Finance Digest for Week of June 19, 2006

BERNANKE’S LITTLE PROBLEM

At first glance the 2001-03 plunge in U.S. interest rates seemed to have delivered the goods. Growth in output and employment slowly accelerated, and inflation stayed within the Federal Reserve’s comfort zone, under 2%. However, by mid-2004 the Fed realized that the rate of inflation was creeping up after bottoming out in 2003. And so it slowly but steadily ratcheted up the short-term cost of money. The overnight money rate is back up to 5%. The screw-tightening is not necessarily over. At least tha is how Wall Street read Fed Chairman Ben Bernanke’s June 5 warning about prices.

The Fed’s standard line is that it looks at all indicators of inflation. That said, it is no secret that the Fed’s preferred inflation gauge is the “core” measure for Personal Consumption Expenditures. This gauge, which tracks what people spend broadly (except for food and energy), over the past year has risen by only 2.1%. While this rate exceeds the Fed’s informal target of 2%, it is still low enough for the Fed to claim that inflation is contained. However, other inflation measures challenge that benign characterization. The PCE that includes food and energy, for example, has increased by 3% in the past year. The CPI, based on a fixed basket of goods and services (energy and food included), is up 3.6%. Moreover, there are good reasons to believe that the government’s price indexes, with or without the volatile food and energy components, are sending out artificially weak inflation signals. For example, the recent boom in housing prices does not even show up in the CPI. Something called “owner’s equivalent rent” is used as a proxy for the cost of homeownership. This metric has not kept pace with house prices.

If we look at real market data, such as that generated by commodity markets, the inflation picture changes dramatically. Over the past year the price of gold is up by 51% and crude oil by 35%. Indexes that include market-clearing prices for a broad range of industrial and agricultural commodities are also up sharply. Government statistics, like the PCE and CPI, lag behind changes in commodity prices. Accordingly, I expect further increases in the government’s inflation metrics and more Fed tightening. My investment advice? Dump your conventional bonds and replace them with Treasury inflation-protected securities (Tips). Put 10% of your portfolio in commodities, gold being an ideal choice.

NO NEWS IS GOOD NEWS

You could, if you were predisposed to pessimism, find much in the news to despair over: global warming, abuses by the military, loose borders. But think, also, about the bad news that you are not seeing: recession, runaway inflation, oil embargo, unemployment. You should not let gloomy thoughts stop you from buying stocks. There is not any genuine news in immigration – nothing happening any differently at our borders now than one, three or five years ago. The only different thing is that Congress and the President are all for expensive legislation that will not accomplish much. But then, there is not anything new to that.

Today we have the Internet to bombard us with more news than ever. Still, it is bullish that the most exciting headlines have to do with Angelina Jolie’s baby and Barry Bonds’s home runs. There is again nothing to hurt stocks. I am pretty confident our upcoming elections will not damage stocks. Control of Congress may shift, further lowering the probability of an extension, past 2010, of the 15% dividend and capital gain tax rate. But it is unlikely, and that risk is already priced into stocks now. This year’s elections probably will not budge the market.

So count the immigration saga as an absence of news, and remember that, for investors, no news is almost always good news. Pray for a wall of coverage on the latest social commentary issued by a movie or rock star (among the hundreds to chose from). It would be great if toward the end of 2006 we could get a newsmagazine cover on some nonevent like anomie in our youth or a crisis in American culture. And while you are waiting for these insights from the mainstream media, buy good stocks.

Dow Chemical (NYSE: DOW, 39) is dirt cheap because the market thinks Dow’s profitability cannot last. I worry less. Dow was one of the first stocks I ever studied, and owned, as a kid. My father owned it for his clients from the mid-1930s until the later 1970s as it emerged from being a speculative specialty chemical outfit into America’s second-largest chemical company. Since then it has become the world’s second largest, and America’s largest. From its early days Dow was built to dominate. The price is 80% of revenue and 8 times 2006 earnings, darned cheap for the world’s greatest basic materials company. The dividend yield is 3.5%.

FREDDIE AND FANNIES’ TEFLON BONDS

What do greedy chief executives, derelict directors, fake earnings and humongous government penalties all have in common? Fannie Mae and Freddie Mac. These government-sponsored enterprises, whose misdeeds were a tame version of what went on at Enron, have seen plenty of negative news in the past few years. Stock in Fannie Mae, the worse offender, has swooned as a result. In September 2005 when investigators found a new crop of accounting violations atop the harvest they reaped the year before, Fannie’s shares slid 11%.

Today they sit at $50 (versus $88 at their December 2000 high). The company had a cookie jar of reserves that it dipped into in order to smooth earnings, taking the edge off poor results and pulling back good ones that would set too high a mark for later. Fannie also monkeyed around with derivatives that allowed it to spread losses over a number of years instead of recognizing them at once. These ploys let Fannie’s management pocket rich bonuses. Since the scandal came into public view Fannie’s chief, Franklin Raines, has been sent packing, although his number two guy, Daniel Mudd, is in charge now. Following release of a late-May report from federal regulators, Fannie agreed to pay $400 million in fines, just part of what it has had to shell out because of the accounting mess.

Freddie Mac has caused less shareholder agita, but its sins are almost as egregious. It also manipulated earnings to keep them on a smooth upward climb, deferring unanticipated earnings to later periods. Its headman, Gregory Parseghian, got the bounce because of his active participation in the strategy. In April Freddie paid $410 million to settle a class suit.

So what has happened to their bonds? Well, they are evidently Teflon-coated. Fannie and Freddie bond prices have barely moved. Their credit ratings, from both Moody’s and Standard & Poor’s, remain unblemished at Aaa and AAA. How odd. Typically nowadays a financial restatement or missed regulatory filing date can put a bond on negative credit watch immediately. No waiting until too late, as happened in the Enron and WorldCom era. The high credit ratings are attributable to a perceived implicit guarantee of government backing. It is generally assumed that if something went seriously awry, the Treasury would bail out the troublesome twosome, lest they harm mortgage issuance, a linchpin of the economy and the banking system. But no law obliges the government to stand behind these mortgage funders.

Freddie and Fannie have successfully weathered past blow-ups. But there is a drip-drip-drip factor. Every time we hear assurances that all the bad stuff is behind these two, another nasty revelation comes forth. Expect more ahead. The Justice Department is continuing its investigation of Fannie Mae. A point will come when big investors, notably public pension funds and foreigners, will have had enough. The bonds will sell off. So stay away if you are not getting paid for taking on the extra risk of these creatures.

GOLD AND SILVER ARE “FAT PITCH” BUYS

It is always desirable to own the best instruments the markets have to offer, but it can be hard to pick a spot to buy. Gold and silver have been in huge bull markets the last 2 years. Recently, we had a big spike in prices followed by a fast hard correction. Gold and silver are now flashing a “Fat Pitch” buy for those who like to buy pullbacks. Let us review!

This chart shows the run in gold and then the big spike. Finally it has a sharp correction and pulls back to the 200 day moving average (the 200 day moving average usually is a good place to buy on the dip.) This chart shows the run in silver and then the big spike. Finally it has a sharp correction and pulls back to the 200 day moving average. A “Fat Pitch” is a stock that has had a sharp sell-off in price and is now at point where we can successfully pick a trading bottom. It is usually a fast moving successful momentum stock that has had an extended run and has had a hard bout of profit taking occur. Sometimes the instrument trades back to new highs, and sometimes it only bounces a few percentage points.

For the streetTRACKS Gold Trust Shares (NYSE: GLD) and iShares Silver Trust (AMEX: SLV), we see all of our indicators hitting their lows all at the same time. This a great place to go long because the risk to reward ratio for a successful profit is at its maximum.

Elliot Wave gold update.

Last week, if you felt like the person in the accompanying cartoon, you were probably in good company. It was a gut-wrenching downward plunge that challenged the emotions. Relax, there is some good news. There is also some bad news. The scenario outlined in my last update was voided when the gold price dropped below $610. The declines have extended to 23.4% in the Comex 2nd month contract. In the cash market in London there was a brief probe into the $540’s, producing a decline of around 25% from the peak levels.

These declines mark the largest correction in the bull market to date and are in the 20%-25% range that was expected for major Wave TWO. The logical conclusion is thus that the market peaked in Major Wave ONE at the 12 May 2006 peaks of $733 on Comex and $725 on the PM fixings and is now busy tracing out Wave TWO. The 20%-25% range was determined by adding 50% to the approximate 16% magnitude of waves II and IV in major Wave ONE. We have not had a correction of the Wave TWO magnitude in the bull market to date, so we have nothing historical to guide us and the decline may be greater than 25%.

The good news is that if the market is indeed in Wave TWO, it establishes where the gold market is in the Elliott Wave cycle and, perhaps more importantly, the bulk of the probable decline has already been seen. In fact, the sizes of the declines to date are already of a magnitude adequate for Wave TWO, so there is a possibility that the lows of the correction are behind us. As Wave TWO is the largest correction of the bull market to date, it is likely to extend for some further weeks or months and the initial down move may only be the first wave in a more complex sequence of minor waves within Wave TWO.

