Wealth International, Limited

Finance Digest for Week of August 21, 2006

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


Several months back, as the U.S. appeared headed for a confrontation with Iran, oil prices soared. Energy stocks moved higher with almost every wire report. But once tensions decreased, oil stocks tumbled. Early in July inflation indicators turned negative, and the overall stock market seemed about to drop into the abyss. Then as soon as the inflation outlook seemed less threatening, stocks and bonds rallied. You can trade yourself poor buying and selling on news like this.

Many investors, individual and professional alike, react to each news release like Pavlov’s dogs. In the early 1980s, when the Federal Reserve was battling double-digit inflation, announcements about the money-supply gauges (M1, M2, M3) moved markets. Today the M’s are long forgotten. Now people become hysterical over oil inventories or the Consumer Price Index. If the news is better than expected, the DJIA shoots up 150 points. If worse, the drop is just as steep. Hedge fund managers, day traders and swarms of other quick-buck types trade instantly to get the edge from news flashes. Maybe you can make money trading on these moves, but only if your transaction costs are nil and your computer is 10 seconds faster than every other trader’s. Neither condition holds.

Sometimes you can ride a long trend that is impervious to daily news bursts. The day traders of the late 1990s had the powerful upward momentum of the dot-com stocks on their side and rolled merrily along for a good while. Then they got hammered, and tech stocks have been a volatile sector ever since, subject to the whims of the news cycle. Stay away from the trading trap and stick to fundamentals. Buy stocks that are cheap and whose outlooks are good. Ignore the weekly wiggles in prices. Think of long-term risks and long-term rewards. Here are three companies to look at. …

Link here.


What treasures, what pitfalls lie in the murky territory beyond a company’s balance sheet? With help from analysts, real estate professionals and private equity dealmakers, we mined for real estate value at non-real estate companies. First an accounting primer: Companies generally carry real estate at historic cost, with no obligation to reveal, even in a footnote, what the fair market value of that real estate is. In this regard real estate is unlike inventory, investment securities and receivables. The march of time (and in some cases deductions for depreciation) make the book value of long-held real property a fiction.

Asset strippers and takeover tycoons make fortunes unlocking value hidden in real-estate-rich corporations. A quarter-century ago Carl Lindner did that by acquiring control of the previously bankrupt Penn Central, which owned plenty of urban real estate. In 1995 Steven Roth snapped up Alexander’s, an inept department store chain, thereby getting his hands on a block of Manhattan that housed the firm’s flagship store. Roth’s Vornado recently put a 55-story skyscraper on the site. Hedge fund operator Edward Lampert is a billionaire in large part because he saw value in K-mart. After getting control of the firm during bankruptcy proceedings, he sold the deeds (or leaseholds) for 600 of its stores, reaping large gains, and moved in on Sears, Roebuck, another retailer that had seen better days.

We have assembled a list of potentially cheap stocks based on their undervalued land and buildings. In the included table we show the price/book using official book values and the same ratio using an estimate of what the book value would be if real estate were carried at fair market value. We have not deducted for the 35% corporate capital gains tax because a new owner can often duck the fee. One way is to use tax-loss carryforwards. Another is by not selling the land, instead just developing it and collecting rent - which is what Vornado did with the Alexander’s property.

Pep Boys, the $2.2 billion (sales) auto parts chain, currently trades at 0.9 times its book value. It owns 55% of the stores it uses and, depending on specific lease agreements, could also sublease stores it does not own at higher rates, pocketing the difference. Figure in current real estate values and you find that Pep Boys is trading at a 30% discount to book value – noticeable in a market that collectively trades at 275% of book.

Lone Star Steakhouse & Saloon owns 148 of its 250 restaurant buildings. The top line is weak. In March it announced that it would close 30 stores, generating $20 million from the sale of leases and land. Some shareholders pushed the company to keep shedding real estate. But Lone Star Chief Executive Jamie B. Coulter, who controls 11.3% of the stock, says these land sales have gone far enough.

Link here.


The domestic automakers are in a stew, with GM in the deepest. Nevertheless, the largest company in what seems to be a dying U.S. industry may get a new life. At least that is the possibility held out should dealmeister Kirk Kerkorian be successful in midwifing an alliance between GM’s chief, Richard Wagoner, and Renault/Nissan Motor’s, Carlos Ghosn. If the alliance goes through, GM may gain a cash infusion and cost savings from combining production with the French-Japanese partners. Then long-suffering GM bondholders will not be exposed to a Chapter 11 filing, which is the fate many investors mentally assigned the company not long ago. So now, on that basis, an investment in GMdebt obligations might make sense.

But the better bet is in bonds of the company’s relatively robust finance unit, General Motors Acceptance Corp., which, unlike the parent, turns a profit. While both credits are below investment grade, GM’s rating is junkier, B from Standard & Poor’s vs. GMAC’s rating of BB. Small wonder. GM’s future rises or falls on whether it can sell vehicles. GMAC’s rests on loan payments for cars and trucks already sold. Yes, the finance arm would suffer if GM fell into bankruptcy, but GMAC is diversified, with operations in home mortgages and insurance. GMAC is also eyeing used-car financing and loans for non-GM cars. Recently, the Pension Benefit Guaranty Corp., the federal agency overseeing corporate pensions, has agreed that GMAC has no liability for GM’s billions of dollars in unfunded pension liabilities.

Since GMAC bonds enjoy better ratings and hence are not as risky as GM paper, they yield 2.7 percentage points less, giving roughly a 7.5% yield to maturity. Some GMACs that are now only a couple of pennies below par were trading a year ago at 85 cents on the dollar. Most investors did not have the stomach for GMAC bonds back then. I will pay the smaller discount for the greater peace of mind it brings; the yields still are handsome. That said, not all GMAC bonds are worthy. Do not under any circumstances buy what are called GMAC Smart Notes.

Link here.


Something big happened in the currency markets on July 1, but if you read only the mainstream media, you might have missed it. On that date Russia made its ruble fully convertible for the first time since August 8, 1914. More precisely, it lifted all restrictions on ruble flows into and out of the country. The ruble can now be freely traded on international exchanges, and foreigners can hold ruble deposits in Russia and abroad. Investors are no longer required to keep interest-free deposits at the Central Bank (and pay an implicit tax) when they invest in Russian fixed-income markets. Did this loosening cause a run on the ruble? Far from it. Over the past year the ruble is up 6.3% against the dollar, including 0.7% gained since July.

This move toward free markets is a very positive development in a country that has had a rocky conversion from communism to capitalism. Russia’s fledgling capital markets stand to become deeper, more efficient and more fully integrated with international markets. In short, convertibility will push Russia further along the globalist path, stimulating capital inflows and further ruble gains against the dollar. Why did reporters miss the ruble story? Because they have got their minds made up that Vladimir Putin is taking Russia back to its authoritarian past. They cannot imagine – let alone print – that a former KGB man could be presiding over any kind of economic liberalization.

Since Charles de Gaulle delivered his famous February 1965 speech in favor of a role for gold in the international monetary system, it has been no secret that France has had an international currency strategy: Any system that counters U.S. dollar hegemony is good. This explains why the French were European Monetary Union enthusiasts in 1999. Jean-Claude Trichet, European Central Bank president, is promoting a French point of view when he says that the cheap Chinese yuan has given China a competitive trading advantage. The neomercantilist Bush Administration, supported by parochial special interests, has stumbled over this French tripwire. The U.S. has led the campaign to force the Chinese to unlink the yuan from the dollar and let the yuan float. If that were to happen, the French would have their prize. The other countries that link their currencies to the dollar and form the Asian dollar bloc would cut their dollar tethers and the bloc would break apart. This would roll back the U.S. dollar hegemony, inject instability into what was the Asian dollar bloc area and retard the flow of Asian savings to the U.S.

There is a good way for the Chinese to thwart both the French and the American protectionists: adopt a fixed yuan/dollar exchange rate while introducing full convertibility. Such a change would leave China where it wants to be and with the same type of monetary regime as Hong Kong’s. The Asian dollar bloc would remain intact. I think it is a bad idea to buy the yuan with the expectation that the Chinese will allow a major appreciation.

One more currency development merits attention is the Swiss franc’s apparent loss of its safe-haven status. You would expect that war in the Middle East and rising oil and gold prices would make the franc a desirable store of value. The Swiss economy, moreover, is generating strong growth, low unemployment, low inflation and a huge current account surplus. And yet the Swissie is trading near its 6-year low against the euro and at a 2-year low against sterling. Why? Low Swiss interest rates (one-year money costs 2%) have attracted mass franc borrowing by individuals and small businesses in Eastern Europe (especially Hungary) and Turkey. However, these mom-and-pop borrowers must service their Swiss franc debts with incomes denominated in Hungarian forints and Turkish liras, creating a dangerous currency mismatch. This is a train wreck waiting to happen – particularly when novices are at the controls. When the wreck occurs, expect a sharp rise in the value of the Swiss franc vs. the Euro.

Link here.


The S&P 500 is up 2.4% this week through last Thursday’s close, which is remarkable in the face of the economic data out last week. And when combined with some of the action we are seeing in other markets, it leaves little doubt the economy is slowing. Treasury bonds are rallying with the yield curve fully inverted, oil and commodities are declining, and the advance in home prices has completely halted relative to one year ago. Is the stock market, with its advance this week, seeing something all these other markets are missing?

