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SILVER AS AN INVESTMENT?
For the record, this Optimist does indeed think of silver as a winning investment. That is an easy viewpoint for those of us who purchased much of our silver in the $4 to $6 range over the previous few years, and now have profits of substantially more than 100%. Since none of us can go back in time to capture again the great gains we have already seen, the ever pressing essential question is always what do we do now for the future? Once again for the record, the Optimist is a strong bull on all precious metals prices in general, and on silver in particular. As many other analysts have recently pointed out, the inflation adjusted prices of precious metals today is much lower than the heights precious metals already reached in 1980. As inflation continues to escalate, the Optimist firmly believes that silver and gold will dance ever upward to the beat of a much higher tempo.
Most readers have only read about the metals rise before 1980, though a few were investing along side me back then. For those who did not experience those times, I can only tell you that it was truly exhilarating. I am happy to confirm that I expect all of us to have the opportunity to again experience the thrill of victory as silver and gold explode to heights that few today can even contemplate.
But a reader who sent me an email seems focused on the agony of defeat. In January 1980, silver did crash from above $50 to almost $10 in just a few trading days. Will the future rhyme with the past? The Optimist does not think so, because this time it really is different. The crash of 1980 was precipitated directly by the Fed raising interest rates to significantly higher than inflation. Administering that type of strong economic medicine to the national economy in its now weakened condition would surely be terminal for the patient. The Optimist concludes that the Fed will only apply band aids, and perhaps occasionally push on pressure points in a way that might be temporarily painful, but which will cause no lasting harm to the economy or to our investments. The result that seems likely to the Optimist is that inflation will march relentlessly upward, and that ever increasing inflation will propel silver and gold prices to unimaginable heights. All games eventually end, of course, but the Optimist offers the cheery viewpoint that the game of perpetually higher prices for silver and gold is likely to end only with the demise of the dollar. Silver and gold will retain their value throughout the end game, while other investments measured in fiat will lose purchasing power even as their nominal prices increase but at a slower rate than inflation.
How is this for an optimistic approach to investing? Buy real physical silver (or gold or palladium or platinum) metal, and keep it in a safe place. That is the full plan. Buy the good stuff and keep it safe for a no risk approach to investing. Long after stocks have fulfilled their destiny to fill the pockets of bankruptcy lawyers, and houses lose the inevitable battles with Mother Nature, and T-Bonds revert to the value of the fiat dollars they will be repaid in, an ounce of precious metals purchased now will still be worth an ounce of precious metals. Buy when you have surplus fiat to invest. If you must sell, then do so when interest rates rise to significantly higher than real inflation. Sleep soundly each night without worry about the latest price quotes for silver or other precious metals, because each ounce of precious metal that you own will always have the value of an ounce of precious metal, and your purchasing power will be protected.
Yes, a simple and safe investment plan offers little more excitement than watching grass grow. Since mining stocks will explode upward with the rising metals price, then greed shouts at us to get more leverage by using options, and futures, and options on futures to maximize the amount we have invested. Only after we are using the maximum available margin and leverage, possibly with money borrowed from other sources, will the greedy voice inside each of us begin to slip back into the shadows of our minds. The next voice to interrupt our daydreams about all the baubles we will buy with the abundant profits from our extremely leveraged position is the painful screech of fear. The conversation that fear induces inside us goes something like, “What! Silver prices just dropped a few percent. I thought it could only go up. At maximum margin, I would be wiped out! I must sell now to avoid losing everything I own. I will call my broker and tell him to sell all my positions immediately, so I won’t lose more when silver goes all the way back to zero.”
The Optimist understands very well the intense pressure for excitement through leverage, the irresistible lure of greed, and the devastating terror of fear. Losing money by betting in the wrong direction is painful enough, but losing while betting on the right market to move in the right direction is especially difficult to handle. The problem is not that people bet that silver would rise. Silver has moved sharply higher from the $4 level three years ago to more than triple that now. The problem is that greed caused those losing investors to use too much leverage at the wrong time, and then fear forced them out of the game just when they should have been buying more.
The cure for investors whose results suffer from the afflictions of greed, leverage, and fear, is to take a step back to a quiet, calm, and simple investment process. Tell the greedy voice inside to just shut up. Avoid leverage, and there will be no need to do anything about the internal voice of fear, because there will be no fear. Instead of taking huge risks now to try to get rich quickly, invest a reasonable amount of funds for the long term, and let time be your ally to help your well chosen investments to prosper. The Optimist tries to convey a sense of perspective over time in his charts. By showing the long term monthly, and medium term weekly, in addition to the near term daily charts, he hopes to better illustrate the long term trends without the confusion that the near term market noise often contributes.
To profit from the coming explosion in silver prices, one needs to have pockets which are deep enough to hold only a single U.S. FRN dollar. Any elementary school kid with a dollar of allowance can buy a U.S. silver dime dated 1964 or earlier for just about one FRN dollar. By simply putting that dime away in a safe location and waiting for time to pass, one can be assured of an eventual profit measured in FRN fiat, and of conservation of that much purchasing power through the years to come. Investors who have more fiat dollars available to invest need not change the process, but simply buy more silver and put it away in a safe place.
The investment community is not yet on the silver bandwagon, and many people do not even think of silver as an investment. The Optimist can confirm that in recent weeks, he heard many news headlines about the rising prices for gold and base metals like copper, but he did not hear any mention of the rapid rise in silver prices over the last three years. The news silence on silver, and the corresponding vacuum of information among the public, bode very well for future silver price increases. Every person who does not yet know about the very bullish fundamentals of silver is a potential future buyer, and will help to push prices ever higher.
The Optimist encourages everyone to silence the internal voice of greed which frequently leads to losses, to quell the near term confusion caused by corrections and market noise, and to stay firmly focused on the long term progression of values in silver and the other precious metals. The Optimist thinks the future for silver looks as bright as the past, and he encourages readers to share a part of that future by accumulating real silver metal in a secure place. Cheers!Link here.
Thoughts on the gold/silver stock correction.
The month of May proved to be an eventful month for the leading gold and silver stocks with lots of wide swinging movement, mostly to the downside. This volatility did not go unnoticed by Wall Street either, with several articles appearing in the leading financial publications drawing investors’ attention to the “attractive” volatility currently underway in the metals arena. The question weighing on the minds of most gold and silver stock traders is whether the sector has bottomed and if not, how much longer until it does?
On an immediate-term basis the gold/silver stock sector is “oversold” based on several internal indications and could get a mild relief rally in the coming days. For example, among 50 actively traded and representative gold shares that I look at each day, most of them are currently below their 15-day moving averages. For the last few days there have been at least 40 of these 50 stocks closing each day below their respective 15-day MAs, which indicates at the very least that the sector should get at least a baby bounce to correct this internal imbalance in the immediate-term.
A relief rally coming off an oversold extreme is not the same as the start of a new bull market leg. For that to happen the sector will require some more time to repair the internal damage inflicted following the previous rally peak in earlier May. One of the main confirmations of a gold stock bottom will be in the internal momentum readings of the short-term momentum indicators for the sector. Previous gold stock corrections ended when the internal momentum among the 50 actively traded gold shares reversed from a lower reading to a higher reading. At market tops, momentum tends to precede a decline in the XAU while at bottoms a reversal in momentum from down to up happens concurrently with price reversals.
One of the main indications of a reversal in short-term momentum is reflected in the chart showing the rate of change (momentum) of the new highs and new lows among the 50 actively traded gold shares. Known as GS HILMO (Gold Stock Hi-Lo Momentum), it shows the reversals in internal momentum on a 5-day, 10-day and 20-day basis and the interactions between them. At the low back in March, GS HILMO reversed higher after falling below the “zero” line in February to confirm the bottom. In the most recent GS HILMO reading, this has not occurred yet. Therefore the gold stock correction is presumed to still be underway, and notwithstanding the possibility of an oversold rally, there could still be a lower low among the actively traded gold and silver shares before the next bottom is confirmed.Link here.
GOLD, INFLATION, AND … AUSTRIA?
The nation of Austria probably does not come immediately to mind when you think about inflation, gold, and the business cycle – but it should. I am not talking about gold Austrian Shillings or bullion sales by the Austrian central bank. I am talking about the Austrian School of Economics and the Austrian theory of the business-cycle. The Austrian theory of the business-cycle offers the only plausible explanation for the cyclical boom-bust pattern we have come to expect in the U.S. and global economies, and which is partially responsible for the exponential increase in the price of gold over the past five years.
The term “business cycle” refers to the recurring pattern of “boom” periods in the economy which are seemingly inexplicably followed by a “bust” or recession phase. The term does not refer to individual events that cause a recession (like a massive hurricane or a plague). The term refers to periods like the roaring 1920’s which were followed by a sudden, unforeseen and terrible recession, and the booming 1990’s which were followed by the recession which began in 2000. The reason why we need a sound theory of the business cycle is that the very existence of the boom-bust cycle is perplexing. Why are huge numbers of business owners and investors unable to foresee the slowdown in the economy and take precautions which would lessen its severity? Why does the economy not progress at an even rate?