Summary: The probability is that $725 marked the peak of major Wave ONE. The consequence of this is that there are inconsistencies in the minor waves forming part of wave V of Wave ONE, but it is possible that these inconsistencies and distortions have been caused by deliberate manipulation of the gold price. These distortions relate to several spheres but downside distortions are eventually followed by distortions to the upside. Consequently it is possible to accept that short term minor waves my not accord with classic Elliott Wave patterns. If the low of Wave TWO is in the region of $545, possible targets for the peak of the strong Wave THREE to follow could be of the order of $1,542 or possibly even as high as $2,496.00 Wave TWO may have covered an adequate number of dollars to the downside, but it could have to absorb several more weeks or months and may exceed the 20%-25% size expected for the current correction.

Remarkable development in the gold market

Over the past years that I have been privileged to participate in this fledgling generational bull market in gold, I have written a goodly number of essays detailing the Commitments of Traders reports and analyzing how that relates to the price action experienced in the gold futures pit at the Comex. Having been at this game for a long time now, I can usually get a pretty good feel for who is doing what during the course of the week by comparing the price action in the pit against the previous week’s CoT report and looking at the long term trend of a market.

In what I consider to be “normal” markets, a rising market in an established bull trend will usually see the bulk of the speculators, both large and small, on the long side with the bulk of the commercials taking the opposite or short side. That only makes sense as commercials/producers are using the speculator buying to implement scale-up selling programs to lock in profits. They sell a little here and a little there and continue to do so as prices rise, assuring themselves of a profit and minimizing risk which the speculators are more than willing to assume in exchange for an opportunity to make a profit. The higher the market rises, the happier these true or bona-fide hedgers are as that means higher selling prices for their goods.

Imagine my surprise then to learn from today’s release of the CoT report that the commercial category went even one step further than I had come to expect from them. It detailed something which I have not seen during the course of this entire bull market since 2001, namely, increasing short sales by the commercial category in the midst of a falling market – not just a falling market, but a precipitously falling market at that. This is a startling new development. What is even more remarkable is that the big trading funds, instead of dumping their longs into the lap of the waiting commercial cartel, actually appear to have been buying on the way down – also is a FIRST! In other words, we have seen in one week a COMPLETE REVERSAL of the norm of the last 5 years in the gold market. I assumed that the gold cartel would dupe the trading funds into establishing a huge number of new short positions even as that same category sharply cut the number of long positions. I also assumed that the same thing would happen among the small speculator category.

What actually happened was the exact opposite except for the small speculator who ditched more shorts than they did longs! The big trading funds INCREASED their net long position as the market fell – something they have not done throughout the history of this past bull market. Instead of piling on a ton of new shorts, the trading funds added only a bit more than 700 new shorts and almost 4,000 new longs into the price weakness. Could it be that this category is finally wising up and actually learning to beat the commercial cartel at its own game? We will have to see but the fact that this has occurred at all is nothing short of astonishing.

What does this mean? There was a concerted effort on the part of this group of short sellers to FORCE THE GOLD PRICE DOWN. They had absolutely no interest in booking profits on existing shorts as the price tumbled some $100. This is a stunning development as it clearly indicates a concerted attempt to derail what was becoming a runaway bull market in the gold price that was threatening to garner far too much public attention. Gold’s perennial function is to serve as the financial “canary in the coal mine” which alerts the workers to hidden, toxic dangers. Gold’s stunning rally to $730 in the matter of a few months time was sending shock waves through the corridors of the monetary elites who were “looking into the abyss” if gold continued its meteoric rise. Something had to be done and quickly or this thing was going to get out of hand. Jim Sinclair and Bill Murphy and the GATA gang had been saying that the recent price decline in gold was an orchestrated and deliberate attack by the Central Bankers of the West to break the back of the gold market and defuse the warning message that gold was sounding abroad. There is no doubt that the plan worked to near perfection. Out of everywhere, as if on cue, analysts confidently pronounced that the bull market in gold and in commodities was over, finis, kaput!

In conclusion, we will need to see the price action and the CoT next week along with the daily open interest reports to see if the gold cartel is forced to cover those brand new shorts, and whether the funds will now trade this gold market a bit more intelligently. We want to see if gold can hold the recent lows on any possible subsequent revisiting of those lows. If so, and if especially the volume dries up in comparison to that of the day when the lows were made, then the bottom is definitely in and gold will start its next leg up from this region after a period of base building. We know that down at those levels there are huge buyers waiting in the physical market who want to obtain gold at what they consider to be a “value” area. That is the key. Those guys want all the cheap gold they can get and will pounce on it at a price they are happy with. If the CB’s want to dump more gold on the market, those big buyers will be more than happy to relieve them of it all. Heaven help the new shorts in this market if that gang of physical market buyers decides this is as cheap as gold is going to get again.

Gold market behavior.

Have the Commercials thrown in the towel or is another sucker punch heading towards the Trend Chasers? On May 12, (one day before gold prices began to decline) I was asked if the Commercial positions in the oil market might help to put a floor under falling prices as they do in the gold market. In part, my reply was as follows: “I can tell you this, speculators hold about 50% of the long positions in the crude oil market while about 85% of the long positions in the gold market are held by speculators. Also when I say the gold commercials can and have held prices from falling too much in a correction, (by covering shorts and buying into the falling price) I do not mean to suggest they can hold it every time nor would they want too. There will come a time when they stand aside and watch the speculators destroy one another.”

The above scenario did in fact play out but rather than simply standing aside to watch speculators slaughter one another, the commercials played along and sold out as well. Follow up selling (into a falling price) by the commercials was a first since the bull market began back in 2001. The decline from this selling caused the price to fall down to $619. The rest is history as all traders became sellers driving the price down to $542 in the cash market. Certainly the gold manipulation theorists will consider this action by the commercials as more fuel for their cause to convince Investors that the market is rigged but keep in mind that the commercials did not start the selling from $732 nor did they sell any significant long positions until the price had fallen almost $100 an ounce.

The practice of buying long and covering shorts to halt a decline has been a play of the Commercials for a very long time. In Comex’s most recent Commitments of Traders report of 6/13/06, we see a return to normal operations by all traders as a near term bottom has been apparently found. The trend chasers are buying and the commercials are selling into the rebounding price from $542. It also happens that $542 is within a band of support that is critical for the overall trend so needless to say a decent bounce from this area is highly likely with first resistance at $600.

Let us take a look at a couple of long term charts (1984-2006 and 1969-2004) of gold to gain some perspective as to pattern. How many times have you seen a pattern like the one beginning in 2001 finish any other way than the one below that began in 1970? A close look at both patterns reveals that they are almost exactly alike in the bull stage and nearly indistinguishable in pattern during the first wave down from the top. So have the commercials thrown in the towel and given up on this market? No way my friend, they will try and trap you at every near-term top from here on out regardless as to overall trend direction.

2006 silver rally was the most parabolic since 1980.

Few if any financial markets have been as volatile -- and as interesting -- as silver has been in the past three years. From lows near $4.50 in mid-2003, silver began a parabolic rise that peaked near $8.50 in March 2004, its highest price in some 18 years. Then, in a matter of weeks, prices plummeted back down below $5.50. But sure enough, silver went on another 6-month rally, to around $8.17 in December 2004. You can guess what followed – sellers took the price back below $6.40 as 2005 began, and prices were flat for most of that year. The real action began in December 2005. That is when prices rallied above $9.00 for the first time since 1987. And this rally became the most parabolic since 1980, which was the mother of all metals manias. The 2006 rally eclipsed $15.00 on May 12.

What followed this time is what has followed previously: A waterfall decline that took prices down at a pace even more manic than the rally. Within some eight weeks, silver had lost more than one-third of its value. Nearly every rise and fall has been more extreme than the previous one, yet this price action is anything but arbitrary. Silver has moved in a series of recognizable Elliott waves. The pattern could not be more pronounced, and is still in the early stages of unfolding at four degrees of trend. The recent issues of both The Elliott Wave Theorist and The Elliott Wave Financial Forecast anticipated the price action we have seen since April, while the Short Term Update has followed the near-term to a tee.

ANTICIPATE BEFORE YOU PARTICIPATE

Understanding market volatility of the Gold BUGS Index is key to managing expectations for gold stocks and mutual funds.

A fundamental aspect of investing is deciding how much risk and volatility you are comfortable with, and then choosing investments that fit into that comfort zone. Generally speaking, the greater the volatility of a given security, the higher its loss and reward potential for the investor. Investors may find it difficult and time-consuming to figure out which funds provide the optimal balance of risk, volatility and reward, but it is worth the effort. Understanding the volatility and risks involved with the markets is vitally important to maintain both your investments and your emotional health. Chasing performance or trying to guess tops and bottoms in share prices can be both emotionally and financially draining.

Standard deviation, also known as “sigma”, is a valuable statistical tool for gauging a fund’s volatility, as it measures how much the fund’s returns vary from their mean, or average, over a given period of time. For most funds, returns will be within one standard deviation (one sigma) of their mean (average) 68% of the time, within two standard deviations (two sigma) of the mean 95% of the time, and within three sigma 99% of the time. You can see this basic concept in the bell-shaped curve to the left. The straight line down from the highest point on the curve is the mean return over the specified time period. The area in blue is one sigma above and below the mean. By adding the area in green, you have gone out two sigma on either side of the mean. The yellow segments expand the white area to three sigma. As an investor, sigma can help you understand the level of volatility to expect from a particular investment. That knowledge allows you to manage your risk and it keeps you from getting overly excited when your investment’s ups and downs fall within its normal range. It can also help you identify when to buy or sell a stock or a fund.