In a word – no. In fact, it is growing more likely that stocks will be the last group standing without a chair when the music stops. There are other forces at work powering this rally, and it has nothing to do with the economy and everything to do with options expiration. The rally has everything to do with inflicting maximum pain on options holders, and almost nothing to do with economic reality. For instance, one week ago, the QQQQs were flirting with a breakdown below $36, but with close to 700,000 $36 put options set to expire at the close of Friday, there was no way the market was going to let those options close in the money. In fact, there are over 1.2 million put options spread between strikes $35-38 for the QQQQs, all of which will expire worthless with a close above $38 this week. On the flip side, there are significant numbers of call options at strike $38 and $39, and not much at lower strikes relative to the numbers of put options. The bottom line? A QQQQ close near $38 this week [Ed: QQQQ closed at $38.79 on Friday] will have the largest number of puts and calls expire worthless, which is a spot of maximum pain to options holders that the market often seeks to find at the end of expiration week.

The same forces that brought the QQQQs back up to $38 this week also affected the Dow and the S&P 500. The market, especially the Nasdaq and the small caps, has been declining, and it appears there have been so many put options built up that a short snap-back rally was needed to clear the air. This effect usually lasts through expiration, and then the following week, the market gets back to other business.

We have a lot to say about this seasonal decline in stocks in next week’s issue, including the lack of progress on the downside thus far. We would like nothing more than a good decline this summer and fall to set up the next significant rally, but perhaps the market has other things in mind. We have see some contra-seasonal and countercyclical action in past market tops and were going to examine a few of those past periods to see what can apply to the current market. But in the meantime, stocks have rallied, fueled by hundreds of thousands of burning put options that will expire worthless Friday. When that fuel is used up after this week, we will see whether the market will wake up to what bonds and commodities are saying.

And speaking of commodities, we looked at gold two weeks ago and noted the weak rally from the late-July low into resistance. Anyone waiting for gold to take off after the Fed announced a pause in its rate hike campaign did not get the reaction he or she was hoping for. Gold has long appeared to be in a reaction rally of the decline from the $730 top in May to the low in June, and in our minds, it remains likely gold will head down at least one more time before embarking on any significant rally.

The Survival Report Web site.


A financial pundit who is always wrong is much more valuable than one who is occasionally right. You need only remember to do the opposite of what he says all the time. That is why our favorite British columnist is Anatole Kaletsky. Kaletsky is a smart writer and a good thinker, but his wrongness is profound and reliable. For instance, in 2004, after years of being bullish, he turned to a “much more cautious stance.” That should have been signal enough – back up the truck, buy U.K. stocks. And, indeed, in the following two years, stocks rose nearly 30%. But now, the man suggests the storm to have passed. The “dreaded ‘day of reckoning’ for the British economy may be over already, before it even began,” he writes.

We did not merely read that sentence. We stared at it like a child at a jack-in-the-box, willing something to pop out that would make sense. We presume Kaletsky drives a car as safely as anyone else. We suppose he pays his bills and puts his pants on without falling over. But when it comes to economics, he so misunderstands the way the world works, he cannot take a step without falling on his face. The “day of reckoning” suffered by Britain must have been an odd duck. It neither quacked nor waddled. Nor did it have any feathers. And according to Kaletsky, it died before it was even hatched. Why no “day of reckoning” in Britain … or America? The most likely explanation is that it has not come yet.

American readers can readily draw a picture of Mr. Kaletsky. He is Thomas Friedman with a brain. Just as wrong, but more thoughtful and original. Exploring Mr. Kaletsky’s world is like entering some magnificent science fiction world. There are the gleaming towers of the future. There are the handsome industries and innovative enterprises. And there are the wizards and wonks – the captains and commanders – who make it all work so well. It is a world with challenges, to be sure, but no challenges so great they cannot be met with courage, intelligence, and a positive attitude. Solving problems, in the Kaletskian world, leads to constant forward motion – progress. In this strange world, days of reckoning can end before they begin, because there is never really anything to reckon with.

Mind you, it is not a bad place. Indeed, many might prefer it to our own world. And you can see why. In Kaletsky’s world, the pieces fit together. There is action and reaction. Thought, word and deed all work together without sin, without accident, with hardly ever a surprise or a snafu. And, the sun shines all day long, everyday. Comparing the real world to this wannabe world is like comparing the Amazon jungle to the Baltimore City Zoo. In the zoo, there are wild animals, but apart from taking an arm off an occasional visitor, the zoo critters stay where they are supposed to stay, and do what they are supposed to do. Out in the real world, on the other hand, you never know what the animals will do.

Mr. Kaletsky believes two absurd things at once. The first, that you can have a day of reckoning without ever reckoning with anything. And the second, that if it comes to it, London will save Britain from any reckoning. As to the first – here is a simple way to tell if you have had a day of reckoning or not. If the economy is as lopsided and unbalanced at the end of the day as at the beginning, you have not.

As to the second – privatization, globalization and market liberalization protect the United Kingdom from a downturn because London has become such an important financial center. We do not doubt that financial services may remain an important industry in Britain, as they are for New York. But every industry has its ups and downs. Booms beget busts, and riches beget rags. That is what days of reckoning are for. The one industry that has most profited from the boom in credit - financial services - will be the one that most feels the bust in credit. When U.S. consumers stop buying what they don’t need with money they don’t have, the whole world economy is going to have excess capacity it does not want. That is when globalized, liberalized, privatized commerce slows down … and the duck waddles over and bites the financial industry on its fat derriere. In the real world, every day is a day of reckoning … and any night could be a night of terror.

Link here.


Next time a big private-equity deal is announced, do not assume it will not affect you. How those buyouts are being structured could reverberate across corporate America. The private-equity firms are piling debt on to the companies that they buy, and then often using the cash that the loans generate to enrich themselves rather than putting it toward improving the companies’ financial health. Things could get ugly should that debt grow too big for the companies to handle, not so much for the buyout firms themselves, but for everyone else from workers to suppliers to banks.

Private-equity firms used to buy a company, overhaul its operations, and then use the cash flow from its improved business to start paying down its debt. The big profits would then come from taking the companies public. But a slow IPO market in 2002 and 2003 caused the buyout firms to rethink how to guarantee themselves fat payouts. Many started to increasingly use something called a dividend recapitalization, which meant the companies borrowed money that they mostly use to pay themselves back for their initial investment with a dividend rather than invest in the business. The lower tax hit also made the issuance of dividends attractive. In 2003, the government cut the dividend tax rate to 15%, well below the capital gains tax on ordinary income of 35%.

Such benefits have turned cash-out borrowing into a regular practice. There has been more than $38 billion in dividend recaps so far this year, up from about $7.7 billion in 2004, according to Dealogic. While this is guaranteeing the private-equity firms cash in their pockets, the added debt means higher loan payments, which not every company will be able to manage. A new report from credit-rating agency Standard & Poor’s tracked 52 debt deals between 1995 and 2003 that raised money to pay private-equity firms and found that about 6% of those loans ended up in default. That compares with a 3.7% default rate for all leveraged loans tracked by S&P’s leveraged commentary and data group. What makes those findings worrisome is that it came even before the buyout firms really stepped up the number of dividend recaps that they were doing.

Given how things can go, investors must beware. This really affects anyone who is interested in buying stock in companies backed by buyout firms that have recently gone public or are slated for IPOs. They should check out if such recaps are happening, and when, the most troublesome are those that happened soon after the initial buyout. For most Americans, such dealings might seem like a world away. But when jobs get lost or stress is put on the banking system, it could certainly hit home.

Link here.
Firms cannot get enough of their own shares – link.


Requirements of the new pension bill signed by President Bush could have an impact on credit ratings, warns Moody’s Investors Service. In a new report, the credit-rating agency explained that companies with underfunded pension plans will likely borrow to cover the increased contributions that the new Pension Protection Act of 2006 will require starting in 2008. Generally, the additional borrowing will not affect credit ratings because companies will be exchanging pension-related debt for contractual debt, Moody’s acknowledged.

However, “in certain circumstances, substitution of pension debt with contractual debt could reduce the cushion under existing covenants or require some firms to seek waivers to existing credit agreements,” said Moody’s managing director Gregory Jonas in a press statement. “Also, we expect that lower rated companies will likely see increased pressure on coverage ratios given the likelihood of borrowing at higher interest cost to fund increased pension contributions,” posited Jonas, who co-authored the report.

The report was careful not to sound the alarm bells. The credit agency pointed out that the new law’s 2008 effective date, and several transition provisions, should give companies enough time to adequately prepare for additional funding requirements. Still, Moody’s contends that the law may change corporate behavior in several ways. For example, companies with poorly funded plans may redirect cash flows into pensions to avoid having plans deemed “at risk.” Moody’s also expects that the law will cause more companies to freeze pension plans or exit the plans entirely. In addition, some companies may shift their funding away from equities and toward fixed-income instruments to better match the cash flow from their assets to benefit payments, thereby “immunizing their pension liabilities.”

Link here.


Despite regulators’ warnings that some popular types of mortgages are risky, lenders are still making them, and mortgage insurance companies have begun pleading with federal banking agencies to act quickly to restrict them. The loans under scrutiny include interest-only mortgages and “option” mortgages, in which borrowers decide each month how much to repay. Because monthly payments are lower than with traditional fixed-rate mortgages, borrowers can buy more expensive houses. In the past five years, millions of Americans have bought or refinanced homes using these loans. The risk comes because eventually these loans “reset”, meaning the payment is adjusted upward – sometimes as much as doubling – to repay the full interest and principal owed.

