Wealth International, Limited

Finance Digest for Week of June 5, 2006

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


If you still do not believe there is a massive housing bubble that is beginning to deflate, look no further than Toll Brothers. This home builder caters to the mushrooming ranks of the well-to-do who have enough income and assets to laugh off rising interest rates and energy costs. But in the year’s first fiscal quarter Toll orders fell 32% from a year earlier. The company blames the fall on cancelations by speculators. With dreams of huge appreciation dancing in their heads, speculators indeed drove the housing frenzy in the high end. Now that prices are flagging, they are fleeing. These investors and vacation-home buyers accounted for 40% of house sales last year, up from 36% in 2004. A lot of these investors rent out the properties. Despite low-payment interest-only mortgages, they cannot cover their cash outlays with rents, which are depressed by the proliferation of spec houses.

This is the first nationwide housing bubble since the 1920s, and it is driven by three nationwide forces: low interest rates, loose lending practices and the desperate search for a stock substitute after the 2000-02 debacle. Previous real estate bubbles were regional, spurred by economic cycles like the rise and fall of the oil patch in the 1970s and 1980s, and southern California’s aerospace leap in the late 1980s during the Reagan defense buildup, which ended with the Cold War’s demise. The speculative housing craze is crashing from its own excesses, not Federal Reserve action. Mortgage payments still are low, and lenders remain accommodative. Since the Fed started to tighten in June 2004, 30-year fixed mortgage rates first dipped from 6.3% to 5.6% in June 2005 and now sit at 6.5%.

No amount of lender accommodation will be sufficient to offset the mass exit by speculators and the hesitation of builders to slash production in the face of falling sales. With inventories high and sales falling, the ratio of inventory to sales flow is rising. Inventories for both new and existing homes have jumped from 3.5 months in 2003 to 5.8 months and 6 months, respectively. It is reasonable to expect those ratios to climb into the 6-to-8-month range of the real-estate-troubled early 1990s. Already inventories since last year have jumped 91% in Boston, 236% in Miami and 149% in Los Angeles. Asking prices have been cut on one-third of listings in Boston, San Diego, Sacramento, Los Angeles and Miami. Nationwide median prices will probably fall at least 20% before the break is over.

Even a 20% price decline will be devastating for many homeowners. A house-price collapse will be far worse than the 2000-02 bear market on Wall Street and will bring a serious global recession. Half of households own stocks or mutual funds, but 69% own homes. The resulting unemployment will kill many subprime borrowers’ ability to make payments. Both Toll Brothers at the high end and D.R. Horton in the starter market will suffer. It is not too late to sell home builder stocks. You can short-sell the bunch through the SPDR Homebuilders Index Fund (XHB). Building suppliers and mortgage lenders are suspect. Home appliance makers and do-it-yourself retailers are also vulnerable. Wait to remodel until contractors are hungry.

Link here.
Affluent Americans sour on real estate – link.
Collectors buy condos just to house their vehicles – link.

Homebuilders crumble under pressure. How close is the bottom?

The second quarter is proving to be troublesome for homebuilders. They have been cutting their full-year earnings projections in droves as orders look weak and cancellation rates rise. “If it is not already painfully apparent, the soft-landing thesis for the homebuilding industry is dead,” wrote A.G. Edwards analyst Greg Gieber in a research note. One hedge fund manager, who plays the sector long and short, said that this Monday’s selloff could point to a worse-than-expected downside scenario for builder stocks, where the news gets bad at a very fast pace, rather than a slow shakeout over an extended time frame.

As the builder stocks continue to drop, they are looking cheap. But gauging a trough for earnings is not an easy task. The mere thought of buying a stock at a P/E multiple where the “E” keeps falling is not easy for investors’ stomachs. Most investors like to buy for value when they can see the bottom. With this group, the bottom keeps moving out another year. “The problem is a significant inventory overhang [at least a half million units that are vacant and for sale – and growing – per our estimates based on Census Bureau data] and falling fundamental demand that should continue to trail downwards in a likely forthcoming environment of a weakening economy and rising longer-term mortgage rates,” Gieber wrote.

A number of noted value investors continue to go long builders. The largest buyer of homebuilder stocks in the first quarter was Bill Miller at Legg Mason Capital Management, followed by Jeffrey Gendell at hedge fund Tontine Associates. Miller and Gendell are considered to be some of the wisest investors around. “(Homebuilders) were easy shorts at one point,” says another hedge fund manager who plays the sector, but “we’re looking at covering our shorts here. It’s an interesting point to start looking at the group (from the long side).”

Link here.

No competition for “worst performing” stock market sector …

In the recent stock market declines, there is no real competition for “worst performing” sector. This year-to-date chart tells the story. That is a chart of the home construction index vs. the S&P 500, and those are large losses indeed for an industry of this size. Some of the biggest individual homebuilding companies have seen still larger losses, e.g., the Ryland Group’s share price has fallen some 48% since the January highs.

As for why homebuilding stocks are plummeting, well, the National Association of Realtor’s chief economist called on the Federal Reserve to stop raising interest rates. But in truth, the Fed does not – repeat, does not – control mortgage interest rates. This should be obvious, given that mortgage rates have not followed the central bank’s steady ratcheting up of the fed funds rate. The current 6.17% rate on a 30-year fixed mortgage is well within the historically low range of the past five years (between around 5%-to-6.5%). The broad stock market – and certain important economic sectors – are sending a clear signal. As usual, however, the people who are supposed to “get” that message are looking and listening in all the wrong places.

Link here.


I have written before how current market trends do not favor the individual investor, but rather the hotshot trader found at hedge funds and the like. The quick-trading mentality always has been with us, of course. Back when I worked at Salomon Brothers, the firm’s chief, William Salomon, did not like to see cash lying idle. Surely someplace in some market, Billy Salomon would tell us, there was an opportunity and our job was to find it. The trouble is that today this approach has subsumed everything. That is a big reason that large-company stocks have not gone much of anywhere, since their prices cannot zip up fast enough for the trading crowd.

Sarbanes-Oxley, intended to clean up Wall Street, has imposed huge costs on smaller companies. A study by the GAO found that onerous new auditing requirements are pushing companies to go private. The SEC has turned back a staff proposal to exempt smaller companies (70% of U.S. publicly listed issues) from the Sarbox audit dictums. The Sarbox reform is going to be not much of a blessing for investors if it removes a large chunk of the capital market from their reach, leaving profits from smaller firms in the exclusive possession of private-equity players. Meanwhile, the crackdown on research abuses has left us with very little that is useful. Many of the best equity analysts have fled to the lightly regulated hedge funds. Nowadays the public gets pretty skimpy stuff from analysts. Recently I received a two-page research report from a large brokerage, with five pages of legal boilerplate attached.

Institutional memory is, as a result, fading away. Earlier this year, with little notice paid on Wall Street, we experienced a yield-curve inversion where yields on 3-month Treasurys exceeded those of 10-year Treasurys. In four of the last seven such occurrences a bear market began within a month – but not this time. The reason for the exception appears to be that the 10-year yield was held down by massive foreign buying, which since has eased, with the yield curve returning to its customary shape. What bothers me is that too few in the financial community cared that the curve had inverted. Maybe their indifference stems from superior insight, but I doubt it. When the next storm warning comes, will the present crop of Wall Street pros see it?

Another change for the worse is that financial fundamentals count for less lately. One seasoned investor I know created a screen for lousy stocks that he could short. He looked for the usual indicators: low return on capital, low yield, prices within 15% of their 52-week high. Three months later these stocks, which should have gone down, were vexingly up 17.7%. Alas, what should be short-term dislocations now are long-term. Ebay, which continues to expand new listings while increasing revenue and earnings smartly, is in a stock slump since it narrowly missed its fourth-quarter 2004 earnings consensus estimate. Ebay’s valuation has been halved.

For most individuals this is a difficult climate. Unless investing is your full-time job, my advice is to diversify more than ever.

Link here.


Every big enterprise needs a sustaining myth to drum up repeat business. Hollywood filmmakers, for example, know the power of movies about the underdog, from High Noon to Rocky to Kill Bill. Yet if the underdog is a proven moneymaker, it cannot hold a candle to Wall Street’s sustaining myth, known affectionately as “The Benefits of Diversification”.

Diversification became the mutual fund industry’s myth of choice in the early 1980s, at the start of the great bull market. In 2005 the 100 largest U.S. money managers owned some 68% of U.S. stocks, and the industry overall had $7.5 trillion under management. In 1950, mutual funds owned 3.0% of equities and the industry managed less than $1 billion, as individual investors directly owned 97% of U.S. stocks. I would call that a pretty powerful myth. So powerful, in fact, that the number of U.S. mutual funds actually surpassed the number of publicly traded stocks during 2001.

Diversification is beneficial – if mediocrity is your goal. From 1984 through 2002 the S&P 500 saw a 12.2% average annual return, while equity investors earned 2.6% annually over the same period. This poor comparative performance may have had something to do with an annual turnover of shares of between 23%-40% among equity fund investors (1984-2000), though this was less than the equity fund portfolio turnover rates of between 51% and 108% annually (1980-2000). Yes, I said 108%. (All the figures above come from John C. Bogel, founder of The Vanguard Group.)