Let us look at the Amex Gold BUGS Index (HUI) as an example of how to use sigma.

Over the five years ending 6/14/06, the HUI has had a quarterly sigma of 17.79%. That means if you marked each quarterly return for the last five years on a graph, you could expect 68% of those marks to be within 17.79% above or below the average (mean) return. 95% of those marks would predictably fall within 35.58% - 2 x 17.79% – above or below the mean return. A gain of 10% in a quarter might sound exceptional for an investment, but for the HUI, that level of return falls within the range of normal over the past five years. Likewise, a quarterly drop of 10% can sound scary, but if you know the sigma for the HUI, you know that too is within its normal movement.

You should pay closer attention when returns fall outside one sigma during a specific time period, whether that variance is positive or negative. If an index’s performance rises more than one sigma, it could signal that it is overbought, so you might consider selling or holding off on buying. Statistically, there is only a 16% chance that it will end up higher for that time period. Conversely, when a performance drops more than one sigma it suggests the index’s stocks may be oversold, so you might consider buying or not selling.

Again, look at the sigma over the weekly, monthly and quarterly time periods for the HUI. The HUI has a weekly sigma of 4.77%, so one might think that the monthly sigma should be about four times higher because there are four weeks in a month. But in reality, the monthly sigma of 9.96% is a little more than double the weekly figure. Likewise the quarterly sigma was less than double the monthly number.

Investor psychology suggests that investors are more comfortable buying a stock after it has moved up and are more willing to sell when it declines sharply. Many investors use the 200 day and the 50 day moving average to make their decisions, however, this simple process can be problematic when the sectors are more volatile. We believe it is wiser to use dollar-cost averaging and set limits on exposure to any asset class and rebalance annually to catch, not chase volatility.

BULL MARKET CORRECTIONS ARE GOOD TIMES FOR CALL SELLERS

It is always entertaining to hear the mainstream financial media try to build a running theme around certain markets in order to give their stories some context. Months ago, the theme was the housing “bubble” and where and when it would burst. May was the month the stock market was approaching new record highs and the sky was the limit. Then fear of more interest rate hikes caused a correction and one would think from listening to the stories that the crash of 1929 was only days away. The latest market to fall victim to the doomsday bears is the commodities markets. The theme of this one is that slowing world economies will cause massive price depreciation in everything from crude oil to corn. The proponents of the theme will quickly provide statistics and reports to back up their views.

It is the collective view of market analysts that tends to create and feed these themes themselves. If the public buys it, it can sometimes become a self-fulfilling prophecy. The Wall Street Journal reported this week that cash has become the new hot investment. With public sentiment now bearish the real estate market, the stock market and the commodities market, what else is there? We are not here to make a call either way. Fortunately, we do not have to. You might not have to either. Traditional investors are used to making their profits when markets go up. When markets go down, they are losing money and therefore it seems a good time to go to the sidelines and park money in cash investments.

But what about selling calls? Selling calls is how bears make money in bear markets. Bearish the stock market? Sell S&P calls. Bearish copper? Sell copper calls. The beauty of selling calls is that if the market does indeed fall, the strategy will be profitable. However, if the market does not fall but merely consolidates, the strategy can still be profitable. The market can even rally by a certain degree, and the strategy can still be profitable. Therefore, as long as the market does not immediately reverse and go into an aggressive bull market, selling calls would seem to be an ideal strategy. This observation will obviously seem simplistic to investors already familiar with option selling as an investment strategy. But for the novice, it can be a revelation.

Obviously, investors using this strategy should be aware that selling calls in the futures markets contains a higher degree of risk than that of a CD or money market account. This is a strategy for the active or more aggressive investor. One should fully understand the risks involved in commodities trading before committing funds to such an endeavor.

Our personal opinion is that the commodities markets as a whole are not entering into a long term bear market. However, given the recent unprecedented gains in several markets, a certain “cooling off” period would seem a reasonable expectation. There are, of course, exceptions as commodities are not as correlated to each other as stocks and tend to follow their own set of fundamentals. Crude oil, for instance, is a market where it seems hard to imagine prices dropping substantially in the face of the Iranian situation and the beginning of driving season in the U.S. However, there are several markets that currently possess bearish fundamentals of their own, on top of the overall weakness in commodity prices. It is our opinion that markets such as coffee, soybeans and wheat are all excellent candidates for call selling. We say this because these markets are being affected by bearish individual supply and/or demand fundamentals, independent of worldwide price depreciation in commodities. The coffee market is getting ready to digest the 3rd largest Brazilian harvest on record. Wheat has had a good run in prices but with harvest upcoming in several parts of the world, it appears overvalued. Soybeans continue to suffer from hefty South American supplies, a good start to the U.S. growing season and fears that bird flu will sink demand.

The real bears may wish to sell calls in markets like copper, silver, gasoline or the S&P 500. If the bear trend continues, these could turn out to be excellent trades in 30 days. However, if the commodities “correction” ends tomorrow and a new leg up begins, our view is that the agricultural contracts listed above would continue to lag, as they would still have to deal with either bulging supplies or lagging demand. And they are much less susceptible to the whims of Fed Chairman Bernanke. This makes them, in our opinion, the highest probability candidates for call sales in the current environment.

EVEN FORECLOSURE HAWKS HURT BY SAGGING REAL ESTATE MARKET

They gather outside the courthouse every day for the latest real estate auction. Some are professional investors. Others come to ply skills gleaned at get-rich-quick seminars. All of them are trying to scoop up homes that belonged to others who died, divorced, were thrust into bankruptcy or fell too far behind on their mortgage payments and failed to sell. But these days, those investors are having a harder time finding good deals, as the once red-hot housing market cools amid rising mortgage interest rates. Many homes that do end up in court are saddled with more than one mortgage and have little or no equity – so the investors take a pass. “In the last six months or so, it has been like this,” said James Lee, who has mined trustee auctions for investment property for 15 years.

When home price increases were stronger, investors could buy a property and sell it a few months later for a hefty profit. “Now you’re getting into the market where there is plenty to buy, but there is nowhere to sell it,” said Peter Winn, owner of San Diego-based Westminster Investments. The number of homes up for grabs could increase in the coming months based on signs that more homeowners are having trouble making mortgage payments. Nationwide, foreclosures hit a historic low last year at about 50,000. But that figure has more than doubled since then, according to property tracker Foreclosure.com.

Real estate experts said that number is still very low and noted that, traditionally, the overwhelming majority of strapped homeowners have avoided foreclosure by selling their home or somehow coming up with a payment. As the market slows, however, finding buyers in time to avoid foreclosure can become more difficult, said Brad Geisen, president and chief executive of Foreclosure.com. That could aid well-funded investors who buy directly from homeowners and may no longer have to compete with buyers who took advantage of cheap borrowing in recent years to drive up prices. “There’s definitely a turn,” Gelsen said.

Some experts are forecasting Armageddon-level increases in foreclosures in overpriced markets during the next few years. But some economists counter that a mortgage crisis is unlikely unless there is a major economic downturn with heavy job losses. Still, other factors suggest problems ahead for the housing sector. Historically, borrowers who run into trouble paying their mortgage tend to do so within the first three to five years of the loan period. Currently, more than half of the nation’s $9.2 trillion in outstanding residential mortgage and home equity loans are less than three years old, said Doug Duncan, chief economist for the Mortgage Bankers Association. Another potential trouble spot: About 24% of all home loans are adjustable, which can be risky if borrowers end up paying far more than they bargained for as the Federal Reserve hikes interest rates. California, where the median price of a home hit $468,000 in April, leads the nation in the percentage of homes purchased with adjustable rate mortgages.

Fear grips Phoenix housing market.

Greed drove metropolitan Phoenix’s home prices and sales to new records in 2005. Fear is driving the market this year. Home buyers are worried about paying too much and are waiting to purchase. Concerned about dropping home values, some owners are trying to cash out. Builders, struggling to sell even deeply discounted new homes, are scaling back production and warning of lower profits. Each day more people, from contractors and mortgage firms to real estate agents, are losing jobs or money in the metropolitan Phoenix’s rapidly slowing real estate market.

Until recently, the market’s slowdown had been considered a necessary, short-term hardship to offset last year’s wild run-up in prices. But now many analysts and economists say it looks as if the slide will continue for at least the next six months, possibly pulling down home values as much as 10% before it is done. No one is calling for the Valley’s housing market to crash as it did in 1990 because the rest of the area’s economy is so strong now. With the housing industry accounting for at least one of every three dollars generated in the Valley’s economy, any slowdown will hurt. Consumers will be particularly vulnerable. Analysts say the demand for Valley homes and housing prices both were hyperinflated by 25 to 30% last year, mostly because of investors.

New-home buyers in driver’s seat.

For new-home buyers, it is time to be wooed. Incentives long have been used to drum up business during the winter doldrums or to jump-start activity at a moribund development. But the frenzy of deals, which some national builders rolled out in late 2005, is snowballing into summer. It is another sign of how residential real estate sales are slowing and inventories of unsold homes are mounting. After a half-dozen years of record growth and torrid levels of construction, builders are finding their orders dropping sharply. And as the business plummets, buyers, aware that they are in the driver’s seat, are demanding – and getting – price breaks or special financing.