What causes the business cycle, according to the Austrian School, is tampering with the rate of interest by the government. The central bank instigates the boom-phase with its “easy credit policy” by reducing the rate of interest below what would be established on the free-market. This lowering of the interest rate tricks business owners into believing that further investment in their productive capabilities would be profitable, and they borrow more capital than they would have at the higher free-market rate of interest. The capital that is loaned out, moreover, is not backed by any real savings (as it would be under a gold standard) – it is simply created out of thin air by the fractional reserve banks. The inexorable effect of this artificial lowering of the interest rate is a boom phase, during which capital is invested in lines of production that would not have occurred at the market rate of interest.
At some point, the business owners who have increased their productive capacities in areas that are not really desired by consumers (because they have been tricked by the low rate of interest), come to recognize that they have overinvested, (because they are not earning a return on their investment that is sufficient to cover their loans), and they must liquidate this overinvestment. This is the beginning of the bust-phase, or the crisis phase. The bust phase of the business cycle is the period in which the malinvested capital from the boom phase is liquidated and moved to more productive uses.
The Austrian theory of the business cycle, therefore, identifies an increase in the money supply as solely responsible for the cycle. Not just any increase in the money supply will cause the cycle, however. Only an increase in the money supply that takes place specifically in the credit markets that causes the boom-bust cycle. Tampering with the rate of interest produces a situation in which business owners are misled and investment is squandered.
What can the Austrian theory of the business-cycle tell us about the price of gold over the past two decades? First, during the boom-phase of the 1990’s the artificially lowered rate of interest spurred investors to channel their investments into the ostensibly booming industries that were receiving the influx of new credit. In the late 1990’s this new credit particularly inflated the residential and commercial real estate markets. At the same time, the world’s central banks released massive amounts of gold bullion through bullion banks which dramatically depressed the price of gold. As a consequence of these two phenomena, investors dramatically shifted their investments away from gold toward the booming industries receiving the new credit (like real estate). The boom phase lowered the price of gold dramatically below what would have been established on the free-market in the absence of these government-caused phenomena. This boom-phase suddenly and unexpectedly slowed in 2000-2001.
We are now in a position where the commercial and residential real estate markets are poised to rupture violently, which will release a massive amount of capital from these inflated sectors of the economy for investment in more productive areas. The problem is, the U.S. dollar is itself in a dangerously precarious position, and investors are wary of investing in U.S. dollar assets. In other words, the market is ripe for an incomparably massive investment in gold and other precious metals when the tear in the 1990’s boom inevitably turns into a massive rupture. The correction in the precious metals markets is temporary. You will not want to be left without gold when the impending bust phase inevitable hits.Link here.
ENERGY MANIAS, THEN AND NOW
Concerns about the looming oil shortage are intense. It seems that most people from Wall Street to Main Street to those in government are worried about the phenomenon called “Peak Oil”. Unfortunately, there are some laggards who are not sufficiently motivated and a leading expert slams the skeptics and, at the same time, elevates the status of the true believers. Although energy is mainly a secular matter, the expert writes “This is a question of almost religious importance which needs the study and determination of every intelligent person.” And the key message is, “It is the material energy – the universal aid – the factor in everything we do. With petroleum almost any feat is possible or easy; without it we are thrown into the laborious poverty of early times.”
Amen to this, but it is important to stress that these quotations have been provided without a date and with one key word changed. The date was 1865, the important energy source was coal, and the writer was Stanley Jevons – a leading economist. His book, The Coal Question was thoroughly researched and broadcast his personal concerns that the industrialized world was about to run out of coal and civilization, as they knew it then, was about to collapse. Now, the concern is that we are running out of oil and great distress will follow.
As with any such concerns before then and right up to now, the intellectual speculation seems mainly driven by soaring prices. Commodity prices had been increasing for 20 years, and were soaring with the U.S. Civil War and the dollar depreciation that went with it. The market soon attended to the price problem and even to this day there is no shortage of coal. This time around, crude oil has the headlines and if we adjust the price by the producer price index it tells an interesting story. The real price soared to $73 with the 1980 crisis and then plunged to $16 in 1986. Now, 20 years later, it is again back to $73 and those who insist that their intellect and personal concerns are superior to market forces are again getting the headlines. This was the case for coal in 1865 and the last time it happened to crude oil was in 1980 when the then U.S. Secretary of Energy stated that market forces did not apply to crude oil – his exact words were: “One thing is for certain, [crude] prices will continue to rise … traditional criteria of supply and demand don’t apply.” ~ Charles W. Duncan, Secretary of Energy, February 25, 1980
It seems that the higher a mania runs, the higher the intellect that succumbs to it. If, indeed, oil prices moved solely on dysfunctional Middle East politics, then the chart would show a relentless rise from lower left to upper right – beginning as the Royal Navy converted from coal to oil in the early 1900s. However, crude’s history records major price changes dependent upon the 4 to 5 year business cycle as well as recurring manias in commodities. Quite likely, petroleum prices will still be subject to the long term trends, with the ups being provided by great asset inflations and the downs provided by the lengthy post-bubble contractions.
Also evident in the price history are fluctuations with the perennial 4 to 5 year business cycle. Also evident in the price history are fluctuations with the perennial 4 to 5 year business cycle. On the most recent one, crude prices have rallied from $17.48 (spot West Texas intermediate) in November, 2001 to the recent high of $75. It is important to peer through the distortions caused by the policies of deliberate currency depreciation and this can best be done by adjusting the price by the Producer Price Index (PPI). The “big” high with the 1980 Iranian Crisis was $73. This sets the 2001 low at $21.82, from which it has soared to $75. In 1980, the tout was that crude would get to $90, which compares with today’s touts of $100.
Obviously, conditions are as speculative as at the 1980 high. With such market compulsions evident again, it is natural to ask the question Are we there yet? In this case, the “there” means the end of yet another speculative trip in energy prices and, for this, it is prudent to observe that every great mania in energy prices has occurred close to the peak of a business cycle. For many, the main explanation to a slump in crude prices would require a cessation of Middle East troubles, which is unlikely. For the more disinterested, the best explanation would be just another post-bubble business contraction whereby prices for most commodities (including oil) go down.
One of the most relentless forces acting on commodity prices is deliberate dollar depreciation. If the Fed’s intentions were supreme, the dollar chart would be a straight line from the upper left to the lower right, but this is not the case as there are times when the Fed just cannot depreciate. Typically, this also occurs during the post-bubble contractions when implacable market forces deny the policies of depreciation. According to the technical analysis that identified the dollar’s low in December 2004, the dollar index is poised for a rally, in which case an essential part of the compulsion to consider commodities as an asset class to “invest” in will diminish. Speculative excesses have captured the imagination of pundits, punters, policymakers, and intellectuals in a manner unseen since similar excesses were displayed by the same crowd in 1980 or at any great blowoff in commodities in history.Link here.
CAUTION WARRANTED IN FOLLOWING JIM CRAMER’S INVESTMENT ADVICE
One screams and throbs at the camera, while the other would address his viewers with the wooden calm of an English gentleman at tea time. Yet despite the Jekyll-and-Hyde differences between Jim Cramer and the late Louis Rukeyser, there is one notable similarity between their TV programs: any mention of a company could move its stock. This is a crucial fact for individual investors to understand because the stock market is a crafty place where the smart money loves to prey on predictable patterns like the instant bounce for stocks touted by Cramer on CNBC’s Mad Money program. And when the pros win, the ordinary folk are bound to lose.
Cramer fans need not despair. Rather than swearing off the former hedge fund manager’s advice, all that may be required is the poise and patience to wait a couple of weeks before putting your money where his mouth is, judging from a study into trading patterns after each airing of Mad Money on weekday nights. Cramer himself urges viewers to avoid the temptation to rush right in, especially during after-hours trading, though he does not see a need to hold off for weeks. Investors flock to Cramer’s show for good reason. It is rare for average investors to have direct access to a professional stock picker with Cramer’s vast knowledge and experience. Which is why shows like his have the effect they do, and why caution is advisable.
There was a time, before the Internet, where it was hard to get stock and bond quotes, let alone timely advice from the pros. One easily accessible resource was the weekly edition of Barron’s. Even more accessible to the masses was Rukeyser’s long-running Wall Street Week, which appeared once a week, free of charge, on PBS. Since Barron’s came out on the weekend and Rukeyser’s show generally ran on Friday nights, there was an entire weekend to mull the information imparted by the money managers and investment analysts featured in either venue. Invariably, by Monday morning, the pent-up demand would push the touted names higher. The pace has quickened dramatically since the mid-‘90s, stoked by all-day market coverage and prognostication on CNBC, countless Web sites and frothy online message boards.
At the same time, technology has provided the computing power and sophistocated software to crunch all that real-time information in real time, enabling professionals to prowl for opportunities afforded by the market’s herd-like reactions. With a stream of stock tips as steady and high-profile as Cramer’s, it does not even take technology to see there is a pattern to exploit. So for better or worse, it seems the pros are scoping out the joint when it comes to Mad Money, judging from an academic study into trading following each edition of program.
