Wealth International, Limited

Finance Digest for Week of October 30, 2006

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


The award for the most perplexing career move of 2005 goes to David J. Winters, formerly CEO and chief investment officer of Franklin Mutual Advisers. Winters resigned from that $35 billion fund behemoth in order to found his own mutual fund. That is mutual fund, not hedge fund. He calls his creation Wintergreen.

By its charter, Wintergreen could almost be a hedge fund. It can invest anywhere, in anything. It can buy stocks or sell them short. It can invest in bankruptcies, liquidations and distressed securities. It can do business at home or abroad. But Winters does not get 20% of the profits, as hedge fund operators do. The investors keep all of the upside, net of fees and expenses, which happen to come to a stiff 1.95% of assets yearly. It is worth it.

Winters, 44, is the antithesis of the popular conception of the hedge fund manager. Mainly, he is an outright owner of common stocks. He keeps a sizable cash cushion. He is acutely price conscious. Ask him the question most often put to hedge fund jockeys by jumpy institutional investors: “What is your edge?” And he replies, “We are long-term investors.” This is a phrase you might not have heard recently. If it means anything these days, it means holding on for 12 long months to qualify for the 15% capital gains tax rate. Winters means something else by it. A member of the value investment tribe, he means that good things happen to cheap stocks over the sweep of years. Five years is Winters’s idea of a decent holding period.

Most money managers nowadays are held on a short leash. Their performance is monitored by the week or the month. They are admonished to track an index or to hew to a “style”, and woe betide the stock picker who suffers a “drawdown” (i.e., loss), is found guilty of “style drift” (i.e., opportunism) or who is so headstrong as to buy more when the market goes against him. Winters is the best kind of opportunist. True to Graham and Dodd tenets, he believes that the future is a closed book and that nobody – at least not he – can forecast stock prices. From which it follows that the thing to do is to armor oneself with a margin of safety. The less you pay for an investment, the less you have to fear from the unfathomable future.

For Winters, as for all value seekers, cash is the default investment. It is what they own until something better comes along. And who knows? Something just might. Winters contends that the world is chockablock full of cheap stocks. Yet Wintergreen has a 25% cash cushion. “You get paid 5% to wait,” Winters says. “And there are lots of opportunities in the world. You never know what is going to happen. We are just always looking under rocks for gems and waiting for that big, fat slow pitch in our zone.”

In their determination to not overpay, value investors sometimes invest in stocks that deserve to be even cheaper than they are. Last spring Winters was buying newspaper stocks. Yes, he acknowledged, the Web was a threat to hard-copy publishers, but the bad news was likely already reflected in the stock prices. It has turned out that the world needs steel more than it does USA Today, as Winters acknowledged the other day. He said he had traded out of his newspaper stocks. He had only belatedly come to realize how fast the industry is sinking. Anybody can form a conviction. The good investors, like Winters, can also change their minds.

Link here.

Newspapers have been on the decline in the developed world. The O’Reilly family’s solution? Go where readership is robust and the Internet small - link.


Two decades ago Morten Arntzen was a junior banker at Manufacturers Hanover in charge of repossessing vessels. One Greek shipowner “literally handed us the keys to six ships,” Arntzen recalls, including a bulk carrier that had washed up in Montreal with 6-foot holes rusted through its decks, a victim of deferred maintenance. Now at the helm of Overseas Shipholding Group (NYSE: OSG), the second-largest publicly traded shipping company – after Teekay Shipping (NYSE: TK) – with a 90-ship fleet, Arntzen learned a valuable lesson from being a lender. Strengthen your balance sheet in the good times because, as surely as the tides go out, shipping rates will fall. “When times are bad, that’s the very worst time to cut and run,” says Arntzen.

Those times may be just up ahead for the tankers that haul crude oil from Saudi Arabia and West Africa to insatiable buyers in China, India and elsewhere. From as low as $9,000 a day in early 2002, the charter rate for a 2-million-barrel tanker soared to $220,000 in late 2004, including crew and fuel. Ship prices jumped, too, from $70 million in 2003 to $120 million today. But charter prices have fallen recently to $70,000 or so a day, says Jefferies & Co. analyst Douglas Mavrinac. They could keep dropping – perhaps to $35,000 next year. The case for the pessimistic forecast? The world’s fleet of 480 crude carriers holds 960 million barrels. Shipyards are currently at work adding 306 million barrels of capacity. Allow for scrapping of old ships and you are looking at a 6.7% increase in the fleet. But demand for ocean transport of crude (measured in ton-miles) is expected to rise only 4%.

Arntzen, prepared for the worst, hopes for the best. Owners, he argues, will be forced to scrap older, single-hull ships at an accelerating rate because of tougher environmental regulations. Investors do not seem to be taking the optimistic view, though. At around $61 OSG shares trade at 5.2 times last year’s earnings. (From a low of $15 in late 2002 the shares climbed as high as $70 before backing off.) And what if rates do crash? With debt just 27% of equity and with $177 million in cash, Arntzen is running the company more conservatively than his competitors. OSG also has an untapped $1.8 billion line of credit to use if it spies another opportunity like 40-ship Stelmar Shipping Ltd., which it acquired for $1.4 billion in 2004.

