Wealth International, Limited

Finance Digest for Week of October 23, 2006

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


There is a lot going on in the commodities and currency markets. For instance, despite the breakdown of the broader CRB Index, it looks like many base metals and other commodities are getting ready to head higher. It also looks like the dollar has started a short-term decline against many of the majors that has the potential to turn into a bigger decline – a trend that will no doubt aid our gold miners position. These are some of the things we will go over in detail next week, as there are many new important trends to be aware of. In the meantime, the stock market has remained in its uptrend channel, although not gaining much since a week ago.

One notably weak index this past week has been the Semiconductor Index (SOX). Like the Dow transports, the SOX has been a leading index post-2000 and a reliable check on the health of the market. It turned down in 2000 and remained down while the S&P continued to edge higher later in the year, and it also maintained relative strength in early 2003, while many other indexes made lower lows. Both the SOX and the transports remain well below their spring lows in a glaring divergence from the S&P 500 and the Dow industrials. If this were a healthy bull market, all these indexes would be rallying together – which they were doing until this spring.

What do we do in the face of these clear red flags? The answer is simple. We let others chase the last few percent of this extended rally from the 2002-2003 low and move on to other sectors and markets with much more potential. The entire goal of this kind of intramarket analysis is to see large-scale trend changes in advance so that we have enough time to make adjustments. We have had the signs for over six months, so there has been plenty of time to search for other areas beyond the major stock indexes that will provide good returns over the next year or two.

And of course, one sector with glaring bullish credentials right now is mining stocks. It took almost five months, but most of the hot money has seemingly been washed out of the miners. Now we have a technically clean advance off a good-looking low with hardly a whisper of attention being paid to it – the perfect time to enter. The HUI index has tested its 20-day moving average from above this past week and looks ready to head higher in earnest. Our position in GDX is a short-term one for now, but based on new evidence we have seen in the past few weeks in related markets, this could easily become a long-term position with serious potential for gains. If you have not already done so, make sure to buy this ETF (or shares in related stocks) before this one gets away.

From most recent weekly Survival Report update.


Mr. James Surowiecki wrote a wise and moronic piece on gold in The New Yorker. His wisdom is centered on the insight that neither gold nor paper money are true wealth, but only relative measures, subject to adjustment. “Gold or not, we’re always just running on air,” he wrote. “You can’t be rich unless everyone agrees you’re rich.” In other words, there is no law that guarantees gold at $450 an ounce. It might just as well be priced at $266 an ounce, as it was when George W. Bush took office for the first time. Since then, a man who counted his wealth in Krugerrands has become 70% richer.

But gold was not born yesterday, or four years ago. Mr. Surowiecki noticed that the metal has a past, just as it has a present. He turned his head around and looked back a quarter of a century. The yellow metal was not a great way to preserve wealth during that period, he notes. As a result, he sees no difference between a paper dollar and a gold doubloon, or between a bull market in gold and a bubble in technology shares. “In the end, our trust in gold is no different from our trust in a piece of paper with ‘one dollar’ written on it,” he believes. And when you buy gold, “you’re buying into a collective hallucination – exactly what those dot-com investors did in the late nineties.”

Pity he did not bother to look back a little further. This is the moronic part. While Mr. Surowiecki looked at a bit of gold’s past, he did not see enough of it. Both gold and paper dollars have histories, but gold has far more. Both gold and dollars have a future. But – and this is the important part – gold is likely to have more of that, too. The expression, “as rich as Croesus,” is of ancient origin. The king of historic Lydia is remembered, even today, for his great wealth. Croesus was not rich because he had stacks of dollar bills. Instead, he measured his richness in gold. No one says “as poor as Croesus.” We have also heard the expression, “not worth a Continental,” referring to America’s paper money during the Revolutionary War era. We have never heard the expression, “not worth a Krugerrand.”

Likewise, when Jesus said, “Render unto Caesar that which is Caesar’s,” he referred to a denarius, a coin of gold or silver, not a paper currency. The coin had Caesar’s image on it, just as today’s American money has a picture of Lincoln, Washington, or Jackson on it. Dead presidents were golden back then. Even today, a gold denarius is still about as valuable as it was when Caesar conquered Gaul. America’s dead presidents, whose images are printed in green ink on special paper, lose 2% to 5% of their purchasing power every year. What do you think they will be worth 2,000 years from now?

Gold has a long history. And during its history, many was the time that humans were tempted to replace it with other forms of money – which they believed would be more convenient, more modern, and most importantly, more accommodating. Gold is hard to find and hard to bring up out of the earth. By its nature, the quantity of gold is always limited. Paper money, by contrast, offers irresistible possibilities. The list of bright paper rivals is long and colorful. You will find hundreds of examples, from assignats to zlotys, and from imperial purple to beer suds brown. But the story of paper money is short and predictable. Since the invention of the printing press, a new paper dollar or franc can be brought out at negligible cost. Nor does it cost much to increase the money supply by a factor of 10 or 100 – simply add zeros. It may seem obvious, but adding zeros does not add value.

Still, the attraction of being able to get something for nothing has always been too great to resist. Once people were able to create money at virtually no expense, no one ever resisted doing it to excess. No paper currency has ever held its value for very long. Most are ruined within a few years. Some take longer. Even the world’s two most successful paper currencies – the American dollar and the British pound – have each lost more than 95% of their value in the past century. Some paper currencies are destroyed almost absentmindedly. Others are ruined intentionally. But all go away eventually. By contrast, every gold coin that was ever struck is still valuable today, most have more real value than when they first came out of the mint.

Central bankers reported in early 2005 that 70% of them were increasing their reserves of euros. As for the world’s erstwhile and present reserve currency, the dollar, they seemed to have, not growing reserves, but growing reservations. We also have reservations about the dollar. Whatever it is worth today or tomorrow, we are sure it will have less worth eventually. That it is not regarded as worthless already is remarkable. The average dollar is nothing more than electronic information. It exists thanks only to the ability of digital technology to keep track of it. Relatively few dollars ever make it to paper, and many of them end up in the pockets of Russian drug dealers and African politicians. Most dollars inmost people’s accounts are not even graced with the image of a dead president. When the end comes, they will not even be useful for starting fires.

It is imperial vanity that keeps the dollar in business. And it is vanity that will make it worthless. Economists want money they can control. Central bankers want money they can debase. And politicians want money they might get their mug on. The trouble with gold is that it turns its back on world improvers, empire builders, and do-gooders. It is money that no central bank promotes and none destroys.

“Gold goes up and down, just like other kinds of money,” say economists. Which is true. “You can protect yourself from inflation in other ways,” say the speculators. True again. “Gold pays no dividends or interest,” say the investors. True. Even as money, gold may not be perfect. But it is better money than anything else. Gold was around millions of years before the U.S. dollar was invented. It will probably be around a billion years after. This longevity is not in itself a great recommendation. But the reason for gold’s longevity is also the reason for its great virtue as money. It is inert. It yields neither to technology nor to vanity.

The world improvers will always be with us. They will spend more than they have, boss other people around, and generally make the world a worse place to live. It neither laughs nor applauds. Gold is money that no central bank promotes and none destroys. Paper money is a handy tool for the world improvers. They use it like politicians use civil service jobs and generals use heavy bombers – to get their way. Bread, circuses, war – the imperial program costs money.

How to get more money for these great new programs, these marvelously worthwhile ideals, these fabulous public spectacles? Gold flatly refuses to cooperate. Paper money, on the other hand, barely needs encouragement. Start up the presses! Lower the interest rate! Relax reserve requirements and lending standards! Sell more bonds! Create more paper! Paper money is ready to go along with anything. Like George W. Bush, it never met a boondoggle it did not like. Sooner or later, it ends up as worthless as the projects it was meant to pay for.

Gold is merely the subversive investor’s way of protecting himself.

Link here.


An unassuming research economist at the Dallas Federal Reserve Bank has created a new way to measure inflation. Wait, come back! This is important. Jim Dolmas’s work could start to affect all of us within the next few months. Mr. Dolmas’s new index indicates that inflation is closer to 3% than the 2% rate sought by our central bank. That could mean current interest rates may stand or increase, not decrease as many hope.

“In the grand scheme of economics, this is not rocket science. It’s just something that needed to be done,” Mr. Dolmas said in a recent interview. A senior economist and policy adviser at the bank, he introduced a new treatment of the personal consumption expenditures index, the broad inflation index the Fed prefers over the more familiar consumer price index. We will leave the details of how his measure is figured in a black box somewhere filled with the nasty little creatures that statisticians deal with, like kurtosis and skewness. Suffice to say the “trimmed mean” rate is created by eliminating the extreme changes in price measures in any month. Instead, it concentrates on the more central changes. Only time will tell if Mr. Dolma’sq measure will gain favor among policymakers. It is, however, in regular use by the Dallas Fed.

Since most of this is pretty arcane stuff, I asked whether he would start by explaining why the Fed preferred the PCE index over the CPI. The PCE “is a much broader basket of consumption goods,” he said. “The CPI is a typical urban consumer index based on a basket of goods and services. The PCE goes with everything that gets consumed.” The PCE avoids the inaccuracy introduced when people move their purchases from traditional department stores to discount stores.

