being converted into scrap and sold on the black market for big bucks. Technically speaking: The 37% gain in copper futures so far this year has lifted the price for scrap metal from $1.67 a pound to today’s going rate of $2.20. And if ain’t barrels of Brewski, many thieves are taking the not so Budwiser approach of stealing copper pipes out of the walls in buildings slated for demolition AND even those under construction in developing neighborhoods.

Pure and simple – a penny saved these days is a penny potentially TURNED into scrap as one Associated Press piece observes: “Another rise of the same magnitude would make the metal content in the U.S. one-cent coin worth more than its face value.” As for WHY we are at that level in the first place – well, in the words of the mainstream experts, “robust demand from China (the world’s largest consumer of copper) will likely outpace production.” Connect those dots, and you have got a market factoring in a potential supply deficit.

Problem is, the laws of supply and demand do not make much cents in the real world of market trends, as this March 20 report by the International Copper Study Group makes plain: In December 2005, “mine utilization was up to an amazing 98%,” while year-end supplies experienced a “SURPLUS by 2,000 tonnes.” In 2005, copper prices rocketed 40% HIGHER. Here is a penny for these thoughts: External factors are not behind the rally in copper. The trend in mass social mood, as reflected by the wave patterns unfolding in prices IS.

Blowoff!

The $3.00 copper price is a freak. It is the love-child of commodity fund money and wonton speculation. There is just something about this creature that is not quite right. 16 out of the last 20 trading days, the copper price has advanced, gaining 30% in the process. This just does not feel right, especially when the U.S. housing market is slowing noticeably. Therefore, as the frothiest of the frothy commodity markets, copper seems the most vulnerable to a sudden and painful reversal of fortunes. We still love commodities – copper included – for the next five years, but we love them somewhat less (We never say “hat”q) for the next five weeks. The price action in most commodity pits is way too frothy, and the fundamental connection between price and demand is way too tenuous. As the chart below illustrates, parabolic price spikes in the commodity markets are as numerous as stalagmites in Carlsbad Caverns. The base metals have been conspicuously strong.

As long-time commodity bulls, we certainly do not object to rising prices. But we do object to falling prices, which is what we fear we might be seeing very soon. Asset prices have an uncanny way of falling very sharply – and very suddenly – immediately after they have been rising parabolically. In other words, we are delighted, but terrified. This delicious combination of emotions may be appropriate in a roller-coaster car … or maybe even in a bedroom, but not while sitting in front of a quote screen.

No market terrifies us more than the copper market. At $3.06 a pound its price is double that of one year ago. Maybe the price spike is warranted, but we doubt it. China’s economy may be booming, as the copper bulls never tire of mentioning, but the housing markets in the Western world are slowing noticeably. U.S. construction industries consume about 10% of the world’s annual mined supply of copper. At the margin, therefore, a slowdown in U.S. residential construction could influence the copper price. And if a slowing housing market is indicative of broader economic weakness, the copper price could fall dramatically. But fundamental influences like these seem as irrelevant to the copper market as prime-time TV to an earthworm.

The copper market is doing what it is doing, mostly because rivers of speculative money are pouring into the market. The Marketvane survey reports that 96% of commodity advisors are bullish on copper. Obviously, that is the highest bullish reading ever, and a terrifying sign of irrational exuberance. As we have pointed out on several prior occasions, commodity fund money is flooding into all corners of the commodity world. And as it sloshes around in these markets, it sometimes creates freakish prices. $3.06 copper is one of those freaks. To repeat: The upside blowoff in copper is the lovechild of fast money and wonton speculation. We do not wish to preach to the market, but neither do we wish to engage in its orgy.

“PSYCHOLOGY TODAY” … BUT NOT YESTERDAY?

When prices are rising, yet the facts show a balance in supply & demand, it is hard to blame the former on the latter. Still, this is exactly what we have heard for more than a year regarding crude oil, as in “rising demand from China”, “civil unrest in Nigeria”, etc., even though supply and demand stayed in balance the entire time. But when prices go up even as supply inventories climb to an 8-year high (as commercial crude oil did last week), well, someone is bound to have a fit of common sense and realize that supply & demand ain’t the issue.

Thus the Wall Street Journal at least tried to delve into an explanation besides supply and demand, in a page one piece which began this way: “Crude oil closed above $70 a barrel for the first time, highlighting a phenomenon reshaping the petroleum world: Investment flows into oil futures are supplanting nitty-gritty supply-and-demand data as prime drivers of prices.” Not what we would call a bull’s eye, but at least this did not miss the target altogether. With a bit of editing the second sentence could have said, “Investment flows into oil futures are the prime driver of prices.”