Instead of increasing his fleet of big tankers, Arntzen is taking advantage of high prices to sell older ones and buy newer ones that cost $5,000 a day less to operate. (The buyers are mostly Greeks who have a knack for running older ships at a profit as long as charter rates hang high.) He is also diversifying. From 93% of revenue in 1998, international crude transport revenues have fallen to 67%, as Arntzen assembles a fleet of smaller ships to haul gasoline and other refined products shorter distances. So maybe the tanker-owning business will get really rough next year or the year after. That will sink profits but offer opportunities for a strong player looking to acquire assets cheaply.

Link here.


I have been bullish for a long time. I have been on the right side of the global market as it has risen year after year since 2003, beating bonds or cash. For all the reasons I have rattled off over the last two years I still think there is a big bull move ahead. But suppose I am wrong.

Bears think the consumer is tapped out, the economy about to crumble, corporate earnings at an unsustainable share of national output, the commodity boom snapped, the housing bubble burst and the Federal Reserve trapped between rising inflation and a wobbly world economy. You might have that nightmare in which the Democrats sweep Congress and you wake up one morning to find Charles Rangel sitting at your kitchen table filling out your 1040. The New York liberal might be the next House Ways & Means Committee chairman. Suppose, that is, that my last column, predicting that the GOP would hold both houses, is just wrong. (For which I can thank Mark Foley.) How bad will a Democratic win be for investors?

Not bad enough, I submit, to sell stocks now. Market timing is a dangerous game, best limited to the rare occasions when you have good reason to expect a significant bear market – meaning a decline of 20% or more. This column has gone truly defensive only on a few occasions, in 1987, 1990 and 2001. But I just cannot justify the cost of in-and-outing to sidestep small corrections.

Could we have a big bear market now? I do not think so. Bear markets come from a combination of positive sentiment with bad surprises virtually no one anticipates (like the 1973 oil crisis). Today too many gloomsters and not that many big-time boomsters (like me) are around for this combination to occur.

I also know I always may be wrong. CXOAdvisory.com, a site that ranks 33 public prognosticators, puts me at the top with a 69% accuracy since 2000 on 58 market-timing calls. That means I have been wrong 31% of the time. So I always plan to own some stocks that will do well if what I expect to happen does not happen. Right now that means stocks that would do relatively well in a slightly bearish market, stocks that have some defensiveness to them. These five should fit the bill.

Link here.

2000 redux? Or worse?

The markets more or less shrugged off the Bush-Gore election drama of 2000. I am not so sure about the drama that may be to come. John Fund of the Wall Street Journal offers up one potential reason control of the House will not be decided the night of November 7. I am sure there are others, but this is the first time I have seen someone in mainstream media spin a scenario for a long drawn-out post-election mess.

While the outcome will not have a lot of consequence in terms of the continued growth of the federal Leviathan, many people out there nonetheless think the outcome matters a whole lot. And my sense is that if there is no definitive resolution on election night, matters will not be resolved quite as peaceably as they were in 2000. The lingering anger from those days has had six years and a couple of wars in which to fester, and it could easily erupt on the ground of a closely-contested House district.

Link here.


Regional mall trusts are like the last horse in a field of Thoroughbreds. For real estate investment trusts overall, total returns (stock appreciation plus dividends) are spectacular, an average 29% this year, versus 11% for the S&P 500. Mall REITs are trailing the rest, albeit with a hardly disgraceful 18% thus far in 2006. Time to take a look at the relative laggards.

If you believe the economy will not tank soon and pull down mall stocks with it because consumers curb their shopping, these less-favored REITs are very affordable. Many mall trusts are changing hands these days at significant discounts to their net asset values, or NAVs, says Green Street Advisors, an independent research firm specializing in REITs. The NAV is what a REIT would fetch if all its properties were sold and the debt retired. Mall REITs are trading at an average 5% discount, while REITs in total are at a 7% premium. The mall group’s NAVs over the past five years have advanced at a double-digit clip, thanks to the hordes of shoppers who have thronged the retail emporiums, credit cards flashing. Mall trusts get both rents from the stores that lease space and a cut of the merchants’ sales. Every other type of REIT makes do with just the rent.

The market is understandably wary of mall REITs lately. There are indeed some hints that ever fickle consumers may be curbing their free-spending ways at America’s shopping meccas. Rising gas prices have taken a toll on consumer outlays. The Consumer Confidence Index has wobbled down since spring. “The big question mark is the economy potentially slowing further,” says Ross Nussbaum, a Bank of America REIT analyst. “You might expect retailers to elect to slow down expansion plans.” The bearish thinking is that, if an economic slump occurs, malls will suffer first. Vacancies will rise, their cut of the stores’ take will shrivel. No such signs of a slowdown are apparent in other REIT sectors. Mall REITs’ stats have suffered from the blowup of one prominent member, Mills Corp. Take out Mills and the sector’s earnings are not bad at all. Moreover, retail in general is so far showing some resilience to bad economic news.