His measure, the “trimmed mean PCE,” works to include more meaningful indications of general inflation. In late June, for instance, Mr. Dolmas found that the number of PCE index components that were rising at rates over 3% had risen from 33% to 57% since December 2005. He also found that index components rising faster than 2% had risen from 47% to 68% over the same period – both indications of a broadening higher inflation. This month he found that the trailing 6-month annualized rate for the trimmed-mean PCE was (1) larger than the PCE excluding food and energy, and (2) rising. Although both had started at a 2.4% trailing rate in March, the PCE excluding food and energy had risen to only 2.6% by August, and the trimmed-mean PCE had risen to a 3% rate over the same period.

What does this all mean for you and me? For the moment, it means that inflation is higher than the Fed would like it to be. The Fed is likely to act accordingly. That means interest rates are more likely to remain stable or increase than to decrease.

Link here.


The mood has shifted in Japan. Six months ago a clear sense of euphoria was in the air. Conviction was deep that the long nightmare was over – deflation was coming to an end and economic recovery was finally viewed as sustainable. Today, the view is more granular and disconcerting. After extensive meetings with investors and business leaders, I detected two sets of concerns – one internal and other external. Worries were deepening over Japan’s lack of a personal consumption dynamic, and its excessive dependence on China was increasingly viewed as a potential risk. No one feared the type of relapse that frequently punctuated the rolling recessions of Japan’s 15-year deflationary nightmare, but there was certainly a more cautious assessment of the staying power of the growth miracle that was so widely celebrated just a few months ago.

The private consumption story has long been the most important missing link in the current Japanese recovery dynamic. Since the onset of the current economic upturn in the first quarter of 2002, private consumption has risen at just a 1.6% average annual rate – well below the 2.3% growth rate in overall GDP. As a result, the consumption share of Japanese GDP has fallen from 58% in early 2002 to 56% in mid-2006. While our Japan team has had an upbeat call on the overall economy for most of the past three years, it has been much more of a capex and exports story than one driven by organic growth in consumer demand. Their cautious assessment of consumption is tied to the likelihood that sluggish real wages will remain a persistent drag on household purchasing power. That very much dovetails with what has been a most disappointing performance on the Japanese wage front in 2006. They reject the possibility of a spontaneous rebound in Japanese consumption driven by a declining personal saving rate, newfound wealth effects, or a shift in the distribution of income generation from capital to labor.

In my meetings this week in Tokyo, I got the distinct impression that concerns are mounting over this important missing piece to the Japanese economic recovery story. A Japan that is lacking in support from a self-sustaining internal consumption dynamic is, by definition, more dependent on capex and external demand. Significantly, external risk assessment suddenly looks a bit murkier as the Japanese peer into 2007 and worry about possible shortfalls in two of most important foreign sources of its recovery – the American consumer and the Chinese producer. While US consumption has held up quite well so far – providing ongoing support for Japan’s largest export market – there is understandable concern that such support may diminish in a post-housing bubble climate. And now there are concerns that a China slowdown may finally come to pass - undermining support for what has now become Japan’s second largest export market. Collectively, the U.S. and China currently account for fully 37% of total Japanese exports – by far, the largest and most concentrated piece of Japan’s external demand.

Japan’s tilt toward China is on everyone’s mind in Tokyo these days. The North Korean missile crisis has certainly heightened the attention on the strategic relationship between the two nations. But there is an important economics angle at work as well. Leading Chinese officials have recently refocused the debate on the off-again-on-again “cooling off” campaign for this overheated economy. There can be little surprise in the heightened interest I detected in Japan with respect to the China factor.

The big puzzle in all this is Japan’s lack of internal support for private consumption. I am struck by the similarities between the Japanese predicament and conditions in other major industrial economies. In my view, this is an unmistakable manifestation of one of the great paradoxes of globalization – a powerful global labor arbitrage that continues to put unrelenting pressure on the labor-income generating capacity of high-wage industrial economies. Japan is hardly alone in feeling this pressure – it is a serious constraint in Germany and even the U.S. To the extent that the fixation on intensified global competition and productivity enhancement rests on the tactics of increasingly aggressive corporate cost cutting ongoing – and that labor continues to account for the lion’s share of business costs – it is hard to envision a spontaneous improvement in internally-driven income generation.

There are some unique aspects of the Japanese consumption experience that separate this economy from that of other industrial nations: the ending of lifetime employment, a more urgent demographically-driven aging problem, and the very vivid recent memories of 15 years of rolling stagnation and deflation. But I do not think it is just a coincidence that Japan is suffering from the same problem of labor income compression that afflicts the rest of industrial world. The initial euphoria of recovery tends to swamp those concerns – especially, since in Japan’s case, it came after such a long nightmare. But as recovery matures and gives way to expansion, reality often sinks in and there is a perfectly natural refocusing of attention to any economy’s lingering stresses and strains. That refocusing is now under way in Japan. The mood in Tokyo is very different than it was six months ago. With the American consumer and the Chinese producer in play, the missing link of the Japanese economy suddenly seems more problematic.

Link here.


Hard as it is to believe, backdating may not be the only risky area in stock-option accounting. Independent auditors should also be able to sniff out fraud when their corporate clients start monkeying with the metrics they use to gauge the fair value of option grants, the Public Company Accounting Oversight Board thinks. Since there are not any markets employers can use to measure what the options they issue are worth, companies use pricing models to measure the options’ fair value. Such models, including Black-Scholes and the lattice method, are packed with assumptions and estimates that are ripe for improper manipulation and intentionally misstated accounting, the PCAOB suggests.

But taking a stab at the market value of an option is no longer optional. In 2004, the Financial Accounting Standards Board issued a revised standard, FAS 123R, that required companies to use the grant-date fair value of an options award in recognizing the grants as a compensation cost in their financials. And FAS 123R began to apply to financial statements of companies with fiscal years ending on or after June 15, 2006. To help auditors find their way through the minefields of their clients’ fair-value options estimates, the PCAOB issued a question-and-answer guidance on October 17. Following hard on the heels of a July staff alert telling auditors which backdating problems they should be focusing on, the board’s fair-value guidance highlights possible client booby traps in compensation estimates.

Link here.

Costco CFO and CEO decline bonuses.

Costco Wholesale Corp. said its CFO and CEO declined their bonuses for 2006 in an effort to acknowledge their ultimate responsibility for the company’s misdated stock options. The retailer said in a regulatory filing CFO Richard A. Galanti would have been entitled to an $82,000 bonus while CEO James D. Sinegal was in a position to receive a $200,000 bonus. The company previously disclosed that a special committee of the board of directors concluded that there were “imprecisions” in the company’s stock option granting process and that “these two officers had responsibility for administering that process.”

Link here.


The Securities and Exchange Commission is creating a new financial “language” that is designed to provide individual investors with an advantage previously available only to securities analysts and huge firms. Soon, all corporations will report their financial information in a format called XBRL. You do not have to understand the technology to reap the benefits. This new reporting format will make all data interactive. That means anyone can go online and easily find and make comparisons of all the data that has been filed – including financial reports, footnotes and management’s discussion of the company’s prospects. SEC Chairman Christopher Cox says, “We are on a campaign to liberate business and financial information that is now filed at the SEC, but is currently trapped inside dense documents.”

The SEC currently makes its required company filing data available on its Web site. The database for all that information is called Edgar, an acronym established about 20 years ago when filings such as 10K reports and quarterly 10Q reports first went online. But except for securities analysts, few individuals would dare wade through all the posted material. Soon that old database will be replaced by the new XBRL system, where every piece of information will be tagged to create an easily searchable database. Numbers such as for “net income”, “operating income” and “current liabilities” will pop up on request – for one company or for many companies. Interactive data will be used globally, and is already being tested and used from Shanghai to Spain.

Because of the special coding format of the new language, users will require special reader software. The SEC will have two of those readers on its site for downloading. The new technology is based on an open software standard format, meaning that companies that want to make and market software for analyzing XBRL data do not have to pay anyone a royalty.

In the history of the securities industry there have been some watershed events. The Securities Exchange Act of 1934 created the SEC, and reporting requirements. “May Day” in 1976 deregulated commissions and changed the brokerage business. The switch to decimals in 2001 narrowed spreads and enhanced the incentive to use electronic trading. And the new XBRL interactive data era will be another one of those landscape-changing events for the securities industry and investors.

Link here.


It was 1996, and one stock picking system was working extraordinarily well for everyone. It worked for the stockbrokers who used it to bring in hundreds of millions of dollars in client assets. It worked for their clients, too, who were making an average 17.7% per year following this system. And on top of being profitable, it had the extra-added bonus of being extremely easy to follow. All you had to do was look at the 30 industrial companies that make up the Dow Jones Industrial Average. By selecting the 10 Dow stocks with the highest dividend yields, the five cheapest of that bunch – according to the system – represented the best values amongst this high quality group. It was called the “Dogs of the Dow” Strategy.

Of the Dow 30, the five cheapest of the 10 highest yielders were the ones to buy – and hold – for one year. In one year’s time – the “anniversary day” of the day you bought them – you took all of the dividends those stocks paid you, sold the original Dow 5, and rolled all of that money into the new Dow 5. The beauty of the system was that the money you invested at the beginning appreciated, and along with the dividend income, allowed you to buy even more stock in next year’s five. Simple, right? It was. And it worked for years. Eventually, though, as with many successful stock market strategies, it collapsed under its own weight. Once “everyone” knew the secret, it got harder and harder to make a profit doing it.