Many local and regional builders have joined the major players to offer incentives right through the industry’s key spring sales months, into the beginning of summer. “This is probably the first time we’ve seen them through the peak selling season. It’s unusual that the incentives have continued all year,” said housing consultant Tracy Cross. Cross doubts builders will see the profit levels of the 2003-05 boom years, but “the margins today are normal by traditional years,” he said. As for how long the incentives will continue, Cross said, “It is really, really competitive. I really, really don’t know.”

SAN ANTONIO BOOM MAY DRY UP AS WATER EBBS AND PEOPLE FLOW IN

Water supplies are declining from San Antonio to Austin, the Texas capital, as a mushrooming population and drought conditions strain underground reservoirs, threatening to stall the region’s growth. “I’ve been in this business for 14 years, and this is by far the worst I’ve ever seen,” said Jim Blair, owner of Bee Cave Drilling, which drills water wells in two of the Austin area's fast-growing counties. “I’m scared because we’re heading into our dry season.”

San Antonio is the 3rd-fastest-growing large city in the U.S., according to Census Bureau estimates, and Austin has the 8th-fastest growth for a metropolitan area. Expansions by companies including Dell and Toyota are fueling a housing boom. Water systems are not keeping up with the new subdivisions, and wells used by some homeowners are drying up. Central Texas received only two-thirds of its usual rainfall last year and is running behind again this year, leaving reservoir levels below normal, according to the Lower Colorado River Authority, which regulates surface water. The San Antonio and Austin areas get much of their water from the Edwards-Trinity aquifer system, overlapping reservoirs that extend from southeastern Oklahoma to western Texas. The San Antonio Water System alone pumps more than 136 million gallons (515 million liters) a day from the Edwards Aquifer.

Outside municipal water systems, Texas’s “rule of capture” lets owners pump an unlimited amount of groundwater, regardless of the impact on neighbors. The rule is similar to regulation of the Texas oil industry, which dotted the landscape with derricks in the early 20th century as drillers raced to tap deposits that extended under multiple parcels of land. Boone Pickens, an oilman and hedge-fund manager, sees similar opportunity in the water shortage. He proposes building a $2 billion system to transport 320,000 acre feet of water per year to the greater Dallas area from the Ogallala Aquifer, part of which sits under his ranch in the Texas panhandle. That would meet more than 20% of the metropolitan area’s water needs. So far, he has no takers. The land around the ranch is not irrigated, so the water is “surplus and stranded”, he said. Pickens paid a neighbor $50 million for half the water rights to 200,000 acres of land.

Companies already benefiting from rising water demand and falling supplies include Aqua America Inc., based in Bryn Mawr, Pennsylvania. Its Aqua Texas unit is the largest owner of public water systems in Texas. Aqua Texas has 13,000 customers near Austin and forecasts 6% to 8% growth for the next year, said Bob Laughman, the unit’s president. The company plans to spend $10 million on new wells and other equipment in the state during the next year.

Water prices are rising in central Texas. In San Antonio, residents pay 88 cents per 1,000 gallons, up 7.3% from last year. Aqua Texas charges its residential customers in the Austin area $2.60 to $2.80 per 1,000 gallons. Prices to drill a well in the suburbs south and west of Austin have risen 20% or so in the past year to about $18,000, said Blair. About 10% of his business comes from re-drilling wells that have gone dry.

FED, CENTRAL BANKS STEAL PUNCHBOWL, PARTY ENDS, HANGOVER STARTS

Move along, people. There’s nothing to see here. Move along.

There is nothing mysterious or sinister behind the declines we have seen recently in global financial markets. The Federal Reserve has taken away the punchbowl it spent two years pouring absinthe into. The party is over, and the guests are staggering off to endure skull-cracking hangovers. So far, so predictable. “Excess liquidity leads to mispricing of risk,” says Nick Parsons, head of the macro research group at Commerzbank AG in London. “Repricing of risk involves deleveraging, and deleveraging is brutal and indiscriminate.”

Investors are bailing out of trades that look the riskiest or the most crowded, or where they can book a profit to balance losses elsewhere. So copper is down more than 20% from its May 11 record of $8,800 a metric ton. Gold is down 20% from its May 12 peak of $730 an ounce. So far this year, investors have lost almost 5% on U.S. government bonds maturing in 10 years and more. The Dow Jones Industrial Average has lost 500 points from its May 10 peak of 11,670. Morgan Stanley’s index of emerging stock markets is down 20% from its May 8 high. Corporate credit risk has deteriorated, with the cost of investment-grade debt insurance climbing to 34 basis points from a low of 27 basis points at the start of May, according to an index of credit-default swaps. The most prevalent trade among global investors in recent years has been to bet on a declining dollar, Parsons at Commerzbank says. So that is where investors started scaling back their positions, goosing the U.S. currency by about 2.5% against the euro in the past five weeks.

You do not need an inflation monster, an incompetent Fed or the breakdown of civilization as we know it to explain these moves. You certainly do not need to pretend that either the inflation outlook or inflation expectations have suddenly made the dollar everyone’s favorite currency. The U.S. central bank has raised its overnight rate 16 times, and there is more to come. Investors are bound to price risk differently when the Fed funds rate is 5% and rising, rather than 1% and flatlining. It is not just the Fed. The European Central Bank has cranked its benchmark rate to 2.75% from 2% in three moves, and threatens to keep going. The Bank of England now looks more likely to raise borrowing costs than cut them. In Asia, the Bank of Japan is poised to end its zero interest-rate policy. China’s central bank said it will stamp harder on the brakes to slow its juggernaut economy.

“It is difficult, if not impossible, to recall a time when so many central banks were so crystal clear about their desire to withdraw liquidity from the system,” wrote Tim Price, a strategist at Union Bancaire Privee in London, in a research note. “As always when leveraged investors are invited to the party, everyone thinks they can be first out of the door when they hear the chimes at midnight.”

When the price of money changes, the costs of investing change. It is got nothing to do with whether U.S. consumer prices excluding food and energy increased by 0.3% or 0.2% in May. Stocks, bonds and commodities are following their script to the letter. When global central banks remove liquidity by raising rates, asset prices decline. Plenty of people warned last year that spreads on corporate bonds were too tight, commodity prices were too hot and emerging markets were priced for perfection. Less clear was what the trigger might be for investors to become more risk averse. The excuse – and it is an excuse, not a reason – seems to be the arrival of Ben Bernanke as the new Fed chairman.

Investors and traders do not know enough about Bernanke to be able to judge how successful he will be at steering policy. His predecessor, Alan Greenspan, has left an awkward legacy. “Greenspan was a bit of a coward, he should have raised rates more aggressively before he left,” says Yra Harris of Praxis Trading in Chicago. “Money is fascist. It craves stability more than anything else. Nothing bothers money more than uncertainty.” Right now, “Money is looking very nervous,” he says. Back in October, Union Bancaire Privee’s Price advised investors to “enjoy the party, but dance near the door.” Until the central banks of the U.S., Europe and Japan get back to being predictable, the party’s over.

Emerging market stocks fall as interest rate concerns increase.

Emerging-market stocks fell for a second day after comments from U.S. and Japanese policy makers heightened speculation that interest rates will increase, luring investors away from riskier assets. “Rising interest rates mean the halcyon days are over for emerging markets,” said David Shapiro, a senior trader at Sasfin Ltd. in Johannesburg. “They’re going to continue to come under pressure while the big money shifts elsewhere. The easy money’s been made.” Asian markets led the slide, and Taiwan’s Taiex was the worst performer among 80 benchmarks tracked by Bloomberg News worldwide. Funds investing in emerging-market equities lost $8.4 billion from withdrawals in the three weeks ended June 7, according to Brad Durham, managing director at Boston-based Emerging Portfolio Fund Research, which tracks 15,000 funds with more than $7 trillion in assets.

Stock markets in the Middle East have been among this year’s biggest losers. Six of the world’s 10 worst performing indexes in 2006 are in the region. The Dubai Financial Market Index has lost more than half its value this year. Saudi Arabia’s Tadawul All Share Index, tracking the region’s largest market, is almost 40% off its February record.

OUT-OF-CONTROL LEVERAGE, EMOTION AND PANIC!

With the recent beatings the markets have taken there is no shortage of blood in the streets. Historically, in a bull market, this is a signal of terrific buying opportunity. Is this the case now? There is no debate of the fact that the precious metals have been in a bull market for several years. There are many questions that one can ask to assure themselves that nothing has changed in the long term scheme of things. I believe the reasons for owning the precious metals have only intensified and become more obvious as each day passes. In the end, if the world continues moving in the direction that it is currently headed ownership of precious metals and precious metal stocks may be the only way to protect ones assets.

I have read many articles which state the blame for the severity of the selloff in the markets are as a result of the “Fed This” and the “Fed That”, “Bernanke This” and “Bernanke That”. In my opinion, the single most important factor behind the severity of the selloff in the markets evolves around the leverage associated with pure speculation and greed. Without a doubt the accelerating price appreciation in the precious metals was beginning to get carried away to the upside. The implosion of the excessive leverage of the hedge funds and commodity funds, in my opinion, was the largest contributing factor in taking what could have been a normal correction and turning it into a rout. The speculation and margin calls fed on themselves to wipe these people out. I am sure there will be some very interesting stories that come to light after the dust settles on these markets.

