Wealth International, Limited

Finance Digest for Week of September 4, 2006

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


In most of the gold analysis I see now, it appears that most of the bullish assessments are based on the world economic growth of recent years, but little regard is given to a coming severe U.S. economic contraction. That is to begin in earnest by about January 2007. The U.S. and West are going to find a world hostile to their intent, and become enmeshed in a deconstruction of the great World War II Western Prosperity Bubble. The world will have to reorganize economically, in great pain, to replace this prosperity bubble. The U.S. housing bubble will lead to a once in a century depression like the 1930’s, and the heavily indebted west, the E.U. and Japan, will follow into a deep recession. The rest of the world, even gangbusters China and India, will follow soon after.

After WWII, the West, led by the U.S., totally dominated the world economically. The West defined then was Europe, Japan, and the U.S.. Since then, we have all accumulated massive public and private debts. This was done as the children of the baby boomers attempted to live at a standard of their parents, and the victor generation of WWII. At that time, China was an economic basket case. Russia was a blustering but bankrupt command economy, and Latin America a constant political mess. But the resource bull of recent years has filled Latin America’s coffers, and they are breaking away from the Western economic/political juggernaut. Russia is finding itself financially strong again, now with close to $300 billion of reserves, largely built from the resource boom. China is exploding economically, as we all know. But Japan is mired in a seeming constant battle with deflation, their recent economic prosperity aside. Europe is socialistic. The U.S. is a finance basket case. Then all the other players, China, India, Russia, Latin America, Asia, will deconstruct. When the post-WWII prosperity bubble pops they will have to create a new way to function economically. In the meantime, I foresee riots and deep economic depression for them too.

What is the big question about gold now? Firstly, gold is horizontal for the last month or so – no major trends have been established or even continued. Of course, quiet periods are usually a harbinger of major action. The entire world is balancing between gangbuster growth in the East and an actual depression about to emerge in the U.S. The big gold story right now is the impending economic recession or depression coming right now upon the U.S., and the end of the post WWII prosperity boom in the West. If the U.S. was showing better economic health, gold right now would be about at least $50 and probably $100 higher. I think gold first, and the commodity market in general, is going to reflect declining world economic demand that will become more clear by January 2007.

If economic activity – in the world’s largest economy by far – collapses, as I suspect it will beginning in 2007, gold will find that inflation vanishes, industrial production drops precipitously, and all those expensive commodities now are going to tank starting in 2007. Now, there are seasonal reasons for gold to rise this winter/fall. But if war fears barely even kept gold up in the Middle East, who is to say that seasonal gold purchases in the Fall/Winter will keep gold up either? I smell a weak or horizontal gold market this winter.

Do you know that a typical new house has something like 1200 lbs of copper? Imagine the drop in copper demand if new real estate construction halts. Of course, China appears to be able to consume all the copper they can buy, but if the U.S. slows greatly and their exports to us drop, and their own out of control building bubble pops, how much will copper drop? A lot. Financial writers forecasting strong gold into December are frankly looking at the recent economic past, but not the turning economic situation in the U.S. now.

Often, financial writers stay caught up in the latest financial trends and miss the changes afoot. The financial trends of recent memory are (1) rising inflation, (2) commodity shortages, (3) world economic boom from finance bubbles and the mother of them all – a world real estate bubble. Changing financial trends afoot now are (1) collapsing U.S. and world housing bubbles, (2) weakening interest rate environment and inverted yield curve, (3) coming U.S. economic contraction and loss of U.S. consumer confidence. The markets have not quite realized the extent of this change coming upon the world, nor the clear effects it will have on stocks and commodities too. But gold might indeed be smelling the implications – hence, gold is very weak on the upside, and normally bullish news barely takes hold.

Link here.

IMF warns of “severe global slowdown”.

The world is set to enjoy a 5th record year of high growth next year, says the International Monetary Fund, but it warns that the risks of a sharp slowdown have significantly increased. The IMF will say next week that the world economy is on track to grow at 5.1% this year but the risk of a severe global slowdown in 2007 is stronger than at any time since the 2001 terror attacks on the U.S. “Risk to the global outlook is clearly tilted to the downside,” the IMF said, adding, “there is a one-in-six chance of growth falling below 3.25 per cent in 2007.” The warning comes in a report to finance ministers at next week’s meeting of the G7 in Singapore.

The IMF warns slower growth could be triggered by a sharp U.S. housing market slowdown or by surging inflationary expectations that forced central banks to raise interest rates. Although the IMF has been warning for several years of mounting risk for the global economy, it is the first time it has warned so strongly about such a sharp potential slowdown.

Link here.
Will income growth offset weak housing? – link.


The annual Honor Roll highlights great funds to hold for the long haul – 10 exceptional funds that pair impressive long-term performance with the much underappreciated trait of consistency. The survey also presents the latest semiannual performance grades for roughly 2,500 U.S. and non-U.S. stock and bond funds through both up and down market cycles, and “Best Buys” for balanced funds, European funds, foreign funds, global funds, index funds, Pacific funds, bond funds, and stock funds.

Link here.

How the Forbes Honor Roll is guaged.

You want to own a fund that posts great returns and does not unduly sap you with fees, expenses and taxes. In our yearly Honor Roll we find those exceptional funds that pair impressive long-term performance with the frequently underappreciated trait of consistency.

Consistency? Our 10-member Honor Roll of 2006 is remarkably similar to last year’s cast, with 9 of 10 members returning from 2005. There are two reasons for the steadiness in the list. One is that our measurement period goes way back (to January 31, 1994). The other is that we put particular emphasis on how well a fund holds up in a down market. About most of these funds you could say that it is not that they make more, it is that they lose less. Raw performance, the usual metric of fund raters, tends to reward funds that are lucky in spurts.

To assess long-term performance we look at how well funds have fared over four market cycles. Funds have to earn a B grade or higher in down markets and at least a C in up markets. Calamos Growth Fund, an Honor Roll member for three years running, fell off the list this year because its down market grade slipped to a C. Managers must have been on the job for at least six years: The record you see is from the manager you get. We want portfolio diversification, which eliminates some exceptional sector funds. Another stipulation is that Honor Roll members must be open to new investors. We calculate hypothetical investment results after considering any sales commissions and taxes forked over by an upper-income investor.

Link here.
The best … and the worst – link.

Fees are shrinking at certain mutual funds. But this might not mean your own bill gets smaller.

Is it getting cheaper to own mutual fund shares? Yes and no. Yes, if you know what you are doing. The Investment Company Institute, trade association for the $9.3 trillion U.S. fund industry, calculates that average fund expenses have fallen by half over the past quarter-century, from 2.3% of assets annually to 1.2%. To arrive at this happy conclusion it throws upfront sales commissions into the pot (by spreading them over up to 15 years and looking at commissions investors actually pay). That tilts the cost-curve downward because upfront commissions were once more common than they are now. The ICI also weights fund expense ratios by the size of each fund. This gives a lot of weight to the ultracheap index funds that have proliferated. John Bogle, retired chairman of the Vanguard Group and a self-appointed crusader for fund shareholders, comes up with a different answer to the question. He argues that fund ownership costs display an upward creep over the years.

Both of these experts are right. Yes, fund ownership is now a bargain if you seek out low-cost offerings for the bulk of your portfolio. You might, for example, put half your assets into an index fund to be held indefinitely, and seek out enhanced performance with the other half. But if you buy blindly, without looking at costs, funds are no bargain. The (size-weighted) average cost of the U.S. stock funds in the Lipper database is nearly 1%. Sales commissions, if you pay them, are in addition.

For decades Forbes has put special emphasis on costs in its evaluations of mutual funds. Over time the difference between a bargain fund slicing 0.5% off annual returns and a bad buy costing 2.5% adds up to a huge sum. And fund costs are one aspect of investing that you can control. Portfolio results are, to a large degree, a matter of luck. Why might costs be drifting down? Besides the pileup of money in index funds, one factor is price competition. Some funds are bucking the trend toward lower costs. WesBanco Bank says it hiked the fees on its WesMark Growth Fund (from 1.14% to 1.28%) because it is more expensive to meet regulatory standards now. Take that, Eliot Spitzer.

The ICI says it has a study showing that investors are doing a lot of price shopping these days and care more about fees than performance or risk. That will surely come as a surprise to anyone familiar with fund ads that display Morningstar stars or performance figures. And do not believe any sob stories about pricing pressure without taking a look at the financials of the publicly traded fund companies. Janus (NYSE: JNS) has a pretax profit margin of 18%. For a lot of players this remains a very lucrative business. Here are the polar opposites. On the left are funds (including one ETF) that are the rock-bottom cheapest going, with annual expenses of a tenth of a percent or less. On the right are the high-cost boys, whose expense ratios are outrageous.

Link here.
What is a better way of keeping fund costs down: lawsuits or plain old price competition? – link.


This is the day of exchange-traded funds. ETFs, baskets of stocks held in a fixed proportion, have three things going for them. (1) They have low expense ratios, generally much lower than expenses on comparable open-end mutual funds. (2) They are tax-efficient, minimizing capital gain distributions to holders. And (3) they are very, very liquid. ETFs are traded as stocks, just like old-fashioned closed-end funds, but – unlike those closed-ends – can be counted on to trade at prices very close to their net asset values. ETFs can be bought and sold around the clock with a mouse click. Traders can place stop and limit orders on these securities, and even can short them. Not so with funds.