I have a strategy designed to harness the power of small-cap stocks – and I am confident that it could be just as successful as Dogs once was. And right now, only a few people know about it. But before we get into that, let us check out another great stock market system. Joel Greenblatt, Founder and Managing Partner at Gotham Capital, has his own strategy he calls the “Magic Formula’. Using this formula over the last 17 years, you would have beaten the market in every single 3-year period since 1988, turning $11,000 into over $1 million. Greenblatt’s formula is remarkably simple. He devised a point system ranking the companies with the best earnings yields and returns on invested capital. He then invests in the companies with the highest scores.

Your own system does not have to be complicated; it just needs to keep you on track. The reason I recommend you use a set strategy for your investments is that it trumps your emotions. If you have a system in place, you will not rush to your broker to buy every “hot stock” on the market or carelessly sell a lagging stock because it feels like the right time. Taking your emotions out of your investing is the perfect way to avoid making the most common mistakes of every other investor out there – buying high and selling low. You know how that works. You get a tip from the television/a friend/a co-worker, you buy the stock when everyone else is buying, and the price drops a few months later and you sell for a loss.

I have been busily perfecting a 10-point small-cap stockpicking system and its 10-point screen for more than a year now. And while it is tough to improve on a screen that has been so successful in the past, I am still working to adapt it to flag stocks that could produce the biggest gains. I have wanted to share this with you for some time now, but I refused to publish it until it was near perfection. I am confident that this system has the potential to open your small-cap portfolios to the best (and most overlooked) companies out there. Here are the nuts and bolts.

  1. Market capitalization must be less than $1.5 billion
  2. Must trade on a major exchange (NYSE, NASDAQ and AMEX)
  3. Share price must be $10 or less
  4. The stock must exceed $1 million in trading volume every day
  5. Revenue growth should be up year over year
  6. Net income must be up year over year
  7. Gross profit margin should be up year over year
  8. Price/Sales should be less than 1.5
  9. Price/Book should be less than 1.5
  10. Price/Earnings should be less than 25

Those are the criteria. However, the system I use to make my picks is proprietary. The good news is that my readers are the sole beneficiaries of my work. This screen is so selective that it only yielded six companies – out of the 5,585 public companies with market caps under $1.5 billion. I will break some of them down for you next week, as well as the origins of this successful system and where you will be able to find it in the near future.

Link here.


Using this investment strategy, Thomas Rowe Price Jr. discovered companies such as Black & Decker, Merck, Avon and Xerox. Back in the ‘40s, ‘50s and ‘60s, these were speculative stocks that no one, except Price, had the guts to buy. They all went on to rise between 62- and 237-fold. And today, Price’s company manages over $269 billion in assets. Jim Oberweis, a famous portfolio manager from Chicago, used the same investment strategy that Price did. Since 1987, his flagship fund has averaged a 12.5% gain. A $10,000 investment with Oberweis in 1987 is now worth $111,833.

The investment strategy that made both of these men wealthy many times over is known as GARP – growth at a reasonable price. GARP combines value and growth investing into one neat little package. A GARP investor wants to own high-growth companies. But he does not want to overpay for the right to own that growth. Price bought companies with expanding profit margins, quarter-over-quarter sales increases and a history of accelerated earnings growth (both year over year and quarter over quarter). If a company met these requirements, he was not so concerned if it happened to have a high P/E ratio or not. The theory was simple: If a company was growing quickly enough, it would narrow the gap between earnings and price over time.

Oberweis has a similar, but more stringent, philosophy. As he said in an interview a few years ago, “We’re looking to buy companies for a P/E not higher than half the rate of growth. So if a company is growing at 50% annually, we don’t want to pay a P/E higher than about 25.” In addition to buying growth companies for a reasonable price to earnings, Oberweis also insisted on:

  1. Rapid earnings growth
  2. Future growth potential
  3. Earnings acceleration
  4. Low relative price/sales ratio
  5. Quality earnings
  6. Top quartile of relative strength
  7. Rapid revenue growth

These criteria make up what Jim calls his “Oberweis Octagon”. Each investment decision must pass his octagon test before it makes it into his portfolio. And while the name is somewhat silly, the results he has racked up are nothing to snicker at.

So what stocks might Price and Oberweis buy today? To answer that, I created a GARP screen of my own (based on both Price’s and Oberweis’s investment criteria). I looked for:

  1. Market capitalization of $1.5 billion or less
  2. Net profit margin had to improve in each of the last two years
  3. Earnings per share growth of 25% or more in each of the last two years
  4. Sales growth of 25% or more in the last two years
  5. Quarter-over-quarter sales growth
  6. P/E of 40 or less
  7. Relative strength in upper quartile

Only five companies came up on this GARP screen. They are:

  1. American Oriental Bioengineering, Inc. (AOB)
  2. Epicor Software Corp. (EPIC)
  3. First Regional Bancorp (FRGB)
  4. Pinnacle Financial Partners (PNFP)
  5. TALX Corp. (TALX)

If you are looking for a short list of growth stocks at reasonable prices, I would start here. Each of these companies has awesome growth numbers. And unlike many so-called growth opportunities, these actually have real earnings and improving profit margins to boot. That says they have established products, services or brands that command premium prices. It also says management runs the business with the shareholder in mind. That is a rare combination on Wall Street these days.

Just remember one thing if you decide to invest with a GARP bent. Both Oberweis and Price made their fortunes by holding onto their stocks for years, not months or weeks. You do not walk away with 23,000% gains in a few weeks.

Link here.


Since the recent drop in oil prices, the market appears convinced that we have seen the last of their stratospheric rise – the NYMEX oil futures contracts remain under $70 per barrel for the next 2 years, for example. However, the free market economists’ theory that supply will always arrive to meet demand increases is pretty shaky in the oil sector, and the market looks likely to be wrong.

In conventional analysis, the surge in demand from the emergence of India and China and a strong economy in the West is believed to be temporary. Prices may be boosted by an unexpected event such as Hurricane Katrina or the Nigerian oil disturbances, but a sustained period of high prices such as in 2005-06 produces additional sources of oil supply. These take time to appear but eventually satisfy demand and drive prices down to their equilibrium level, currently thought to be in the $25-30 per barrel range.

This analysis may be wrong for a number of reasons. On the demand side, this is not an ordinary economic boom, but has been “turbocharged” in China and India by the Internet’s one-off enabling of outsourcing to those two countries. Thus the world’s economic growth is heavily concentrated in China and India, particularly China, rather than in the countries of the West and Japan in which oil demand is relatively saturated. For example, the Chinese automobile market has grown from 3.2 million vehicles in 2002 to 7 million in 2006, and is now the second largest automobile market in the world, just ahead of Japan, 40% of the size of the U.S. market and 10% of the world market. It may thus take considerably longer than is currently projected for high prices to suppress demand. Demand-pull pressure on supply is stronger than normal, and may be more sustained.

The supply side of the picture is also disquieting, because of politics. Traditionally, it has been supposed that new supplies of oil will be brought on stream as prices rise. Thus a doubling in world oil prices, such as we have seen since 2002, should bring a massive surge in supply that, together with increased conservation, matches and then surpasses demand, bringing prices tumbling down close to their traditional level, or a little above if the new supplies are more expensive. It is a nice theory, but it depends on oil producers behaving as economically rational operators, seeking to maximize long term profits. In the 1973-82 oil price surge this was still true – just. The oil price rise, while initially caused by political decisions in the Middle East, eventually proved unsustainable, although even then it was 12 years before oil prices fell back in 1985-86.

This time around, while everybody’s expecting the market to react as it did in the early 1980s, the reality is very different. Of the major new sources of supply, only Canada, home of the Alberta tar sands, is pro-Western and market oriented. The oil companies themselves are almost all short of supply, and have genuine control of only a modest part of the oil they produce. The biggest change is the rise of oil producing countries which control their own supplies, have the necessary technology, but are motivated by political rather than economic considerations and are generally unfriendly to the West, especially to the U.S. However strong may be the economic forces pushing them to open new supplies (if they have them) these countries do not place economic wealth maximization as their first priority and are enjoying their new found power from expensive oil far too much to want to lose it again in a supply glut.

In ascending order of hostility to Western interests, apart from Canada, the major potential sources of new oil supplies are Saudi Arabia, Russia, Venezuela and Iran. Saudi Arabia is the most potentially friendly of these countries, and has a big interest in keeping the Middle East quiescent and in preserving the U.S. as a potential bulwark against Islamist revolt. However, apart from the possibility of an Islamist revolt itself (currently fairly remote, but devastating to the world oil market if it happened) Saudi Arabia is also keen to avoid another 15-year period like 1985-2000, when the world ignored its political wishes, oil prices remained low and domestic unrest festered. It is also possible that its reserve production capacity is much lower than has been thought and its ability to increase output is in fact modest.

Russia was thought to be a major new protection for the West against Islamist problems in Saudi Arabia and the rest of the Middle East, and a major private-sector-oriented swing producer of oil which would keep price rises moderate. One can only laugh hollowly, and reflect on the folly of those such as George W. Bush who thought in 2001 that they had detected in Vladimir Putin a secret liberal reformer. The Putin government seems to be pushing Western oil interests and even the Russian private sector out of the oil business altogether, in order to use Russian oil production for strategic warfare against first Russia’s neighbors and then the West. Putin is infinitely more sophisticated than the old Soviet regime, and at least equally ruthless. Low oil prices and secure supplies would wreck Russia’s leverage. Putin will do all he can to avoid them.

