Finance Digest for Week of May 15, 2006

IS THE COMMODITIES BUBBLE READY TO BURST OR NOT?

Lindsay Williams interviews commodity expert John Clemmow of Investec in London about the booming global commodities markets, and his view on the speculative bubble that is waiting to burst.

“The last time I spoke to John Clemmow the world was a safe place for commodity investors – gold was probably around $550 an ounce, and copper was below $5,000 a tonne – and that was not that long ago. The last few months has been an extraordinary time for the sector. John, we have not spoken for two or three months – the pace of the commodities boom at that was fairly fierce, but it has become almost an untenable situation with the long legs it has suddenly got.”

“I think that is fair to say. I think almost everybody would now acknowledge that what we have seen is a fully-fledged bubble emerging in commodity prices – is the bubble about to burst or not? I would have to say that the supply and demand fundamentals for the commodities that are consumed – remember gold is not really consumed, so supply and demand does not really come in there – but supply and demand fundamentals for most of the commodities does not justify pricing anywhere near these kind of levels. The bullish investors that remain out there are justifying prices purely based on speculative fund buying, and frankly I think that is pretty scary.

“… Me telling you I think that price is outrageous does not mean that BHP Billiton or Anglo American are not achieving that price. … Last year we saw global copper consumption actually fall while the price shot up, and that was in reaction to prices that are substantially lower than they are now … To say China is booming therefore demand is insatiable – that is not strictly true. If prices go too high – and I would suggest they are at those levels now – we will see serious consequences for demand, and equally we are seeing the producers beginning to respond with new production. It could all get very messy in the end.”

“Do you think then that this last 15% or 20% is going to be damaging long-term not only to the investors that are getting in right now because the bubble is going to burst, but also to producers like BHP Billiton and Anglo American?”

“I think that is very fair to say. What they will do is reap short-term benefits, and they will get cash flow they could not have expected – but the consequences for long-term demand could be very profound. Equally, these prices are going to encourage new entrants into the market – so they will wake up five to 10 years down the line and there will be a lot more, again using the example of copper, producers out there. Again, I have got to say that my caveat all the time is that gold is different.

“… I think the interesting point here is that really nobody saw prices of the base metals getting to these levels. If you look at metals that are not traded – and it is very difficult to have a speculative interest in them – prices have been nothing like this, and in some cases the prices are actually down on those of last year. It is clear that the funds are having a material influence in these markets – but it is very difficult to say when that influence is going to turn and go the other way.”

Industrial Commodities Bubble

Asset bubbles have dominated financial market experience over the past six years. The world is now in the midst of another bubble – this one in commodities. It, too, will burst. The only question is when. In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. The super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years. China is unlikely to do that. A rebalancing toward slower growth will reduce its impact on global commodity prices and demand. Contagion is rapidly spreading into the far corners of commodity markets – including precious metals. Moreover, signs of psychological excess are building – in an era of globalization, tales of the “new era” are as convincing as ever. Price increases are begetting more price increases – indicative of a speculative blow-out that can only end badly.

Now for the details.

Asset bubbles have dominated financial market experience over the past six years. First equities, then bonds, property, and spread assets. Like clockwork, liquidity-driven investors have migrated from asset to asset, desperately in search of yield. In my opinion, the world is now in the midst of another bubble – this one in commodities. It, too, will burst. The only question is when.

This is not about thresholds – $700 gold, $4 copper, $70 oil, and record prices for a broad array of other base metals. I am not making this case based on the parabolic increases in many key commodity prices that have occurred over the past couple of months. I leave that to the market technicians and traders. But suffice it to say that many key materials prices are tracing out patterns that very much resemble the dot-com mania of late 1999 and early 2000. That speaks to an important aspect of any speculative bubble – that price excesses have now permeated the far reaches of an asset class. I make my case, instead, purely from the standpoint of global macro – emphasizing the extraordinary decoupling that has occurred between a broad aggregation of industrial commodity prices and world GDP growth. There is nothing all that exceptional about today’s world growth climate when compared with earlier periods global vigor, yet the current surge in commodity prices has been off the charts when compared with those of the past.

The Journal of Commerce composite gauge of industrial materials prices – for my money, the best of the so-called macro commodity price measures – has increased by 53% over the past four years. This is a sharper rise than that which occurred in any of the four previous periods of global recovery. Moreover, as seen in “real” terms – scaling the JoC by the cumulative increase in the U.S. headline CPI over the same periods – the current surge in commodity prices stands out as even more extreme. The real JoC is up 42% over the past four years – nearly double the 23% average gains that occurred in the two commodity booms of the 1970s and in sharp contrast with the relatively stable trends during the global growth cycles of the 1980s and 1990s. This latter result is a big deal, in my view. It is the functional equivalent of the macro smoking gun of a commodity bubble. It was one thing for commodity prices to surge during the Great Inflation of the 1970s. It is another thing altogether when commodity prices surge in a low-inflation environment as they are doing today – and when that spike actually outstrips those of the classic commodity booms of yesteryear. In the midst of a slightly subpar upturn in global growth, a low-inflation world is experiencing the sharpest run-up in commodity prices in modern history. If that is not a bubble, I do not know what one is.

Of course, there are a multitude of counter-explanations as to why this is not a commodity bubble. This is a classic response – borrowing a page right out of the time-honored script of psychological denial that always occurs toward the end of an asset bubble. Every bubble has its perfectly plausible story – the “new era” that is always used with great passion to justify fundamental support to sharply rising asset prices. From tulips to dot-com, with plenty in between, the believers are convinced they have a credible and sustainable story. This time globalization is its story – and China is its poster child. China accounted for only about 4% of world GDP in 2005 but consumed nearly 9% of the world’s crude oil, 20% of aluminum, 30-35% of steel, iron ore, and coal, and fully 45% of all the cement in the world. With Chinese economic growth driven by the commodity-intensive activities of urbanization, industrialization, and infrastructure, there is good reason to believe that high and sharply rising commodity prices are here to stay.

This is a great story – in fact, one that I have been telling for quite some time myself. The problem with the story – like most tales of new eras – is that it, too, has its limits. The key here is to realize that China is not going to keep increasing the commodity-intensity of its GDP growth. In fact, in the just-enacted 11th Five-Year Plan, the Chinese leadership announced explicit targets to reduce its energy content per unit of GDP by 20% over the next five years. The Chinese do not have to develop new technologies to enhance commodity efficiency. They merely need to copy those already in existence elsewhere in the world. Great at copying and courtesy of higher input prices, China’s appetite for industrial materials seems likely to diminish in the years ahead.

This is a key reason why China has now embraced a very different macro strategy over the next five years – moving away from a commodity-intensive export and investment growth dynamic toward more of a commodity-saving strain of consumer-led growth. Yet the super-cycle theory of ever-rising commodity prices is based on the false premise that China stays the same course it has been on for the past 27 years. Similarly, the New Paradigm crowd of the late 1990s presumed the U.S. was on a path of ever-accelerating productivity growth. Like Nasdaq, irrationally exuberant commodity markets will also be taken by surprise.

My conclusions are macro. They are not aimed at the event-driven stories that can impact commodity price fluctuations from time to time. Nor am I expressing a view on gold or other precious metals that seem to have some very special characteristics of their own. My focus, instead, is on industrial materials. Parabolic price increases have become the norm, spreading across an increasingly broad spectrum of the asset class with a powerful contagion. To the extent this contagion takes on a life of its own – not uncommon for full-blown asset bubbles – it could also infect precious metals and agricultural products. The psychological signs of excess are equally classic. From China to “peak oil”, perfectly plausible stories of the new era abound. Price increases are begetting more price increases. Yes, it can go on for longer than we think – speculative blow-outs usually do. But history tells us how it will end. Play the commodity bubble of 2006 at your own peril.

Copper trade losses spark fear of defaults on London Metal Exchange.

The risk of defaults was hanging over the LME on Thursday after a clutch of clients failed to meet margin calls on losing copper trades, leaving brokers struggling frantically to match their books. The liquidity crunch follows another day of wild gyrations at the exchange, where copper, aluminium, zinc and lead all tumbled on bad U.S. inflation data after failing to conquer new highs. Copper fell 3.3% to $8,080 a tonne in late trading on Wednesday. “The hedge books of the banks are seriously underwater on copper, but apart from that there are now brokers in trouble because clients can’t meet the margin payments,” said a market source.

LME brokers are liable for the margin calls of their clients, who are given 24 hours to stump up the cash. “Some of the wire cable manufacturers and industrial users can’t meet payments because of cash flow problems, so the brokers are left holding the bag,” he said. He added that the banks were bleeding heavily because of a mismatch between their short-term and long-term futures contracts.

The market reached fever point late last week with all-time highs across the spectrum of base metals, led by an explosive spike in copper to almost $8,900 a tonne – up 170% in a year. Speculation by hedge funds prompted LCH.Clearnet to raise margin calls 71% to $25,000 per 25-tonne lot earlier this week, after doubling them just eight days earlier.

No bubble to burst in commodities, says PIMCO.

The drop in oil and metal prices this week has raised fears that a speculative bubble in commodities is bursting, but giant U.S. fund manager PIMCO says fundamentals will hold up the asset class. “In considering commodities, we need to take a more strategic view instead of trying to predict in very short term what prices might give,” said Bob Greer, senior vice-president and manager for real return products at the $600-billion-fund which mainly invests in fixed income. Many analysts saw the corrections as a normal pause needed in bull markets, particularly for energy futures and copper, which hit record high prices in the last four weeks.