Naturally, the keepers of the sustaining myths tend to use them as a rallying point in difficult moments – such as the month of May in 2006. Never mind that the diversifications of choice – overseas markets, real estate funds, commodities – have seen the strongest declines. Wall Street and the fund industry know that fund shareholders have tolerated underperformance, excessive fees, and even scandals for many years. The myth has worked before, so why shouldn’t it now?

Link here.


Gold is an August monetary asset but an undependable investment. Producing no income, it is inherently speculative. I am a value investor, but I am also a gold bull. Value investors buy stocks or bonds by the numbers. They compare price with value and buy if the discount is suitably deep. They turn a deaf ear to macroeconomic theorizing. Whether the GDP is rising briskly or not at all is immaterial if a particular company is priced at less than its readily ascertainable net asset value. Gold is something different. You buy it solely for macroeconomic considerations. I buy gold as a hedge against the stewards of paper money. I buy bullion coins suitable for burying in the turnip patch. I expect the price of the gold coins to keep going up, but I do not know how high.

There is much I do not know about gold. There is much that nobody can know – critically, for example, what the price ought to be. It is guesswork. If this is a cockamamie way to invest, I draw courage from the theory of central banking, which is more cockamamie still. These days it boils down to picking an interest rate and imposing that rate on the market. Some would call this “price-fixing”. Can you name a single successful government price-fixing operation? For a year, through June 2004, the Federal Reserve held the federal funds rate at 1%. Chairman Alan Greenspan and the chairman-to-be, Ben S. Bernanke, said they were fighting an anticipatory battle against deflation. They wanted to preserve the U.S. from a Japanese-style funk following the bursting of the stock-market bubble in 2000-01. So they dropped lending rates to the floor and pushed home prices to the moon.

Now house prices are falling, and mortgage rates are rising. Do you remember Greenspan’s advice to homeowners in February 2004? He suggested they take out adjustable-rate mortgages. Many did – and are discovering that their disposable income, after mortgage payments, is adjusting to the down side. The real-estate-dependent U.S. economy is starting to wheeze. And inflation is inconveniently starting to percolate. It is a quirk of the U.S. statistical apparatus that residential rents count for 29% of the measured rate of consumer price inflation. During the housing-price boom, rental rates sagged. But now that homeownership is losing some of its luster, rental rates are turning up. They are taking the CPI up with them.

You are Chairman Bernanke. What do you do? A conscientious fellow, you try first to do no harm. You have made a lifelong study of deflation and the Great Depression. Of all the mistakes you could make, there is one you really want to avoid. You do not want to go down in history as the scholar of the Great Depression who inadvertently steered the highly leveraged U.S. economy into Great Depression II. You will be slow to tighten monetary policy when home prices are deflating, let the CPI be what it may.

Gold competes with the Bernanke dollar, just as it did with the Greenspan dollar and just as it has with government-issued money since the invention of the printing press. The historical record is undebatable: (1) Currencies ultimately lose their value. (2) Gold is a lousy long-term investment. (3) Yet when markets lose confidence in paper, there is nothing quite like a Krugerrand.

The post-1971 dollar is uncollateralized. Its value is derived from the world’s faith in America as much as from the strength of the U.S. economy or the level of U.S. interest rates. Reading the newspapers, I judge that faith to be wavering. The gold price has doubled in the past three years, but it has only just kept up with the price of lead and has badly trailed the prices of copper and zinc. Arguably, then, gold’s rise to date is not as much a reflection on U.S. monetary management as it is an echo of the commodity boom. You can be sure that gold will have its own bull market when the dollar resumes its bear market. When will that day come, and how high is up? I do not know – and neither does Bernanke.

Link here.

Surging commodity prices have got investors thinking about ways to play gold, oil … even uranium. Here come the promoters.

Not so long ago everything was going wrong for Rick van Nieuwenhuyse. A onetime exploration executive at Placer Dome, he had quit his job and taken over penny stock NovaGold Resources to look for the yellow metal in his home state of Alaska. Then gold plunged to $255 an ounce in 2001. To make ends meet Van Nieuwenhuyse had to turn NovaGold into a sand-and-gravel producer in western Alaska. But with precious-metal prices recently hitting a 26-year high, he is a changed man. “In the next couple of years,” he declares, “you will see gold at $1,000.”

There are believers. The market cap for NovaGold, which trades on the American Stock Exchange, recently reached $1.1 billion. Van Nieuwenhuyse says the shares are undervalued. Never mind that the company still has very modest revenue. Van Nieuwenhuyse is expecting something of a miracle. By 2012, he says, NovaGold will pull 700,000 ounces a year out of the ground. To get there NovaGold will need to raise $1.1 billion in debt and equity, and quickly build mines in remote locations. Van Nieuwenhuyse shrugs off the daunting obstacles. “In a more ho-hum market it would be a huge challenge,” he says.

Ho-hum? Try hysterical. Gold hit $723 a troy ounce (that is 31.1 grams) in May before settling down to a recent $643, still up 24% since the start of the year. Investors poured $4.2 billion into U.S. gold mutual funds between January and April, compared with $3.7 billion for all of last year. Two new gold-exchange-traded funds have pulled in $7.1 billion since their creation in late 2004. Gold fever has seized giants like Barrick, which spent $10.4 billion to acquire Placer Dome, the sixth-largest gold-mining outfit, at the beginning of the year.

The commodities craze has also kicked up prices for silver, copper, uranium and, of course, oil. Name your driving force: demand from China and India; anxiety over Iraq and Iran; a desperate hedge against inflation. Whatever the causes, the phenomenon has given hope to goldbugs hoping to end their quarter-century diaspora and to investors whose stock market losses have still not been made whole. And it has given opportunity to hucksters who seem to be more adept at selling shares than selling any commodity. Some of these impresarios are legit and may even strike it rich. Some have few assets (other than investor funds), no financial history, and even less operating experience.

Then again, who remembers the disreputable Vancouver Stock Exchange, long a haven for thinly traded stocks that drilled unsuccessfully for one metal or another, which finally shuttered in 1999? The American Stock Exchange and the OTC bulletin board are willing to list these latter-day stock vendors. What about the Bre-X scandal of 1997 – when promises of a mountain of gold in Borneo turned out to be a few ore samples salted with gold dust? New requirements (in Canada, at least) for verification of claims by a geologist are but speed bumps to the fastest-talking pitchmen of precious metals. Mining companies with no revenues raised $6 billion last year by issuing shares on stock exchanges, largely in Canada, the U.K. and Australia.

Tempting as it may be to participate in the commodity frenzy, some of the most ardent fans are starting to eye the exits. Arthurornia., told followers who packed a New York City conference room in May to start selling their positions. “Make the money and take the money,” he advised. “We are in the best boom since the 1970s. Don’t waste it.”

Link here.


It has been six years since the bubble burst, and tech is still mud on Wall Street. The Nasdaq has dropped to its lowest level since January, the only big U.S. index in the red thus far this year. Dell, Microsoft and even tech hotties like Google and Apple Computer are down for the year. Bears point out that an overabundance of technology gear, from storage equipment to disk drives, is pushing prices down. Another deadweight is a new accounting rule forcing Silicon Valley’s beloved stock options to be deducted from earnings. But that is like reading the history of Microsoft and stopping at the chapter about its mid-1990s challenge from Netscape.

Here is the bullish story. Technology companies are doing what all companies are supposed to do, which is to create cash for their owners. The cash balances at the 115 tech companies in Goldman Sachs’s Tech Index, an in-house roster of tech stocks covered by its analysts, totaled $250 billion at the end of last year, says Laura Conigliaro, a Goldman analyst. That is up from $180 billion three years earlier.

Charles Mulford, a professor at Georgia Tech and director of its Financial Analysis Lab, which specializes in cash flow research, has a slightly different way of looking at the cash picture. He creates a composite of 70 technology firms in the S&P 500. This group has seen a 43% gain in cash flow from operations over the past five years. (Mulford uses a composite rather than a raw total to adjust for the effect of companies entering and leaving the list.) That boost in cash profitability comfortably exceeds the 32% increase in revenue. Maybe technology managers have matured a bit since the crash. Instead of counting eyeballs or worshipping the top line, they are measuring success by how much folding green they put into their owners’ pockets.

Cash flow from operations differs from the bottom line you see on a profit-and-loss statement. It is defined (roughly speaking) as net income with an add-back of noncash charges like depreciation and with a further adjustment for certain working capital changes. Cash-draining increases in inventories and receivables count against the cash-from-ops total. Cash-sparing behavior like running up accounts payable works in favor. Cash from ops is the money that would be available to pay down debt or pay dividends if the company spent nothing on capital goods.

To be sure, it is possible for a company to become too fixated on cash and not enough on its future, professor Mulford warns. One way to build up the cash balance is to be niggardly with capital expenditures – the average tech company’s cap-ex has fallen from 13% of revenues in 2000 to 6% in 2005, says Mulford. Another way: Pay bills late. Still, cash from ops is a useful perspective on a sector that usually gets more attention for its net income or its growth. To find cash-rich tech bargains, we looked at 873 tech companies with market caps above $500 million and with positive sales-per-share growth. We confined our attention to companies with a positive net cash – cash and equivalents minus interest-bearing debt – balance. We also wanted stocks that are cheap. The list shows companies trading at 15 or less times cash from ops.

Link here.
Web stocks awash in worry – link.


The Office of Federal Housing Enterprise Oversight (OFHEO) released first quarter housing price data this week. Nationally, prices were up 2.03% (8.12% annualized) during the quarter, with a y-o-y gain of 12.54%. While this was the weakest quarterly price gain in eight quarters, it is worth noting that not a single quarter surpassed 2% appreciation during the entire decade of the 1990s.

