Finance Digest for Week of August 7, 2006

SPECULATIVE PEAK

Our proprietary Peak Momentum Indicator topped out in early May. This is a rare event, and one of the more interesting examples anticipated the blowoff in gold, silver, and crude oil in January 1980. Such signals also anticipated the blowout in banks with the LTCM disaster in 1998.

Last year’s signs of the times: “Home Sales Soar Sky-High. … Experts say this is no bubble but sustainable growth driven by confidence.” (Vancouver Sun, June 3, 2005). And “Measured by the increase in asset values over the past five years, the global housing boom is the biggest financial bubble in history. The bigger the boom, the bigger the bust.” (The Economist, June 23, 2005) These were from a year ago, and The Economist’s view was timely as the home builders index (HGX) peaked at 291 in July and the average house price index topped in August. The HGX has slumped 36% to the recent low of 187. By these measures, the bubble is clearly over and the contraction in this sector has begun. Will this lead to a bust as The Economist observed? Probably.

Our proprietary Peak Momentum Indicator measures speculative dynamics and it does not matter what the game is. For example, on the one in 1987 it was the stock market and the one in November 1973 led that peak in commodities by 3 months. However, the example in late 1979 may be the most pertinent to today’s condition. The signal registered in November 1979 and led the peak in gold and silver by 2 months. That mania also included crude oil, which plunged from $39.50 in 1Q 1980 to $10.40 in March, 1986. Any price decline eventually dislocates leverage taken on during the price rise and the plunge in crude took out a number of hitherto aggressive banks. This reminds of the crash in the energy play in the mid-1980s. At congressional hearings, outraged politicians were working over the CEO of a busted Oklahoma bank. When asked where the depositors’ money had gone, as reported by the Wall Street Journal, he said, “Oh, we spent it on wine, women, and song – the rest we just pissed away.”

Speculation in house prices was part of that play and, as memory serves, higher end homes in Toronto and Vancouver fell to 1/3 [no typo] of their highs. The latest signal from our Peak Momentum Indicator registered on May 9 and, while it was not as extreme as in 1998 (1.35) or in 1980 (1.37), it spiked to 1.21 and, in reversing, it says the play is over. At the time, we noted that the signal was likely coincidental rather than leading and the rapid cooling of the action in base metals and the stock market seems appropriate. The homebuilders index remains weak and perhaps the likely shutdown of the home as an ATM is forcing the recent plunge in retail stocks.

Although the headlines in early 1980 were mainly about precious metals and crude oil, base metals were part of the play and copper rallied from 59.6 to 143.7 on February 11, 1980. The cyclical low was 53.6 in June 1982. This time around, copper’s high was 398 (LME) on May 12 and, so far, the low has been 305. The reduction in speculative fever, while significant, has not encompassed all the games. The blowout in oil, homes, and metals in 1980 was accompanied by the biggest crash in senior currency government bonds in history. Yields soared from 4.4% in 1967 to 15% in 1981. With this, Baa corporates went from 4.78% to 17.29%.

Obviously, much of the recent boom has been accompanied by falling long rates as, for example, long treasuries declined in yield from 6.73% in 2000 to 4.31% a year ago (now at 5.10%). This important financial sector has shown excesses on the upside possibly equivalent to the downside in 1981. Of interest is that the retrospective Peak Momentum reading in 1980 was also a “buy” on bonds. Now it is a cyclical “sell” on most corporate bonds, which have been very much part of an outstanding speculation. A breakdown in lower grade bonds, which is best monitored by credit spreads, will mark the end of the mania in risk and that will likely mark the beginning of a severe leg down in stocks, commodities, and residential real estate.

SURVIVAL REPORT UPDATE: TRENDS ARE DIFFICULT TO RIDE, ESPECIALLY WHEN THEY ARE POINTED DOWN

2006 is a very important year in which to be thinking about financial survival, as we are seeing many markets in the middle of significant trend changes: housing, the stock market, Treasuries, and perhaps commodities. We have already laid out our position on many of these markets by the positions in our portfolio. We remain short the many stock market index ETFs, including tech stocks (QQQQ), small caps (IWM), and large caps (SPY). We also have short positions in various other sectors and markets that we believe will eventually succumb to gravity. Our stance on these markets is clear: They are in a downtrend until proven otherwise.

But even in a declining market, there are always pockets – if not sectors – of strength in full-blown bull markets. Even during the decline of 2000-2002, there were great opportunities on the long side: homebuilders, miners, tobacco stocks, and select health care stocks are a few examples. As we head into another period of turbulent markets, we have been searching for what will be the pockets of strength this time around.

Treasury bonds are still on the fence (so to speak) of a long-term trend, but the short-term trend is up, so we will hold TLT and TIP until there are clear signs telling us to exit. If Treasury yields have in fact put in their high for this cycle, TIP and TLT will do very well in the coming months. And if they have not put in their high and yields are destined to break out to new highs, we will lose a little on TLT and TIP, but gain much more through our stock market short positions – the stock market WOULD NOT be happy if the 30-year bond broke out of its 25-year downtrend!

We are also watching several other sectors for a possible entry. Gold (GLD), silver (SLV) and miners (GDX) are at the top of that list. Gold has rebounded from a low at $542 in June to a recent spot near $650, but remains below its May high at $730. We had identified $540-580 as a significant area of support during the decline from the May high, but one of the essential rules for financial survival during a bear market is to not gamble and try to catch falling knives. Gold did indeed stop at $542, but it would have easily dropped straight to our long-term target near $475. This target is not necessary to meet for us to enter gold and miners, but it is one of two entry points: We will either enter gold at significant long-term resistance so that our potential downside is limited, or we will enter when we are very sure about the long-term trend being up. Right now, neither condition is met, so we remain on the sidelines. In the short term, gold may continue it uptrend from its recent low at $602, but this leg up looks decidedly weaker than the previous rally, so keep your stops tight if you are trading it. Both the short-term and the long-term charts suggest gold has more correcting to do before it’s ready for another major advance.

The other market we are watching closely for an entry on the long or short side – depending on which way it breaks – is oil and the Oil Services Index. Crude oil remains firmly in its uptrend, but the Oil Services Index, represented below by the Oil Services HOLDRs (OIH), has been weak since the general market topped earlier this year. The decline from the high at $169 is overlapping and corrective looking, but as of now, it remains in a pattern of lower lows and lower highs – which could ultimately resolve in a breakdown from here. So we will wait for the market to give us some hard evidence one way or the other.

Like the gold stocks (represented by the XAU), the oil stocks will continue to be effected by the direction of the general market, and here we see unhealthy signs abound. We see a market that has a lot to prove before we take any rally seriously enough to cover our shorts and go long. Even though we have a 60-point rally in the SPX, we see no reason (yet) to change our stance. Stocks are pricing in a perfect soft-landing slowdown in the economy. Yet the deepening yield curve inversion and the falling dollar suggest some markets are anticipating something more than a “moderation of growth.” Today, stocks may like the idea of the Fed pausing, but the real test will be the market reaction to the continued weakening of fundamentals.

The Survival Report’s first responsibility is to keep you out of areas of significant risk, and the general market right now definitely fits that category. Gold and oil also fit that category for now, but we think they remain in their long-term uptrends, so we are waiting for the all clear to enter. With any luck, we will get those entries at lower prices than today.

PENDING MARKET LIQUIDATIONS

Geopolitical events combined with the latest pipeline problems in Alaska should have gold over 700, but gold is $50 lower. That is a very big signal that gold is going lower in a few weeks at the outside. Please do not interpret this to mean that you should sell bullion. I have just bought gold bullion at 635 spot this last week. I believe in buy and hold, and I do this personally. This viewpoint on gold is a short term view – that I see huge bearish forces.

By far the biggest overhang on commodities is pending financial market liquidations. I still firmly believe that world markets are set up for big liquidations. The fact that gold is at $645 now is mostly because of the Mid East turmoil. If that situation were either to stabilize or calm significantly, gold could go below $600. Believe it or not, markets are set up for huge liquidations within two months, and gold is going to take some of that too.

THE BAD STUFF HAPPENS FIRST

The Federal Open Market Committee meeting Tuesday is likely to be a difficult one. The political and economic pain from rising interest rates is beginning to bite, and it is going to get worse. Meanwhile, there is no sign of a decline in inflation, nor is there likely to be, as real interest rates remain near zero. The Fed is in a corner, but it did not have to be.

The Fed raises interest rates to achieve certain policy objectives. Most important of these objectives is controlling inflation, but in this cycle, which itself has occurred because of excessive Fed laxness in the past, it is also necessary to reduce the U.S. trade deficit, currently approximately $800 billion per annum and climbing, and restore the U.S. savings rate, which has dropped to minus 1.5% owing to excessively easy money that has made it trivially easy to borrow and left no incentives to save.

All these objectives take time to occur. Reducing inflation, now running at well over 4% per annum, requires “real” interest rates (net of the inflation rate) of at least 3-4%, thus nominal interest rates in the 8% range. There is a very long way to go on the trade deficit, and we may have to endure a lengthy recession to get there – to get it back down to the $200-300 billion range we are talking a shift of 5% of GDP, or an increase of more than 30% in U.S. exports. Changing the savings rate is largely a matter of behavior. The continuing strength of mortgage refinancing, down from the last few years but around the 1998-99 peak levels in a year that interest rates have increased significantly and house prices have stalled, indicates that the U.S. consumer will go on maxing out his credit cards until he is forced not to.