The study tracked the performance of about 250 companies that drew a favorable mention on Cramer’s evening program between late July and mid-October 2005. Overall, shares of the recommended companies outperformed the market by an average of 3.5% on the first day after Cramer’s tout. The smallest companies outperformed by 6.2% on average. Almost immediately, however, the stocks beat a hasty retreat, surrendering the initial gains within about 12 days. In tandem with this activity, the researchers found a sharp uptick in opportunistic behavior among short sellers. Starting with the next morning’s opening bell, short-selling in a Cramer-recommended stock spiked to six times the normal volume in the first few minutes of trading and then remained above average for three days. Cramer said he repeatedly warns his audience to steer clear of after-hours trading, when he says buyers outnumber sellers, making it easier to get burned.
Importantly, the researchers did not pass any judgement on Cramer’s stock-picking prowess or concern themselves with the longer-term performance of the companies. The main lesson is that those who believe Cramer’s insight is valuable may do themselves a favor by stepping back and waiting for the initial storm of activity to blow over. Any gains to be had with his recommendations will only be enhanced by avoiding a costly mad rush to follow the Mad Money.Link here.
WALL STREET TOUTS TRANSPARENCY, YEARNS FOR SECRECY
Scandals like the one that toppled Enron have sparked calls for greater corporate transparency, but the outcry for openness ends where Wall Street’s murkiest worlds begin. Hedge funds and derivatives, both largely unregulated, are among the least understood arenas in the world of finance – and look set to stay that way. With recent extreme volatility in global commodities and stock markets boosting an aversion to risk on Wall Street, some worry that hedge funds and their affinity for highly complex trades pose a threat to the financial system. In many cases, these secretive funds use even comparatively simple derivatives contracts for speculation rather than their intended purpose – mitigating financial risk.
The trend has supported a credit boom that continues to fuel global economic growth, but has also swelled the credit derivatives market to an estimated $17 trillion. Its sheer magnitude may also hold the seeds of disaster, say pessimists. “A possible scenario is that many hedge funds will fail simultaneously from exposure to credit derivatives,” said Edward Chilcote, economist at Bard College’s Levy Economics Institute in Annandale-on-Hudson, New York. “The market might become illiquid, and the potential for a cascade of losses could rise.” The ramifications of such an event would be huge because a simultaneous unwinding of positions could both wipe out individual investors and endanger the financial system as a whole, some analysts say. Another concern is that the sector’s opaqueness leaves it wide open to mischief. “With over a trillion dollars under management and both the ability and the incentive to cut corners, it seems to me the least we can do is shine a little light on the industry,” says David Skeel, professor of corporate law at the University of Pennsylvania Law School.
The International Swaps and Derivatives Association, a New York-based group representing industry participants, says regulating lenders in derivatives trades is enough to ensure the system works. But some analysts say the scandals that have plagued corporate America in recent years suggest that the temptation to skim off the top is simply too great given the huge sums at stake. They say that, even after the recent convictions of former Enron Chief Executives Ken Lay and Jeffrey Skilling, corporate crimes continue unabated. Skeel is skeptical of claims that profit-driven bankers can regulate themselves. “The big money – and the reason so many people are leaving investment banks to run hedge funds – comes from the fact that hedge fund managers usually get 20 percent of the profits they bring in,” said Skeel. “This creates a huge incentive to bring in profits however they can. The industry doesn’t seem to want anyone shedding more light on it in any way. But with the misbehavior we’ve already seen, and the huge amount of money sloshing around, surely this can’t be the right solution.”Link here.
THE GREAT HEDGE FUND DEBATE HEATS UP
This is just the start of the new era of hedge fund scrutiny. The key point of the hedge fund proponent in a Wall Street Journal article is that if hedge funds pose “such a dire threat, then why haven’t [they] been tainted by the many financial scandals of our time?” His opponent rightly points out, however, “There have in fact been more than a ‘few, small scandals’ related to hedge funds. And these frauds, bankruptcies and disruptions to the global financial system will continue without significant regulatory changes.” Our point is that they will, in fact, accelerate as the markets head lower. Interestingly, even the hedge fund supporter in the WSJ article notes that there is a “serious issue raised by the growth in hedge funds: systemic risk.” He cites LTCM’s 1998 failure as an example: “There were worries that it could spark a more general panic in the markets and threaten the functioning and strength of key financial institutions. Without question, this could happen again.”
The WSJ’s hedge fund defender also adds that “no government institution short of a global, omniscient regulator is likely to nab a future LTCM in advance. In truth, our largest commercial and investment banks are the primary line of defense. They seriously don’t want to extend credit to hedge funds that might blow up. The problem is that the banks are also profit-seeking enterprises, and hedge funds can be very profitable customers. Standards can slip.” They always do at the end of a long advance, like that of 2002-2006. The hedge fund proponent urges the creation of a rainy day, hedge fund blow-up fund as insurance against disaster. Of course, it is a little late for that. At this point, there is no way banks have enough capital to cover the potential loses. In other words, the hedge funds that survive the debacle may wish they had not.Link here.
THE BIG GLUT IN SECOND HOMES
It would seem to have it all: 4 bedrooms, a guest house, a pool and a rock waterfall. But the vacation home in Naples, Florida, has not been drawing much interest from buyers, so the seller recently threw in that most modern of amenities: the $1 million price cut. That has brought the asking price down a full 25%. “If you want to sell, you’ve got to go back to ‘04 prices,” says Chip Harris of Coldwell Banker Previews International, which is handling the property.
The market for second homes could use a second wind. After a long string of double-digit annual price increases, a number of second-home meccas across the country are suddenly suffering from plunging sales volume and burgeoning inventories of unsold homes. Result: Naples-style discounting is starting to spread. It hit the town of Pocasset, on Massachusetts’s Cape Cod, just as retired executive Jack Reen was trying to sell his 4-acre, 6-bedroom beachfront home. He cut the price several times, for a total of 42% off the listing price, before striking a deal at $3.95 million. Reen takes a philosophical view of the experience, noting that the original price was set at the top of the market. “Calling the tops and bottoms is impossible,” he says.
Although the official figures on sales prices have yet to reflect the current round of cuts, interviews with real estate pros and others strongly suggest that the averages are deteriorating in a number of key markets. Just look at green and hilly Litchfield, Connecticut, about a 2-hour drive from New York City. It was a magnet for Wall Streeters during the past five years, and prices climbed accordingly. But in the past 10 months, prices in the lower end of Litchfield’s market – homes of $300,000 to $600,000 – are down 12-14%, and volume is falling at the next level up, says Stephen Drezen of the local Portfolio Properties Group.
It is all a big change from the seemingly endless rises in prices. For more than a decade, baby boomers have been flocking to the second-homes market and lifting prices, just as they had earlier lifted the market for primary residences. The demographics – 75 million boomers – still bode well for long-term growth. But first, the market has some correcting to tend to. While pundits debate when the bubble might burst in the primary-housing market, the air already is whooshing out of parts of the second-homes market. Naples, on the sun-drenched edge of the Gulf of Mexico in Southwest Florida, is perhaps the most striking example. Last year alone, buyers bid up the area’s median price by 30%, to $482,400. Today, about the most visible activity in that area is the 400 or so daily additions on the multiple listing service – and price reductions by the dozens. With mortgage rates rising and home-price appreciation slowing or vanishing, buyers in Naples have pulled back in a big way.
It is true that the total second-homes market nationwide has managed to keep posting gains over the past two years. But the National Association of Realtors’ chief economist, David Lereah, expects the volume of second-home sales to decline at least somewhat this year. And there is every reason to think that some markets could be hit hard. For starters, many second homes have been sold not to serious vacationers but to speculative investors hoping to cash on the national real-estate craze. The danger is that if enough of those investors decide the market has peaked, they could trigger a selling frenzy throughout the second-homes market. That, in turn, could add to the pressures in the main housing market. In Myrtle Beach, S.C., long a favorite vacation and retirement destination, investors bought a full 58% of properties in 2004. The normal level is closer to 14%.
The price runups of the past several years are reason enough for concern. A report from Cleveland-based National City, a top banking and mortgage concern, points to serious overvaluation in a number of second-home hot spots in Florida, California and elsewhere. Tucson, Prescott, and Phoenix in Arizona are estimated to be as much as 52% overvalued based on income levels, population densities and historical prices. Behind all this is a fervor eerily reminiscent of the late 1990s on Wall Street. Some 65% of second-home owners surveyed by the National Association of Realtors said they considered their second homes better investments than stocks, and 29% said they planned to buy additional properties within two years. An eye-popping 64% of investors with four or more properties planned to buy another property within two years. But those high rollers could lose their nerve quickly if prices continue to weaken.
Southern Florida has shaped up as the epicenter of the looming glut. Investors hoping to sell luxury condos that they bought over the past couple of years could be in for some special trouble. A recent report by San Francisco-based JMP Securities analyzing the Florida condo market estimated that 25%-40% of the of condo units now for sale in Florida belong to such investors. Florida condo sales are down 20%-50% year over year in most markets, JMP says. And the report cites estimates of 50,000 new condo units announced for Miami-Dade County alone, adding to the 50,000 either under construction or ready to begin. That compares with the 10,000 total that have been built in the area in the past 10 years.