One of the best buys among mall REIT stocks is Taubman Centers (NYSE: TCO-G). With only 23 malls, Taubman is among the smallest REITs but it has the highest-quality properties. As a result, it can charge the highest rents. Taubman malls tend to reside in tony enclaves like Beverly Hills, and feature chi-chi anchor stores like Neiman Marcus and Saks Fifth Avenue. The concentration of high-end stores insulates the company from any economic downswings since their affluent shoppers are less prone to scrimping. Even if sales slow, Taubman executives say they will be fine.

Link here.
Social mood changes the economy, not the other way around – link.


The Federal Reserve’s pause in its rate hiking campaign has dovetailed with the decline in energy prices and interest rates sending the Dow Jones to record territory. It is now universally accepted by the market that the slowdown in housing and the economy will result in a soft landing, one that keeps the Fed on hold and GDP at trend growth or slightly below. These market cheerleaders have embraced this perfect scenario and their recidivism to their behavior prior to the equity collapse of 2000 may be to the downfall of investors. What is being overlooked by most pundits is that the unraveling of the housing bubble will be much longer lasting and more damaging to the consumer than anticipated.

During 2007, approximately $1 trillion of the $9 trillion in outstanding mortgages will reset. The increase in these adjustable rates will send consumers’ monthly payments hundreds of dollars higher and cause many more foreclosure homes to enter into this already saturated market. According to the Indymac bank of California, up to 4% of home owners might lose their home in the next few months – four times the average rate of borrowers who normally default on their loan!

Remember the axiom that as goes the housing market, so goes the economy. One has to look beyond home equity extraction which has reached a total of $600 billion per year. When you account for the durable goods, commodities and labor that are supported by the housing market you begin to realize the expanse of the spectrum related to this part of the economy. What is difficult to factor into the equation is consumer’s response to flat or declining home values. It is reasonable to assume that their current negative savings rate (it was negative for only two other years 1932-1933) will again turn positive as consumption declines.

A key point that must be stressed again is that home builders are still expanding supply well beyond the intrinsic demand. Home construction is running at 1.7 million units while actual demand is about 1.15 million units. This could add another 0.55 million units to an already near record 4 million unsold homes. In order for the market to achieve balance, home construction must drop below population growth and price to income ratios must fall. Neither of those situations is occurring. Sellers have been trying to avoid lowering their asking prices. This has kept year-over-year declines muted and hence caused prognosticators to claim the bottom as been reached and the worst is over for real estate.

Through real estate, many banks are exceeding federal guidelines regarding concentrated loan exposure. Ten states have over 50% of total banks in violation of guidelines for real estate loans, meaning the dangers of a banking debacle similar to the S&L crisis are elevated. But the stock market is too busy rejoicing over better than expected pro-forma earnings reports to worry about financial disruptions like bank failures or home builder bankruptcies.

What appears evident is that the economy is slowly weakening due to housing and the decrease in money supply and credit (inflation). And the equity markets are not pricing in the shortfall in earnings which should accompany the slowing economy. Keep an eye out for an unusually weak durable goods number or G.D.P. number this week. Any crack in the soft landing mantra would prove damaging for stocks, especially after this huge rally. This leads me to present the best play in the market today: Invest in the stocks of balloon companies – you know, the ones you tie “For Sale” signs onto.

Link here.

Home lenders bite nails.

When the housing market was in high froth, lenders did a lively business issuing mortgages in amounts perilously close to the full value of the home being bought or refinanced. Where are those loans now, with home prices teetering? Christopher Cagan of First American Real Estate Solutions calculated what that 29% of homeowners who closed mortgages in the first nine months of 2005 were sitting, as of February, on zero or negative equity. He also calculated that a further decline of 5% in home prices would jack that fraction up to 38%. This number spent most of 1985 through 2004 in the 5-10% range (see chart).

Aggravating the situation is the fact that paying off principal is now viewed as old-fashioned. A large number of borrowers are paying only interest. All this means trouble for speculative lenders like New Century Financial (NYSE: NEW). The Irvine, California company is tightening lending standards, but analyst Christopher Brendler at Stifel Nicolaus has a sell on the stock, noting its $2.4 billion in revenue flows almost entirely from subprime lending.

Link here.
As buyers balk, builders carry on – link.


In a world in which information is an increasingly important commodity and intellect is the principal means of producing such information, David Ricardo’s 1817 Doctrine of Comparative Advantage may no longer be valid. However the theory that free trade enriches all participants, central to modern globalization, depends crucially on Ricardo, with protectionists being denounced (sometimes correctly) by professional economists as economic illiterates. What then is an economically literate framework for trade in a post-Ricardo world?