On the other hand, the bad stuff happens pretty quickly. Although there is a lot of fat in the homebuilding sector from the boom years of 2002-5, so real pain is some months away, there cannot be much doubt that by the end of this year there will be some serious squawking from the sector. The trouble is rather more imminent in automobiles, whose sales were down by 17% in July from the inflated levels of the preceding year (caused by an “employee prices” promotion that severely dented margins.) Domestic producers were strong in SUVs and minivans whose July sales were down 30% from the prior year. Oil prices are not likely to drop back soon, so the outlook for automobile profitability and employment must be grim. Both houses and autos are mostly financed by loans, so purchases are heavily affected by interest rates.

In fighting inflation it is the real interest rate that matters. Only by raising short term rates to a level at least 3-4 points above the current inflation rate can the Fed hope to have any effect. Conversely, in automobile or home financing the loan’s real rate of interest is less important than its monthly cash cost, which rises with nominal not real interest rates. Of course, over time the real value of the loan payments will lessen, but that does not make the monthly payments more affordable now. So demand for housing or automobiles is severely affected by rising nominal interest rates, even if real rates remain low.

This (in reverse) explains the housing boom of the last few years. Even though inflation was low, so real long term interest rates were not generally negative, nominal rates were far below their levels for any period since the early 1960s, so housing “affordability” was exceptionally high. This allowed house prices to be driven up to levels that were in real terms far above those of the last boom in the late 1980s, when both inflation and mortgage rates were higher. If only inflation had remained low, long term interest rates would also have remained low and house prices could have remained at their new elevated levels. Although the automobile sector has provided the first evidence of pain from the Fed’s interest rate rises, it is in the housing sector that their long term effect will be most bitterly felt.

The long series of ¼% rises over the past 26 months in the Federal Funds rate, from 1% to 5¼%, has so far had very little political or economic cost. The housing and automobile sectors have weathered the increases easily, largely because long term interest rates have risen much less than would have been expected from such a large rise in short term rates. However, this is about to change. The political and economic pain from further interest rate rises will be substantial, and will get considerably worse as the lagged effect of past rises on the housing and automobile markets kicks in. When nominal rates are raised enough to throttle inflation (8% is needed at present, but higher if the rise is delayed and inflation gets worse) the effect on the housing and automobile sectors will be correspondingly more vicious.

In other words, by raising rates so slowly, the Fed has managed to engineer a situation in which none of the benefits of higher rates have happened or are imminent, while the costs of higher rates are about to hit the U.S. economy and political system like a repossessed Mack truck. Alan Greenspan and Ben Bernanke, once again, a masterstroke! Guys, if you are worried about inflation you need to raise rates quickly, not slowly, to get to a teeth-clenching real rate of interest without allowing inflation to chase rates upwards.

If the Fed had raised the Fed Funds rate from 1% to 6% in one jump in June 2004, removing the excess accommodation it had introduced into the system since January 2001, inflation would have stopped increasing. Home mortgage rates and automobile loan rates would have risen, but to a level only modestly higher than today’s. Once inflation was firmly under control, interest rates could have been ratcheted downwards as inflation fell and economic recovery would have occurred. House prices would have dropped, but from the lower price levels and lower debt levels of 2004, therefore producing a smaller, more manageable downturn, with fewer bankruptcies. Similarly, Detroit would have faced higher automobile financing costs with oil at $40 per barrel not $80.

Oh, and the stock market would have dropped too, albeit from its somewhat lower level of 2004. You say the stock market has not dropped yet? Wait and watch, ladies and gentlemen, wait and watch. It should be quite a show!

ARE HOUSING PRICES HEADED FOR A BIG FALL?

As the slump in the U.S. housing market picks up speed, homeowners and sellers in the once-hottest markets of the country now face the biggest price declines, say analysts. And even if the U.S. economy remains healthy, it could be a year – or more – before the market bottoms out, they say. After posting back-to-back years of double-digit gains, housing prices have flattened across the country and in some areas started to decline. Overall, the median price of an existing home was up just 0.9% in June – the smallest gain in a decade, according to the National Association of Realtors. Prices fell 1.7% in the South and 0.5% in the Midwest.

And those statistics may not tell the whole story. Sellers coast-to-coast are now making concessions that do not show up in the official sales price, like picking up the cost of repairs or paying buyers’ closing costs. Home builders are giving away valuable upgrades – everything from fancier kitchens to a free pool – to move new homes. “So the the effective price is lower and probably already falling, but you don’t see that in the market price,” said Mark Zandi, chief economist at Moody’s Economy.com. “I’m expecting 5 to 10 percent peak-to-trough declines in a third to maybe half of the nation’s markets.”

The markets hit hardest by price declines will be the same ones that were the biggest beneficiaries of the runup of the past few years, say analysts. Those include the Northeast and East Coast down to Washington, D.C., much of Florida, California, hot western markets like Arizona and Las Vegas, and once-strong markets like Chicago and Minneapolis. The reversal of the once-hot market has been swift. After a 5-year boom that set records in sales volume and price gains, sales of both new and existing homes have plunged, and the level of unsold inventory has hit a 9-year high. A rise in mortgage rates over the last year has shut some potential buyers out of the market. Home builders are reporting a sharp drop in demand for new homes. Last week, Pulte Homes, the second largest U.S. home builder, reported a nearly 30% drop in orders – on top of a rise in unsold homes. “People that signed contracts six to eight months ago are canceling on their home purchases,” said Pulte Homes CEO Richard Dugas.

Despite the runup in supply and drop in demand, prices so far have held relatively steady overall. Part of the reason, say analysts, is that homeowners are holding out for their asking price and hoping to wait out the market downturn. That could delay the market’s recovery. “In the stock market you might get a quick adjustment and then things would start to recover,” said Michael Carliner, an economist with the National Association of Home Builders. “I think the adjustment (in the housing market) is going to be a lengthy process, but it’s also going to be more of a flattening out than a real decline.”

Glut, high prices put condo projects on hold across the country.

In a city cluttered with condominium construction, Old City 205 aspired to shine as an ultramodern residence for the well-heeled with its zinc and glass facade, loft-style homes and windows that span floor to ceiling. Too bad no one will get to move in now. The $40 million project in Philadelphia’s Old City neighborhood will not break ground after the housing market softened and increasingly picky buyers balked at its price tags from $400,000 for a studio to more than $2 million for a three-bedroom penthouse.

From coast to coast, developers are nixing or delaying condominium projects as home sales decelerate, construction costs soar and lenders start to balk at financing units that might not sell. What is making it worse is the glut of high-priced condos and too few people who can afford them. “We’ve gone through the biggest real estate boom in the last eight or nine years and some of these projects haven’t started yet. Do you think they’re going to start building now?” said real estate executive Allan Domb, dubbed Philadelphia’s “condo king”.

With housing looking increasingly anemic, it is not surprising that developers are bailing out. Domb said he has gotten about half a dozen phone calls over the past four weeks from developers asking whether he would like to buy their properties. In May, the volume of apartment-to-condo conversions plunged to $334 million from $1.65 billion a year ago, said Gleb Nechayev, senior economist at Torto Wheaton Research, a real estate research firm in Boston. The all-time high was $4 billion, hit last September.

Builder confidence, as measured by the National Association of Home Builders/Wells Fargo Housing Market Index, fell in June to its lowest level since April 1995. Confidence took a hit from rising mortgage rates, high home prices and investors and speculators fleeing the market. The index surveyed builders of single-family homes, where the sales decline has not been as severe as for condos. Jack McCabe, chief executive of McCabe Research and Consulting in Deerfield Beach, Florida, said desperate developers with finished condos are offering incentives in South Florida. McCabe considers the condo market, especially the luxury end, at risk of a crash. Over the next few years, he sees prices falling by double-digit percentages.

McCabe said about 25,000 condos are under construction in Miami-Dade County, with two-thirds costing $700,000 or higher. Another 25,000 units have gotten building permits and 50,000 have been announced for future construction. He said the median household income in the county qualifies local buyers for a $225,000 home, so the luxury units are targeted mainly toward affluent, out-of-state buyers. Meanwhile, speculators have driven up prices by flipping units, he said. But they are now leaving the market – driving down demand – and putting up for sale properties they own, adding to the glut. Aside from Miami, he said areas at risk include Boston, San Diego, Las Vegas, Seattle, Chicago, Orlando (Florida), Washington and Manhattan. Many condo projects are priced high, in part because developers have to recoup the high prices they paid for land. But most buyers cannot afford it.

Slim pickings for real estate vultures so far.

As signs mount of a slowing real estate market, the “vultures” are beginning to circle. But home prices may still have to fall further to create the bargains they crave. These savvy home buyers who “save their pennies, wait for bargains and then pounce” are already out and about in Manhattan, according to Leonard Steinberg, an executive vice president with Prudential Douglas Elliman. There are so many circling Manhattan this summer that they may be canceling each other out. Any little price weakness attracts them and the competition they provide keeps prices from decreasing. Steinberg tells of a listing that has not sold for several months at a price in the mid-$6 millions. A buyer finally stepped up and offered just $5 million flat – the offer was rejected.

Pam Liebman, CEO of the Corcoran Group, a brokerage that specializes in Manhattan, Eastern Long Island and Florida properties, says she has seen no price fall off to date in Florida. “Buyers may be negotiating more, but sellers are mostly holding firm,” she says. “There’s been a drop in sales volume but not in prices.”

Jonas Lee, a co-founder of Redbrick Partners, makes his living by buying residential properties at the right price. Lee has not noticed any wholesale bargain hunting yet, though he says the general slowdown in markets nationally should create buying opportunities for vultures. Lee says that there could be some bargains soon in some once bubbly markets, such as South Florida. Another market that Lee identifies as ripe for a fall is the condo segment in the District of Columbia and its upscale suburbs. And he iss eyeing California’s Central Valley cities, including Bakersfield, Stockton and Modesto. Lee think prices in San Francisco will also hold up. “Everyone thinks it is overpriced,” he says. “But it’s a highly constrained market, difficult to build in and very wealthy.”