But some say too many speculators were bidding up prices too high to justify demand supposedly coming from hungry economies like China and India. Some economists also fear a sudden exit of speculative investors like those that have caused real estate and dotcom stocks to crash in the past. Greer, who oversees a $12 billion allocation for commodities at PIMCO, said his model showed economics would support prices of natural resources. “To have a speculative bubble, you need one or both of two things – one, a restricted supply of whatever it is that’s going to bubble up, and two, you need to lose all concept of an objective measure of value.”

“The former was true in real estate.” he said. “Real estate is in limited supply and you can certainly bid up the price of that limited supply. In the case of dotcoms, there was a classic case of losing all concept of what a measure of value was. Neither of that holds for commodities.” Greer said the “real” debate over commodity investments was about the passive investments in commodity futures indexes made by funds, pensions, endowments and wealthy individuals looking to hedge their investments in stocks and bonds. Analysts say passive investment portals such as the Goldman Sachs Commodity Index, the Dow-Jones AIG Commodity Index and Reuters Jefferies CRB Index have seen total inflows of more than $100 billion in recent years, leading to an all-round surge in raw materials prices. “I do not believe that long-only index investors are driving prices,” Greer said.

Greer said although there were instances when futures led cash prices of commodities, “It is more likely that futures will converge to the cash, and not the other way around. In the short term, you might have some traders in one pit looking at what is happening in another pit. But over the longer term, it will still be the fundamental economics that are unique to that market that will prevail. So, you don't have the necessary requirements for a speculative bubble.”

GOLD OVER $700: TOO MUCH, TOO FAST?

Bull markets and bear markets follow one another as surely as a person in- and exhales. And, as with breathing, the longer you hold your breath, the more urgent and powerful the subsequent intake. Commodities in general, but precious metals in particular, went through a deep bear market that lasted an entire generation. Gold fell from over $800 in 1980 to $256 in 2001; silver from $50 to $4. These are fantastically deep and prolonged bear markets. But they were even worse than they seemed because the dollar was losing about two-thirds of its value at the same time. For Americans to keep track of value, over time, with dollars is as idiotic as for an Argentine to try to do that with pesos.

The financial crisis of the late 1970s drove the metals to those highs. We are now looking at another crisis, one that will dwarf the turmoil of the 1970s and likely bring on a depression worse than the 1930s. With so much trouble just ahead, there is good reason to believe that the metals will exceed their old highs. In today’s dollars that means gold over $2,000. Let me reiterate what I have said for years: This time, gold is not just going through the roof. It is going to the moon. And there are other reasons. Because the bear market was so long and deep, there has been relatively little exploration for new deposits of not just precious metals but of all metals – copper, nickel, moly, zinc, you-name-it. Meanwhile consumption has risen steadily all over the world, but especially in China, and now India. Entirely apart from that, most areas of the world have been pretty well explored. As with oil, the easy-to-find, rich, near-surface deposits have been cherry picked. In a nutshell, the world has been living out of inventory for a long time.

But, as far as the precious metals are concerned, these factors will be greatly compounded by the brewing monetary crisis. It will be of historic proportions. But has gold moved too far, too fast? The bears argue, quite correctly, that commodity run-ups are always self correcting. Consumption drops just as production increases and prices retreat. The bulls, including myself, argue that, while these things are true, both fundamental and monetary factors militate for perhaps a decade of higher prices until the fundamental trend reasserts itself. In other words, I think we are in a period that is going to run against the norm. Stocks, in bear markets, tend to fall twice as fast as they previously rose. Commodities, in bull markets, rise twice as fast as they previously fell. We are in one of those times.

When the bubble arrives – and I am very confident it will – it will be easy to tell. The magazine cover stories, the cocktail party buzz, the talk of legislation in Washington to “do something” about high prices, the reports from brokerage firms – there will be lots of indicators. Of course, few people will pay attention to them in the right way – they will think they are accurate descriptions of reality, not indicators of a mania. It was the same with the Internet stocks a few years ago.

Generally there are three stages to a bull market. (1) The first is stealth, when prices go up but nobody cares or even notices. With commodities, that happened from about 2000 to 2003. (2) Next is the “Wall of Worry” stage. People see that prices are rising, but expect them to fall back to the bear market levels they had gotten used to. People come up with all kinds of reasons why they are overpriced. They are confused by the new reality, and many “old hands” and commodity producers take the opportunity to sell, since they have not seen good prices for years. This is the stage of the market we are now in. (3) Finally, there is the mania stage, when broad masses of the public get involved. It is where the big profits – but also the big risks – are.

Personally, I am more comfortable buying when everyone says you are an idiot for doing so, or at least when they are skeptical. When we are all hearing about what a great investment gold is, I will be looking for other opportunities. But my guess is that we will not really be there for another year. And when it arrives, the mania should last for some time, as it did most recently with the Internet stocks. While I was expecting to see a big surge, there is little doubt that gold and silver may be getting ahead of themselves for the short term. A market trend, even an unstoppable one, is still going to periodically correct.

Get used to it. That is especially true if you are an investor in the mining shares, which is absolutely, without question, the right way to play this market. Buy on dips (historically, we see buying opportunities in the summer months) and do not be chased out of the market by volatility. When this thing does finally come to an end, the better-managed gold and silver stocks will be trading for many multiples of what they trade for today. This trend is your friend … get comfortable with it.

Gold finally gets selloff.

Gold and metals fell sharply on Monday, with a slide in crude oil prices and a bounce in the dollar helping extend Friday’s drop from stratospheric heights. Gold for June delivery plummeted $26.80, or 3.8%, to $685.0 an ounce, after touching a session low of $654.80 intraday. The precious metal had started declining on Friday after reaching $732, a level unseen since September 1980. Silver fell even more sharply, with the July contract plunging 90 cents, or 6.3%, to $13.33 an ounce, after reaching a 25-year high at $14.93 last week. As for copper, the July contract fell 11.75 cents, or 3%, to $3.74 a pound, after last week touching a new all-time high at $4.04. With most metals having advanced sharply since the start of the year – without any meaningful pullback – many analysts have warned of a pending correction.

The shares of metal-mining companies were also falling sharply on Monday, with the Philadelphia Gold and Silver index losing 6.7%, the Amex Gold Bugs index down 7.4%, and the CBOE Gold index losing 7.5%.

Selling naked stock options a profitable tactic that is not for the faint of heart.

“While awaiting that delightful Armageddon that might propel gold to $2,000 or $3,000 an ounce,” your editors observed in last Thursday’s column, “we gold bulls will certainly endure a large number of ‘down days’. We will suffer through harrowing price declines that will produce large mark-to-market losses … and anguish.” One of those days has just arrived. The gold price tumbled more than $50 from its high point last Thursday to its low point on Monday. “The True Believers among us will ‘buy the dips,’” we remarked, “but many of our weaker brethren will panic and sell. Happily, there may be a middle road: Selling naked or ‘covered’ options.”

In Thursday’s column, we examined a couple of ways to sell covered options. Today, we will take a look at the much riskier (but perhaps more timely) tactic of selling naked options. But please remember, selling naked options can be VERY DANGEROUS. Only the most seasoned and sophisticated of options traders should consider engaging in this practice. Selling naked options, to use the vernacular of Las Vegas, is the same thing as “booking the bet.” The option-seller grants to the option-buyer the right to exercise an option at a certain price on a certain date. If the bet “loses”, the option seller-keeps the bet. But if the bet wins, the option-seller must pay it off, plus the odds.

We have been warning of an impending selloff in all resource stocks. And so it has come to pass. But our short-term angst does not diminish our long-term affinity for resource stocks. So selling naked puts (thus granting the put buyer the right to sell to the seller as a the option strike price) seems like a reasonable – albeit frightening – tactic. Let us imagine, for example, that a silver-loving investor wished to own Pan American Silver (NASDAQ: PAAS). Tactic #1: Buy the stock. Tactic #2: Sell naked puts on the stock. Tactic #3: Buy call options on the stock. Using the October series of options, the nearby table presents a sampling of outcomes under all three scenarios. Which tactice turns out best depends entirely upon the subsequent direction of the share price. That said, we would offer a couple of observations.

The stock would have to fall by more than 17% for the in-the-money put-seller to fare worse than the out-of-the-money call-buyer. Alternatively, the stock would have to climb more than 40% for the call-buyer to be better off than the put-seller. The put-seller enjoys a fair amount of wiggle-room, by virtue of the fact that he is RECEIVING option premium instead of PAYING it. This hypothetical math becomes even more enticing when dealing with out-of-the money puts on an even more volatile stock – in this case, Pacific Ethanol. Assume that PEIX is selling for $37.80 – almost midway between the September $35 put that we sell naked and the September $40 call that we buy. Because the option premiums on this volatile stock are so rich, the option-seller receives an even bigger cushion than the seller of PAAS options. PEIX shares would have to fall by more than 40% for the put-seller to fare worse than the call-buyer. Alternatively, the stock would have to climb more than 37% for the call-buyer to be better off than the put-seller.

Despite these attractive economics, it bears repeating that the seller of naked put options assume the entire risk of a drop in the underlying stock, EXACTLY AS IF HE OWNED THE STOCK ITSELF. Bottom line: Do not sell naked put options unless you want to want the stock. Option-selling strategies function best amidst very volatile market conditions, because high volatility produces high option prices. That is what we have got right now in the resource sector. It is an option-sellers market.