As we contemplate an extraordinarily uncertain future, it is interesting to reflect back a year. I certainly do not remember anyone forecasting yet another year of double-digit mortgage credit and home price gains. The consensus view had housing slowing rapidly, in the process forcing the U.S. consumer to retrench. Some saw the Fed wrapping things up last June at 3.25%. Others expected that the Fed would be well into another easing cycle by now. With 10-year bond yields stubbornly below 4% this time last year, a view was taking shape that the global economy was beset by intransigent disinflationary forces. If inflation had not made its appearance after a few years of ultra-loose global monetary policy, we were told, it just was not likely to happen. Or so they thought.

As the dollar index approached a double-digit gain by mid-2005, a fanciful notion also took hold that the risks associated with dollar weakness had passed. The “Bretton Woods II” hypothesis became all the rage. It was going to remain mutually beneficial for U.S. consumers to consume and Asian producers to produce, while their tightfisted consumers and determined central bankers ensured at least several more years of Asia as steadfast buyer and price-setter for our Treasury and bond markets.

We have not of late heard much of the global disinflationary backdrop or the virtues of Bretton Woods II. Instead, there has been a reality check as inflationary pressures take center stage. Global bond yields have surged to multi-year highs, the dollar is sinking back toward multi-year lows, and commodities price indices are near record highs. Where did the sanguine inflation and rate analysis go wrong?

First of all, the view from a year ago that anticipated a rebirth of global disinflationary pressures was the upshot of a flawed analytical framework. It simply disregarded the ongoing massive (U.S.-led) global credit inflation and attendant financial flows, choosing instead to fixate on generally tame global goods prices and the underlying surfeit of cheap labor. The difficult but key aspect of the analysis is to recognize how financial flows are changing and the ramifications for such change. I do not believe the crude market is a bubble waiting to burst. Instead, I view $70-plus crude as the most prominent price manifestation to emerge from global credit inflation dynamics. This price surge should be recognized as a major escalation from inflationary effects that were until recently isolated largely to asset markets and Asian manufacturing capacity.

It was only a matter of time before our unending current account deficits and (resulting) unhinged global credit systems created both heightened demand for energy and the excess liquidity to drive its price significantly higher. And it was precisely this amount of time until speculators fancied oil, metals and commodities rather than Treasuries. I recognize that it is popular nowadays to predict the imminent bursting of myriad bubbles – “energy”, “emerging markets”, “global risk assets”, “commodities”, and “hedge funds”, etc. Bursting bubbles are expected to lessen global liquidity, aggregate demand and general price pressures. What I do not see much of is analysis of the ramifications for the historic shift in the flow of global finance to the oil producing economies and their financial institutions. I do not claim I have any great insight other than to suggest that readers contemplate the possibility that current monetary trends are moving in the direction of a radical departure from the nature of global (dis-)inflation experienced over the past two decades.

I believe the unfolding shift of finance to oil producers throws a problematic monkey wrench into the very premise of a manageable global monetary regime (“Bretton Woods II”). The proposition that our trade deficits were being driven by the purchase of under-priced discretionary consumer goods from undervalued (“mercantilist”) Asian currency regimes must now be adapted. Going forward, a major part of our trade imbalance will be due to high-priced energy priced (for now) in our own depreciating dollar. Accordingly, the weaker the dollar the higher the ongoing bill for our oil dependency. The hope that a weaker dollar will rectify global imbalances can be thrown out the window, along with the dream that it will always be in the interest of our trade partners to buy dollar securities. It is wishful thinking to expect oil producing central banks to be such anxious buyers of dollar balances from their domestic companies, and almost inconceivable that these central banks would so predictably recycle balances back to the U.S. bond market.

To state that global monetary – and, specifically, dollar “recycling” – dynamics are today much more uncertain is quite an understatement. There was some truth to the notion of the symbiotic relationship between the U.S. as borrower and consumer and Asia as producer and saver. The significant financial and economic power now shifting to the oil producers entails quite different dynamics and should be cause for concern. We do not enjoy such a symbiotic relation with the oil producing community, while the rising prominence of energy on the world stage will diminish the Asian infatuation with our securities markets. We could always count on the Japanese to do what we wanted, and the Chinese and other Asian countries have to this point basically followed a similar path. But many oil exporting countries clearly hold us in contempt. That we have become so economically and financially dependent on the Middle East is contemptible.

I purposely attempt to stay well clear of geopolitics in my articles, but I am this evening compelled to mention the deteriorating situation in Iraq. U.S. standing in the region is heading from quite bad to absolutely terrible, at the same time that relations with Russia are increasingly strained. Considering the confluence of problematic global financial flows, acute dollar vulnerability, and U.S. financial and economic fragilities, I see ample evidence to suggest an unambiguous risk of an unfolding liquidation of dollar holdings.

Link here (scroll down to last subsection of page content).


The newest intrigue in corporate America, the apparent backdating of stock options to boost top executives’ compensation, is rapidly taking on the dimensions of a major scandal. The number of public companies under investigation by the SEC or federal prosecutors has grown to more than 30 and executives at several companies have been fired. Yet to be determined is whether federal prosecutors will bring criminal charges against any of the companies or executives. Subpoenas have been issued by U.S. attorneys’ offices in several cities including New York, which led off the wave of criminal investigations.

At issue is whether company insiders manipulated the timing of stock option grants to bring big payoffs to executives by improperly backdating the grants to coincide with low points in stock prices. As first noted in a series of groundbreaking articles in The Wall Street Journal, these patterns of almost too-good-to-be-true timing took place in the late 1990s and early years of this century. Stock options become more valuable as the market price rises above the exercise price, so backdating fattens the spread – and executives’ payoff – when they eventually sell their stock. Unlike the byzantine financial schemes concocted by Enron and other poster companies of the corporate scandals of recent years, options backdating is fairly easy to comprehend and goes straight to the issue of whether executive remuneration is out of control.

Link here.

Moody’s: Backdating is a credit risk.

Backdating stock options could negatively affect a company’s credit rating, says a report by Moody’s Investor Services. The report lists several credit risks associated with backdating, including financial and reputational risk, which figured into a ratings action announced last month that dropped the credit outlook for UnitedGroup from stable to negative. Spawning the report was the growing number of investigations by the SEC and the Department of Justice into the timing of corporate stock option awards.

In general, government probes are being launched to determine whether the grants were backdated to a point shortly before the company announced good news, so option holders could capitalize on a lower market value. Although the practice is considered controversial by many investors, backdating is legal if disclosed in regulatory filings, allowed by the company’s own policies, and accounted for properly.

According to Jeffrey Benner, a Moody’s analyst and one of the report’s authors, backdating inquires could raise ratings questions about a company’s leadership, reputation, governance practices, and financial performance. For instance, the report points out that investigations into backdating have already led to leadership shakeups, as senior managers at several companies under investigation departed abruptly. Any wrongdoing the investigations uncover could soil a company’s reputation enough to affect a company’s standing with customers, employees, and investors. But evaluating reputation risk is “difficult”, contends the report, because it often takes a relatively long time for the effects on a company to become apparent.

Link here.

Options’ deluding effect.

The backdating scandal has put stock options under the microscope again. But in their focus on how executives gamed the system to get bigger payouts, investors may be missing the big picture. More disturbing is what executives have done with options right out in the open – without bending or breaking any rules. “Options are one of the great fiascos of all time,” says Gary Lutin, an investment banker and shareholder rights’ advocate. Corporate managers “came up with lots of creative ways to take shareholders’ property, some of which were legal.”

A case in point: Many institutional investors and analysts keep track of the dilution that might be caused in the future by outstanding and prospective options grants. But few, if any, have kept track of how much dilution has been caused by options already exercised. At a number of companies, that form of dilution – actual as opposed to possible dilution – amounts to sizable portions of their outstanding share count. At Yahoo!, for instance, employees and executives have exercised 430 million options from 1997 through the first quarter of this year – or about 29% of the company’s overall share count, factoring in the stock buybacks that the company has done in recent years to soak up some of the dilution. Options exercised since 1998 represent about 27% of what Broadcom’s share count would be if not for stock buybacks. At Apple, the figure since 1996 is 20%. For eBay, 16%, going back to 1999. This dilutive effect is important, because it essentially represents money taken out of shareholders’ wallets.

Without the weight of all those optioned shares holding it down, Yahoo!’s stock would be trading about 35% higher today than it is, assuming it had the same market capitalization. Exercised options also represent a massive transfer of wealth from shareholders to corporate insiders. In 2005 alone, for instance, Yahoo! employees and executives gained about $2.17 billion from exercising options, according to data extrapolated from the company’s annual report. In contrast, Yahoo’s reported net income last year was, excluding stock options expenses, about $1.9 billion. Had companies avoided the use of options, they would have had to compensate their employees in cash, which likely would have lowered reported earnings. But the amount of that higher salary payout would have been far less than what employees reaped through options. Last year, for instance, the average eBay employee made about $65,000 just from exercising options. “Why would any responsible money manager ever buy these stocks [when] the employees are making more money than the company?” asks Albert Meyer, an investment advisor at Bastiat Capital. “You can’t run a business over a long period of time on that basis.”