Jim Gillespie, CEO of Coldwell Banker, does not think that the once bubbly markets on both coasts offer much. Prices are still just too high and rents, although strong, do not throw off enough cash to produce cash flow. Investors buying in most of these areas would have to rely on big price rises, something that may not be in the cards for a while.

New residential foreclosures reach highest point of 2006.

Data released today by Foreclosure.com indicates that July registered the highest number of new residential foreclosures in 2006, with Michigan, Colorado and Ohio among the states hardest hit. According to Foreclosure.com’s monthly nationwide data report, there were 28,130 new residential foreclosures in July – a 4.95% increase over June and a 10% increase from July 2005. Foreclosure.com maintains America’s largest and most accurate database of residential foreclosures.

While the company tracked an overall increase in new foreclosures, July statistical data reveals the active foreclosure inventory for the month dropped to 86,562 – a decrease of 3.1% from June. The decline in active foreclosures can be attributed to many of these properties being purchased, according to Foreclosure.com. “New residential foreclosures across the nation are up this year, driven in large part by increases in adjustable rate mortgages,” said Foreclosure.com President and CEO Brad Geisen. “That means investors and homebuyers – if they haven’t already – will be able to find many great bargains in this segment of the real estate market. Put simply, foreclosures are hot and getting hotter. And this is just the beginning.”

Geisen points to almost 35% of available foreclosed homes being purchased in July – a 5% increase over the first half of 2006, twice the rate of existing home sales nationwide. “Clearly, investors are becoming savvier when it comes to buying homes in foreclosure,” Geisen concluded.

Toll Brothers: Residential construction slump worst in 40 years.

Homebuilder Toll Brothers said the current slump in residential construction is unlike any it has seen in 40 years as it became the latest to warn of a glut in new homes for sale and a slowdown in the closely watched real estate market. In a statement, company chairman Robert Toll warned there is a glut of supply of homes for sale in the market, as the building boom of recent years seems to be turning into a bust.

The slowdown “is the first downturn in the forty years since we entered the business that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors,” Toll said in his statement. “Instead, it seems to be the result of an oversupply of inventory and a decline in confidence. Speculative buyers who spurred demand in 2004 and 2005 are now sellers; builders that built speculative homes must now move their specs; and nervous buyers are canceling contracts for homes already under construction.” Markets where the company recorded big increases in cancellation rates included Orlando, Northern California, Palm Springs, Las Vegas and Phoenix.

The Pennsylvania-based builder said it expects to deliver at least 14% fewer units than its previous guidance indicated. And the company announced signed contracts in the just completed quarter plunged 45% to $1.05 billion from a record of $1.92 billion a year earlier. The company said it is not under as much pressure as many builders to cut prices because it builds relatively few homes on spec. But Toll said that much of the supply of finished and near-finished product is being marketed using advertised price reductions and increased sales incentives, which in turn is leading many potential buyers to delay their purchase decisions as they wonder about the direction of home prices.

Beware of Alligators

The Sarasota Herald-Tribune is reporting, “Rental Market Caught in Real Estate Downturn”: “"The Southwest Florida market for rental properties is all whacked out. Where demand is highest – in the affordable segment – the supply of apartments and rental houses is tight. But at the higher end of the market, there is a glut of properties aching for tenants … Investors initially bought single-family homes in the hope of benefiting from the rapid appreciation in values. When prices of properties rose too high, they turned to condominiums and converted apartments. Most of the neophyte landlords figured it would be easy to rent their properties at prices that would cover their costs until it was time to sell. But it is now dawning on them that the rental market is not a no-brainer, and selling out during the current sales slump is not an option unless owners are prepared to dump their properties at significant discounts. …

“One way to resolve the glut would be for owners to sell their properties and get out of the rental business. ‘But there’s no one buying,’ said [president Al] Holmes of the Sarasota Landlords Association. … Owners will either have to drop their prices to a point where it makes sense for the next landlord to invest, or hang on until rents rise or real estate sales pick up.’ Another way to solve the oversupply problem would be for landlords to drop rents. ‘Instead of making money, landlords will see money going out,’ Holmes said. ‘It’s called an alligator, and it will eat you every month.’”

It seems like it is getting very expensive to feed that alligator. I gave Mike Morgan a call and asked him what the average carrying cost would be on a $400,000 condo and a high-priced $1 million condo. For a $400,000 condo at 7% interest the monthly nut is $3,100, or a $37,200 annual carry cost if not rented. IF rented (a tough proposition), I asked Mike what one could get. Morgan thought $1,500-2,000 rents were possible – but not mean likely, given the current oversupply. IF rented (most are not), the carry cost is (at $1,750 a month in rent) $3,100-$1750=$1,350 a month. Annualized, that is $16,200. Bear in mind that does NOT include special assessments. Anyone who knows anything about condos knows those will be coming. Special assessments will happen to cover tuckpointing, hurricane damage, mold, improvements, and low-ball initial maintenance fees. So the $16,200 is best case. On a $1 million condo, multiply the numbers by 2.5, minimally (it is more, actually, because rents do not rise proportionately). Let’s face it. That is a serious snapper.

Another problem is the demand to purchase condos has been dropping like a rock, but supply is constantly being added by flippers wanting to bail out, and builders still foolishly building the damn things. Mike Morgan sent me some pictures from the Miami area with cranes - multiple cranes from the downtown area. As I look at those images, I say to myself that it is nearly impossible for anyone who bought near the peak to ever break even. There is 10 years worth of supply coming on the market at current sales rates. Prices will drop, and in 10 years, there will be new condos still coming on at reduced prices. By the time rents catch up with carrying costs – if they ever do – those condos may be worth 50% less than they are today. Right now, it seems that no one wants to rent (at the high end), and no one wants to buy. In that scenario, prices have nowhere to go but down, yet insurance rates and low-ball maintenance fees will be rising sharply.

House Broke

When Shawn Howell saw the house in the summer of 2004, he thought he could not lose. The location – close to family and in an upscale subdivision in Louisville, Kentucky – was perfect. The 3+ bedroom loft was just right. The price was a little high at $217,000 – especially as Howell’s wife, Niki, had just given birth to their second child. But the couple learned they could purchase it with no money down by taking out two adjustable-rate mortgages. The monthly payments would start at a manageable $1,100. And Howell figured the value of their home could only go up in the five years they planned to live there. Instead, two years later, the family have put their home on the market for less than they paid for it – desperate to find a buyer before the bank forecloses on the property. “Looking back, I wouldn’t advise anyone to do what we did,” says Howell, an Iraq war vet who worked two jobs but still fell short on the monthly payments after they jumped by more than $300. “We just couldn’t afford the house anymore.”

Across the country, millions of homeowners are finding themselves in a similar situation. Real estate purchases that once seemed like such moneymakers have become financial burdens instead. U.S. homeowners now owe about $9 trillion in mortgage debt. Of that, about $425 billion in adjustable-rate mortgages – initially pegged at historically low rates, but designed to shift with market trends after periods ranging from one to 10 years – will reset sometime this year, according to Freddie Mac. Another $600 billion in home equity lines of credit (or HELOCs) and second-lien mortgage loans, which became popular when rates were low as a means of paying off credit card debt or financing home improvements, are also being readjusted.

Those with fixed-rate mortgages payable over 15 or 30-year periods may be seeing little change, but those who banked on rates remaining near the 4.6% lows of 2003, are getting some unpleasant shocks when their mortgage bills arrive in the mail. As their payments rise, many are struggling to keep up. Foreclosures and delinquency rates are rising. And with the markets cooling in many regions there are growing fears of a looming crisis. Howard Dvorkin, president and founder of Consolidated Credit Counseling Services, a nonprofit debt management organization, says up to 10% of those now seeking counseling are being squeezed by adjustable-rate mortgages or home equity loans. “And this is just the tip of the iceberg.”

Fannie Mae, the country’s largest source for home mortgage funding, estimates that nearly one-third of the total outstanding mortgage debt is set at an adjustable rate. So even more loans and mortgages will readjust in the next few years – almost certainly in an upward direction.

MICHAEL MILKEN SAYS CHINA’S ECONOMY WILL OVERTAKE THE U.S. THIS CENTURY

Michael Milken, the controversial financier and philanthropist, said China will overtake the U.S. economically this century, though for now the U.S. should concentrate on Mexico. “Our projections show the United States will be the world’s second-largest economy and India will be the third,” some time this century, said Milken, 60, chairman of the Milken Institute, an economic research group in Santa Monica, California. “The most important country in the short run to the United States, however, is Mexico.” With “maybe 40 million young people looking for jobs and opportunities, anything we could do to help the Mexican economy to grow will be fabulous for the United States, and we would have a great economic partner.”

The former head of junk bond trading at now-defunct Drexel Burnham Lambert also said the U.S. health-care system needs a radical makeover and President George W. Bush’s July 19 veto of legislation to expand federal funding of embryonic stem cell research will slow but not stop work being done in that area. Milken’s roller-coaster life has taken him from high-flying financier and junk bond king in the 1980s to imprisonment for securities violations in the early 1990s. He is now a philanthropist focused on improving medical research and curing life-threatening diseases such as prostate cancer, which he was diagnosed with and treated for in 1993.