WHAT THE DOW LOOKS LIKE IN TERMS OF GOLD

Do you think the rally in the Dow is the real thing? There are reasons to think otherwise, especially if you look at the Dow not in its nominal terms but in terms of real money (otherwise known as gold). The Dow/gold ratio has crashed to new lows. This ratio of the Dow in terms of real money has lost 65% since the top in 2001, and it shows how bogus this rally in stocks has been. The last times we saw anything like this were 1968, when the Dow approached a new all-time high in nominal terms while sitting well below its 1966 high in real terms, and 1973, when it made such a new all-time high.

Then, as now, Elliott wave analysts interpreted those advances as bear-market rallies, and the lower real value of the stock averages reflected that assessment. The experience of the past three years dwarfs those events, both in terms of the extent of the rally and the extent of monetary deterioration. The Dow may be near its high in nominal terms, but it is nowhere near that level in real terms.

Here is an amazing fact: The Dow Jones Industrial Average today is cheaper than it was in 1966 in real-money (gold) terms. Despite all the talk of a “New Economy”, all we have witnessed is a paper revaluation, while the underlying corporate assets have deteriorated. Despite 40 years of supposed economic growth, the top 30 industrial companies of the United States have gone exactly nowhere in terms of their value in gold. As the Dow/gold ratio continues to fall, it will soon move below its 1929 high, which will mean zero net increase in the value of U.S. industry in three-quarters of a century. The paper-credit system of money hides from the average person this massive deterioration in the value of productive assets.

BANKS AND BUBBLES

Back in January, I posted a short piece on how banks tend to pile into whatever is hot just as it is about to implode. Bank of America’s acquisition of credit card giant MBNA, at a time when consumer debt was setting records was, I predicted, the deal that would put an exclamation point at the end of history’s longest credit boom.

Okay, maybe that was a little premature. The real orgy, it seems, is just beginning. Last week, money center bank Wachovia agreed to buy Golden West Financial, California’s second largest S&L, for $25 billion. The deal gives Wachovia 120 new branches in California and more than doubles its home-loan portfolio. And – get this – almost all of Golden West’s mortgages are adjustable rate. “We now have the geographies that we have coveted in this deal, and we will focus on these high-growth markets,” said Wachovia CEO Kennedy Thompson. The next day, MarketWatch ran an article titled “Wachovia deal may force more mergers”, which concluded that other banks will now feel compelled to make big acquisitions “to avoid losing ground in the huge California market.” And then Bloomberg reports that Merrill Lynch is shopping around for a major mortgage lender. As amazing as it sounds, the big banks are suddenly hot to get into real estate, especially California real estate.

So … let us take this piece by piece, working from broad to narrow. In 1990 American families owed banks, car dealers and credit card companies about $3.6 trillion. Today we owe nearly $12 trillion. The cost of servicing this debt eats up about 17% of disposable income, a level typically associated with the onset of recession. And since much of this debt is in the form of variable rate mortgages and adjustable rate credit cards, its cost is ratcheting up as rates rise across the yield curve. Not the profile of a society about to make mortgages a growth market.

That some formerly hot markets are imploding is common knowledge by now. From the Honolulu Star Bulletin, May 6: Honolulu home sales down 41% year over year in April, and Maui condo sales off by 50%. The New York Times, May 9: The inventory of homes for sale in the Fort Lauderdale area has quadrupled, year over year, to 20,000. Dow Jones Newswire, May 8: Preliminary reports from builders Hovnanian Enterprises Inc. (HOV) and Toll Brothers Inc. (TOL), whose quarters ended April 30, indicate demand is falling faster and more sharply than previously thought, and that the pullback is no longer confined to hot markets that had seen sharp home price run-ups in the past few years. According to real estate consultancy Majestic Research, new-home sales in all 40 markets it tracks fell during February and March. The major homebuilders, instead of pulling back in the face of falling sales, are apparently trying to make it up on volume. As all those adjustable rate mortgages ratchet up, it is getting harder for last year’s marginal homebuyers to make ends meet.

Roughly 80% of San Diego homebuyers chose adjustable rate mortgages in both 2004 and 2005. Home sales are down 46% in Sacramento, 30% in San Francisco, and 50% in Los Angeles/Long Beach, year-over-year. As for the idea that California’s population will keep growing because everyone wants to live there, real estate analyst Rich Toscano at Piggington.com notes that San Diego’s population actually shrank in 2005. In fact, it turns out that for three years running, more people have moved out of San Diego than have moved in – and the trend is strengthening. And on a personal note, my little town in northern Idaho is crawling with transplanted Californians. A final word from Rich Toscano: “There has been zero upward price pressure this spring, for the first spring in who knows how long. It looks like things are truly going to start falling apart.”

What does all this mean for banks? Well, since they make money by lending it out and getting paid back, a crash in home sales and a spike in defaults would seem to be a bad thing. The housing bubble has been more a lending bubble. It will be the impairment of the financial institutions that will stop the flow of credit to the real-estate market. In turn, that will accelerate the collapse in house prices somewhere along the way.

So Wachovia has done us two favors with one stroke of a pen. First, it has validated the idea that the longer a credit expansion goes on the crazier bankers become. Second, it has handed the Sound Money community another classic short. When the housing crash moves from business section to front page, and stories of dispossessed formerly middle class Californians are everywhere, and bad loans are chewing through bank income statements like demented termites, the owners of Wachovia LEAPS puts will be rich. Load up the wagons!

WHAT GAS CRUNCH?

Many regular readers of STR will also have read Rothbard’s masterpiece, “What Has Government Done to Our Money?” and will therefore be taking the current hype about gasoline prices with a large pinch of salt. Superficially, of course, they are 10 times where they were half a century ago … and thanks to the training delivered in government schools, a superficial look is all it usually gets. On the sky-is-falling basis, I have actually heard some in the media tell us “The market is working; the high oil prices are stimulating development of alternative fuels!” – just as if the newscaster understood what a “market” is.

The alternatives include ethanol, and biodiesel from soybeans, as well as the old familiar coal, hydro, wind and nuclear. The latter has had a really rough break from the eco-freaks, for it is probably the safest of the lot. “Hydrogen” and hybrid cars are favored in PC circles. The Toyota Prius has received from them a heap more praise than it deserves. I drove one for a couple of weeks, and it is an ugly vehicle with little cabin space and does not deliver 60 MPG city, or even highway. Or not if one treats government speed limits with even slight contempt. Then of course there are the enormous oil fields waiting to be exploited in ANWR and under the outer US continental shelf, as soon as Nanny gives permission in D.C. There is no energy shortage at all, given time for development and the normal market stimuli of higher prices – and the “time” element is more political than logistical.

But wait. Are we quite sure those stimulating high prices have arrived? I surfed the Net and found a splendidly useful site called randomuseless.info on which a kindly Texan had posted news of every price he paid at the pump during the last 27 years. Here is his graph. Adjusting prices for the government’s devastation of its “dollar” and by running the eye across the chart from 1979 to the present, it is easy to see that the real price of gas is almost identical today to what it was 27 years ago. And that for most of the years in between, it was lower.

Further, for the 20 years from 1981 to 2001, prices fell, gradually but rather uniformly in those real terms! True, after a group of radical Muslims, outraged by six decades of U.S. Government support for its enemy the State of Israel, took a terrible revenge in 2001 and the Feds responded by invading one major oil producer and menacing another, real gas prices have risen – from about 50 cents to 85 cents a gallon, in 1979 dollars. Gosh, whoever would have thought it? Simultaneously the Feds, who were advised a couple of centuries ago to avoid all entangling alliances but to pursue peace and honest trade with all foreigners, have also managed to fall out with other major oil producers like Nigeria and Venezuela. Gee, it is almost as if they wanted high oil prices! Why could that possibly be?

But let us suppose that in the next year or three, there is a withdrawal from Iraq and a patching up of relations with Iran and even some of the other producer nations. It might happen, you never know. Likely result? Lower prices, even though an emerging middle class in both India and China is said to be steadily raising demand for the black stuff. Perhaps prices will fall back in real terms to where they were in 2000. In that case, what will happen to all that alleged stimulus for alternative energy sources? I could be wrong, but I have been underwhelmed by any rush to develop alternative energy sources and the reason, I think, is plain in the graph. The stimulus of rising prices is illusory, absent.

However, equally important, is the falling cost of those alternatives. I have no handy-dandy chart to prove this, but I think the real cost of providing a unit of power cleanly from coal and solar and nukes and corn and soybeans and even wind and tide may be gradually falling, perhaps faster than that of extracting oil. If so, a slow but steady transfer to some of them is not only probable but certain, thanks to the inexorable long-run operation of the market. I think the next quarter century will see a transfer to better and abundant power sources, any oily affiliations in Washington notwithstanding. I doubt that it is quite time to dust off that bicycle.