The dilution issue also is a pertinent one as proxy season gets into full swing. At their annual meetings, a number of companies, such as eBay, either have or will ask for expansions of their stock programs. The problem is that most analysts who determine the merit of those expansions simply look at the so-called “overhang” – the number of options that have already been granted and are still outstanding, or that might be granted if the expansion is passed. Some institutional investors and proxy advisers set a limit on how high they will allow the overhang to get before they oppose new attempts to expand options plans.

But that focus is “myopic”, says Ken Broad, a portfolio manager at Delaware Investments and a longtime critic of stock options, because it ignores the degree to which shareholders have already been diluted. Using those formulas, a company whose employees already exercised the million options they have been granted would look better than a company that still had a million options outstanding, even though the dilution would be the same, he notes. Indeed, a better way to look at it would be to look at the total of past and potentially future dilution from options exercises, Broad says. So at eBay, in addition to the 226 million options that employees have already exercised, insiders hold another 143.5 million options, or about 10% of the company’s current share count. “To just focus on [the overhang] as a measure of dilution is completely wrong,” he says. “This is yet another overlooked area” in the options debate.

Link here.

Pay for Toyota’s top execs averages $320,000 each.

Toyota Motor Corp. paid its 26 top executives, including President Katsuaki Watanabe, a combined $8.27 million – an average of about $320,000 each – last fiscal year, little changed from a year earlier. Toyota posted a fourth consecutive year of record earnings in 2005 as U.S. demand boosted sales. The carmaker’s market value has surged 45% to $188 billion since Watanabe took charge in June 2005.

GM, the world’s largest automaker, cut Chief Executive Rick Wagoner’s pay for 2005 by 46% to $5.48 million. Wagoner did not get a bonus because the Detroit-based company lost $10.6 billion for the year. Toyota’s board adopted a resolution in April to stop paying bonuses to retiring executives as of the shareholders meeting scheduled on June 23.

Link here.


The rising cost of oil has put a squeeze on the companies that use oil as an ingredient for their products. Although they are down from the records seen recently, oil prices are up more than 20% from a year ago and are more than 150% higher than they were five years ago. Natural gas prices have also risen. Chemicals made from oil are used by companies to manufacture many products consumers rely on every day, such as plastic bottles, aspirin, lipstick and deodorant.

Even though oil-based products are so pervasive, the direct impact of the rise in the cost of making such goods on consumers has been – and likely will continue to be – minimal. Manufacturers, faced with strong global competition, are unable to pass along all of the added costs to customers. That means prices for most oil-derived products will likely barely budge as a result of higher energy costs. But the impact on manufacturers and other companies that use oil-based ingredients could be significant, causing a ripple effect throughout the economy. As firms are faced with rising prices and see their margins cut, they may have to cut back on production, reduce pay increases or maybe even cut jobs or shut down.

Link here.


It turns out that it is not just money that makes the world go round. To cash, add credit and related financial instruments. That equals liquidity, the lifeblood of financial markets. Liquidity surged in the past decade, fueled by relaxed monetary policies by central banks, globalization, new technologies and such exotic financial instruments as derivatives. They in turn drove down interest rates and bond yields and encouraged investors to pump more money into riskier assets, propelling stock markets.

No more. Rising inflationary expectations, growing political risks and, most especially, actual and anticipated increases in interest rates are combining to make investing and speculation more expensive. “The era of underpriced capital in constant supply is ending,” said David Roche, president of Independent Strategy, a global economic and financial consulting firm in London. “The global cost of capital is rising, and risk appetite will diminish.” He warned that if liquidity kept shrinking, it would “squeeze asset prices and damage economic growth.” Roche said that the higher cost of capital – the cost of issuing new equity or borrowing money – was bad for both bonds and equities. Still, American dependence on foreign financing for its burgeoning current account deficit makes U.S. stocks more vulnerable than Japanese or European equities.

The Dow Jones Stoxx 600 in Europe is down 6.7% from its 5-year peak last month, while the Nikkei 225 in Japan has fallen 8.7% from its May high. The S&P 500 index is down 2.8%. Morgan Stanley’s emerging market index has dropped 13% from its May high. “The sell-off in risky assets is a sign that global excess liquidity, which has been buoyant for many years, has finally begun to shrink,” said Joachim Fels, chief fixed-income economist at Morgan Stanley in London. Both the 1994 crash in the bond market and the bursting of the technology bubble in 2000 were preceded by sharp contractions in excess liquidity, Fels noted. His advice? Stick to government bonds and cash, and avoid risky assets like emerging-market stocks and bonds, as well as high-yield debt and commodities. Joseph Quinlan, chief market strategist at Banc of America Capital Management in New York, said, “In a nutshell, the era of easy and abundant global liquidity is coming to an end – a change in the global monetary backdrop that usually inflicts pain on those asset classes highly dependent on easy money.”

Link here.

Nightmare carry trade scenario.

I have been thinking about the nightmare carry trade scenario. In other words, what is the worst possible situation for carry trade players? For those unfamiliar with the term “carry trade”, I will use the definition found on Freebuck.com: “Carry trade – The speculation strategy that borrows an asset at one interest rate, sells the asset, then invests those funds into a different asset that generates a higher interest rate yield. Profit is acquired by the difference between the cost of the borrowed asset and the yield on the purchased asset.”

I view the nightmare scenario something like the following:

  1. End of quantitative easing (QE) in Japan
  2. End of zero interest rate policy (ZIRP) in Japan (Rising interest rates)
  3. Rising interest rates in Europe
  4. Falling interest rates in the U.S.
  5. Tightening credit in the U.S.
  6. A rising yen vs. the U.S. dollar

All in all, it looks closer than anyone might have thought. Perhaps that is the message of a $100 plunge in gold, copper going down lock limit several times, silver ramping to the moon just to fall off a cliff, various emerging markets indexes plunging, and global equity markets taking a collective nose dive. Should a nightmare unwinding of various carry trades unfold as I expect it to, “dry powder”, as in cold hard cash, just may be a good thing to have.

Link here.

Carry trade unwind victim Iceland’s new PM urged to cut spending.

Geir Haarde, Iceland’s new prime minister, has been urged to “stand on the brakes” to rein in inflation and reduce the chances of the economy suffering a hard landing. He inherits an economy in considerable flux after two credit rating agencies downgraded their outlook for the country from stable to negative over concerns that the economy is overheating. “It’s just a question of how fast the whole thing unwinds,” said Paul Rawkins, senior director at Fitch, the ratings agency that first downgraded its outlook on Iceland in February. Economists, analysts and industry representatives urged Mr. Haarde to implement quickly a reduction in government spending on projects such as roads, bridges and other construction.

Iceland has experienced a credit, investment and housing boom since 2004 that has pushed inflation to 7.6%. The central bank has raised interest rates 14 times in two years but to little effect. It raised rates by 75 basis points last month to the current 12.25%. Fitch, alongside fellow credit ratings agency S&P, believes inflationary pressures will eventually trigger a “painful adjustment”. But foreign observers in Iceland argue that despite these short-term concerns the Icelandic economy is not as weak as it has been portrayed. They point out that Iceland’s companies derive 65% of their profits from their overseas operations and are protected against domestic shocks as a result. Unemployment is also close to zero and the country’s banks are well capitalized.

Nevertheless, Fitch’s decision in February spooked investors and the Icelandic krona weakened 30% against the euro to a 5-year low and the stock market fell 18%. Monday’s downgrade by S&P also prompted a further 2% weakening of the krona and a 1.8% drop in the stock market. But the foreign observers argue that the currency was at least 20% overvalued in the first place and that the correction was a necessary one. They add that the severity of the decline was fuelled by money lured to Iceland by the carry trade, which involved borrowing in low interest rate environments such as Japan and investing in Iceland. These short-term investors – such as hedge funds – exited Iceland in a hurry following the Fitch report, exacerbated the decline of the currency and made other investors nervous, which in turn added to the selling pressure, they said.

Link here.


It has been said that if you spend 15 minutes a year thinking about the economy, you are wasting 13 minutes. That is generally true. But as an amateur historian, I cannot help myself. And I am forced to believe that this is a time when the subject is worth some real thought.

My view is that the longest, and certainly most important, trend in history is the ascent of man. I have little doubt that it will not only continue but accelerate. But that does not mean there will not be nasty setbacks along the way. Possibly the best definition of a depression is a period when most people’s standard of living drops significantly. You can also define it as a period when distortions in the economy and misallocations of capital are liquidated. The distortions are almost always the result of government intervention in the economy, through things like taxes, regulation and currency inflation. Those are the factors that caused the unpleasantness that began in 1929. Since the government is exponentially more powerful and invasive today than it was in either the 1920s or the 1970s, I expect the consequences will be much worse this time around. Things could have come unglued, and almost did, back in the 1970s. I do not see how we will dodge the bullet this time. A depression is probably inevitable this time.

The only serious question in my mind is whether it will be essentially deflationary in nature, as it was the case in the U.S. in the 1930s, or inflationary like in Germany in the 1920s. My guess is the latter because the government is so much more powerful today. Or it could actually be both at once, in different sectors of the economy. Inflation could drive interest rates to 20%. This would collapse the bond and real estate markets, wiping out trillions of dollars of purchasing power – which is deflationary. Meanwhile, that same inflation doubles the cost of food and fuel. In other words, the opposite of what we have mostly had for the last generation, when we had “good” inflation in stocks, bonds and property, but stable or dropping prices in “cost of living” items. This time the pattern could reverse, which would be a nightmare for most people.