Milken said he would not consider the U.S. losing economic preeminence to be a negative development. “The growth of India and China will bode very well for the United States in its growth,” he said. “There are tremendous opportunities for growth throughout the world.” Milken also said corporate governance changes mandated by the 2002 Sarbanes-Oxley law, which toughened reporting requirements for companies and increased penalties for financial crime, help the economy and investors. “Anything that increases transparency and confidence reduces the cost of capital, makes it operate more efficiently, and I think that is what they have brought, and gives you more confidence,” he said.

COLLEGE FRESHMEN FACING STICKER SHOCK AT BOOK STORE

Sticker shock will hit many college freshmen when they head to the bookstore this fall. With the average new text costing more than $100, the typical student can expect to spend more than $900 a year on books. Savvy students can save money if they purchase used books at the campus store or online, check out local book swaps, consider international editions and sell when they are done.

In June, the U.S. House of Representatives Advisory Committee on Student Financial Assistance began an investigation into the cost of college textbooks, its impact on students and ways to make them more affordable. The investigation came in response to a General Accountability Office report last summer that showed textbook prices rose 6% per year on average between 1987 and 2004. That was twice the overall rate of inflation and almost as high as the 7% annual increase in college tuition and fees. Congress is concerned about textbooks because nearly half of undergraduates receive federal financial aid and the cost of books is one factor considered in making these awards, the GAO says. Today, the average book would cost almost $115, given the rate of textbook inflation.

The CalPIRG Higher Education Project and the GAO blamed the soaring cost of textbooks on more-frequent revisions and the bundling of textbooks with CD-ROMs, workbooks and other products that are often not used. Bundling increases the initial cost and makes it harder to sell used books if the ancillary products are lost, broken or used. Dave Rosenfeld, CalPIRG’s program director, says, “Two dynamics in the textbook market make it unique.” Consolidation has left the market with few competitors, and the person who orders the merchandise – the professor – does not pay for it. The same thing happens with doctors and prescription drugs.”

Juan Pablo Moncayo, a senior and student body president at California State University Fresno, says he has found a “wide spectrum” of price sensitivity among his professors. “Some are extremely sensitive,” he says. “Some will ask me, ‘How do you find out the price?” I’m, “Oh my god, you talk to the guy who sells it!’” Moncayo is involved in a coalition of student government and advocacy groups in 14 states trying to find a long-term solution to soaring textbook prices. According to its Web site, its campaign includes persuading professors and publishers to keep editions on the market longer, unbundle books and ancillary products, and develop more forums where students can buy, swap or rent books. In the short term here are some ways to save money.

Credit cards a dangerous convenience for students.

There is a very good chance a student will get a credit card as soon as he or she enters college. Parents may even encourage them to get one for emergencies or to build up a credit history. “Credit is something everybody needs,” says Ed Mierzwinski, consumer program director at the U.S. Public Interest Research Group. “But many young people are getting too much credit and are unable to handle it.” According to Nellie Mae, a major provider of student loans, 76% of all college undergraduates started the 2004 school year with credit cards. The average outstanding balance on those cards was $2,169.

To a student, “A credit card seems like free money,” says Jim Boyle, president of College Parents of America. “That lure really sucks them into a situation where they’re paying for their purchase many times over because of the interest.” Ed Mierzwinski also worries about the kids who do not pay off their balance each month. “They’re taking advantage of these kids and getting them into trouble at a young age,” he says. But the banking industry insists that is not the case. “College kids are better than the general public at managing credit cards,” says Tracy Mills, a spokesperson for the American Bankers Association. Mills says college students are more likely than the average cardholder to pay their bill in full each month.

Most college students have not developed a credit history. They have very little income, if any. And in many cases, they have huge student loans to repay. So why do banks bombard them with credit card offers? Because students are a prime marketing opportunity. “If they can be in that kid’s wallet, they are more likely to have a customer for a good long time,” explains Geri Detweiler of ultimatecredit.com. That is why banks set up kiosks at on campus, offering T-shirts and other goodies to students who apply for a card. By doing this, Mierzwinski says, “banks make getting a credit card an impulse purchase.”

Many colleges and universities get big bucks to help banks market credit cards to their students. James Scurlock, who directed this year’s award-winning documentary “Maxed Out”, says he was “shocked” to learn some schools are paid millions of dollars “to literally hand over their students’ personal information.” The banking industry likes to remind parents and students that getting a credit card in college can be a good way to start building a credit history. But as Jim Boyle with College Parents of America warns, “If you take out multiple cards and are late on paying, then you are in fact digging yourself a credit hole.”

$3+ FOR GAS, BUT AMERICANS KEEP BUYING MORE

If anyone ever questioned America’s love affair with the automobile or our willingness to pay up for gasoline, this summer should remove all doubt. Despite record-high gas prices that seem relentless – $3.13 a gallon in New York, $3.23 in L.A. and Chicago – Americans are on track to burn through more fuel this summer than ever. Even though the average cost of a gallon of gas is 25% higher than it was a year ago, Americans in the last four weeks have consumed 140,000 barrels more a day, a 1.5% increase from last summer’s 9.4 million barrels. “We just don’t see any price response yet,” says David Kirsch, who tracks gasoline for PFC Energy, a Washington-based consulting firm. “The American consumer never ceases to amaze us with their willingness to pay more for gasoline.”

Gasoline has always been what economists term “price inelastic” – in other words, consumer demand is not affected much by price increases, at least in the short-term. Over the long term, according to Larry Goldstein of PIRA Energy, an international energy-consulting firm, every 20% increase in price leads to a drop in consumption of only 1%. “Gasoline is the most price-inelastic of the petroleum products,” he says. “Poor consumers have already felt the pain and adjusted their habits. For other consumers to make changes, you’d need a much bigger price increase. … About 85% of us go to work by car, and a lot of people don’t have a choice. Where it comes back and bites is that demand for everything else goes down.”

That spells more pain for mass retailers like Wal-Mart and – investors take note – other consumer discretionary plays like restaurant chains. Meanwhile, a big winner is likely to continue to be Valero, the nation’s biggest independent refiner. Last week, Valero reported second-quarter earnings of $1.9 billion, up from $843 million a year ago, and predicted the third-quarter would be another show-stopper. Indeed, Valero has been benefiting from strong refining margins, and fears of another bad hurricane season are likely to push its shares higher. Valero stock closed at $66.20 last week, not far from its 52-week high of $70.75. Other oil stocks, like BP, Exxon, and Chevron tend to trade according to the ups and down of crude rather than gasoline.

DOGS OF THE DOW BARKING UP THE RIGHT TREE

The dog days of summer may be wilting investors, but the dogs of the Dow and the mutual funds that invest in them are putting in a strong showing. As of August 2, the value-based basket of stocks has posted a year-to-date return of 14.6%, well above the 4.5% for the Dow Jones Industrial Average and the 3.7% for the S&P 500. Moreover, the mutual funds that are built around the dogs are seeing returns that beat broad-market indices as well.

For those not familiar with the dogs, the investment strategy advocates buying the 10 Dow Jones Industrial stocks with the highest dividend yields on the last day of the preceding calendar year. Most dog investors put an equal dollar amount in each stock and hold them for one year. Since prices and yields move in opposite directions, investors pick up 10 value plays. The strategy was popularized by Michael O’Higgins in his 1991 book Beating the Dow. O’Higgins showed that his dog strategy averaged a 17.9% annual return from 1973 to 1989, compared with 11.1% for all 30 stocks in the Dow. Since then, investors have come up with myriad variations on the dogs of the Dow, most often by taking the five dogs with the lowest stock price. These stocks are often called the small dogs of the Dow or the puppies of the Dow. The dogs of 2006 are General Motors, AT&T, Verizon, Merck, Altria, Pfizer, Citigroup, DuPont, JPMorgan Chase, and General Electric.

While the back-tested results for the dogs seem impressive, the strategy is not failproof, and the stocks have truly had some doggish years. In 2002, the dogs posted an annual return of -8.9%, while the DJIA saw a -15% return. In 2003, returns for the dogs and for the Dow were just about the same. What is boosting returns this year? The market winds have shifted, making large-cap defensive plays and value stocks the new hot picks. It makes sense that a basic value and dividend-driven strategy would work in this environment.

Russell Kinnell, director of fund research at Morningstar, is skeptical about investing strictly in the dogs, per se. “The Dow has been overhauled dramatically over the last few years to have more tech names, and that has really reduced the number of components that could be [dogs],” he said. “Traditionally, the Dow was made up of stocks that all paid dividends. Now it’s not, so you’re picking from a [smaller universe].” Neil Hennessy, who manages the two mutual funds based on the dogs-of-the-Dow investment strategy, says, “This adds some stability to your portfolio. No quarterly window dressing. No style drift. What you see is what you get.” Hennessy also contends that in many ways the mutual funds are actually more effective on a cost basis than doing it yourself - even with such a simple investment strategy.

PUBLIC PENSION PLANS FACE $BILLIONS IN SHORTAGES

In 2003, a whistle-blower forced San Diego to reveal that it had been shortchanging its city workers’ pension fund for years, setting off a wave of lawsuits, investigations and eventually criminal indictments. The mayor ended up resigning under a cloud. With the city’s books a shambles, San Diego remains barred from raising money by selling bonds. Cut off from a vital source of cash, it has fallen behind on its maintenance of streets, storm drains and public buildings. Potholes are proliferating and beaches are closed because of sewage spills. Retirees are still being paid, but a portion of their benefits is in doubt because of continuing legal challenges. And the city, which is scheduled to receive a report this week on the causes of its current predicament, still has to figure out how to close the $1.4 billion shortfall in its pension fund.