Most of this speculative money entered this sector solely because of “action and momentum”. Most of these people do not have a clue as to why they should be exposed to the precious metals sector nor do they care. Their only interest lies in the direction and volatility of the sector. I am glad to see them cleaned out! By cleaning this “froth” out of the market the precious metals sector can get back to “business as usual”.

Those serious investors who are accumulating gold and silver as a necessity to protect their wealth and assets are not going to change their investment philosophies as a result of gold and silver prices becoming more affordable. I believe the true advocates of gold and silver are grinning from ear to ear as a result of the sharp pullback in prices. This is what corrections are all about … taking advantage of other peoples mistakes!

Nobody knows exactly where the bottom will be in the price of the precious metals as well as the precious metal stocks, therefore I am adding to my positions gradually. If I am correct with this line of reasoning then I am going to look back on the opportunities in today’s markets and be very thankful that I built my positions at a time when I was seeing my favorite stocks at prices I never thought I would see again. The investors I stay in closest contact with all are amazed at the severity of the pullback but they all realize the value of what they own. They, like me, know that corrections are a normal and healthy part of all markets. They are also very well versed on the fundamentals and the direction of the companies they own. Meanwhile, those who seem to be most concerned or on the verge of panic as a result of the severity of the correction all share one very distinct trait in common and that trait deals with the fact that they are all advocates of technical analysis paying absolutely no attention to the underlying fundamentals of the investments they own. (Please do not think that I do not believe in technical analysis as I do.)

I would very much like to help these people who have panicked or are on the verge of panic, but past experience tells me that they are their own worst enemies and no amount of effort on my part can help them until they learn to help themselves. Knowledge and education, which usually means starting from the beginning, may be their only salvation. Their greatest enemies are their emotions and acting on impulse. In the end, their greatest source of education will wind up being experience and that unfortunately will come at a very high cost. As always, everything I write, that I share with you, is my opinion and my opinion alone. It is up to each of you to do your own homework and due diligence as the possibility always exists that I can be wrong.

ADVANTAGE: LITTLE GUY

Skittish hedge funds are selling oil stocks. Intrepid individuals should be buying them. The S&P Supercomposite Integrated Oil and Gas Index (Bloomberg: S15IOIL Index) has not gained any ground whatsoever since February 24, 2005 – a span of 16 months. Over the identical 16-month span, the price of crude oil has jumped 34% – From $51.39 a barrel to $69.00 – while unleaded gasoline has soared more than 50%. After a comprehensive analysis of these surprising data, we arrive at the following conclusion: Either oil and gasoline are overpriced or oil stocks are underpriced. If forced to choose between these two opposing interpretations, we would choose the latter.

Large cap oil stocks seem downright cheap, both in relation to the prices of crude oil and gasoline and in relation to the rest of the stock market. For example, S15IOIL trades for a mere eight times annual earnings – less than half the PE ratio of the S&P 500. A P/E of 8 is a low valuation … very low. It is the sort of valuation that one normally finds only among Wall Street’s walking wounded [or terminally dull]. But oil companies are hardly wounded. They might face rising taxation, but nothing that would greatly impede their growth prospects. No fundamental rationale justifies such lowly valuations. Perhaps, then, fear is the reason that oil stocks command such pitiful valuations. Nothing says “fear” like 8 times earnings (except maybe 6 times earnings). Single-digit P/E ratios are common when fear prevails. In 1982, for example, the S&P 500 sold for less than 10 times earnings. An 18-year bull market followed. We would not be too surprised to see history repeat itself. At 8.2 times earnings, S15IOIL sits are multiyear lows, and sells for only half the valuation of the S&P500.

Another plausible reason for the lowly valuations that prevail in the energy stock sector, it would be the prevalence of “hot money”. Throughout the last 24 months – and especially the last 6 months – commodities and resource stocks have become a bit too popular. Hedge fund money has been pouring into the red-hot sector looking for big returns. As long as the sector performed, the money remained. But as performance started to waver in early May, many hedge funds started tip-toeing toward the exits … or running. Hedge funds, you see, do not enjoy the luxury of long-term investing. If they are to attract institutional clients, they must perform well each and every month. Most hedge fund managers, therefore, do not care how a given stock might perform over the next 6 months, they care only about how it might perform over the next 6 days.

The tyranny of month-to-month performance evaluations promotes acute performance anxiety among hedge fund managers, and causes them to do things no reasonable investor would ever do. It causes them to sell stocks they should be buying. It causes them to ignore long-term investment prospects in favor of short-term performance objectives. And that is no way to manage money. In this unique case, therefore, the little guy holds an advantage. He can simply try to buy ‘em when they’re cheap and sell ‘em when they’re not. Oil stocks are cheep.

THE VIX VOLATILITY INDEX: A PRIMER

With the large gyrations we have been witnessing recently in the major stock indexes, there has been a lot of talk in the financial media about “volatility” becoming more a part of the everyday market. Although it pains me to say it, the purveyors of business news, gossip, and opinions are right this time. I guess that just validates the “broken clock” and “blind squirrel” theories. The stock market has, in fact, been subject to a greater degree of volatility in recent weeks. But how do we measure that volatility, and what are the financial pundits actually referring to? It is a metric constructed by the Chicago Board of Options Exchange (CBOE) known as the Volatility Index – or VIX for short. Just what is the VIX, and what information can be gleaned from its readings?

Let us begin by considering what the VIX measures and how it is constructed. Here is an excerpt from a report on the VIX found on the CBOE website: “VIX continues to provide a minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days. This volatility is still calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.” Notice the use of the word “continues” in the first sentence – the report was prepared in 2003 by the CBOE to introduce a change in the methodology behind the VIX. The VIX was originally conceived in 1993 to provide traders and investors with an up-to-the-minute gauge of market volatility. The VIX measures the amount of volatility embedded – at any moment in time – in option premiums. In its original form, the VIX was constructed by using a weighted average of the implied volatility of the at-the-money and near-the-money options on the S&P 100 index. In 2003 the CBOE created a “new” VIX by making two changes to the original version. First, options on the S&P 500 index were substituted for those on the S&P 100. The second change was to increase the number of options used in the calculation of the weighted average. All options used in the VIX calculation are either in the nearest month to expiration or the second nearest – the CBOE’s goal being to estimate the implied volatility of what an at-the-money option on the S&P 500 would contain with 30 days left until expiration.

The VIX is quoted in terms of a number between 0 and 100 – and normally trades at the far lower end of that range. The number represents the anticipated percentage movement, both up and down, in the S&P 500 index over the next 30 days. The VIX provides you with a reasonable projection of the expected range within which the S&P 500 is likely to trade within the next month. The S&P 500 closed on June 19 at 1240.14. The June 19 closing VIX reading of 17.83 suggests that options traders and investors are betting that between now and July 19, the S&P 500 is likely to trade roughly within 1.49% range – 17.83 divided by 12 (months) – of 1240.14, or between 1221.71 and 1258.57. That does not mean the S&P 500 will actually trade within that range. The VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500 option premiums. Thus the projected S&P 500 trading range for the next month is being constantly revised.

And that reflection of traders and investors’ attitudes is the heart of the VIX’s value. When you can correctly gauge market participants’ attitudes – and then use that information to anticipate likely future price action – you have acquired an additional edge in your efforts to make money in stocks.

DILEMMAS AND REDUX

Don’t look now, but a dilemma faces almost every single policy maker on the planet, and some tyrants roaming the planet. A few tyrants have no dilemmas like Putin in Russia, Chavez in Venezuela, and the faceless Sudanese dictator. They continue to rampage and pillage. Morales in Bolivia already made his decision. His die is cast. A fork is presented in the road in at least five power centers globally - the U.S. Federal Reserve, the Bank of Japan, China, Russia, and the U.S. military. As anyone with a sense of odds, chance, gambling, or probability knows, each fork has two choices. That makes for a great many combinations of directions, 32 actually (two to the power five). No analysts worth their salt can competently put forth a forecast without contingencies and various scenarios. No one power center make can be deemed more important than another. They are all critical. As one center takes action, other centers respond or join in a similar action. The entire globe is stretching and heaving. Financial tectonic plates shift.

Oftentimes one hears how the current commodity boom resembles the 1970 decade, when gold peaked at $850 in 1980. My analysis finds little in common except a rising crude oil and gold price. Sure, oil and gold zoomed in price to gather world attention. But that is about as far as the parallel extends. Here are differences, which paint a profoundly different picture in 2006 from what we lived through in the 1970 decade.

BUBBLES IN THE BATHTUB

Suppose that company HN has been used to selling cars for cash at $10,000 apiece, but that business has been a little slow lately. Faced with the imperative to re-energize the dealership, inspiration strikes some genius in the marketing department. Shortly afterward, he emerges smiling from a lunch with one of his buddies up in finance and makes straightaway to the CEO’s office suite. The gist of his idea is this: henceforth, HN will overcome sales resistance by offering a hot new deal. It will sell its cars for a sticker price of $9500 – an ostensible 5% discount – and it will also allow the customer 5 years to pay back the money at a monthly rate of “only” $192.625. This financing represents an interest rate of 8% monthly, or 8.30% compounded annually, and the “discount” will, in fact, cost the owner a total of 60 x $192.625 = $11,557.54 by the time he has fully paid for the car.