Small wonder that assets in ETFs, which began in 1993 as a curiosity, have grown wildly. In the 12 months ending in June their assets shot up 38% to $335 billion, according to the Investment Company Institute. This year through July 2006 investment firms, some of them fund companies like Vanguard, have launched 56 new ETF issues – slightly more than debuted in all of 2005.

But hold on. ETFs’ cost advantage is not so clear-cut. In a number of cases, you would be better off sticking to plain old mutual funds. Yes, the average ETF costs just 0.38% of assets yearly, versus 0.54% for index mutual funds and 1.12% for actively managed mutual funds, reckons Financial Research Corp. As with stocks, however, buying ETFs means paying broker commissions that can range between $10 and $50 per trade. The amount depends on the size of the trade, assets invested and whether one uses a discount or full-service broker. When buying a fund, unless you are foolish enough to pay a sales load, the entry charge is zero. There is more. Like other stocks, ETFs have bid-ask spreads, so you will get nicked a little there if you go in and out.

So if you want to be in ETFs, the best strategy is to buy good ones in one lump sum and then hold. And as with anything else in investing, make sure that you are getting the cheapest ones possible, since fees over time will erode your returns. We have collected lists of some of the cheapest ETFs.

ETF owners seem to have the upper hand when it comes to the capital gains surprise. That is the year-end gut punch that investors too often get from mutual funds, when a fund manager sells positions to get money for a better opportunity or simply to meet investor redemptions. Remaining fund holders get slapped with the cap gains tax from the sale. ETF owners are not totally exempt from a nasty cap gains surprise. Even indexes occasionally need to be rebalanced, as when companies get bought for cash and ETF managers need to sell underlying stocks, leading to cap gains for investors.

Link here.

The tax-wise alternative to pure passive investing.

There is something to be said for passive investing. Put your money into an index fund mimicking the whole market and just forget about it. No fretting about the stock you sold too soon or the stinker you are going to unload just as soon as it gets back up to what you paid. Money management costs are minimal, not much more than 0.1% of assets annually. If that is a little too simpleminded for you, consider the idea of putting $30,000 into bonds, $40,000 into exotic things like commodities and foreign stocks, and $50,000 into U.S. stocks – for a $120,000 model portfolio – into ETFs.

Why take a simple concept like indexed investing and make it more complicated (and slightly more expensive)? By carving up your portfolio you get more opportunities for what is called loss harvesting. That means culling losers, realizing tax-deductible capital losses. Sell a loser after holding it for less than a year and you have a short-term capital loss, which can absorb any amount of capital gains plus up to $3,000 of your ordinary income per year (namely, your salary). Replace the deleted positions with similar ones, or, if you can stand to wait 31 days, with the identical ETFs. Unused capital losses can be carried forward. Ideally, you would hang on to your winners indefinitely.

Which ETFs? I threw in the finance one because banks, being boring, may be underweighted in your portfolio; Sweden, in the hope that it will become less socialistic; Hong Kong, as a gateway to China; energy, so that you can shrug off $3 gas; bonds, because Gary Shilling just might be right about deflation; gold, because James Grant may be right about inflation. The tax angle could backfire. A year hence every one of your positions is in the plus column and there are no short-term losses to grab. Probably you can live with that outcome.

Link here.
Beware of many so-called tax-efficient funds – link.

Most bond fund managers are restricted to buying one type or maturity. Not Carl Kaufman.

Carl Kaufman dislikes how stratified many bond funds are by maturity and by credit quality. “We don’t have handcuffs, so we get to use common sense,” he says, describing his method of picking bonds for smallish ($60 million assets) Osterweis Strategic Income. Osterweis’s charter allows him to buy any kind of bond he chooses, from high yield to high grade, from mortgages to international. And any maturity – short, intermediate, long. The flexibility has served his investors well. Strategic Income has returned an annual 9% since inception four years ago. So far this turbulent year it has returned 5.2%, ranking Kaufman number one among the 189 funds in research firm Morningstar’s multisector bond category. “A lot of funds are style-driven,” says Kaufman, shaking his head. “It’s easier for the marketing guys.”

Multisector bond funds have outpaced other types of bond funds except for high-paying emerging market paper (up 13.3% annually over three years) and domestic junk bonds (8.4%), both, of course, riskier. The most famous hybrid bond fund is Pimco Total Return (assets: $93 billion), managed by the celebrated William Gross. Gross’s performance since his 1987 start there has been remarkable, yet the smaller and more nimble Osterweis fund has outdone him lately. Over three years Osterweis is ahead an annual 7.2% to the Pimco fund’s 3.9%. Pimco has a 3.75% load, Osterweis none. The minimum direct investment in Osterweis Strategic Income is $5,000 ($1,500 through major fund supermarkets). Its annual expense ratio of 1.5% is high for a bond fund, even a hybrid, but as assets grow, this should come down.

To Kaufman, the beauty of multisector bond buying is an ability to navigate fixed-income cycles, which relate to interest rates and economic growth. Treasurys do much better than other bonds in recessions. In an economic rebound, high-yield bond funds do better since their odds of defaulting recede. Because of a flat yield curve now, where longer-term bonds return not much more than short-term paper, Kaufman and comanager Gregory Hermanski see the best opportunities in short maturities. They also are partial to convertibles – and junk.

Links here and here.

How Delafield Fund prospers from buying unloved stocks.

Say “capital preservation” and most folks would think of investments in U.S. Treasurys. Or perhaps blue chips. But knocked-down stocks? Well, the guys running the Delafield Fund prove that you can make big money pursuing what they charitably call “special situations” – the battered and bruised – and still limit your risk. Longtime partners and New Yorkers J. Dennis Delafield and Vincent Sellecchia have successfully piloted the $425 million (assets) Delafield Fund to its second appearance on the Forbes Honor Roll. What immediately catches the eye is the A+ grade we reckon their fund deserves for its performance during down markets, along with a solid B grade in bull markets. Only one other 2006 Honor Roll member, Bruce Fund, earns an A+ from us for its showing during bearish times.

Since it was launched 13 years ago, Delafield has had only two years where the returns were in negative territory – rocky 1998 and 2002. And while Delafield lost 7.5% in 2002, the S&P 500 lost 22.1%. Delafield and Sellecchia want improving balance sheets, steady earnings growth, copious free cash flow. They also want cost-cutting managers, skilled capital allocators who can smartly deploy that free cash. They find the most opportunity among small and midcap stocks. Since early 1994 Delafield Fund has produced a tidy 14% annualized total return, vs. the S&P 500’s 10%. A $10,000 investment in the fund 12½ years ago is now worth $43,400 after considering expenses and taxes. Had you put ten grand into the cheap Vanguard 500 Index Fund back then, you would have only $30,200 today. So far this year, in a range-bound market, Delafield is up 6%, a bit ahead of the S&P 500.

While the below-the-radar Delafield Fund has a certain, almost famous aura – marketing is not exactly a priority – there are boldface connections going way back. Dennis Delafield, 70, was the private money manager for the Ziffs (of publishing fame and Forbes 400 renown) for 23 years starting in 1967. Then in 1990 the enterprising Ziff children decided to take over the $900 million pile they had with Delafield and set up a family office. While the parting was amicable, Delafield Asset Management shrank overnight.

From Dennis Delafield’s paper-strewn Fifth Avenue office at Rockefeller Center, Delafield and Sellecchia, 54, explain their value investment strategy. Maybe there has been a missed earnings forecast, a botched acquisition, a screwed-up business unit. If the company’s valuation makes sense, they buy. And the world often comes around to their way of thinking.

Link here.


Nowadays the stock market has lots of political fear priced into it. Shrug off the fear and buy. You will find stocks a little cheaper than they should be. The fear is of a Democratic congressional sweep. The Dems’ taking both houses (gaining 6 Senate seats and 15 in the House) could destabilize markets. And markets do really hate political change. It is not that Republicans are good for stocks and Democrats bad. After all, stocks did well in the 1960s and 1990s, when Democrats had the White House, Congress or both. And stocks have disappointed during the current all-Republican era. What worries investors is simply any change in control – always.

Iraq, gasoline prices and the Middle East have the incumbent party on the defensive now, but here is something to appreciate: As congressional elections heat up, popularity shifts toward that party with the structural advantage. By that I mean which has fewer Senate seats up for reelection, which has fewer open seats (without an incumbent running), how seemingly close districts vote on other issues, which has more money and which controls the bulk of the state houses. These are all advantages. At the moment Republicans have the edge. In 2008 Democrats will, because there will be vastly more Republican Senate seats up for reelection. I might not be bullish in mid-2008, but I am now.

A basic rule of politics and a little-known fact is that the Senate changes hands so much more easily than the House that in 100 years the House has never changed hands unless the Senate has, too. For the Democrats to win the House they must win the Senate, which means they must win almost every close race – something that almost never happens. I count only seven this year. There are more Democratic than GOP Senate seats up in 2006. My forecast is for the GOP to lose three seats in the Senate and six in the House. Sometime before the election the market will perceive this likely outcome and will move upward in response.

Link here.


