Finance Digest for Week of August 14, 2006

THE COSTS OF GLOBAL GLOOM

The difficult Israeli campaign against Hezbollah in Lebanon, the continued sectarian violence in Iraq and the attempted terror attacks on transatlantic flights have combined to throw a remarkable gloom onto the world geopolitical outlook. This gloom has clear economic costs, to which we need to adjust. Even though we are avoiding political judgments, some non-economic political decisions will be taken in such an environment, and will affect the economy. Defense and homeland security spending will remain high, and will tend to increase, with knock-on effects on the Federal budget and the economy as a whole. Some system of state funded catastrophe insurance is likely to appear, to protect those institutions and industries most affected by terror attacks (the airline industry, Manhattan’s prestige buildings and hotels, the Washington Metro, etc.) Political and economic relations with the Middle East will be affected. As offensive military activity is scaled back or bogs down, greater attention will turn to defensive measures against terrorism, including more vigorous enforcement of border controls and probably an electronic ID card tagging system.

The Federal budget is likely to remain a problem for many years. The long term difficulties involving Medicare and social security will combine with military and homeland security expenditures to create continued upward pressure on public spending as a percentage of Gross Domestic Product. Since Congress has shown repeatedly that it lacks the will either to raise taxes or to economize in other areas, the federal budget deficit will grow further. This will tend to push up real interest rates – the decade long holiday from real interest rates above 1-2% will come definitively to an end. Nominal rates will depend on inflation, which the government and the Fed will attempt to fudge, but in the end the sheer volume of long term financing to cover the Federal budget deficit will make the reported rate of inflation almost irrelevant. Thus if inflation is reported as 4% per annum and is really 5% per annum, as today (while the Fed, by leaving out whichever items are rising in price, persists in claiming a 2-3% rate) the 30 year Treasury bond rate will be around 8%, and home mortgages will be unobtainable below 9%.

Long term interest rates around the 8% level will devastate the stock market, the housing market, private equity funds and hedge funds and thereby cause a serious and prolonged recession, which will exercise little if any downward pressure on inflation since its cause was not excessive monetary tightness. This in turn will further worsen the Federal budget deficit, which will eventually force Congress to make a serious attempt at budget balancing. Since military and homeland security expenditures will be sacrosanct, and taxes can be increased only modestly in a recession without causing a 1931/33-type downward spiral, the budgetary axe will unquestionably fall most harshly on social security and Medicare/Medicaid, particularly the latter, in which cost control is weakest. As a first step, draconian price controls will be placed on prescription drugs, as purchased through government programs, and on Medicare reimbursements to the medical services industry. Ultimately, those over 80 who require expensive medical treatment will find themselves subject to rigorous cost-benefit calculations.

The U.S. airline industry is already reeling, close to bankruptcy in spite of a strong economy and public insouciance about the dangers of flying. It must now be abundantly clear that the airline deregulation of 1978 did not work, because of the peculiar economics of the airline industry – it has just resulted in the airlines becoming serial bankrupts, at enormous eventual cost to the U.S. taxpayer through defaults on their pension obligations. Subsidizing the airlines to prevent them going bankrupt repeatedly merely subsidizes indirectly the leisure travelers whose excessive numbers make airline and airport security such a problem in the first place. Instead, we need to tax air travel enough to pay for its security costs, and for the insurance costs of terrorist attacks, thereby reducing the volume of travelers through increased prices. Needless to say, tourism is also an area to avoid as an investor, except for those destinations which can be reached by automobile, bus or train from major population centers. Romania and Bulgaria will do OK; the Seychelles will not.

Continued terrorist activity, and counter-terrorist military activity, will make it hard to maintain normal economic relations with Middle Eastern countries, for both political and economic reasons. Conversely, it will become even more difficult than it is already for Middle Eastern countries to develop into stable and prosperous democracies. In this respect, the Israeli incursion into Lebanon was a tragedy. The “Cedar Revolution” government of 2005-06 was pursuing apparently sensible economic policies, and developing Lebanon’s undoubted potential as a trading entrepot and tourist destination. Needless to say, those hopes are now gone. Countries such as Dubai, wealthy but where much of the workforce is “guest-workers” from elsewhere in the Middle East will also find it hard to prosper and will be treated with suspicion in Western markets. The current stalemate in Congress over border controls is likely to be broken in the direction of more severe restrictions on illegal entry.

We can only devoutly wish that the battle against terrorism will be quickly won. Nevertheless, if at some point it proves impossible to win it, an alternative will have to be found. At that point, the only possible strategy will be one of attrition. If an aggressive foreign policy produces not victory but recruits for Al-Qaeda then the only remaining alternative will be an isolationist approach, devoting large resources to intelligence, border control and counter-terrorist security, but ceasing to intervene militarily in the Middle East and to the extent possible reducing the cultural and economic footprint of the U.S. in that region. The rhetoric and policy of Winston Churchill will have to be discarded, and replaced by that of Neville Chamberlain, who after all combined the Munich agreement with the production of Spitfires in case war indeed proved necessary. An appeasement that reduces the number of one’s enemies may well be an approach worth trying.

NOT MUCH FIZZ LEFT IN THE GLOBAL ECONOMY

There is nothing like the seduction of a boom. The recent vigor of global economic growth is a siren song. By IMF metrics, world GDP growth probably averaged 4.8% over 2003-06, the strongest four years since the early 1970s. As tempting as it is to extrapolate this into the future, that may be a serious mistake. There is a much better chance that global growth has peaked and the boom is about to fizzle. The world’s main growth engine, the U.S., is slowing. That is the verdict from the labor market, the housing market, and the consumer – whose inflation-adjusted spending growth fell to 2.5% in the spring period, one percentage point below the heady trend of the past decade.

America’s slowdown represents an important transition in the sources of economic growth, away from the vigorous wealth creation of asset bubbles – first equities, then housing – and back towards more subdued labor income generation. The delayed impact of higher interest rates is also taking a toll. The confluence of higher energy prices, rising debt-servicing burdens, and negative personal saving rates reinforces the possibility of a pullback in discretionary U.S. consumption and GDP growth.

This is an equally critical transition for the global economy. The world is about to lose significant support from the key driving force on the demand side of the equation – the American consumer. In a post-bubble climate, U.S. households will be unable to save through asset appreciation, prompting America to increase income-based saving and reduce its claim on the pool of global saving. That points to a long-awaited reduction in the big U.S. current account deficit – initially painful for export-dependent economies elsewhere in the world but ultimately a welcome resolution for global imbalances.

But who ill fill the void as the U.S. consumer pulls back? The simple answer is … maybe no one. Europe, the world’s second largest consumer, is an unlikely candidate. Do not count on a rejuvenated Japanese economy to fill the gap either. In dollar terms, Japanese personal consumption is only 30% of that in America. As a weak second quarter GDP report indicates, a surge is unlikely, especially as Japan copes with a stronger yen and higher energy prices. Nor are the two dynamos of developing Asia, China and India, likely to counter the slowing trend in the developed world. China has a seriously overheated economy and has little choice but to introduce tightening initiatives. China must shift its economy towards private consumption, a sector that sagged to just 38% of GDP in 2005. (A healthy rate would be at least 50%.)

All this points to a moderation of China’s growth beginning in 2007, with attendant reductions in its voracious appetite for commodities. That should spawn additional ripple effects in commodity producers such as Australia, Canada, Brazil and Africa. The world’s big oil producers would also feel repercussions from a Chinese slowdown. As would China’s Asian suppliers, such as Japan, Korea and Taiwan. India is far too small to pick up the slack, at less than half the size of China on a purchasing power parity basis. Imperatives of fiscal consolidation, with the delayed effects of recent monetary tightening, could also tip growth risks to the downside.

There is a deeper meaning to the coming slowdown. The global boom of the past four years was never sustainable. It was supported by the excesses of the liquidity cycle, which arose from emergency anti-deflationary actions of the world’s big central banks. The ensuing vigor of global growth was dominated by the U.S. consumer, but America’s binge came at the cost of a record drawdown of domestic saving funded by the capital inflows of a record U.S. current account deficit. The boom was balanced precariously on unprecedented global imbalances. Excess liquidity bought time for a precarious world. As central banks move to normalize monetary policy, that time has run out. Without the unsustainable support of asset bubbles, it is back to basics – with aggregate demand supported by more modest labor income generation rather than the excesses of wealth creation.

So much for the artificial boom of an unbalanced world. It could be about to fizzle out.

A HIGHER INFLATION OBJECTIVE?

The Fed is not an inflation-targeting central bank and has yet to articulate a “numerical objective for price stability.” Yet it is widely accepted that Fed officials implicitly aim at core inflation measured by the personal consumption price index (PCEPI) excluding food and energy in a range of 1-2%. Then-Governor Ben Bernanke articulated the case for this range, or “comfort zone”, early in 2003. He argued that it was low enough to ensure policy credibility, but high enough to allow a cushion both for disinflationary shocks and measurement bias. Based on the experience of the 1980s and 1990s, such a range seemed a reasonable working goal, and other Fed officials at least tacitly agreed. This implicit objective got further support as recently as this February, when the Fed agreed to a “central tendency” projection for inflation in 2007 of 1¾-2% – a projection that Fed watchers largely viewed as an implicit target.