Venezuela is a smaller potential source of supply than Russia or Saudi Arabia, but it is close to the U.S., and in the hands of a friendly government its Orinoco tar sands would be an important new resource, probably viable at an oil price of $50-60 per barrel. Needless to say, it is not currently in friendly hands. What is more, president Hugo Chavez has found a new friend in China, with whom Venezuela is to develop its new reserves, shipping 500,000 barrels per day round the world to the Chinese market, an economically idiotic but politically very astute move. While Chavez is there, Venezuela’s oil reserves will be used primarily as a strategic weapon against the U.S.

Finally we have Iran, a country currently committed to anti-U.S. activity, and identified by Bush as a charter member of the “axis of evil”. When Bush made that speech, in 2002, Iran was pretty clearly no such thing. Its moderate president Mohammed Khatami, in office since 1997 and re-elected in 2001, had indicated repeatedly that he wanted normalization of U.S.-Iranian relations. What he got instead, from both the Clinton and Bush administrations, was the back of the hand. Little wonder that Iran pursued its nuclear ambitions wholeheartedly and that in a (rigged?) election in 2005 it rejected moderation and elected the extremist Mahmoud Ahmadinejad. In reality, Iran has the best chance of the antagonistic swing oil producers to remove its hostile government and choose the path of moderation and economic development, but it will not do so without major policy changes by the West.

Given the rapid growth in demand and the limited potential for near-term supply improvements, an oil price of $100 per barrel seems almost inevitable, probably within the next 24 months. At some point, soaring oil prices, perhaps even as high as $200 per barrel, will produce a deep world recession, probably accompanied by surging inflation, which will temporarily solve the demand problem. Only then will the West have the opportunity to bring the situation back under control. If that is done, the long term equilibrium oil price is probably in the $40-50 per barrel range, but getting to that point seems likely to take several very painful years.

In May 2004, when oil prices passed $40 per barrel, I wrote a light-hearted piece looking at the economic effect of $80 oil, while explaining that I thought it unlikely that oil prices would reach anything close to that level in the near future. Three months ago, oil prices peaked only just short of $80. That now looks far too conservative as a forecast of the oil price peak, and the relatively mild effects of that price look almost trivial compared to what we may have to face in the years ahead. When contemplating the oil market, the Bear becomes even more Bearish than usual!

Link here.


I continue to read analysis postulating that the Fed overshot … that rates were hiked above some so-called “neutral rate”, In this age of unlimited, asset-market-centric global finance there is no such animal as a single U.S. interest rate to stabilize our credit and economic bubbles into some equilibrium state. And while we can attempt to discern the state of Financial conditions from analyzing day-to-day marketplace nuances, quarterly financial sector earnings reports do provide the clearest view of system credit availability and the general liquidity backdrop. Despite some unsettled market conditions during the third quarter, there is no evidence of tight financial conditions in the reports from our largest and most powerful financial institutions. In short, the mindset remains very much “full steam ahead!”

Intense competition and margin pressure continue to drive lending volumes and capital market activities. The sharp slowdown in home sales activity is offset by more aggressive home equity, credit card, and small business lending. Almost across the board, commercial lending volumes are strong. Industry executives certainly exuded confidence during their respective conference calls. While delinquencies and credit losses ticked up a bit, they do not yet appear to be a source of worry. And the scope of share repurchases remains astounding. Citigroup, BofA, and JPMorgan combined year-to-date repurchases stand at an incredible 427.6 million shares. Virtually all institutions noted strong inflows into their investment management businesses.

It is also worth noting earnings disappointments from the mortgage players. Mortgage industry profits are petering out, although I am still in no hurry to call for the imminent demise of the mortgage finance bubble. At this point, industry earnings troubles are more a reflection of massive overcapacity and a sharp reduction in originations, rather than rapidly escalating credit losses and lender/investor/speculator revulsion. Accordingly, credit availability remains generally loose. Some regional housing bubbles are bursting, which has set in motion quite problematic dynamics for those individual markets. Conversely, other markets have hardly missed a beat. With respect to the national economy, credit bubble dynamics will for now continue to counterbalance what would in normal circumstances be the devastating consequences of a major housing downturn.

It is important to repeatedly remind ourselves that these are anything but normal times. In true credit bubble blow-off fashion, the push into commercial lending and capital markets activities (spurred by waning mortgage profits) has evolved into a key facet of resilient employment and income growth trends. Those analysts most intensely fixated on faltering housing markets tend to avoid giving general credit and liquidity trends (financial conditions) deserved consideration.

I still get stomach aches from all the humble pie I have consumed from my predictions of an imminent bursting of the mighty bond market bubble. Everything I thought I understood about market bubbles, financial history, and the unprecedented degree of leveraged speculation that had come to permeate the U.S. credit system left me cocksure that the bond bear would be one elongated and ferocious grizzly. Well, wrong and more wrong (at least so far). I now appreciate that I failed to adequately take into account the global credit and liquidity backdrop. U.S. and global financial conditions were extraordinarily loose, which (so clearly in hindsight) ensured that abundant liquidity flowed continuously into U.S. Treasury, agency, and debt markets – recycling massive U.S. Current Account deficits, as well as enormous “carry trade” flows from Japan, Switzerland and elsewhere. The global liquidity backdrop has proved itself overpowering.

Clearly, housing bubbles demonstrate different dynamics than a bond market bubble. There are prominent local characteristics creating varying degrees of housing vulnerability. One can today examine Florida and California, for instance, and see markets acutely susceptible to bursting bubble dynamics. These local factors (expanding inventories and inflated prices, along with mounting post-bubble speculator revulsion) will now – even in the face of a resilient national mortgage finance bubble – play a more pronounced role in dictating market dynamics than declines in mortgage rates. At the same time, we should not dismiss the possibility that the generally loose U.S. and global backdrops will continue to present a countervailing force supporting home prices around the country, similar to how they have cushioned the bond market bubble.

With global credit conditions underpinning employment and income while stoking systemwide liquidity over-abundance, I will continue to approach the unfolding housing bust with analytical caution. The housing grizzly goes on a rampage with the breakdown of the mortgage finance and credit bubbles. In the meantime, I am willing to predict escalating monetary disorder and resulting wild marketplace instability and divergences in housing, securities, and commodities prices – a backdrop poised to confound the Fed and limit their flexibility for responding to deepening housing troubles.

Link here (scroll down to last subheading on page’s left column).
Also see this article, scrolling down similarly.


Two years ago, specialty mortgages were all the rage. Issued during a period of historically low interest rates – adjustable-rate mortgages clocked in below 4% in 2003 – many mortgages allowed buyers to pay only the interest on a loan for a certain period of time, or pay down very little on loan principal. Many included gimmicks like instant home equity loans to offset down payments, or required scant documentation, making them popular with buyers who were stretching to purchase homes in a red-hot real estate market. By some estimates, last year 30% of mortgages had these special features.

Today, the financial grim reaper is at hand. Hundreds of billions of dollars in adjustable-rate mortgages that were underwritten in the first wave of the trend will get kicked up to higher interest rates in the coming year, and that promises to trip up a lot of homeowners. If you are facing such a situation, it is time to assess your financial situation, and even begin to cut back on your spending. Being aware that your credit score will help if you want to switch loans. The Consumer Federation of America, a Washington, D.C.-based advocacy organization, offers these and other tips for homeowners headed for a jam. Smart borrowers will use them.

Link here.


“Price Reduced” is the sign of the times in real estate. Jack Timmons knows the pain. His Fort Lauderdale home has been on the market for six months. Buy his house for $349,000 today? He will throw in a new plasma flat-screen TV. “We didn’t have to do this a year ago,” says Timmons. “Nobody did.”

Nationwide, homes that sold in four weeks a year ago are now sitting on the market twice as long. So, to sweeten the deal, sellers are offering free furniture, luxury cars, even the use of a private jet. “The buyers have to be very cautious when they look at these gimmicks out there, because a lot of them are gimmicks, to be honest with you,” says Bruce Hersey with the EH Building Group in Port St. Lucie, Florida.

Another trend: Home auctions are up nearly 6%. Some auctions promise to sell a house on a certain date. But it can be “seller beware”. Byron Meo in Riverside, California, wanted $680,000 for his three-bedroom home. He got $200,000 less. “It was real disappointing,” he says. But what is disappointing to sellers is good news for buyers. And real estate experts say they see no signs that will change soon. Popular in California and now spreading, so-called “staging” sellers pay thousands of dollars to decorate their homes “just for show.”

Link here.

Home sellers sing the blues as price drop sets record.

Then: San Diego’s housing market was so hot that the town house next to Jeff Cruce’s was flipped from buyer to seller three times in three years. The owners, who never moved in, did not even need to put up a “For Sale” sign.

Now: Since August, Cruce and seven of his neighbors have put their town houses on the market (that is nearly 20% of the units in the complex). All have cut their prices, including Cruce, who chopped his price last month by $30,000 to $559,000. Not one has received an offer yet. Each time one owner would lower the asking price, it put pressure on the others to follow, says Cruce, 38, a salesman who is moving to Atlanta.