The modern economy is much more subject to intellectual piracy and outsourcee reverse-engineering. If you outsource software to India, Indian software engineers acquire technical capabilities that enable them to manufacture software of the same or better functionality. If you outsource chip design to China, Chinese chip designers acquire design skills that they can sell to your Chinese competitors. In principle, services such as tourism, construction and personal services that can only be provided on-site are relatively invulnerable, but the advent of cheap travel and overwhelmed immigration bureaucracies have rendered even these services vulnerable to price competition driven by cheap labor.

Given that most intellectual property is portable and non-excludible, if the world economy is to consist largely of intellectual property, with physical goods being manufactured by robots and their design being far more important in their cost than human direct labor, then the world trading system is in deep trouble. Companies in rich countries that outsource intellectual property production to cheaper labor environments will soon find their trade secrets no longer secret and their outsourcees competing with them with an unbeatable wage cost advantage. U.S. and European top management that enters into outsourcing without proper thought, in the hope of boosting short term earnings, will find itself out of a job.

In the pessimistic view of an information-ruled world, since both the world’s population and its growth are concentrated among the poor, is that as knowledge disseminates worldwide Western living standards will be averaged sharply downwards, particularly among the less intellectually gifted. Even if everybody in the West were to get degrees, the academic learning ability of the bottom half of the population is such that those degrees would add little value to a high school education. The optimistic view is that if the benefits of higher education are spread to a greater proportion of the world, without a “dumbing down” in quality such as would accompany increasing university education in the West, then the creative fires of more people will be available for improving the world’s economic performance, and growth rates overall will increase. The problem with this is that there appear to be diminishing returns. Shakespeare and Newton appeared within a century, in a society of less than 5 million population. Logically therefore the world should now see over 1,000 equals of Shakespeare and Newton, which it clearly does not.

The belief by the U.S. and European electorates that they are not enjoying growth in living standards is correct. Rising GDPs are going to capital, government and speculators, leaving little or no increase in affluence for the rest of us. Globalization is immensely beneficial for competently governed poor countries. It benefits the rich West only to the extent that it proceeds at a moderate pace and with appropriate safeguards for Western living standards.

Link here.


Surely, there must be more to a $46 trillion global economy than the American consumer and the Chinese producer. Not only is that the current verdict of financial markets, but it is consistent with the sentiment I have been picking up from a broad cross-section of our clients – business executives, investors, and senior government officials – as I travel the world this fall. While they concede the possibility that these two engines of global growth may, indeed, slow in 2007, there is a general belief that other economies are now perfectly capable of filling the void. Hope springs eternal that such a global decoupling would allow an increasingly vibrant global economy to keep growing while barely skipping a beat. My advice? Do not count on it.

Given the dominant role that the U.S. consumer has played in driving the demand side of the world economy and the equally important role played by the Chinese producer in shaping the supply side, decoupling will not be easy. By our calculations, China and the U.S. collectively have accounted for an average of 43% of PPP-based global GDP growth over the 2001-06 period – well in excess of their combined 35% share of world output. Globalization makes decoupling from such a concentrated growth dynamic especially difficult, as ever-powerful cross-border linkages have become increasingly important in tethering the rest of the world to these dominant engines of growth. Decoupling requires economies to cut the cord and develop new sources of growth. In my view, for an economy to be classified as a “decoupler” it must satisfy three conditions: (1) It must have self-sustaining domestic demand – especially private consumption. (2) It needs to have a diversified export mix – both in terms of products and destinations. (3) It must have policy autonomy – the ability to establish independent settings for monetary, fiscal, and even currency policies.

The global decoupling thesis can be drawn into serious question on all three counts. That is especially the case with respect to the lack of support from domestic demand outside the U.S. The non-U.S. world continues to be heavily dependent on exports as a major source of growth – with the bulk of that dynamic overly reliant on end-market demand in the U.S. Lacking in internal demand to fill the void left by a U.S.-led shortfall in external demand, and with only limited policy options available to counteract such a development, America’s slowdown could quickly become a global slowdown. Meanwhile, Beijing’s increasingly determined efforts to cool off a runaway Chinese investment boom could transmit an equally powerful downshift through its pan-Asian supply chain and the world’s commodity complex.

Contrary to widespread belief, a U.S.- and China-centric global economy has not changed its stripes overnight. A failure to rebalance has left an unbalanced world highly vulnerable to a slowdown made in both America and China. To me, that means the risks to global growth remain skewed to the downside of consensus expectations, which are currently centered on the IMF’s latest forecast of 4.9% world GDP growth in 2007. Global decoupling could certainly prove me wrong, but I think such a possibility is wishful thinking.

Link here.
Japan must beat Roach’s forces of globalization – link.


Dow 12,000 is so last week. Who cares about 30 stodgy companies, none with the foresight to acquire YouTube? Buy and hold? More like buy and mold. At last check, 20 of the 30 Dow stocks were below where they were trading back when the index peaked in January 2000. No wonder investors continue to pile into hedge funds where they can get some real action. Oh sure, a hedge fund may buy a Dow stock or two, but only the quaintest would do so without tying the purchase to some spiffy relative value arbitrage strategy.