Some home buyers are seeking a measure of stability by venturing away from the traditional hot markets. But plenty of once-tranquil towns already have been discovered. The tough conditions in the second-home market are no small matter for the people who own the homes. And the so-called mass affluent – folks with investable assets of $100,000 to $1 million – will probably take the brunt of any price declines. All the same, many experts are cheering the current shifts in the markets. They call it an essential correction, a step that must be taken before the second-home market resumes its ascent. There is certainly hope for the long term. The trouble is, home owners may have to wait quite some time.Link here.
Texas foreclosures: 1980s vs. 2006
George Roddy is no stranger to real estate cycles. The president of Addison, Texas-based Foreclosure Listing Service Inc. has been collecting data on the industry for 36 years. When he started producing reports on foreclosures, the end result was a hard copy that encompassed Dallas, Collin, Denton and Tarrant counties. Mr. Roddy pioneered online data access back in 1994. In the 12 years that have followed, FLS has grown to cover 18 counties across Texas. As local foreclosure rates approach the heights of the savings-and-loan scandals of the 1980s, Mr. Roddy’s depth of experience enables him to draw parallels – and distinctions – between yesterday and today.
The most recent figures on foreclosures per capita place Dallas-Fort Worth behind only Indianapolis and Atlanta among U.S. metro areas. Mr. Roddy recently sat down to discuss the current state of the local market and its future as the biggest real estate boom in U.S. history winds down.Link here.
FANNIE MAE BOARD MAY FACE ENRON-TYPE SCRUTINY
Fannie Mae directors, who have so far escaped the kind of blame heaped on boards at bankrupt companies such as Enron and WorldCom, may soon find their free pass is being revoked. In this case, the government-sponsored entity remains a going concern – but federal accusations that Fannie’s directors are partly responsible for an “arrogant and unethical” culture may reverberate even after the departure of Thomas Gerrity, chairman of the company’s auditing committee, corporate-governance experts say.
Fannie’s regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), placed much of the blame for $11 billion in accounting errors on former management but demanded a review of current executives and that board oversight be enhanced. “It’s pretty clear that the board as a whole was asleep at the switch,” said Paul Lapides, director of the corporate governance center at Kennesaw State University in Kennesaw, Georgia. “There is an element of luck” that ran out for Fannie directors.
OFHEO’s findings last week were the culmination of an investigation it launched following the discovery of accounting manipulation at Fannie peer Freddie Mac. The findings went beyond a previous report by an investigator hired by Fannie Mae directors that insulated current management and the board from blame. Luck was even more important for directors who may have stretched themselves too thin, said Lapides. Directors likely became complacent as Fannie Mae’s size and earnings grew with the housing boom that was in full swing by the time Franklin Raines became CEO in early 1999, Lapides said. The board approved of policies that tied Raines’s compensation to earnings, which the former CEO pledged to double in his first five years at the helm. “It’s not like they missed it by accident,” Lapides said. “It was right in front of their face that executives were paid extraordinary rewards just to do their jobs.” The board failed to act independently of Raines, who earned more than $90 million from 1998 to 2003, OFHEO said in its report. Of that amount, $52 million was tied to meeting earnings-per-share targets, the office said. Fannie Mae separated the chairman and CEO positions after Raines was ousted in December 2004.Link here.
NOT EVEN PAULSON CAN SAVE THE DOLLAR
The nomination of Henry Paulson as U.S. Treasury secretary is seen as a boon for financial markets, but the Wall Street free-marketeer is unlikely to stand in the way of the falling dollar. The depth of the U.S. current account deficit is such that financial markets increasingly believe this fundamental root of widening global imbalances will adjust only if the dollar weakens.
Having the market-savvy chief executive of Goldman Sachs at the helm of the world’s largest economy instead of John Snow, often seen as more of a cheerleader for the White House’s economic policies than a policy-maker himself, could lend confidence to Wall Street’s perception of the Bush administration. But it will not be enough to prop up the dollar. “Financial markets do typically like it when a Wall Streeter takes a key role in the administration,” said David Mozina, head of foreign exchange strategy with Lehman Brothers in New York. “It could be modest positive for the dollar, but still, with what has been thrown at the dollar, it’s not going to be allowed to have a respite for too long,” he said.Link here.
China says it will start withdrawing from the currency market.
China’s central bank said it will start withdrawing from the country’s currency market, allowing investors a greater role in setting exchange rates. The People’s Bank of China sets daily reference rates for trading around which its currency is allowed to move, buying and selling the yuan to keep its value stable. U.S. lawmakers accuse China of using such measures to artificially weaken the yuan and fuel an export boom that has expanded the U.S. trade deficit with the Asian country to a record for five straight years. “The frequency and strength of the central bank’s open market currency operations will gradually weaken and be phased out,” the bank said in its quarterly monetary policy report.
The economy will grow by about 10% this year, the central bank said on its Web site, adding that investment is growing too quickly and threatening to stoke inflation. A stronger yuan would increase the cost of China’s exports abroad and make it cheaper for the country to import goods, helping the economies of competitors in Asia. Shipments abroad propelled the pace of growth in China to the fastest among the world’s 20 largest economies in the first quarter of this year. The Japanese yen leapt against the dollar after the central bank statement. The yuan in May had its first monthly decline since China ended a decade-old peg to the dollar on July 21, falling 0.1% to 8.0219 against the dollar.Link here.
China should buy gold, central bank adviser says.
China should use its foreign-currency reserves, the world’s largest, to buy gold and oil as a hedge to guard against the risk of a sudden drop in the U.S. dollar, said an adviser on the central bank’s 13-member policy board. The country has 1% of its reserves in gold, compared with more than 70% in the U.S. dollar. Booming exports and investment doubled Chinese reserves to $819 billion in the past two years, with economists estimating more than two-thirds of the cash went into U.S. Treasuries. “China has more than enough foreign-exchange reserves,” said Yu Yongding, who advises on policy as a committee member of the People’s Bank of China. “While they cannot be reduced sharply all at once, China has decided to take measures to curb their growth rate and diversify investment of its reserves.” The central bank would likely use new reserves to diversify away from the dollar and into other assets, rather than shifting current holdings, he said in an interview in Beijing on May 26.Link here.
THE RISK BUBBLE
There can be no mistaking the power of the risk reduction trade that has just occurred. It is on a par with the big reversals of the past. What is particularly interesting is that this outbreak of risk aversion has occurred in the absence of a financial crisis and in the absence of a major shift in the underlying fundamentals of the global economy. The tentative conclusion is that this episode is more about the markets than anything else – and the fear that the liquidity goose that hatched the golden egg is about to take flight.
A couple of years ago, our foreign exchange strategy group constructed a proprietary measure of the appetite for risk embedded in world financial markets. The GRDI is both cross-border and multi-asset in scope. It is designed to measure the movements in a variety of risky assets relative to their riskless counterparts. It includes comparisons between emerging-market and developed-market bonds, base metals versus precious metals, cyclical versus non-cyclical equities, equities versus bonds, volatility in equities, bonds, and FX markets, and credit market and swap spreads. The index has been back-tested to 1995 and has a good record in capturing the big moves in risk appetite clustered around the major financial crises of the past decade – including the Asian crisis of 1997, the Russian debt crisis of 1998, the bursting of the Nasdaq bubble in 2000, the 9/11 terrorist attacks of 2001, and the deflation scare of 2003. It is more descriptive than predictive, but can certainly signal important flash points at either end of the risk spectrum.
Recent trends in the GRDI underscore the significance of the latest risk-reduction trade. In late May, the risk-appetite metric moved to extremes last seen during the deflation scare of 2003. At work was a widening of spreads in a number of segments of the risk universe – especially, emerging-market debt and base metals – together with a long-overdue rebound in market-based measures of volatility. A widening of credit and swap spreads also contributed to this move. For those who claim that asset bubbles cannot be identified until after the fact, this dramatic move in the GRDI provides compelling ex post confirmation of a bursting of a bubble in risky assets. The GRDI hit a low on Monday 22 May, and has since retraced more than half its plunge into negative territory. It is hard to know from the empirical history of the GRDI if this latest move signals an end to the risk reduction trade.
The current risk-reduction episode is quite different from those of the recent past in one very important respect. It was not sparked by a discrete, event-driven crisis. Sure, there has been an inflation scare, but it is hardly a serious one. At the same time, there has also been a growth scare – prompted by fears of a Fed overshoot. This presumes that the Fed might fall victim to its seemingly classic tendency to overdo monetary tightening and push the U.S. economy into recession. Here, as well, the fears are hardly extreme – especially with Ben Bernanke going out of his way to telegraph the likelihood of a pause in the Fed’s tightening campaign. Finally, fears of a dollar crisis were evident briefly in the immediate aftermath of the 22 April G-7 meeting. However, while the yen and the euro have both moved up in response, the post-G-7 increases have been measured – about 3% for both currencies versus the dollar.