“We are deeply concerned about the potential contagion effect from poorly underwritten or unsuitable mortgages and home equity loans,” Suzanne C. Hutchinson, executive vice president of the Mortgage Insurance Companies of America, wrote in a recent letter to regulators. “… The most recent market trends show alarming signs of undue risk-taking that puts both lenders and consumers at risk.” Many borrowers are paying as little as possible. About 70% of the people who take out an option adjustable-rate mortgage, which lets the buyer avoid paying even the full interest on the loan, end up paying the lowest permissible amount each month, according to the FDIC, which regulates banks. The amount unpaid is added to the mortgage balance, so borrowers end up owing more than when they started. Having no equity in a home increases the risk of foreclosure, especially when housing values fall and houses are hard to sell.

Late last year, regulators began telling the industry that some of the new loan types put some buyers in jeopardy and lenders at risk of loan losses. But lenders continued making the loans at a fast clip. In 2000, just 1% of American homeowners who got new loans had these types of loans, but by May 2005, about a third of all borrowers did – about the same percentage as in May 2006. In the expensive Washington area the proportion was about half in May 2006.

Regulators also told lenders last year that they were considering an advisory called a “guidance”, setting new rules on these nontraditional loans. Lenders would be expected to require borrowers to have higher down payments and better credit, to verify borrowers’ income, and to make sure borrowers could withstand a payment increase. Lenders would also be required to explain the loans more carefully. Regulators say the final version of the rules will be announced within a few months. The rule change has few supporters in the lending industry, and much opposition. In written comments to regulators, the Mortgage Bankers Association called the proposed ruling “overly prescriptive” and said heavier regulation might stifle product innovation. J.P. Morgan Chase & Co. said that it was unfair that restrictions would apply to only banks and thrifts under federal oversight, giving more loosely regulated lenders a competitive advantage.

But the mortgage insurers, which cover the losses when loans go bad, see big problems. Their trade group, in a plea to regulators delivered in a comment letter last month, alluded to its fear of widespread foreclosures if some of these new borrowers default on their loans. An increase in such problem properties could weaken the real estate market and drive down home values even for those who bought conservatively and diligently paid their mortgages.

Not all lenders agree with the big banks and industry trade groups. David Dowling, a loan officer with First Trust Mortgage in Tampa, asked regulators to “ignore the lobbying efforts of those in my industry about keeping lax lending standards.” He said he has had a string of elderly clients come to him for help after lenders placed them in adjustable-rate, interest-only or option loans. Accustomed to “traditional underwriting standards”, he said, these borrowers did not understand that they had placed themselves at risk of losing their homes. Dowling said he has met people who had owned their homes free and clear and who lost them to foreclosure after taking out these loans.

Link here.

Millions of homeowners could soon see their adjustable rate mortgage payments skyrocket.

Lenders, mortgage investors and financial regulators across the country are concerned about the ability of millions of homeowners to handle the potentially painful payment hikes coming due on loans they took out during the height of the housing boom. Though estimates vary, some industry experts say that at least $500 billion worth of loans with reduced initial payment terms are scheduled to reset during the coming year.

Many of these mortgages carry “negative amortization” features that permit borrowers to pile on additional debt beyond their original balance, and make minimal payments for the first several years. Once the initial period is over, however, payments can shoot up by 100% or more as the loan resets. Other programs allow interest-only payments with no reduction in the original loan balance until the reset point. Then payments can jump by 50% or more in order to amortize the debt balance over a compressed number of years.

Federal and state financial regulators are expected to issue mildly restrictive guidelines for lenders making new loans this fall, but tightened rules will not help homeowners who are heading for payment resets in the coming year and possibly remain unaware of the financial shocks they face. John G. Walsh, a senior official at the federal Comptroller of the Currency, recently described his agency’s concerns about poorly informed borrowers who do not realize that their artificially low monthly payments will not continue indefinitely.

Lenders active in nontraditional mortgages carrying negative-amortization and interest-only features say they have taken care to ensure that their customers comprehend the inner mechanisms of their reduced-payment loans. They also insist that they have reserved these high-risk programs for borrowers with solid credit scores, large down payments and excellent employment histories.

Wall Street analysts have questioned those confident assurances, however. Standard & Poor’s warned last year that it was observing disturbing numbers of minimum-payment loans being extended to borrowers with sub-par credit profiles. To head off potential problems, the largest mortgage originator in the U.S., Countrywide Home Loans, has begun sending out letters to thousands of borrowers who have been making only the minimum payments on the company’s popular PayOption adjustable-rate mortgages. The letters explain that “this is an early message to alert you that, based on your current payment trends and potential future interest rate changes, the monthly payment you will be required to pay may increase significantly.” Maybe other lenders will see the benefits of reaching out to their customers before they get smacked with payment shocks they never knew were coming.

Link here.

Will credit market be up in ARMs?

If your adjustable-rate mortgage will reset next year – as $1 trillion worth of ARMs will – you are gritting your teeth. The interest rate that seemed so enticing four years ago is about to rise, along with your monthly payment. That has the potential to affect consumer spending, since households will have less cash to spend. The question is, how much?

Goldman Sachs chief economist Jan Hatzius answers, “Not much.” “The maximum direct impact on cash flow from ARMs resetting over the next several years is fairly small in the context of total U.S. consumer spending,” he wrote. For the $1 trillion in ARMs that reset in 2007, rates will rise from about 3.4% to the current 5.8%. This increase implies an extra $24 billion in annual mortgage payments. This amounts to only about 0.3% of consumer spending, which is running at a 2.5% growth rate. And anyway, chances are the actual damage will be mitigated as many homeowners refinance into new loans that reduce their payments. This is already happening across the country, and the refinancing process will be greatly enhanced as the Federal Reserve moves to shore up the economy by cutting interest rates.

However, there is a complication. The critical assumption is that the refinancing homeowner will be able to match an appraisal in a falling price environment to the amount of the loan. Some people will be able to refinance; others will not. Those who cannot will be hit hard. Mr. Hatzius illustrated his point by applying the 2.4% rise in interest rates to a $275,000 mortgage. This would increase payments by $550 a month. Compare that with average U.S. household consumption of $6,700 a month. “This is a payment shock of nearly 10 percent of consumption – almost two orders of magnitude larger than the aggregate impact, and large enough to cause increases in mortgage delinquencies and foreclosures for households unable to refinance,” he said. So overall consumer spending will not be affected much, but some individuals will be, with big consequences. “These increases could cause significant credit market impacts even without impacting the wider economy.”

To prove the point, the recent rise in delinquencies and foreclosures has been even more pronounced among subprime borrowers and those who have taken out riskier mortgages, including ARMs and option ARMs. And that is where things get complicated for the Fed. Battling one bubble is bad enough. Dealing with the fallout of the credit and housing bubble together is a challenge of a different magnitude.

Link here.
Bernanke, back at Jackson Hole, grapples with house-boom legacy – link.

CEO of the nation’s biggest home-mortgage lender tells investors to buckle up for a bumpy ride as the housing market slows.

Angelo R. Mozilo, chief executive of Countrywide Financial Corp., the nation’s biggest home-mortgage lender, rarely misses a chance to remind people that he has been in the business for more than 50 years. Now he has a sobering message for investors about the near-term outlook for housing and mortgages: Buckle your seat belts. “I’ve never seen a soft landing in 53 years,” Mozilo told analysts in a conference call last month.

To minimize shocks, Countrywide is tapping on the brakes as the housing market cools and competition among lenders intensifies. This more cautious stance follows a growth spurt that increased Countrywide’s annual home-mortgage lending to $491 billion last year from $66.7 billion in 2000. But earlier this month, Countrywide said loan production fell 19% from a year earlier. Countrywide’s fans take Mozilo’s warning as a comforting sign that he will not chase growth at the expense of profit. Bears counter that the less-aggressive stance confirms that investors should be wary as Countrywide struggles to slash costs in a slowing market. In any case, Mozilo’s bucket of cold water should serve as a warning that the housing market could take more than just a few months to rebound.

Link here.
Home improvement superstore battle: Home Depot vs. Lowe’s – link.


For investors wondering whether the U.S. economy risks being seriously wounded by a housing market downturn, Australia’s experience of the past three years holds a potentially valuable lesson. If anything, the Australian boom was far bigger than that in the U.S., with average house prices doubling from 1996 to 2003. Four interest rate increases during 2002 and 2003 took the wind out of housing, but the resulting slowdown was remarkably modest by historical standards. Indeed, the local housing market has showed clear signs of strengthening again this year and was one reason the Reserve Bank of Australia resumed tightening, with increases in May and August.

On the surface, Australia’s experience suggests that Americans might have little to fear from the slowdown in their housing market. But while the similarities are instructive it is the differences that could really matter, for better or worse.

The cautionary case was laid out last week in a report by two economists at Goldman Sachs. “The U.K. and Australia provide important lessons for the U.S., but the implications are far from benign and support our view that the Fed will need to cut rates by 125 basis points next year,” the two economists, Mike Buchanan and Michael Vaknin, said in the report. They argued that a downturn in housing would have a far greater impact on U.S. consumption than in Australia because U.S. consumers had largely used equity withdrawn from their homes to fund spending. Although Australians had withdrawn just as much equity as Americans, equal to about 10% of disposable income, they spent far less.