That was then. Now, I think that the Fed may implicitly be choosing a slightly higher inflation objective than previously thought – perhaps 1½-2½%. The reasons: The cost of reducing inflation seems to have increased, and the current presumed 1-2% “comfort zone” may leave too little margin for error and for disinflationary shocks.

Now, choosing a higher inflation objective need not undermine policy credibility. Indeed, I will argue in what follows that it could improve them. Moreover, the “Bernanke comfort zone” is only a de facto target range. While many at the Fed have expressed support for a numerical objective for monetary policy, no specific proposal is yet on the table. But if market participants have assumed that the Fed’s reaction function includes such a target, and if an implicit change is afoot, it will have significant implications for monetary policy, for the economy and for global financial markets.

Currently there is a lack of clarity on what exactly is the goal and what are the means to achieve it. One consequence: We and market participants may be misreading the Fed, but for different reasons. In our view, even if the Fed decides not to raise rates further, it will likely stay restrictive longer to bring inflation down. In contrast, many market participants believe the Fed will soon be forced to rescue a faltering economy by easing. But both of these views could prove wrong if policymakers are revising inflation preferences higher. And if those objectives are now also more uncertain, term premiums should rise, the yield curve should steepen further, TIPS should still be attractive, and the dollar should weaken.

Make no mistake: There is nothing wrong with defining price stability as a higher objective than 1-2%. But the goal and the (conditional) policy response to get there must be clear – most observers hunger for consistent straight talk from the Fed about the goal and the strategy for getting there. The risk for policy is that it could allow “base drift” – the tendency to let bygones be bygones – infect the policy process. The parallel risk for markets is that any re-rating of Fed preferences might swing abruptly, adding to market volatility.

THE BELL IS TOLLING FOR THE TRANSPORTS

The Fed announced a pause in its rate-hiking campaign last Tuesday, but it turned out to be a nonevent for the market. The S&P 500 attempted to gap above resistance on Wednesday morning, but by midday, it was clear the attempt was doomed to failure. As of the close of Thursday, the S&P remains within the bearing pattern we showed you last week. This was a clear case of the news being fully priced into the market, and stocks are already looking beyond the Fed. Oil and gold also attempted to rally in the wake of the Fed announcement, but like stocks, they have declined recently – with gold declining more than $12 on Thursday. The U.S. dollar also rallied Thursday. The mini sell-off in stocks, the decline in gold and oil, and the rally of the U.S. dollar is not exactly what you would have expected right after the Fed announced a pause in interest rate hikes. So it is a good thing we do not base our short-term outlook on what the Fed may or may not do – because over the short term, what the Fed does really does not matter.

Right now, the market is wrestling with some very important decisions, and some sectors are making up their minds. We are currently short the exchange-traded fund for the Dow transports (IYT). But when we take a look back at the entire rally from the bear market lows in 2002-2003, we see that the transports have just this month broken their trend from their March 2003 low. So far, the transports have tried to rally back above this trend line once, and they could still take another go at it in the coming weeks, but odds are there is a sizable decline directly ahead. If the transports cannot regain their composure and recover their bullish trend by month’s end, we will have a monthly close below the trend line and a clear sign from a key economically sensitive index that the current downtrend from the May high is more than a correction in an ongoing bull market.

The most striking aspect of the transports’ rally from the 2003 low was the refusal of the industrials to follow onward to new post-2000 highs. We have not talked about Dow Theory much, but we use a variety of analytical tools to assess the market and Dow Theory is an important part of that toolbox. In essence, when the industrials and transports are moving in concert – either both making new highs together in an uptrend or both making new lows together in a downtrend – we have a clue that the trend is healthy and likely to continue. When one index fails to accompany the other (often called a nonconfirmation), then we have a red flag warning that a trend change may be coming.

While the transports have rallied well beyond their 1999 high during this 3-year rally, the industrials have so far failed to rally beyond their 2000 high at 11,722 – the recent high in May was at 11,709. If the industrials ultimately fail to best their 2000 high, we will be witnesses to one of the largest Dow Theory nonconfirmations in the last 100 years. To put it extremely mildly, this would be a bearish sign. With an August close below the 3-year uptrend line at 4,400, the transports will be telling us that their rally is over. Without an immediate recovery, it will be likely that this new downtrend will be leaving the huge Dow Theory sell signal in its wake. The 2000-2002 decline was preceded by a nonconfirmation that lasted roughly seven months, as the transports failed to follow the industrials to a new high in January 2000. So we take a potential 6-year nonconfirmation seriously.

Although we remain long TLT, the 20+ year Treasury bond ETF, we are not married to it and will exit if we get confirmation that Treasury yields are breaking out of their 26-year downtrend. The 30-year Treasury yield rose from February-May, and has since been bouncing above and below the long-term trend line we have looked at a number of times in the past few months -- which is currently around 5.2%. The consolidation from the May high has remained between 5.3-5%. This consolidation could be a correction, which will ultimately give way to another move higher, and in fact, the this week’s action suggests that yields are about to head up in the short term.

There is the potential that this new short-term yield uptrend could turn into something larger, like a breakout above 5.3%, but we will just have to wait and see. We will wait for clear evidence that the 26-year bull market in Treasuries is over before selling our TLT, and in the meantime, we will continue to pocket the monthly cash distribution. If you have not entered TLT yet, it would be best to delay your purchase until we see how this short-term uptrend shapes up.

We said last week that we would see the market’s real reaction to the Fed’s decision by the end of this week. We would have to say the market action has not been encouraging. If bond yields move significantly higher in the coming weeks, it is a sure bet that stocks will not like it. Short or on the sidelines in cash are the places to be for now.

WHY YAHOO!, EBAY, AMAZON, AND AOL ARE TANKING

From the ashes of the 2001-2002 crash there emerged four horsemen of the dot-com apocalypse – Amazon.com, Yahoo!, eBay, and AOL. This quartet of iconic companies, wounded but not destroyed in the crash, survived the plague years and flourished when the market recovered. But in recent weeks, at a time when online advertising and e-commerce are enjoying strong growth, all four have pulled up lame. The group that once led the Nasdaq’s resurgence has generally lagged the tech-heavy index over the past year.

You cannot blame it all on Google. Each of the horsemen is still a leader in its core business, Google or no Google. But each derives the lion’s share of its revenues from a maturing U.S. market, each is finding profit margins slipping as it tries to diversify, and each has foolishly reached back to tried-and-failed ideas of the dot-com era for salvation.

HOMEBUILDERS’ VIEW DIFFERS FROM BERNANKE’S

Listen to Ben Bernanke and most other economists and you will hear sweet nothings on how the current housing cycle will pan out. Words like “orderly” and “soft landing” are, by nature, designed to soothe anxieties. Listen to those in the business of housing and you hear a different story. Last week Toll Brothers warned that the upscale homebuilder’s prospects were deteriorating more rapidly than first anticipated, with orders down nearly 50% from a year ago in the company’s fiscal third quarter, which ended July 31. Chairman and CEO Robert Toll said this was the first housing slowdown in the 40 years he has been in the business “that was not precipitated by high interest rates, a weak economy, job losses or other macroeconomic factors.” These views have been echoed to varying degrees by other national homebuilders, including D.R. Horton and Centex. You might even call the prognosis a consensus.

But many apologists for the housing industry remain insistent that because house prices have never fallen on a national level, they never will. Actually, they already have. Since the fourth quarter, median home prices have fallen about 1%, according to data Goldman Sachs mined from the National Association of Realtors. The numbers are even worse for condos, where the median price of a condo nationwide has been falling at a 9% annual rate since the fourth quarter of 2005, according to Goldman. We all know developers built too many condos to satisfy the frenzied speculative masses. “It is not surprising to see relatively greater weakness in the condo and co-op market, which is concentrated in overheated coastal parts of the United States,” Goldman said.

Other indicators mirror the trend. The average mortgage loan size is declining on an annual basis for the first time since 2001. And over the last year, the housing vacancy rate has risen at its fastest pace since data collection began in 1956. “Since excess supply is perhaps the most ‘leading’ indicator of market weakness, we would strongly caution against the assumption that the housing downturn is already entering the end game,” Goldman added. Mr. Toll echoed as much, warning that the slowdown could exceed two years: “It’s very hard to pick a bottom, and anybody that tries to do that is probably going to get fooled.”

Hard landing predicted for U.S. housing market.

National Bank Financial economists do not buy the idea that the housing market in the U.S. is coasting to a soft landing. And they are not the only ones pointing to the increasingly disturbing statistics on that market. Clément Gignac, chief economist and strategist, and Eric Dubé, an economist, noted that U.S. housing starts are already down 20.7% from their January, 2006 peak, “and some leading indicators are suggesting more declines are to be expected in the months to come,” they warned in a recent economic comment. They also noted that the National Association of Home Builders reported this week that traffic of prospective buyers had tumbled to its lowest level since 1991, a recession year. Furthermore, U.S. building permits have plummeted 22% from their peak last September. “These indicators combined with the skyrocketing inventory of new homes for sales are more consistent with a hard landing, rather than a soft landing scenario for the U.S. real estate sector.”