U.S. companies are spending record amounts of money on their shares, and the repurchases may help stocks exceed the 5-year highs reached earlier in the year. Microsoft, the world’s largest software maker, bought back $3.8 billion of stock last month. Realogy Corp., the real estate broker spun off from Cendant Corp., offered last week to pay as much as $736 million for some of its shares. The offers followed $116 billion of repurchases in the second quarter, the most ever, according to Standard & Poor’s. Buybacks announced in 2006 already exceed the record amount for a full year, according to Birinyi Associates Inc., a money management and research firm. Record levels of cash and relatively low interest rates have spurred buying. “Supply’s shrinking,” said Kenneth Fisher, chairman of Fisher Investments Inc. in Woodside, California, who oversees $32 billion. “That’s got to be bullish.”

Microsoft has risen 20% since June 13, when the S&P 500 reached its low for the year. The company announced plans in July to repurchase $40 billion of stock, including $20 billion through a tender offer. Investors tendered only $3.8 billion of shares. To make up the difference, Microsoft boosted its repurchase program to $36 billion on August 18. That day, its stock gained 4.4%, the most in a month.

Realogy, the company behind the Coldwell Banker and Century 21 real-estate brokerages, offered to buy as many as 32 million shares on August 28. The company agreed to pay $20 to $23 a share in the so-called Dutch auction, allowing shareholders to set the price they will accept. The offer expires on September 26. A week earlier, Realogy authorized a buyback plan for a maximum of 48 million shares. The company said the purchases may add as much as 10% to earnings per share next year. Boeing said on August 28 that it would buy back as much as $3 billion of shares. Amazon.com authorized $500 million in repurchases that same day.

Companies are making these plans after amassing record amounts of cash. S&P 500 members had $614 billion available as of Aug. 30, according to S&P, whose total excludes utilities and financial and transportation companies. “They’re being pushed to do something with the money,” said Howard Silverblatt, a senior index analyst at S&P. Buybacks enable companies to return cash to shareholders without committing themselves to future payments, as dividends do.

Relatively low interest rates have also been a boon for buybacks, Fisher said. S&P 500 companies will earn $87.17 per “share” this year, about 6.6% of the index’s current level, according to the average estimates of analysts surveyed by Thomson Financial. Ten-year U.S. Treasury notes, a benchmark for borrowing costs, yield 4.72%. “What they’re really saying is that the cost of the stock is too cheap relative to the cost of borrowed money,” he said, referring to companies. Repurchases can increase per-share earnings by reducing the amount of stock outstanding. Analysts see profit growth slowing through the second quarter of 2007, providing an incentive to make repurchases.

“Companies buying back their own shares may well reflect a lack of confidence,” said James Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, who helps manage $150 billion. “They feel they don’t have any good investment opportunities.” Announcements do not always lead to purchases. Since 2000, companies have bought only 65% of the shares they said they would, according to Birinyi’s data. Still, many investors cannot help but be optimistic about what the increase in buybacks may mean for the market. “How much can you shrink the denominator before it explodes the price?” asked Kevin Bannon, who helps manage $116 billion as chief investment officer at Bank of New York. “We’re getting closer and closer to that point.”

Link here.


After a five-year party, the real estate festivities are ending. Creative financing has fueled the housing mania as millions of home buyers ogled properties, then bought more house than they could afford. Disturbing fact, from the Mortgage Bankers Association: Last year adjustable rate mortgages hit a record fraction of home buying loans, at 37%. Something close to $500 billion in ARMs will reset this year, which means that millions of Americans will see their monthly payments skyrocket. As borrowing costs rise, the National Association of Realtors forecasts 2006 sales of existing homes will fall 7% and new homes 13%. Housing starts are expected to slide by 9%.

The impact on housing-related stocks has been harsh. In a crunch time many investors run away. The S&P 500 Homebuilding Index is down 42% from its July 2005 peak. Everything from carpet manufacturers to faucetmakers to power tool companies are feeling the ill effects. Some furniture and appliance companies have seen their stocks drop 25% over the past few months. Of course, when I hear bear stories, I get interested. Great value plays are available. The following are a few other bargains to be found in the cooling real estate market.

Link here.

No place like home.

What is killing the market? Horrors abroad. The post-Cold War tranquility lulled us into a false sense of security that September 11 shattered. Every time more ill tidings reach us via the media, the U.S. stock market wobbles. So what are the cheapest stocks to be in now? Those linked to real estate. The great real estate boom that occurred after September 11 initially had as much to do with a deep psychological need to stay close to home as it did with artificially low interest rates. This nesting instinct is once again on the upswing.

I know, I know … the housing market is supposed to be spiraling into the River Styx. But like fellow columnist John W. Rogers Jr. [above], I am skeptical of the oft-repeated assertion that housing is now a rapidly deflating bubble. When stocks take a dip, owners may panic and reinforce the selling pressure. But homeowners cannot simply unload their homes and go to cash. People need to live somewhere. Another factor supporting housing is the tax favoritism that Congress has directed at real estate, from the deductibility of mortgage interest to the near-exemption ($500,000 every two years) of capital gains.

The doomsayers argue that families will passively stand aside while mortgage rates are reset upward and let themselves be squeezed by rising interest costs. What the pessimists overlook is the evolution of homeowners from simple borrowers to liability managers. As interest rates rise and fall and the yield curve changes shape, mortgage holders have learned to be as astute as any corporate chief financial officer. They constantly refinance debt from floating to fixed, from interest-only to teaser rate.

The likely result? The housing market, rather than collapse, will simply remain stagnant for a while. Meantime, though, families across our country will continue to invest in their homes, where they feel safe and secure. This lays the foundation for an eventual housing rebound. The past year’s cooling of the real estate market is creating some terrific investment opportunities in housing-flavored stocks. Many of these have fallen by 40% to 50% in a year. Investors frequently forget that stocks are much more volatile than their underlying businesses. Housing shares are getting pummeled far worse than their fundamentals warrant. Americans love their homes and always will. A decade from now home prices will be at least a little higher than they are now, and housing stocks, collectively, a lot higher.

Link here.


American’s castles (homes) are middle class walls of separation from poverty and want. As goes the house goes the family’s ability to fend off tough times and leverage past wealth for opportunity. Borrowing to bridge low income periods, college costs, medical expenses, bail, renovations, retirement and unemployment are all common. This is the proper frame of discussion for the impending debt/depreciation storming of the castle. A few basic facts are worth repeating. $1.06 Trillion in residential mortgages were written in 2005. Nearly 70% of Americans own their residences. The home is by far the largest asset “owned” by the bottom 80% of citizens. For the last 10 years, and particularly the last 6, things have gotten pretty darn wild in the real estate world. Perhaps unreal estate would be a better phrase?

Housing prices, refinancing, building and improvement, buying and fixation have mushroomed. Many have made significant gains in home asset value – at least on paper. There is no longer debate that things have gone way beyond anything that might be sustained. Such debates are silly and are better handled by psychologists and psychiatrists than economists. As a member of the latter, I will defer to those equipped to comment from real knowledge and experience.

The coming return to earth will be uneven, disorderly and proceed in fits and starts. This we know from past episodes and our extensive and growing experience with bubbles – the new engine of the American Macroeconomy. The housing troubles ahead are serious and this is largely symptomatic of the greater shake-out in progress. A significant portion of the middle class is no more. Housing is about to turn onto another serious problem for these beset masses. It will join health coverage and cost, pension woes, massive debt, intergenerational demands and stagnant wages. All of these afflictions are related and interacting. Wages have not kept up, health care costs run several times the rate of inflation, and college tuitions soar. Aging parents require help with medical costs, children cost more and their early career wages do not come close to supporting a middle class existence. Thus, longer and more expensive support is often required. There are no savings and pensions are shaky. Rising house prices were a godsend to many – financially and psychically. This will soon run contrary.

Housing appreciation has been the lender of first and last resort to millions of families. Refinancing, cash out or interest rate lowering, has paid for more than meager gains in wages – even after some very modest tax relief. Housing appreciation did more for American families last year than wage and salary increases. This is set to reverse. Mortgage News Daily has recently reported an ominous sign of desperation: During the first quarter the median ratio of old-to-new interest rates was 0.98 which means that one half of borrowers who were refinancing mortgages ended up with a new loan with a rate that was 2% higher than the old rate. Thus, refinancing is clearly driven by the need for cash from appreciated housing more than rate changes – which should be discouraging.

Financial firms and employment have been massively assisted by the housing bubble. They are vulnerable to price stagnation and decline. The most recent FDIC Quarterly Banking Profile offers some remarkable numbers. Across Q4 2005 residential home equity lines and mortgages accounted for 38% of new loans and leases. This simply states that families and financial institutions are dependent on housing price gains.

Households also gained – many directly and some indirectly – from the employment generated by housing. Across the early years of the post equity market meltdown (2001-2004), housing and related sectors accounted for over 40% of U.S. private sector payroll growth. Since rate hikes began to effect markets, housing and related sectors have tumbled to account for less than 15% of private sector payroll growth. This is an ominous trend. The fragility and risk associated with housing gains is very serious. Unreal estate price increases are just that. Brace yourself for a dose of reality that will fall heavy on the shoulders of those least able to bare the load.