Just as important, the housing market in Australia peaked right as the country began to benefit from the global commodity boom. Company profits have surged, allowing businesses to pay and hire more while propelling a bull run in equities that has almost doubled the main share index since 2003. Since more than half of adult Australians own shares, the strong market has bolstered personal wealth and cushioned the blow from a flat housing market. The boon also led to a windfall of tax receipts that allowed the government to slash taxes, eliminate net debt and still run sizable budget surpluses. Clearly, the same could not be said of the U.S.

Another fundamental difference between the two countries’ housing markets that can be a potential savior for the U.S. In Australia, about 85% of mortgages are variable-rate loans, so repayments rise and fall with every move in the central bank’s short-term cash rate. In the U.S., about the same percentage are fixed-rate loans, providing insulation for existing borrowers from moves in the Federal Reserve funds rate. Further, most mortgage rates are tied to long-term bond yields rather than the short-term rates the Fed influences. This link often acts as an automatic stabilizer, with yields swinging on investors’ perception of the health of the economy.

Link here.

“Regression to the mean” … and real estate?

“Regression to the mean” is a statistical concept, which in my words means that stuff does not travel far from its usual path. If it does it will eventually come back. A lot of investors use strategies rooted in this idea, and some are really good at it. Warren Buffett sure knows how to spot below-the-mean assets that eventually come back up to the path. Even if all extreme price deviations eventually do regress to the mean, the problem is, as J.M. Keynes put it, “The market can stay irrational longer than you can stay solvent.”

Which brings to mind some of the chatter I am hearing this week about the dismal home sales numbers. A couple of commentators think a regression to the mean is a fancy way of saying “soft landing” – a little bit of a relatively painless slowdown in real estate, then all is well and back to normal. Apparently they do not realize that the regression can accelerate, to the point that prices cross the mean and keep going in the other direction. In case you are wondering how that can really happen and what it looks like, go grab a chart of the NASDAQ from 1997 to 2003. It will speak for itself. So, the importance of statistical concepts duly noted, the fact of irrational prices outlasting solvency may prove more important – again. It is worth keeping in mind, as the $2.7 trillion in mortgage loans adjust to higher rates in 2006-2007.

Link here.
Do not expect the lowest rung of the housing ladder to be any better than the top – link.
A dose of reality needed for housing cheerleaders - link.


The Fed has just announced a pause in its rate-hiking-cycle. So why are the financial markets so jittery? Because the old certainties on which they have worked for so long are being questioned – though not entirely in the right manner. The market is far too dominated by leverage and so projecting central bank rate paths accurately has become almost the full sum of current investment arithmetic. These are no longer so transparent. Nor are they likely to become so again for some time to come. With the Fed seemingly all at sea in its analysis – and avowedly dependent on short-term data to steer its future decisions! – we can expect a series of reversals between believing the “pause” actually heralds a loosening next spring (as is now priced into the eurodollar strip) and fears (perhaps even realized ones) that – reluctantly – the bank will have to revise its assessment dramatically (as has, e.g., the Bank of England already).

The financial markets became shaky in recent months because the central banks have tightened, the experts say. Have they really become more restrictive? Not really. Credit growth is still ample and effective rates are low almost everywhere you look. Additionally, “real rates” are not moving much at all. For example, annualizing the past three months’ change in U.S. median CPI, the average “real” funds rate this quarter is only around 65 basis points – exactly the same as it was when nominal rates were at 3% back in June last year. At the longer end “real” corporate bond yields in the U.S. are at levels not seen since before the Volcker Fed initiated its anti-inflationary drive.

What would “really restrictive” mean in the U.S., in Europe, in Japan and in China? Which interest rates or aggregates should we look at? To begin with, in a world of elastic currencies, ineffective reserve ratios and frantic financial engineering, this is not something one can be too dogmatic about in quantitative terms. One must look at trends in traditional monetary aggregates, at bank lending surveys, business sentiment polls, and at activity in the capital markets. There are few borders to hot money – U.S. M2 may slow down, but, the Europeans may well make up the difference, for example, and one must neither forget that financing purchases of goods or assets in one region with money borrowed in another is all too simple. Also, though the alpha and omega of inflation is an overabundance of money and credit, as with all economic phenomena, the response of the individual to these is critical.

“Restriction” is most likely to be signalled by a widespread withdrawal from risk trades in financial markets, with the proviso that this does not take the form of a brief panic to be instantly countered by “plunge protection” measures on the part of the central banks, as has happened so many times before – not least in the May-June collapse of this year, when the BoJ rushed to inject reserves in the attempt to steady nerves. More significantly, such behavior needs to be reinforced by a general aversion to incurring further indebtedness on the part of consumers and corporates alike, not just a hiatus while a new outlet for hot money and easy credit is found, as for example when the recent housing mania was substituted for the prior tech bubble. “Restriction” ultimately means that while some people at last decide that holding onto their money is more attractive than spending it forthwith, some of those who do still want to borrow actually find it harder, if not wholly impossible, to persuade banks and bond investors to finance them!

Are “really restrictive” policies not urgently needed in order to avoid a boom-bust-cycle like in Japan over the past two decades and in order to bring the world economy back into balance? It is already too late to avoid such a pattern, one might argue. Anglo-American residential real estate and Chinese productive redundancy are but two cases of vast, credit-induced malinvestment. The new cities of skyscrapers, duplicating futures exchanges, and artificial beachfront sprouting up in the Middle East may well represent another. Achieving balance will remain elusive while the attempt to postpone the reckoning for past excesses into the next electoral cycle – then the next and the next after that – remains the main driver of policy.

We saw relatively impressive economic growth in the U.S. until recently, we still see it in large parts of Asia. We see increasing growth-dynamics in Japan and Europe. Is this real growth or just monetary illusion because rising prices are inflating balance sheets and statistics? We have to discriminate between higher spending and genuine economic advance. Until recently, U.S. “growth” was dependent – almost beyond precedent – on gutting the balance sheets of consumers and of gross irresponsibility in government finances. This is still very much the case in the UK and one or two others. Even by their own dubious merits, revisions to the U.S. GDP numbers have recently revealed slower “growth” than thought was realized at marginally higher prices and with much less non-financial profitability, i.e., that the nation was much less vital and that productivity was substantially lower than first supposed.

If one consumes capital on such a scale – and the running of enormous trade deficits, the actuarial bankruptcy of pension plans and welfare schemes, and the acquisition of non-productive assets at the expense of ever-higher debt-income ratios, are all symptomatic of this – one can, of course, appear for a while to be enjoying a high standard of living, much as a dissolute nephew can live the high life, at least until his inheritance is finally dissipated and he has to live once more within his much less expansive means! Conversely, one cannot deny that, however much growth has been forced (and misdirected) by easy money these past years, genuine progress has been made.

There was a lot of talk about deflation in the recent years. On the other hand we saw exploding asset and commodity prices and now even the standard inflation indicators are moving up rapidly. What is really going on? Do you trust in central bankers to fight inflation effectively? As Charles Goodhart put it at an ECB conference in 2002, “In a world of fiat money, deflation is a policy choice.” What he neglected to mention is that inflation is no less a policy choice – the one, moreover, always to be preferred in populist welfare state democracies.

What does it mean for financial markets? How should I behave as private investor? Diapason invests in commodities. Is there not an unjustified hype/overdone speculation, i.e., is a dramatic correction due? Recent corrections have so far not been out of the range of historical experience and have certainly not jeopardized the upward path itself. Ask yourself this: if commodities are really so expensive, why are commodity producers themselves so anxious to swap all of equity, debt, and cash in exchange for proven reserves and existing production capacity, as many of them are trying to do via the current wave of vertical and horizontal consolidation? Why are other companies scrambling to buy in the assets of those who supply them with iron ore, coal, rubber, and so on?

High and rising commodity prices tend to make equity earnings extremely variable. Variable earnings – in today’s short-horizon world – means lower multiples. Commodities are in a phase where they are to be favored over equity, as a broad class. We are hardly an environment conducive to fixed income returns, however wishful the market’s thinking may be about the near-term. Either bond yields will rise – occasioning direct capital losses – or the folly will persist and both principal and interest will be eroded by higher prices. Add in the excesses to be found in the junk bond market, remember our caveats about earnings volatility, and you also have a recipe for a rather nasty unwind of the credit cycle and a corresponding rise in corporate bond spreads, to be suffered on top of the losses accruing to government bonds. In such a world, can you be without at least some exposure to commodities?

Link here.
Why looming stagflation (and other indicators) reminds me of 1973 – link.
“Plunge protection”, fiat money, and the Fed – link.


You board your flight to Chicago, $600 ticket in hand, and do a quick survey of the people sitting around you. Turns out 13D paid only $300 for her flight, while 14E shelled out nearly $1,000 for his. It is a reality of air travel that infuriates passengers, but now several new travel websites are promising to demystify the seemingly nonsensical world of airline ticket pricing.

It was exasperation with existing online travel tools that led Robert Metcalf to develop Flyspy, a site currently in alpha mode using fare data from Northwest Airlines. Flyspy asks passengers for their departure and arrival cities, and then presents 30 days’ worth of fare information in a stock-market style graph. The easy-to-read Flyspy chart is key to its appeal. Passengers can comparison shop based on length of stay (“Will the price change if I stay two extra days?”), or different city pairs (“Is it cheaper to fly into Baltimore or Dulles?”). Flyspy also offers cool extras. Travelers looking to boost their frequent flyer balance can generate a list of flights offering the lowest cost per mile – a few of them to cities you might actually want to visit.