Maybe someone should be paying closer attention in New Jersey. And in Illinois. Not to mention Colorado and several other states and local governments. Across the nation, a number of states, counties and municipalities have engaged in many of the same maneuvers with their pension funds that San Diego did, but without the crippling scandal – at least not yet. It is hard to know the extent of the problems, because there is no central regulator to gather data on public plans. Nor is the accounting for government pension plans uniform, so comparing one with another can be unreliable.

But by one estimate, state and local governments owe their current and future retirees roughly $375 billion more than they have committed to their pension funds. And that may well understate the gap. Barclays Global Investments has calculated that if America’s state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22%, to $2.5 trillion. Only $1.7 trillion has been set aside to pay those benefits. Not all of that shortfall, of course, is a result of actions like those that brought San Diego to its knees. And few governments have been as reckless as San Diego officials in granting pension increases at the same time as they were cutting back on contributions.

Still, officials in Trenton have been shortchanging New Jersey’s pension fund for years, much as San Diego did. From 1998 to 2005, the state overrode its actuary’s instructions to put a total of $652 million into the fund for state employees. Instead, it provided a little less than $1 million. Funds for judges, teachers, police officers and other workers got less, too. To make up the missing money, New Jersey officials tried an approach similar to one used in San Diego. They said they would capture the “excess” gains they expected the pension funds’ investments to make and use them as contributions. It was a doomed approach, leaving New Jersey to struggle with a total pension shortfall that has ballooned to $18 billion. Its actuary has recommended a contribution of $1.8 billion for the coming year, but the state has found only $1.1 billion, so it will fall even farther behind. Nevertheless, the director of the New Jersey Division of Pensions and Benefits, Frederick J. Beaver, wrote recently that “our benefits systems are in excellent financial condition.”

THE NEW MOONSHINE

It is happening across the vast belly of the United States, in little towns like Coon Rapids, Iowa, and Plainview, Nebraska. Across the breadbasket states, in Indiana, the Dakotas, and Minnesota. Farmers are gearing up to produce more and more of the new moonshine. But unlike the old bootleggers’ white lightning, produced from hidden stills under the pale glow of the moon, this shine is legal – and you do not drink it. Your car does. It is ethanol, a fuel additive made from corn. You can also use sorghum (another feed grain) or sugar cane. Other potential sources include wood fibers, switch grass and much more. It is all part of an energy source called biofuels.

Ethanol may or may not be a part of the long-term energy picture. Today, it accounts for only about 3% of the nation's gasoline. It may never make a meaningful impact on energy supply. Most estimates show we will never grow enough corn to account for more than 10-12% of our fuel supply. (By contrast, in Brazil, ethanol accounts for 40% of fuel–- although Brazil uses sugar cane.) Yet there is no doubt that ethanol is reshaping the agricultural landscape. In the U.S., corn is the favored ingredient for ethanol. Large distilleries grind up the corn and mix it with water, producing the familiar sweet-smelling mash. Heat up the mash, add enzymes and convert it to sugar. Add yeast and let it ferment to make the “shine”. You boil off the water, and it is essentially ready to go. That is a quick and dirty recipe for the country’s hottest new fuel.

Ethanol is profitable for farmers, and production is rapidly growing. The AP reports that in the U.S., “Ethanol production is growing so quickly that for the first time, farmers expect to sell as much corn to ethanol plants as they do overseas.” In fact, if you believe the USDA’s numbers, the amount of corn used for ethanol this year will eat up about 20% of the nation’s entire corn crop. So you see, whatever you make of ethanol, the fact is economic patterns are changing, forced into new channels like a surging river flooding its banks.

So what does all this mean for investors? Should you buy ethanol stocks? My recommendation is not to invest in ethanol production directly. The speculative flavor is too strong for me. With the story playing out in the front pages of newspapers and magazines everywhere, it is no secret. The masses are onto that idea, which is why stocks like Pacific Ethanol shot up so much (and have come down equally hard). I prefer the backdoor play – a cheaper, less obvious way to gain entry to the coveted party.

Corn itself, is a compelling backdoor play. Booming ethanol production portends a higher price for corn. And corn is still relatively cheap, especially compared with other commodities. For example, a barrel of oil buys you about 28 bushels of corn today, compared with only five bushels in June 1998. An ounce of gold buys you about 238 bushels, compared with only 105 in 1998. But the price of corn is up 26% from its December lows, a performance topping oil, the metals and the S&P 500. As corn supplies tighten and demand for biofuels continues, corn could go a lot higher.

Now to the backdoor play. We know ethanol is booming. We know it usually takes a lot of corn – at least when it is brewed in the U.S. We know something else about corn. It has the highest fertilizer application rate of any row crop. Farmers will need more fertilizer as more of their acreage is devoted to the production of corn. Agrium (NYSE: AGU) may be that backdoor play. Company president and CEO Mike Wilson describes Agrium as “the only global company today that crosses the entire agricultural input value chain.” It makes over 8 million tons of fertilizer, with significant operations in Argentina and Chile. The plant in Argentina is one of the lowest-cost producers in the world. Agrium sells into Brazil, China, India and all over the world. Production from its Alaska facility goes into Northeast Asia. Its operations in Western Canada enjoy low-cost natural gas and freight-cost advantages, as they are close to their markets. In addition to making fertilizer, Agrium owns the largest retail operation in North America. As Wilson says, “The increase in corn, sugar cane and other crops production for ethanol and biodiesel production will be positive for both our wholesale and retail operations.”

Invest in the new moonshine. It’s legal.

Corn Products International could benefit from ethanol boom.

Ethanol is hot; corn is not … but it is getting warmer. Archer Daniels Midland’s stock is hot; Corn Products International’s is not … but it is getting warmer. If ethanol remains a hot commodity, corn should not remain a lukewarm commodity, and Corn Products International (NYSE: CPO) should not remain a lukewarm stock. CPO is “a leading global producer of corn-refined and starch-based ingredients,” according to the company’s Web site. It is the number-one worldwide producer of dextrose and a leading regional manufacturer of starch, high fructose corn syrup and glucose. As such, CPO is not exactly an ethanol play, but neither is it NOT an ethanol play. Let’s call the company an unwitting beneficiary of the ethanol boom. Corn Products does not operate a single ethanol plant, nor does it derive any revenue from ethanol production. And yet, the nascent ethanol boom may shower unanticipated prosperity upon CPO.

“This, of course, is a speculation,” admits James Grant, editor of Grant’s Interest Rate Observer. “Corn Products’ existing, non-speculative business is corn refining, ‘a capital-intensive, two-step business that involves the wet milling and processing of corn,’ in the company’s own words. ‘'During the front-end process, corn is steeped in a water-based solution and separated into starch and other co-products such as animal feed and germ. The starch is then either dried for sale or further processed to make sweeteners and other ingredients that serve the particular needs of various industries.’”

In particular, corn sweeteners find their way into sodas and processed foods. Although these industries provide a steady demand for corn sweeteners, they are very mature and slow-growing. Not surprisingly, therefore, the price of HFCS has remained very constant until recently. Over the last few months, the price of HFCS has broken out of its years-long slumber. Blame ethanol. As demand for ethanol has boomed, demand for sugar has boomed, thereby boosting its price. And as the price of sugar has boomed, the price of sugar substitutes like HFCS has advanced a little at least. But only a little. As the nearby chart illustrates, a tripling of the ethanol price over the last four years has produced a doubling of the sugar price. But corn sweeteners have barely budged over the same time frame. Perhaps they will begin to budge now.

Recent good earnings news is hardly worth the 18 times earnings that the company’s share price commands. The sex appeal of this stock, if there is to be any, derives from the impact of ethanol on HFCS pricing. “CPO is a businessman’s risk,” as Grant explains. “[It is] a not obviously undervalued stock for the business as it currently stands. What makes us bullish is the possibility that the business will not stand as it currently does, but be transformed by the opportunities afforded by persistently high energy prices (and, by extension, persistently high sugar prices). … If events fall out just right in 2006, the company might eventually come to be seen as a kind of energy stock – or more exactly, a net beneficiary of rising energy prices.”

Fundamentally solid sugar market offers put selling opportunities.

With energy markets in a sustained uptrend and few analysts expecting prices to recede any time soon, many investors are looking for energy plays without having to buy crude oil at such lofty levels. Traders looking for immediate ways to cash in on high energy prices might consider a commodity product that is already actively substituting for gasoline, causing demand to make quantum leaps within the last 2 years. The product is ethanol and one way to invest in ethanol is by investing in its chief component in many parts of the world, sugar. About 60% of the world’s ethanol production comes from sugar.

Granted, the sugar/ethanol play is not a new story to most investors. But while crude oil prices topped $76 a barrel this week, sugar prices have dropped substantially since early 2006, making the alternative fuel source look like a bargain. Sugar prices experienced a heady ascent in late 2005/early 2006 as investors and commodity funds poured into the market as demand for sugar outpaced available supplies. The 2005/06 crop year was the third consecutive year that sugar experienced a world supply deficit.

But much of the bullish story on sugar is old news. Why buy sugar now? It is our opinion that many sugar traders and analyst are not accustomed to trading a demand led market and continue to favor the production side of the equation when making price estimates. The old formulas for projecting demand are not as useful as yesteryear. Demand for ethanol is subject to far more variables than was projecting how much chocolate the world would consume in the coming years. Yet the sugar market has lost its luster in recent months as traders focus on larger supplies expected from Brazil and India. What these traders are ignoring is that 2006-07 will be the 4th consecutive year that ending stocks have declined, and despite increased world production overall supply is still eroding. In addition, it is our opinion that 06/07 demand is being underestimated. In the meantime, sugar prices have fallen to what we feel are below value levels.