Alas, fits of common sense among the financial media tend to be incomplete and short-lived. “Investment flows” is a shorthand phrase for psychology – that, in a word, is what has ALWAYS been the “prime driver of prices” in the financial markets. What is more, psychology itself cannot be supplanted as the price driver, any more than humans can be “supplanted” as investors. We also know that human behavior is patterned, thus predictable within a range of probabilities.

RISING YUAN PUSHES CHINA UPMARKET

If the U.S. persuades China to push up the value of its currency, there could be some unintended consequences: imports of $300 shoes and computer-controlled machine tools from China instead of T-shirts and plastic toys. In the short run, a stronger currency may encourage China to buy more General Electric turbines and Microsoft computer programs. That is why officials in Washington have pushed China for several years to allow the currency, the yuan, to rise sharply in value. A currency appreciation would make Chinese exports more expensive in foreign markets and foreign goods more competitive in China.

The yuan has risen against the dollar by 3.3% since July, and already there are side effects: businesses across China are concluding that their survival may depend on following Japanese and South Korean companies up the economic ladder as quickly as possible, selling more advanced products with fatter profit margins. As a result, China is gradually moving from competing with countries like Thailand and Indonesia to vying with South Korea, southern Europe and eventually, with the likes of Germany, Japan and the U.S.

The Hunan Huasheng Industrial and Trading Company, a 15,000-employee manufacturer in central China that produces shirts, pants and skirts made from linen and ramie, has invested in better sewing and cutting equipment. Higher quality has allowed it to shift from supplying Wal-Mart to manufacturing for Gap, Perry Ellis and Liz Claiborne, said Jeff Mo, Hunan Huasheng’s VP. “We are competing with the Koreans,” he said. Guangdong New Zhong Yuan Ceramics in a nearby city, Foshan, has started advertising its most expensive ceramic tiles around the world in competition with Spanish and Italian products. Making less expensive tiles has become less attractive, partly because the yuan has risen, but also because wage increases have been running at 10% a year. The biggest industry, automaking, is preparing for a similar shift. Until the last year, China mainly exported extremely cheap cars, costing under $5,000 apiece, to Africa and the Middle East, especially Syria. But last summer, Honda started sending compact cars to Europe from a factory on the outskirts of Guangzhou.

Many experts contend that higher wages would force China to move toward higher-priced goods, even if the yuan did not gain value. But many executives say the appreciation of the currency, and especially the uncertainty over how much further the yuan will climb, seems to be giving this shift an extra push.

China investment jump a “problem”, government says.

China’s government said a surge in investment that propelled first-quarter economic expansion of 10.2% needs “attentio”q and signaled it will curb lending in the world’s fastest-growing major economy. Investment in factories and roads in urban areas rose 29.8% in the quarter from a year earlier, said statistics bureau spokesman Zheng Jingping. He said the government will tighten control over lending and the use of land for investment, describing them as “prominent problems that call for our attention.”

“This kind of growth model is unsustainable,” said Zuo Xiaolei, chief economist at Galaxy Securities, China’s biggest brokerage. The central bank has to “break this cycle or we could see a much sharper slowdown in growth than the government wants.”

THE UNFOLDING OF ASIA’S MONETARY “GRAND DESIGN”

Whether by design or accident (and I personally believe there is more of the former involved than the latter), the components of a common currency regime in Asia are falling into place one by one. But because they come in the guise of independent and separate initiatives, it is difficult to see the proverbial forest for the trees and thus the significance of the evolving “grand design” could easily be missed. Next month in Hyderabad, India, the Asian Development Bank (ADB) will unveil its proposal to create an Asian Currency Unit or ACU, which sounds like a common currency for the region but is not (at least at this stage). Also, the Asean+3 finance ministers will disclose their plans for enlarging and “multilateralizing” the regional network of bilateral current swaps known as the Chiang Mai Initiative or CMI.

Seen in isolation, these initiatives give the impression of being of limited or “academic” interest. And yet, perhaps, that is precisely the intention that the masterminds behind these innovations wish to convey, lest people elsewhere get the impression that Asia is getting above itself and trying to upset the global monetary order. In order to see all this in perspective, we need to go back to the Asian financial crisis of 1997. At that time, Japan put forward a plan for an Asian Monetary Fund (AMF) to rescue those countries of the region whose currencies were being attacked by hedge funds and other speculators who had correctly perceived the vulnerabilities of dollar-pegged exchange rates for emerging economies.