Farecast is raising the stakes even higher. Currently offering data from Boston and Seattle to 120 U.S. markets, with plans to roll out others by year’s end, Farecast not only displays the lowest current fares, but uses predictive technology to determine what direction those fares will move in over the next seven days. “We’re the first and only travel site that answers the question ‘do I buy or do I wait?’” says CEO Hugh Crean. A recent search for flights from Boston to Denver, for example, predicted with 80% confidence that the lowest fare between the two markets would jump by at least $50 within a week, and recommended buying at the current price (four days later, fares had indeed jumped, by $42). Customers who buy through Farecast are redirected to the appropriate airline website, and the site also allows shoppers to compare prices by departure time, or view a map that displays cheap flights across the country.

Airlines use revenue management systems to constantly analyze and adjust inventory in each bucket. When full-fare seats are selling well on a particular flight, inventory might be pulled from a discount bucket to make more high-priced tickets available, while seats might be shifted into lower-priced buckets on flights where sales are sluggish. Revenue management is the reason bargain-basement prices sometimes appear and disappear from reservation systems overnight, and why on a typical flight, passengers pay wildly divergent prices for the exact same product. Online travel agencies like Expedia and Travelocity allow passengers to examine prices on a particular route, but cannot predict whether they will rise or fall, and comparing fares using more complex criteria such as length of stay or time/day of departure requires time-consuming multiple searches. That leaves the market wide open for sites like Farecast and Flyspy.

Link here.


If you are interested in trading or “investing” in volatility through the VIX, you can avail yourself of options based on the indexes that trade on the Chicago Board Options Exchange (CBOE). Those options first began trading earlier this year. If you are interested in buying or selling options on the VIX, a number of the strike prices have a large amount of open interest. Therefore, liquidity should not be a concern. So, if you are looking for a directional play on volatility – and particularly on volatility levels on the S&P 500 – you can consider the new VIX options.

The VIX is calculated based upon a 30-day timeframe. So, even though there are longer-dated options available for trading the VIX, the intrinsic value of those options are based upon the VIX index itself, which is calculated through the use of options with an average timeframe of 30 days. But keep in mind that the VIX’s 30-day timeframe is continually updated. That updating does tend to mitigate the short-term nature of the VIX’s value, and enables you to consider volatility in a longer timeframe if you have a conviction regarding the long-term direction of volatility. Because of this timeframe, the expiration and settlement rules regarding the VIX options are different from most other equity options whose underlying security is an individual stock or an exchange traded fund (ETF).

If you do not wish to trade options, you can take a look at the futures market. The CBOE Futures Exchange (CFE) has a futures contract based upon the value of the VIX. The VIX futures contract is based upon a price that is 10 times the expected value of the VIX Index. Thus, a November 2006 VIX futures contract with a value of 132.00 implies a forward VIX level in November of 13.20. You can find plenty of information and on the VIX futures contact at the CBOE website. Trading a VIX futures contract with a distant expiration month would allow you to establish a position with a longer view regarding the direction of volatility. If you are concerned about being exposed to margin calls and the substantial risk inherent in futures trading, you could partially hedge a futures position using the VIX options. You might wish to consult a knowledgeable futures broker to help you out.

But if you do not wish to get involved in futures, there short of it is that there is no other way to establish a long-term position based upon your assessment of the direction of volatility. It seems as if a new ETF is created nearly every day that focuses on a specific area or facet of the stock market, but I am not aware of any currently trading ETF that is based strictly on volatility. However, I would not be the slightest bit surprised to see one before too long.

Given the negative correlation between the movements in the VIX and the S&P 500 Index that I have pointed out in prior columns, you can use the S&P 500 Depository Receipts (SPY), a proxy for the S&P 500 Index, as a way to take a stand on volatility. However, that is not a “pure play” on volatility, but rather a trade or investment you can initiate based upon the information you have gathered from monitoring the VIX. By keeping an eye on the market’s volatility levels, you have an additional weapon at your disposal when making trading and investment decisions. So, for now, unless you are willing to wade into the options or futures markets, think of the VIX as part of your technical arsenal.

Link here.


There are important differences between silver and gold. The demand for gold is almost entirely a demand for holding the stuff for financial purposes (protection and profit) and for uses, such as jewelry. Very little gold is actually consumed. In this respect, gold is the polar opposite of a base metal, such as iron, that people buy exclusively for purposes that use it up. Silver has a foot in both worlds. Some is bought for uses that will consume it, while other ounces are held for financial protection or profit.

Most of the gold ever mined (including the metal in Baal, Cleopatra’s necklace and what Alexander looted from the ancient cities of West Asia) remains above ground in various easy-to-melt forms. Annual mine production is small compared to the existing stockpiles, on the same order as the small amount of gold that is lost or consumed each year. So, the size of the existing stockpile does not change much. Fluctuations in the price of gold come almost exclusively from fluctuations in the demand to hold the stuff.

Silver, unlike gold, is chemically active. When silver is used, much of it gets used up – consumed beyond practical recovery. And because silver is so much less rare than gold, less effort goes into salvaging and protecting it. Annual mine production and consumption are large compared to existing stockpiles, so fluctuations in price come from changes in both those factors and also from changes in the demand to hold silver for financial purposes.

The uses for silver in modern industry are growing. The uses for silver are so numerous that, despite the dwindling role in photography, you can expect demand to remain strong as long as industrial economies remain strong. But since the Hunt brothers’ ill-fated attempt to corner the silver market back in 1980, there has been little investment demand for silver from the public in developed countries. This has clearly and unequivocally changed, as evidenced by the new silver exchange-traded fund (ETF) from Barclays.

Most silver mines are really base metal-silver or gold-silver mines, from which silver is a byproduct. In fact, 70% to 80% of all silver comes as a byproduct of copper, lead and zinc mining. This puts the few mines that do produce primarily silver in an extremely risky position. Over the last two decades, with silver being dug out by base metal miners regardless of how low the silver price went, most pure silver mines consistently lost money, and none were especially profitable. For more than 20 years preceding 2003, no pure silver mining company generated free cash. However, there are many known silver deposits and proven reserves poised for production as soon as silver crosses whatever price line makes them economically viable. So, with silver hitting record highs and base metals doing the same, increasing the flow of silver as a byproduct, hundreds of millions more ounces of silver will be heading for the market. There may even be a production-consumption surplus of silver in 2006, the first surplus since 1989.

However, those figures do not include investment demand. The production-consumption surplus means that inventory will increase, but that still does not tell us where the price is headed. If financial demand (to hold silver for protection or profit) increases faster than the accumulating physical inventory, the price will keep going up. But will it? For one thing, consumption has been eating into above-ground stocks of silver at a phenomenal rate for decades, eroding total world bullion inventories from an estimated 2.1 billion ounces in 1990 to around 400 million ounces today. For another, silver is like uranium as an industrial metal, in that it is hard to replace and it is used in such small relative quantities, that the price could double or triple without having a major impact on industrial usage. But the main reason, as mentioned above, silver is being rediscovered as an investment vehicle, most notably in Barclays’ new silver ETF (SLV). As of August 7, 2006, the ETF has already sucked up 92.4 million ounces of silver. There goes the supposed surplus.

And as silver gets back on trend, and gets noticed by an increasing number of investors, the ETFs will make it easier for those investors to participate. That is also true for certain institutions – most of which are barred from owning physical metals – so they will, in essence, uncork a latent source of investment demand. Throw in well-deserved concerns about the U.S. dollar and about the at-least-it’s-not-the-dollar euro, and increased financial demand will almost certainly outstrip any increase in global silver production for the next couple of years.

But if a high price for silver starts getting people excited, will the masses send their broken candlesticks and seldom used spoons and trays to scrap dealers? Will that source of supply turn into a flood, as it did so dramatically during the 1980 price spike? At some price, yes – but probably not for a while. Stable higher prices will encourage people to sell. But rising prices and the reasons for the growing financial demand will encourage people to put off selling even their unloved, broken candlesticks. Even as the incentive to melt down Grandma’s tea set increases, the “silver is money” factor pushes the other way. The great bull market in silver that ended in 1980 came after 100 years in which the public accumulated relatively cheap silver. A lot of that was cleared out – melted down – in the early 1980s, and there has not been as much time to replace it.

Will silver hit its previous 1980 high? It was $48.70 then, but that is $120 in today’s dollars – almost 10 times the current price. Given that just below the surface, the threats to the U.S. economy are even greater today than in the late 1970s, we can easily envision silver closing in on its previous high and even going way beyond it. When will this come to pass? No telling. But, periodic and inevitable corrections aside, it is going to happen, of that we are confident.

Link here.


Since reaching a 25-year high of 365.45 on May 11th, the Reuters Commodity Index (CRB), has been showing signs of fatigue, after a relentless 4-year climb. The CRB doubled from four years ago, led by commodity superstars, such as crude oil, copper, gold, platinum, silver, and sugar. However, since topping out three months ago, the CRB index has slumped about 9%, whipping up speculation that the “Commodity Super Cycle” is fizzling out.

Defending its decision to pause its two-year rate hike campaign at 5.25% on August 8th, the Federal Reserve predicted that a softer U.S. economy would take the steam out of commodity prices. “Inflation pressures seem likely to moderate over time, reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand,” the Fed said. Putting his fragile reputation on the line, Fed chief Ben Bernanke hinted at a rate pause on July 19th, despite elevated commodity prices. “The recent rise in inflation is of concern, and possible increases in the prices of oil as well as other raw materials remain a risk to the inflation outlook. On the other hand, a slowing economy should reduce inflation pressures,” he told lawmakers on Capitol Hill. The CRB has see-sawed since July 19th. Bernanke’s reputation hangs in the balance, subject to the whims of CRB traders.