That domino effect, rippling through neighborhoods across the country, pushed down the nation’s median home price in September by the largest amount on record, the National Association of Realtors (NAR) announced. The median price for a single-family home slipped 2.5% from September last year to $219,800, the sharpest annual drop since the NAR began tracking the data in 1969. The median-priced condominium fell 2.8% to $219,800, the fourth quarterly annual decline in a row. At the same time, the volume of home sales fell for the sixth straight month, tumbling 14% in September compared with a year ago.

In the softest real estate markets, sellers are waking up to the harsh reality that they cannot get anywhere near what their neighbors sold their homes for last year. So they are grudgingly reducing their asking prices and offering to pay closing costs. At the same time, many buyers, emboldened by the transformed market, are low-balling sellers and getting deals they could not have imagined last year.

Just ask Sevan Derderian and Reggie Johnson. In 2004, Derderian bought a house in Las Vegas as an investment for $281,000. He found tenants, but he kicked them out after 10 months because their rent was always late. “I found that it’s really hard to be a landlord from a state or two away,” says Derderian, 43, a salesman in Los Angeles. He held onto the property for another year, hoping prices would keep going up. Once the market turned south, though, he panicked. He listed the house in the summer for $305,000. Having owned real estate only during boom years, he assumed it would sell in about a week. After a month, he cut the price to $289,900. Another week went by. He offered to pay nearly $9,000 toward a buyer’s closing costs. Then along came Johnson, a 38-year-old truck driver, who snapped up the house and boasts, “I got a great deal.” Derderian, meantime, lost about $25,000 from paying the mortgage on an empty home.

That is a risk confronting sellers in 56 metro areas, including Las Vegas, San Diego, Phoenix, New York and Miami, that are expected to suffer annual price drops, according to a study this month by Moody’s Economy.com. Prices in a few markets, such as Las Vegas and Portland, Oregon, will not bottom out until 2009, the study projected, and in many areas prices will stay flat through the end of the decade. “It was surprising just how quickly the market seemed to turn,” says Mark Zandi, chief economist for Economy.com. “It was like, boom, boom, bust. It was like, ‘What happened?’ The psychology in the marketplace unraveled very rapidly.”

In fact, about half of American homeowners who thought of selling their homes in the past year have delayed putting their homes on the market, according to a USA TODAY/Gallup poll conducted this month. And roughly one-third of those who had considered selling have abandoned the idea. About one-third of the nation, however, is expected to see moderate price growth for the rest of the year. Those areas include Dallas, Austin, Newark, Delaware, and Birmingham, Alabama – areas where prices did not test the stratosphere during the boom. Even in the once-sizzling markets, homeowners and investors who bought their properties more than two years ago should still see modest gains if they sell in the current market. But it is clearly a buyer’s market now.

Link here.

Las Vegas housing downturn reveals sharp rise in mortgage fraud cases.

A slowdown in the Las Vegas Valley housing market is starting to uncover a growing number of mortgage fraud cases. Investigators for the FBI, state Mortgage Lending Division and local law enforcement said complaints of mortgage fraud are picking up and will undoubtedly increase as the number of properties entering foreclosure continues to rise. Many of the complaints involve falsifying home mortgage applications, including exaggerating incomes and claiming investment properties as a primary residence.

“Mortgage fraud is just beginning to jump by leaps and bounds in this town,” said Pete Dustin, a part-time white-collar crime investigator for Metro Police. Dustin said the number of complaints has risen from one or two a month to one or two a day. “When everybody is getting paid, nobody cares. The second they start instituting foreclosure proceedings, they pay attention. The lending institutions are going to start screaming.”

Nevada has the second-highest rate in the country of homes entering foreclosure – a rate that is expected to rise by the end of the year and in early 2007 as mortgage payments increase sharply for those with adjustable rate mortgages. Some of that growing foreclosure rate is attributed to fraud. Colorado is the only state with a higher rate than Nevada. “This is as high a complaint log I have seen in three years in business,” said Scott Bice, commissioner of the Mortgage Lending Division. “And I don’t see it slowing down. Right now with the slowdown in the market, all these little things are popping up. In a rising market, even if people inflate, everything bails them out.”

One of the most prevalent mortgage frauds committed is buyers stating on their loan applications that the home they are purchasing is their primary residence, when they only intended to acquire it as an investment property and flip it, authorities said. By claiming that, the buyer was able to secure a better interest rate and terms such as a lower down payment. In other cases, buyers misstated their income to secure mortgages or mortgage brokers coached them to doctor their applications as a way to secure loans. Even though falsely filling loan applications is a federal felony that can carry a prison sentence and fine, authorities said their focus tends to be on more widespread fraud that involves several people and properties and losses exceeding $1 million in some cases.

Link here.


If there is a Sinatra of mutual fund managers, it is Bill Miller of Legg Mason Value Trust, whose string of hits is unsurpassed. He has beaten the S&P 500 for 15 years running. But this year Miller is way behind. So what are his fans doing? Giving him the boot as though he were an also-ran on America’s favorite talent show.

It is not just Miller’s shareholders. A surprising number of top managers, including Bill Nygren of Oakmark Select and Ron Muhlenkamp of the Muhlenkamp Fund, are in the midst of steep performance slumps, and impatient investors in recent months have been yanking out cash and roasting their heroes. One poster sniped – incorrectly – in an online forum, “Bill Miller has evaporated more money than any other fund manager this year.”

Whoa. It is just flat-out dumb to expect a fund manager to outperform every year. Even the best make mistakes. Miller, Nygren, and Muhlenkamp have loaded up on beaten-down big growth stocks, which have long trailed shares of smaller companies. That kind of contrarian thinking is why a star investor is likely to underperform more often – and for much longer – than you would expect. Consider a study by researchers at investment firm Litman/Gregory, who reviewed the performance of actively managed large- and small-cap funds that beat their benchmark indexes over the 10 years through 2005. The data showed that more than 90% of these elite funds lagged their benchmarks by an annualized two percentage points or more for at least one three-year period. Nearly 30% by more than 10 points.

But if you bail out when it is not working, you will likely sing the blues later. For example, the managers of Longleaf Partners, who buy bargain-priced stocks, lagged badly between 1995 and 1999, when high-flying techs were the rage. But for the next four years, the fund topped the charts, and over the past 10, Longleaf ranks in the top 3% of its peers. While there is no guarantee that a slumping manager will rebound to the top of the charts, and sometimes it makes sense to dump a star, do not base your decision on his most recent record. Instead, look for these warning signs.

Link here.


The emergence of free online trading could have a huge impact on the exchange-traded fund industry. A few weeks ago, Zecco Holdings announced it was launching zero-commission online trades. Shortly after that, Bank of America said it was going to offer the same thing to customers with a combined $25,000 or more in their Bank of America accounts, including checking and savings accounts and CDs.

This could be a major boon for ETFs, because while they are constantly praised for their low annual expenses, transparency, tax efficiency and flexibility, investors have had to pay commissions to buy and sell them. This has alienated a large pool of people, particularly those who prefer to invest in small, regular increments and would get slammed paying $10 a pop in commissions. “The commission costs were the last major wall separating ETFs and index funds,” says Matthew Hougan, editor of indexing industry Web site IndexUniverse.com. “ETFs are a fraction of the broader mutual fund industry ... absent brokerage fees, ETFs are a better structure in many ways. I don’t think many people argue about that anymore,” he says.

Looking ahead, the real question is whether other companies will follow Zecco and Bank of America. If they do, and ETF commissions start to fade away, it could lead to substantially higher asset flows. ETFs had more than $360 billion in assets at the end of September. Widespread elimination of online trading fees also could cause ETF asset flows to shift more in favor of retail investors, where previously institutional money made up the lion’s share of ETF assets. q“It] suddenly makes ETFs appropriate for accumulation, since an investor putting in a regular monthly amount won’t have to pay commissions,” says Allan Roth, founder of investment advisory and financial planning firm Wealth Logic.

However, there are a few caveats that investors need to be mindful of – and they are not inconsequential. “No commissions does not equate to no costs,” says Roth. ETFs, like stocks, have spreads between the bid and the ask price, so even if there are no brokerage fees, investors will have to pay the spread. And unlike buying index mutual funds, where you can invest a specific dollar amount and receive fractional shares, ETFs have to be purchased in whole numbers of shares. Finally, Roth warns investors to be mindful that there ain’t no such thing as a free lunch. With the absence of commissions, he says, “Bank of America and other institutions offering ‘free’ trades expect to make money from the customer in other ways.”

Hougan echoes the last point. In this case, he notes that it is evident in the interest rates. The interest rates for BofA’s money markets savings account and CDs are below industry standards, he says. So this may not be a good deal for customers, as it could substantially reduce their yearly deposit income. Hougan adds a final point: “ETFs are supposed to be long-term investments … just because trading is free does not mean you should do it.”

Link here.

New Financial Sector ETF looks good looking backward. How about looking forward?

The never-ending quest for better mousetraps continues as PowerShares nine sector ETFs that apply Robert Arnott’s fundamental indexing methodology of weighting for book value, income, sales and dividends. This article will focus on the PowerShares FTSE RAFI Financials Sector Portfolio (PRFF). In the Powershares literature, the fund compares itself and its returns to the iShares Dow Jones Financial Sector ETF (IYF) and the S&P Financial Sector SPDR (XLF). All three look to be very similar. They all have large positions in the same mega-cap names – Citigroup, Bank of America, JPMorgan Chase and Wells Fargo. The three funds also have similar weightings in capital-markets names and REITs and tilt toward value over growth.