Perhaps because hedge fund investing, and talking about hedge fund investing at cocktail parties, is such an adrenaline rush, investors threw a world record $44 billion at hedge fund managers in third quarter, according to the number crunchers at Hedge Fund Research. That slug of dough brought total hedge fund assets to $1.3 trillion – a quarter the size of the entire equity mutual fund universe. And get his: hedge funds got all that money without a single actor from Law & Order hawking their product.

Venture capital funds are another investment genre with so much money to spend they can barely get the doors shut at night without $100 bills leaking into the hallway. Investors are just as anxious to put their money with VC funds as the VC capitalists are to spend it. And the sexier the industry the better. The category that has attracted the most funding year to date is biotechnology (motto: “As much fun as online gambling, but legal!”).

Of course, not everyone has the money or the inclination to put their money with a hedge or venture capital fund. Yet many still want the thrill of not knowing how their money is being invested. Luckily, there are an increasing number of “blank check IPOs” coming to market to meet that need. A blank check company is one with no operations. Blank check deals are also called special purpose acquisition companies or SPACs. The idea is that once the SPAC raises the money, it will run out and buy a company with real operations. In theory, the acquired company will gin up enough profits to justify the offering price of the stock. According to Bloomberg, blank check IPOs raised $2.2 billion through early September, with more than $4 billion in new issues in the planning stages.

Fans of the SPAC (like investment bankers) figure the deals offer a win-win situation. First, investors have an exotic sounding investment strategy. (“I am in SPAC’s. How is your money market fund doing?”) And second, investment banks gets fees on the IPO as well as fees on the deals they help arrange with the IPO proceeds. The other hook for investors is that many SPACs have high-profile VIPs, either in management or on the board. Steve Wozniak and friends raised $172 million in a blank check deal last March. Investors can hardly wait to see what high tech gizmos their company will produce.

Lucky for investors, SPAC officers cannot just sit on the IPO money, scheduling three-martini lunches with potential acquirees. The rules require SPACs to buy something within 18 months of going public. The bad news for investors is that SPACs are not the only ones desperate to do a deal. Corporations and private equity funds are pushing merger and acquisition activity to record levels. With all that money chasing the Next Big Deal, and with blank check IPOs having just months to get their deals done, SPAC investors hoping to cash in on the next big Internet thing may discover that they paid top dollar for a chain of tattoo parlors.

Now that really would be special.

Link here.


Credit-default swaps, or CDSs, are derivatives that provide insurance against a company going bankrupt. Investors pay an annual spread, or premium, in return for the promise of a payment in the event of bankruptcy or a similar credit event. As the creditworthiness of companies change, the cost of this insurance fluctuates. CDS are a common investment and trading tool of credit hedge funds, which have used the derivatives effectively over the past five years, Hennessee, which tracks manager performance, said.

However, equity hedge funds have begun trading CDSs more during the past year too, making Hennessee concerned that managers who are inexperienced in derivatives markets may be using them in inappropriate ways, the firm explained. Equity funds have been using CDS in several ways. Instead of being used as a speculative investment, CDS have often been purchased to hedge portfolios of other securities that funds currently own, Hennessee said. Some managers purchase CDS on corporate bonds designed to profit from a widening in corporate credit spreads. Others buy CDS on sub-prime, mortgage-backed, fixed-income securities and indexes as a way to profit from deterioration in credit quality among mortgage borrowers. Some managers also buy CDS on emerging-market government debt to bet on a decline in a country’s credit quality, Hennessee noted.

“While there doesn’t appear to be any imminent risks to the credit markets caused by hedge funds, we are concerned about the use of these instruments by funds that are not well-versed in how these markets trade and the dynamics of counter-party risk,” said Charles Gradante, managing principal of Hennessee.

Link here.


Markets around the world are awash in excess cash, fueling a frenzy of investment from London to Tokyo that may lead central banks to push interest rates higher than investors now anticipate. Money remains cheaper than in the 1990s even after every major central bank raised rates this year, the first simultaneous tightening since 2000. The cash glut is reheating the U.K. housing market, while in Japan companies plan the most investment since 1990. China’s biggest bank this month attracted orders for more than half a trillion dollars with its initial public offering of shares.

Without further tightening, central bankers may have new asset bubbles and inflation risks on their hands. The European Central Bank, whose officials voice the most concern, is convening a conference in Frankfurt next week on the role of money growth in guiding interest rate policy. Among the participants will be Federal Reserve Chairman Ben S. Bernanke, People’s Bank of China Governor Zhou Xiaochuan and Bank of Japan Deputy Governor Kazumasa Iwata.

The ECB, unlike other major central banks, explicitly uses money supply to gauge inflation. Growth of M3, the bank’s preferred measure for the 12 nations sharing the euro, unexpectedly accelerated to 8.5% in September, close to a 3-year high. That added to pressure on the bank to add to its five rate increases since early December. Charles Dumas of Lombard Street Research Ltd. in London calculates that money supply in the world’s top economies is growing at an annual rate of 7.5%. Though down from a 4-year high of 9% a year ago, “that’s still pretty lavish,” he says. Tim Drayson, global economist at ABN Amro Holding NV in London, says major central banks will all have to tighten credit more than investors now assume. His predictions are at odds with futures trading, which suggest most central banks will not raise rates much further, if at all, next year.