If commodity prices are confined into a sideways trading range for an extended period of time, the year-over-year comparison of inflation readings would start to look good. Bernanke has authorized three quarter-point rate hikes to 5.25% under his tenure as Fed chief, attempting to transform his reputation from a super-dove into a wise old owl on monetary policy. The Fed has reached the limits of its tightening campaign, fearful of tilting the U.S. housing market into deflation. Fortunately, the Fed is getting outside support in the battle against the “Commodity Super Cycle”. With the Fed moving to the sidelines on June 29th, other central banks from around the globe are picking-up the slack with baby-step rate hikes, or other methods of tightening global liquidity.

The concerted round of central bank rate hikes are starting to wear down the “Commodity Super Cycle,” and more rate increases look likely in Australia, China, the Euro zone, England, Japan, South Africa, and Switzerland by year’s end. It is probably fair to say, that the legion of 8,800 hedge funds, which control $1.2 trillion, are losing their speculative appetite for commodities, as global interest rates rise, and were behind the August sell-off in the CRB index.

Yet higher interest rates outside the U.S., combined with a steady Fed policy, might erode the value of the U.S. dollar, and ironically, provide a floor for the Reuters CRB index. So while the Fed’s rate hike cycle has probably peaked, the U.S. central bank cannot afford to lower the fed funds rate anytime soon, to defend U.S. homes prices, without triggering a rout of the U.S. dollar. The Fed must wait for the CRB to fall sharply under its own weight first, before contemplating a rate cut. Meanwhile, the U.S. dollar could tumble against Asian bloc currencies, once Beijing loosens its grip on the dollar/yuan peg – in the process enhancing its purchasing power for global commodities.

Perhaps, the Bank of Japan’s dismantling its ultra-easy money policy has been the biggest stumbling block for the “Commodity Super Cycle” this year. Japan’s monetary base, the money in circulation plus bank deposits at the BoJ, has plunged from ¥114 trillion ($982 billion) to ¥90.5 trillion ($780 billion) since January, while the BoJ drained massive amounts of excess funds out of the Tokyo money markets, and then lifted its overnight loan rate to 0.25% on July 14th. While draining roughly $200 billion out of the Tokyo money market, Japanese traders unwound over extended “yen carry” trade positions, where traders borrowed yen at zero percent to finance purchases of commodities, stocks, and emerging bonds, etc.

In the U.S., bond traders are betting that the “Commodity Super Cycle” has topped out for 2006, signaling a peak in inflation, and in turn, the end of the bear market for U.S. 10-year Treasury Notes. Since peaking at 5.25% on June 28th, the U.S. 10-year Treasury yield has declined by 40 basis points to 4.85%. Since the CRB topped out at the 365-level on May 11th, the U.S. T-Note-to-CRB ratio bottomed out at the 0.29-level, and has since turned higher towards 0.3170. A similar bullish view is seen in Tokyo, with Japanese government bond (JGB) 10-year yields sliding to 1.83%, from as high as 2.00% on July 5th. An improvement in the JGB-to-CRB ratio might convince the BoJ to limit its rate hike campaign to 0.50% this year. That would leave negative real interest rates in Japan, which could renew “yen carry” trade demand for the Nikkei-225 or foreign stocks, gold, silver, crude oil, emerging bonds, or any other asset play around the world.

Commodity traders keep close tabs on China’s juggernaut economy, which expanded at an 11.3% annual rate in Q2, its fastest in a decade, for clues about global demand for commodities. The red-hot Chinese economy, single-handedly contributed 13% to global growth last year, and is the world’s largest consumer of aluminum, copper, coal, iron ore, steel, buys 20% of the world’s silver output, 6% of the global zinc supply, and is the second largest consumer of crude oil. China aims to build up strategic reserves of oil and minerals such as uranium, copper and aluminum to help meet rising demand and provide a buffer against supply disruptions. China’s economy is riding a boom in exports and fixed-asset investment in factories, roads and housing, and has repeatedly defied expectations of a slowdown.

China is the key engine of growth in Asia as Australia, Japan, and Koreas’ exports to China have all soared. Any signs of a significant slowdown in China’s economy would be of great interest to commodity speculators, government bond traders, investors in base metal miners, crude oil and gold dealers, and foreign central bank officials. On July 26th, China’s Premier Wen Jiabao issued a strongly worded warning about the dangers of economic overheating, and pledged to implement forceful tightening measures and improve the yuan’s flexibility. Global traders have heard such bellicose declarations from Chinese leaders over the past two years, but the tough verbal jawboning was never backed up with action. However, the People’s Bank of China shocked the markets on August 19th, by hiking the benchmark one-year loan rate by 0.27% to 6.12%, and the five-year loan rate was jacked-up 0.45% to 6.84%. Preventing the economy from overheating has become the priority of China’s economic planners in recent months, as inflationary pressures are ready to explode in China.

Behind the PBoC’s “smoke and mirrors”, it is quite evident that Chinese monetary policy has merely shifted from an ultra-easy policy to an easy policy, with the M2 money supply standing 18.4% higher from a year ago. To avoid a hard landing in the juggernaut Chinese economy, the big-4 Asian central banks in China, India, Japan, and Korea are spreading the risk around, by tightening their monetary policies in synchronization. A hard landing in China would send tremors throughout Asia and rock far away places such as Germany. But Beijing’s leaders are moving cautiously, and simply aim to fine tune the economy towards a 10% growth this year. Still, the latest hike in Chinese interest rates would attract more “hot money” to the yuan, so the next phase of PBoC tightening might center on a yuan revaluation to 7.75 against the U.S. dollar, a bullish factor for commodities in the longer term.

Higher crude oil prices give central bankers the biggest head-ache, because of their direct impact on producer prices and secondary knock-on effects on consumer prices. Since January 2004, U.S. light crude oil prices have doubled towards $70 per barrel, even though oil inventories are 22% higher, as oil companies are hoarding their inventories, due to fear of future supply shocks, given a razor thin 2.2 million barrels per day (bpd) of global spare capacity.

Crude oil has commanded an Iranian “war premium” of $10 to $15 per barrel for most of this year, as the world frets about the likelihood of a nuclear armed Iranian Shiite regime in the years ahead. China and Russia are likely to veto any tough economic sanctions that could topple the Iranian Shiite regime. Therefore, with no prospect of tough economic sanctions in sight, Iranian leaders have concluded that the only stumbling block to acquiring nuclear weapons and “wiping Israel off the map” is a pre-emptive U.S. or Israeli aerial attack on its nuclear installations. Because Tel-Aviv stood in the cross-fire of the Israeli–Hizbollah skirmish, U.S. traders took their cue for the Tel-Aviv-100 index’s “reversal bottom” pattern on July 16th, which ruled out a wider war with Iran and Syria in the first round, and then dumped West Texas crude oil the next day. But bullish Tel-Aviv traders might be living in a fool’s paradise. On August 20th, Israel MK Binyamin Ben-Eliezer warned that “the next round of fighting against Hizbollah could be held within several months. You have to read between the lines. Hizbollah is getting organized, the Syria army is learning lessons. We have to rehabilitate the north, the reserve forces and the army and be prepared for the next round.”

Accordingly, the price of crude oil is the major wildcard moving gold prices, the Reuters CRB index, and inflation expectations these days, and could wreck the best laid plans of central bankers to engineer a soft economic landing. It is short sighted to dismiss a second round of fighting in the Middle East, so both crude oil and precious metals could command “war premiums” in the months ahead.

Over the past few months, the CRB index has suffered a series of body blows from 20 different central banks, but does its latest 5% decline signal a global economic downturn, or just the unwinding of over-extended speculative positions? Right now, the outlook is mixed. Furthermore, the recent round of global rate hikes that have capped the CRB are deceiving, because global monetary conditions still remain super-easy. The explosive growth of the global money supply in developed and emerging economies after 9/11, might explain the buoyancy of global stock markets at a time when sharply higher oil prices, would otherwise have been as a negative influence. For the past few years, the Reuter’s CRB index has “followed the money” and tracked Morgan Stanley’s All-World Index, for clues about the health of the global economy, consumer confidence, and in turn, the demand for commodities. Last week however, the CRB index and the MSCI All-World stock went their separate ways, threatening the tight relationship between the two markets. Such divergences have popped-up from time to time however, but over the long-term, the close relationship has not ruptured into a full blow divorce.

Most likely, the latest sell-off in the CRB is simply linked to the schizophrenic behavior of hedge fund traders, whose sentiment can turn on a dime, and short-sightedness that rarely projects beyond a week or just a few days. If global stock markets stay elevated, projecting a stronger global economy, it is only a matter of time until traders recognize that pumped up money supplies and negative interest rates, are also bullish factors for commodities. Throw in a weaker U.S. dollar, led by a stronger Chinese yuan, and a UN showdown with Iran in September, then the “Commodity Super Cycle” could recoup its losses of August 9-18, led by schizophrenic fund traders bidding crude oil and metals higher.

Link here.
Asia’s central bankers are more like Santa than Scrooge – link.

Parallels between the stockmarket in 2000 and the commodities market of today.