And as people become more focused on speculation in a generally futile attempt to stay ahead of financial chaos, they inevitably divert effort from economic production. Which will decrease the general standard of living even more. The situation is not made easier by the possibility that we are at the start of a secular decline in world oil production. Or the fact that Americans, both individually and collectively, are deeply in debt and living on the kindness of strangers. Wrap this economic environment around the so-called War on Terror, which is rapidly morphing into the War on Islam, which could easily turn into World War III, and you are looking at the perfect storm. The odds of a major conflagration are very high, and it is not being adequately discounted. And that will be accompanied, and compounded, by mass hysteria among Boobus americanus.

At that point, your investment portfolio will be among your lesser concerns. People forget that, in every country and time, there is a standard distribution of sociopaths and misdirected losers. In normal times, they seem like normal people. But when the time is right, they show their colors, and they love to get jobs with the government, where they can lord it over their betters. We live in a world of cause and effect where actions have consequences. That being the case, I expect truly serious financial and economic trouble. And the government will make it vastly worse by trying to “do something” instead of recognizing itself as the cause and backing off. I do not see any way out.

How bad will it be? In historical terms, the last depression was relatively short and mild. The longest depression on record was the Dark Ages. Residents of the old USSR and Mao’s China suffered through a depression that lasted decades. I am not predicting it will be that bad, if only because the U.S. has basically much sounder traditions and institutions and vastly more accumulated capital. But it is hard to overestimate how serious this could be. I sometimes joke that it will likely be worse than even I think it will be. The recession of the late 1970s and early 1980s involved a terrible stock market, 15% inflation with interest rates to match, 10% unemployment and a near war with the USSR. But the country not only hung together, it went on to a tremendous rebound. My guess is, however, that the last 20 years of good times will later be viewed as an economic Indian Summer before a harsh winter.

The good news is that no matter what the economic conditions, technology – the mainspring of human progress – will keep advancing. And many individuals will continue innovating, saving and improving conditions for themselves and their associates. Also, it is entirely possible to go through even the worst of times and not get hurt. Indeed to profit from them. If the price of a house you want now but cannot afford falls 75% (as outrageous as that may sound at the moment) while your own investments in the high-quality gold stocks quadruple, you are much better off. That house now really only costs you 1/16th of what it did before. There is time now to structure your affairs so that you are on the right side of the trade.

What indicators should we watch for that might tell us it is about to get ugly? One obvious indicator is how the price of gold is running. Gold is the only financial asset left in the world that is either safe or cheap. It is also under owned and largely unrecognized, which is why the smart money has been moving into it. Then there is the CPI itself – although I do not think it is very accurate, in that all the adjustments, exclusions, weightings and what-nots the government has insinuated into it over the years makes the CPI as much of a floating abstraction as the dollar itself.

Higher interest rates, which we are already seeing, will inevitably burst the real estate bubble, which is floating on a sea of mostly adjustable-rate debt. Higher rates will also crush bonds and probably stocks. And they will devastate the economy since everybody is deeply in debt. There are trillions of U.S. dollars outside of the U.S. Unlike Americans, foreigners have no reason to hold them. And at some point very soon, perhaps when the Fed finally hits the wall on its ability to raise rates, these overseas dollars are going to start flooding back home, while the products and titles to real wealth flow out of America. Therefore, when the trade deficit starts turning around – which most people will think is a good thing – that will be the real tip-off the game is over. Trillions coming back to the U.S. will skyrocket long-term interest rates and inflation. The dollar will go into freefall.

But although I think these are the things to watch, to my way of thinking it makes no sense to wait until the stampede starts to try to get out the door. If you have not done so already, take advantage of the current correction in gold to begin repositioning your portfolio for what is next.

Link here.


On Monday afternoon, Ben Bernanke soothingly reassured investors that U.S. consumer balance sheets were not cause for concern. With all deference to the Fed chairman, one line item on a report his organization prepares begs to differ. Somewhere in the finer print of the media’s coverage of Thursday’s Q1 Flow of Funds report, if anywhere at all, will be the real news – that households’ debt-to-asset ratios hit a new record. In other words, debts grew at a faster rate than assets, as they have for years.

Northern Trust’s Paul Kasriel points to the most revealing of line items in the report – “Net Financial Investment”. The best way to view this line item is as the surplus or deficit that households are running. More specifically, it is the dollar figure you get when you add up every dollar households added in the quarter to cash, stocks, bonds, mutual funds and any other financial asset you can name and net out any debts added in the quarter. The figure has traditionally been positive. Households have typically had excess financial assets to invest back into the country. These days – which started in 1999, when net financial investment turned negative – households rely on the rest of the world financing their expenditures. In Q4 2005, this figure was running at a record annual rate of $662 billion, up from 1999’s $231 billion. Every indication is that the number continued to grow.

This is nothing new, so why worry now? Think of the game of musical chairs. Now turn the music off. “House prices are no longer rising as rapidly, so the home-ATM machine can no longer be tapped,” Mr. Kasriel said. “And households are devoting a record and rising level of their incomes to servicing their debts.” This means that the backstop households have relied on for the last four years is fast disappearing. You may be thinking that home prices are still going up in many areas of the country. While true, it is beside the point. It was the accelerating rates of price appreciation that allowed households to continue cashing out their home equity. Evidence of the strain was in Wal-Mart’s news that store sales were disappointing in May, a sentiment echoed by auto dealerships. “We’re at a major turning point right now,” Mr. Kasriel added. Though he still jokes about America being another day older and deeper in debt, the stark reality is the punchline is quickly losing its punch.

Link here.


Coal is plentiful. Coal is cheap. Coal is dirty. But what if coal were cleaner? It would still be plentiful, of course. But it probably would not be as cheap. That is the reason we like coal. A new generation of “clean-coal” technologies could increase demand for this filthy fossil fuel, thereby causing its price to rise … perhaps dramatically. No country stands to benefit more from clean-coal technologies than the U.S. We have got a 250-year supply of the stuff. Surely, we will figure out an effective – and clean – way to use it.

As the price of crude oil trudges higher, our energy-intensive economy will seek viable alternatives. Renewable sources like wind, hydro and bio-fuel will certainly play a role. But one of the most viable alternatives, coal, is not really an alternative at all. technologies have created new opportunities for this plentiful, but scorned fossil fuel. The governor of Montana has made the creation of coal-gasification and liquefaction plants a veritable mission. He is convinced that creating liquid fuels from coal is the answer to our energy dependence problem and that “cleaning it” through gasification (the removal of harmful ingredients) will help solve coal’s obvious environmental problems.

It bears mentioning that both China and India have made coal gasification and liquefaction projects high priorities in their respective national energy strategies. Whether China, or any country for that matter, can finally clean up coal is open to debate. What I like about the whole debate, though, is that it is one of the few industries I see out there in which technology actually can lead to cleaner, more efficient, use of abundant hydrocarbons.

Wyoming produces over 35% of the USA’s coal output. Wyoming’s coal is of the bituminous variety. It has fewer Btu per ton vs. anthracite coal of eastern Pennsylvania, but it also has less sulfur. That makes Wyoming’s cheap and abundant coal some of the cleanest burning coal in the country. And for a country that is about to embark on a second love affair with the industrial prowess of coal, cleaner-burning coal will be very popular.

If you are talking Wyoming coal – the kind that can be surface mined or strip-mined by giant machines, then you are talking about the Powder River Basin. The strategic energy investment we are after here is Peabody Energy Corp. (NYSE: BTU). With 9.8 billion tons of proved and provable coal reserves in 36 countries all over the globe, BTU is a coal colossus. It also owns and operates the North Antelope Rochelle complex, which was the No. 1 producing coal mine in American in 1984, at 82 million tons. With total production of 192 million short tons of coal in 2004, Peabody was the largest producer in America.

At $60 a share, the stock trades for about 16 times next year’s earnings. It is also coming off a recent correction, and might continue to correct. I like the stock below $60. I love it below $50. The story with BTU really is about as simple as it gets. As natural gas production declines and reserves deplete, more coal will have to be produced to run the nation’s existing power plants. Add to that the number of new coal-fired plants on the books and you have even more increased demand for low-sulfur Wyoming coal. Am I worried that BTU is also Jim Cramer’s favorite coal stock? A little. But Cramer is mad, not stupid. And even a madman gets it right from time to time.

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


Now that the Dow Jones have slid 246 points in two days and shed 5.5% since mid-May, it is time to ask the question: How do you distinguish a short-term stock market correction from a full-blown bear market? You wait awhile, of course. But already there are clues in technical market data, such as who is doing the buying and selling, the price of stocks relative to corporate earnings, inflation data, and the length of time since the last recession. Corrections – drops of 5% over a few weeks or a month or two – are pretty common. Since 1900, the Dow has fallen at least that much more than 300 times, or an average of more than three times a year, according to Ned Davis Research. But nine out of 10 such slides bottom out and start rising again. It is the other 10% that scare the pants off investors. They turn into bear markets, in which the broad market indicators lose 20% or more and take their own sweet time coming back.