Housing wealth effects are in the process of resetting to run in reverse. Clearly this will occur sooner and more extensively in some places than others. This will last several years and be more than large enough to have negative macro effects on a par with the positive effects that we have seen across this long boom. We believe a pronounced housing slowdown will be followed by localized absolute declines in mean residence price. Given the exaggerated macro benefit that robust housing appreciation, refinance and associated activity have had, we are looking for a virtuous cycle to turn vicious with national and international implications. Low and middle income Americans will have to cut back on all forms of discretionary spending. The coming drastic reduction in purchasing of exports by suffering members of middle class – and soon to be former middle class Americans – will have global impact. Those who earn their keep producing and distributing to these masses will share in the pain as consumption spending is ratcheted down to levels at which America’s families can service debts and stay within modest and pressured incomes.

Link here.

Housing chill begins to pinch nation’s banks.

I have been hearing from acquaintances in the insurance business that the Housing Chill is hitting the bottom line of the insurers as well. People who are short of cash are canceling policies – life AND disability – so as to eliminate the monthly premiums. And the “Whole Life” segment is seeing a rise in early cash-outs, where people are looking for the cash value of the whole life policies. I am hearing this from agents for some pretty big companies, Mass Mutual, Northwest Mutual and Guardian.

A Pittsburgh real estate attorney is currently in the process of losing his Brooks Brothers shirt because he bought into a group of condos and houses in Florida. “I was expecting to flip them, just a layup shot,” as he told me. Now all of his properties are undersecured, and cash-flow negative. One of his lenders is asking for copies of recent balance sheets and cash flow statements. They are sending out the appraisers to do new appraisals. Whoops. This guy is now in the process of cashing out a lifetime worth of whole life insurance policies to get the funds to stay afloat. “This was the kids’ college money, if not my retirement nest egg. What in the hell was I ever thinking? My wife is furious, my kids do not know about this but they are going to hate me, and my dad is just shaking his head, like ‘I thought I raised you better than that.’ I am probably going to have to work until the day I die, and then my family will not have any life insurance on me. Man, did I ever screw myself.”

Note the last line. At this point, he is blaming himself. Just wait. Eventually he, and others like him, will probably figure out that they have been victimized. We will all figure out some way to blame other people, and then sue the class-action crap out of them. Or bomb them back to the stone age.

Link here.

“Priced below assessment”

Falling prices have created a new twist in the suburban Boston real estate market: More homes are selling for less than their assessed values. Massachusetts house prices slumped 3.5% in July, the biggest monthly drop since 1993, as a slowdown in sales brought about by rising interest rates created a glut of homes on the market. As a result, home prices are falling below assessments, which are the estimated values communities place on homes to determine property taxes.

State law requires communities to assess properties at “full and fair cash value”. In a stable market, a property’s assessed value can provide a useful estimate of the home’s market value to buyers and sellers. But for the past five years, most homes sold well above their assessed values because prices were rising faster than assessments, which typically are at least a year old. In today’s declining market, some homes are now selling for less than the assessed value in stable communities like Newton, where top-ranked schools and a short commute into Boston help homes hold their values, and in volatile markets such as Lowell, where professionals and foreign-born residents drove up real estate prices.

“Before, it was, pay no attention to that assessment. Now it’s, pay no attention to that asking price,” said Bill Wendel, owner of a Cambridge fee-for-service brokerage firm, The Real Estate Cafe. Wendel’s blog compares sale prices and assessments of Boston-area houses. He said that 3.4 out of every 1,000 single-family listings in Massachusetts used the words “below assessed” or “below assessment” in the description agents use to promote clients’ properties, according to a search in late August of the state’s property-listing database.

An analysis of Newton home sales showed 16.5% of homes sold below assessment between January and June, up from 10% the prior two years. In the $1 million-plus housing market in Greater Boston, sales plunged 62% this year. The drop is making it “routine” for assessments to exceed asking prices in that market, said Landvest agent Terry Mailtland, causing problems for sellers whose assessments are so high that buyers perceive a big tax bill as “an impediment to a sale.”

In Lowell, where housing values rose faster than Newton’s, more than 20% of its residential and commercial properties sold below assessment in recent months, according to an analysis of property deed records. If house prices continue falling, assessments eventually have to follow. But “the taxes will always go up,” said Richard D. Simmons Jr., the assessor for Belmont, a wealthy suburb northwest of Boston. “I don’t want people to say,‘My values are going down. My taxes are going down. That’s not going to happen.”

Link here.

Mortgages grow riskier, and investors are attracted.

Default rates are inching up, credit ratings agencies have become more cautious and regulators have threatened to crack down on loose lending standards. Yet even as analysts and officials have been ringing warning bells about exotic mortgages for months and fresh housing data has indicated that the risks are rising, investors have seen little reason to abandon the bonds backed by these home loans. To the contrary, they have increased their exposure to the securities.

Among the risks is the growing possibility that declining home values could leave home-owners with too little equity to support their mortgages. In the first six months of the year, investors bought residential mortgage-backed securities totaling more than $1 trillion, up 5% from the period a year ago. And Wall Street has pushed further into the mortgage-backed securities business in recent years, profiting handsomely from the business of packaging and selling mortgages. In a deal seen as an effort to catch up with those firms, Merrill Lynch announced that it would pay $1.3 billion to buy the First Franklin Financial mortgage unit of the National City Corporation, which was among the first to issue interest-only mortgages that allow borrowers to pay no principal in the early years of their loans.

Banks, insurance companies, hedge funds and other large investors are buying the bonds for high returns and because their structures allow them to choose just how much risk they want to shoulder. For all the concerns about the slowing housing market and indebted American consumers, money managers note that investors have few options for earning relatively high returns in an era of low interest rates. If investors stop buying or sell their holdings, either because of troubles in the housing market or an unrelated financial calamity, the cost of home loans would shoot up. Homeowners, meanwhile, could cost portfolio managers millions or billions in losses if too many of them default on payments. Most of the attention has so far focused on the financial health of borrowers. Will they be able to adjust to higher monthly payments as interest rates and monthly payments on adjustable-rate loans climb? Will a feared drop in home values reduce their ability to refinance?

Link here.


Investigative journalist Gary Weiss has revealed the existence of organized crime on Wall Street, leading to many arrests and a colorful book, Born to Steal, about one mob-connected stockbroker. Now he is back with his second book, Wall Street Versus America, which sweeps across the investment world, uncovering the many ways that ordinary investors get fleeced. The book is shorter on original reporting and killer anecdotes than his first, but it is enlivened by prose that is biting and funny.

Hedge funds are “sometimes called investment vehicles, as in the Porsches their managers buy with your money,” he writes. Mutual fund managers are “happy people with high self-esteem who draw fat salaries and bonuses for jobs that could literally be performed by nobody – an unmanaged index fund.”

What does he think about the backdating options scandals? “Actually, I think this backdating scandal shows a high degree of idealism on the part of the individuals involved. Clearly, these were people imbued with an all-American go-getter attitude, and a keen interest in finding new and better ways of outflanking the securities laws. You know, I sometimes think that Wall Street is stuck in a 1960s-1970s counterculture mind-set – an attitude that the “establishment” needs to be ripped off at every opportunity. Abbie Hoffman wrote Steal This Book, but there are any number of execs who could write Steal This Company.”

The proprietary trading desks at the big banks have been churning out huge profits ever since the downturn. How come the house always seems to win, quarter after quarter? “Come now. The big banks’ trading desks aren’t like you and me. They’re not day traders with good broadband connections who try to guess at where the market is heading. These guys are the market. So naturally they tend to do very well at rapid-fire trading, arbitrage and so on. Take away that ‘we are the market’ advantage, and they struggle to beat the indexes like everyone else. Just look at the performance of their house mutual funds and hedge funds.”

Eliot Spitzer seems headed for the governor’s mansion. Assuming his Wall Street muckraking days are behind him, how would you assess his legacy? “His legacy is that he took a sleepy backwater of an attorney general’s office and turned it into a major source of meaty press releases. … I don’t think he did a thing to change in any meaningful way how Wall Street does business, and precious little to help investors. But he generated news and built himself a nice career. He is the Tom Dewey of his generation. He may be a vice presidential candidate some day. If that fails – well, there’s always consulting. I see it now: ‘Spitzer Associates’.”

Link here.


The Wall Street Journal strongly endorsed a paper by Kip Hagopian in the California Management Review denouncing the expensing of stock options, and demanding a return to the previous system whereby stock option costs were as far as possible ignored. The paper was cosigned by 26 eminent figures, including, astoundingly, Milton Friedman. I will defend staunchly the proposition that Friedman is the greatest economist of the last half century, but if the Royal Swedish Academy of Sciences reads the paper and is doing its job it will seriously consider revoking his Nobel.

The Hagopian paper claims that expensing stock options is improper accounting because stock options represent a contract between shareholders and employees, that is outside rather than within the company itself. Thus their cost should not be reflected in the company’s accounts. This claim looks plausible (albeit far fetched, since I know of no other cost item that gets treated this way) until you consider the question of where the stock option expense should be reflected. Contrary to tech sector management’s belief, it is not magic money from nowhere, so if it produces a gain for the recipients of stock options – and it certainly does – it must produce an equal and opposite cost for someone else. If it is a “gain sharing instrument” between shareholders and management, as Hagopian claims, the cost of the gain must be attributed to shareholders.