On August 8th the U.S Federal Reserve left interest rates untouched. The pause ended the streak of 17 straight interest rate hikes that began in June of 2004. The Fed funds rate, which was at a 46 year low of 1% at the start of the rate hike campaign, is now at 5.25%. The Fed justified the pause by stating, “Economic growth has moderated from its quite strong pace earlier this year.” It also implicated “a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices” as factors slowing growth. These statements make it seem like the Fed is calling the shots, however, with the real estate market slowing down, consumer loan rates precariously high, and a sagging stock market the Fed had no choice but to pause. How will the pause affect the precious metals and equity markets? History might provide some insights here.

In 1996, the Fed Chairman Alan Greenspan claimed that the U.S economy was suffering from “irrational exuberance” in the stock market. In other words, too much money was being piled into the booming technology and internet sectors. For a few months, the speech created a short lived downturn in the equity markets. Nonetheless, after issuing the warning Greenspan did not touch interest rates and the S&P 500 continued to soar. Beginning in October of 1998, two years after Greenspan’s infamous speech the S&P 500 exploded – rising from about 1000 to over 1400 by July of 1999. The Fed reacted to this 40% increase in the S&P 500 by hiking interest rates from 4.75% in June of 1999 to 6.5% in June of 2000.

Three months after the interest rate was lifted to 6.5%, the S&P 500 started to crash. The Fed had apparently overshot the interest rate and after a brief lag the S&P began to decline. In reaction to the onset of the crash, the Fed reversed course and began a series of interest rates cuts in January of 2001. Nonetheless, the S&P 500 continued to decline and the Fed continued to cut interest rates. By June of 2002 interest rates were dropped to a historic low of 1%. Yet this accommodative policy did not seem to help S&P 500, which dropped 47%. In April of 2003, five months after the Fed interest rate reached 1%, the bottom for the S&P 500 was established. Again, there was a lag between the conclusion of a series of Federal interest rates moves and the moves in the equity markets.

Since April of 2003, the S&P 500 is up more than 50% and has been rising almost non-stop. The unnaturally low 1% interest rate (negative real interest rate) created by the Fed in 2003 spurred a boom in equity and commodity markets. In turn, the rise in commodities was the driver behind the latest interest rate hike campaign that started in 2004. Like the stock market in 1999, which did not react to the Fed’s tightening policy until months later, commodity prices have failed to respond to the recent rate hikes designed to dampen inflation. It is uncertain at this time whether rates are now high enough to clamp down commodity prices. A $100 a barrel oil price could force the Fed to tighten further. However, taking history as a guide, the Fed tends to overshoot on interest moves and equity and commodity markets usually react after a period of lag. If the Fed has already overshot rates again, history shows us that the equities markets may begin to buckle within the next three to six months. Such an outcome could prompt the Fed to possibly ease rates by early next year.

The pause signals a new era for the precious metals. Since 2004, gold and silver have been rising in tandem with rising interest rates. It remains to be seen whether the precious metals will continue to rise independent of interest rate hikes. As the markets take the time to adjust to the Fed’s interest rate policy, metals investors must become more macro-aware and keep a close eye on the U.S equity markets as well as the metals markets.

Link here.

Big fund flow into commodities seen from Japan.

Commodity markets, long shunned by cautious Japanese investors as too risky, could see an inflow of billions of dollars in the next few years as financial firms in the world’s No. 2 economy hike exposure in hopes of big returns. Global prices have skyrocketed. Non-ferrous metals such as nickel and copper have doubled since the start of the year, while gold jumped nearly 40% to a 26-year high in May and crude oil reached a record high above $78 a barrel last month.

Wealthy retail investors and small and mid-sized institutions have already bought a variety of instruments linked to oil and metals, including bonds and funds. The value of commodities-linked investment trust funds, which are placed publicly in Japan, has jumped to about $1 billion from around $70 million when they were first offered in late 2004. But the market could explode should big institutions, such as mega-banks, life insurers and major pensions, decide to shift part of their assets into commodities. “More and more institutional investors are regarding commodities as a legitimate asset class, while in the past such recognition was very low,” said Naohiro Niimura, a vice president at Mizuho Corporate Bank’s derivative products division. “It may take a while before major institutions actually step in, but funds worth several trillion yen could go to commodities in the next two to three years.”

Link here.


One of our favorite analysts, Doug Casey, over the last few months has referred to “The Shopping Season” … a time to pick up at bargain prices, some of your favorite stocks and long-term warrants before this Fall’s resumption of the bull market. We and some other analysts have been anticipating the markets to take off before the end of August. Staying abreast of the current news, we see that mining companies are actually reporting some good earnings and that exploration projects are advancing and the news is good. All of this, setting the stage for one heck of a rally.

As we write this article with Gold at 625.60, Silver at 12.27 and the XAU at 146.56, we have to conclude that investors should now be leaving the grocery store, proud of their new purchases, take a deep breath and exercise patience. Sure we will have some “backing and filling” but do not dilly dally. Ourselves, we are aggressive investors preferring to purchase the shares of the junior mining exploration companies and or their long-term warrants, if trading. We had our personal “shopping list” prepared 2 months ago and during this corrective phase have made numerous new additions to our portfolio and/or added to existing positions. We were aggressive buyers when some of our favorites were beaten down on this correction. We wish to say thanks to the sellers of those shares that we picked at the lows.

Link here.


And after having warned for the last few years that the growing global imbalances would lead to some sort of crisis, Stephen Roach recently expressed optimism that a terribly disruptive endgame for global rebalancing could be avoided. Had global policy makers ignored the problems, a dollar crisis at some point in the not-so-distant future was a distinctive possibility. “But now the combination of architectural reform, currency adjustments, and monetary tightening points toward a more orderly and hopefully benign strain of global rebalancing.” Still, Roach also warns, “It is important to stress that an orderly adjustment in the real economy is no guarantee of an orderly adjustment in liquidity-driven markets, especially those risky assets that have gone to excess.”

I have to confess that I am far less optimistic about the prospects of the G-7 governments and, in particular, finance ministers, central bankers, and the IMF being able to achieve “orderly” and “benign strains” of the rebalancing act. My principal concern centers on the negative impact of a disorderly adjustment in liquidity-driven markets leading to severe adjustments in the global economy. In fact, the innovative solution advanced by Dario Perkins of the ABN-AMRO research team in London seems to make far more sense: “Consider this – the average European saves 11.5% of their income. But the average American saves nothing. So, if we replaced 106 million Europeans with Americans, the US household saving rate would rise to 4%. And the European saving rate would drop to 7.5%. Suddenly, we have a European consumer boom, a sustainable US saving rate and a significant reduction in global imbalances … But I doubt that even Mr. Brown would take this suggestion seriously – to start, where are we going to find 106 million Americans who have their own passports?”

In the U.S., the cost of food, energy, interest payments, and medical expenses has risen substantially and led to a slowdown of discretionary consumption. That consumer spending is not doing well is also evident from retail stocks rolling over and from consumer discretionary stocks’ poor performance. USA Today reported on July 18 that, in the U.S., “the $70 billion casual dining industry – sit down eateries that generally serve alcohol and sell entrees from $10 to $20 – is taking a hit.” According to Lynne Collier, restaurant analyst at Stephens Inc., in the 12 years she has covered this industry she has never seen a “downturn of this magnitude.” Nine out of the ten casual restaurant chains she follows have seen traffic decline in the past three months vs. a year earlier. What seems to have happened is that diminishing available incomes for discretionary spending due to higher energy prices and higher interest costs have forced consumers to scale down to fast-food stores such as McDonald’s, where Q2 same-store sales were up 4.2%.

The other day, I read Raymond DeVoe’s DeVoe Report, which is always entertaining and loaded with personal anecdotes. His April 26 issue immediately caught my attention:

“The late Bernard Baruch, one of the great speculators of all time, had a strategy that he followed whenever he became bored with his stock holdings. Not only bored, but when he was confused about the stock market’s action – or lack of it. If the stock market appeared to be drifting, not reacting to generally favorable fundamentals and his stocks were going nowhere he closed out all positions, long and short and went away for a month – two months when he sailed to Europe.

“Invariably the stock market was down when he returned, and his former long positions frequently down more than the market averages. He had sensed a subtle change in market patterns, and followed his instincts. … For some time I followed Mr. Baruch’s strategy whenever I planned a vacation – not that I was bored with my stocks, but for another reason. …”

Selling one’s stocks occasionally (or taking one’s losses on short positions) seems to be an excellent concept. In the world of investments, there will never be a shortage of opportunities for the patient, persistent, and disciplined investor. The complacency DeVoe refers to exists – despite all the talk of widespread bearishness – for equities. It is true that sentiment readings have turned more bearish, but also consider the following. Barron’s reported in mid-July (after the market’s May-June sell-off) that “The State Street Investor Confidence Index” – a unique gauge that measures real-money investment flows among various asset classes and which is distilled to represent institutions’ relative risk-taking activity – showed, as of mid-June, a steep increase since February in institutions’ “confidence” or willingness to take on risk – specifically, equity risk. Because State Street is a huge asset custodian for global institutions, its clients’ behavior is a representative snapshot of what traditional, longonly institutions are doing. Moreover, Barron’s reported that “the latest reading was exceeded only once in the past two years, in March 2005, and then only slightly.”

Barron’s also referred to Robert Shiller, the author of Irrational Exuberance, who compiles a monthly institutional investor confidence measure – a simple measure, which tallies the percentage of respondents who think the Dow will be higher in a year. The latest result, for May, showed that 92.6% of respondents believed the Dow would be up in a year – the highest level since Shiller started the survey in 1989! Finally, the COT [Consensus of Traders] Report shows that large speculators are holding their largest DJIA futures positions since the Bush re-election rally and that small speculators are holding a record number of Dow Jones Average futures by a multiple number.