The AMF was an idea before its time, however, and Japan had to retract its bold initiative, not only because the rest of the region was not ready for it but also because at that time Washington’s monetary imperialism was at its height under then Treasury Secretary Larry Summers. To all intents and purposes, the idea then died but subsequent developments were arguably of far greater significance, even if they lacked the “sex appeal” of the AMF. Three years later the CMI was born, with far less fanfare than the AMF had been greeted with. Asean+3 ministers approved a network of bilateral swaps designed ostensibly to enable Asian countries whose currencies came under attack to borrow hard currency from reserve-rich countries within the Asia-Pacific region, rather than go cap in hand to the IMF as they had to do at the time of the 1997 crisis. The CMI has never been put to use in the six years of its existence and yet in Hyderabad, Asean+ 3 finance ministers are expected to approve a “substantial” increase in its resources and also to multilateralize management of these resources.

Is this a covert attempt to create a new AMF in a form that Washington (meaning the IMF as well as the U.S. administration) will not notice this time? Or is it part of a much larger and more significant design for future monetary cooperation in Asia? ADB president Haruhiko Kuroda’s proposal for an ACU – an “index” of Asian exchange rates relative to each other, as he describes it in typically low-key fashion – sounds harmless enough. And yet it has echoes of the European Currency Unit or ECU which was part of the mechanism of monetary cooperation in Europe that led eventually to the euro. What if the ACU and the CMI are both part of the same grand design?

Another strand of cooperation that needs to be put into place among Asian countries before they consider monetary cooperation is the need for mutual economic surveillance. There is little point in seeking to align national exchange rates if the economic fundamentals in the countries concerned are out of sync. Again, the Asean+3 group is focussing on such surveillance and the next step could be coordination of fiscal and monetary policies. The design unfolds.

An oil slick on the road for Asian consumption.

Asian consumers have taken four years of rising oil prices largely in their stride, but this resilience is being put to the test as the price soars above $70 once more, raising worries about sustained high energy costs. The difference between now and the last time oil climbed above $70 a barrel, in August 2005, is that countries have cut back fuel subsidies and exposed their consumers more to the rise in prices. Economists say that at this stage oil prices are unlikely to derail a pick-up in domestic consumption across Asia, especially as labor and property markets are buoyant, but their impact is likely to become more apparent in the months ahead.

NO NIXON MOMENT ON CHINA’S CURRENCY

Chinese President Hu Jintao did not mince words. China’s currency will stay where it is. For the second time in less than a year Asia’s No. 2 economy outmaneuvered the world’s biggest on the yuan. Last July, China announced a negligible 2.1% increase in its currency’s value versus the dollar. This week Hu, on his first official U.S. visit, did not budge amid Bush’s concerns an undervalued yuan is costing the U.S. jobs. The White House spin machine, not about to concede the point, is working overtime to argue the U.S. got the better of the nation most likely to challenge its global dominance in future decades.

As proof Bush bested China, U.S. officials point out that Hu did not get a state dinner, that China spent billions on U.S. goods, that Hu said he “understands U.S. concerns and will continue to take steps” on the currency issue (Hu did not mention the yuan in a speech to U.S. business leaders hours after meeting with Bush) and that there is little likelihood Beijing will suddenly dump its vast holding of Treasuries. Nothing could be further from the truth, and the currency issue is the least of the reasons why.

If the world needed another sign that the Bush administration either does not get what is happening in Asia, or does not care, Hu’s U.S. visit was it. Those hoping for a Nixon moment with a fast-emerging rival both economically and politically did not get it. Adding to the irony is Henry Kissinger’s role in Hu’s itinerary. There was Kissinger last week meeting with Hu in Washington – state, that is. Kissinger was not part of Bush’s posse, but Bill Gates’s. The Microsoft chairman got an audience with Hu even before Bush did. It was a scheduling decision drenched with symbolism: business before politics. By giving China’s leader less fanfare than those of Kenya, the Philippines and Poland – countries that got the glitzy state dinner Hu did not – and sounding like a broken record on currency, Bush played into China’s hands. Perhaps unwittingly, the Bush administration may have given China even less incentive to curb its veto power at the United Nations on key issues like Iran and North Korea.