So on the surface, there is not much difference. But as is the case with most new ETFs, the back test is the compelling question when considering the PRFF. That the PowerShares back test looks so strong is not a shock for two reasons. From a cynical standpoint, if the results of a back test were horrible, it is reasonable to believe there would be no fund launched. From a more fundamental standpoint, it is not surprising a strategy that generally favors value over growth would show better returns in a sector that is more of a value-oriented part of the market.

One contributing factor to PRFF’s outperformance might be the smaller weighting in Citigroup. Over the past five years, Citigroup has lagged both IYF and XLF by a noticeable amount. Citigroup is weighted at 7.86% in IYF, 9.8% in XLF, but only 4.26% in PRFF. Citigroup, as a mega-cap, has been the wrong part of the market, and like most mega-caps, it has lagged its sector. There is no guarantee this will persist, and in fact, it is a reasonable that mega-caps will lead the market again. But the exact timing can only be guessed. I was not able to find the history of portfolio changes as applied to the back test on either the PowerShares or Research Affiliates Web sites. I chose not to inquire directly because I wanted to take the same tact that a do-it-yourself investor would be able to take in trying to decide whether to buy this fund.

So should this fund be bought? I do not believe in speculating on a sector that you believe will do well. For me, the context is if you build a portfolio and access sectors by using sector funds, is PRFF the best way to own the financial sector? I am not sure we can know yet, because the fund is so new and all we have to go on is back testing. I do believe in the concept implemented by Arnott and applied to this fund, and I would not be the least bit surprised to see this fund continue to beat its competition, IYF and XLF. But I would want to see more of a real-world track record (as opposed to just relying on the back test) before making a switch from an existing holding in a competitor. And even if PRFF does turn out to be a better mousetrap, at some point in the future something else may come along that is better still.

Link here.

Dialing overseas for diversification.

Among the bushels of new ETFs that have been listed on the U.S. market lately are 10 foreign-sector ETFs from WisdomTree. The sector funds weight their holdings in a similar manner as WisdomTree’s other funds, keying off of dividends. These are unique, in that they own no domestic stocks, unlike some putatively foreign-focused funds. They have been in the works for a while, and I believe they could be useful to investors.

Out of the gate, the one that looks most interesting to me is a telecom fund called the WisdomTree International Communications Index Fund (DGG). The telecom sector is a good way to add foreign exposure to a portfolio because every country has a phone company (usually they are among the biggest), and they often pay a healthy dividend. The fund fits the bill yield-wise – the index that underlies it has a 4.53% yield, which is a much higher yield than the older telecom ETFs. The fund is well diversified across 20 countries, with 21.0% of assets invested in British companies, 16.1% in France, 7.7% in Germany, and 6.5% in Australia. Like all the WisdomTree sector funds, it excludes Canada.

The stock selection is not as well diversified. Although there are 138 holdings, 9.9% is in Vodaphone, 9.5% in France Telecom and 7.6% in Deutsche Telekom. The top 10 holdings account for 59% of the fund’s assets. Most of the other telecom ETFs are top heavy in this manner as well. WisdomTree’s promotional materials provide back-testing data that compares the fund to the MSCI EAFE Index, but I think the better comparison would be to some of the other telecom ETFs. Clearly the fund holds its own. The case for owning this fund would be to complement other stocks or funds in the sector. I do not see it as a stand-alone proxy for telecom.

Link here.


Signs of a bottom in the energy complex are finally arriving. Bruised and battered from a barrage of ruthless profit-taking in September, the entire complex has been mauled. Now it is time to buy the most profitable segment of the energy bull market since 2002 – the oil services and equipment stocks. After a major decline from over $77 a barrel in August, crude oil prices recently hit a 12-month low below $57 a barrel. But heating oil, gasoline and even hard-hit natural gas seem to be stabilizing. The way I see it, now is the time to step back into this bull market at fire-sale prices, especially for the companies that drill for Black Gold.

The bull market in energy has not been confined to just oil stocks. In fact, one of the most profitable sectors in the stock market remains in the incredibly profitable oil services sector. The oil services sector encompasses a wide array of oil-related duties, including installing and servicing rigs (old and new), labor, replacement parts, seismic testing, etc. And right now, these services are in high demand. The good news for long-term investors is that following a severe correction since late August, the oil services group now trades 22% off its all-time high. Powered by several hugely profitable companies, including Schlumberger, this industry is about to head into overdrive as we surpass $100 oil over the next 12-24 months.

Schlumberger is the king of oil services; it does everything from seismic surveys to drilling for deposits to servicing the rigs. Over the last three years, earnings at Schlumberger have skyrocketed 476%, and are still soaring in 2006. Every oil services exchange-traded fund (ETF) and most energy-dedicated mutual funds and ETFs hold major stakes in Schlumberger.

Oil drilling and services include several sub-sectors as part of this highly specialized industry. The drilling segment includes those companies that physically drill and pump oil and gas out of the ground. The drilling industry offers a highly evolved range of rigs, including land rigs, submersible rigs, jack-ups, and drill ships. The infrastructure of the entire industry requires highly labor-intensive professionals, peripheral parts and supplies that have literally bolted to the moon since 2003 because most raw materials have hit multi-decade highs. Everything from steel tubing to copper has risen significantly over the last three years, putting pressure on lease rates and costing oil exploration companies a fortune to find new and existing supplies, including available labor. Although some industries have been reluctant to pass on rising input costs to their customers, the oil services sector has boosted daily rates on many occasions this decade as oil prices surge and the hunt for new supply grows. This is where it gets interesting: For every barrel of crude oil that is recovered, 53% of that revenue goes to the oil services companies.

The best way to play the secular bull market in oil services is to purchase a diversified, low-cost, ETF. The best ETF to achieve this objective ahead of stronger corporate earnings over the next six months and beyond is the iShares Dow Jones U.S. Oil Equipment ETF (IEZ: NYSE). From its recent May 2006 IPO, IEZ now trades 23% off its high and is loaded with superb oil equipment stocks – especially Schlumberger (19%), Halliburton Company (10%) and Baker Hughes (8%), to name just a few. The Top Ten stocks in this ETF represent 66.2% of total assets.

Oil equipment fundamentals are phenomenal right now. Earnings are roaring, stocks are technically in a powerful long-term uptrend and the geopolitical landscape continues to deteriorate, threatening current supplies. Any lost output due to a conflict or attacks on major installations imply leveraged revenue growth for a sector already boosted by record earnings. From our perspective, the time to buy great companies in the midst of a bull market is following a correction, not when prices are trading at all-time highs – exactly why we are buying the oil services stocks now.

I have never made great money riding momentum or buying a major trend at, or near, an all-time high. It takes guts to buy amid a decline for a sector or stock, but in reality that is how we have made money. Sometimes we have taken hits bottom-fishing, but, overall, buying low or following a steep correction is how you plant long-term seeds for wealth accumulation. Right now, the oil services and equipment stocks are poised for a major recovery. With the index now almost 25% lower since last spring, we are finally buyers. IEZ is an excellent proxy for diversifying in this exciting sector. I expect earnings to remain buoyant as demand booms for rigs and labor. Oil exploration is an expensive business and I think the big money to be made over the next few years will continue to reside in the companies that extract oil.

Link here (scroll down to piece by Eric Roseman).


As the Holiday shopping season kicks into high gear, buying gaming stocks like Take-Two Interactive (TTWO) just makes sense. Its new Bully game (released to the masses last week) is already flying off the shelves as one of the season’s biggest blockbusters. But quietly flying under radar is an $87 million company that could see plenty of buying interest on a much-anticipated November 7, 2006 game release. Here is why you should be excited …

Movie box office receipts have dropped about $500 million in a year. CD sales are in a downtrend across the country. And television networks are struggling to attract viewers with so-so lineups. But one segment of the entertainment industry is booming – Christian entertainment. Coast to coast, movies, books, music and television programming is catering to 225 million Christians starving for family-friendly, religious-themed products. And within this segment of the market, there sits a market virtually untouched by Christian consumers. It is a multi-billion gaming market that could take off in the next few weeks, and could quickly launch an $87 million company called Left Behind Games (LFBG.OB: OTC BB).

What is all the excitement about? Ask the 70 million consumers that bought into Left Behind, a book series centering on Armageddon and the Second Coming of Jesus, now being turned into a much-anticipated computer game. It may not sound as exciting as the rough streets of the Grand Theft Auto series, but it is sure to attract heavy buying interest amongst 70 million fans. In Eternal Forces, based on the first few books of the series, Hell has broken loose and billions of people have disappeared from Earth. That is where you come in and command the Tribulation Forces and battle the Antichrist, who now heads the United Nations (so real), across 500 New York City blocks. Your mission? Recruit members of New York’s population for the side of God, and win over agnostics and non-believers of New York City … or kill them as the game commands, before or after they are pulled to the dark side of evil.

As with other controversial games, there are the critics, who in this case argue that it will promote religious intolerance because the game is about killing those who have a lack of faith. And there is fear that radical Muslims will view the game as a crusade against other faiths. We are not here to take sides, though. We are here to make you money.