REASONS (WHY THE DOLLAR DECLINE COULD BECOME DISORDERLY)

The Financial Times headline read, “Greenback undermined by unlucky combination of events.” Bad luck has nothing to do with the dollar’s predicament. Financial, economic, and policymaking trends have been in place for years that will culminate in a dollar crisis. It is more likely a fortuitous combination of factors has held the dollar together for this long. We are all witnessing first hand an extraordinary period in financial market history. A strong case can be made that global asset-market speculation has gone to a whole new level of extremes from that experienced in the late-‘90s, yet the amount of skepticism, concern, and foreboding these days is a fraction of what prevailed during the technology boom. And while U.S. Credit system and Bubble economy excesses have reached a point unimaginable back during the 1998-2000 precursor-Bubble, there is today virtual unanimity that underlying U.S. and global fundamentals are exceptionally strong and sustainable. There is today virtually no talk of a Bubble.

During what was a most unimpressive dollar bear market, the Pollyanna notion of a sustainable Bretton Woods II global monetary “regime” became all the rage. Others spoke eloquently about economic “dark matter” and benign U.S. current account deficits. Similarly, the idea that U.S. and global yields would indefinitely be pressed lower by a “global savings glut” took (our new Fed chairman and) the world by storm. So far this year, 10-year Treasury yields have jumped 80 basis points to the highest level since May 2002. Over this period, the dollar index has declined about 7%. Note that as the dollar index sank from 120 to 93 between early-2002 and mid-2003, bond yields collapsed from 5.4% to a low of just above 3%.

Through much of the dollar bear market, U.S. bonds continued to generate decent returns. But of late, Treasuries and the dollar have been locked together in poor performance, in the process slapping our distended foreign creditors with stinging losses. Not since turbulent 1994 have the markets had to deal with an extended period of simultaneous dollar and bond market weakness. Not for 25 years have U.S. securities suffered such acute relative underperformance to gold, oil, and other global commodities. Additionally, U.S. stocks are now well into their second year of major underperformance versus global equities. The reality and ramifications of U.S. securities as an out of favor asset class are now just beginning to sink in.

I have always assumed that behind closed doors the Fed frets about the dollar. I admit I lack even a little shred of supporting evidence. But I just assume… There are, however, too many anecdotes that they worry little if at all. For good Reason, markets today believe the Administration and suspect the Bernanke Fed are decidedly in favor of a weak dollar policy. There remains a steadfast view that a gradually devalued dollar will work toward rectifying U.S. imbalances, despite the reality that imbalances have worsened measurably over the four-year dollar drubbing. Everyone wants to believe that an orderly decline in the dollar poses few problems. And after four years of an extraordinarily orderly fall, few see any reason for an abrupt shift to disorderly. But there are reasons.

For one, do not downplay that importance of Wall Street having had four fruitful years to develop instruments, products, derivatives and strategies to generate heady profits (for clients and themselves) from a declining dollar. Any policy shift from “benign neglect” to “weaker dollar” would at this point be playing with (a disorderly) fire.

And there’s another key reason why the 4-year period of “orderly” might be winding down: marketplace perceptions of unending U.S. Credit excess. While there are deep structural issues, the root cause of the dollar’s problem is the excessive dollar liquidity creation and incessant outbound flow to the Rest of World. This liquidity excess largely emanates from an overheated U.S. Credit system that cannot cool. And for the past four years, the credit bubble has been dominated by the mortgage finance bubble. Less marketplace liquidity and household consumption would have been supportive of the dollar. Would have. Today, however, there is increased recognition of the manifestation of myriad other sources of heightened bubble economy credit expansion. Bank credit has accelerated to a 13% annualized y-t-d growth rate, and total credit growth is likely proceeding at record pace. It is also becoming apparent that, despite slowing home sales and a developing mess in key markets, the system is on track for another huge year of mortgage credit growth. As for gross dollar liquidity excess and its propensity to flow abroad, there is today simply no end in sight.

There is little doubt in my mind that the dollar’s drop would have some time ago turned disorderly if not for the yeoman’s work of foreign central banks. But not only are central banks loaded with dollars after four years of unparalleled support, these positions are losing nominal value and significant relative value to other tangible assets (notably gold, metals, energy and commodities). If foreign central bankers are not losing patience with losing “money”, perhaps they are tired of being Washington’s whipping boy. There is also reason to presume that Asian central bankers are increasingly concerned by the unwieldy liquidity inundating their region, as well as heightened inflationary pressures. By now, they should clearly recognize the relationship between ballooning holdings of dollar securities and the global surge in energy, commodities and asset prices/bubbles. Central bankers today have every reason to turn more cautious. Any backing away from dollar support would likely instigate a dollar crisis.

Another reason. While this is purely conjecture on my part, I can envisage changing central banker perceptions. Perhaps they are finally beginning to appreciate that their efforts to ensure orderly currency markets have been self-defeating. Orderly means accommodating only greater U.S. credit bubble excess. Buying dollar-denominated securities today ensures that an ever greater supply will arrive on the doorstep tomorrow.

Let there be no doubt. There is a great deal riding on an “orderly” dollar decline. The reason? Well, if we are, as I suspect, entering a period of more disorderly currency markets, the risk profile of shorting the yen, the Swiss franc, the Euro or other low-yielding currencies (as a source of funds for leveraged positions in higher-yielding securities or assets) becomes immediately much less attractive. What this might mean for the proliferation of global “carry trades” is this evening not at all clear, but it canno’t be good. To what extent “carry trades” have fueled global liquidity overabundance – and, in the process, the “conundrum” and the “global savings glut” – is unknown but clearly substantial.

With the yen, the swissy and Euro surging against the dollar concurrently with sinking global bond prices, some speculators have been hurt and are being forced to retrench, which often leads to more selling, losses, further retrenchment and liquidity issues. Unwinding leveraged trades always poses the risk of getting out of hand, and this is especially the case currently for lots of reasons.

Dollar’s hefty yield premium may be just a mirage.

The yield advantage on dollar-based assets over those denominated in other major currencies may be widening, but the depth of negative sentiment toward the greenback is keeping this premium from being the boon it has been in the past. Currency investors instead see the superior U.S. yield, which supported a dollar rally through much of last year, as a smoke screen obscuring a dark outlook for U.S. inflation and economic growth.

At first blush, the dollar’s advantage appears to be alive and well, as the gap between the yield on U.S. Treasuries and those on German Bunds, for example, is near its widest in a month – and growing. But analysts say that what matters is not the quantity of basis points in the move but the quality. Even as the gap between the yields on U.S. 2-year notes and the Schatz has yawned by nearly 20 basis points in the past month, the dollar has been under almost continuous fire, tumbling to its weakest point in a year against the euro.

The ball started rolling last month when the finance chiefs of the Group of Seven richest countries highlighted the dangers of global trade imbalances last month with a statement that many took as a call for a weaker dollar. So not only have the twin U.S. structural woes of a blow-out trade deficit and current-account gap returned to haunt the dollar, its apparent rate advantage seems to be nothing more than the product of mounting inflation fears. “You’ve had greater and greater worries about inflation, mainly in the U.S., and that is making people nervous about holding heavy positions,” said Rebecca Patterson, senior currency strategist at JPMorgan Chase. “If the Federal Reserve is raising rates not because of strong growth but relatively more because of inflation risk, investors worry that the Fed maybe is behind the curve.”

Weak dollar is central to rising global risk premiums.

Risk premiums are on the rise and the use of risk aversion strategies is growing in global financial markets, thanks in no small part to the fall in the value of the U.S. dollar in the past few weeks. The greenback’s sharp slide since last month’s meeting of the Group of Seven finance chiefs has been accompanied by a renewed burst of fund buying of commodities that has pushed many of these assets to new multiyear highs. The value of the greenback is a key driver of the prices of commodities as many of them are traded in dollars.

Meanwhile the stocks and bonds of emerging markets have soared in recent months also as the economies of some poor countries have benefited from the rising prices of their exported commodities. Yet traders riding these seemingly one-way trains are vulnerable to whiplash when the brakes are pressed, as evidenced by the screeching reversal in the prices of some commodities and some emerging markets on Monday. “Risk premia that were so drained from capital markets in recent years as credit cheapened have done an about face are showing up everywhere, as they should,” said David Gilmore, partner at FX Analytics in Essex, Connecticut. Gold fell more than $30 an ounce, posting its biggest one-day decline since mid-1993, while copper lost 9% at one point after hitting record highs last week. Meanwhile spreads on emerging market bonds widened and global stock markets tumbled this week.

The dollar though saw its biggest gain in over a month on Monday but few observers think the dollar’s woes are behind it. Most analysts reckon the combination of the widening U.S. current account deficit, narrower interest rate differentials between the rest of the world and the U.S., and a slowly rising Chinese currency, will drive the dollar even lower. If so, more volatility can be expected in the prices of many assets leading investors to become more risk averse as liquidity in many markets is drained. “Risk aversion is up and up at a point in time when arguably speculators are more leveraged up than at any time in recent memory … long gold, base metals, oil, carry trades, agency debt, corporate debt, equities and emerging markets (currencies), and short dollars,” Gilmore said.

With the era of cheap money coming to an end, investors may grow more reluctant to add to their riskier bets. For Julian Jessop, chief economist at Capital Economics in London, the dollar is central to what he considers are two major risks facing the global economy: the yawning U.S. current account deficit and softening U.S. economic growth outlook. “Risk premia have been driven so low in emerging market bonds because of carry trades. But these positions are vulnerable to a fall in the value of the dollar. A weaker dollar versus the yen could have a knock-on effect in other markets,” Jessop said. A carry trade involves borrowing in currencies with low interest rates, such as the yen, to buy assets denominated in higher-yielding currencies, such as the dollar.

Dollar rallies across the board on Friday.