For individual shareholders, this would not matter. Most of them would attempt to claim the loss on their tax return, then grind their teeth when the deduction was disallowed. However, in the case of mutual funds, the grant of stock options clearly increases the management costs and expenses of the funds, and so should be added to such costs. This would be highly salutary, but not very helpful for the tech sector, as tech sector mutual funds would all report management and operating costs of perhaps 8-9% of assets per annum. Since mutual fund shareholders, unlike hedge fund shareholders, are not stupid, nobody would invest in tech sector mutual funds on such a basis, and the tech sector would be unable to raise money from the mutual fund pool. Not only is the accounting treatment recommended by Hagopian bizarre, therefore, it would also if carried through logically render the tech sector a highly unattractive investment unless stock options were eliminated altogether – presumably not the result he had in mind. In reality, stock options are executive compensation just like any other executive compensation. Thus they need to be expensed on the income statement. The only question is how they should be valued.

The principal objection to “free” stock options for management is not accounting but economics – it provides management with incentives that are highly detrimental to the interests of shareholders. The principal difficulty in making shareholder capitalism work is the agency problem between management and the shareholders. In the Anglo-American system (the German system is different, and in some respects better) management is appointed by the Board of Directors, who are elected by the shareholders at the Annual General Meeting. In a family company, as were most enterprises in the early years of industrialization, this works fine – any nonsense from management and the family gets together to put pressure on the directors to remove them.

In a company with a broad public shareholder base, it is not so easy. Obviously, one difficulty is that it may be very difficult to assemble a coalition to do anything, so that shareholders’ rights may not be properly asserted. More important, many of the shareholders are institutional, therefore having owners who themselves have an agency problem with the managers of the money. This immediately provides a temptation for institutional managers to collude with company management against the interests of shareholders. If that happens, individual shareholders might as well give up immediately. They have neither the voting power nor the organizational capability to resist.

In the case of stock options, it would at first sight appear that management and institutional shareholders have a traditional win/lose relationship. As value is extracted by company management through stock option grants, stock performance should suffer and the institutional money managers be correspondingly penalized. However, in the case of stock options, two factors mitigate this. First, if the options are not expensed and exercise of the options is delayed several years, their granting has no impact on the financial statements of the granting company, and hence money managers have no incentive to prevent the options being granted – in five years time, when a massive transfer of wealth from shareholders to management occurs, they will be managing other money and their role will be forgotten. Even with expensing of options, they may not be properly expensed. The current FASB Statement 123R allows a wide choice of methods for options expensing, and it is safe to assume that the majority of companies in the tech sector will choose the method that is least damaging to the income statement, hence generally least adequate as a statement of reality.

However, there is a greater and more generally important conflict in the stock options issue, which is that both company management and institutional money managers mostly belong to the MBA-educated affluent management class. Without buying excessively into Karl Marx’s vision of inevitable class conflict, it has to be admitted that if a particular class of persons together control the economic system (which between them, corporate management and institutional money managers do) they may be able to rig it in their favor.

Judging from the Census Bureau’s 2005 “Income, Poverty and Health Insurance Coverage in the United States” that is precisely what has happened. Real median household income in 2005 was lower than in 2000, but the top 5% of income earners have seen a significant increase, even though their income from investments has sharply declined from 2000’s bubble high. The household Gini coefficient of inequality has risen to 46.9, well towards Latin American levels (mostly in the 50-60 range) and far above its early 1970s level of around 40. The top 1% of earners have seen their average remuneration rise from 8 times the national average in 1980 to 16 times in 2004. Fortune 500 CEOs received around 240 times the compensation of the average worker in 2005, up from a ratio of 20 to 1 in 1980. The compensation of institutional money managers has increased commensurately, with the fee and compensation structures in the hedge fund sector exerting a particularly sharp upward pressure in recent years.

In the long run, competition from foreign companies with less exorbitant management pay scales will prick this bubble, and a good tight-money recession will precipitate reform. However, the mechanism by which the bubble was inflated is pretty clear, and unexpensed executive stock options have been a key element in that mechanism. Their economic damage, as well as their accounting fallaciousness, really is not seriously debatable. Stock options incentivize management to pump up short term earnings and engage in other activities that inflate the stock price in the short term at the expense of the long term health of the company. Accounting chicanery in particular is attractive to option-compensated executives, as shown by data on the prevalence of “extraordinary items” in corporate income statements, which averaged 5% of earnings of companies in the S&P 500 Index in the 1980s, reached an alarming 60% of corporate earnings in the recession year of 2002 and are now running around 15-20% of Index earnings.

There is a case for banning incentive stock options altogether in publicly held companies. They are un-transparent, prone to fraud (as in the options backdating scandal), incentivize management poorly and encourage management and institutional money managers to pump stock prices at the expense of long term shareholders. There is no justifiable case for losing the hard-won gains of 2004 by removing options costs from the income statement. The “free money” un-expensed stock options zombie needs to stay dead.

Professor Friedman, there is a runaway U.S. monetary policy that needs your attention!

Link here.

Report estimates the costs of a stock options backdating scandal.

A new study estimates that the stock options backdating scandal may cost shareholders hundreds of millions of dollars. The study was released on the eve of two Senate committee hearings that plan to examine the scope of the widening investigation into improper options practices. Three researchers at the University of Michigan estimated that backdating stock options between 2000 and 2004 helped sweeten the average executive’s pay by more than 1.25%, or about $600,000. But the fallout from the recent options investigations has caused those executives’ companies to fall in market value by an average of 8%, or $500 million each. “For about $600,000 a year to the executives, shareholders are being put at risk to the tune of $500 million,” the study concludes.

The working paper, expected be made public later this week and to be published in The Michigan Law Review next year, appears to be the first to put dollar figures on the costs and benefits of backdating. It analyzed thousands of stock option grants at 48 companies that announced they were under investigation as of the end of June, and measured the maximum gains for those executives if their options were backdated over a 90-day period as well as the drop in value at those 48 companies in the 10 days before and after news of a backdating inquiry was released. “From a shareholder’s perspective, it’s not just the extra compensation the executives got, it’s not just the extra taxes they have to pay,” said H. Nejat Seyhun, a University of Michigan finance professor who is one of the study’s co-authors. “There may be additional payouts for class-action lawsuits as well as worrying about the quality of the top management.”

As an economic analysis, the study assumed that investors’ calculations of those risks, not irrational panic, was responsible for the substantial stock market declines. The researchers also assumed that the stock prices of those 48 companies would not recover.

Link here.
Backdating scandal hits retailers – link.


A type of initial public offering that vanished in the 1990s in a wave of scandals is making a comeback, and regulators say they are concerned investors may be defrauded again. NASD, which polices more than 5,000 U.S. brokerage firms, says it is investigating the resurgence of “blank checks” – shell companies that raise money in public markets without saying what they will spend it on. This year, blank-check companies have sold $2.2 billion of stock in 28 offerings, and $4.3 billion more in new issues is planned with help from some of Wall Street’s best-known banks and underwriters, including Citigroup and Merrill Lynch, according to data compiled by Bloomberg. The data from filings show that firms have earned fees averaging 6.4%, generating a potential $417 million.

“I’m not sure that all that’s going on with these securities is above-board,” says James Shorris, head of enforcement for the Washington-based NASD, formerly known as the National Association of Securities Dealers Inc. Shorris says he is troubled by the possibility that the renewed trust in blank-check deals will trigger new abuses. NASD is examining whether anyone is trying to artificially create or inflate demand for the shares. One firm, EarlyBirdCapital Inc., says it has been contacted by NASD. The Melville, New York-based company has underwritten at least 14 blank-check IPOs since 2004, raising more than $840 million.

Blank-check companies, also known as special-purpose acquisition companies, or SPACs, sell shares to the public in anticipation of merging with or acquiring an existing business they have not yet identified. Investors bet on the prowess of the shell company’s executives, who have 18 months to find a suitable target or return investors’ money. Prospectuses, which spell out terms of an IPO and are filed with the S.E.C., are short on specifics because principals are barred from talking to potential targets before the offering. The most they will do is name an industry or geographic region.

The investments, also sometimes called “blind pools”, are attracting some big names. Apple Computer co-founder Steve Wozniak and former White House national security adviser Richard Clarke founded blank-check companies this year that raised more than $200 million, according to S.E.C. filings. Former CIA Director George Tenet sits on the board of Granahan McCourt Acquisition Corp., a Hopewell, New Jersey-based company targeting the media and telecommunications industries. Michael Gross, founder of New York private-equity firm Apollo Management LP, raised $300 million for Marathon Acquisition Corp. in an offering underwritten by Ladenburg Thalmann, UBS AG, and Citigroup, the biggest U.S. bank.

So far, NASD has not accused anyone of wrongdoing. The larger investment banks are getting involved because they can make money during several steps in the process, including underwriting the initial sale, advising on the subsequent acquisition and helping arrange bank loans, says Mitchell Littman, a lawyer at Littman Krooks LLP in New York who has worked on half a dozen blank-check offerings. Underwriters for Marathon Acquisition made $21 million.