That plays into China’s strategy of stepping aside to watch the U.S. squander its influence in Asia. The U.S. is already overstretched diplomatically and militarily in Iraq, Afghanistan and, at least from what one reads in the media, potentially Iran, too. An overstretched U.S. will not be able to come to Taiwan’s aid if conflict flared there, and that is just the way China wants it. It is astounding how little attention the Bush administration has paid to the world’s most vibrant economic region, one where the U.S. once enjoyed huge influence. During the 1997-1998 Asian crisis, this region looked to the U.S. for help. Since the Sept. 11, 2001 attacks on New York and Washington, the White House’s dealings with Asia have focused on terrorism. That remains a miscalculation. Asia cares plenty about avoiding deadly explosions in its cities, but other issues – like reducing poverty – loom even larger.

The vacuum left by a distracted U.S. enabled China to fill the void. More and more of China’s imports are coming from developing Asian economies. While Japan, Asia’s traditional growth engine, is recovering, Asians have already hitched their hopes to China’s 10% growth. It is a risky bet. While much could go right in China, plenty could go wrong. China’s rickety financial system is littered with bad loans and Shanghai’s stock markets have more in common with casinos than equity bourses. Risks of social instability abound amid worsening pollution, a widening gap between rich and poor and corruption in the Communist Party. The risk is that Asia has moved too quickly to rely on stable Chinese growth. That also goes for Japan’s recovery, which owes much to China’s boom.

For better or worse, China is beginning to play the role the U.S. long did. Driving that shift is not just China’s ambition, but U.S. indifference. That was clear enough in December when the U.S. pointedly was not invited to the first East Asian Summit. There are plenty of reasons to criticize China. Still, a Nixon moment was needed this week and we did not get it. Corporate America continues to scramble toward China. Maybe Washington should take the hint. Whether U.S. officials like it or not, China has arrived and its influence will only grow. The U.S. needs to engage China – not try to contain it. It just might get the White House closer to realizing its goal of a stronger Chinese currency.

BAD ADVICE DECLINED

So China did not give on the great currency issue after all. After months of increasingly intense expectations, Chinese President Hu Jintao’s visit to Washington ended pretty much as it began on this great bone of contention. The Chinese leadership has rejected the advice to institute a major revaluation of the renminbi offered by a broad array of so-called U.S. experts – from prominent academics and business leaders to a majority of the political establishment. While China will now have to face the wrath of the protectionists, in my view, the Chinese leadership has made the right decision at the right time. The U.S. body politic has given China truly terrible advice on this key issue.

This is not the first time that Washington has tried to browbeat a major U.S. trading partner into submission by using the blunt instrument of currency appreciation as the “remedy” for a trade imbalance. Repeatedly during the 1980s, when the U.S. was in the midst of its first external crisis – a current account deficit that peaked at a then-unheard of 3.4% share of GDP – Washington pounded on Japan to let the yen rise. After all, the bilateral deficit with Japan was the biggest piece of the then-gaping U.S. multilateral trade deficit. The theory was if Japan repriced its “unfair” competitive advantage, all would be well for an unbalanced world. Unfortunately, the Japanese heeded this advice, and the yen/dollar cross rate soared from 254 in early 1985 to an intraday peak of 79 in the spring of 1995. Japan’s “endaka” (strong yen) was a major factor behind its subsequent undoing – fueling the mother of all asset bubbles in equities and property that ended with a sickening collapse into a protracted post-bubble deflation. Politics never cease to amaze me, but I am incredulous that a mere 20 years later, America is offering the Chinese the same bad advice that took Japan down a road of unmitigated macro disaster. Fortunately, saner minds have prevailed in Beijing.

It is worth belaboring this comparison a bit further. Japan was a very wealthy and prosperous nation when it acceded to endaka in the 1980s. Then – and still – the world’s second largest economy, Japan was operating from a position of strength. In 1985, its per capita GDP was about 50% that of the U.S. It thought – incorrectly, as it turns out – that it could afford to take a gamble with currency appreciation. China, by contrast, is still a very poor economy. Its per capita GDP of $1,700 is only 4% that of the U.S. Moreover, China is at a very delicate point in its reform process – undertaking a truly extraordinary transformation in its system of ownership that has great consequences for the world economy. Unlike the Japan of 20 years ago, China is operating from a position of weakness as it confronts the calls for a sharp RMB revaluation.