Other economists are also sounding the alarm about the U.S. housing market. David Rosenberg, North American economist at Merrill Lynch, referred to data from the National Association of Realtors in his morning market memo earlier this week. It showed that 26 metropolitan areas in the U.S. recorded year-over-year price declines in the second quarter. Moreover, he pointed out that “an increasing volume of homes are being put up for auction – one sign of an increasingly distressed market.”

The interactive housing bubble.

Thanks to the wonders of the Internet, you can now watch the housing market tank from the comfort of your own living room. Log on to Craigslist online classifieds, click on the real estate for sale section, and search using the keyword “reduced”. In some of the bigger markets, like Miami, you will find more than 850 matches for reduced houses and condos (and the site only saves posts for one month).

Click on your favorite overpriced listing and copy the address. Now go back and paste it in the keyword search for the real estate section and there you have it: All of the previous posts and prices for that one address. A lot of the homes I have found when performing the “reduced Craiglist” test on the Baltimore market had their prices slashed by $15,000 to $20,000 in less than a month.

According to this article from an industry publication, we could see more for-sale-by-owner homes listed as markets cool and sellers attempt to maximize profits by cutting out commissions. But as we have already seen, the FSBO crowd is already getting frustrated.

Foreclosures soar in North Texas.

More and more North Texas homeowners are in big trouble. Residential foreclosure postings are at record levels – up 30% from a year ago. More than 3,800 houses are threatened with foreclosure next month in the Dallas-Fort Worth area. And for the first nine months of 2006, more than 28,000 home foreclosure postings have been recorded. “This is bringing back nightmares of 1988 and 1989,” when thousands of Texas homeowners lost their properties during a regional recession, said George Roddy, president of Foreclosure Listing Service. “The average number of postings in 1989 was about 2,000 a month. And that is when we saw a massive devaluation of residential properties in some areas.”

This time, however, instead of a recession, poor financial planning and rising living expenses appear to be putting record numbers of North Texans out of their homes. “Some of the mortgage originators are not going over the worst-case scenario with borrowers,” said Gary Akright with Dallas’s Dominion Mortgage Corp.

“There are a lot of people out there who live on the edge,” Mr. Roddy said. “If our economy had stayed about the same as when they bought the property, things would probably be going OK for them. But add the tremendous increases in the cost of living, driving, cooling and credit cards, and it all turns bad. And of course, there have been bumps in interest rates which have dramatically impacted payments on adjustable-rate loans.”

The cash-out refinance has rarely looked so good.

Remember back when you refinanced your home mortgage to get a lower interest rate and pay less every month? How quaint. Now the rage is refinancing into a higher interest rate while pulling out cash. Almost nine out of 10 homeowners who refinanced during the second quarter “cashed out” additional money – often tens of thousands of dollars and more – according to mortgage investment giant Freddie Mac. The 88% cash-out refi rate was close to the all-time record and could surpass it later this year. Meanwhile, the typical refinancer has not been scouring the market for an interest rate lower than his or her existing first mortgage. To the contrary, according to Freddie Mac, most refinancers are opting for larger replacement first mortgages with rates averaging about one-half of a percentage point higher than on their old loan.

Should you consider a cash-out? Not unless you really need the money, you do not want to play roulette with an adjustable-rate equity line, and you want to lock in your mortgage debt at a relatively low long-term fixed rate. Check out fixed-rate second mortgages as well.

Homeowners say “Downsize Me!”

Americans are carrying a lot of excess weight and desperately want to slim down. No, not their waistlines – in the size of their homes. “Steeply deteriorating”. “Hard landing”. “Kaput”. These are some of the terms used by analysts to describe the slowing of the U.S. housing market. And with the glory days of home-price appreciation now over, some homeowners are declaring, “Downsize Me!”

Manufacturing job losses lead to drop in home prices.

The loss of manufacturing jobs helped drive down home prices in 26 metro areas between April and June compared with the same period last year, the National Association of Realtors said. That is 10 more areas than in the first quarter, and it spotlights how joblessness in industrial states such as Illinois, Michigan, Ohio and Indiana is rippling through housing markets. The hardest-hit this year? Danville, Illinois, where prices at which existing homes were sold fell 11% in the second quarter after a 12% drop in the first quarter. General Motors, General Electric and Hyster, a maker of forklifts, were among the companies to close plants in Danville, leaving behind hundreds of unemployed residents. The median price for a home has fallen to $65,200 – the cheapest in the country.

The exodus of auto, textile and other factory jobs has a direct effect on home prices. People leave town to look for work, boosting the supply of homes for sale. Others sell their homes because they cannot keep up with the mortgage. At the same time, foreclosure rates in these cities are among the highest in the country, and banks are quick to cut prices to get the homes off their books. “There were a lot of divorces, a lot of single mothers – all they could do is refinance their house or put it on the market and let it go cheap,” says Jerry Urich of Century 21 Home Team Realty in Danville.

Backsliding from conversion.

Easy money can do a lot of things and one of them is giving people a burning desire to purchase a condominium, even folks who previously failed to show a flicker of interest in owning the innards of a building, including those who were happily renting an apartment and spending their Saturdays at Starbucks instead of Home Depot. In the chart below, we see how the Fed’s No Renter Left Behind policy boosted the demand for condos in the last several years. For the record, existing condo sales increased 44% in just six years. And condo prices rose and kept rising, in part because new condo construction drove up the cost of materials, and because everyone wanted to participate in the American dream of owning their own interior living space. By June, prices of existing condos had jumped 87% in six years.

Easy money also gives developers the burning desire to sell condos, and lots of them. Just ask Ivana Trump whose knowledge of people who know about real estate is legendary. Ivana and her developers were all set to build a luxury condo tower billed as the tallest building in Vegas. But even with the full support of the Federal Reserve and the real estate community’s vow to avoid the word “bubble”, only seldom say “slowdown” and never, ever, say “crash”, Ivana and friends are changing their minds about selling air in the desert. She is not alone. One luxury condo builder in Florida told the AP that new orders fell 84% in the second quarter.

Part of the reason for the reversal in building plans is that the condo supply has been inflated by the conversion of apartment units for rent to condo units for sale. Interest in the conversion business is fading around the country. Nationwide, 28,000 apartments were converted to condos last September, the peak of the conversion frenzy. By June, so many had lost faith that converts only numbered 3,354.

The No Renter Left Behind Fed policy has also kept rents artificially low for years as the homeownership rate moved toward 68% after holding at 64% for decades. But now that real estate – both the real thing and inner space – has priced so many Americans out of the housing market, renting is becoming more attractive. And more expensive. Ironically, the consequent rent increases are playing havoc with the government’s inflation figures while exploding housing prices did not do much, if anything, to boost official inflation rates. Maybe easy money makes government economists do strange things as well.

SECRETS IN THE PIPELINE

Wall Street, where information is transformed into cold, hard cash, is also a place where secrets have their own special currency. And while trading on inside information, to most people, means buying a stock ahead of news that sends it soaring, whispers about events that might depress a company’s stock – such as an imminent securities offering that will dilute existing holders’ stakes —–can also produce stellar profits for those in on the chatter.

More often than not, according to recent regulatory actions and lawsuits, those in the know have been hedge fund managers. Over the last 18 months, the S.E.C. has filed four lawsuits against individuals and hedge funds that the commission said had profited on nonpublic information about stock offerings. Brokerage firms that underwrite stock offerings and thereby have access to potentially market-moving information are also being examined by regulators concerned about whether the firms are tipping off clients to deals. The hot tips at issue in these cases involve an increasingly popular type of security called a “private investment in public equity” – PIPE’s for short. These securities are not registered with the S.E.C. Companies that need cash quickly (sometimes because they are in financial trouble) sell PIPE’s privately to institutional investors, with brokerage firms getting a fee for acting as intermediaries on the transactions.

Because PIPE’s dilute existing shareholders’ stakes and are sold to buyers at a discount to the issuer’s prevailing stock price, news that such a deal is in the PIPEline can depress a company’s shares. Companies that issue shares this way are typically small enough that raising capital can have a more magnified impact on their existing shares than might be the case with a larger concern – making advance knowledge of a PIPE even more attractive to traders looking for stocks poised to head south.

Not every PIPE causes a company’s stock to drop. Measured Markets, a Toronto research firm that looks for anomalies in stock trading, examined PIPE’s valued from $100 million to $250 million that companies on the Nasdaq or the American Stock Exchange issued in the first half of this year. Only half – 9 of 18 – had their shares drop in the 30 days leading up to the deals. (One of the company’s stocks stayed flat and the other eight rose.) Of those that fell, the average decline was 8.6%. Of those that rose, the average increase was 20%. Measured Markets also identified unusual activity in one-third of the deals that lost value in the 30 days leading up to the PIPE. The firm’s analysis showed abnormal trading volume in the stocks, an unusual number of trades executed on certain days, or odd movements in stock prices – sometimes all three. The unusual trading occurred on days when no news or other public announcements occurred that might have affected the stocks. “Looking at our data on the PIPE’s examples felt like being in an episode of The X-Files,” said Christopher K. Thomas, founder of Measured Markets. “We could identify strange behavior, but had no explanation for it at the time or shortly thereafter.”