In the late 1980s and early 1990s, blank checks run by Michael Studer and Meyer Blinder cheated investors out of tens of thousands of dollars by illegally inflating share prices. Investors stopped putting money into blank-check companies amid the criminal prosecutions and regulatory sanctions. In 1993, the S.E.C. imposed tighter safeguards, including a requirement that funds be held in escrow until an acquisition is complete. If that does not happen within 18 months of the IPO, all the money except for about 5% in underwriting fees is returned to investors. Also, blank-check shareholders now vote on an acquisition. If they do not like it, the managers have to find another target by the deadline or dissolve the company. Blank check filings started to increase in 2003. “They’ve made a comeback because enough time has gone by, in terms of the taint of what those ‘blind pools’ used to be,” says Littman.

Besides the potential for fraud, NASD also is looking for any conflicts of interest that might arise from an investment bank underwriting a blank-check deal and then advising the company on acquisitions, Shorris says. The S.E.C. said in an April 2004 rule proposal, “Neither blind pool offerings nor blank check offerings are inherently fraudulent.” It also said the tighter safeguards have been “successful in deterring fraud and abuse.”

The current boom is “a temporary fad that will fade after investors have had their fingers burned,” says Jay Ritter, a finance professor at the University of Florida in Gainesville. “There were regulatory changes that gave investors some protection, but I think it’s just the triumph of hope over experience.” The deals appeal to institutional investors and hedge funds because they are sold in units including one share of common stock plus one or two warrants to buy shares, creating more opportunities to trade the securities. (Warrants are company-issued certificates giving the holder the option to buy or sell a certain number of shares at a specific price before a predetermined date.) After a set period, usually 90 days, the shares and warrants split and trade separately. “The principal market at this point seems to be hedge funds,” Shorris says.

None of the latest blank checks has folded, according to the Reverse Merger Report, a publication tracking the offerings. Since 2003, 30 of more than 100 blank checks have closed mergers or announced deals, according to the Petaluma, California-based quarterly. As the number of companies filing has increased, the fees banks charge are down from 7.2% last year and 9.8% in 2004, to 6.3% so far this year. The decline can be attributed to more competition for underwriting as well as investors’ demand that banks defer some fees until after an acquisition is complete, says Brett Goetschius, Reverse Merger Report’s editor and publisher. That deferment helps underwriters convince investors the IPO is not a black hole.

Link here.


A record amount of consumer borrowing in Russia, for everything from foreign cars to DVD players, is creating a new bond market. Russian banks sold $1.3 billion of asset-backed debt in the last 12 months, compared with $350 million in the previous year, according to data compiled by Bloomberg. Sales may top $10 billion by 2008, said Levan Zolotarev, a senior vice president at Moscow-based Russian Standard Bank ZAO, the biggest issuer of the securities.

The bond sales are enabling banks to lower their funding costs and increase the amount of credit offered in car showrooms and shopping centers like Moscow’s Mega mall, where $2,000 Italian fur coats are sold. Russian Standard Bank raised €300 million ($386 million) in March in a sale that shaved more than 1.5 percentage points off its previous borrowing costs. “For Russian issuers, asset-backed bonds give them access to a very deep investor base that they couldn’t otherwise reach,” said Mike Strange, a director at Barclays Capital Inc. in London, who helped arrange Russian Standard Bank’s deal. “For many of them, this is cheaper funding than they could get in the unsecured market.” The higher credit ratings on asset-backed debt allow Russian banks to lower their borrowing costs by 1 percentage point to 2.5 percentage points, according to data compiled by Bloomberg.

Link here.


Will the baby boomers save the U.S. economy? The idea that they will not is not new. Here is how Dick Hokensen, chief economist of the formidable and regrettably now defunct firm Donaldson, Lufkin & Jenrette, explained it in 1999: “Baby boomers do not drive consumption. Baby boomers trade. We trade one house for another; one car for another; one office for another. The group that drives consumption are the people who go from zero to one.” Absent this entry-level age group, pricing power dries up.

What a simple concept. Too bad it is lost on the current generation of corporate America, because it is certainly not lost on the 77 million or so baby boomers. A 57-year-old recently retired Rhode Island reader emailed to say that his cohorts are generally looking to downsize to 1,800-square-foot ranch homes or single-level condominiums. He suggested that the builders who insist on erecting 6,000-square-foot McMansions are missing a huge segment of the market and would be well served by reading AARP magazine. A few days ago, a reader from Missouri echoed this sentiment, saying a soft landing is simply not in the cards for the economy this time around, that “the demographics show that there’s nowhere for the economy to ‘land.’”

In what will go down as one of his most eloquent missives, Bill Gross of Pacific Investment Management Co. recently explained the impact of the coming wave of boomers. “Approaching 60, their focus is less on off-roading and more on off-loading – retirement, the transfer of responsibility and anxiety to a younger generation, as well as the assumption that they will be well cared for in those hospital rooms.” Complicating this process is the fact that there are so many more boomers than their succeeding generation. One solution is more babies, but as Mr. Gross astutely noted, “babies take 20-plus years to grow into worker bees, and we’ve long since passed the point of no return.”

The arguments offered by the bullish Wall Street community have become increasingly insulting. The theory is that baby boomers, with their vast stores of wealth, will choose to retain not just one, but both of their homes. Mr. Gross’s counter? “In financial terms alone, Laurence Kotlikoff, a Boston University economist, has estimated the unfunded liabilities associated with health care and retirement amount to $80 trillion, over seven times our annual GDP!” The implications stretch well beyond the housing market. The broad economy and financial system face huge challenges in the years to come.

Link here.


It is my pleasure this week to bring to you a reader pick that is not only making some money, but also handing out a pretty hefty dividend. Eagle Bulk Shipping (EGLE: NASDAQ) is a $574 million worldwide dry goods shipping business. EGLE is a holding company for its wholly owned subsidiaries that charter big boats that carry dry goods such as iron ore, coal, grain, cement and fertilizer. It is also the largest U.S.-based owner of a dry bulk vessel called a “Handymax”. The fleet is mostly made up of the “Supramax” class vessels, “a larger and more efficient Handymax design that enjoys strong demand from customers around the world,” according to EGLE’s website.

Eagle holds a competitive advantage over other bulk shipping fleets because its ships are relatively brand new, according to a company filing. And newer ships means less dry-docking fees and maintenance. The company employs a long-term chartering strategy – they essentially lease their giant ships for several months to years at a time. Only one charter is expiring in 2006 throughout Eagle’s entire fleet. The rest expire either sometime in 2007 or 2008. This means predictable, stable income for the immediate future.

Monster dividends are probably what attract investors to this stock. Eagle gives its shareholders around 50 cents a share every recent quarter in dividend payments. Since the share price is only a little less than $16, that is a divident yield of a little more than 12% a year. But it is important to remember that Eagle Bulk Shipping is a young company, and it is also at the mercy of shipping cycles and the economy. So do not run out and purchase shares thinking you are in for a guaranteed 12% a year on dividends alone. Company policy is to declare dividends in amounts up to its quarterly earnings before interest, taxes, depreciation and amortization, less maintenance and dry docking costs, as long as the company does not breach its loan covenants. So Eagle will give to shareholders when it can. But if revenues drop, do not expect any free cash.

Even after paying out the big dividends, Eagle has managed to more than double its cash position since the beginning of the year. As of the end of the second quarter, the company was sitting on $54.5 million in cash. The one thing I could do without would be the company’s building debt, which is up to $182.4 million. Something else to worry about with Eagle could be dilution. It will need to fund the purchase of new vessels to grow. A portion of a recent private placement was used to help pay for three new vessels.

All in all, Eagle Shipping is a speculative play. It is too young to have a consistent track record of positive earnings growth, yet it has shown four straight quarters of decent earnings. If it can continue acquiring vessels while controlling its debt, Eagle could become a powerful growth stock sometime in the near future.

Link here.


In our recent monthly letters, we have shown you a list of potential long positions that has included the likes of Pfizer and TECO Energy, among others. But despite the market rally over the past month, we have remained on the sidelines for a reason – and this is why. When we buy a stock, we want to feel like there is a good chance for appreciation over the next six months or more. When we feel there is a good chance that the market will suck everything down with it in a given time frame, we hold off from new purchases until some clouds clear. This is a critical time in which the market is making decisions about the next multiyear trend. The last thing we would want to do would be to throw out a short list of some of our favorite long-term stocks to hold right before the market puts them “on sale”. Rest assured, if we see that the market is going to throw off the weight of the inverted yield curve, a breakdown of leading indexes like the Dow transports, and the other issues we outlined in last month’s letter, we will be ready to ride the rally. But until then, we will remain mostly on the sidelines.

Beyond stocks, the big news of the month is clearly the break of the CRB’s five-year bull market. It seems the commodity bull is over, and nobody (beside us) is talking about it. We have been highlighting this chart since spring, warning that a breakdown was a real possibility. We cannot emphasize enough the significance of this trend change, if only because the rally in commodities has become so engrained in people’s consciousnesses. Over past five years, oil has more than tripled, gold has rallied almost 300%, and other components like copper went completely parabolic. It seems taken for granted that all these trends have much further to go, but as we see time and time again, it is often at that moment of near-universal sentiment that a trend changes.

By the looks of it, the weakest part of the CRB appears to be oil-related futures – which could drag the entire index down by itself. The nature of an index, being a basket of loosely related products, is that not all of the individual components will always trend with the larger group. It is entirely possible that some components will buck the trend. But even so, this breakdown adds an additional burden of proof on the commodity sectors we are watching for an entry – they need to clearly show us the goods before we commit ourselves.