By process of elimination, that points the finger at the markets themselves. In my view, this is all traceable to the excesses of a super-liquidity cycle – aided and abetted by inflation-targeting central banks that have paid minimal attention to pressures building in asset markets. Ironically, the road to price stability has been more perilous than the authorities envisioned. By ushering in an era of single-digit returns on financial assets at precisely the point when the demographic imperatives of retirement planning require higher returns, the resulting asset-liability mismatch has forced investors much further out on the risk curve than might otherwise have been the case. That tendency was exacerbated by an unusually cheap cost of “carry” (i.e., short-term funding costs) set by overly-accommodative central banks and a growing tendency toward herding by momentum-driven investors. This has resulted in the now-infamous multi-bubble syndrome, as yield-hungry investors have swarmed into one high-yielding asset after another. First equities, then bonds, then spread products (emerging market and credit instruments), then property, and most recently commodities – the excesses of the super-liquidity cycle have created bubble after bubble. The tight correlation of bubble-like blow-offs in a broad array of risky assets may well be the ultimate manifestation of this liquidity-driven mania.
By its very nature, the concept of the bubble lulls investors into a false sense of security. Absent the “pin” – normally thought to be an interest rate spike – investors have no fear of bubbles. Yet, this imagery is actually quite misleading. Yale Professor Robert Shiller has long stressed the tendency of asset bubbles to implode under their own weight (see Irrational Exuberance, second edition, 2005). In 2000, dotcoms were the weak link in that chain – not the overall equity market. Yet when the dotcom bubble burst in March of that year, the resulting carnage was sufficient to take the entire S&P 500 down by 49% over the next 2 1/2 years. Contagion within an asset class – and across asset classes – is a classic symptom of a liquidity-induced multi-bubble climate. That, in my view, is precisely the risk today.
Our internal debate over this possibility has been quite intense. By Joachim Fels’s reckoning, the global liquidity cycle has already turned. He reaches this conclusion based on his analysis of both the quantity and the price of liquidity. While I can hardly fault his logic, I am less convinced that our metrics are robust enough to render a precise verdict on the timing of any shifts in global liquidity. In particular, while I believe central banks are headed in that direction, I am reluctant to conclude that they have done enough to stem the torrent. It is in the world’s best interest to manage the endgame of the risk reduction trade very carefully. But there are no guarantees the authorities can pull it off without a hitch. In the end, the only way to change that course is to break the liquidity-induced addiction that has fed an increasingly dangerous profusion of asset bubbles. That will take nothing short of determined and courageous efforts on the part of politically independent central banks. And there is still likely to be considerable breakage on the road to global rebalancing – irrespective of determined efforts on the part of the authorities to avoid that outcome.
The risk reduction trade may well be capturing the downside of the benign strain of global rebalancing. Just as there are perfectly plausible stories that explain the willingness of investors to abandon historical risk parameters, there are equally plausible stories as to why the dismissal of that risk makes little sense. For emerging markets, a likely reduction of excess consumption in the U.S. spells potentially tough adjustments for these still externally-dependent economies. Commodity markets appear to have been pricing in open-ended support from China at just the time when the Chinese are signaling the move to more of a “commodity-light” growth dynamic – less exports and investment and more consumption.
The power of the recent risk reduction trade, as validated by our proprietary GRDI metric, is a strong reaction to bubble-like excesses in the prices of these highly correlated risky assets. Global rebalancing tells me that these trades probably have a good deal further to go.Link here.
ECONOMISTS PROBE EMERGING MARKET WEAK SPOTS
A likely U.S. economic slowdown this year may mean capital flows to emerging markets will slow, testing the resilience of emerging market economies. Capital flows to developing countries rose to a record $491 billion in 2005, according to the World Bank, but may slow this year as high oil prices and a cooling of the U.S. housing boom, will likely lead to slowing growth in the world’s No.1 economy. The huge run-up in crude oil and metals prices, as well as the rise in U.S. Treasury bond yields in the past two months, has been followed by the worst week for emerging stock markets in about three years last week.
“The first element of a global slowdown has emerged – the United States – and with the world some 50 percent more trade dependent than it was in 1990, that slowdown will spread like falling dominoes. That is what happened in 1995, and it will happen again,” said Canadian Export Development Corp. economist Steve Poloz. “What this means is that the investments made in the past year to augment capacity will create a global deflationary environment – super competitive – next year.”
In addition, with world economic growth running at about 5.0% and crude oil prices rising to record highs this year, central banks around the world have raised interest rates in many countries to contain inflationary pressures. “This all suggests that interest rates have limited upside. The most vulnerable are places like Turkey and much of Latin America because their governments still have a lot of debt, including foreign currency debt,” Poloz said.
However, some emerging market economies are likely to be more resilient than others. Given the macro-economic reforms in recent years in Mexico, Brazil and Colombia, those countries would likely fare better than others in any downturn said World Bank-International Finance Corp. economist Simeon Djankov. By contrast Peru, which recently earned investment grade status, could see its fortunes reverse very quickly now that two leftist populist presidential candidates face off in presidential elections in that country on Sunday, June 4. Bolivia’s May 1 nationalization of its natural gas reserves and Venezuela’s threats to curb foreign investment are tainting the region, except for Mexico, Brazil and Colombia, where significant investor protections are in place, Djankov said.
Regional factors should come into play though in central and eastern Europe where countries like Romania, Bulgaria and Hungary have large current account deficits, but the bulk of their foreign direct and equity investments come from EU countries which are unlikely to pull back their funds. “Their investors are their neighbors and they are very certain of where the regulatory environment is going because it’s all within Europe (EU). Not so for Turkey because although they have had discussions with the EU they are not a member,” Djankov said.
But a further rise in oil prices which slows world economic growth, and cuts demand for other commodities like copper, could prove a difficult combination for many emerging market economies, especially in Africa. “If there were to be an oil supply disruption and a persistent increase in world oil prices we could see some substantial problems in Sub-Saharan Africa,” another World Bank economist said.Link here.
ETF OPPORTUNITIES GET BETTER WHEN TRADED IN EUROS
The United States remains the epicenter of exchange-traded-funds, or ETFs, with the S&P 500 Index, or SPIDERS, home to $50 billion dollars in assets – the largest ETF in the world. ETFs in the U.S. managed $296 billion as of December 31, 2005, and remain the fastest growing segment of the fund management industry over the last five years. But a whole universe of ETFs also trade across the Atlantic in Germany and France. Though many products are similar, European-listed ETFs offer one major advantage to U.S.-listed ETFs. All of these exchange-traded-funds are traded and denominated in euro.
ETFs provide low cost indexing across sectors, countries and even commodities while also levying much smaller annual management fees than actively-managed mutual funds. In the long-term, ETF fees can save an investor a small fortune. The average actively-managed fund in the U.S. charges 1.47% per annum compared to just 0.35% for the average ETF. ETFs in Europe are all valued in euro, a currency that should continue to appreciate against the dollar over the long-term.
ETFs in Europe have boomed over the last six years. The Deutsche Borse Group in Frankfurt has emerged as the largest hub for euro-denominated ETFs. Assets of German-listed ETFs have leapt 64% year-over-year through December 31, 2005 to €26.9 billion or $31.9 billion. As of March 31, 2006, German ETF assets have grown a further 20% to €32.3 billion or $39 billion. If an investor wants to play sectors, countries or even commodities, Frankfurt is by far the best and most liquid destination for exchange-traded products. A total of 117 ETFs now trade in Frankfurt – all euro-denominated. The third-largest hub after the U.S. and Germany is Euronext NV, a consortium of three European bourses – Paris, Amsterdam and Brussels. Euronext now trades 105 euro-denominated ETFs, mostly in Paris. And in London, the FTSE Index is home to 28 British sterling-denominated ETFs. In Canada, where the first ETF was launched in the early 1980s, a total of 19 products trade in Toronto.
ETFs are useful and cost-efficient vehicles, but should be used diligently in a broad-based asset allocation portfolio including bonds, alternative investments, commodities, real estate and foreign currencies. Also, most markets and sectors today are trading at either all-time highs or multi-year highs, offering poor values.Link here.
ALAN GREENSPAN DEMOTED FROM “MAESTRO” TO EQUITY “BUBBLE MAN”
The Bond Market Association announced last month that it is creating an annual “Alan Greenspan Award for Market Leadership”. According to author Peter Hartcher, Greenspan himself would be ineligible on grounds of incompetence. In Bubble Man: Alan Greenspan and the Missing 7 Trillion Dollars, Hartcher accuses the former Federal Reserve chairman of dereliction of duty for allowing a U.S. stock-market bubble to balloon and then burst on his watch. Hartcher sets out to convince the reader that Greenspan, the man dubbed “Maestro” in Bob Woodward’s biography, could and should have tried to restrain surging equity prices. Much to my surprise, Hartcher succeeds.
Like a skilled prosecutor, he uses the words and deeds of the accused to make the charge stick. As a former Washington bureau chief for the Australian Financial Review, Hartcher brings an outsider’s perspective to the capital’s machinations. While his book lacks the historical perspective of John Kenneth Galbraith’s The Great Crash 1929, it rattles along at a cracking pace, like a well-constructed documentary.
Greenspan has stated publicly that central banks should not meddle with asset prices. Hartcher uses Fed meeting records to show that Greenspan started with a different opinion, and mulled increasing the amount of money investors must set aside to cover stock-market bets. The central charge is guilt by omission. Had Greenspan done more to restrain the stock market, the trashing of retirement savings in the collapse would have been limited.