Even the professionals have trouble telling the two apart. In 2005, the Dow dropped more than 800 points – 8% – in March and April before rallying, then dropped an additional 400 points in September and October before climbing some more. In both cases, investors who jumped out prematurely would have suffered losses and missed another good rise. On the other hand, analysts were full of rosy predictions in 2000 and 2001 that the market was simply resting briefly and would soon resume its dizzying climb. None of the major indicators have ever returned to their early 2000 highs. “Picking the short-term movement of the stock market is like standing at the roulette table and saying, ‘I think red is coming up next’ and then congratulating yourself when you are right,” said Andrew Smithers, a British economic consultant. Though he published a book in March 2000 that correctly predicted that stocks were overvalued and about to tank, he called the timing “pure luck”. Now, consider today’s investing environment.

“There’s some panic in the street,” said Al Goldman, chief equity strategist for brokerage firm A.G. Edwards, “but I don’t feel it’s justified. … We don’t have any signs that a recession is at hand, and inflation, although it’s up, is still pretty well contained.” George Feiger, who runs Contango Capital Advisors, looks at the same signals and sees trouble. “All the technical indicators are showing that we must be getting near the end. The economy is slowing down, the dollar is tanking, people are pulling their money out of equities and putting them in cash, huge amounts of debt have been issued by below-grade [high-risk] issuers,” he said. “Where else can it go? The real question is not where will it go but how far.”

Interviews with nearly a dozen economists and market analysts turned up widely varying views on whether this particular market correction will develop fur and claws. That is partly because each one looks at different signals to determine where the equity markets are going. Charles Biderman, chief executive of TrimTabs Investment Research, argues that the real answers lie in mutual fund flows and in whether companies are spending money to buy their own stock or that of other companies as part of a merger. His conclusion? “The economy is doing very well, and the market is underperforming.” James W. Paulsen, chief investment strategist for Wells Capital Management, also predicts good times ahead for stock buyers. He argues that corporate profits and consumer spending are still relatively strong and notes that even though the Federal Reserve has repeatedly raised the benchmark short-term interest rate over the past two years, the current level of 5% is still low by historical standards.

Some analysts are far less sanguine. Many of them rely on the relationship between a company’s share price and its earnings to determine whether it is over- or undervalued, and they say that rapidly rising corporate earnings were the crucial engine behind the stock market’s long rise from late 2002 through the first part of this year. S&P 500 companies are trading around 15 times operating earnings, well below where they were at the last market peak in 2000. But some analysts are worried that high energy prices and the possibility of a cooling economy could combine to make it harder for companies to post strong earnings growth. “Earnings are going to be a little harder from now on,” said Peter Jankovskis, director of research for OakBrook Investments LLC, although he thinks the current drop is a correction rather than a bear market. But, “The market definitely has cycles: Sell in May, stay away. Markets are generally weak in the summer. … It won’t hurt you to stay on the sidelines for a while.”

On the other hand, investors who are already invested in equities should not run for the exits, market watchers said. “The worst thing that can happen is that people panic at the bottom, and it takes them a year or two to get over that panic. By that time, you’ve missed most of the next bull market,” said Ken Tower, chief market strategist for CyberTrader, a Charles Schwab subsidiary that focuses on active traders.

Link here.

How low will stocks go?

Everyone on Wall Street is asking the same question, from hedge fund managers who piled into once-hard-charging plays like mining stocks, commodities and crude oil to technical analysts who study each wobble in the indexes to predict the market’s next move. Have we reached the bottom? Although the drop, which began last month, has only taken the S&P 500 down about 5%, the fact that the overall market has not experienced a 10% correction in more than three years has left many investors more shaken up than usual. Adding to the general anxiety level is the more painful plunge overseas – Japanese shares have fallen 12.7% while European indexes such as Germany’s DAX and France’s CAC are off 9.7% and 7.3%. Emerging markets like Russia and Turkey have been hit harder. So there really has not been a safe haven anywhere – even gold has lost its luster.

So far this week, the Dow has lost more than 300 points. Technical strategist Mark Newton at Morgan Stanley says he is watching several key support levels on the S&P 500 and the Dow to gauge how vulnerable the market is to a further downdraft. Like other technical experts, Newton uses tools like past highs and lows, advance-decline ratios and support levels to predict the direction of the market. Going into Thursday’s trading day, he saw a key level for the S&P 500 of 1245 (the May low for the S&P), which the market dipped below less than three hours into the trading day. The next stop down, he says, is 1230. “If we get below there, that will cause a real deterioration in the technical structure,” he says. In terms of the Dow, he sees key short-term support levels at 10,735 and 10,684. “It really needs to hold where it is now and stay above 10,500 – that’s the trend line support from the lows in October of 2004.”

Newton says the timing of this move should not surprise market veterans. “Since 1960, 90 percent of market troughs have occurred 16 to 24 months after a presidential election,” he says. What is more, we are in the fourth year of the cycle in terms of market bottoms, he says, noting the troughs in October of 2002, 1998, 1994 and 1990. So while the current correction is certainly painful, it is hardly out of the ordinary in terms of market history. “It’s a correction, not a bear market,” adds veteran market strategist Byron Wien of Pequot Capital. “I don’t think we’re quite at a bottom but we’re getting close.”

One key sign that the market has bottomed is what insiders call capitulation-panic selling, and a belief that the market is not about to simply shoot higher. I am not sure we are there yet. Two weeks ago, I wrote that commodity plays like Phelps Dodge were still scarily high, and I got angry email from still-hopeful investors. PD was in the mid-80s when I wrote that story – it closed at $79.99 Thursday. There is still too much easy optimism in the market – a sell signal if there ever was one – but we are getting closer to the inevitable bottom as the mad money gets worn down.

Link here.

Cool Hand Ben brings down the house?

On June 6 the world did not end. However, for those watching the action in the U.S. stock market, the day did take on an air of doom when the DJIA plummeted below 11,000 for the first time since March 10 – on the heels of the market’s 200-point decline 24 hours earlier. As for Who the Devil to Blame for the sell-off – one name alone has passed the lips of the mainstream financial press: Federal Reserve chairman Ben Bernanke, and his June 5 International Banking Conference testimony. According to the usual sources, Bernanke’s speech “threw a monkey wrench into the works” with its clearly “aggressive” stance on the need for future rate hikes to stave off inflation. (Bloomberg) We are sorry, but for the three people who actually took the time to read the complete transcript of Bernanke’s statement, the fact remains that he leans in one unwavering direction about as much as a reed in a wind tunnel.

“We don’t,” begins a June 6 San Francisco Chronicle article, “have a consistent view about the current Fed chair’s thinking.” In fact, it calls to mind the famous quip from the movie Cool Hand Luke: “What we have here is a failure to communicate.” We also have a failure to see that stocks have been falling long before Ben opened his big, ambiguous mouth. From its 6-year high on May 10, the DJIA has fallen more than 5%, erasing nearly all the gains of the past five months in four short weeks. And, on the day of the market’s peak, the May 10 Elliott Wave Theorist special Interim Report came forth with this analysis: “Excitement is mounting. The wave count shown for the Dow appears to be ending its smallest subdivisions. These figures indicate a top for the Dow near today’s close.” It does not get any easier to understand than that.

Elliott Wave International June 6 lead article.

Bernanke is finding out the hard way that openness is not the same thing as clarity – link.

Fed, under pressure, may go ahead with another rate increase.

Federal Reserve officials, under pressure from financial markets to demonstrate yet again dedication to fighting inflation, now appear likely to raise the target for the overnight lending rate later this month. Most of the policy makers probably would prefer to leave the target at 5% – 400 basis points higher than when they started to tighten two years ago – at the Federal Open Market Committee meeting June 28-29.

Link here.


The world’s central bankers are likely to keep raising interest rates to snuff out faster inflation, undeterred by the turbulence their words and actions are having on global financial markets. “They shouldn’t be happy, but they have a job to do, which is keep their eye on inflation,” said Harvard University Professor Martin Feldstein, once a candidate to succeed Alan Greenspan as Federal Reserve chairman, a job that went to Ben S. Bernanke.

The ECB, Bank of Korea, Reserve Bank of India and South African Reserve Bank all raised rates Thursday, sending Asian stocks to the biggest slide in two years and pushing Europe’s Dow Jones Stoxx 600 Index to its low for the year. Prices for zinc, copper and aluminum weakened, while bonds rose. The Dow Jones Industrial Average rose 0.1% yesterday after losing as much as 1.6%. “The contentious bit is the old one about whether central banks should pay particular attention to asset prices,” said Christopher Allsopp, who teaches economics at Oxford University and is a former Bank of England policy maker. “They take them into account and they react quickly, but they shouldn’t divert from their overall remit of inflation-targeting.”

Bernanke, who had been criticized for not tackling inflation aggressively enough, kicked the week off by telling a banking conference in Washington on June 5 that price increases were too fast for his comfort. Traders judged a quarter-point increase in the Fed’s rate this month to 5.25% to be almost a done deal after the remarks. The Fed’s tightening cycle, the longest in a generation, began in June 2004. “The big policy blunders have been associated with the failure of central banks to keep inflation expectations under control,” said Mark Gertler, head of New York University’s economics department, who wrote a series of papers with Bernanke when the chairman was a professor at Princeton University. “That is where the current Fed is coming from.”