In comparing a crude oil chart to a sugar chart, the better value becomes obvious if one is considering an energy play. In addition to being a less volatile market, sugar has corrected substantially from its highs in January while Crude Oil has continued to hover near its highs. For investors considering taking a position, we recommend the strategy of selling puts. As a put seller, you are not betting that prices will go up, per say. You are only betting that prices will not decline substantially before option expiration. While prices are bound to rise and fall on a daily basis, we find it difficult to envision sugar prices falling substantially lower given the current demand environment.

JUNK BOND INVESTORS SEE MORE DEFAULTS AFTER FED PAUSES ON RATES

Junk bond investors say the Federal Reserve’s decision this week to stop raising interest rates is a signal that the best is over in the market for high-yield, high-risk debt. Corporate defaults jumped and bonds with ratings below investment grade performed worse than Treasuries the previous four times the U.S. central bank ended a cycle of rate increases, according to data compiled by Merrill Lynch. Junk bonds fell an average 5.12% in 2000, the last time the Fed stopped boosting borrowing costs, Merrill data show.

Pacific Investment Management, which runs the world’s biggest bond fund, and Lehman Brothers Asset Management are reducing their holdings of junk bonds, which have provided higher returns this year than any other type of debt. Investors withdrew 2.7% of their assets from high-yield mutual funds in May and June, according to AMG Data Corp. “We cut back on risk,” said Richard Knee, managing director at Lehman Asset Management in Chicago, which has almost $50 billion of fixed-income securities under management. “We’ve got the lowest high-yield percentage that we’ve had in five years.” Bonds rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s now make up 3% of Lehman’s total, down from as much as 10% in 2004, Knee said.

STOCK OPTION PROBES TOP 100

The number of companies that have disclosed internal or federal probes of their stock option grants has reportedly hit triple digits. At least 102 companies are now under some sort of scrutiny, according to Bloomberg. The widening scandal has also forced many of the companies to delay the filing of their June quarterly results. Bloomberg counts 19 people who have lost their jobs in the wake of the options scandal and five who face criminal charges. The latter includes Comverse Inc. founder Jacob Alexander, who is currently a fugitive after failing to show up for his arraignment this past Wednesday.

Some of the companies under scrutiny are seeking the standard five additional days to file and said they plan to file by August 14. Others, however, concede they cannot identify a date when their quarterly filing will be ready. The delayed reports could hurt the companies’ underlying stock prices since there suddenly will not be up-to-date financial results for investors to consider, Howard Silverblatt of Standard & Poor’s told Bloomberg. Further, the longer a company goes without filing results, the more it is prone to being delisted by the exchange on which they trade.

BASE METALS

Many readers have asked us to update our comments on base metals, which we last addressed in any substantive way just over a year ago, when we sold most of our base metal plays in the July 2005 issue of the International Speculator, on the basis of an expected correction in base metals prices. We are still expecting a greater correction in base metals than we have seen so far. We were out early, we admit – but we vastly prefer to be out early, rather than late, and cannot complain about having locked in the profits we did.

Base metals are called that because they oxidize, corrode and react easily. The primary ones we are concerned with are copper, nickel, lead, zinc, aluminum and iron. Their inherent value lies in their industrial uses, not as money, like the precious metals – although silver is an interesting hybrid. Compared with precious metals, base metals are plentiful in nature and therefore much cheaper, of course. The exploration question is not generally one of finding them, but one of finding enough of them concentrated in a large enough deposit to make them profitable to extract for a substantial length of time. Eventually, their fortunes are tied to the state of the world’s economy – the fundamentals of supply and demand.

As we go to press, copper prices have recovered somewhat from this summer’s correction, in part because of a possible labor strike at Chile’s Escondida mine. This is characteristic of all base metals. Numerous factors, including political and labor unrest, and even floods, affect the supply of base metals. In addition, cranking up supply in the short term is usually impossible. The process of prospecting, exploring and developing a mine takes many years, sometimes decades. The scale of most base metal mines is huge – they take an enormous amount of financing, require endless environmental permissions and need extensive infrastructure. These factors make it very difficult to balance supply with demand in the short term (meaning, up to a few years), creating frequent cycles of price increases when supplies tighten, followed by corrections when new supplies come online.

On the demand side, Asia, particularly China, has stayed in high gear, requiring prices to go up to match demand with supply. Some day soon, India will join the arena. Base metal prices during the last couple of years have risen faster than the price of precious metals, generating a lot of interest and excitement, even among mainstream investors – a sure sign to a contrarian of at least an intermediate high, although prices can go higher before they correct. In fact, we would not be surprised if they went to the sky, given price-insensitive demand and fixed supply and the involvement of hedge funds in the metals market. But any spike like that would be short lived, and for now we still see base metal prices as having gotten far ahead of themselves. In addition, we are bearish on the U.S. economy and are not sure that even China can pick up all the slack we see coming, especially with so much of their economy going into exports to the U.S. At the same time, continually high prices have prompted everyone with assets that can be put into production quickly to move in that direction, so there could be a short-lived supply glut as that inventory of near-to-production assets come online.

Over the next decade or so, we are bullish on commodities, believing that we are in a super-cycle that corresponds to the 20-year bear market for commodities that started in 1980. In the medium range (3 to 5 years), we are also bullish, as anything that can be quickly dusted off will have been, and new discoveries will take longer to bring online. In the short term (zero to 12, maybe 18 months) we see a high probability of economic woes leading to a major correction. That will be our time to reenter base metal plays aggressively.

Are we just guessing? Not entirely. Consider the data from the futures market: Copper for delivery in 27 months is $5,590/tonne vs. the current $7,260. Nickel: $16,675 vs. current $27,350. Zinc: $2,293 vs. current $3,125. Furthermore, the higher prices have brought enough new supply online that base metals are not actually in a state of shortage at the moment. Consequently, we are holding off on buying any new base metal company stocks, unless the company has something of such extraordinary potential that we do not want to wait, or if a company also has a lot of precious metals, which hedges our base metal bet.

Copper is the perfect investment.

This base metal has not received nearly the press that its precious peers – gold, silver, platinum and palladium – have. But it should. Copper is one of the most useful metals on Earth. It is an efficient conductor of electricity. It is flexible and strong and it does not corrode easily. It is used for heating, air conditioning, plumbing, roofing, adapters, computers, cars, mobile phones, wiring, electrical leads, transformers, motors and lighting units. In short, copper is used in nearly every major industry of the world – transportation, engineering, machinery and equipment, electrical, building, automotive and computer.

Thanks to significant demand worldwide, this base metal has outpaced all of its higher-profile precious peers by a significant margin over the last five years. Spot copper prices are up 393% from their lows in 2001. Meanwhile, gold is up only 151%, silver is up 188%, platinum is up 202% and palladium is up 122%. Surely, copper prices have gotten way ahead of themselves and are due for a major correction. Right? That is what the bears are saying these days. But the underlying fundamentals in the copper sector paint a different picture. They show a world in which prices will go higher – much higher.

World-famous commodities pundit Jim Rogers said there are three questions you need to ask (and answer) to determine if a commodity is worth investing in: How much production is there worldwide? Are there new sources of supply? And are there new potential supplies? The perfect scenario for a commodity on the rise is that worldwide production is limited or declining, there are no new supply sources that could boost production in the near-term and there is no viable replacement when prices get “too high.” Based on all three requirements, copper is the perfect investment right now.

THE “REAL” REASON YOU SHOULD OWN GOLD

Gold pays no interest. It is just a lump of yellow metal. If the bank is paying you 7% interest on your cash, chances are you would rather have your money in the bank. It makes sense in this case, thanks to compound interest – in 10 years you would have doubled your money. Hold gold for 10 years and you still have the same lump of yellow metal. Now imagine the bank was paying 0% interest, then which is more attractive, paper dollars or gold? In this case, a rational investor would choose gold. Gold is beautiful, rare, and easy to exchange, no matter where you are in the world. Paper money, on the other hand, is just paper. Governments can print as much of it as they like. Governments can print money to pay off their debts. But they cannot create gold.

As a rule, money flows where it is treated best. If interest rates are high, then gold performs poorly relative to money. If interest rates are low, money flows toward gold. When interest rates are zero, gold becomes a no-brainer. “But wait,” you say. “Interest rates soared in the ‘70s. How did gold manage to run from $100 to $800 during that time?” Yes, interest rates soared in the 70s … but let us consider the effects of inflation. If the prices of the items you buy on a regular basis, like food, gas and accommodations, are rising at 5% and – at the same time - the bank is paying you 5% interest on your savings, the bank is not compensating you for holding your wealth in cash instead of gold. In this case, economists would say your “real” interest rate – the interest rate AFTER inflation – is actually zero.

Back in 1979, short-term interest rates were 8%, but inflation was 13%, so “real” interest rates were negative 5% a year. Is it any wonder the people rushed into gold and away from paper money? By 1981, Fed Chairman Paul Volker had driven short-term interest rates to 15% and inflation to 6%, so the real interest rate was almost 10%. By 1982, gold was back below $400. Today, we see nominal interest rates advertised at around 5%. At the same time, inflation is around 5%, and Federal Reserve chairman Ben Bernanke says he is almost done raising interest rates. Real interest rates are close to negative.

You should own some gold, even if it is purely to lower some of the risk in your investment portfolio, as gold and stocks often move in opposite directions. If you are not there right now, it is time make the move.

THE EMERGING MARKETS ROUT: BUY TURKEY?