Other central banks including the Bank of England and the Bank of Japan are starting to share the ECB’s view on money growth. That is a shift from a few years ago, when following money supply was deemed a relic of the 1970s. But the Fed no longer sets a target for monetary growth and stopped publishing one measure of money supply in March.

For central bankers, the threat is that overinvestment pumps up asset bubbles that lead to economic busts, just as the explosion of investment in U.S. technology companies did at the turn of the decade. Available money is encouraging “barely profitable and highly risky” investments, French Finance Minister Thierry Breton said last month. The Bank of England is now grappling with the fastest expansion of money in 16 years. The Bank of Japan is also keeping a closer eye on liquidity. Cheap cash means China may also be overheating. Industrial & Commercial Bank of China this month completed the world’s biggest IPO, raising $19.1 billion and attracting more than $500 billion in orders, equivalent to twice Citigroup’s market value. “This was massively oversubscribed,” says John Fildes, managing director of Instinet Pacific Services Ltd. in Hong Kong. “There is a huge pent-up wall of money.”

Link here.


“Central banks are now realizing they must take global levels of liquidity seriously,” the ECB’s former chief economist, Otmar Issing, said. “I am concerned about excessive liquidity in the world,” Issing told a conference for economic students. This concern is shared by the current members of the ECB’s Governing Council, who have taken the lead in alerting other central banks to the risks at hand, Issing noted. “There is now increasing support of the view that excessive liquidity world-wide is fueling asset prices and is something which has to be taken seriously by central banks. ... This is a real concern.”

Third quarter nominal GDP decelerated to a 3.4% pace, down from Q2’s 5.9%, which was down sharply from Q1’s 9.0%. We will have to wait for Q3 “flow of funds” data to have a clearer picture with respect to the relative activity of the Credit apparatus. During Q2, financial credit accelerated to a 10.2% growth rate, up from Q1’s 8.6%. And with bank commercial & industrial (C&I) lending expanding at a 15% rate during the third quarter, I would not be surprised if we learn that total business borrowings expanded at a 10% rate.

At this point lacking all the pertinent data, I will nonetheless postulate that the immense gap between ongoing U.S. system credit expansion and the actual financing requirements of the real economy extended further during the quarter. This would help explain the loosening of financial conditions we have witnessed over the past few months, as well as the “excessive liquidity in the world” that worries Dr. Issing and the ECB. U.S. and international equities markets have been posting big gains, global bond prices have rallied nicely, already narrow corporate credit spreads have become only narrower, and emerging markets have inflated spectacularly. And with recent GDP deceleration largely explained by the abrupt slowing in residential construction combined with a jump in imports, there is ample support for the view the economy is not being buffeted by any tightening of financial conditions.

I believe very strongly that current global securities market and asset inflations are associated with some underlying disarray in the credit mechanism – with destabilizing finance – with monetary disorder. What is it? Where is it? And why is it? I remember how the GSEs’ almost 30% expansion during 1998 (to total assets of $1.4 trillion) became a prevailing source for a marketplace liquidity bubble that culminated in the technology/telecom mania in 1999/early-2000. They provided an invaluable backstop to the leveraged speculators, arresting potentially destabilizing deleveraging, while fostering general liquidity over-abundance. Major bubbles are dictated by powerful evolving processes, and clearly market perceptions of both abundant liquidity and the backstop for speculative activities cultivated a self-fulfilling boom in credit and speculative excess.

Returning to today’s monetary disorder, the environment beckons for a steadfast focus on the bowels of the credit system, especially with regard to unusual monetary processes with the proclivity for nurturing credit and speculative excess. As such, where are the key sources, intermediation, and uses of system credit/liquidity/purchasing power? What dynamics, on the margin, are influencing the biases and endeavors of the expansive pool of speculative finance? Well, I do not believe the ramifications of our massive current account deficits receive the attention they deserve.

Unprecedented in size and duration, U.S. current account deficits create one of history’s most commanding – and, I would contend, destabilizing – flows of finance. Think in terms of a highly integrated credit system comprised of bank, Wall Street, finance company, securitization, and securities (leveraging) finance. This credit apparatus freely creates financial claims/purchasing power, and a large portion of these dollar balances flow to the accounts of manufacturers, energy producers, and other exporters from around the world. This massive flow of finance, much of it then acquired by and intermediated through foreign central banks, is directed back to a limited supply of perceived top-quality and liquid U.S. securities. No serious analyst would dismiss the view that a dynamic involving such massive financial flows on a protracted basis would impart severe marketplace distortions.