Regulators also say that the close and profitable ties between hedge funds, famous for seeking outsize returns on behalf of their investors, and brokerage firms eager for the unusually rich commissions the funds pay them, are rife with potential conflicts.

JUICY DETAILS IN OPTION SCANDAL

The stock option backdating scandal had not been reading like great fodder for Hollywood. Then the government laid out its case against former Comverse Technology executives. The court papers released last week are rich with material – imaginary employees, a slush fund named for “The Phantom of the Opera” and a botched coverup. Now we are getting the kinds of details that can overcome the eye-glazing effect that the term “option backdating” induces. More important, the Comverse case could put to rest the idea that what went on with stock options at many technology companies in the 1990s and early 2000s amounted to a minor bending of the rules – practices that, even if shareholders had known about them, would not have troubled anyone much.

Three years ago, the mutual fund industry had the same initial response to the trading scandal that ultimately enveloped it. Then, as now, many of the people involved asserted that very little of what went on rose to the level of a crime. But that was not true about abusive mutual fund trading, and the government clearly thinks it is not true about abusive option practices. “People who are trying to minimize this are missing the point,” says Harvey Pitt, a veteran securities lawyer and a former chairman of the SEC. “This is cheating. This isn’t an ambiguous situation.” The SEC says it has more than 80 companies under investigation for possible option abuses. Much more frightening to tech executives is that the Justice Department is bearing down with criminal cases, and has filed two in a period of three weeks.

At the heart of the backdating scandal is that some firms played fast and loose in deciding on option grant dates in the ‘90s and early 2000s. If you could cherry-pick the grant date, after the fact, you could boost the potential payoff from an option. In just one example from the Comverse case, the government alleges that executives had the voicemail-technology company’s board approve option grants on November 28, 2001. But instead of pricing them that day, when the stock closed at $21.01, the officers reached back to price the options as of October 22, 2001, when the stock ended at $16.05 – which just happened to be the second-lowest price of that year. So recipients of those options, who included the three executives charged in the case, had an instant paper gain of nearly $5 a share on those grants.

The former executives of New York-based Comverse, led by founder Jacob Alexander, had an even more complex fraud going for years, the government alleges: They created make-believe employees and submitted the phonied-up names to directors for option-grant approval. Those grants then were transferred to a slush fund account under the name of “I.M. Fanton”, which was derived from phantom – as in “The Phantom of the Opera”. The unnamed assistant who kept track of the phantom account chose that name because “it fit what he/she was being asked to do (i.e., create phantom employees),” an FBI affidavit filed in support of the government’s case against the Comverse executives said.

PENSION CHANGES: WHAT YOU NEED TO KNOW

The pension bill that President Bush is expected to sign into law this week represents the most sweeping changes to the country’s pension laws in more than 30 years. What does it mean to you? Basically, it is another step toward putting more responsibility on you to save for your retirement, rather than government and corporations taking care of you in your old age.

The legislation overhauls funding rules that have allowed companies to claim their pensions are financially sound even when they have staggering liabilities. The intention is to improve the health of corporate pensions, which have suffered low-investment returns, thanks to the bursting of the stock-market bubble and low interest rates. However, experts say that the bill also will speed the disappearance of traditional pension plans because companies will find them much more expensive to keep up. “It’s going to probably dampen what remaining employer support there is for defined-benefit plans,” said Norman Stein, a law professor at the University of Alabama and an expert in pension law.

Those that keep defined-benefit plans are expected to move toward cash-balance plans. The pension legislation created a legal framework to convert traditional pensions into cash-balance plans. In a traditional pension plan, workers’ pensions are determined by a formula in which years of service are multiplied by average pay in the worker’s last few years of employment, and then by a percentage, typically 1% to 2%. In such an arrangement, workers earn benefits slowly at first, but the curve gets steeper as tenure grows longer. So those who work many years at a company can earn substantial pensions, while those who work fewer years earn disproportionately less. In a cash-balance plan, the employer sets up a hypothetical account for each worker. Benefits accrue in a more linear pattern, so short-tenured workers end up with a better pension than they would under a traditional pension plan. With cash-balance plans, workers can take what they have in their accounts when they leave their jobs – making the plans ideal for younger workers, who tend to be more mobile during their careers.

FROM ONE TECHNICAL ANALYST TO ANOTHER

Bob Prechter is usually busy writing, but he was glad to take time to be interviewed by The Technical Analyst magazine for its July/August cover story. Here are a few of the questions and answers, which touch on topics that range from volatility to market theories to Bob’s long-term forecast.

Does very high (or low) market volatility make any difference to the formation of Elliott waves? Elliott waves predict high and low volatility. In the stock market, high volatility comes in wave 3 and sometimes wave 1. In commodities, it comes in wave 5. Corrective waves can sport extreme volatility, although it almost always occurs in subwave 3. High volatility helps clarity. Slow markets are harder to read. Volatility is also great for trading. I hate slow markets.

Do you see any clash between Elliott wave theory and the theory of market and business cycles? What can be said if the two do not coincide? It does not clash with our theory of the market and business cycles! Socionomic theory holds that social mood causes actions to express that mood, two of which are making investment and business decisions. A positive mood induces people to buy stocks and expand business. A negative mood induces people to sell stock and contract business. The latter activity takes time to implement. That is why the stock market turns before the economy.

Do you think Elliott waves work better in any specific markets (i.e., commodities) or over certain time frames? Elliott waves work better with markets that express overall social mood, such as the stock market. They also work less well the further one looks below Minor degree. The reason is that mass psychology is the only residue recorded at major degree, while all sorts of random or chaotic influences can distort the expression of mood at very small degree such as minute-by-minute.

What is your view of the current markets? Are we in an equity/commodity bear market, or are we seeing a correction in a secular bull market? What does Elliott wave say about this? We are in a global bear market in stocks, property, commodities and most bonds. It is the biggest bear market in 300 years. The overriding theme will be deflation. None of this is obvious to anyone yet, and when it is finally obvious to everyone, it will be over.

RICH MAN, POOR MAN

With the shutdown of the Trans-Alaska Pipeline, gasoline is not only expensive, but could soon be in short supply if you happen to live out west. But I doubt something like the 1970’s-style gas purchase rules – odd numbered license plates on odd-numbered days, etc. – would fly today, when Americans are increasingly reluctant to sacrifice anything at all, even a few days a week to fill up their tanks. However, sacrifice could very well be the new tune everyone is forced to sing as higher gas prices continue to take their toll. As the rest of this year unfolds, you will see revised earnings and slower sales at plenty of familiar retail and restaurant chains as the middle class is forced to curb spending.

I have read plenty of theories on how this will play out. Some analysts have said that rank-and-file middle-class workers will turn out to be the ones who will quit spending the most due to higher energy costs. High-end retailers will continue to perform well (the rich will always have money to spend), while places like Target and The Gap will suffer. But I am not buying it. The phenomenon Americans have been experiencing for the past several years is one of mass affluence. In order for companies that offer traditionally higher-end goods (think Starbucks and Tiffany) to continue strong growth, they have to appeal to a broader market: The upper-middle and middle class spenders.

Slate Moneybox columnist Daniel Gross spells it out for his readers in his August 7 column, “The Rising Cost of Living Well”: “Sales at Starbucks and its sister high-end retailers may be faltering because the cost of living well is rising more rapidly than the overall cost of living.” Starbucks disappointed shareholders with its most recent quarterly results. The coffee giant said that due to the summer heat, there were more orders for icey coffee drinks, which contributed to longer lines because they take longer to make. And longer lines caused more thirsty patrons to find their caffeine fix elsewhere. Gross sees the announcement as the beginning of hard times.

Gross continues, “Merrill Lynch economist David Rosenberg has examined the spending and consuming habits of his colleagues and clients on Wall Street and has created his own ‘Wall Street core inflation index,’ which tracks the rise in prices of the necessities of yuppie life: ‘jewelry, spas, lawn care, health care, sporting goods, housekeeping services, tuition, airlines, hotels, salons, legal/financial services, and dry cleaning.’ His conclusion: The price of spoiling yourself rotten is rising rapidly. ‘The Wall Street core CPI is running at 4%, nearly double what it is for Main Street,’ he wrote in a report on July 28. … In other words, forget about the heat and the Frappuccinos. Sales at Starbucks and its sister high-end retailers may be faltering because the cost of living well is rising more rapidly than the overall cost of living.”

Gross blames tax cuts and rising home values for contributing to the ranks of the mass affluent consumer. While this may be the case, it could go back even further. There was the great stock market run-up in the 1990s, where the average investor could get his hands on easy money. And if the tech bust of 2000 left you broke, there would soon be easy money to be found in your home. Don’t own a home? Not to worry … there is plenty of credit to go around.

The trouble with all of this is not so much that it is happening, but that even the companies are in denial about it. The Starbucks longer-line theory does not even come close to explaining what is really happening: It is getting too expensive for most people to maintain their current lifestyles. Many people have sustained for more than 10 years on the tech boom and the housing and credit bubbles. Will they be smart enough to alter their lives before they become a casualty of changing times? Unfortunately, many will continue forward like Starbucks, refusing to admit what has already arrived.