ECB President Jean-Claude Trichet signaled he is not swayed by the market slide and said further rate rises are warranted. He told reporters that the stock-market drop is “a normal correction phenomenon” after “a long period of very low volatility.” Bank of Japan policy makers, who are considering lifting their rate from zero, the first move in more than five years, may be similarly undeterred. “The moves of markets aren’t being caused by changing fundamentals of economies,” Deputy Governor Kazumasa Iwata told a news conference. “They are moving because investors are adjusting their positions.” An extended period of easy credit around the world encouraged investors to take greater risks, said Louis Crandall, chief economist at New Jersey-based Wrightson ICAP LLC. With that era coming to an end, the markets are adjusting. “To a large extent what we’re seeing is a normalization of risk premiums rather than a loss of confidence,” said Crandall, whose company is a unit of ICAP Plc, the world’s largest inter-dealer broker.

Emerging markets have led global declines in equities in the past month as the prospect of higher rates led investors to favor safer assets. MSCI’s emerging-markets index, tracking 25 markets, has fallen 21% from an all-time high on May 8. India’s Sensitive Index has slumped by a quarter in the past month, leading declines in Asia.

The central banks are tightening in response to a global economic expansion that is stoking inflation. According to the IMF, the world economy is on course to grow 4.9% this year, capping the strongest 3-year stretch since the early 1970s. Such growth is straining resources, allowing companies to raise prices. Barclays Capital calculates that worldwide inflation is at a 10-year high, with the global GDP deflator running at an annual rate of 2.4% in the first quarter, up from 2% last year. “I have found the recent inflation data somewhat troubling,” Fed Governor Donald Kohn told the Senate Banking Committee in Washington at a hearing on his nomination to the vice chairman of the central bank.

The tough talk from Bernanke and his colleagues is making some investors nervous. Gold has dropped 16% from a 26- year high of $730.40 an ounce on May 12, copper is down 17% from an all-time high, and aluminum has also retreated from a record. Yields on U.S. 10-year Treasury notes yesterday fell below those of 2-year securities for the first time since March as investors sought a haven from falling stock and commodity markets. “The markets are telling the Fed that it risks going too far,” said Jason Trennert, chief investment strategist at ISI Group in New York. “The chances of a financial player being carried out on a stretcher have gone up dramatically.” Bernanke and his fellow central bankers are betting that they can succeed in capping inflationary pressures without unduly hurting their economies in the process.

Link here.


Commodities have never gotten the respect they deserve, and it has been something of a mystery to me why. More than three decades ago, as a young investor searching for value wherever I could find it, I realized that by studying just a commodity or two one began to see the world anew. Suddenly, you were no longer eating breakfast but thinking about whether the weather in Brazil would keep coffee and sugar prices up or down, how Kellogg’s shares would respond to higher corn prices, and whether demand for bacon (cut from pork bellies) would go down during the summer months. (Consumers prefer lighter fare for breakfast.) Those headlines in the newspaper about oil prices or agricultural subsidies were no longer just the news. You now knew why OPEC prefers higher oil prices than Washington and why sugar farmers in the U.S. and Europe have a different opinion about price supports than do their counterparts in Brazil and elsewhere in the Third World.

But knowing about the commodities markets does much more than make you interesting at breakfast. It can make you a better investor – not just in commodities futures but in stocks, bonds, currencies, real estate, and emerging markets. Once you understand, for example, why the prices of copper, lead, and other metals have been rising, it is only a baby step toward the further understanding of why the economies in countries such as Canada, Australia, Chile, and Peru, all rich in metal resources, are doing well; why shares in companies with investments in metal producing countries are worth checking out; why some real-estate prices are likely to rise; and how you might even be able to make some money investing in hotel or supermarket chains in countries where consumers suddenly have more money than usual.

Of course, I have made a much bolder claim in my book, Hot Commodities: that a new commodity bull market is under way and will continue for years. I have been convinced of this since August 1, 1998, when I started my fund, and have been making my case for commodities ever since. I have written about commodities and given scores of speeches around the world filled with experienced investors and financial journalists. I have met with bankers and institutions. I have even been asked to confer with some mining companies to explain why I think they are going to do so well. But, as kind and hospitable as my audiences have been, some seemed no more eager to invest in commodities when I finished talking.

It was as if the myths about commodities had overtaken the realities. For most people, when you mention the word commodities, another word immediately comes to mind: risky. It is weird. From my own experience, I knew that investing in commodities was no more risky than investing in stocks or bonds – and at certain times in the business cycle commodities were a much better investment than most anything around. Some investors made money investing in commodities when it was virtually impossible to make money in the stock market. When I pointed out to people that their technology stocks had been much more volatile than virtually any commodity over time, they nodded politely and kept looking for the next new thing in equities.

One of the main reasons I wanted to write this book was to open the minds of investors to commodities. I wanted people to know that it took no measure of genius on my part to figure out when supplies and demand were about to go so out of whack that commodity prices would benefit. How hard could it be to make the case that during bull markets in stocks and bear markets in commodities, such as the most recent ones in the 1980s and 1990s, few investments are made in productive capacity for natural resources? If no one is investing in commodities or looking for more resources, no matter how much of a glut there is, those supplies are bound to dwindle and higher prices are likely to follow? The next step is as clear and logical as anything in economics can be: that if, in the face of dwindling supplies, demand increases or even just stays flat or declines slightly in any fundamental way, something marvelous happens, and it is called a bull market.

But even with the formidable forces of supply and demand on my side, I could not prove beyond anyone’s doubt that without commodities no portfolio could be called truly diversified. I could make my arguments, cite examples from my own experience, point to historical and current trends. Still, I had not done the heavy lifting, the professorial analysis and detail, to prove academically, with charts and graphs, how commodities performed vis-à-vis stocks and bonds. But then, as I was deep into the writing of this book, two professors who had actually done the research and analysis of how commodities investments performed relative to stocks and bonds reported their results. In short, commodities are not just a good way to diversify a portfolio of stocks and bonds; they often offer better returns. And, contrary to the most persistent fantasy of all about commodities, investing in them can be less risky than investing in stocks. This is dramatic news. I call it revolutionary, because it will change in a major way how financial advisers, fund trustees, and brokers treat commodities. To dismiss investing in commodities out of hand will now be liable to criticism and reproach – backed up by a reputable academic study.

But please keep this in mind that even in a bull market, few commodities go straight up. There are always consolidations along the way. And not all commodities move higher at the same time. Copper may already have peaked. In the last long-term bull market, which began in 1968, sugar, as we have seen, reached its peak in 1974, but the commodity bull market continued for the rest of the decade. A bull market by itself, no matter how impressive, cannot keep every commodity on an upward spiral. Every commodity, as we have seen, is guided by its own supply and- demand dynamic.

You will know the end of the commodities bull market when you see it, and especially once you have educated yourself in the world of commodities and get some years of experience under your belt. You will notice increases in production and decreases in demand. Even then, the markets often rise for a while. Remember that oil production exceeded demand in 1978, but the price of oil skyrocketed for two more years because few noticed or cared. Politicians, analysts, and learned professors were solemnly predicting $100 oil as late as 1980. Bull markets always end in hysteria. In the first stage of a bull market, hardly anyone even notices it is under way. By the end, formerly rational people are dropping out of medical school to become day traders. Wild hysteria has taken over – and I am shorting by then. I usually lose money for a while, too, as I never believe how hysterical people can get at the end of a long bull market.

The commodities bull market will come in its own form of madness. Instead of CEOs and VCs in suspenders, you will see rich, smiling farmers and oilrigs on the covers of Fortune and Business Week. CNBC’s “money honeys” will be broadcasting from the pork-belly pits in Chicago, and the ladies down at the supermarket will be talking about how they just made a killing in soybeans. Small cars will be the norm, homes will be heated five degrees below today’s preferred room temperature, and there might be a wind farm on the outside of town as far as the eye can see. When you see all that, then it is time to get your money out of commodities. The bull market will be over.

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

Wheat, and other sexy investments.

“Why is it that the Asian central bankers continue to support the dollar, the American economy, and the huge American structural deficits?” I recently asked Dr. Marc Faber, editor of The Gloom, Boom and Doom Report. “Don’t they have better places to invest their money, like their own economies, for example?”

“Of course they do,” Dr. Faber replied. “But most central bankers are idiots. That won’t change. But I tell you this; a grand exit from dollar-denominated assets is already underway.”

A few days later, Faber delivered a similar message to a packed, but mostly lethargic, roomful of professional money managers. For many investors, dire warnings about the imminent demise of the dollar serve merely to garnish a polite conference lunch of braised lamb and red wine. Surely, such warnings are not to be taken seriously. But for some people – let us call them contrarians – the dollar’s decline is a tremendous opportunity.

A currency only retains its value if its issuing government is not a deadbeat borrower. The U.S. government is not exactly a deadbeat borrower. At least not yet. Even so, a few investors around the globe are beginning to notice that America borrows a lot more money each year than it repays. In other words, it looks like the rest of the world is catching on that U.S. government bonds, even at higher yields, might be a lot riskier than America’s AAA credit- rating would imply.

Meanwhile, the shift out of debt-based assets into real assets is gaining momentum. Want some evidence? Try this: Gold and silver are at 20-year highs, oil is back above $70 and, 10-year U.S. Treasury notes are over 5% and 30-year mortgage rates are over 6%. Those “stupid investors” and central bankers in Asia are getting smarter. They are buying fewer U.S. government and mortgage-backed bonds, and investing more in commodities. Global capital flows are shifting away from the U.S. and – for the time being – shifting into commodity and resource stocks and funds. Which brings me to the Deutsche Bank Commodity Index Tracking Fund (NYSE: DBC. Recent price: $25.20).