On September 24, 1996, Fed Governor Lawrence Lindsey suggested the U.S. central bank might consider trying to rein in stocks “while the bubble still resembles surface froth.” Greenspan’s attempt at a solution came on December 5, 1996, by which time the S&P had climbed a further 8.3%. In a 5,000-word address that day on “The Challenge of Central Banking in a Democratic Society”, Greenspan raised the possibility that “irrational exuberance has unduly escalated asset values.” Greenspan, Hartcher says, was testing the waters in an attempt to expand the scope of monetary policy to cover asset-price inflation. “All his power, his skill and, crucially, his courage were about to be put to the test,” Hartcher writes. “This was Greenspan at his best. He was alert to a new danger, and he was about to demonstrate intellectual and institutional leadership in confronting it.”
He failed the test, Hartcher argues. “Greenspan had set out on a course of what he judged to be a wise policy, but then had allowed himself to be intimidated by the political difficulty involved. He changed direction completely, and clasped the whole madness to his aged breast with the zeal of a convert.” The author also offers a pointer to the future. “Asset price inflation is the new inflation for central banks, one that is becoming more virulent, not less, and one for which there is not yet an agreed treatment,” he writes. The conclusions to that argument among the world’s guardians of monetary policy may yet provide Hartcher with another book.Link here.
The last four weeks demonstrate the continued existence of gravity in markets long unfettered by shifting realities in the risk/reward environment. The May 22 international market downdraft signals the presence of linked fears and risks. Sadly, the context is changing and the responses are not. U.S. dollars and markets remain the gold standard. Scared of the precarious nature of a global imbalance centered on U.S. consumption and rising rates, investors retreat to America? Downdrafts of this variety are not productive. These repricing episodes do not signal new thinking or positioning. This is crucial because the arrival of new understanding would be required for a long, tempered and transparent wind down.
Asian central bank cash, UK Area funds and Petro Dollars still find their way into American assets far more than prudence would suggest. Commodities take a hit and send people running for the safety of their default buys. Emerging markets come in for a round of selling on declining loose money from The Fed, ECB and BoJ, and decade-overdue fears about U.S. imbalance weakness. If that scares the money out of these markets, what sends it running to U.S. assets? America borrows about 80% of world excess saving, who is most vulnerable to rising rates? This is the Catch 22 of asset markets. Decision makers seem to have taken in the dependence of present asset prices on loose money from leading central banks. When pressed, they found nothing new to buy and ran to the usual risk exits.
We see the standard reaction coming despite changes – still being ignored – in global asset markets. China sits vulnerable to a U.S. consumer slowdown and inflated raw material prices, but her growth remains robust. India is struggling toward growth despite energy and infrastructural risks worthy of concern. South America is pursuing alternative development paths 20 years into the sorrows of ill-shared and inadequate gains from orthodox economic policy. Asia sits ready as the world’s emerging workshop with inadequate domestic demand and a still heavy export dependence on legions of broke American consumers. Materials and energy exporters have coffers bloated from robust demand and high prices. What about that justifies running for Treasuries? Pure habit and continued neglect of structural shifts in the global economy. For the legions of offshore buyers, their interest rate risk is compounded by the prospect of further losses for the dollar.
The U.S. scene is defined by overdue cooling in profit growth, a need to raise rates into a fragile housing market and a mutually exclusive impulse to defend overvalued and overheld greenbacks. Even if interest rates are done rising, the process of adjustment and the filter through of past rate hikes will weigh on borrowers with no budget slack. This is the Catch 22 in U.S. policy. How can we defend an overvalued dollar while holding down spiraling trade shortfalls, and keep housing from its past due reversion to trend (or worse)? What policy will allow the dollar to stay strong, cause imports to wane, exports to grow and interest rates to stay low? The short and dirty is, at least one of the above will prove outside reach.
Years of consumption outrunning incomes and a redistribution of wealth upward form the foundation of America’s position in a world of imbalance. All this is funded with massive capital importation which supports dollars and asset prices. The U.S. and broader world have become dependent on an unsustainable dynamic and the bubbles that arise from increasingly desperate efforts to extend it. When spooked by recognition of such risks investors run to the safety of Dollar debt? The U.S. has become a leveraged eating machine consuming imported goods and capital with reckless abandon. The world has put its stock in the U.S. to cash in on the splurge that debt and redistribution built. There is only temporary shelter offered by flight into the eye of the hurricane.
The Catch 22 facing the world involves exposure to U.S. debt-driven consumption and dollar denominated assets. The very flight to safety is dangerous and exacerbates the structural problems that generate it. The present arrangement is rendered more precarious by the increasingly bellicose, unilateralist and protectionist bent of American politics. No one sane and independent wants the present imbalance to persist. However, no one can conceive an adequate replacement for U.S. demand and asset inflation based earnings and income. That is the central Catch 22 and what leaves us weary of short and shallow downdrafts seen curative for this serious structural ailment. Few will have to ask if this is the big rebalancing when it arrives. The drama of rapidly shifting understanding and relative asset price swings will scream out its arrival.Link here.
DEALING WITH THE DOLLAR
Not all economists agree that currency empires, like the one the dollar has enjoyed since 1973, end with a great inflation. Some investors, whom I respect a great deal, such as Bob Prechter and Gary Shilling, believe we are actually headed for deflation whereby cash will be king. But I cannot think of any example from history in which a currency empire ended with the currency in question actually gaining in purchasing power. When currencies fall apart, it usually means inflation. For the record, looking at the world as a bull hunter, I think we will have both inflation and deflation in the coming years. Most stocks, bonds, and real estate will experience falling prices. People will not want to own paper. They will want to own stuff. For other things, such as commodities or certain kinds of stocks or currencies, there will be a lot more demand. People will trade an asset falling in value, the dollar, for something that retains value much better.
It is safe to assume that you would not want to be in a situation where your cost of living doubled or, put another way, your money went half as far as it did the day before. The money in your wallet that you once thought was, say, as good as gold, turns out to be nothing more than pretty green paper. This kind of inflation – where it takes more and more money to buy simple things – is a lot more common than you might think. The history books are full of disgraced currencies. It happened to the British pound sterling in 1931. Everyone thought that currency was unsinkable, too – until it sank. It happened to the German reichsmark as well. You can spend a whole hour in the money exhibit at the British Museum looking at pictures of once-valuable currencies that inflated away into worthlessness.
The truth is, currencies come and go only a little less frequently than governments. Good governments do everything they can to create a sound currency. You could say that a currency is basically a referendum on the economic health of a country. A country with sound finances and a healthy economy tends to have a sound, or strong, currency. But if currencies are like beauty pageant contestants, then the dollar is currently a big, fat pig with bright red lipstick. Investor Doug Casey calls the dollar “the unbacked liability of a bankrupt government.” Jim Rogers says that the dollar is a “deeply flawed currency”. All of them are referring to the monstrous debts run up by the U.S. government.
By now, you are certain to have heard and read many other bearish statements about the dollar. But the question is, what can you do about it? When Germany experienced hyperinflation in the 1920s, there was little the average German could do, unless he or she owned wealth in some other form – silver dinnerware, for example, or gold jewelry, or even livestock that could be traded for essentials. Today, the danger to the currency in question (the dollar) is just as great. But the good news is that you have far more ways to reduce your dollar risk and make a profit than any other investors in the world have had at a similar economic crisis point.Link here (scroll down to piece by Dan Denning).
SHIFTING DEMAND AND WEALTH
I have great sympathy for the view that over the last 200 or so years investments in commodities performed poorly when compared to cash flow-producing assets such as stocks and bonds. I also agree that, as the team at GaveKal suggests, “every so often, we experience a massive break higher in commodity prices in which commodity indices triple in less than three years,” which is then followed by a period of poor performance. Still, we need to ask ourselves why in the last 200 years, commodities, adjusted for inflation, were in a continuous downtrend and whether it is possible that something might have changed in the last few years, which would suggest that this downtrend is about to give way to a sustained out-performance of commodities compared to the U.S. GDP deflator. The other question is of a more near-term nature. Should commodities, having approximately trebled in price since 2001, be sold, or should we expect far more substantial price increases? I have to confess that I have little confidence that I can answer these questions satisfactorily. Still, the following should be considered.
In the 19th century, and for most of the 20th, industrialization was concentrated in a few countries, which for simplicity we shall call the Western industrialized world. The world’s economy was at the time characterized by an abundance of land, resources, and cheap labor (certainly in the colonies and later in the developing countries) and a relatively limited supply of manufactured goods. At the same time, growth and progress was concentrated among a very small part of the global economy – either in the Western industrialized countries or among a tiny part of the population (the elite) in developing countries. In addition, there were hardly any other sectors in the economy where productivity improvements were as high as in agriculture and mining. These factors – abundance of land, labor, and resources combined with huge productivity improvements and limited demand from the then still small industrialized world – may, at least partially, explain why commodity prices failed to match consumer price increases for much of the last 200 years.