The dollar climbed to an almost 2-week high versus the yen and rallied against other major rivals early Friday after comments from Bank of Japan governor Toshihiko Fukui were viewed as less hawkish than expected. The BoJ on Friday kept interest rates unchanged at zero percent. Fukui damped expectations of a June rate hike and emphasized that “we did not specifically discuss the end to zero interest rates at this policy meeting,” and that “We have no preset idea on the specific timing for exiting zero interest rates.” The euro last traded down 0.8% at $1.2744. The dollar surged 1.1% to 111.8 yen. The British pound was down 1% at $1.8746, while the Swiss franc fell 1.3% to $0.819.

BERNANKE SAYS FINANCIAL AUTHORITIES MUST STAY ATTUNED TO RISKS POSED BY HEDGE FUNDS

Financial authorities must stay attuned to any potential risks posed by the growth of hedge funds, an investment domain of the wealthy that has become more popular with smaller investors, according to Federal Reserve Chairman Ben Bernanke. “Authorities should and will try to ensure that the lapses in risk management of 1998 do not happen again,” Bernanke said, referring to the collapse of Long-Term Capital Management, a hedge fund that had received a $3.6 billion private bailout. Bernanke made his remarks to a conference in Sea Island, Georgia, on hedge funds and risk organized by the Federal Reserve Bank of Atlanta. A copy of his remarks was distributed in Washington.

While Bernanke made a case for close monitoring of hedge funds, he shied away from advocating that they be directly and more heavily regulated like banks. “Direct regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking but, in the case of hedge funds, the reasonable presumption is that market discipline can work,” Bernanke said. Today some 7,000 to 9,000 hedge funds in the U.S. command an estimated $1 trillion in assets and are believed to account for as much as 20% of all U.S. stock trading. Debate about hedge funds – their benefits and risks – abated for a time but “has now resumed with vigor – spurred no doubt by the creation of many new funds,” Bernanke said.

BE AFRAID OF THE IMAGINARY BEAST … VERY AFRAID

Small children have vivid imaginations. Some dream up monsters that are under the bed, others dream up imaginary friends to play with. But I think a relatively small number of these kids who never grow up – they continue to believe in imaginary creatures, and that the non-existent beasts have purposed to do them harm. This is my best guess at trying to understand the stuff I read in the media last week and into today (Monday), to this effect: (1) The creature called inflation is real enough to talk about, and 2) This beast made the stock market go down.

Now, I am not talking about oil prices – I did kinda notice that gas is more expensive. I am talking about quotes like this one: “We’re watching a sea change in psychology after people have spent three years in denial about inflation. People are recognizing that inflation is problematic.” In other words, embrace your fears. Recognize the beast. He is problematic. Yet I will stop using words to describe the beast, because we actually have his picture – here.

OK, so he used to be real, and probably was pretty scary in the ‘70s and during WWII. But today? In truth I think the beast has best been described in the past tense since about 1981, 1990 at the latest. Yes, I see that the trend is slightly higher since about 2002, but look where it was then – inflation had fallen to a 40-year low, as did the central bank’s vaunted Fed Funds rate. It is curious too, that on Friday and again today, precious metals declined, when “everyone knows” that “inflation fears” are supposed to make gold and silver go higher.

Inflation, suspect numbers, and proving the positive.

An unusually large number of emails came to me about yesterday’s column, to inquire or make angry accusations about the chart and commentary I offered. The common thread was suspicion about the inflation numbers I included: Some readers said I used flawed data or manipulated it myself. I cannot disprove a negative (“Show me that you didn’t manipulate the numbers!”), but I will address honest suspicions as best I can.

The Bureau of Labor Statistics surveys the monthly prices of goods and services in 87 urban areas across the U.S., and compiles the data into the Consumer Price Index (CPI), which is the standard measure of inflation. This index can show the data in many ways: by region, city, expenditure (housing, medical care, etc.), even without certain components (such as food and energy). You can also look at changes in the CPI according to a base year (1984=100), or by annual percentage change (3.4% increase in 2005). The most inclusive measure of the data is the CPI for All Urban Consumers (CPI-U), which covers some 87% of the U.S. population. This measure is the one you saw in the chart I posted yesterday. I am aware that the CPI has been modified a number of times over the years: pre-1998 data used a base year of 1967, for example. And until 1983, the CPI included home prices, plus mortgage interest, property taxes, etc., while today the CPI uses a rental equivalence to reflect housing consumption costs.

What is more, there are other ways to measure inflation and changes in the cost of living. I use the CPI-U because it is the one most people recognize. Finally, I am going to include three charts today, all taken directly from the Bureau of Labor Statistics web site. The first is exactly like yesterday’s chart, the CPI-U going back to 1914. Second is the CPI less food and energy (this dates from 1958, when this data series was started). Third is the CPI-U from 1958, so you can see the difference food and energy make in calculating the numbers.

One other point on the difference food and energy prices make: the components that go into these consumer prices obviously include base commodities, which in most cases means they include price changes to futures contracts that trade in the open market. And as we know, the extreme price fluctuations in futures are more a reflection of psychology than of supply and demand. If you have read this page long enough, you know full well that the above is not exactly the kind of fact I would exclude in my argument.

Yet more on inflation.

I have to write about inflation again today. But it is not my fault. The media made me do it. It all started a week ago (May 10), when the Dow Industrials closed just 80 points shy of the January 2000 all-time high. The next morning, the Wall Street Journal ran a page-one story under the headline, “Behind Surging Stock Market: Old-Fashioned Economic Boom”. Among the quotes from that story, “A series of developments that skeptics thought would kill the bull market – resurgent inflation [blah, blah, blah] haven’t materialized. Federal Reserve Chairman Ben Bernanke gave investors a boost in late April when he told Congress that surging energy prices have so far failed to bleed into other prices.” And, “The situation resembles the Goldilocks economy of the 1990s – not too hot, not too cold – with inflation moderate and economic growth downright strong.”

Are you starting to get the idea? A week ago there was not enough inflation to scare anyone out of doing anything. The Grand Pooh-Bah at the Fed said so himself. But that was then. Today the Dow closed 200 points lower, so it is “Consumer Inflation Sinks Stocks” – that bad ‘ole CPI that I have been going on about was released this morning, and it showed a whopping 0.2% increase over the previous month. Here is a chart (courtesy of Briefing.com) so you can see for yourself just how bad it was. “Wait,” you say, “the only real increase is the 8.8% rise in motor fuel.” Umm, true enough. In fact, look closely in case you missed it: Nearly every other category was either unchanged or actually declined vs. the previous month. And by the way, does the reported price increase in motor fuel surprise you – or anyone who managed to get beyond the third grade in school?

So as I said, the media made me do it. That is my story and I am sticking to it. I will not dwell on the fact that today’s stock market fall simply continued a decline that began a week ago, because that is the ancient past – you know, back before this morning’s CPI release showed the colossal 0.2% increase. In truth, there is no “ancient” past when it comes to the stock market. The trend we see unfolding now really does fit into a pattern that links to the previous week, month, year, and beyond. It is a pattern you can understand and learn how to recognize.

THE GENERALS HAVE NOT BEEN FOLLOWING THE SOLDIERS. NOW WHAT?

Only one-quarter of the companies listed on the Dow Industrials accompanied the index to its new 2006 peak. One in particular – General Electric – is the hot topic of a May 16, 2006 Dow Jones MarketWatch piece. Over the last five years, corporate earnings for GE have soared 22% while the company’s stock price is now $17 below its 2001 level. More striking is the fact that from May 2005 to May 2006, the DJIA gained over 11% while GE shares actually lost 2% in the midst of booming orders, multi-billion dollar bets on energy, and “buy” ratings across the board.

GE is far from alone in its inability to – shall we say – bring good things to life. Last we checked, everyone from Mickey Mouse to Microsoft and Intel to Pfizer has suffered a similar fate, leading one April 17 Business Week to declare an official outbreak of the “Blue Chip Blues”. As for why – well, the BW column goes into great detail about a possible “global rebalancing” act taking place, whereby average investors can now seek higher yields from sectors once closed off to them by a lack of income (hedge funds), interest (emerging markets), regularity (commodities), or return (small caps). “Big U.S. stocks face much more competition for investors’ dollar than ever before and must duke it out with new issues,” explains one analyst. “Diversification is back,” concludes the same source, “And that’s not a bad thing.”

Back in February, we revisited the issue of “A Big Boy Breakdown”. In our words, “The absence of participation in many of the most important blue-chip stocks” meant the imminent presence of a downturn in the market at large. “When the generals abandon the front lines to the soldiers,” we observed, “carnage” tends to follow for the “more speculative shares.” On May 5, the S&P 600 Small Cap index peaked and has outraced the major indexes lower. On May 10, the DJIA came within a whisker of its all-time 2000 high and has fallen steadily since. On May 15, the global marketplace experienced a widespread fall-out as big-name averages from Singapore to South Africa, Argentina to Australia, Dubai to Denmark – all turned down. On May 15, metal markets for gold, silver, and copper joined prices for crude oil and gasoline in the prev-AIL-ing slide.

All of which means one thing. The question is NOT whether one market will save the day for the shortcomings of another. It is whether the rising tide of liquidity that has lifted all the same markets together as one WILL return again to put an end to the “Blue Chip Blues”.

ECONOMISTS CLUELESS ON THE ECONOMY?