The U.S. is also in a far more vulnerable position today than it was back then. Its current-account deficit is twice the size of the peak shortfall in 1987 – and undoubtedly heading for further deterioration. As I have droned on ad naseum, it is a critical outgrowth of America’s unprecedented saving deficiency – a net national saving rate that plunged to a record low of 0.3% of national income in the second half of 2005. The U.S. saving rate was in the 6% zone in the mid-1980s, providing much more of a macro cushion than is evident today. The irony, of course, is that Washington has no one to blame but itself for this predicament. The combination of chronic budget deficits and a negative personal saving rate has all but obliterated the saving capacity of the U.S. economy. To blame China for this is the height of hypocrisy. America’s saving shortage is an outgrowth of America’s wrong-footed policies – not China’s.

America is going nowhere on its saving agenda and, therefore, nowhere in reducing the macro pressures that virtually guarantee large current-account and trade deficits. China bashing – like the Japan bashing of 20 years ago – is apparently much easier than getting your own house in order. As long as the U.S. can continue to pile up ever larger external deficits with impunity, why worry? Sadly, the New Math of a symbiotic sustainability is all smoke and mirrors – it rests solely on the expectational underpinnings of a paper currency (the dollar) from a world that believes it cannot afford to bet the other way. Yet the Old Math of unsustainability – the relatively straight-forward capitalization of the implied debt flows of large current account deficits – will ultimately be the undoing of this pipe dream. The only question is, when? Washington takes the acquiescence of the markets as a green light for scapegoatism – in this case, putting great pressure on China to revalue its currency. Alas, only a crisis may unmask this folly. Meanwhile, China is wise to resist the bad advice it is getting from its largest trading partner.

LOCK AND LOAD

“Insiders might sell their shares for any number of reasons,” Peter Lynch, the longtime Magellan Fund manager, famously declared, “but they buy them for only one: They think the price will rise.” Applying Lynch’s reasoning, Tweedy Browne (one of the most respected small-cap money managers on Wall Street) found that tracking insider buying is one of the five most proven ways to make money in the stock market. I agree. In fact, I have come to believe that no single bit of information contains more investment value than insider buying.

Take for instance Smith & Wesson Holding Corp. (SWB:AMEX). For the past several months, insiders at the company have been buying the stock at ever increasing prices. The heavy insider buying is easy to understand in light of the company’s strong profit growth trend. Smith & Wesson is the most famous gun manufacturer in the world. It has been around since 1852. Normally when you think about a company that is 150 years old (plus), words like “mature” and “stodgy” come to mind. You rarely think growth. But in Smith & Wesson’s case, growth is exactly what you should be thinking about. Third-quarter sales boomed 24% over the same quarter last year. The company said it expects sales to grow 20% in 2006 and another 20% in 2007.

All of this good news has company insiders opening their own wallets to get in on the action. Since last December, insiders (including the CEO, a vice president and several directors) have bought 145,000 shares at prices ranging from $3.62-6.12. Notice that the insiders have been buying shares of SWB at higher prices for the past several months. It means the folks who run the business have confidence in the long- term outlook of their own stock. Also, you can clearly see the classic pattern of “cluster buying” with these SWB purchases. This is where two or more insiders buy stock in their own company at nearly the same time. The most recent insider acquisition was made on March 29 at $6.12 – near today’s prices. Since the initial insider buying started last December, shares of SWB are up 54%.

At the end of the day, Smith and Wesson is exactly the kind of company you want to have in your portfolio. It has a major foothold in an established market. It has nailed down millions in contracts – which have yet to be realized. And in the last four months the company insiders have spent over $500,000 to own this stock for themselves. I would not be surprised to see this under $7 stock hit $10 (or higher) before the end of 2007.

AN EVASIVE RECOVERY

In the early 2000s, Mr. Greenspan earned himself the honorable title of “serial bubble blower”. Fearful of a painful burst of the equity bubble, he aided and abetted a bond bubble in order to boost the housing bubble. Measured by the mildest postwar recession, it appeared a smashing success. But taking measure of the following anemic recovery, and particularly the following dismal employment and income performance, into account, it was an utter policy failure. Any assessment has to further take into account that the government and Federal Reserve have supported this recovery with unprecedented fiscal and monetary lavishness. Tax cuts reduced government revenue by $870 billion, while the Fed slashed its fed funds rate to 1%, its lowest level since the Great Depression. The decisive failures of these policies have been in business fixed investment and in employment, both displaying a drastic shortfall in relation to reported GDP growth.