That institutional investors have great “confidence” in the market rising soon is also evident from the equity mutual funds cash to assets ratio. As Robert Prechter points out, it will take time to break fund managers’ complacency and to bring the cash to assets ratio to above 10%, which usually occurs at major market lows (1974, 1982, and 1991). Finally, I follow the NYSE Uptick-Downtick indicator (Tick index). From June 26 to July 24, this index rose to above 1000 (short-term buying panics) on more than 60 occasions. But how many times did it show a reading of minus 1000, which indicates some kind of short-term selling panic? On just six occasions. The Tick indicator would therefore, at present, indicate enormous latent bullishness rather than any strong desire to liquidate stock positions and to “get out at any cost”!

Link here.


It is the most tantalizing question in Asian economics: When can the region stand alone from the U.S.? The world’s biggest economy is the dominant trading force. Sure, China is booming, India is catching up and growth remains strong in Southeast Asia. Yet the region is thought to be doomed if the U.S. falters. The numbers tell the story. China’s economy is less than 20% of the U.S.’s. Toss in India and the rest of Asia – excluding Japan – and we are still only talking about less than 40% of U.S. GDP. Also, much of the region is running trade surpluses, meaning their economies are demanding less than they are producing. And so, it would seem to follow that if the U.S. slows significantly, so does Asia.

Not so fast, says David Carbon, an economist at DBS Bank in Singapore. Carbon argues the impact of a U.S. slowdown will be “less than one would think, and certainly less than in the past.” Yet it is his take on Asia’s exponentially increasing role in the global economy that may come as a surprise to many. The basic gist of Carbon’s argument is that in five years’ time, domestic demand in Asia will outstrip that of the U.S. The reason? Asian economies are booming, rapidly integrating and their young, growing populations will support strong growth.

Is Chinese growth, coupled with Asian demand, really a replacement for the U.S.’s $12.5 trillion economy? Personally, I would say not yet. While it is certainly possible that Asia will surpass the U.S. in economic influence, there are some things to keep in mind. Asia needs the U.S. in the short run. In order to continue integrating to create a European-style single market and maintain strong growth, Asia will require considerable political will. Such resolve will only be possible if the region continues to expand rapidly. A U.S. slowdown may dent that political will.

China’s rise simply is not stable enough or of significant magnitude to play the role the U.S. currently does in Asia, or the one Japan did before it fell into the deflationary isolation of the 1990s. China’s $2.2 trillion economy is loaded with risks ranging from a rickety financial system to rampant pollution and social instability. The 11.3% growth that China recorded in the second quarter is setting off alarm bells in Beijing, and officials are trying to calm things down. Even louder bells may ring if a U.S. slowdown slams China. For now, China is at best a support for Asia and will come in handy if the U.S. weakens. Someday, China may have the booming domestic market that will allow it to become Asia’s economic engine. It does not yet exist. The economic future may indeed be Asia’s. The irony is that the region may have a hard time realizing it without help from the U.S. in the short run.

Link here.


Insider buying – one of the most reliable buy indicators you will find – has picked up a bit in the last couple weeks, as you can see from this chart. As you can see, there is a very clear relationship between insider buying and the “price” of the overall market. Namely, when stocks are cheap, the insiders load up (a la 2001 and 2002). And when the market is expensive, insiders sell more than they buy. Today, we are in that expensive zone. More insiders are selling their stocks than buying. But there are some opportunities to be had for diligent investors.

I ran a screen looking for the most significant insider purchases in the small-cap market since the beginning of August. I wanted to know all of the companies (with a market capitalization between $300 million-1.5 billion) that met certain criteria. 32 companies fit the bill. Equipped with this short list of stocks, I looked for some trends to see if I could narrow the list even further. So I noted every company’s industry. You will often find that the insiders have a tendency to load up on beaten-down industries that Wall Street hates. For those of you who are aware of these situations, you can find some interesting buying opportunities long before the mainstream press figures them out. Remember, the insiders are not stupid people. They will only invest when they see some upside potential.

With that in mind, the three industries (in the small-cap sector) with the most insider buying this month are regional banks, REITs, and automotive. Of these three, the auto industry has been punished the most. Thus, it should be no surprise that insiders have spent $3.2 million buying shares of Pep Boys – Manny, Moe & Jack (NYSE: PBY), $444,000 buying shares of Superior Industries International (NYSE: SUP) and $129,590 buying shares of Lithia Motors (NYSE: LAD).

Pep Boys is the leader in the automotive aftermarket. It has 593 stores and more than 6,000 service bays around the country. The last year has not been a good one for PBY. The company is in turnaround mode. And it is dealing with the effects of higher gas prices – the higher gas prices go, the less people drive, and the less demand there is for replacement auto parts. PBY’s stock price plummeted from $16.50 in February to $9.50 this month. Of course, the million-dollar question is, how low can this stock go? The insiders do not think it will go much lower at all.

Superior Industries designs and manufactures aluminum road wheels for original equipment manufacturers like Ford, GM, Isuzu, Jaguar, Toyota and Volkswagen. Back in 2000, nearly 100% of Superior’s sales came from Ford and GM. Given Ford and GM’s recent problems (read: colossal meltdown), Superior recorded a loss in 2005, after netting $1.68 in earnings per share the year before. Its stock has fallen from $23 to $17. Over the last year, Superior has worked hard to diversify its customer base. According to its latest annual report, 73% of its business comes from Ford and GM today, and 11% of all sales now come from international OEMs. This is an improvement – although it is still heavily exposed to the “big two”. Despite these obvious risks, Superior’s CEO just bought 25,000 of stock at $17.76 a pop, spending $444,000 – or 68% of his annual salary – on a stock that has been in a tailspin of late. If a few more insiders follow suit, you should pay attention. This could be a nice turnaround story.

Lithia Motors “is one of the largest full-service new vehicle retailers in the United States, with 97 stores in 38 markets located in 13 states in the Western United States. Lithia offers 25 brands of new domestic and imported vehicles, all makes of used vehicles, service and parts and finance/insurance.” With higher interest rates and record high fuel prices, Lithia’s margins have taken it on the chin of late. If the company nets only $2 in earnings per share for FY 2006 – lower than the current expectations – that means LAD is currently trading for 12.3 times earnings, about 0.2 times sales and just over 1 times book value. Maybe that is why the company’s president, Dick Heimann, just slapped down $129,000 to buy shares for his own portfolio. Again, I would not go out and buy this stock just yet. But if a few more insiders start buying LAD at today’s prices, you may want to take a close look at it.

Link here.


Cricket is a game of passion, say the fans. But unlike, say, soccer fans, cricketers generally are not known to rampage through city streets burning cars and breaking windows after their team has lost. A game for true gentlemen, it is probably the only sport in the world that incorporates obligatory “tea intervals”. Which only makes the incident in London on Sunday, August 20, so much more unlikely. Here is how it all went down. The British and the Pakistani teams were playing a friendly game, a part of the 5-day series. But when they broke for another “tea interval”, the Pakistani team went into their dressing room and did not come out, forcing the umpire to give the victory to the English team “by forfeiture” – the first such case ever in cricket’s history.

What made the Pakistani players so upset was the umpire’s accusation that they had tempered with the ball. As in baseball, in cricket any scuffing of the ball for “aerodynamic effect” is illegal. More than that, even: It is the “the most grievous act anyone can commit on a cricket pitch.” And that is precisely what the umpire said the Pakistani payers did before he “awarded five penalty runs to England,” thus giving that team a big advantage (LA Times).

Even if that decision were unfair, it is hardly the first unfair decision by a referee in sports history. But the Pakistani team took it as a racial “slur” and “cricket spun out of control,” summed up The Independent. Granted, the umpire Darrell Hair has been a part of a racial controversy on at least one prior occasion – but it was 11 years ago. We at EWI are not cricket aficionados by any stretch, but perhaps the Pakistani players took Hair’s decision a little too personally? And if so, why? From an Elliott wave point of view, the answer is simple: Social mood is changing its course. Here is how Bob Prechter describes the effects of such a change in his Conquer the Crash:

“The main social influence of a bear market is to cause society to polarize in countless ways. That polarity shows up in every imaginable context – social, religious, political, racial, corporate, by class and otherwise. In a bear market, people in whatever way are impelled to identify themselves as belonging to a smaller social unit than they did before and to belong more passionately. It is probably a product of the anger that accompanies bear markets, because each social unit seems invariably to find reasons to be angry with and to attack its opposing unit.”

Can that description be applied to the ongoing “unprecedented cricket crisis”? The answer becomes more obvious after you take a look at this chart of Pakistan’s Karachi 100 stock index. After peaking above 12,000 back in May, the index then proceeded to lose about 3,500 points, or about 30%. In the financial industry, a decline of 20% or more is generally recognized as a bear market. It may be a bit of a stretch to say that the Pakistani papers have accused the umpire Hair of “racist behavior”, called him a “mini-Hitler”, and some of the fans even chanted “Death to Darrell Hair” in the streets purely due to the after-effects of the recent downturn in Pakistan’s social mood, as indicated by the change in the direction of the country’s stocks. After all, sports is sports, and fans often get overly emotional regardless of the stock market trend. But it makes you wonder, doesn’t it?

Link here.
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