The May-June sell off mowed down all stock markets like a drunken professional boxer letting loose the latent power in his right hand in a bar full of non-fighters. It seems no matter where you looked, investors were nursing their cracked jaws and busted noses. Hong Kong. Japan. Brazil. There were more. One of those particularly hard hit was Turkey, down about 45% in dollar terms in the space of about two months. The Wall Street-types will call it a correction. That is what I call a bloody rout. As is my inclination, I am attracted to the aftermath of such calamities. I do not always invest in trouble (i.e., we have avoided newspaper stocks and auto parts suppliers, to name just two). But I often find it worthwhile to take a look and see if such indiscriminate smashing left some cold, unbroken bottles of beer still in the fridge.

So what possible allure could Turkey hold? Nestled between Greece and Syria, with the Black Sea to the north and the Mediterranean to the south, Turkey straddles the fuzzy line between Europe and Asia. Geography alone, however, does not define Turkey’s untidy place in the world. As the Financial Times observes, “Turkey is big, awkward, Muslim, poor, rural, rough-edged and not really European.” Stitched together from the remains of the old defeated Ottoman Empire, Turkey is about the size of Texas, with a population of 70 million people. And the classic stereotype does not fit what is happening in Turkey today. As the FT reports, Turks are “increasingly urban, gradually getting richer, at least officially secular and arguably neither more nor less religious than the Italians or Poles.”

In recent years, the economic picture in Turkey was a bright one. Its $350 billion economy grew by a third between 2002 and 2005. Price inflation, which was once running around 70% per year, was cut down to under 10%. It also became a hot spot for global tourism, especially for winter-weary Germans and Russians. Global capital flows poured steadily into Turkish markets. Things looked pretty good. Vainly so far, Turkey has tried to gain access to the EU – Turkey also has problems, the kind of problems the EU is not sure it wants to inherit. And the recent slide in emerging markets has exposed some of those problems in stark contours.

Price inflation is threatening once again. The lira is down 21% against the dollar since April. Unemployment is still high, around 11%. And never mind the political turbulence in the Kurdish south and an upcoming election for the embattled prime minister. Though investors often forget – indeed, it often seems forgetfulness is as much a force in the market as fear and greed – they have not yet forgotten the meltdown in Turkey in 2000 and 2001, in which investors lost a lot of money. Based on the action in the market, investors seem worried such a setup exists again. Bloomberg notes, “Turkey is closing in on Argentina as the country considered most likely to default on its bonds, according to prices in the swaps market.”

Have prices come down enough so that they discount all that bad news and now represent good values for investors interested in the long-term story? For American investors, the options look limited. There is the Turkish Investment Fund (TKF), which gives investors the advantage of owning a bunch of Turkish companies they otherwise could not buy individually (at least not without great expense). As a general proxy on Turkey, the fund may make sense. I do not like mutual funds all that much, even though I own a few. They are hard to analyze, and I much prefer a more targeted investment. My experience investing in crises tells me that you do not have to rush them. They take time to play out, and prices have a way of moving lower than anyone thought reasonably probable.

And a lower price does not always mean a better buy. Grant’s Interest Rate Observer had an interesting interview with Arjun Divecha, who runs the $15 billion GMO Emerging Markets Fund. Since its inception in 1993, the fund has been among the better performers in its category. Divecha, commenting on Turkey, said, “The price has fallen less than the economic prospects; therefore, it’s more expensive. So in my view, it is not entirely true that stocks in Turkey are cheaper now than before the economic crisis. I wouldn’t call them cheap. I would say that their price is lower.”

It is one of those little lessons every investor must learn, sometimes the hard way. Single-digit price-earnings ratios are not always bargains. And lower prices do not always mean better values.

IRAN GOING FOR THE JUGULAR

“Going for the jugular” is an expression used in sports and business life, indicating a strongly aggressive move or an especially competitive strategy. In casual use of the phrase, we forget the graphic nature of what is being described. The external jugular vein carries deoxygenated blood from the brain back to the heart. If the jugular is cut, death from blood loss is likely to follow. We forget too that “going for the jugular” can carry significant risk for the attacker – be it man, mountain lion or terrorist-sponsoring nation state.

In geopolitical terms, Iran is going for the jugular here and now. With the Middle East pretty much a constant powder keg, it is easy to imagine this recent flare-up is just another example of business as usual gone unusually bad. It is not. Through the proxies of Hezbollah and Hamas, with Syria as its lapdog, Iran has deliberately chosen this moment to up the ante. As Iran sees it, the U.S. military is exhausted and overextended. The American public’s taste for military adventure is at low ebb. The world community is more committed to Chamberlainesque pacifism than ever. And the mullah’s baby steps toward nuclear capability have not only gone unpunished, but they have actually been rewarded with hints of diplomatic concession.

Smugness aside, Iran (and Syria and Hezbollah and Hamas) is taking a very big gamble. In one sense, they are reimplementing Saddam Hussein’s old game plan on a more subtle scale, calculating that the West does not have the will or the way to prevent their goal: the arrival and recognition of a new dominant power and force to be reckoned with in the Middle East. Iran’s ambition is to become the uniting force behind Shia Islam (in competition with Sunni al-Qaida), a nuclear counterweight to Israel and a true power broker on the world stage. This is a generalization, as it must be. The situation on the ground is complex, and all players have their own motivations. (Sheik Hassan Nasrallah of Hezbollah, for one, has waited many years for this moment in history to unfold and has spent the last few years preparing for it.) This is not a regional spat between the Hatfields and the McCoys, in which the two sides can just set a spell and work out their differences. The situation is far more dire, far more calculated, and far more serious than that. It is clear we are experiencing a raging bull market in geopolitical tensions.

From an investing perspective, the knock-on effect of these events will be to remind Wall Street that not only are the reasons for $75 oil not going away, they are getting even stronger. Kevin Kerr and I have gone on record calling for triple-digit oil, as have other better-known prognosticators, like Jim Rogers. We have been beating that drum for some time now. Wall Street is still waking up to this. There are no easy answers to the situation we are in and legitimate question as to what the hard answers should be. Military action against Iran would accelerate and worsen the very problems that now have us in their grip: sky-high energy prices, out of control spending and inflationary pressures – not to mention all the horrors of war, the question of how to measure success and whether success would even be possible. Yet choosing to sit back and do nothing is a recipe for nuclear proliferation and, ultimately, nuclear exchange. Not to mention an open invitation for further consolidation of a terror-exporting power base and future attacks on the West.

Iran knows all this. Iran knows how hard the answers are. That is why it is acting as it is, and now. Iran is going for the jugular. The country’s timing gives it a powerful hand, but there is huge risk in this strategy. Some observers believe that the mullahs are playing with a fire that could wind up consuming them. Hanson warns that if and when the West wakes up to the danger it faces and decides that survival is on the line, there could be an overwhelming forceful response of awe-inspiring proportions – disproportionate force like we have never seen.

INFLATION NON-CENTS

When was the last time you actually bent down and picked up that penny you dropped? The U.S. penny is on its way to extinction so it is time to bid farewell to the basic coin and share with you an inflationary “penny for your thoughts.”

From the U.S. Mint website: From 1787 to 1837 the composition of the penny was pure copper; From 1837 to 1857, the penny was made of bronze (95% copper and 5% tin and zinc). From 1857, the penny was 88% copper and 12% nickel. The Cent became bronze again (95% copper and 5% tin and zinc) in 1864 and stayed that way until 1962. In 1962, the cent’s zinc content was removed. Then, in 1982, the composition of the penny was changed to 97.5% zinc and only 2.5% copper.

Why the U.S. have to switch from a penny that consisted of mostly copper, to one that is almost all zinc? Well, before 1982 the old copper coin weighed 3.1 grams. 100 coins – or $1.00 worth – weighed 310 grams. Since a pound is about 453 grams, 100 pennies at 310/453 = 0.68 pound. Today, at $3.45 a pound for copper, 100 of those 1982 mostly copper pennies are worth about $2.35.

The U.S. government, which is in the business of “making money,” has done a fabulous job of profiting on this coin. Since 1982, they have used an inexpensive copper (zinc) as something of greater value (copper) in the minting of the penny. With inflation today, even the zinc in the penny is now worth more than the penny itself. It actually pays to take your paper money to the bank and exchange it for pennies, then sell them for scrap. I guess the time has really come to stop making these coins. But the real story behind the now-worthless penny is, by far, the surge in inflation. If the core inflation rate is, indeed, only 2.6%, and the year-over-year increase in the CPI is 4.3%, I wish someone would explain why my household expenses have gone up so much (see chart below). This chart does not even include the cost of groceries or prescription drugs. Take-out food can cost as much as eating out. And parking garages in a city like New York are charging $10 more a day to park, reaching $40 a day in some garages.

Worse yet, global warming has led to record heat in the Midwest and pushed up the cost of wheat to a 10-year high. Fruit is also shriveling and nuts are getting burned in their shells. It is so hot, farm workers can sometimes work only half a day. This has not helped the cost of food one bit so I am stocking up before the middle class figures this out and there is a mad rush at Costco to buy groceries cheap, especially cereal.

When the penny is retired and prices for goods and services are subsequently “rounded up” – an item that would ordinarily cost $1.97, may cost $2.00 – expect a little extra pop in inflation. (The Europeans saw a lot of this rounding up when they turned in their local currencies for the euro.) For as long as I can remember, inflation has been with me, even as a kid when I bought penny candies. In the 1950’s, my father actually purchased a brand new modest two-bedroom house in the Midwest for $11,700 and a new car for $2,500. (Some suites at fancy hotels in Las Vegas can charge $2,500 for one night). Inflation also makes planning and saving for retirement a real issue. Unless you know how long you will live, I have to assume that the core cost of goods I need will be going up at least 10% to 15% in nominal dollars a year.