Since the breakdown of communism and socialism, the world’s economic fundamentals seem to have changed very importantly. Initially, the impact of the end of socialism was muted. Rising industrial production in former communist countries such as China largely substituted for production in the West. But over time, rising investments and industrial production boosted real per capita incomes considerably and made way for a tidal wave of new consumers. In turn, these additional new consumers lifted industrial production further in order to satisfy not only the demand from their export markets but their own needs as well. Thus, industrial production and capital spending increased further. This led to additional income and employment gains, further domestic demand increases and so on (multiplier effects). In short, the opening of China and of other countries has permanently shifted the demand curve for consumer goods and services and along with it the demand for industrial commodities and, notably, energy. Now, if all goes well in India (a big if, I concede), then the demand for goods, services, and hence commodities will continue to increase very substantially for another 10 to 20 years.
There are a few more points to consider. For much of the last 200 years, developing countries, where many of the world’s natural resources are located, had trade and current account deficits with the industrialized world. These deficits were a constant drag on these countries’ ability to accumulate wealth. But now, through its current account deficit, the U.S. is shifting around $800 billion annually to the economically emerging world. This represents a huge shift in wealth from the rich U.S. to the current account surplus countries. That this shift in wealth stimulates their economies and consumption, and along with it their own demand for commodities, should be clear.
Now, for most countries a current account deficit the size of that of the U.S. would lead to some sort of crisis and then to a curbing of consumption. However, the U.S. is endowed with a reserve currency, and trade and current account deficits are simply financed by “ printing money”. So, at least for a while (but not forever), the shift in wealth to the emerging world will not have a negative impact on America’s economy and consumption. On the contrary, the global imbalances arising from “over-consumption” in the U.S. have brought about a global economic expansion, which, while unsustainable in the long run, is nevertheless firing on all four cylinders at present. Simply put, the excess liquidity which the Fed has created – and which it is still creating, I might add – has led to a global and synchronized economic boom.
The following point regarding the demand for commodities is frequently overlooked. In the developed countries, commodities account for a very small part of the economy. As a result, price increases for oil and other commodities have a very minor impact on growth rates and on consumption. However, in the commodity-producing countries (Middle East, Africa, Russia, Latin America), commodity production is an important part of the economy. So, when commodity prices rise, their economies are, as in the case of the Middle East, turbo-charged. GDP per capita then soars and leads to a consumption and investment boom, which then increases these countries’ own demand for commodities.
In sum, we could argue that the emergence of a large number of new consumers in the world following the breakdown of communism, expansionary monetary policies in the U.S., which have led to a rapidly growing current account deficit, the U.S. dollar’s position as a reserve currency, which enables the Fed to create an almost endless supply of dollars, and new demand from the commodity producers themselves, have all led to a significant increase in the demand for raw materials. I am not predicting here that, from now on, the demand for commodities will always outstrip the supply. In time, new technologies will permit resources to be used more efficiently, and conservation will curtail demand for raw materials. But until the effects of these factors kick in, a tight balance between rising demand and existing supplies could remain in place for quite some time.Link here (scroll down to piece by Dr. Marc Faber).
THE U.S. CONSUMPTION BIAS
In general, the high esteem of American policymakers and economists for consumer spending as the motor of economic growth is attributed to the influence of Keynes. In reality, it originates in the early 1920s, long before Keynes, in America itself. This thinking originates in a bizarre episode involving leading American economists. In the early 1920s, two until then completely unknown persons began to write a whole series of books that all propagated the idea that the capitalistic economy was chronically threatened by a lack of consumer income and demand. Their names were William Trufant Foster and Waddill Catchings. Their writing attained the widest circulation in the U.S. and was accepted in universities. In all their books, they warned of the danger of deflation and agitated for monetary inflation and public works.
The pair gained particular fame through a campaign that they launched with the explicit intent to “convert economists” by offering a prize for the best adverse criticism of their book Profits. An illustrious jury – among them America’s top economist professor, Wesley C. Mitchell, and Owen D. Young of “Young Plan” fame and chairman of General Electric – was to choose the best essay. Among the authors of the essays were 50 professors of economics, 40 authors of books on economics, 60 accounting experts, bankers, editors and some of the “ablest men in the Federal Reserve”, etc. A later published collection of the essays revealed that all authors, except two, had unreservedly accepted the main thesis of Foster and Catchings that there exists a chronic bias in the economy toward a chronic deficiency of consumer purchasing power. Any objections were directed against minor details. They proposed for every crisis a (for the time) revolutionary solution: “It would be easy to arrange an increase in consumers’ credits; it is only in this way that the deficiency in purchasing power of the consumer, and thus the cause of the Depression, can be removed.”
We have recalled this episode because it is widely unknown. On the other hand, it strikingly reveals that the American high esteem of consumption as the motor of economic growth has a long tradition. But in particular, it attracted our interest in view of the fact that the U.S. economy in the late 1920s went with an orgy of wealth-driven – the bull market in stocks – consumer credit into the Depression.
Thinking about the business cycle and the possible regular causes really started only at the end of the 19th century. As industrialization progressed, investment spending and employment in the capital goods industries also played a rapidly growing role. A few economists, at first, identified and pointed out the importance of variations in business investment in determining economic activity. What finally revolutionized thinking about the business cycle and economic growth in Europe was a book from a Russian professor, Dr. Michael Tugan-Baranowski, titled Theory and History of Trade Cycles in England, published only in German in 1901. Based on a detailed study of British cycles and crises, he made several revolutionary statements, such as that the ultimate aim of production is not to improve living standards, but the creation of productive capital stock and the pursuit of profits by entrepreneurs. As to the business cycle, he emphasized the overriding role of variations in the production of capital goods as compared with the even advance of the production of consumption goods. He also, for example, stressed that capital formation and production have their true limit in available saving, not in consumer spending.
Being written in Germany, the new business cycle theory virtually bypassed the English-speaking economists. Yet one admitted a strong influence. In his A Treatise on Money, published in 1930, J.M. Keynes explicitly stated: “I feel myself in sympathy with the school of writers – Tugan-Baranowski, Spiethoff and Schumpeter – of which Tugan-Baranowski was the first and the most original.” Tugan-Baranowski analyzed in astonishing detail the various crises that the British economy and its banking system experienced during the 19th century. His conclusion was that every crisis arises from the fact during the boom and the following downturn the “proportional distribution of the productive forces is deranged.” Equilibrium of demand and supply is shattered. In the prosperity phase, some branches expand faster than others. With Tugan-Baranowski, a new way of thinking about the business cycle began in Europe. It became the accepted central idea that economic growth and prosperity depend on autonomous capital investment guided by relative prices and profit expectations.
We have recalled these two episodes in the history of economic thought because they give food for thought about the present situation in the U.S. Over the past few years, U.S. policies have boosted private consumption as never before in conformity with the conventional thinking that this must stimulate investment. Its true counterpart is the lowest level of business fixed investment. It is a common refrain in the reports of American economists that government borrowing tends to crowd out business investment. But its logical correlative that consumer borrowing must essentially have exactly the same negative effect on business investment is never mentioned.
The policy dilemma currently facing the U.S. can be simply stated. Economic growth has become completely dependent on consumer spending, and this, in turn, has become completely dependent on rising house prices providing the collateral for the most profligate consumer borrowing. This borrowing has become a necessity because income growth has abruptly caved in. Rock-bottom short-term interest rates and utter monetary looseness were the key conditions fostering altogether bubbles in bonds, house prices, residential building, and mortgage refinancing. What developed is an economic recovery with an unprecedented array of escalating imbalances: declining personal savings; a widening current deficit; exploding government and consumer debts; and, on the other hand, a protracted shortfall in business fixed investment, employment and available incomes.
We must admit that the staying power of this extremely ill-structured and debt-laden recovery and the stubborn buoyancy of the financial markets have rather surprised us. Under the prevailing conditions of rampant global liquidity excess, there has apparently developed an unprecedented and virtually unlimited tolerance for economic and financial imbalances. Consider that Iceland has a trade deficit of 16% of GDP. But this only lengthens the rope with which to hang oneself. What American policymakers and most economists studiously keep overlooking is that the credit bubbles are doing tremendous structural damage to their economy. The longer the bubbles last, the greater the damage.
This time, we want to focus on the dramatic shortfall of employment and income growth that radically distinguishes this recovery from all its precedents in the postwar period. To make our point perfectly clear: The present U.S. economic recovery has never gained the traction that it needs for self-sustaining economic growth with commensurate employment and income growth. As to its main cause, all considerations lead to the conclusion that it must reside in the protracted, appalling shortfall in business fixed investment. Investment spending is, really, the essence of economic growth.Link here (scroll down to piece by Dr. Kurt Richebächer).
OMINOUS WARNINGS AND DIRE PREDICTIONS OF FINANCIAL EXPERTS
I have the most informed, intelligent and savvy subscribers one could ask for. One of them, Lorimer Wilson, previously wrote me with his insights on “Our Worst Nightmare – the Puncture of the Current U.S. Housing Bubble”. It was very well received when published by me recently and he has just sent me more information which I think you will find timely and of particular interest.
Together we have compiled a remarkable summary of the ominous warnings, dire predictions and perceived devastating consequences that the vast majority of economists, financial analysts, economic research firms and financial commentators are saying about our current economic situation and what is most likely to unfold in the months and years ahead. It is a must read to more clearly understand and appreciate the financial state of the union, the impact it will likely have on various investments, and how better to allocate ones assets. Nobody has a crystal ball, but to just ignore the following warning signs and hope that everything will turn out okay would simply be foolish. This article is Part 3 of Wilson’s 6-part article. Part 1 is here, Part 2 here.