CAPITALIZE ON THIS SHOE CRAZE

Sometimes the best investment opportunities appear when you least expect them to. Last weekend, I was shopping with my wife … and when I say shopping, I mean I was dragged to the mall, kicking and screaming, as the watcher of my four-month old baby, so my wife could shop. Not that there is anything wrong with that, mind you. But as I walked, shoulders down, grim-faced, I noticed a gaggle of young girls screaming about the latest fashion craze in the window of the mall’s shoe store. “Like, oh my gawd,” one of them said. “I, like, must have those shoes.”

That is when I saw the next big investing opportunity sitting in front of me and I, too, found myself overjoyed with the opportunity. “Like, oh my gawd,” I screamed in my head. “This is the latest in funky footwear fashion that everyone has been talking about.” I am the last person to talk about fashion, but I do know a good investment opportunity when I see it. The company: Crocs Inc. (NASDAQ: CROX). The bulky shoes in your shoe store window are flying off the shelves quicker than you think. So fast, in fact, that this Colorado-based business quickly flew from $1.2 million in 2003 to more than $108 million by 2005 – quite impressive considering that in 2002, the company reported $24,000 in revenue and sold 1,500 clogs. Last year, they sold 6 million.

In February the company had its IPO at $21. Since then, shares have ranged between $20 and $37, and are currently at $25. Q1 revenues increasing 309% to $44.8 million, compared to the same quarter last year as net income tripled to $6.4 million, or 17 cents per share. Q2 was not too shabby either, as profits skyrocketed as sales of its clogs tripled on strong domestic and international demand, helping Crocs to easily beat Street expectations. Even better, the company boosted Q3 guidance well above guidance. Q2 net income came in at $15.7 million, after preferred dividends, or 39 cents a share vs. $3.3 million, or 10 cents per share on sales of $25.8 million. For Q3, EPS between 38 and 40 cents is expected on revenue of $87 million to $90 million.

We had been expecting a hot summer for Crocs, considering they sell sandals. And if you have not already taken notice, now is the time to. Why? One, there is seasonality. And two, not only is it cheap after being beaten down from $37 to $25, but look at the Q1 numbers. The company had about $45 million in revenue in the winter months. If people are paying for sandals in the winter, think of what they will buy in the spring and summer months. The raised estimates may be too conservative given the growing popularity of this type of footwear. Crocs is selling these shoes in 7,300 stores. 900 of those were added in Q1, and include the likes of Dick’s and Dillard’s. Even Wild Oats and Barnes & Noble are selling them. The best part – the bulky clogs, are winning over every one from food service personnel to nurses to boaters and swimmers, and beyond.

We are bullish on shares of Crocs under $26, seeing only explosive near-term growth. The stock’s secondary offering of 9.9 million shares forced the share price lower, making the stock a steal on the cheap.

A NEW DRUG SHOWS PROMISE OF GREATLY IMPROVING MEMORY AND ALERTNESS

A new drug shows promise of greatly improving memory and alertness for those with sleep deprivation as well as age-related decay. According to New Scientist, CX717, which is a member of the new class of drugs called “ampakines”, can increase alertness without any of the over-stimulating effects of substances such as caffeine. It has wide-ranging effects: Memory, attention, alertness, reaction time and problem solving all were dramatically improved in tests involving sleep-deprived men.

Ampakines boost the activity of glutamate, a crucial neurotransmitter. The body metabolizes them in just a couple of hours, so they have few side effects. While the drug was originally intended as a possible treatment for narcolepsy, jet lag, Attention-Deficit Hyperactivity Disorder (ADHD) and perhaps even Alzheimer’s Disease, it obviously will help healthy people as well. As a practical matter, the FDA never approves drugs for the purpose of making so-called healthy normal people better. (Don’t get me started on the FDA, which I have come to regard as a snake’s nest of political intrigue and machinations with a regrettably inconsistent connection to solid science.) Fortunately, assuming CX717 is approved for any of the above-mentioned conditions, your doctor can legally prescribe it to you for any purpose whatsoever that he or she deems appropriate.

I will be watching for approval of this drug and, assuming it shows no serious side effects, will recommend it in this space when available. Meanwhile, consider taking galantamine-containing supplements, such as Durk Pearson and Sandy Shaw’s GalantaMind, as well as a good source of daily choline. Galantamine is derived from the common snowdrop and other herbs. It blocks the age-related breakdown of the neurotransmitter acetylcholine, an essential molecule that supports memory function. Interestingly, it was used by the legendary Greek hero Odysseus, known as the champion of memory and enemy of forgetfulness, 3,200 years ago. Perhaps the ancient bards were attempting to encode valuable knowledge into legend.

THE PETER LYNCH OF BRITAIN

There is a very successful investor in England you have probably never heard of. Yet he has produced a 20% compound annual return for more than a quarter of a century, managing one of the largest mutual funds in the U.K. His sustained record of excellence earns him a number of superlatives, as well as the sobriquet “the Peter Lynch of Britain”.

I have come to believe that there are core elements to successful long term investing – elements that run through all of these stories of great investors. With this thought in mind, I recently picked up a book by Jonathan Davis entitled, Investing With Anthony Bolton: The Anatomy of a Stock Market Phenomenon. Bolton runs the Fidelity Special Situations Fund (U.K.). He works in the heart of London. His guiding philosophy: “If you want to outperform other people, you have got to hold something different from other people. If you want to outperform the market, as everyone expects you to do, the one thing you mustn’t hold is the market itself.” In other words, the successful investor does not fear straying from the herd. In fact, Bolton relishes “turning over stones” in search of overlooked opportunities. He also advocates a long-term perspective. Do not do a lot of “dealing” – or trading – as he says. Give your ideas time to work out. Think years, not months.

Like most successful investors, Bolton suffered a few setbacks along the way. He invested in companies, for example, that ultimately went bankrupt. In 1990, Bolton’s fund lost 28.8% of its value for the year. He followed that with a paltry 3% return in 1991. That is a 2-year stretch when investors did not make any money following one of the greatest investors of our time. And despite this and other periods in which Bolton trailed the market, or lost money, his overall track record puts him in the Hall of Fame. “Investment is an odds game,” Bolton explains, “No one gets it right all the time; we are all trying to make fewer mistakes than our competitors. In fact, the key to this business is as much to avoid losers as it is to pick winners. On the other hand, running money with a style that is so defensive that it avoids all losers is also, I believe, counterproductive to superior returns.”

Bolton has the ability to “shrug off the occasional failure … confident that the gains will on average outnumber the duds.” Investing takes some balance of courage. You cannot believe every flesh wound is mortal. Part of successful investing is an ability to stick to your discipline, even during stretches when it appears not to be working well. Bolton, as with many great investors, does not switch horses mid-race. That does not mean he is sure of everything he is doing. And this is an interesting psychological part of investing that you do not hear all that much about. When conviction is high, then you make big bets. When conviction is low, you should sit on the sidelines or invest smaller amounts. One misconception people have about the great investors is that they are always sure of what they are doing. “You are in a constant state of questioning your convictions.”

Bolton does not spend much time on macro forecasting, instead working to understand individual companies. This is where you can build an edge. He invokes fellow Briton Jim Slater’s Zulu Principle: “If you are expert on something, however small it may be in the broader context of things, you have an advantage over other people.” He also focuses on balance sheets: “One vital lesson I have learned, is that when things go wrong, the companies I lost the most money on were those with weak balance sheets” … and cash flow: “The ability to generate cash is a very attractive attribute. In fact, the most favorable of all attributes.”

Bolton’s core investment principals reinforce the lessons I learned during a decade of banking. A strong balance sheet and copious cash flow do not guarantee investment success, but they certainly reduce the odds of failure.

THE U.S. HEALTH CARE FIASCO

In “Medical Tourism”, on July 12, I noted that heart care surgery, which costs in the region of $30,000 in the U.S., can cost as low as $8,000 in India. I asked a couple of simple questions at that time: (1) Why have routine (and not so routine) medical and dental services performed in the U.S. when you can have them done cheaper elsewhere and get a free vacation out of it to boot? (2) How much longer will it be before some HMOs require someone to fly to India or Thailand for treatment? It did not take long to get an answer to those questions. The LA Times on July 30 reported, “U.S. Employers Look Offshore for Health Care”.

Is India a Solution? It seems to me a better question is “Why isn’t India a solution?” The market (via India) is providing a wonderful solution to highly priced and overrated U.S. health care services. If I were a major medical provider in the U.S., I would start offering lower rates to anyone willing to travel. I would also be contracting for services in India, Bermuda, and Mexico. Why fly to India, when flights to Mexico are cheaper? Take $6,500 for a coronary artery bypass surgery. Add in another $3,500 for plane fares and other miscellaneous expenses and the cost is still less than one-sixth the price of the same operation in California. Without the leeway, it is one-tenth the cost.

The price of medical services – as with the price of houses – has outstripped people’s ability to pay for them. The market is finally weighing in on the situation. It has decided that a coronary bypass operation should cost $6,500 (plus travel expenses). I agree. Given enough time, the market will gravitate to the low-cost provider if quality remains constant. In this case, medical care in India may actually be of higher quality. It just takes time for the masses to learn about those options, and the education process is now underway.