Take the above chart as a clear warning that there are big changes afoot in the market. Some of the assumptions we have held for the past few years are going to have to be re-thought, and some are going to have to be discarded. If we are going to grab hold of the next big trends, we are going to need to remain open-minded and ready to let go of old assumptions in favor of a new paradigm. For example, with all the signs of inflation around us, not many people think Treasury yields can drop below the lows seen in 2003 and 2005 – but they can, and we are currently positioned for it.

From The Survival Report September 1 newsletter.


Of course, the more companies you evaluate, the more chaff you have to sift through. On any given day I come across all types, from well-meaning but generally inept geologists to out-and-out hucksters who spin pirate-esque yarns of unimaginable treasures and then laugh all the way to their Mexican beach homes, bought and paid for with millions lifted off of feckless investors. Surprisingly, however, scam artists are not an investor’s biggest worry. Far more dangerous – and numerous – are the “competent” professionals who swell the middle of the industry’s bell curve.

That is because while “competent” may sound like a desirable quality, it can often be less than a good thing. Competent people are those who execute their tasks with an adequate degree of skill, satisfactorily meeting minimum requirements. But many competent people are neither inspired nor cutting-edge. Even government officials can, on occasion, be competent (even if only to the degree that they competently interfere with the progress of humankind). But make no mistake that a competent explorationist can pose a very specific danger to unaware investors. I am talking about the variety of explorationist that has a reasonably encouraging background with one company or another, often times even a blue ribbon major. While the individual in question, whether a geologist or an executive, has no significant discoveries to their credit, they can still proudly point to their long career as proof of their competence.

Which impresses many investors, who then go out and buy the stock thinking, “Well, Mr. Geologist worked for Barrick or Exxon for five years … he must know what he is doing.” But you see, Mr. Geologist lacks the creativity and the fire in the belly that is absolutely critical for making big finds. He will have a half-decent property, which a dozen or so other half-decent geologists have looked at in the past and drilled with limited success before passing on. And Mr. Geologist, urged on by the company promoters standing just behind him, will take your money and drill more holes a few hundred feet from where the last person drilled. He might even hit a couple of interesting intersections you will read about in the daily email touts that besiege us all. But ultimately, the property will turn out to be a sub-economic money-pit, eventually returning to resource oblivion, waiting to be resurrected by the next competent geo in the next bull market.

Simply put, the resource sector is not for the merely competent. We all know that the odds are very long against an exploration prospect making it into production – by some estimates the chances are one in a thousand, but some astute observers put it at more like one in three thousand. Given that the chances for the average company are so slim, why should we risk investing in an average management team? Here is the key: Most mines and oil pools of any significance are discovered by just a few individuals. I have spent my career following these professionals. I can tell you that to call them “competent” would be an insult. These people are mercilessly driven – often sleeping scant hours per night between work on numerous projects – and perfectionist students of their science. But most of all, they are inspired, out-of-the-box thinkers. The kind who would rather die in a cave-in than endure the boredom of plugging a few more futile holes in a sub-par property in the hopes of lifting some easy cash off of the investment unwashed. They come up with ideas most geologists would never dream of, and would never have the courage to implement even if they did. The type of unique business models that make serious money for shareholders.

These professionals are freaks, in the absolute best sense of the word. Outliers at the far reaches of the bell curve. And make no mistake, they produce the real wealth that gets generated in our sector. Let me give you a few examples. …

Link here (scroll down to piece by Doug Casey).


Today, the average company on the Russell 2000 trades for 23 times earnings, versus 17 for the average large-cap company on the S&P 500. In other words, small-cap stocks are more than twice as expensive as they were four years ago, while large-cap stocks are selling for 50% off their early 21st-century highs. Instead of people hating small-cap stocks like they did in 2002, everyone loves them now. Most have made countless amounts of “easy money” over the last several years. But the days of easy money (when you buy anything and get a 30% return in three months) are over.

Unlike four years ago, interest rates are on the rise. It is not as easy (or as cheap) for smaller companies to get that $50 million loan they need to stay in business. On top of that, political unrest seems to be the rule, not the exception, in 2006. Every sign that pointed to small-cap stocks rising in 2002 now points to them falling over the next three years. Whether you like it or not, we are at or near the top of the current small-cap cycle. The writing is on the wall. Over the last seven months, the worst small-cap companies, aka “garbage stocks”, have led the market. They are up 8.71%, while the fundamentally sound companies are down 18.8%.

This kind of irrational buying always occurs at or near the end of a bubble period – just before it goes “pop”. People get used to making easy money. They forget about fundamentals – things like earnings, cash, growth and price. Instead, they opt for story stocks with great promise, but no real businesses. How else can you explain why companies like Applica (APN: NYSE), CryoLife (CRY: NYSE) and Xanser (XNR: NYSE) are up 191%, 76% and 23% since the beginning of the year? None of them make a dime in earnings or throw off any cash whatsoever.

My friends, exuberant buying can only end one way – badly. Just think back to the dot-com blowout of 2000. It was not Berkshire Hathaway that was bid up 400% in 12 months. It was the worthless tech companies with no real businesses to support such a stock run-up. And when people finally realized this, millions of people lost 80%, 90% and 100% of their investments in a matter of months. While the small-cap sector has not been bid up the way the Nasdaq was in 1999 and 2000, it is overinflated. Small caps are trading at a premium to the rest of the market. And with rising interest rates, political unrest all over the world and garbage stocks leading the pack, you need to be careful going forward. All the warning signs point to a sell-off.

On July 17, John Hussman published an essay called “Tornado Warnings”. He leads off by saying, “Tornadoes are more likely to strike when a tornado warning is in effect.” Of course, just because a warning is issued does not mean a twister will knock your house down. But it is smart to take some simple precautions during such an event. Common sense, right? Well, the same kind of logic applies to the markets. All the signs point to the possibility of a tornado touching down in the small-cap sector. Now is the time to prepare for a sell-off. Now is the time to take profits on the speculative small-cap stocks in your portfolio you would not be comfortable holding should the market fall 10%, 20% or 30% in a year. Now is the time to insist on investing in fundamentally sound companies that will not fade into oblivion just because the market takes a breather. And now is the time to think about holding good stocks for years, not months.

So, do these fundamentally sound companies exist? Despite the pitfalls that exist, the answer is a resounding YES. In the small-cap sector, there are still solid companies for you to invest in. Remember, two-thirds of all stocks on the market have a market capitalization of $1.5 billion or less. And one-third of all equities have a market cap of $250 million or less. That explains why (1) 73% of all stocks trading for 10 times earnings or less are in the small-cap sector, (2) 93% of all stocks trading for less than book value are in the small-cap sector, (3) 80% of all stocks trading for less than one times sales are in the small-cap sector. And when you combine these stats with the fact that 50% of these undervalued small-cap companies have no analyst coverage whatsoever, there are plenty of opportunities for us to sift through in the small-cap sector.

Link here (scroll down to piece by James Boric).


What is a disaster? The Latin roots of the word are “dis” and “astro”. Literally, the two combined words mean “ill-starred”. In ancient times, if you offended the gods, the deities would align the stars against you and bring a bad set of events down upon your house, if not upon your head. So the word itself has come to mean, according to the Oxford English Dictionary, “a sudden or great misfortune; an event of ruinous or distressing nature; a calamity; complete failure.” The Athenian invasion of Sicily in 415 B.C., the sinking of the steamship Titanic on the night of April 14-15, 1912, and the explosion of the Space shuttle Challenger on January 28, 1986 are examples.

Can we really say that a disaster results from just the single triggering event? Of course, every disaster has its penultimate cause. In Sicily, the Athenians lost a battle at Syracuse. The rivet heads of the Titanic were shaved off. And the O-ring on one of Challenger’s booster rockets burned through. But is this the end of how to think about it? Not by a long shot. In the case of the Challenger explosion, no less a mind than Richard Feynman, physicist and Nobel Laureate, noted that the source of the explosion was a pervasive cultural disease within the institution of NASA.

Now let’s take a look at the idea of “financial disaster”. “What is a financial disaster? The phrase brings to mind images of panicked merchants huddled around an exchange waiting for the latest news to arrive via post, telegraph, or computer, of stock market crashes, of unemployment and charts showing a precipitate drop in the price of shares, indexes, or currencies.” The foregoing comes from the introduction of a remarkable three-volume set of books entitled History of Financial Disasters 1763-1995, released in April 2006 by the London-based firm of Pickering & Chatto.

As the title implies, these three volumes review the origins and consequences of the Western world’s most important financial crises in the past quarter millennia. The editors have chosen to highlight and delve into 19 seminal economic crises between 1763-1995. Rare public and private papers, offering trenchant firsthand accounts from some of the principal insiders, offer rich source material and penetrating background on the events that occurred. In addition, the editors have culled the stacks of academic literature to assist the reader in interpreting these events and in drawing conclusions and lessons for our own time. There are only a few people in the economic world that could have assembled this type on insightful collection. In general, the editors follow the definition of “financial crisis” established by the great analyst Charles Kindleberger. That is, financial crises are “associated with changed expectations that lead owners of wealth to try to shift quickly out of one type of asset into another, with resulting falls in prices of the first type of asset, and, frequently, bankruptcy.”