The Wall Street Journal’s Monthly Economic Forecasting Survey continues to be a case study in how clueless economists are about the economy. Just as interesting is the fact that the WSJ will politely revise the questions from given one survey to the next, in a way that helps economists look like they have more of a clue than they really do.

In August 2004 crude oil prices hovered in the mid-$40s. One of the survey questions asked this, “What price for crude oil, if sustained for a meaningful period, would tip the U.S. back into recession?” It was a multiple choice question: “$50-$59”, “$60-$69”, and so on, up to “$90 or more.” What was the preferred answer? You guessed it – “$50-$59” got the most votes. In April 2005 oil prices were between $50-$60. The survey asked exactly the same question, with the same multiple-choice price ranges. This time the highest price range ($90 or more) received the largest number of votes. The low end got no votes, given that $50-$59 is precisely where crude oil prices had been.

Onto February 2006 – crude was in the $60-$65 range, but, well, the WSJ survey question is only sort of the same: “To date, the increase in oil prices hasn’t been passed through by businesses to a degree that would cause a significant increase in inflation pressure across the economy. What price would crude oil need to reach on a sustained basis to trigger that kind of price pressure?” Notice the assumption missing from this revised question, namely that the price of crude oil could “tip” the economy into a “recession”. Nice of the WSJ to be so accommodating – we would not want to face that assumption again either, especially if crude prices had long been above the level I said would “tip” the U.S. into a recession. By the way, the $70-$80 range received the vast majority of votes.

Last but not least is this month, May 2006. Crude prices have been mostly above $70 since early April. And behold, the WSJ again revised the question: “How high would gasoline prices need to rise and be sustained for a meaningful period of time to threaten the economic expansion?” So, the Q & A between the WSJ and economists is no longer about crude oil prices at all, much less about a tip into recession. Crude prices again reached the level where most economists said a significant increase would trigger recession/inflation, yet the CPI (inflation) was 3.3% in 2004, 4.3% in 2005, and the monthly CPI has actually been declining since September of last year. We would rather change the question too.

If the “experts” are this ignorant about oil prices, inflation, and the economy, can they have a sweet clue about the stock market? The Dow Industrials have fallen out of bed just as the Wall Street was ready to celebrate a new all-time high. If there is a time that investors need to understand the price AND psychological trends in the market, this is it.

YOUR SECRET CONNECTION TO THE INSIDERS

Imagine if every time you bought a stock, you knew exactly what the company’s CEO, CFO, board of directors and even its legal team thought about its future. Maybe the CEO would pull you aside and say, “Listen, next quarter is going to be a big one. We just landed a multi-million dollar contract with a brand new client. When Wall Street finds out about it, our stock will double.” If you had this kind of “insider information” you would always know what to invest in and when. But you do not have access to a company’s top management on a daily basis. And even if you do, they SEC prohibits them from doling out such crucial information.

Well, there is a way to know what the insiders are thinking before you ever buy another stock. Thanks to Section 16 of the Securities Exchange Act of 1934, insiders are obligated to reveal any trading of company shares by the 10th day of the month after they bought or sold their company stock by filling out something called a “Form 4”. On these Form 4s, the insider is required to disclose how much stock he bought, at what price and when he bought it. This is all crucial information. And you have access to it all. By scouring the market’s Form 4s everyday, you can know exactly what stocks the insiders are bullish on. You can know exactly where the so-called “smart money” is betting the highest returns will be.

Financial sites like Yahoo! Finance, investor.com and morningstar.com all have an “insider transaction” link you can click on to see if insiders in any given company are buying or selling stock. These sites simply download information from the Form 4s and publish it for their readers. The bad news is, it is not as easy as it may seem to decipher the insider transactions you see on the Form 4s or the financial Web sites. For starters, there are hundreds (if not thousands) of insider transactions reported in a given day. So it would literally take you ALL day to go through them. And even then, you have to know what to look for. Unfortunately, not all insider activity is useful – even the reported “buys”.

You want to look for the stocks that the insiders are loading up on with their own money – not just cashing in options – and enough of it that they would feel the pain if they lost out. Between 1958 and 1976 five prominent insider-buying studies were published by Rogoff, Glass, Devere, Jaffe and Zweig. They all wanted to show how much money you could make by buying the same stocks the insiders bought – shortly after they laid their money down. In each study these gentlemen followed two hard and fast rules. First, there had to be more than one insider buying stock in the company – known as “cluster buying”. And second, the number of purchases had to significantly exceed the number of sell transactions. By following these rules, they were able to beat the market by a 2:1 margin.

We look for at least two different insiders buying at about the same time. And it should involve top management putting up their own money – not just directors. The total number of buy transactions must significantly outnumber the total sell transactions. And actually, there is another rule. Small-cap stocks have dominated the market, outpacing the large caps in each of the last seven years. Historically, small-cap stocks have always led the market. Since 1926, there has NEVER been a period of 25 years or more where investing in large-cap stocks has proven more lucrative than investing in small-cap stocks. Net-net, if you combine the explosive small-cap market with the insider-buying strategies, you put yourself in a great position to identify the stocks market’s very best up-and-comers.

This chart presents the ratio of insider-buying to insider-selling across the broad stock market. Clearly, over the last few years, corporate insiders have become increasingly persistent sellers of their own companies’ shares. These folks-in-the-know are now selling about 5 shares for every one they buy – a multi-year low. If so many insiders are selling, should we outsiders be buying?

BUFFETT BETS ON OIL

While many contrarian investors are predicting a correction in the red-hot energy sector soon, the legendary Warren Buffett laid a bet that the streak will go on. Buffett’s holding company, Berkshire Hathaway, revealed a 17.9 million share stake in ConocoPhillips in its quarterly regulatory filing. The investment comes from the world’s preeminent value investor, even after shares of the oil company have increased 13% so far this year, after adding a whopping 52% last year. “I doubt that [Buffett] thinks ConocoPhillips is a screamingly cheap company,” says Glenn Tongue, managing partner with T2 Partners. “He probably thinks it’s a predictable asset-rich company that will grow in value far in excess of what his costs of financing are. That rationale goes along with some of Berkshire’s previous investments like Wal-Mart and Wells Fargo.”

Berkshire also disclosed new positions in General Electric and United Parcel Service, both of which fit Buffett’s philosophy of buying stable businesses that are industry leaders. The ConocoPhillips stake also fits Buffett’s game plan. He has experience in the energy sector, having made high returns by investing in PetroChina, and he has long said publicly that he views energy as an attractive area. Still, the move seems bound to raise some eyebrows, particularly after Buffett’s longtime sidekick, Charles Munger, made some controversial comments at the recent Wesco Financial conference. He suggested that future generations will curse present-day Americans for consuming fossil fuels at such a high rate, since the supply of oil will be greatly diminished.

“Those were pretty strong words,” says Tongue’s partner at T2 Capital, Whitney Tilson. “You rarely see Buffett and Munger investing in something that’s just had its biggest run in history in the last five years, [like the oil and gas market]. One reason may be that they believe oil prices are going to be high, if not higher, for a long time.” Added Tongue, “Conoco makes up a very small percentage of Berkshire’s overall portfolio, so people probably shouldn’t read too much into it.”

ASIAN TIGER, HIDDEN CONSUMER

Emerging stock markets did very well last year, with Morgan Stanley’s index gaining 30% as foreign investors piled in. Many of those economies were robust. Conditions there were very reminiscent of the 1990s when the emerging economies of East Asia – including Thailand, Taiwan, South Korea, Indonesia, Malaysia, Singapore, the Philippines and Hong Kong – were the portrait of stunning economic growth. The region thrived by providing the West with cheap electronic components and other exports. As international capital markets opened up, foreign investors began pouring money into the East Asian countries to profit from the region’s growth. As subsequent events proved, however, much of that money was ill-spent. The problems became clear with the currency crisis that began in Thailand in July 1997, when that country devalued its baht currency, and investors responded by pulling money out in a virtual stampede as the currency nosedived.

Beyond Thailand, South Korea and Malaysia also experienced rapid money depreciation as currencies fell in domino fashion. The withdrawal of capital led to significant retrenchments in other areas of those economies. Growth rates fell through the floor in 1998, especially in Indonesia, Thailand, Korea and Malaysia. The region’s stock indices plummeted. Within a few short months, the emerging economies of East Asia, once heralded as shining examples of export-driven growth, offered newer lessons on the shortcomings of their development. Topping the list were cronyism, lack of transparency, undeveloped capital markets, inadequate banking regulation and plain old-fashioned graft and corruption.

The industrious Asians, however, did not remain depressed for long. Sure, nepotism and other unsound business practices, at least by Western standards, were eliminated more on paper than in fact, but economic growth revived and the region was depressed only to a limited extent by the U.S. dot-com collapse and 2001 recession. These export-driven countries have also been aided by the collapse in their currencies in 1997-1998. Some of their currencies have subsequently gained against the dollar, but remain well below their pre-crash levels. Direct foreign investment has been returning to those lands, although collectively well below China’s, as nonperforming loans drop. In the aftermath of the 1997-1998 collapses, a number of the Asian Tigers realized that part of their vulnerability lay in excessive dependence on exports for economic growth. Two of these countries – South Korea and Thailand – tried, without much success, to promote domestic growth to reduce that dependence.