So far, it seems that it is mainly self-insured companies that are taking the “medical tourism” route. At those savings, how long will it be before some major company like Citicorp or ExxonMobil decides to do the same with its health care plan? The U.S. has the highest health care costs in the world. What are we getting for it? Our laws (essentially written by pharmaceutical companies) ensure U.S. costs will always be highest. We cannot import drugs from Canada or other places. That will change, simply because it has to. Something like 70% of all health care costs are incurred in the last year of someone’s life. That, too, cannot last. By definition, if something cannot last, it will not, but the path from here to there is likely to be a long one.

The Huffington Post is reporting, “Cuba Has Better Medical Care Than the U.S.”: “Figures from the World Health Organization clearly show that The United States lags behind 36 other countries in overall health system performance ranging from infant mortality, to adult mortality, to life expectancy. … The U.S. health system looks especially dysfunctional when you consider how much money we spend per capita on health care – $6,0000-plus per year, twice as much as any other country – and how little we get for it. Canada spends $2,163 and boasts a life expectancy of 79.8 years, 2½ years longer than the U.S. … Switzerland spends about 11% of its gross domestic product on universal health care for all its citizens, while the U.S. (with 50 million uninsured this year) spends 15% of GDP, with embarrassing results. One grand irony, Cuba, whose economy has been bankrupt for the last decade – food shortages, drug shortages, chronic unemployment, etc. – and which annually spends a miserly $185 per person on health care, has better infant and adult mortality rates than the U.S., and has a life expectancy nearly equal to ours.

“Why has our vaunted free enterprise system … failed so completely with regard to this most fundamental need? Simple, buyers don’t shop for health care. Sick people don’t negotiate with doctors or hospitals or drug companies. They don’t care what it costs; insurance or the government will pay. This vulnerability has been exploited and hijacked by greedy doctors, drug companies, insurers, personal injury lawyers, HMOs, and hospitals. About 50% of health care funds never even get to doctors or hospitals – which themselves run bloated operations. Maybe we have finally reached the ‘Tipping Point.’ Not because people are needlessly dying, but because big business is being crippled by astronomical health costs.”

Please consider the article “Inside Job: How Humana and other insurance companies rigged the Medicare prescription drug plan”: “Last week saw the news that Humana, one of the country’s largest health insurance companies, experienced much better second-quarter earnings than had been expected. The announcement amounted to confirmation that the Medicare drug benefit is working exactly as planned – not for the people enrolled in it, but for the insurers who drafted it. … [Humana CEO Michael] McCallister told analysts … that the Medicare business was ‘a long-term growth engine’ for the company. Indeed, Humana and UnitedHealth/PacifiCare together cover nearly half the seniors who have enrolled in drug plans.”

It is time to cut out the middleman. If we are going to have our laws written by lobbyists, let us hire lobbyists directly, as opposed to senators and congressmen who are supposed to represent us. At least the system would be more honest. As for now, if you want great health care for cheap, you head to India. If you want low-priced drugs, you head to Canada or Mexico. If you live in the U.S., you are screwed.

YUAN GAINS MOST SINCE PEG ENDS AS CHINA ALLOWS IT TO TRACK ASIA

China permitted the biggest gain in the yuan since ending a peg to the dollar in July of last year, a day after allowing the largest decline, suggesting the central bank is easing controls over the exchange rate. The yuan rose as much as 0.24% against the dollar on Wednesday, as 13 of 15 leading Asian currencies climbed. The central bank on August 9 said it would allow more “flexibility” in the new system, which allows the yuan to float with reference to currencies of leading trading partners.

Allowing larger swings would help ease tensions with the U.S. and Europe as long as it results in a stronger yuan, which has advanced only 1.5% against the dollar since the currencies were de-linked. Lawmakers in the U.S. blame exchange rate manipulation for a flood of cheap Chinese imports, lost manufacturing jobs and the nation’s record trade deficit. “China is indeed loosening control and allowing the yuan to move in line with other currencies,” said Hideki Hayashi, a foreign-exchange strategist in Tokyo at Shinko Securities Co., a unit of Japan’s second-largest lender by assets. “The yuan will gradually strengthen.”

China says it allows the yuan to rise or fall by a maximum 0.3% from a “reference” exchange rate it sets every day. The yuan has never traded up or down that much in a single day. The central bank says it sets the rate each morning by averaging prices from lenders it appointed as market makers, as well as using a basket of currencies to manage the currency. “There’s some in the market who say China just flips a coin and some who say they use a trade-weighted basket to set it, but either way it’s very unclear,” said David Mann, a currency strategist at Standard Chartered Bank Plc in Hong Kong. “There certainly seem to be bigger moves at the moment.”

GOVERNMENT EXACERBATES THE HOUSING BUBBLE; MORTGAGE INSURERS ARE SET TO GO HURTING

Preoccupation with the housing market has become more than a national pastime in the U.S. It is now vital to the continued growth of consumer spending, and by extension, growth of the economy. About 9-10% of the housing market turns over every year. Compare this low turnover with volume in the stock market, where the typical S&P 500 stock has about 150% turnover per year. You can be reasonably sure that the stock sitting in your portfolio is worth within a fraction of a percent of the last tick. The low housing transaction volume makes aggregate national housing value statistics misleading. The near-term value of your house is completely dependent on what current shoppers are willing and able to pay for your house. The “willing” part is psychological, and psychology has morphed from “my house will appreciate 15-20% per year” to “my house will appreciate 8% per year.” The “able” part is dependent on global liquidity and mortgage financing aggressiveness.

When studying the housing bubble’s formation, it is crucial to take a good look at the federal government’s historical promotion of homeownership. The first influence that comes to mind is the obvious effect that GSEs Fannie Mae and Freddie Mac have had on mortgage banking – they constantly replenish the firepower of mortgage originators, allowing originators to rake in fees for each approval. Due diligence on risk now rarely goes beyond checking off credit score and income range boxes, often over the phone or online. The Federal Housing Administration (FHA) was created in the 1930s to stoke the housing market. It provides default insurance for lenders leery of homebuyers without the ability to afford the high down payments required for mortgages. In hindsight, the consequences are clear. The artificial influence of government-subsidized housing is resulting, and ultimately will result, in a gross misallocation of resources, and usually asset bubbles.

Decades of housing market inflation attracted several private companies to enter the mortgage insurance business. They viewed it as a no-brainer investment to take on the risk of default in return for modest monthly premiums. It is important to respect the government’s aggressive response to the private sector’s share gains in this market. It is one of the many threats to the company I am recommending to my subscribers as a short opportunity.

The private mortgage insurance industry was invented in 1957 by Max Karl, the founder of Mortgage Guaranty Insurance Corp. [MGIC, or “MaGIC”], after he observed a disconnect between those who could not afford a 20% down payment on a house and lenders who, for good reason, avoided extending mortgages with greater than 80% loan-to-value ratios. Until Mr. Karl’s entrepreneurial venture, the FHA had a monopoly in the mortgage insurance business. Memories of the Great Depression were still fresh in the minds of bankers in those days. They respected the importance of avoiding overexposure to mortgage debt in a long economic downturn where job losses were involved. But Mr. Karl clearly saw an opportunity to bridge the gap between mortgage buyers and mortgage sellers by assuming a portion of default risk in return for premium payments. This evolution of the insurance industry has undoubtedly contributed to the nonstop buying pressure on housing over the past 50 years.

This sounds like a cash machine-type of business, provided that premiums are priced at a highly profitable level (“piggyback” loans and the FHA are a threat to this), housing prices do not decouple from income growth (they have), and the willingness of lenders to extend mortgages does not fall short of required demand (this looks like a distinct near-term possibility). Two widely respected economists assert that in order for the U.S. housing market to sustain current price levels, either household debt must continue growing exponentially or real wage growth must revive from its current doldrums. Poorly written mortgages can quickly turn sour. As this unfortunate occurrence spreads more widely across the U.S., mortgage insurers will transform from cash-generating businesses to cash-burning businesses in a heartbeat.

DEPRESSION AND EMPIRE

Predicting depression is one of the hardest chores a financial analyst can ever undertake. People have an obvious economic incentive to avoid getting into a state of general impoverishment, and governments have an equally obvious incentive not to be tarred and feathered in the history books for allowing it. This incentive is so powerful that any popular book explaining the cause of a future depression, no matter how tightly reasoned and realistic it is, often deals itself out as a predicative tool. Forewarnings are always forearmings, at least to some. Thus, a successful prediction of a depression is, to the financial analyst, as much a feather in the cap as an undefeated record is to a chess champion. People who achieve either are not just kudoed, but practically worshipped for doing so.

There is an unusual split in depression analysis, one whose sides play off each other. The mainstream theories focus upon what could trigger a depression. The simplest ones are all variants of confidence theory. The more sophisticated ones do attempt a causal analysis, but wind up becoming trigger theories by concluding that a government agency, or the public, brought ruin to paradise through certain mistakes. What all trigger theories have in common is the assumption that everything was fine in the pre-depression economy, or would have been if those mistakes had not been prefaced by immediately previous “irrationality”.