Not dissimilar to the impact of GSE operations back in 1998, the massive expansion of foreign central bank dollar holdings has gone a long way in underpinning market confidence. The overwhelming consensus view has evolved to the point of believing the bond market is safe from yield spikes and the currency markets are protected from abrupt dollar declines and crises. Clearly, Treasury market participants have for some time operated with the perception that liquidity would remain abundant and prices supported. And, more generally, bond and dollar speculators must today take comfort that irrepressible foreign buying will continue to provide an invaluable market “backstop”. Derivative players have no fear of illiquidity or market dislocation.

Beyond underpinning market confidence and liquidity generally, how has this massive ongoing foreign dollar balances “recycling” operation distorted the nature of underlying speculative flows? This is where the analysis gets more interesting. I have convinced myself that foreign buying has distorted pricing in “top-tier” U.S. securities to the point of significantly reducing prospective returns – for speculators and investors alike. And the inverted yield curve – that was seemingly destined to be a temporary anomaly in an age of (borrow short/lend long) speculative securities leveraging – now has more the appearance of an enduring effect of current unrelenting credit excess. The confluence of a massive cumulating pool of global speculative finance and eviscerated speculative profits in “top-tier” (notably Treasury and agency) securities has surely fomented some serious recalibration of speculative trading strategies. The speculator community has been pressed into “lower-tier” credit instruments to achieve acceptable returns. This helps to explain the insatiable demand for securities in some notable sectors, including emerging market debt and “private-label” mortgages.

It is my view, however, that the greatest unfolding credit system distortion is a resurgent corporate debt bubble. Importantly, the current account “recycling” distortion-induced flight into “lower-tier” credits coincides with a significant decline in mortgage originations. The banking system is now aggressively pushing commercial lending in an ill-advised endeavor to sustain (mortgage bubble-induced) inflated lending profit growth. The wall of finance flowing into the corporate debt market has had a profound effect on the availability of credit. Spreads have narrowed and even the most vulnerable corporate borrowers have enjoyed the capacity to recapitalize. Meanwhile, those hedge funds and proprietary trading groups investing in “credit” are today sitting near the coveted top of the global performance leader board. Writing corporate credit protection these days is akin to writing flood insurance during a long drought – the only limit to profits is the amount of insurance that can be written. It is become a full-fledged mania in desperate search of more tulip bulbs.

And this is where it gets dangerous. Over-heated demand for underlying corporate loans has instigated a self-reinforcing lending boom, especially for M&A, LBOs, and stock buybacks (lending to finance real investment is simply not large enough to satisfy the enormous demand for loans). Especially after suffering through this year’s stock market volatility and painful corrections in the energy and global “reflation trade”, the relative stability of returns available from the various methods of writing (flood) credit insurance has of late looked awfully appealing. And to what extent the bubble in corporate credits has been fostering speculative flows into U.S. corporate securities – and in the process supporting the dollar today but creating dangerous systemic vulnerability in the process – is something to ponder.

It is not only the resurgent corporate debt bubble that has me recalling 1999/2000. It was not just happenstance that NASDAQ went parabolic about the time deterioration in underlying fundamentals was gathering pace. Today, an extraordinary confluence of factors is fueling a corporate debt bubble with a present scope and future consequences that greatly exceed anything from 1999. The tech bubble was only a warm-up ...

I have focused on U.S. credit system dynamics, but our massive current account deficits have as well spurred lending, liquidity and speculative excess around the world. Our degraded currency has certainly unleashed systemic global credit inflation, with profligate domestic credit systems no longer disciplined by the (dollar-anchored) global marketplace. It is more aptly described as “Global Wildcat Finance,” with credit and asset inflation readily condoned by a speculating community that has come to wield incredible power and influence.

There have been scores of current account apologists, from Wall Street to leading academics to the very top of the Federal Reserve System. Is the Fed really going to simply look the other way as yet another destabilizing speculative boom engulfs U.S. and global financial markets? The last thing this unsettled world needs at this moment is a slew of runaway credit, speculative and economic bubbles.

Link here (scroll down to last subheading on page’s left column).
Bob Prechter talks to Financial Sense Onlinelink.


Sometimes boring is good. There are plenty of amazing companies out there that make completely boring products – and make a lot of money doing it. But sometimes, these essential companies can get you into trouble if you buy in at the wrong time. Today, I am writing to you about cement and gravel – in my opinion, one of the easiest businesses to understand. And while there are few mysteries in this business, there are bigger economic factors in play. I came across this one concrete company when I was scanning the market for undervalued small-caps in beaten down sectors.

On paper, U.S. Concrete (RMIX: NASDAQ) is a great business. It is making money, it buys out almost every other ready-mix concrete firm in its areas of operation and it has benefited recently from higher concrete prices. The company operates ready-mix concrete facilities in California, New Jersey, Michigan and Texas. As of March, the company had 100 fixed and seven portable-ready mixed concrete plants, eight precast plants, three concrete block plants and two quarries. In 2005, it spent more than $41 million buying out competitors. And in 2006, the company laid down a cool $165 million for Alberta Investments and Alliance Haulers, which brought in combined revenues of $181 million last year. This is an acquisition that could up U.S. Concrete’s revenue by 27% if it continues to perform.