What is appealing for fans, however, is the fact that the Left Behind game has no sexual content, blood, decapitation, severed limbs, or vulgar language. Recall that Left Behind Games has already sold more than 70 million copies of its book series. Of the millions of consumers that bought the book series, 72% of them play video games. If, say, the 72% represented 10 million consumers, then multiplying that by $50 a game is $500 million in revenue for an $87 million company. Better yet, the company will not just release one video game. With expected blockbuster sales of this one, expect to see numerous follow-ups. And be sure that demo copies are being spread throughout churches, camps and youth groups from coast to coast. The buying momentum will be huge.

Corporate America would be foolish not to want a piece of the Christian consumer market. The Christian book market is estimated to be worth more than $4 billion. The Christian music market has become an industry powerhouse, selling 43 million albums in the U.S. in 2004. The general video game industry is expected to grow … fast. Estimates are that the video games market could be worth more than $55 billion by 2008 from the $22 billion reported in 2003. Wal-Mart, for one, is smart enough to know from selling about 550 Christian music titles and more than 1,200 Christian-themed books.

There is now hope for a similar boom in Christian gaming. Games, like N’Lightning’s Catechumen has sold more than 80,000 copies since 2001. Ominous Horizons sold more than 50,000. The market is so hot that companies like Crave Entertainment, in 2005, went from selling World Championship Poker to The Bible Game, where players answer questions on biblical scenes from David and Goliath to Noah’s Ark. The current video game industry is worth about $12 billion. Christian video game sales tap only 1% of that market right now.

Left Behind Games’ stock ran despite negative criticism. Chuck Jaffe, for one, called Left Behind the “Stupid Investment of the Week” on September 8, 2006. The stock, then trading at a low of $3.65, now trades above $5. I expect further upside from the Christian entertainment-buying consumers before and during the Holiday shopping rush.

Link here.


The UK base interest rate is set to to rise to 5% in November 2006. Some market commentators are already seeing this as a potential peak despite real UK interest rates being at historic lows.

The current spread between the base rate (4.75%) and RPI (3.6%), is at 1.15%, or marginally higher than the low set in 2003 of 1.1%, which preceded a rise in interest rates from 3.5% to 4.75%. This took the spread to 2%. Since that time, RPI has risen and interest rates fell to 4.5%. This puts the UK under similar interest rate hike pressures as during the start of the rate hikes in 2003. So either UK inflation falls or UK Interest rates rise from here. The key target here is a move back to the 2% spread, which if inflation stayed put, projects a rise in base rates to 5.75%, substantially higher than market economists are forecasting at this point in time.

The most recent data shows domestic inflation running far ahead of imported inflation, which has fallen due to the recent drop in crude oil. This is likely to also be reversed once commodities resume their uptrend. Sterling is also expected to be weak due to the large trade deficit, and a weak sterling will cause high additionally imported inflation. The trade and budget deficits are likely to result in Gordon Brown breaking his Golden Rule of balancing the budget over an economic cycle, i.e., printing excess money. This will ensure that sterling is likely to decline even if interest rates rise. So for the forseable future, inflation is unlikely to fall.

Another major inflationary influence is that the UK money supply growth is running at 14.5%! That represents a 16 year high. This alone is alarming and should prompt the BoE to raise interest rates as well as other measures to reduce the money supply growth which, unless addressed, will cause even higher future inflation. We can speculate how high: given RPI of 5% + 2% = 7% base rates – well beyond current expectations, and recent experience. But neither has the money supply growth been running at levels not seen since 1990, when interest rates had risen to 15%.

Link here.


It may be time for Corporate America to do more with less as the economy slows, judging from the rising stocks of Wal-Mart, Amazon.com and JetBlue Airways this week on news of the companies’ plans to ease capital spending. “It’s anticipation of a slowdown, and you better watch your costs,” said Al Goldman, chief market strategist at A.G. Edwards, in St. Louis. “When everything is coming up roses, costs you do not worry about, because you are getting big revenue increases and cost problems kind of get hidden.”

After facing several years of headwinds, including rising interest rates and volatile energy prices, the U.S. economy is slowing. The Commerce Department is expected to report this week that U.S. GDP grew about 2.2% in the third quarter, according to economists polled by Reuters, down from 2.6% growth in the second quarter.

Wal-Mart, the world’s biggest retailer, said it would slow its pace of U.S. store expansion, allowing it to rein in the growth of its capital spending budget. Executives at the company said they would aim to raise capital spending by 2% to 4% next year, well below the estimated 15% to 20% increase for 2006. That change reflects plans to open fewer stores in the U.S., where the company already has nearly 4,000 locations, while continuing to expand abroad. “It’s just prudent management and this point in the business cycle,” said Ted Parrish, principal of the Henssler Financial Group, a money management firm in Kennesaw, Georgia.

Amazon.com, the second most popular e-commerce site behind eBay, said late Tuesday its fourth-quarter profit would improve as the company slowed its increase in spending on technology. That helped its shares to climb 11.7% to $36.55 on Wednesday, though they are still down 20.3% on Nasdaq for the year.

Link here.


Americans are betting that hedge funds will make them rich even at a time when these once high-flying portfolios are lagging behind the broader market. Research firm Morningstar polled 600 advisers in August and found that 65% of them expect more than double-digit growth in alternative investments, which include hedge funds. 67% of them report that more than 10% of their clients are already using alternative investments.

Loosely regulated hedge funds earned a reputation for delivering huge returns to wealthy investors and pension funds a few years ago. Now financial advisers who help a broad swath of Americans invest their savings want in, too. Roughly 9,000 hedge funds jointly invest about $1.3 trillion, about twice as much as five years ago.

But expectations for high returns might be unrealistic. This year hedge funds returned roughly 7% in the first nine months of the year, lagging behind the average stock mutual fund, which is up roughly 8% and the broader Standard & Poor’s stock average, which is up about 12%. The last time hedge funds delivered double-digit returns was in 2003, when they were up nearly 20%, according to Hedge Fund Research data. In 2004 and 2005, they returned less than half that, gaining only about 9% each year.

Even though hedge funds have captured the public imagination, many financial advisers listed three reasons for staying away – the portfolios are complicated and secretive and they are expensive. Hedge funds can use trading techniques that are off-limits at most mutual funds and most charge performance fees on top of the management fees most mutual funds charge.

Link here.


The deficit country is absorbing more, taking consumption and investment together, than its own production; in this sense, its economy is drawing on savings made for it abroad. In return, it has a permanent obligation to pay interest or profits to the lender. Whether this is a good bargain or not depends on the nature of the use to which the funds are put. If they merely permit an excess of consumption over production, the economy is on the road to ruin.” ~~ Joan Robinson, Collected Economic Papers, Vol. IV, 1973

Finally, the greatest boom in American housing history is going bust. The impact on the economy has only just begun to be felt. Demand for homes is sharply down, while the number of vacant dwellings is ballooning – up more than 40% for existing homes and more than 20% for new homes year over year. At issue now is the severity of the impending bubble aftermath. It does not seem, though, that there is a lot of worrying around. There appears to be a widespread belief that the U.S. economy is now out of trouble because the Fed decided not to raise interest rates.

Treating bad economic news as good for the financial markets, Wall Street is running wild with more aggressive speculation. “The world economy is on track to grow at a 5.1% rate this year, but the risk of a severe global slowdown in 2007 is stronger than at any time since the September 2001 terror attacks on the United States,” said the IMF in a report to finance ministers, mentioning two possible triggers: a sharp slowdown in the U.S. housing market or surging inflationary expectations that would force central banks to raise interest rates.

Taking this forecast into account, the sudden plunge of commodity prices may not be totally surprising. On the other hand, prices of risky assets and mortgage-backed securities have, despite the obvious problems in U.S. housing and consumer finance, held steady. Stock prices of U.S. lenders up to their necks in subprime, interest-only and negative-amortizing mortgages have been rising 5-10% since late August. Since hitting bottom in June, emerging stock markets have rebounded 20%. Developed international markets have risen by 12%, and U.S. stock markets by around 8%. A vertical slide by the yen since May suggests that yen carry trade is back with a vengeance.

There is talk of recession, but definitely no recession scare. Popular perception appears to trust that the U.S. economy will again prove its outstanding resilience and flexibility. And are the balance sheets of private households not in excellent shape, as rising asset valuations have vastly outpaced the rise in liabilities over the years? The possible scary parts of the new development, a deeper recession and a precipitous decline in economic growth, have not yet come to the fore.

Protracted sharp rises in house prices served private households as the wand providing them with prodigal borrowing facilities to increase their spending. For years, it was the economy’s single motor. Large equity extractions on the part of private households prevented a much deeper recession. Absence of any wealth gains could have easily induced private households to do some saving out of current income.

For the consensus, the U.S. economy’s shallow recession in 2001 is the most splendid justification of Mr. Greenspan’s repeatedly expressed idea that it is better to fight the bubble’s aftermath with easy money than to prick it in its prime. This is plainly a gross misjudgment, because America’s shallowest recession was followed by five years of the shallowest economic recovery, with unprecedented large and lasting shortfalls in employment, income growth and business fixed investment. Actually, there have been major changes in the U.S. economy’s pattern of employment and resource allocation, but altogether changes for the worse, not for the better. These structural changes are bound to depress U.S. economic growth in the long run.