DBC is an exchange-traded fund (ETF) that holds futures contracts on 6 highly liquid commodities: light sweet crude, heating oil, gold, aluminum, corn, and wheat. The amount invested in each of the six commodity classes (the weighting) is pre-determined and reset annually as follows: 35% crude, 20% heating oil, 12.5% aluminum, 11.25% corn, 11.25% wheat, and 10% gold. Thus, this particular ETF provides a very focused, if somewhat quirky, play on commodities – both those have suffered large corrections recently, like crude oil, heating oil and gold, as well as the agricultural commodities, like corn and wheat, that have not yet produced big gains during this commodity bull market. DBC is not the only commodity ETF, but it may be the most interesting, given its particular commodity exposure. It holds a smaller energy weighting (55%), for example, that the Goldman Sachs Commodity Index, which commits more than 70% of its assets to energy-related futures. Thus the DBC has been holding up better than the GSCI during the recent selloff in the energy complex.

DBC is not without risk. Perhaps we are on the doorstep of a simultaneous crash in all assets (excepting cash), and commodities will begin to correlate closely with stocks, bonds, and real estate. There is also the risk that the hot and fickle money of global capital markets rushes in chasing a quick return, and rushes out just as quickly, ignoring the long-term bullish commodity trends. But I would prefer this risk to the risk of investing in homebuilding stocks or mortgage lenders or any of the other industry sectors that are just beginning to face serious difficulties. The long-term bull market in commodities remains intact, even if it stumbles from time to time.

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


If you have not heard of the BRICS (or BRIC) yet, you most certainly will, and soon. BRICS is an acronym that stands for Brazil, Russia, India, China and (usually) South Africa – an alliance that, according to Frontpagemagazine.com, was supposedly formed in 2002 “to muscle the U.S. out of global markets where possible.”

If you think about it, the BRICS and the G-7 are in two opposing camps. It is the producers of the world vs. the consumers of the world. In the first camp, there is an army of eager and willing workers who are rapidly learning the latest tricks of the trade. In the second – an army of complacent, porky shoppers who are rapidly outsourcing their manufacturing and servicing bases to the people in the first camp. Camp #1 makes an ever-growing portion of the world’s goods, pumps the ever-more-needed oil and gas, mines the ever-more-expensive gold, silver and diamonds, and provides the ever-more-expanding number of services. Camp #2 – well, you know.

The India Daily likens the emergence of the BRICS to the declaration of a “new Cold War” and says that, “While America is busy in Iraq, Vladimir Putin is positioned to take control of the world as another superpower.” From an Elliott wave point of view, the emergence of the BRICS alliance fits in well with the wave pattern we have been watching in global stocks since 2000. That year, global stock markets went into a tailspin, indicating a global shift in social mood from positive to negative. And as we have observed in our research, when social mood bearish, “it produces a greater sense of opposition, anger, discord, desire to gain power over people, and polarization amongst various groups.”

Only history will tell how this all may end. Change always comes when you least expect it – and people in the first camp seem totally oblivious to the fact that the ground under their feet is starting to pivot.

Link here.


Hurricanes destroy almost everything in their path, except call options on commodity futures. The connection between hurricanes and commodity options is not precise or automatic, of course. But the a category-4 hurricane often blows some good toward futures markets like natural gas, orange juice, and sugar. Last year’s disastrous Gulf Coast storms triggered huge price spikes in several commodity markets. Four Category 3 storms – Dennis, Katrina, Rita and Wilma – struck the U.S. coast last year. All together, these storms destroyed 113 oil and gas platforms and over 400 pipelines. Hurricane Katrina, alone, caused more than $100 billion in damage, making it the most expensive natural disaster in U.S. history.

Gulf Coast residents have barely picked up the pieces from last year’s disasters and now it may be time to do it all over again. The National Hurricane Center optimistically predicts that the conditions do not appear ripe for a repeat of 2005’s record activity. Nobody can say for sure what the upcoming season has in store, but if experts are correct that a new hurricane “supercycle” has begun, we can expect 15 to 20 more years of rough weather.

As traders, it is important to look for ways to hedge our portfolios from what can be the ripple effects of the hurricane in the financial markets. The commodity markets provide an ideal vehicle. Since no early storms have approached the Gulf Coast, many of the hurricane-sensitive commodity markets are trading well below last season’s levels. Natural gas spiked to more than $14.50 per thousand cubic feet (mcf), immediately after Katrina hit. But today, natural gas sells for only $6.21 per mcf. The drain on energy supplies and refining capacity, for example, can be one of the biggest problems with an active hurricane season. The Gulf Coast, particularly the Houston Shipping Channel, is the heart of oil and gas production and transport. 17% of production is still knocked out because of last year’s storms, even before we begin this season. Any new disruptions, therefore, would almost certainly boost the prices of all energy markets.

We are not hoping for hurricanes, you understand, merely preparing for the possibility. In other words, we are hedging. When we purchase fire insurance on our homes we do not hope it will burn down … at least not usually. We buy it merely to protect our investment. Call options on unleaded gasoline are one kind of “hurricane insurance”. These calls provide an excellent risk/reward proposition, heading into an active hurricane season. The combination of higher oil prices and any additional damage to refineries will almost certainly result in gasoline prices surging to $4.50-$6 in some states. As for crude oil, severe weather combined with the seemingly endless geopolitical risks could throw predictions out the window.

Orange Juice calls provide another kind of insurance. Much like the energy markets, orange crops have been decimated by last year’s hurricanes, as well as disease. That is why orange juice is already in a full-blown bull market. A strong storm season could push O.J. prices even higher. Sugar is another market that has seen its crops hard hit in Florida and elsewhere from last years hurricanes. Sugar has the added benefit of being a key ingredient in production of ethanol and is already in high demand. All of these commodities, and a few others, are almost certain to see intense volatility throughout the hurricane season.

One trading tactic we are employing is to buy selected commodity options during the current weakness in these markets. Then, as we enter the hurricane season, we hope to sell into the early anticipatory rallies, even before the first winds start to really hit. It is entirely possible, of course, that powerful hurricanes will bypass the Gulf Coast this year. But just to be safe, why not “board up” your portfolio while the weather is still pleasant and the winds are still calm?

Link here.


Wow! The markets are giving us Christmas presents in June this year! Let us see if I have the big picture in proper focus. The Fed talks tough (but talking is the only thing they can do, since the essential national housing market resembles a California mansion just before the hillside it is built on slides down a slippery slope into a sea of mud and muck). The fantasy investments on Wall Street feel a draft from a brief breeze of reality, and stocks catch a long overdue case of pneumonia. And yet somehow, the precious metals babies are also sold off in sympathy with the bath water tossed out by Wall Street. The Optimist sees a near certainty that inflation and world tensions will continue to get worse, so an opportunity to buy silver and gold at temporarily reduced prices is truly wonderful and positive news.

Olivia Newton-John said it well in 1981: “Let’s get physical, physical, I wanna get physical, let’s get into physical.” Although Olivia’s hit song was in another context, the Optimist does not know of any songs which extol the virtues of investing in paper. A simple experiment should be sufficient to demonstrate why investing in paper is not celebrated in song and dance. Into one hand, place a 10 ounce silver ingot or a one ounce gold or palladium coin. In the other hand, hold a few pieces of paper. It will not take most people long to feel the difference. Regardless of what pretty artwork may be engraved onto the paper, or what promises are written there, the physical silver or gold clearly demonstrate their value in a far more immediate and satisfying way than the hopes one has for eventually getting something of value from the paper. It is difficult to think of any situation in which paper would be preferred to real physical silver or gold metal.

For those readers who were impatiently waiting for me to get to the point, now is the time to wake up and pay attention. Although this commentary is likely preaching to the choir, many members of that choir continue to sing the praises of stocks in precious metals mining companies. Historically, that may have made sense because stocks in mining companies were easier to hold than a possibly large weight of precious metal. However, the Optimist thinks it likely that many investors may prefer mining company stocks over the physical metal because of the operating leverage that the mining stocks promise. But in the real world gold increases in price at the same time that inflation also accelerates, and the rising inflation adds significant additional costs to the mining operation, which will reduce the potential profits and the hoped for leverage that a mining company stock might otherwise offer. If one also considers that mining companies are subject to costs (dilution of the company stock, depletion of the reserves, high taxes, etc.) and risks (nationalization, mining accidents, embezzlement, etc.) which would further reduce mining company profits, then the attraction of investing in physical metal bullion becomes more obvious.

Some investors who agree with the desirability of investing in real physical metal try to make the process easier by having the metal stored for them. Numerous companies, as well as the gold and silver ETFs, are happy to hold your metal for you and issue paper equivalents of IOUs as your claim for the value of metal that you have on deposit there. Although that out of sight, out of mind storage process works reasonably well during good times, it would be beyond optimistic to simply assume that the metal you have entrusted to a company for safe keeping will always be kept safe for you. One of the few financial certainties we have is that there will be big problems in the future. Many of the companies which offer to store your metal for you today may abruptly stop taking phone calls when they go out of business or when governments confiscate their inventory in the perilous times to come. The Optimist presents the positive perspective that there will be no need to worry about whether or not someone else will return the metal they owe you, if you simply keep your metal in a safe place where you can get access to it at any time without needing permission or assistance from anyone else.

Link here.
Gold pressured from all sides in Thursday’s market action – link.
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