The angle for the car company is that it knows that, with the help of its favorite partner in the Money Trust, it can now repackage the loan (“securitize” it) and sell it on to the bank at an internal rate of return of 5.85% (net of servicing fees accruable to HN), thus ensuring that it will receive its original $10,000 as an up-front payment which it can book directly as income. Thus, the car company’s profits will be unchanged, despite the lower selling price. Conversely, unless the customer can invest the $10,000 he would formerly have spent on the car in an annuity at the same rate of 5.85% (which, as a retail customer, he is highly unlikely to do), he is worse off under the financing deal than before, despite the illusion of an initial saving. But – hey! – what does he care? By paying out less than $200 a month for his wheels, he is now free to decide whether he should play the stock market with the rest of his funds, or put it towards that second condo he wants to buy in the hope of flipping it for a quick turn.

From HN’s perspective, of course, the additional benefit is that the new programme will allow lesser-quality, would-be customers who have not accumulated $10,000, or who could not previously borrow for so long or so cheaply, to buy the car, for the first time. Therefore, the deal could well result in even higher sales and hence profits for HN – and all this despite the fact that car selling prices have declined by 5% as far as those collecting data for official government indices are concerned. Inflation – properly defined as the securitizing bank’s monetary creation which supplemented the car company’s circular diversion of profits towards this act of customer finance – has thus seemed to reduce the kind of “inflation” which is routinely misdefined as a rise in the consumer price level.

Lulled into false security by this seemingly benign outcome, the central bank will now be happy to keep interest rates lower for longer and so it will promote this very act of monetary expansion in future. As interest rates fall, the maths means that lower dealer prices can be quoted, while generating the same or higher accounting profits, in turn encouraging the central bank to greater laxity, lower rates, and so on round again and again … This is in no sense an academic exercise since, in Canada and the U.S., the relatively low official CPI rates of recent years have accompanied rising corporate profits, yet these same higher earnings are, in good part, being used to finance increased consumer indebtedness and/or outright household dissaving (the same is true, to some extent, of NZ, Australia, and the UK).

But we must not stop there, for there is a deeper and more ironical inference to be drawn from all this. As Bob Woodward never fails to mention in his gushing hagiography of our lately-departed “Maestro”, in the late 1990s, Alan Greenspan became so puffed up with his idea that productivity gains in the U.S. were being drastically understated that he ludicrously likened his bathtub insight to Einstein’s theory of General Relativity. Greenspan argued that the higher profits which were seemingly being delivered against barely changed prices could only mean labor productivity was higher than estimated. Eureka! No need to raise rates or slow the growth of credit!

With hindsight, we now know, of course, just how reliable profits of the WorldComs, Enrons, Nortels, and Fannie Maes really were as a measure of increasing prosperity, but, as the above exercise in the arithmetic of securitization shows above, even barring bad accounting or outright fraud, the whole darn thing may have been little more than an artefact of financial engineering. In other words, in seeking to boost sales by exploiting the possibilities of modern finance (in a perfectly legal manner), GMAC and Ford Motor Credit, GE and John Deere (among countless others) may have misled our preening, erstwhile Maestro into financing the whole wasteful bubble of the late 90s!

The naked truth about inflation.

In the Hans Christian Anderson fable The Emperor’s New Clothes, said ruler is hoodwinked into spending a small fortune on a robe made of magical silk and which of course remains invisible to those who lack the “worthiness” to see its beauty. One morning, the emperor ventures out among his townspeople to model the luxurious garment, when a pure and innocent child, unmotivated by fear of falling away from the crowd, shouts aloud, “But he hasn’t got anything on!” As if a spell were broken, both the rabble and the ruler suddenly react to the emperor’s total nakedness. Lesson learned: Next time, hire a babysitter.

In other words, there is no underestimating the power of persuasion (i.e., fear of getting your head chopped off for acknowledging the obvious). Whether it applies to Danish fairy tales or to the real world of finance, that fact never seems to change. Consider that every mainstream economist of late has abided by the same dress code: One “outfitted” for a fight against the “spectre”, “beast”, and “enemy” of INFLATION. And for lack of boldness or brains or both, the popular press has been doing their best to compliment its leaders on their lavish attire. Yet it only takes one objective voice to cry out – “Those aren’t business suits, they are BIRTHDAY suits” – for everyone to see the bare, naked truth.

Plain and simple: By definition, “inflation” signifies the “increase in the general level of prices.” ALL prices, including those of financial assets. Yet in the past few months, the values of housing and hedge funds, commodities and small caps have all been going DOWN. Since peaking last summer, the key U.S. homebuilder stocks have lost between one-third and one-half of their market value. Oil prices have not budged from a tight-bound range between $68 and $73 per barrel since May. From its May 10, 6-year high, the Dow has lost over 600 points. All three major stock indexes have erased all previous gains during 2006. From their respective mid-May peaks, gold is down 20%, copper 25%, and silver 44%.

We will say it now, and we will keep repeating it until everyone can see the truth: INFLATION is not the problem. Labor costs are DOWN. The Core CPI has been unchanged for the past three months in a row. There is no sign whatsoever that “the rate of pass through from higher energy prices and other commodities to core consumer inflation” is anything but “low”. (Fed Chairman Ben Bernanke, June 5).

AS GOES ONE MARKET, SO DOES THE OTHER?

If there is one topic that the talking heads on financial TV networks love to muse on, it is inter-market correlations. The most frequently discussed “relationship” has to be the one between the price of oil and the trend in stocks. Hardly a day goes by without someone saying something like “crude up – stocks down”, or vice versa, as if that alone explains the day’s action. Analysts also like to make forecasts based on common trends in related markets – such as crude oil and natural gas, for example. Or gold and silver. Or the international stock markets. There is a persistent belief on the part of many, if not most, fundamental analysts that when it comes to the trend in these markets, as goes one, so does the other.

But as it is often the case, a quick look at the facts makes you go “hmmm”. That is not to say that inter-market correlations do not exist, though. They do – but only for a while. Some last longer, some disappear fast – but they always disappear. All market analogies eventually fail, which makes them hardly suitable for sound investment decisions. What does not disappear are Elliott wave patterns. In every liquid market – whether crude oil, gold, the DAX or the euro-dollar exchange rate – the same wave patterns appear again and again. The repetitive nature of these patterns is exactly what makes the markets predictable.

U.S. dollar in a a lose-lose situation?

The dollar bulls used to cheer every new rate hike by the Fed, now they shun it. Even strong U.S. economic data do not help any more – because the stronger the U.S. economy, the more likely the Fed is to raise rates, and that would cool the economy. The buck just cannot win these days, can it? The USD is cornered by the “fundamentals” and it is almost as hard to find someone bullish on it as it was back in December 2004, when it stood at a low of Y102.17 against the JPY. But experienced forex traders know that when a market gets so one-sided, it is usually a sign of an impending reversal. Couple this knowledge with a well-made Elliott wave count, and you have got a really strong indicator. That is how we made our dollar-bullish forecast back in December 2004.

While it generally pays to fade the crowd, there is one important nuance. There is one point in the Elliott wave pattern when the crowd does “get it right”. It is the middle of the third wave, the so-called point of recognition, when the crowd realizes underlying trend and chases after it, giving the market the fuel to move sharply. Is now one of those moments? If so, it could have profound implication for the dollar’s position in the days, weeks and months to come.

PEAK OIL IS NOT THE GIST OF THE MATTER

Does it really matter that the U.S. has two trillion barrels worth of recoverable oil shale resting in the shadow of the Rockies? Not anytime soon. Before you spit out your coffee, let me explain. In terms of the long run – we are talking decades here – Peak Oil is serious business. The same is true of that oil shale bonanza out in Colorado and Utah. Eventually, we might find the will and the way to tap it. But in the intermediate term – the next five years or so – neither Peak Oil nor recoverable U.S. oil shale will have any real bearing on the energy landscape.

While it may be playing an indirect role, the Peak Oil phenomenon has not kicked in as a direct price driver for energy yet, and may not do so for a while. It is true that Saudi fields are looking sketchy to some outsiders, and new replacement reserves are getting harder and harder for the globetrotting oil majors to find. But there are more factors there than meet the eye. The toughness of finding new replacement reserves, for example, is arguably more of a geopolitical issue – it has a lot to do with state-run energy behemoths muscling out the private players where the pickings are good.

Back to U.S. oil shale. A number of subscribers wrote in after receiving a special report titled “The U.S. Government’s Secret Colorado Oil Discovery”. It spoke of “the next American oil boom” and said the U.S. could become “the new Middle East.” This led at least a few readers to ask reasonable questions like, “What does this mean for the energy bull market?” How does this affect the Peak Oil scenario?