In 2001, the Greenspan Fed could cushion the fallout from the bursting equity bubble with the creation of the housing bubble. This time, manifestly, there is no alternative bubble available to be inflated to cushion the fallout from the housing bubble. Rather, there is a high probability that the popping housing bubble will pull the stock market down with it. That is the first ominous difference between 2001 and today. The second ominous difference is that the economy and the financial system have accumulated structural imbalances and debts as never before in history. Vastly excessive borrowing for consumption and speculation has turned the U.S. economy into a colossus of debts with a badly impaired capacity of income creation.

And finally, equity and real estate bubbles are very different animals, of which the latter is manifestly the far more dangerous. In its World Economic Outlook of April 2003, the IMF noted that the association between general economic booms and busts was stronger for housing than for equity prices, and that all major bank crises in industrial countries during the postwar period coincided with housing price busts. Severe cases of bursting housing bubbles badly affecting the banking systems happened in the late 1980s in England, the Nordic countries and Switzerland. And, of course, there was Japan, where, however, commercial real estate played the key role.

Link here.


What we have here is an asset story – another case in which you can buy a bundle of attractive, cheap, hard-to-replicate assets all in one stock. Unusual, in this case, is that these assets also come with a high-growth kicker. The company is Inversiones y Representaciones SA (IRS: NYSE), which means Investments and Representations in Spanish. Investors simply call it IRSA. The IRSA story begins with company chairman, Eduardo Elsztain, a crisis-tested Argentine with a nose for the best in Argentine real estate. I say “crisis-tested”, but perhaps that is redundant. Any Argentine businessman operating since 2001 and still in business today is, by definition, crisis-tested. But Elsztain has been navigating Argentina’s serial crises for 25 years.

Eduardo went to work for his grandfather’s business in Buenos Aires in 1981. The decade would prove disastrous and ultimately bankrupt the family business. Elsztain nursed his wounds in the relative calm of New York, heading there in 1990. He was determined to return, though, convinced of the opportunities in Argentina in the wake of that crisis. While in New York, Elsztain got the ear of billionaire superinvestor George Soros. Elsztain made the case that Argentine stocks were super cheap. Convinced, Soros gave Elsztain $10 million to buy beaten-down Argentine stocks.

Elsztain headed back to Argentina and bought IRSA for $120,000. It was not much more than a shell company, but it had one valuable commodity – a listing on the Buenos Aires Stock Exchange. Then Elsztain began his buying spree in earnest. When the stock market soared over the next two years, Elsztain took the profits and reinvested them in cheap real estate. The properties were throwing off 20% in cash-on-cash returns. Elsztain kept reinvesting and Soros kept backing him. Soon, IRSA had amassed an impressive portfolio of real estate. But Elsztain had the foresight to sell a lot of those properties in the late ‘90s as things were heating up in the country. So by the time the 2001 crisis rolled around, IRSA was sitting on a fair amount of cash.

Still, the severity of that crisis left no company unscathed. IRSA generated losses in 2000, 2001 and 2002. Yet the company survived, and it was in good position to resume development activities once the economy improved. In its darkest days, in the summer of 2002, IRSA shares changed hands at $3.95, vs. about $30 at its peak. Even though the stock has tripled from its all-time low, it still sells for less than half its all-time peak. As the nearby chart illustrates, IRSA’s share price has been trailing well behind the Argentine Merval Index. But we expect a reversal of fortunes!

RSA owns a diverse portfolio of real estate in Argentina. It owns a portfolio of office property in and around Buenos Aires. Financial crises have a way of stopping the creation of new supply. No one built much of anything for more than three years in Argentina. As a result, the quality “class A” sort of space IRSA specializes in is in short supply. Occupancy rates are 94%. That is good. And Elsztain reports, the future looks still brighter. Real estate is a business with a lag effect. IRSA’s leases are for 36-month terms and numbers do not show the full effect of the Argentine recovery … yet.

IRSA also has a portfolio of shopping centers it owns through a publicly traded subsidiary, Alto Palermo. These properties enjoy occupancy rates of 99% – nary any empty space at all. There are also three luxury hotels, consisting of nearly 700 rooms. Occupancy rates are about 78% and rising. Hotel rates increased 18% year over year. Tourism returning to Argentina boosted the hotel business. As cheap as Argentina is as a place to visit, this trend should continue. Along with these properties, IRSA maintains a healthy development pipeline of apartments and residential communities available for sale. In this mix, IRSA also owns a considerable stockpile of land – about 2,500 acres. Some of this land lies in choice locations in Buenos Aires. A parcel called Santa Maria del Plata could be worth what the whole company is trading for in the market.

If you were to go through and value each of IRSA’s real estate properties and sum them all up, you would get some high numbers – certainly some multiple of book value. Currently, IRSA trades for little more than book value. By this measure, IRSA is about as cheap a real estate stock as you will find – especially in an economy of Argentina’s size. And IRSA has put up growth numbers that need little translation. Shares are changing hands for around 16 times 2006 earnings. Again, you have got more upside as leases roll over. It is an asset play with a growing cash stream plugged into it. IRSA is also in good financial shape, with little debt and ample cash.

The risks here are as obvious as they are unavoidable. In IRSA, you assume some of the risks of investing in a volatile emerging market. Less obvious, perhaps, is a murky corporate governance issue. IRSA and Cresud (an Argentine agribusiness) and the Elsztain family interests intersect in ways that open the possibility of deals made at the expense of one for the benefit of the other. However, the cheapness of the shares and the pile of assets backing the stock make up for these warts, in my view. Plus, we are investing in a market still recovering from one of the worst financial meltdowns the Western world has seen in the last quarter century.

Link here (scroll down to piece by Chris Mayer).


A current “eerie stillness” on Wall Street? Well, not really since the DJIA is resting some 1200 points above its mid-July lows. However, we still cannot shake the “eerie” feeling that something is unnatural about the stock market’s action. Yeah, I know that when someone is wrong in their market prognostications there is the tendency to make excuses, and my firm has clearly been too cautious since those lows. And we are not conspiracy theorists, believing that Lee Harvey Oswald acted alone and that George W. Bush really did win the election. Yet, there remains an eerie “bid” in the equity markets since those July lows.

For example, markets typically rally, then correct by about one-quarter to one-third of that rally’s point gain, before beginning another rally phase. After that phase, they again correct by one-quarter to one-third before re-rallying. This has not been the case recently. Indeed, every time it looked like the indices were about to correct, mysterious buyers materialized in the futures markets – in turn driving stocks higher.

Evidentially, we are not the only ones that have noticed this situation for savvy seer Dr. Robert McHugh recently wrote, as paraphrased by me, “The rally since July has been almost entirely short-covering. We get one big move, about once a week, on buying panic, then no follow-up. … Get this: all of the progress of this three-month summer/autumn rally, all of it, occurred in only nine days of trading, and all but one of the nine was a short-covering rally. … Other than those nine trading days out of 63 since July 14th, the other 54 days of trading produced only 4% of the upside progress, and zero since July 19th. ZERO …!”

While my firm cannot tell if those nine sessions were all “short covering”, we did take the time to check Dr. McHugh’s keen insights and found them to be right on point. Nine sessions accounted for 1155 of the Dow’s 1200-point gain from the July lows. Even more amazing is that on ALL of those nine trading days, according to our notes, showed that the aforementioned “mysterious” futures buyers were at work. When we combine this “mysterious” equity action with the “mysterious” rebalancing of Goldman Sachs’s much institutionally indexed commodity index (GSCI), from a 7.3% gasoline weighting to 2.5% into the November elections, we find ourselves “mysteriously cautious”.

Those views were reflected when we recently suggested SELLING those stocks/sectors that have been working on the upside and BUYING those stocks/sectors that have not been working. That strategy is driven by the belief that with the institutions’ October 31st fiscal year-end, they will be window dressing on the upside with the “working” sectors and “undressing” with the under-performing sectors. That should, at a minimum, provide a dearth of buyers for the darlings du jour and a cessation of selling in the underperformers. Accordingly, my firm agrees with our fundamental analyst’s “carpet bombing” downgrade of the casual dining sector, as well as the notion of selling the retailers, and the buying of the energy space. We also embrace the reaccumulation of the “stuff stocks” (oil, natural gas, coal, timber, base/precious-metals, cement, agricultural stocks, etc.), preferably names with a yield, between now and calendar year-end. Moreover, we like the utility themes as reprised in an October 16 New York Times article titled “A Power-Grid Report Suggests Some Dark Days Ahead”.

In conclusion, for the past few months my firm has suggested that the equity markets were likely to rally potently into the November elections. While we do not trust it, nor understand it, in this business what you see is what you get! Yet, with 85% of the shares on the S&P 500 above their respective 50-day moving averages, we think the equity markets are WELL overbought. Still, the “ball” feels like it will go on into the ascribed timeframe, reminiscent of Adam Smith’s quote from the [all-time investment classic] book The Money Game:

We are at a wonderful ball where the champagne sparkles in every glass, and soft laughter falls upon the summer air. We know at some moment the black horsemen will come shattering through the terrace doors, wreaking vengeance and scattering the survivors. Those who leave early are saved, but the ball is so splendid no one wants to leave while there is still time, so everyone keeps asking, what time is it? But none of the clocks have hands.
Link here.
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