A deeper analysis rejects that assumption, and substitutes a more long-range causal analysis for the short-termism in all mainstream explanations. According to causal theories, depressions expose a structural weakness in an economy that appears fine, but is not. The Austrian theory, as explained in Murray N. Rothbard’s America’s Great Depression, singles out the instability that is created by central bank creation of business credit out of thin air. Once it permeates the economy, thanks to the fungibility of credit, the stage for future decline is set. A depression is caused by the general realization that the supposed real wealth backing some of the credit simply is not there. Depression results from a large number of malinvestments, ones that are the result of central bank interference with the credit market, being exposed as such, quickly.

Forecasts of depression based upon the inflation-of-business-credit theory are apt to go wrong because government has an obvious reason to keep the credit bubble going. Keeping the show going keeps the governed from getting angry at the government. Letting the credit bubble get out of hand will induce anger of a different sort, even if the blame is sometimes displaceable onto parts of the private sector. Governments, therefore, also have the incentive to partially deflate the credit bubble from time to time, usually in response to general price rises becoming unacceptably rapid. (This rise in the price level results from the proceeds of the thin-air credit being spent.) The mainstream synthesis in economics is based squarely upon this call-it-as-you-see-it approach. So is the mainstream conclusion that the needed juggling act can be kept up forever if mistakes are avoided. Earlier forecasts of depression that have been wrong, or mistimed, are held up as evidence that causal theories, including the Austrian one itself, are wrong. The causalists respond that governments have simply pulled out new tricks to keep the bobble game going.

It should always be remembered that mechanistic economic theories presuppose that economic agents act like robots. These theories make a kind of sense in times when sticking to habit is economically rational. When a wide-scale change in habits becomes economically rational, though, those previously accurate-enough mechanistic theories turn vacuous. The collapse of the mainstream, with the consequent pinning of blame for depressions where it belongs by citizens, is a frightening prospect to its members. So, both they and the government itself have a large incentive to find, and reach for, any funds needed to keep the credit bubble from being punctured.

It is true that the much-forecasted Greater Depression in the 1990s never took place. What should be examined is why. To put it bluntly, the American economy was saved from depression in the 1990s by its permanent trade deficit. This deficit, and the consequent accumulation of capital in foreign hands, has been diverted largely to increases in foreign holdings of U.S. securities, primarily the debt obligations of the U.S. government. This agreeableness of creditor nations, held in place by the underlying fear that refraining from this helpful rollover will trigger a trade war, is the patch job that has kept the debt-ridden U.S. economy from imploding into a deflationary depression.

This stopgap is the current reason why the forecast of depression made in an otherwise erudite and insightful book, The Great Reckoning by James Dale Davidson and William Lord Rees-Mogg, was one of the two main predictions in it that have not stood the test of subsequent events. The second was a forecast of the U.S. declining in power and influence. (The other predictions have fared better.) Both the continuance of U.S. prosperity and the emergence of a full-blown U.S. empire do feed off one another.

If this was all there was to the case for permanent U.S. ascension, then it would be time to roll out the predictions of depression again. There is, however, a new fallback this time, one that will keep feeding the aggrandizement of the State. The crucial difference between the past hegemony of the U.K. and the present hegemony of the U.S. is that the British Empire’s was creditors’ hegemony, while the U.S.’s is debtors’ hegemony. The debtor nation is the one who’s doing the fighting for the creditors. This position, geopolitically, is much more advantageous than it seems. One of the insights in The Great Reckoning worth remembering is that debtor nations suffer less from global depression than creditor ones do. The consequent implosion of financial assets all but ensures it. If a deflationary depression should visit the world as of soon, then America’s creditor nations will suffer more than America itself. It is plausible to assume that the creditor nations are so agreeable because they know it, or have been made aware of it.

U.S. militarism fits neatly into this precipice if it is added to the U.S. government “doing its part.” The bargain cut seems to be this: the U.S. citizenry does the bulk of the fighting, the killing, the dying, and the consuming. The others supply the preponderance of goods and credit, in part as matériel. This kind of reciprocity keeps an increasingly unstable global economy going. Economically, the cobbling together of this international credit tie implies that there will be no depression soon, despite the increasing debt overhang that will trigger one eventually. The U.S. Keynesian system has kept itself running through putting pennies in the fuse box, and through shifting appliances from one circuit to another. There may very well be more fuses that can be replaced in an emergency.

SILVER TO THE PEOPLE!

Wow! Is it really almost time for another Silver Summit? How time flies when we are in a precious metals bull market! I cannot get there this year, but I hope to in 2007. The Silver Summit needs an optimist to offset the cloud of gloom and doom that hangs heavy over Mogambo’s head!

The Optimist views physical silver in your possession not as an investment, but more like an insurance policy against some of the really dreadful events or situations that we could see in the years ahead. It is, unfortunately, easy to imagine the possibility that the U.S. dollar could degenerate in value so much and so quickly that it would no longer be an acceptable medium for purchasing the reduced quantity of items that may still be available for sale. It is possible that other paper currencies, which are all just fiat I.O.U. Nothing pieces of paper, could also become unacceptable in trade for goods or services. I saw something like this many years ago when a porter happily accepted a U.S. dollar as a tip (Yes, Virginia, there really was a time when the U.S. dollar was a desirable currency!), but he absolutely refused a ten million note from an adjacent nation, even though that note cost me $2 to purchase at the prevailing (but rapidly deteriorating) exchange rate. Although the obvious store shelves may be empty, there could be back rooms filled with items (Yes, Mogambo, including pizza and ammo!) for sale to people who have an acceptable means to pay for those items. In the midst of a currency crisis, the list of acceptable means will probably not include plastic or paper currency regardless of what color the paper is or what numbers are printed on it. Physical silver and gold (preferably in a form that is easily recognized to be authentic), however, will always be an acceptable currency for any transaction.

Surely, there must be something useful one can do with a massive amount of physical silver that is safely stored away as insurance for when we will really need it. One can get a little bored while holding a life preserver on the deck of the Titanic waiting for the rendezvous with a large ice cube. Some readers have asked me about swapping silver for gold after silver makes a spike higher in price. My view is that gold will go much higher in price over the years ahead, but silver is likely to continue to appreciate faster than gold. The Optimist views his purchase of physical silver as a one way street, in which silver is only accumulated but never sold, until there is so much chaos that the economic traffic laws no longer control the flow of financial traffic. Then will likely be a time when I will be very happy that I have whatever amount of physical silver I was able to safely store away.

OK. Let’s talk trading. Everybody, including me, wants to sell the high tic in every major thrust higher, and then buy back lots more near the bottom of the blistering correction that will happen immediately after we take our profits at the top. When we look at a chart, it seems so easy that we could have sold the previous highs, and then bought back the following lows. Anyone who can do that in real time, however, has more than my respect for his skills as a master trader. He also has an infinite amount of profits, and he could not care less if I respect him or not. I made the decision some time ago that the physical silver I purchase is not for sale, at least until after the economy’s foul smelling refuse encounters the inevitable rotating blade. Rather than drag out my stash of silver when I want to take partial profits near the top of channel, I keep a reasonable amount of funds in the paper world of investments. That makes it easy to sell a little when the markets seem high, and to buy more later at lower (hopefully) prices. There is no need to consider reducing the value of my physical silver insurance just to take a few paper profits.

There are also other things to purchase with our abundance of profits from precious metals. Personal security is near the top of the list, and this seems like a good time to allocate a significant amount of resources to enhance the personal security of one’s self and family. In a recent article titled “You Can’t Eat Gold”, David Andrews highlights some interesting observations about preparing for the bad times ahead. The Optimist’s positive perspective is that with appropriate planning, we can keep our stash of silver safe for the bad times ahead and use other funds for essential preparations.

Alert readers of the preceding paragraphs may have noticed that the Optimist does not recommend selling any physical silver. Not now; not later; not ever! Physical silver is like a fire insurance policy that should be saved for use when the economic structure is on fire. There is, however, one exception. The Optimist recommends that all of us make an effort to invest some silver. Consider, for example, that you and family or friends may go out to dinner this weekend. If the bill runs around $100 and the service is OK or better, then you will likely leave a tip of 20%. Instead of leaving cash, the Optimist encourages you to leave the equivalent amount of silver instead. Since silver is no longer legal tender, we can not pay our bills in silver, but we can leave gifts of silver anytime that we would have left gifts of cash instead. Note that giving gifts of silver does not deplete our stash of physical silver safely stored for the bad times. We can just use the fiat cash we would have given, and purchase more silver for gifts with that cash, so there will be an unlimited supply of silver we can invest.

The Optimist hopes that by distributing silver back to the working people of America, and educating them about the concept of real money in the process, we can expand our list of supporters from just a few hundreds to hundreds of thousands. Real silver coins closely resemble the cheap slugs that replaced them, so make sure you accompany the gift with an appropriate explanation. You do not want a waitress to dream about bad things to do with your food the next time because you only left her two quarters as a tip for good service after a $20 meal! It would be a good idea to also leave a short note with an explanation that silver is real money to save instead of spend. Giving silver to the people, so they too can begin to save real money, will help to make the future better for everyone. Cheers!