The comments are from some of the best minds in the business and what they have said about our current financial situation and what is in store for us in the years ahead. We advise investors to listen, to learn and to recognize the need to be strategically positioned in a wide variety of assets including precious metals, mining shares, and long-term warrants. Nothing like taking what the experts say to heart and investing accordingly.Link here.
INSIDE WALL STREET’S CULTURE OF RISK
Investment banks are placing bigger bets than ever and beating the odds – at least for now.
Wall Street has always been about taking risk. But never has the “R” word been such an obsession for the men and women who rule the nation’s biggest investment banks. Never have they had to reconcile so many bets made on so many fronts. The conditions have been ripe. Historically low interest rates and relatively calm markets in the last few years have allowed a new type of firm to flourish, one that acts primarily as a trader and only secondarily as a traditional investment bank, underwriting securities and advising on mergers.
Goldman Sachs’s CEO Henry M. Paulson Jr. has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business. The biggest stunner came in March when Goldman announced that in three months it had tossed off $2.6 billion in profits – nearly half as much as it earned in all of 2005 – on $10 billion in revenues. Not just coincidentally, Goldman also put a record amount of the firm’s capital at risk of evaporating on any given trading day. Its so-called value at risk jumped to $92 million, up 135% from $39 million in 2001. “[Goldman is] a horse of a different color now,” says Samuel L. Hayes III, professor emeritus of investment banking at Harvard Business School.
As Paulson prepares to move to Washington to serve as U.S. Treasury Secretary, Goldman shows no sign of easing up. Nor do its followers. This trading boom, fueled by cheap money, is fundamentally different from the ones of the past. When traders last ruled Wall Street, during the mid-‘90s, few banks put much of their own balance sheets at risk. Most acted mainly as brokers, arranging trades between clients. Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more. They are shouldering risks for their clients to an unprecedented degree. They are dabbling in remote markets from Brasilia to Jakarta, and in arcane products like credit-default swaps and catastrophe bonds. Led by Goldman, many investment banks now do more trading than all but the biggest hedge funds.
What is more, banks are jumping into the realm of private equity, spending billions to buy struggling businesses as far afield as China that they hope to turn around and sell at a profit. With $25 billion of capital under management, Goldman’s private equity arm itself is one of the largest buyout firms in the world. The moves are not unrelated to trading. In both cases, banks are flocking to exotic and inaccessible markets where there are few competitors. Counterintuitively, they are seeking out the investments that would be the hardest to get rid of in the event of a disaster. They are betting that handsome returns when times are good will make up for losses when things turn ugly.
So far, the rewards are justifying the risks. Big investment banks are booking record profits, and their stocks have zoomed, up 64% since 2001. But once-calm global markets are getting rocky as interest rates rise, choking off the easy money. Fears of more rate hikes to come have triggered sell-offs in stocks, bonds, and currencies around the world since early May. That is raising the stakes for arguably the biggest game of risk ever to play out on Wall Street. If banks succeed, they will rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable. “A world where huge amounts of leverage have been brought into the system is a dangerous world,” Berkshire Hathaway’s CEO Warren Buffett observed at his most recent annual meeting. And “as interest rates rise … people will stretch even further and take greater risks,” warns John H. Gutfreund, senior adviser at the investment bank C.E. Unterberg, Towbin and former CEO of Salomon Bros.
Just as investment banks are taking more risks, so are millions of individuals. They have bid up prices and accepted thinner safety cushions in the past few years on commodities, international stocks, and shares of the riskiest U.S. companies. Penny-stock trading has soared, up 640% from three years ago. Home buyers have leveraged up, buying more expensive houses with more complex mortgages. Says James Grant, editor of Grant’s Interest Rate Observer and a financial market historian: “The world is stretching for return.” The last time investors stretched so far, during the dot-com boom of the late 1990s, the results were disastrous.
But the biggest danger may be on Wall Street. As the banks trade in ever-more-obscure products with ever-more-opaque clients such as hedge funds, observers worry that they might not be able to settle their trades in the event of a market shock, intensifying the damage. Yet for all the risks they are taking on, banks insist they are safer than ever. Their arguments have been good enough for investors, who have been cheering banks on to raise their risk profiles even more. If you thought the recent volatility in the emerging markets would have discouraged them, think again. Analysts expect that any rise in volatility will create even more trading opportunities. The question is, how far will Goldman and the others go? From the looks of it, pretty far. All of them are ramping up teams of so-called proprietary traders who play with the banks’ own money. Banks are building out their infrastructures, too. Transactions have become so complex that some traders have eight computer screens at their desk.
Wall Street’s exuberance is palpable as the pain of big blowups of the past recedes from memory. John Meriwether, the former head of Long-Term Capital Management, is now considered a hero to some. To some extent, the jubilation is understandable. Banks in recent years have been remarkably successful in shrugging off crises, from the downgrading of General Motors’ credit to junk status last spring to the destruction of New Orleans, that could have triggered meltdowns. The degree to which risk management has evolved in the past few decades is astonishing, say analysts. As is the development of trading itself.
Some on the Street argue that such confidence is misplaced, and that the relative stability in the global markets since 2003 has lulled traders into a false sense of security. So much speculation has crept into commodities markets, for example, that in April they were trading at prices 50% higher than they would have been based only on fundamentals, estimated Merrill Lynch. A sharp sell-off followed in May. Are bank traders and hedge funds living on borrowed time? One senior bank executive thinks so. He worries that at any moment volatility could spike to levels never seen before.
How the markets will respond to such an event “is up in the air,” says Leslie Rahl, president and founder of a New York-based consultancy. That is because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives. They also use any number of risk models whose predictions vary wildly depending on the assumptions. Wall Street chiefs are aware of risk models’ limitations. During an investor conference last November, Goldman’s Paulson was asked to talk about his readiness for a big blow to the financial system. Paulson issued a litany of warnings. The main risk measure Goldman discloses, value at risk (VAR), “always assumes that the future is going to be like the past,” he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from. “The one thing we do know,” Paulson explained, “is [that] if and when there is another shock, things you hope wouldn’t correlate are going to correlate.” Seemingly unrelated assets like, say, silver and options on Japanese commercial mortgages could all go into free fall.
Yet, even if the financial markets do not crash, banks’ aggressive moves into trading threaten to scare off clients who wonder where they will rank if a panic triggers a sell-off. Will the bank perform its fiduciary responsibility to its client and execute its trades, or will it cover its own hide? If banks are seen misusing client information to gain a trading edge, they could find themselves right back in the regulatory quagmire that followed the scandals of the ‘90s, when they were accused of pushing lousy stocks on unsuspecting investors to win what were then lucrative underwriting deals. So why, then, are banks racing ahead to build bigger, more complicated trading operations, risking huge losses and long-term damage to their credibility if things go wrong? For one, the banks think they can handle the risks. For another, their shareholders and clients are demanding it. Investors argue that trading is booming now while most traditional banking businesses are languishing. Big firms can no longer subsist on underwriting or stock and bond trading as the combination of more rivals and cheap electronic trading drives down profit margins. Businesses that once accounted for most of the profits at investment banks are now viewed more as gateways that lead them into the lucrative land of risk.
More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade. It is a high-risk, low-reward endeavor designed to keep clients coming back to pay for more lucrative business in the future. In the bond markets, money managers ring up traders routinely and ask them to bid on messy multibillion-dollar portfolios of bonds and other financial products with expiration dates ranging from 2 to 10 years. “You have a trader committing in one or two minutes to a trade that could lose or make tens of millions of dollars,” says Thomas G. Maheras, head of capital markets at Citigroup.
Risky though the trading may be, it is the forays into private equity that keep many risk managers awake at night. Fully formed companies are the hardest assets for banks to get off their books if things go wrong. Private assets are also difficult to value on a daily basis and do not fit neatly into risk managers’ models. Against this backdrop, VAR numbers seem utterly inadequate. What risk managers particularly fear are “fat tails”. The term comes from the shape of a bell curve of probabilities, in which the long, thin tails on both ends represent extremely rare outcomes. Fat tails mean catastrophes are more likely than one would guess given normal day-to-day fluctuations. Risk managers are quick to point out that world events do not always hew to the shape of a bell curve. “The abnormal is really abnormal,” says a risk manager who was part of the team that bailed out Long Term Capital Management. At least one big investor is not taking many chances on banks. Anton V. Schutz, who manages the $131 million Burnham Financial Services Fund, held almost every investment bank stock last year. Now he holds only Morgan Stanley. “Investment banks are trading like there’s no risk in the world,” he says.
Wall Street moves in cycles of excess. Before the current cycle turns, the odds are good that at least one bank will take things too far. That is what happened in the 1980s, when banks churned out an array of new products like junk bonds and created whole new markets for them, then abused those markets for their own ends. It happened again in the 1990s as bankers cashed in on the Internet bubble. It is possible that all of the banks will show more restraint this time as they chase returns in the red-hot risk market. But don’t bet on it.Link here.
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