Consider this recent quote from Bob Loucks, a former manager with Shell who oversaw its shale oil recovery operations: “Despite all the attempts to develop a shale oil industry in the United States over the past 100 years, the fact remains that no proven method exists for efficiently moving the oil from the rock there are a number of candidate processes possible, but none has demonstrated a practical capability to produce oil.” Bob Loucks is no diehard pessimist or skeptic. In addition to his field experience, he is also the author of the book Shale Oil: Tapping the Treasure. Loucks is long-term bullish on the prospects for America’s oil shale. But he recognizes that, here and now, we are still not there yet technologically.

There are a number of problems yet to be solved before U.S. oil shale can be recovered on any type of meaningful scale, let alone a mass scale. And getting the extraction technology right is only one monkey wrench in the works with U.S. oil shale. There are others. For example, there are questions of air quality regarding domestic oil shale operations. There are questions of water availability. There are questions of a power source. Do we expect the green crusaders to smile and go right along with construction of the largest coal-fired power plant in history in one of America’s most beautiful Western states, when a patch of Alaskan ice and a couple of scraggly caribou already had them lathered into a frenzy? We may actually tap America’s oil shale one day. But it will not be tomorrow. That day will be many, many years into the future, if ever. There are just far too many logistics problems yet to be solved.

For those of you who still worry what the overhang of recoverable U.S. oil shale might do to the energy markets, a simple question: Remember Canada? Our neighbors to the north are sitting on their own private Saudi Arabia too, in the form of the Athabasca oil sands. Those oil sands are being developed at flat-out top speed, because the Athabasca region is so sparsely populated that Canadian oil sands have virtually none of the headaches a U.S. oil shale project would face. Consider why oil is still in the $60s and $70s with all that northern bitumen just ready for extraction. How can it be that the price of crude is so expensive when there is so much recoverable oil in the ground? Because the whole trick is getting it OUT of the ground.

Here is why I do not think Peak Oil matters much for the time being. The high cost of energy is being set at the margins and driven by an intersection of demand and geopolitics. Secular demand for energy is growing at such an aggressive long-term clip that available supply sources are running flat out to supply it. Oil fields have a maximum rate of output per day. It is a good thing substitution technologies are already starting to kick in, because if they were not, prices might be even higher. It is an infrastructure problem … a bottleneck problem. The fact that there are billions of barrels worth of recoverable oil in the form of tar sands and shale does not really matter at this point. Heck, “peak infrastructure” is a better explanation than “Peak Oil” for the long-term commodity bull. At some point, the world’s inadequate extraction and distribution infrastructure for energy and metals will finally catch up with demand – and when that happens, the commodity boom will be well and truly over. But that day is 5-10 years away or more.

I would love it if that Colorado oil shale report were true. It would not be so hot for oil stocks – when you think about it, everything BUT oil stocks would boom if America became “the new Middle East”. Too bad the logistical conclusions are impossibly, ridiculously optimistic. The main point here is that the long-term energy bull market we are in is more of a demand-driven infrastructure arbitrage, playing out over a period of many years, than a Peak Oil phenomenon. By the time Peak Oil really kicks in, things on the ground will look quite different. And we will hopefully be much farther down the alternative energy road than we are now, enabling us to better deal with the strain.

ACTUARIALLY-DRIVEN INVESTORS AND FINANCIAL FADS

Will institutions regret piling into commodities?

Summary: No matter how wild they get, financial markets do not impose upon the calculation of mortality rates. Unfortunately, the ivory tower culture of actuarial work is vulnerable to the vast but recurring changes in fashions in stocks, bonds, real estate, and (shudder) now in commodities. Recently, HSBC estimated that by the end of 2006 institutions will hold some U.S. $100 billion in commodity indexes. This compares to U.S. $10 billion held at the end of 2003 and very much less at the cyclical low for commodities in late 2002. This is the first direct venture by such funds in history and marks a remarkable departure from “The Prudent Man Rule” into the fad de jour. In the past, the clash between the aloof long term view and undeniable market forces has resulted in corporate damage.

The term actuarially-driven investors refers to insurance companies and almost anything related to pension funds. These, of course, include sponsors and pension fund managers, with the connecting theme being long term studies by actuaries on mortality rates as well as projected investment returns. Obviously, so-called federal government pension plans are not included, as they fall under a heading of electorally-driven promotions. In contrast with a rapidly changing financial world (particularly with volatility exceeding that typical of previous new financial eras), mortality rates change at a glacial pace. Often this culture of a virtual constant state sets itself up as removed from the variable nature of investment markets. At other times, it locks on to investment fads.

It is one thing to be detached from shorter term fluctuations, but the pedestal of the “dignified long term perspective” has, in a number of cases, been isolated – particularly from the remarkable financial volatility typical of great asset inflations. For example, at interest rate lows in the 1940s and 1950s, insurers were very comfortable with the fashion to favor fixed income investments over risky equities. Regrettably, the unthinkable was building and that was soaring CPI inflation which, in the early 1960s, was considered a plague that could only happen in inferior countries. Looking back on it, the irony is exquisite. As bonds were being trashed, salvation was found in equities which, in turn, were soon trashed by soaring alternative investments in commodities or real estate, which eventually turned disappointing as well.

By the late 1960s, widespread concerns about another depression had been dispelled by a wonderful bull market. As that one was peaking, the popular projection claimed there would be so much institutional money coming into the stock market that there would be a “shortage of equities”. Expanding earnings multiples and new issues were also featured. Despite this allure, the policy at a large life company was that any investment that fluctuated in value had no value because the actuary could not match with any certainty the sanctified 30-year forecast of mortality rates. Investments, therefore, required fixed income. All bonds were held to maturity. Even if the issue was rated as junk, it qualified as an “in” investment while equities and real estate were “out”. In the early 1960s, equities were restricted to 15% of investment funds and undesirable real estate was kept at 1%.

The greatest bear market in history for bonds accelerated in the 1960s, making fixed income investments unpopular. As the rate of inflation was getting well beyond most coupons, actuarial assumptions suddenly forced direct investments in real estate. Pension funds bought a wide variety of properties at inflated prices. Out of the speculative real estate collapse in the early 1980s, another great bull market for common shares started. With this, another cult of equities developed with actuaries eventually recommending a 60%+ weighting. Despite the collapse of radical speculation in techs, this has maintained. This compares with an aggressive 52% weighting by Sun Life in 1929. Using the DJIA, equities did not break even until 1955. This, so to speak, is an actuarial life-time and, although there was little change in mortality rates, the investment culture had changed to minimize rather than celebrate equities.

More recently, equities are very much in fashion, real estate again has been wonderful, and confidence in the Fed’s ability to depreciate the dollar “forever” is so strong that former champions of fiduciary responsibility are speculating in commodities. Recent changes in the yield curve and credit spreads are indicative of the financial stresses that accompany the culmination of any great boom. In 1873 the leading New York newspaper editorialized that nothing could go wrong because, without a central bank on a gold standard, the Treasury Secretary had ample powers to prevent a contraction. It lasted from 1873 to 1895 and senior economists called it “The Great Depression” until as late as 1940. However, as history has shown, institutional infatuation with a fashionable asset class provides a reliable indicator of a paradigm change.

For around 150 years and despite an august dedication to the long term, financial institutions have flocked to fashion and then suffered chagrin. This ranged from being overweight in bonds at a 3% yield in the 1940s to being overweight equities in the late 1960s when the S&P started a 66% decline in real terms. If Sun Life, for example, suffered considerable remorse in being overweighted in stocks in 1929 at a 3% dividend yield, is a similar remorse possible with being overweight now at a 1.84% dividend yield? Taking this line a little further, what is the potential for chagrin when positioned in commodities with no coupon, let alone dividend? The history of the investment behaviour of financial institutions provides an answer.

U.S. CEO’S MADE 262 TIMES MORE THAN WORKERS IN 2005

Last year, the average CEO was paid $10.9 million a year, or 262 times an average worker’s earnings of $41,861, the Economic Policy Institute said. The research group also found a CEO earned more in one workday in 2005 than an average worker earned in 52 weeks. The group includes salary, bonuses, stock options and other payments in its definition of CEO pay. Soaring levels of executive pay have outraged shareholders at some companies including Home Depot, and securities regulators have proposed heightened disclosure of CEO compensation to empower investors to reign in undeserving corporate chiefs.

CEO pay relative to workers’ pay has grown steadily since at least the 1960s, the institute says. In 1965, CEOs of major U.S. companies earned 24 times more than the average worker. In 1978, corporate chiefs earned 35 times more than workers and in 1989, 71 times more. The ratio hit 300 at the end of the recovery in 2000, the group said. U.S. corporate officers’ pay is typically higher than that in other countries. In 2003, for example, U.S. executives earned 1.6 times what their counterparts did in the United Kingdom. The same year, U.S. CEOs’ incentive payments like options were 5.2 times what they were for U.K. CEOs, according to a University of Pennsylvania study.

AS COMPETITIVE PRESSURE MOUNTS, EVEN HEALTHY FIRMS ARE KILLING OFF PENSION PLANS

By now most everyone knows that the old-style pension is in a heap of trouble. Desperate companies like UAL have already dumped plans. Other basket cases such as Delphi and Delta are threatening to do the same. But the most surprising news – and the most ominous for tomorrow’s retirees – is what one healthy company did earlier this year: IBM froze its traditional pension. That plan is fully funded, and IBM is strong. Yet as of January 1, 2008, no one in the plan will accumulate any more benefits. The move was a landmark in the realm of employee benefits, where Big Blue has set standards for decades.