I have long felt that probably the most important result of the Industrial Revolution was the development of the vast middle classes in Western economies. Before that, the agricultural societies concentrated wealth and income at the top of the economic spectrum. That created enough domestic demand to spawn largely self-sufficient economies. I have argued that developing countries, including China, have not yet gained big enough middle classes to spawn domestically driven – as opposed to export-driven – economies. I believe the Chinese are simply spending the money coming from exports and direct foreign investment. With the next global recession, probably initiated by a U.S. house price collapse and fall in American consumer spending and imports, we will see who is right on the Chinese domestic-led growth argument.

In any event, the Asian Tigers remain dependent on exports, most of which, directly or indirectly, are bought by U.S. consumers. American incomes have been insufficient to finance consumers’ robust spending, so they have relied on the equity in their houses to support higher borrowing and lower saving. The combination of some financial and business reform among the Asian Tigers and more importantly, robust export-led economic growth, attracted foreign investment that hyped their equity markets, last year. That promoted more interest this year. U.S. institutional investors, such as pension and endowment funds, are also pouring money into emerging market hedge funds. As a result of all this foreign buying, Asian Tiger stocks are no longer cheap. The export-led Asian Tiger economies will be especially vulnerable if the current softness in U.S. housing activity turns into a full-blown collapse. Then American consumers will have no other means of supporting their spending and will retrench to the considerable detriment of Tiger exports.

Furthermore, a strong dollar – which I forecast, on balance, for this year – can slash gains in foreign investments for Americans. Then there is the threat of protectionism. Congressional ire is now focused on China, but history shows that any export-driven country is fair game when a weak U.S. economy spikes unemployment at home. Furthermore, rising global interest rates, as at present, have historically been punishing for stocks, especially in volatile emerging markets. Also, remember that small-country markets leap when foreign money floods in, but collapse even faster when it departs.

Why won’t we see a repeat of the 1997-1998 debacle among the Asia Tigers? They are more export-dependent now than in 1996. Short-attention-span hedge funds are now involved in their markets. And, if things start to somehow unravel, foreign investors will recall their big 1997-1998 losses and want to beat the crowd out the door. There is also the matter of correlation among stock markets. For years, I have analyzed the close correlations among stock markets around the world, most of which usually follow the U.S. The evidence is that markets are moving more in sync now than earlier, not surprising in an increasingly interconnected global economy. This suggests that troubles in the U.S. economy and stocks cannot be sidestepped by emerging stock markets in Asia and elsewhere. At the same time, however, the history of the late 1990s indicates that troubles for the Asian Tigers do not necessarily spread globally.

It is possible, then, that the Asian Tigers could once again go their own way, but I suspect that their fates lie in the hands of U.S. consumers, who buy the exports that propel their economies. So, the softness in American consumer spending I expect to accompany a big house price drop, will weaken both the U.S. and Asian Tiger economies. In turn, that will logically sire synchronized declines in stock markets on both sides of the Pacific.

BOOMERS BET ON PROPERTY FOR RETIREMENT SUPPORT

Baby boomers love their real estate. So much that they are counting on it to help them fund retirement. Since most of them have not saved much, they will probably need it. One in four Americans born from 1946 to 1964 own more than one property, according to a survey of nearly 2,000 boomers done this spring by Harris Interactive for the National Association of Realtors. They are also much more likely than the total U.S. population to own their primary residences. Boomers have “an almost insatiable desire for real estate,” David Lereah, the NAR’s chief economist, said in a statement. They see real estate as “a way to build and protect a nest egg.”

Boomers own 57% of vacation homes and 58% of rental property, according to the NAR. Beyond their primary residences, 13% of boomers own vacant land, 8% own rental property, 7% own a vacation or seasonal home and 2% own commercial real estate. Vacant land? “For a lot of people, it’s a dream to have a second home, but they really can’t afford it,” says Peter Francese, founder of American Demographics magazine, who was asked by the NAR to help interpret the survey. “So, they buy a lot.” At the same time, many of those surveyed say they are not financially prepared for retirement. While 37% say they just have enough to make ends meet, 17% say they are having financial difficulty.

Real estate ownership has become a key part of boomers’ retirement plans, says Alicia Munnell, director of the Center for Retirement Research at Boston College. That is largely because the national savings rate is so low, she says, and the availability of pensions is declining. Unlike previous generations of retirees who tended to pay off their mortgages and live “rent-free” in retirement, many boomers see their homes as money in the bank, Munnell says. Many previous retirees also chose to hang on to a house to pass down to their children. By contrast, boomers are more likely to use the equity in their homes, through home equity loans or reverse mortgages, to finance purchases or to help fund their retirements, Munnell says.

For boomers, vacation homes are not seen as merely a chance to have fun in the sun or on the ski slope or at the lake. Four in 10 boomers who own a vacation home intend to make it their primary home eventually, the NAR survey found. “Folks who own second homes are testing the waters to see if they want to live there when they retire,” says Mark Bass, a financial planner in Lubbock, Texas.

ARMs starting to hurt.

Thousands of Denver homeowners gambled on adjustable rate mortgage loans three years ago. Now those bets are coming up short. These homeowners are facing the hard truth that their ARM mortgage payments are going up several hundred dollars more each month as their rates adjust skyward. The higher payments are expected to cost many homeowners in the metro area tens of millions of dollars in higher mortgage payments and drive up the already near-record number of foreclosures. “In a sense, they were really playing Russian roulette,” said Ed Jalowsky, owner of Classic Advantage Realty in Denver. “Russian roulette is a form of gambling, and that’s what they were doing – they were gambling.” An estimated $2 trillion in home loans nationwide is expected to adjust upward in 2006 and 2007, according to Moody’s Economy.com.

The Denver area may be hit particularly hard because homeowners in Colorado on average have little equity in their homes. In Colorado, 28.5% of homeowners have 5% or less equity in their homes, and 47% have 15% or less equity, according to a report released earlier this year by Christopher L. Cagan, director of research and analytics at First American Real Estate Solutions in California. Only Tennessee homeowners, on average, have less equity in their homes, the report said. This lack of equity is one of the driving forces behind the rising Denver-area foreclosure rate, according to many experts.

This year is on track to eclipse 2005 as the second worst ever for foreclosures. Last year, more than 14,000 Denver-area homeowners defaulted on mortgages. Increasingly, people who locked in three-year ARMs with rates in the 4% range are finding loan rates rising by 50% or more. Next, the downward spiral begins. They cannot afford the higher payment, they cannot sell their homes for a profit, or they cannot refinance because they have little or no equity in their houses or they are precluded from refinancing because of pre-payment penalties. “People were still riding the euphoria of the late ‘90s, when they thought housing prices were just going to keep going up quickly.” So they locked in adjustable rate mortgages that had fixed below-market rates for three, five and seven years, Jalowsky said. Jalowsky estimates that 75% to 80% of homeowners defaulting on their mortgages in the Denver area took out ARMs in recent years. Jalowsky is listing a home for one client who is going to see his monthly mortgage payment rise by $1,000 on June 1, when his ARM adjusts.

Brian Bartlett, of RE/MAX Southeast, agrees. “It is absolutely mortgage roulette,” Bartlett said. “Either buyers were not informed by the mortgage broker or all they chose to hear was the answer to the following question: What is my initial monthly payment? When you combine ARMs, 100 percent financing, negative amortization, seller-paid closing costs, rising rates, falling prices, rising inventory and a continuing sluggish Denver economy, you have a recipe for 1987 to 1990 revisited.” That is when the local housing market crashed.

Keith Gumbinger, vice president of New Jersey-based HSH Associates, which tracks mortgage rates around the country, said a typical borrower who took out a 3-year ARM in 2003 at 4.18% could see that loan rise to 6.18% this year and 7.625% next year. The first bump would drive up the monthly principal and interest on a $240,000 loan by $296, to $1,467. And next year, they could see their monthly payment rise to $1,699, a $528 increase from the initial amount.

It is not entirely doom and gloom for the Denver housing market. Dan Jester, a spokesman for Moody’s Economy.com, said the Denver area is in decent shape because it did not see the huge run-up in prices that other areas have seen, so it is unlikely to experience the big crashes that could occur on the coasts. “If you were Orange County, (California), I’d be a lot more concerned.”

Housing boom a bust?

South Florida was once so hot speculators flocked to buy and flip properties. Now the market has cooled so much they are walking away from $80,000 deposits. The U.S. housing market has endured a boom of historic proportions over the past few years. Adjusted for inflation, real price increases have been the highest on record, letting consumers extract equity in their homes to fund spending like never before. But many of the hottest markets in California and Florida have cooled. A Canadian reporter traveled to Florida’s east coast and found the mood souring faster than in Silicon Valley in the spring of 2000.

Bernanke: Housing market is cooling, in an orderly kind of way.

The housing market, after flying high for five years, has lost altitude and appears headed for a safe landing, Federal Reserve Chairman Ben Bernanke said. “It seems pretty clear now that the U.S. housing market is cooling,” Bernanke said in a question-and-answer session following a speech he delivered on banking in Chicago. He noted that home sales are slowing as is housing construction. “Our assessment at this point … is that this looks to be a very orderly and moderate kind of cooling,” Bernanke said.

One of the things that Bernanke and his Fed colleagues are keeping close tabs on is the extent to which a housing cool down will slow overall economic activity. The housing market has been a top economic performer. The sector has racked up record-high sales five years in a row. Rapid appreciation in house prices has made homeowners feel wealthy and has powered consumer spending, helping the economy move solidly ahead. Cooling of the housing sector is expected to be a factor in slower economic growth in the months ahead.