Thus, according to the editors, financial crises are a product of sudden alterations of expectations, rooted in reality or imagination. If you are looking for a way to avoid financial disaster, this is the key level of understanding. The impending alteration of people’s expectations sends a glaring signal to which you should train your mind to react. In these three volumes, and for each of the financial crises that bears examination, the editors provide the reader with a look beyond the immediate crisis itself, and a view of the series of events that constituted the whole disaster. Here is the true value of this set of books. The editorial approach is similar to the way that one might view the onshore wreckage caused by a hurricane. To avoid the impact of the storm, you should learn to forecast the weather. And then prepare yourself for the hit, if not just plain get out of the way.

The editors use a broad conception of financial disasters that includes objectively describing the origins and resultant consequences of the phenomena. But the editors go many steps further as well by presenting information about how each disaster related to broader themes of the times. This includes providing the reader with fascinating information about the historical context, changes in the view of government intervention in the economy, the development of broad economic thought, the role of the media, and the openness (or what we now call “globalization”) of markets. Each of the three volumes in this series looks at events in which sudden changes in market expectations led to either large-scale insolvency or an inability to pay. Of course, many events lead to changes in market expectations, and the editors provide examples to illustrate the points and put each event into its own context.

Large-scale changes could be triggered by the dawn of a realization that a government’s currency policies were highly inflationary. As an example, the editors review both the French Assignat inflation of the 1790s and German Weimar hyperinflation of the 1920s, and what followed when people came to realize that their currency was plummeting to worthlessness. Or people may begin to perceive that a government might have less political stability than had previously been thought, such as occurred with the Mexican peso crisis of 1994. On occasion, the financial meltdown begins not with overt monetary inflation, but with the pricking of a credit balloon and associated asset price bubble, such as the New York crashes of 1929 and 1987. Or there could be a herd mentality when investors respond to rumors and fears of insolvency, as with the collapse of the British entity of Overend & Gurney in 1867. Often, a financial disaster is triggered through the confluence of several factors, rather than one defining cause.

From the standpoint of an American reader, the history of the financial disasters in the U.S. during its formative, post-Colonial years offers great insight, particularly by way of comparison with current times. The editors do an excellent job of illustrating the circumstances of the Second Bank Crisis of the U.S. in 1818, as well as the devastating Panic of 1837. Each of these events had much to do with both the economic and political evolution of the U.S., to include pushing the nation down a path that sharpened sectional divisions and rivalries, eventually steering the nation toward its Civil War. (It is far too facile just to say that the U.S. Civil War was “all about slavery.”)

In addition, no one can consider himself or herself knowledgeable about the origins of modern monetary policy, and, in particular, the role of the U.S. Federal Reserve, without a solid grounding in the events of the Crisis of 1907. This section alone ought to be required reading for anyone who wants to understand the Fed and its origins, as well as its future direction as the U.S. dollar continues its century-long decline in value. History of Financial Disasters 1763-1995 is a treasure chest of historical perspective on the subject of economic and monetary disasters, and a valuable tool in your personal workbench of financial and historical knowledge. These books give you insight into the origins and consequences of financial disasters.

There is a limited number of copies of History of Financial Disasters 1763-1995 in print. If you have that certain hunger for knowledge, and the driving desire for financial success in the midst of some future disaster that may (no, will) come down the road, this book is your kind of reading. The information in these volumes is priceless. If you attempted to do your own research on these topics, to develop the perspective that you will find in this publication, you would spend months combing the stacks of a very good university-level library. So if the publisher was to set a figure of thousands of dollars on the content of the product, it could be worth every cent.

Link here.


A weakened U.S. economy should not surprise anyone. It is a direct result of the questionable nature of the so-called economic recovery. Any other country faced with these many imbalances would have collapsed long ago. But the U.S. dollar was spared this fate when Asian central banks began accumulating the dollars needed to avoid rises in their currencies. Both the U.S. and China practice credit excess, but with a crucial difference. In the U.S., the credit excesses went into higher asset prices and, more notably, into personal consumption. In Asia, credit excesses went into capital investment and production. The result is an odd disparity between the two economies. Americans borrow and consume, and the Asians produce. This symbiosis plays out in the trade gap. Ironically, this ever-growing problem is ignored on the national level and plays virtually no role in U.S. economic policy or analysis.

During the 1980s, policy makers and economists worried about the harm that trade deficits were causing in U.S. manufacturing. In a September 1985 move orchestrated by James Baker, the U.S. Treasury secretary, the finance ministers of the G-5 nations agreed to drive the dollar sharply down in concerted action. By the mid-1990s U.S. policy makers decided that trade deficits were beneficial for the U.S. economy and its financial markets. Cheap imports were playing an important role in preventing inflation and, as a result, higher interest rates. Had the decision been to allow interest rates to rise, it would have had the effect of slowing down consumer spending. Instead, spending is out of control and the trade gap is the consequence. Ultimately, the victim in all of this is going to be the U.S. dollar.

The economic cycle involving inflation, higher interest rates, monetary tightening, recession, and recovery has a predictable postwar pattern in America and in the rest of the world. But we have taken a departure from this for the first time. A critic might argue that now the U.S. is enjoying a prolonged period of strong economic growth with low inflation and low interest rates. What could be bad about that? The fact that we are not experiencing strong economic growth. U.S. net business investment has fallen to all-time postwar lows, under 2% of GDP in recent years. At the same time, net financial investment is running at about 6% of GDP. In other words, the counterpart to foreign investment in the U.S. economy has been higher private and public consumption, accompanied by lower saving and investment.

Official opinion in America says that the huge U.S. trade gap is mainly the fault of foreigners, for two reasons. One is the eagerness of foreign investors to acquire U.S. assets with higher returns than in the rest of the world. Two is supposed to be weaker economic growth in the rest of the world. In this view, the trade gap directly results from foreign investment because it provides the dollars that the foreign investors need.

The first thing to realize about a deficit in foreign trade is that, by definition, it reflects an excess of domestic spending over domestic output. But such spending excess is actually caused by overly liberal credit at home, and not really by cheaper goods produced elsewhere. Just as shaky is the second argument, ascribing the trade gap to higher U.S. economic growth. Asian economies, in particular China, have much higher rates of economic growth than the U.S. Yet they all run a chronic trade surplus, which is caused by high savings rates. This is the crucial variable concerning trade surplus or trade deficit.

The diversion of U.S. domestic spending to foreign producers is, in effect, a loss of revenue for businesses and consumers in the U.S. This is important. The loss is higher than $500 billion per year. This is America’s income and profit killer, and it cannot be fixed with more credit and more consumption. This serious drag of the growing trade gap on U.S. domestic incomes and profits would have bred slower economic growth, if not recession, long ago. This has so far been delayed by the Fed’s extreme monetary looseness, creating artificial domestic demand growth through credit expansion. The need for ever-greater credit and debt creation just to offset the income losses caused by the trade gap is one of our big problems. Officially we are in great shape, but the numbers do not support this. Personal consumption in the past few years has increased real GDP at the expense of savings, while business investment has grown only moderately.

This can only end badly. Normally, tight money forces consumers and businesses to unwind their excesses during recessions. But in the latest round, the Fed’s loose monetary stance has stepped up consumers’ spending excesses. Our weight trainer is feeding us Big Macs. If we were to measure economic health by credit expansion, the U.S. has the worst inflation in history. And still our experts are puzzled by a soaring import surplus. The problem here is that American policy makers and economists fail to understand the significance of the damage that is being caused by monetary excess and the growing trade gap. The trade gap is hailed as a sign of superior economic growth, while the hyperinflation in stock and house prices is hailed as wealth creation.

Until the late 1960s, total international reserves of central banks hovered below $100 billion. At the end of 2003, they exceeded $3 trillion, of which two-thirds was held in dollars. By far the steepest jump in these reserves, of $907 billion, occurred in the years 2000-2002. With China and Japan as the main buyers, Asian central banks bought virtually the whole amount. American policy makers seem to want a lower dollar, apparently believing (or hoping) that this will take care of the U.S. trade deficit, and they appear to regard this as an easy solution to this problem. But this will not solve the problem at all. The premise is wrongly based on the assumption that an overvalued dollar has caused of the U.S. trade deficit - an entirely unsupported view.

It is widely assumed that rising stock and house prices will keep American consumers both willing and able to spend, spend, spend their way to wealth – indefinitely. But the transfer of U.S. net worth to interests overseas is alarming, and it endangers U.S. economic and political health. Warren Buffett, who kept his vast fortune invested at home for more than 70 years, decided in 2002 to invest in foreign currencies for the first time. Buffett and management of Berkshire Hathaway believe the dollar is going to continue its decline. We should not need confirmation such as this to recognize the inevitable – but it bolsters the argument that the dollar is, in fact, in serious trouble, and that this trouble is likely to continue.

In addition to debt problems at home, Buffett made his decision based at least partially on the ever-growing trade deficit. Buffett is especially concerned about the transfer of wealth to outside interests. He notes, “Foreign ownership of our assets will grow at about $500 billion per year at the present trade-deficit level, which means that the deficit will be adding about one percentage point annually to foreigners’ net ownership of our national wealth. As that ownership grows, so will the annual net investment income flowing out of this country. That will leave us paying ever-increasing dividends and interest to the world rather than being a net receiver of them, as in the past. We have entered the world of negative compounding – goodbye pleasure, hello pain.”

Link here.
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