CURRENT RECOVERY IS BY FAR THE WEAKEST POSTWAR RECOVERY

Trying to assess the situation and further growth prospects of the U.S. economy, the first important fact to see is that the U.S. economic recovery since November 2001 has been by far the weakest in the whole postwar period. Just a few tidings composed by the Economic Policy Institute in Washington: (1) Inflation-adjusted hourly and weekly wages today are below where they were at the start of the recovery in November 2001. (2) Median household income (inflation adjusted) has fallen five years in a row and was 4% lower in 2004 than in 1999. (3) Total jobs since March 2001 (the start of the recession) are up 1.9% and private jobs 1.5% (at this stage of previous business cycles, jobs had grown 8.8%). (4) The unemployment rate is low only because several million people have given up looking for a job.

And here are some cursory remarks on our part: (1) Job growth has steeply fallen during the last three months, from 200,000 in February to 75,000 in May. (2) All the job growth has come from the artificial net birth/death model, implying that it is booming among small new firms not captured by the payroll survey, while slumping in existing firms. (3) Private household indebtedness since 2000 has soared by 70%. This compares with an overall increase in real disposable personal income by 12%.

According to the popular GDP accounts, consumer spending in the first quarter has burst by a record rate of 5.2%. That is the fact on which everybody happily focuses. Few people realize, first of all, that this is an annualized figure. The true increase against the prior quarter was 1.3%. In any case, though, it is a grossly distorted figure. The ugly reality of the first five months of 2006 is that the consumer-spending boom of the past few years has effectively broken down. This sudden weakness in consumer spending has an obvious reason. The spending bubble on consumer durables – that is, on autos and housing durables – is going bust. It was largely spending borrowed from the future to be implicitly followed by payback time.

For us, this rapid, steep decline in the growth of consumer spending is the first decisive consideration to expect in the U.S.’ impending serious recession. Remarkably, this is happening with record credit growth and even before the housing bubble is truly bursting. That this most important fact goes completely unnoticed says something about the depth of research. Moreover, this sharp slowdown in consumer spending strikingly conforms to the downward shift in the growth of real disposable personal incomes. In 2005, it was already down to 1.3%. So far in 2006, it is zero.

Under these miserable income conditions, the strength of future consumer spending manifestly depends on the possibilities of ever-higher cash-out mortgage refinancing against rising house prices. It hardly requires any intelligence to have realized by now that this is flatly impossible. Looking at the accelerating credit expansion, we are more than doubtful that the slowdown in the economy and the housing bubble has anything to do with the Fed’s rate hikes. What crucially matters for both is the current credit expansion, and that keeps accelerating. But the problem is that more and more credit creates less and less economic activity, as measured by GDP. The unrecognized problem in the U.S. is that economic growth driven by a housing bubble is extremely credit and debt intensive. It needs, firstly, heavy borrowing to drive up the house prices and, secondly, further heavy borrowing to turn the resulting capital gains into cash. Put this together with minimal or now zero real disposable income growth and you have something like a credit Moloch devouring credit and leaving less and less for economic growth.

Yet we are sure that the U.S. economy’s extraordinary debt addiction has other reasons unrelated to the housing bubble. One is the huge trade deficit, and the other is extensive and rapidly increasing Ponzi finance. Persistently large and growing income losses from the trade deficit would have pulled the U.S. economy into recession long ago. It has not happened because the Greenspan Fed, by way of loose and cheap money, provided for a compensating increase in domestic demand through additional credit creation. It succeeded, true, but the thing to see is the additional credit and debt creation. This was justified with low inflation rates. Ironically, the import boom in the trade deficit has been very helpful in suppressing U.S. inflation. Moreover, the big loser is the export industries in manufacturing while the gains, via the surrogate demand, have been in consumer services and goods. In essence, the trade deficit alters the economy’s structure in a negative way. The losing manufacturing area is the sector with the highest rate of capital formation, and therefore also the highest rate of productivity growth. For good reasons, it also pays the highest wages.

Pondering the U.S. economy’s unusually high addiction to credit and debt growth in relation to GDP growth, we are sure of another evil factor – Ponzi finance. Ponzi finance means that lenders simply capitalize unpaid interest rates. Ponzi finance creates credit, but it is bare of any demand and spending effects in the economy. In the conventional American view, balance sheets of private households are in their very best shape because increases in asset values have vastly outpaced the sharp increases in debts. With such great optimism about the U.S. economy still prevailing, it is a safe assumption that lenders have been more than happy to capitalize unpaid interest rates as new loans, at least until recently. As widely reported, lending standards have been extremely lax for years. Nevertheless, there is bound to come a point where Ponzi lending stops.

The crucial difference is in the ghastly difference between runaway debt growth and nonexistant real disposable income growth as the income component from which debt service has to be paid. In 2000, consumer debt growth of 8.6% compared with real disposable income growth of 4.8%. During the first quarter of 2006, private household debt growth of 11.6%, annualized, compared with zero real disposable income growth. These numbers suggest that, in the aggregate, all debt service occurs through Ponzi finance. Essentially, borrowing against existing assets is required to service debt. Another striking evidence of extensive Ponzi finance is the unusually large difference between rampant credit growth and much slower money growth. Capitalizing unpaid interest rates adds to outstanding credit and debt while adding nothing to bank deposits (money supply).

To get an idea of the actual extent of Ponzi finance, we make a simple calculation. Total outstanding debts in the U.S. amount to $41.8 trillion. Assuming an average interest rate of 5%, this implies an annual debt service of about $2 trillion. This compares with an increase in national income before taxes of $616 billion in 2005. Consumer incomes are even stagnant. Under these conditions, the only question is the severity of the impending U.S. recession. The most important thing to realize is that the spending and debt excesses that have accumulated in the U.S. economy and its financial system on the part of the consumer during the past 10 years are altogether of a size that vastly exceeds the potential for debt service from current income. With stagnant real disposable income and double-digit debt growth, the American consumer is caught in a vicious debt trap. What, then, makes most people so optimistic of further economic growth?

The consumer has accumulated debts at a level vastly exceeding his abilities of debt service from current income. Probably many never had any intention of such kind of debt service. The general idea, certainly, has been to settle debt and debt service problems simply by selling later to the highly appreciated greater fool. That is what most economists take for granted. Given this precarious income situation on the one hand and the debt explosion on the other, it should be clear that at some point in the foreseeable future, there will be heavy selling of houses, with prices crashing for lack of buyers.

As to the level of asset prices in the U.S., an additional comment is probably needed. With savings in negative territory, all asset purchases essentially depend on available domestic credit and capital inflows. Buying assets on credit used to be the exception. In America today, it is the rule. For good reasons, the Fed is fearful to make money truly tight. It would crush the markets. A study by the IMF published in 2003 under the title “When Bubbles Burst” examined the differences in economic effects between bursting equity bubbles and bursting housing bubbles. It left no doubt that the latter are the far more dangerous specimen.

The situation today in the U.S. reminds us strongly of late December 2000. At its previous meeting in November, the Fed Open Market Committee directive had called future inflation the economy’s greatest risk. But then, all of a sudden, the bottom fell out of the economy. At its next meeting, on December 19, the FOMC changed the bias, declaring that the risk of economic weakness was outweighing the risk of inflation. Two weeks later, January 3, 2001, shocked by worsening economic news, the Fed dropped its funds rate, through a conference call, by 0.5%. The U.S. economy today is incomparably more vulnerable than in 2000. All the growth-impairing imbalances in the economy – the trade deficit, the savings and incomes shortage and the debt levels – have dramatically worsened.

Very rapid interest rate cuts and prompt massive government deficit spending succeeded in containing the recession. The phony “wealth effects” derived from the escalating housing bubble became the key source of demand creation in the U.S. But the unpleasant longer-term result of the new policies was an unusually weak and lopsided economic recovery, particularly seeing drastic shortfalls in employment and income growth.

Shrill Statistical Alarm Bell

The Q2 2006 Advance estimates of GDP from the Bureau of Economic Activity recently were dramatic. You might not have fully noticed because market indexes soared and Middle East violence stole the headlines away. This report is well worth a second glance. The Q1 and Q2 GDP comparisons are no less breath taking than the before and after photos of Beirut that dominate TV news of late. Every indicator of macroeconomic health and vigor either weakened or turned negative with the exception of private expenditure on services. The rate of increase in consumer prices – including food and energy – ran up just shy of 50%. Q1 2006 readings showed acceleration of 2.7% and Q2 advance readings ran at 4%. The preferred and lower core rate – excluding food and energy – actually fell from 3.0% to 2.9%. I guess you can predict which number will get the attention?

In case the ramblings of an economist might serve in anyway to clarify – a difficult proposition – I offer the following. The contents of the BEA July 28, 2006 Advance Q2 2006 GDP estimates read like a text book example of brewing economic trouble. Yes, absolute numbers are still fairly good. Virtually every meaningful change was dramatically to the downside. Prices seemed resilient to trouble in sales, growth, savings and inventory build-up. Rates are still fairly low and dollar valuation can not survive any real rate cuts. The U.S. and world are still awash in massive excess credit and easy money. This forestalls monetary policy response. Federal spending is still high and more painful tax cuts are being bundled into the minimum wage bill to facilitate incumbent reelection dreams as we head toward a nasty looking November.

Fiscal policy is already unsustainably expansionary. Federal tax and spending policy offers very little possible remedy to sharp deceleration. Profits, though still good, are showing signs of strain. Sales are under pressure and consumers are beyond tapped out. In short order minimum wages will begin rising and tax receipts will be falling as growth decelerates and prices run above Fed comfort levels. At least that is what this report screams out in clear, shrill statistics!