REMEMBERING THE CONGLOMERATES

The first stock market new era that I lived through and traded in was the go-go 60s. A major glamour group in those days was the conglomerates. Originating in the 50s, these were companies like International Telephone and Telegraph (ITT), Ling-Temco-Vought (LTV), and Textron that built themselves up by acquisitions of unrelated companies. Conceptually, the conglomerates became somewhat like closed-end mutual funds, but with a greater hand in running the companies in their portfolios. Closed-end funds usually sell at close to book value or slightly less. But the conglomerates sold at premiums in the 60s. Furthermore, their operations were not especially profitable or safe, and they also carried more debt than average. They seemed overvalued. They were glamourous.

For quite a few years, the conglomerate stocks rose and rose, and to this day I do not think anyone knows exactly why. What tempted investor psychology appears to be that the mother company seemed to promise new types of economies of scale, called synergies in those days. Meanwhile there were realities. The conglomerates were paying big premiums over market value when they bought out companies. If there were to be economies, the selling company shareholders of the target firms were getting the lion’s share. How one company could create value for its shareholders by paying a big premium over market value to buy another company in an unrelated industry was a mystery, then and now. The company heads were empire-building. They were being paid according to the revenues they managed, so they grew revenues by acquisition. Seeing through the accounting for dozens of acquisitions was exceedingly difficult. Most did not try. Eventually, Abraham Briloff single-handedly exposed the accounting peculiarities in a series of articles in Barron’s. He punctured the balloon and conglomerate stocks began to underperform the market. Fortunately, the worst was not all that bad. The conglomerates always held the companies they had bought. There was hidden value in the portfolio always waiting to be unlocked. The time would come when it would be unlocked.

Eventually Wall Street marked conglomerate prices down along with other stocks. The new era ended. Bear markets proliferated and turned into a secular bear market that lasted for 16 years from 1966 to 1982. Meanwhile academic finance came along. Having arrived after the conglomerate era, it did not pay as much attention to it as it merited. But it paid some. The research showed that, after the glamour period, conglomerates came to sell at a discount to what their pieces will bring if they are sold off in the open market. Like a closed-end fund, the whole was worth less put together than if taken apart. The conglomerates of the 50s and 60s got new management in the 70s, and the managers realized that they could make money simply by de-conglomerating. Thus began an era of breaking up companies into pieces that extended into the 70s and 80s. The conglomerate era began to run in reverse. The goal became to create sharply focused businesses.

The old conglomerates sold and spun off units with abandon. They created value by doing so. New, stand-alone companies suddenly acquired the will to innovate and prosper when the managers could reap more of the benefits of good decisions and see less of it taxed away by central management. De-centralization worked. Business gurus noticed something they had missed before. Businesses that seem close together, like publishing books and publishing magazines, can be quite different. They frequently can be managed better by separating them. Conglomeration is a minefield of problems. Whenever a company begins to acquire others, let the investor beware. On the other hand, after the inefficiencies of conglomeration result in the stock price being beaten down, an investment opportunity arises. There is value waiting to be unlocked in such a company. If new managers or even the old managers switch gears and start a policy of selling off companies, this will create value.

Human beings are adept at rationalizing all sorts of things they observe. The number of explanations of why conglomerate prices rose was large, and many of them had surface plausibility. Upon reflection, the order of magnitude of the proposed synergies could not reasonably account for the stock price increases. But sober and orderly reflection was inundated by the sheer number of stories, the publicity, and the fact of rising earnings and rising stock prices in a bull market. Let the investor beware of being carried away. This is hard to learn. A simple rule of deferring any purchase one is anxious to make will help. A rule of weighing the prospective gains against the losses will help. Most of all, if one cannot understand the reasons for investing and if those reasons do not make sense, then do not invest.

De-conglomeration in the modern era continues in new ways. It means creating businesses in which even the basic functions that used to be housed under one roof are separated. A business may farm out its accounting, its cash management, its production, its marketing, etc., or even sub-functions of these, in order to achieve efficiencies. Contrary thinking warns us that this too can be overdone. What is inside a firm and what is outside a firm, where market prices stop and where they start are open matters. One wonders what a firm is. However firms evolve, those of us who made our first forays into the stock market in the 60s will fondly remember the almost daily excitement of a new conglomerate acquisition.

COL. DRAKE AND THE AGE OF OIL

There he was, as big as life and looking quite good for a man who died in 1880. I was on a visit to the Drake Well Museum, just south of Titusville, Pennsylvania. I was walking into the museum compound, and whom should I encounter but Col. Edwin Drake, dressed in the period garb one is accustomed to seeing in the grainy old photos. OK. It was not the real Col. Drake. This fellow is an actor who has been playing the role of Col. Drake for about 10 years. He gives talks to museum visitors and appears in films or news articles that call for a Drake look-alike. He has read much of the literature available on the life and times of Drake, he dresses for the part, and he is just the plain old spitting image of the famous man, down to his bushy brown beard. He is as near as one can get to being in the company of the famous man, and his life and remarkable times.

“Let me make something clear,” said Drake. “It was not I who found the oil of Titusville fame. The area is one of many oil seeps, from which petroleum simply flows from the ground and then runs down into the creeks and streams. … [M]y achievement was not really in discovering oil, because the oil was already there for the taking. Nor was it my idea to use the oil for whatever purpose, because there were others who came before me. It was not even my role in history to extract the oil by digging downward for it, because others were already attempting the same thing. But my most notable accomplishment was in applying the concept of using a conductor pipe to protect the walls of the drill hole on the way down to the oil-bearing formation. This technique is still in use today, and is the foundation of the technology upon which is built the modern oil industry.”

Col. Drake brings up many good points that serve to explain the origins of the oil age, if not the origins of modern history. Why do some things happen the way that they do? What makes history? People had known about the oil of the Titusville region for at least many centuries, certainly long before it was called Titusville. Why did the Seneca Indians, or their more ancient forebears, not usher in the Age of Petroleum? In another part of the world, by comparison, starting in the 16th century, the Spanish were importing barrels of oil from what is now Trinidad and Tobago, as well as from Venezuela. The queen of Spain, among others, used the oil to treat various family ailments. And people certainly knew about digging pits, if not making holes in the ground, as well, long before Col. Drake muddied his boots along the banks of Oil Creek. At about the same time that Drake was drilling his well in Titusville, other people were drilling holes in the ground in what is now West Virginia and eastern Ohio and southern Ontario near Petrolia. Again, why does the credit for ushering in the Age of Petroleum go to Col. Drake?

What created the modern petroleum industry was a confluence of circumstances, and certainly of events. Col. Drake’s innovation in driving a hole into the earth was just one of many things along a long chain of events. The oil, of course, had to be there, and Titusville was the right place with its relatively shallow oil-bearing rock formations. And one of the principal virtues of the Seneca oil was that it was (and is) devoid of asphaltic fractions. It is light, sweet, and even smells kind of good. But science also had to advance to the point at which there was a rational, if not economic, purpose behind the demand for what Col. Drake called “large amounts” of oil.

Backed by the Connecticut investors, Col. Drake perfected a means to extract oil by drilling a hole lined with conductor pipe. But Col. Drake may not have been the first person to do this either. But after Drake’s well came even more wells. By late 1860, the wells were starting to come in on a regular basis and oil drilling was becoming a relatively predictable business. And then came the U.S. Civil War. U.S. federal expenditures skyrocketed, and the central government rapidly exhausted its reserves of gold and silver. The U.S. government resorted to issuing paper currency, the well-known “greenbacks”. These fiat dollars flooded the U.S. economy, causing a general inflation in price levels. People who understood the nature of inflation were keen to find some means of protecting their purchasing power. Then as now, money flowed into hard assets, and there are fewer assets harder than bedrock sandstone filled with oil.

Much of the federal spending for the Civil War would end up in the pockets of two classes of people: New York bankers and Pittsburgh industrialists. It was this mixture of capital and industry, building upon the presence of oil, a scientific use for the substance, and a novel means for extracting it, that sparked the world’s first true oil boom. Even in the midst of a general Civil War, the New York money flowed to the iron mills of Pittsburgh to purchase pipe and other equipment to install in the oil patches of Titusville. The foundries of Pittsburgh could just as easily roll tubular goods for the oil fields as cast cannon for the Union Army. The equipment shops of western Pennsylvania could just as easily manufacture pumps and gear drives and sucker rods as any other implement of war. And so they did.

As a necessary concomitant of the oil boom, the Civil War itself created a vast underground army of laborers for the oil fields – including deserters from combat on both sides of the fight, draft dodgers, immigrants from foreign shores, and freed slaves who were searching for work away from the sound of the guns. Thus did the U.S. Civil War bring together a large amount of new money, invested in leaseholds in the oil country of Titusville, plus capital equipment and a ready supply of labor. Here was the confluence of events that sparked the modern petroleum industry.

As the oil wells came in, they sparked an oil boom in the mid-1860s. Production soared and prices crashed. Investment waned, and by the late 1860s, the price of oil was drifting upward again. There was another boom and another bust in the early 1870s. The industry was irrational from an economic perspective, and something had to happen. Something did happen, in the form of a man who desired, and eventually acted, to bring some semblance of rationality to a chaotic industry. He was a businessman from Cleveland, Ohio, named John D. Rockefeller. He conceived a method of bringing a certain sense of standardization to the oil industry, and eventually did exactly that. Without Rockefeller’s effort, one wonders where the oil boom would have gone. Where would we be today? We are all both products and prisoners of history.