Yes, the decline of traditional pensions has been striking and much discussed, but IBM's action suggests a different perspective. In today’s world, why do these things exist at all? Today’s low long-term interest rates, combined with a stock market that is no higher than it was six years ago, have made traditional defined-benefit plans a crushing financial burden to many firms – just as they are feeling the heat from foreign businesses that do not have plans. In addition, research shows that young employees increasingly do not care about traditional pensions, designed to pay off big after a lifetime of work with one company. And a raft of coming regulatory changes will make those plans even more burdensome to employers.

Result? “There’s not an organization I know of that has not had discussions about its defined-benefit plan in the past year or won’t be having them in the coming year,” says Alan Glickstein of the Watson Wyatt consulting firm. At some firms that discussion is epochal. “Some of these plans have not been looked at fundamentally since World War II,” he says.

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% respectively. 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.

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. 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 Thursday’s trading. 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's 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.”

“DHANDO!”

This past month, I journeyed to Los Angeles for a unique kind of conference. It was called the Value Investing Congress. The gathering featured some of the most successful cheapskates of the investment world. These are the guys who do not like to pay much for anything, who are usually bearish on most things and who like digging around in the dumpsters and sewers of finance, trolling around for overlooked goodies. Basically, a variety of top-performing investors offered up insights and ideas over two days to a packed audience.

My favorite speaker was Mohnish Pabrai, and not because I was so interested in his stock pick (it was Berkshire Hathaway, which, by the way, was probably the most talked-about stock at the conference. Everybody seemed to think it was a bargain). I enjoyed Pabrai’s fascinating and insightful story about Mr. B. U. Patel. B. U. Patel is the founder and CEO of Tarsadia Hotels and probably the richest South Asian in Southern California. He started with one 20-room motel in Anaheim, California and eventually grew to over 4,400 rooms across America – becoming one of the dominant motel operators.

Apparently, the Patels were refugees from East Africa. They had a strong entrepreneurial drive and a smart sense about value. They strived to put themselves in situations where they could make a lot or lose a little. Such situations would cause the Patels to exclaim, “Dhando!” Literally translated, it means “business”. But the connotation was “a very good deal.” Or, as Pabrai put it, “Heads I win, tails I don’t lose much.” Anyway, the Patels would buy a motel for little money down, move their clan in and fire all the workers. The family then ran the motel and dropped prices. In a short amount of time they would fill up the motel and earn lots of cash. Then, they would take their money and do it again and again and again. Each time, they reinvested in new motels in similar situations. In time, they became the dominant motel operator in the country. About 1/3rd of all U.S. motels are operated by Patels – it is about a $40 billion enterprise.

Pabrai’s point in telling this story was to show how they only looked for situations where they could make a lot and lose a little. Mohnish Pabrai created a list of what he calls the Dhando framework, which outlines the Patel philosophy. It is a nice little model for investors.

• Invest in simple, unchanging businesses.
• Focus on distressed businesses/industries.
• Invest in businesses with durable moats.
• Few bets; big bets; infrequent bets
• Fixate on arbitrage.
• Margin of Safety – always!
• Heads, I win; tails, I don’t lose much!
• Copycats trump the innovators.

A couple of the principles could use a little explaining. Number 5 simply means that the Patels are looking to take advantage of relatively easy opportunities. Like their motel operation, it was a simple matter to dismiss all the existing workers – which represented huge cost savings – and replace them with family members. Eventually, this gap closed as the Patels themselves got bigger and as they ran into competition that copied their methods. Number 8 is interesting, too. Pabrai quoted the work of Amar Bhide, who found that most Inc. 500 entrepreneurs had adopted – or appropriated – their central business idea from a former employer – and many times the employer was not even interested in the idea.

Pabrai has a very solid track record, beating all the major indices and 99% of all funds since its inception. He runs a tight, portfolio of only about a dozen names. He makes big bets, holds on to his stocks and “takes naps in the afternoon.” Most hedge fund managers spend the afternoon sweating, not sleeping. For those interested, I highly recommend his book Mosaic: Perspectives on Investing. It is a short collection of insightful essays about investing. Well worth it. Here is a look at his 12-name portfolio, from largest positions to smallest [Berkshire Hathaway is the 5th biggest position] …

Why this $9 stock should trade for at least $14.

26.8%. That is how much John Lewis’s small-cap hedge fund (Osmium Partners) has averaged every year since November 1, 2002. Yes, nearly every small-cap stock, fund and index is up since November 2002. But John outperformed most of them, including the Russell 2000, by a healthy 7-point margin. This past month, John gave an intriguing 40-minute presentation at the second-ever Value Investing Congress, held in Los Angeles. The title of his speech was “Tiny Companies, Big Value”. It was about three small-cap companies that have been kicked to the curb by Wall Street but harbor some deep, unrealized value that could make investors a nice profit.

Lewis believes, as we do, that over the long haul, there is no better place to put your money than in the small-cap sector. Lewis pointed out that since 1927, small-cap stocks have returned 14.8% a year, compared with the S&P 500’s 12.3% return. Yet despite the magnificent returns, Wall Street still routinely ignores these tiny outperformers. Roughly one-third of all publicly traded companies have a market capitalization of $250 million or less. Nearly 50% of them are not covered by a single Wall Street analyst. And only 1% of all invested capital goes into the small-cap sector. When you combine this distinct lack of coverage with the sheer number of small-cap stocks on the market, there are almost always opportunities to take advantage of. The key is to weed out the noise from the real value. To do that, Lewis screens for companies with lots of cash, hidden assets that Wall Street has overlooked, insider buying and low multiples. Three of Lewis’s favorite small-cap companies right now are The Boyds Collection (BOYD), MOD-PAC (MPAC) and INVESTools (IEDU).

INVESTools sells investment courses and seminars to people who wish to manage their own accounts. Their typical client is 48 years old, has a net worth of $1.1 million, has $500,000 invested in stocks and makes at least $100,000 a year. But he does not have faith that his pension plan or Social Security will be around when he retires. So he wants to manage his own account. INVESTools gives these high-net-worth DIY investors the tools they need to be successful in this (or any) market. The company puts on a number of free conferences/events in major cities all over America. Hundreds of people come to these seminars to listen to qualified instructors teach courses about options, value investing, technical analysis, currencies, etc. The idea is to use the seminars as a gateway to the company’s products. Once their appetite is whetted, folks are encouraged to pay for the company’s more comprehensive instructor-led workshops and in-depth home study programs.

More that 209,000 people have completed one of INVESTools’ basic courses. And the company has 68,000 subscribers to its various Web programs. Lewis estimates an INVESTools’ customer will spend between $9,000-11,000 with the company from start to finish. This is known as the lifetime value of a subscriber. Once you know a publishing company’s LTV per subscriber, you can make some rough estimates about how much a business is worth – factoring in historical growth figures and cost structures. Depending on which LTV you use – $9,000, $10,000 or $11,000 – and how many subscribers you assume the company will have, INVESTools is worth anywhere between $10.05-29.16 a share. Yet as of today, the stock traded for just under $9. Wall Street cannot see past what appears to be steady earnings losses. The company reported a loss in 7 of the last 9 quarters. People think it is a bad business. But the value is simply hidden away a bit.

Despite the routine earnings losses, INVESTools has generated $39.9 million in free-cash flow over the last three years. And its cash from operations is even more impressive – totaling $50.3 million. So how can such a cash-generating machine take a loss every quarter? INVESTools is forced to defer millions and millions of dollars in revenues every quarter. Because it sells subscriptions, seminars and one-on-one training sessions, it is not allowed to realize any revenue until the services have been delivered. For instance, if a customer pays $4,000 up front for four coaching sessions, the revenue can only be recognized as the coaching sessions are completed. So after the first session, it realizes $1,000. But the remaining $3,000 is deferred. Eventually, it will realize most of these deferred revenues. And that will have a positive impact on both the company’s top and bottom line.

For now, the best way to value INVESTools is on a revenue and cash basis. INVESTools trades for less than half what its peers trade for on an Enterprise Vale to sales basis. It is at least 53% cheaper than its cheapest peer by the price to cash flow measure. INVESTools would have to rise to between $13.57-$18 to be fairly valued – in line with John’s calculations. And because INVESTools is growing rapidly, it is not hard to see how it might trade for a premium to its peers. At the end of the day, Wall Street is put off by INVESTools’ “losses”. But once it wakes up to its strong cash position, healthy balance sheet (the company has almost no long-term debt) and growing customer base, this stock could rally quite significantly.

Despite INVESTool’s upside potential, I wonder how the company will fare now that the market is not as robust as it was say a year or two ago? When money is not as easy to make, will customers continue to spend $9,000 a year? And if consumer spending weakens (which it is starting to do), will a company that depends on the consumer dollar take a beating? I do not know, so I am not going to put INVESTools in our portfolio at this time. However, this is a company I will continue to follow. I like its business model. And I love the fact that it generates so much cash.

Since BOYD trades on the Over the Counter Bulletin Board and MPAC is extremely illiquid (average daily trading volume is just 7,000 shares), I will not cover those in this space.