Historical experience and economic theory leave no doubt that business fixed investment and employment play the crucial role in providing economic growth with the necessary traction to become self-sustaining. Even in its fifth year, the present U.S. economic recovery remains fully dependent on the housing bubble to drive the consumption bubble. The same, by the way, applies more or less to all Anglo-Saxon countries. Over the past few years, all of them have hung on the steroid of inflating house prices providing the collateral for outsized consumer borrowing-and-spending binges. All of these economies have, in essence, become bubble economies. This means that monetary policy impacts the economy primarily through inflating asset prices, which in turn stimulate and facilitate credit-financed consumer spending.

An important adverse feature of all asset and credit bubbles is that they inherently break an economy’s pattern of growth. In the English-speaking countries, consumers have enjoyed unprecedented borrowing facilities to spend as never before in excess of their current income. What resulted were extremely unbalanced economies. Distorted demand over time invariably also distorts the economy’s supply side. What has actually happened in all these countries is that domestic spending has increasingly outpaced domestic output. On the other hand, low domestic saving and capital investment keep a brake on output growth. The infallible result in all these countries, except Canada, is large, chronic trade deficits. Evidently, all this is structural, not cyclical.

Essentially, the low savings, the low capital investment and the soaring trade deficits act as major drags on economic growth. Over the past few years, these drags have been offset by the rampant demand creation through the housing bubbles. But the trouble with this recipe is that it worsens the structural distortions and imbalances. Nevertheless, all asset and credit bubbles eventually run out of steam. Plainly, this is going on in all these bubble economies, the U.S. included. For us, the key question about whether there will be a hard or soft landing is the extent of the prior excesses. They are the worst in history.

Any assessment of the U.S. economy’s further course has to start with the recognition that the housing bubble is doomed, and in its wake the consumption bubble. Only the vigor of their slowdown is in question. Given this virtual certainty, the U.S. economy urgently needs an alternative source of growth. Unfortunately, there is but one possible alternative source, and that is sharply rising business fixed investment and exports. The consensus, apparently, takes a strong revival of business fixed investment for granted. Assessing the relevant figures, including profits, we take for granted that business investment and hiring are going to fail in the future even more than in the past. Business fixed investment in the U.S., even though heavily bloated by hedonic pricing of computers, recently accounts for a record low of 11.5% of GDP, as against more than 70% for consumer spending.

Common arguments in favor of a comeback of capital investment are high business liquidity and high profits. Plainly, they have recovered from their lows, but growth has sharply slowed from 2004, when tax incentives gave a strong impetus. New orders for machinery are up over the year, but by far not enough to suggest a developing investment boom. There is every reason to assume that the rise in new orders of capital goods barely reflects rising depreciations. Profits of the whole nonfinancial sector almost trebled, from $322 billion to $868.5 billion, from 2001 to late 2005. Wall Street, of course, eagerly seizes them. For us, these numbers are so absurd as to require investigation. The profit boom of the last few years was narrowly centered in the category “other”. The fact is that the housing bubble has been crucial not only in creating demand and GDP growth, but also in creating employment and profits. Most astonishing is, of course, the steep jump in profits from $534.2 billion in 2004 to $863.3 billion in 2005. Two phony causes are easily identified. One is a sharp decline in depreciations. This is hardly a desirable way toward higher profits. The second major cause of the sudden profit surge was a tax incentive that induced companies to repatriate a large amount of foreign profits into domestic profits.

Leaving aside the grossly distorted profit figures for 2005, we focus on the period from 1997-2004, the former marking the U.S. economy’s prior profit peak in the postwar period. Over these seven years, including the “New Paradigm” boom years, overall profits barely rose. For all sectors producing or moving goods, manufacturing and transportation, it has been seven years of profit disaster, and moreover of steady deterioration. In contrast, it has been seven years of profit bonanza for retail trade, wholesale trade and in particular for the branches captured under “Other”. Here construction and real estate agents have been the main contributors. We would say that overall this is a dismal profit performance. Measured against nominal GDP, which has risen 41% between 1997-2004, it is a profit collapse. This lopsidedness in the profit pattern perfectly reflects the extraordinary lopsidedness of the U.S. economy’s growth pattern during these years. The housing and consumption bubbles rule.

It always amuses us when Mr. Greenspan and Mr. Bernanke criticize the government for its budget deficits. The irony is that the chronic deficit spending by the consumer, induced by their monetary looseness, is doing far greater structural damage to the economy.