The economy in the first three months of this year grew at a brisk 4.8% pace, the fastest in 2½ years. Many economists predict growth will moderate to around 3% in the April-to-June quarter, still a good pace. Bernanke did not discuss the future course of interest rates in his speech or in his remarks afterward. The Fed, which boosted rates last week, left its options wide open in terms of future rate decisions. It suggested that another rate increase could be possible if inflation worsens, or a pause in its two-year-old rate-raising campaign could be in store if economic growth slows.

Some economists believe the odds are growing that the Fed will bump up rates again at its next meeting, June 28-29. Those analysts said the odds went up after a government report Wednesday showed that consumer inflation bolted ahead in April. Others, however, believe the Fed will pause in June on the grounds that economic growth will slow and ease inflation pressures. On the issue of risky home mortgages, Bernanke pointed out that the Fed has issued some guidance for lenders and he underscored the importance of borrowers making sure they understand how interest-only and other nontraditional mortgages work. Borrowers and lenders holding exotic mortgages could get clobbered if housing prices drop or interest rates rise sharply.

COMIC ECONOMICS 101

The comic book specialty store fills a need in much the same way as did the barbershop of yesteryear. Often, customers come in to talk as much as read, and there is no limit to the topics: relationships, politics, business, jobs, games, or anything else that may be on a visitor’s mind. Economic shocks like the recent spike in gas prices often crop up in people’s conversation. But the very surrounding shelves of wonderful graphic novels can provide a wonderful antidote to the inevitable socialist bromides that rattle loose from many people’s lips. A poor soul can be guided back onto the path of economic common sense with a few examples understandable to a 12-year-old.

THE FEVER FOR EXOTIC STOCKS

Simon Nocera runs a hedge fund that invests in emerging markets, and so, perhaps not surprisingly, prides himself on having a keen appetite for risk. But even he had to draw the line when his broker tried to get him into Zambian treasury bills. “It was pure, baseless speculation,” said Mr. Nocera, who has been investing in developing markets for more than 15 years. “If I am going to play the casinos, I would rather go to Las Vegas.” Mr. Nocera did not make the trade, but a number of his even more adventuresome peers did. Propelled by a boom in copper prices, Zambian government bonds, denominated in kwachas and yielding 25% for 5-year paper, returned more than 40% this spring for those with a stomach strong enough for such a risky venture.

Four years into what has become the longest bull market in the brief, turbulent history of investing in emerging markets, investors from hedge funds to mutual funds to public and private pension funds have shown a willingness to take on increased levels of risk in developing markets. Benchmark stocks in the largest markets – like Brazil, Russia, India and China, collectively labeled B.R.I.C. – have experienced gravity-defying run-ups, prompting return-starved investors to look farther afield. Now in vogue are banks in the former Soviet republic of Georgia, airline companies in Kenya, oil refineries in the central Russian republic of Bashkortostan and start-up stockbrokers in India that go by the name of Indiabulls.

How short memories can be. This week, a round of mini-devaluations in Turkey, South Africa and Indonesia was a reminder that emerging markets, despite their improving economies and stabilizing currencies, remain volatile and unpredictable. Seasoned investors note that while the Mexican devaluation of 1994, the Asian currency crisis in 1997 and Russia’s default of its debt in 1998 were ultimately spawned by faulty policies in each country, the pandemic nature of these blow-ups was deepened by the panicked selling of unsophisticated investors. Now, in the eyes of some, this combination of record capital inflows and indications that investors have once again have become indiscriminate in their buying, spells trouble.

For James Trainor, a portfolio manager at Newgate Capital, a leading emerging markets hedge fund, the sign that the fever for emerging market stocks was running too high came earlier this month when he overheard the short-order cook at his local diner debating which oil stocks in Venezuela he should be buying. “He was saying, ‘Just wait until oil hits $100 – then these stocks will double,’” he recalled. “My reaction was: now things are really getting top-heavy.” Mr. Trainor, who manages more than $3 billion in assets and is a survivor of the previous decade’s market meltdowns, sees other warning signs as well. “Brazilian banks are trading at five time earnings. Russian debt has become investment grade. The risks associated with international investing have been pushed aside because of the returns,” he added.

Despite the market turmoil this week, there is no indication yet that developing markets are prepared to collapse. Dollar reserves are at historic highs and the broad macroeconomic health of many of these countries is vastly improved, helped by soaring commodities prices and robust exports. Indeed, these economies have undergone startling economic transformations. “The center of gravity has shifted,” said Antoine van Agtmael, a long-time investor in developing economies, who coined the term emerging markets. “These countries have become creditors instead of debtors. Current-account deficits have become surpluses.”

Nevertheless, the pell-mell rush of funds into these markets as well as the push for more exotic, riskier investment fare suggests that memories of past emerging market crises may have dimmed. Last week, funds that invest in emerging markets took in one of their highest weekly sums ever, bringing this year’s figure to $33 billion, already outpacing last year’s record $20 billion, according to EmergingPortfolio.com. For hedge funds, always on the lookout for the next hot investment fad, it has been an opportunity not to be missed – 153 funds were formed last year to invest in emerging markets, according to Hedge Fund Research.

There is much anecdotal evidence to be found that shows how investing in emerging markets has evolved from a niche area for hardened globetrotters and steel-nerved investors. In India, for example, a market that has shot up 141% over the last two years, some of the largest shareholders of top Indian companies are American mutual fund companies like Janus, known more for its momentum style of investing than for its emerging markets expertise. Just as technology stocks were good to Janus in the late 1990’s, so have Indian stocks been this time around. In the foreign large-growth mutual fund category, according to Morningstar, the top three performing funds over a one-year period are all from Janus.

Bidding wars have broken out between hedge funds for Indian investing talent. In Russia, where the stock market is up 150% over the last two years, investors have been piling into commodity-based stocks. It is not just foreign money that is pushing up stocks abroad. In Pakistan, where suicide bombings remain a frequent occurrence in Karachi, the country’s commercial center, an aggressive economic overhaul has lured billions of dollars from Pakistanis at home and abroad into the stock market. Since 2001, the stock market capitalization has exploded from $10 billion to its current $55 billion, and it has only been in the last six months that foreign investors have started to dip their toes back into the market.

Perhaps the broadest indicator that shows how comfortable investors have become with emerging market risk is the historically narrow interest rate spread that separates the government bonds of countries like Indonesia, Mexico, Turkey and Pakistan from U.S. Treasury bonds, long the paragon of risk-free investment. But as these countries have turned their economies around, narrowing budget deficits and accumulating current-account surpluses, their credit ratings have improved. In a curious reversal, many of these countries, in Asia especially, are now the largest buyers of the Treasury securities that the U.S. government has been selling as its own budget deficit has widened. “For the first time in modern history, poor countries are financing the rich,” said Marc Faber, a global investment analyst noted for his gloomy prognostications. “I would not rule out one day that Brazil will have a better credit rating than the U.S.”

But with spreads widening, seasoned investors like Mr. Trainor worry that that the sudden influx of new money, especially from hedge funds, many of which now are among the largest shareholders of companies in Turkey, Argentina and Mexico, may not have the patience or experience to withstand the volatility of these markets. “Shining returns have attracted all walks of investors like mosquitoes around a lamp post,” said Mr. Trainor. “For an asset class best left to dedicated investors, those that are not afraid to kick the tires in some of the most remote parts of the world, these mosquitoes better be careful or they might just get zapped.”

Chasing returns overseas? Know this.

Threats to U.S. economic growth seem to have mattered less to domestic investors in the last year. The fact that the latest index of leading indicators went from growth to decline took economists by surprise, but investors hardly noticed. One reason may be that investors see a slowing economy as good news for interest rates. But research by Citigroup senior economist Steven Wieting suggests another reason. He noted that recently, for the first time, U.S. retail flows into foreign stock funds exceeded flows into domestic stock funds for a full year. TrimTabs Investment Research’s latest weekly numbers show that stock funds that invest in the U.S. had inflows of $700 million, compared with the $2.3 billion that poured into international stock funds. If nothing else, the data show that the worst vestige of the Internet era remains – the deeply entrenched need for impatient investors to chase returns.

But it also raises the question, can the U.S. economy be separated from the rest of the world? Apparently these investors think so. If they believed the U.S. economy was going to pull down the global economy, they would have begun taking money out of overseas investments first. Mr. Wieting asked, “Can a strong acceleration be achieved while the U.S. slows? Not very easily.” I have to agree. It all comes down to a continued reliance on the U.S. to achieve world growth. “We can’t find evidence that dependence on exports to the U.S. has been markedly reduced across world economies,” he wrote.

When you add it up, the U.S. share of global domestic demand has been above 30%. Moreover, Citigroup’s economists figure that share should hold steady through 2007. Other countries’ internal consumption cannot be counted on. Still, many of these countries experienced growth. Where did it come from? Enter exports. Export growth in China has been running at 25% for the last five years, accounting for 40% of economic growth. And, “To the extent that China is a conduit for other nations to sell to the U.S. consumer through intermediate-stage-of-processing exports, this suggests high dependence on U.S. consumers for these other nations as well.” Return-chasing investors who have just headed overseas may not want to hear it. But the reality is, until the rest of the world weans itself of its dependence on the U.S. consumer, our economy will continue to matter the most.