Its valuation is very attractive as well. It is trading for a little less than book value. A value investor might jump at the opportunity to own shares. So, all this makes U.S. Concrete a great buy, right? Wrong ... Residential construction – where U.S. Concrete gets more than 40% of its revenue – is slumping dramatically across the country. And U.S. Concrete has indicated that commercial construction will not be able to pick up the slack. So as housing continues to unravel, U.S. Concrete could get hit hard.

Now, I like out-of-favor companies just as much as the next smart investor, but the bigger economic picture is just too much to ignore in this situation. Even though this stock is beaten down, its bottom could be much, much lower. And after all, we want to catch these out-of-favor companies when they are about to rise, not before they could get slammed again.

Link here.


The Economy

It has been an interesting month since the September report. Amid conflicting data, the Fed is now expected to pause at least through December, and perhaps longer. This past month, we saw many Fed governors beating the drum about inflation even as Fed Gov. Janet Yellen was talking about the Fed being behind the cutting curve because of a “ghost town” in housing. The Dow has been making new highs as divergences pile up. Credit is still expanding, as evidenced by leveraged buyouts, mergers, IPOs, and declines in junk bond yields. Job growth has been very weak. Housing continues to sink. Foreclosures rose over 100% in California.

The Fed clearly has a problem, and that problem is getting harder to handle. This is a damned if they do, damned if they don’t scenario. We believe the single reason the Fed is reluctant to cut is that credit excesses, as evidenced by continued growth in derivatives, increased market speculation, leveraged buyouts, and other such activities, are still running rampant. Make no mistake about it, the Fed is in a very tight box, and that box is about to get smaller. For now, the Fed seems to have decided to stay in its box and wait. Rest assured something is eventually going to shock the Fed into action. In the meantime, we have doubts that the credit market is prepared for anything but an immediate cut, a cut that is for now indefinitely on hold.

Jobs, housing starts, housing inventories, the inverted yield curve, falling crude and natural gas prices, and now a falling PPI are all adding up to a dramatically slowing economy. We are sticking with our recession call starting late this year or sometime in 2007. Conditions continue to deteriorate. Inflation this cycle has peaked. Looking ahead, we see deflation. That belief is founded on the credit collapse we see coming. Along with that collapse, asset prices, and especially housing, will take a huge hit. There has never been a credit bubble that did not implode. This time will not be different.

Japan, like the U.S., is in pause mode waiting for more data. The yen carry trade (borrowing yen and buying U.S. assets) that started to unwind in May on expectations of significant rate hikes in Japan is now back in full force. The current Commitments of Traders Report shows that big specs (hedge funds, mutual funds, etc.) are short 113,000 yen contracts, betting on a rise in U.S. dollar-based assets versus the yen. Each contract represents 12.5 million Japanese yen. I cannot help wonder when that trade blows up. Never before have so many risks been so stacked up as we see today. Which one of those fuses ignites first is anyone’s guess.

Last month, we reported the ZEW Indicator of Economic Sentiment for Germany dropped by 16.6 points, to minus 22.2 points. Sentiment fell once again this month. A 3% across-the-board increase in the VAT will surely crimp spending. Some big-ticket sales were no doubt moved forward in tax avoidance measures, so we look for a considerable slowdown in Germany in the first half of 2007 that is likely to spill over into other European countries. One more rate hike is priced in for the ECB, and one additional hike is priced in for next year, but we remain skeptical of the latter.

Employment numbers, housing numbers, retail spending numbers, and economic data in general from the U.K. vary more widely and in opposite directions than in anyplace else we look. After a long series of hikes, the BOE paused, cut once, paused, and then tightened once with more hikes now priced in even as what appear to be weak data are coming in. For whatever reason, those in the U.K. seem to have learned nothing from the housing bubble bursting in the U.S. and Australia. Bubble madness is fascinating.


With what we are seeing in the economy and the yield curve, and given the state of the housing market, you would think stocks would be in the process of discounting the oncoming economic weakness. Instead, the Dow industrials are at an all-time high near 12,000. Does it sound like something is amiss? Maybe – but maybe not. If we look back at many (if not all) of the major tops and bottoms made by the stock market over the past 100 years, we can finds the signs that gave it all away at the time. There are many, many divergences you could list, but by looking at the industrials, the transports, and the Treasury yield curve, you could have seen all recent severe market declines since 1990 well before they became reality. It sounds simple, right? Well, not quite. But it is easy to see these signs in real time, as we are now seeing the same signs as we have seen prior to past severe market declines. The difficulty is in trusting them and acting to protect yourself when everyone else is riding on the market bandwagon. That is the choice we face at the moment, and it is when our credentials as contrarians prove most valuable. Until we see real improvement by the market that removes the classic signs of impending market weakness, we will remain in our current short stance. History strongly suggests our patience will ultimately pay off.

The current situation for Treasuries could not be much simpler. Yields hit the high end of their channels this summer and have bounced lower. The bull market in Treasury bonds remains intact. The decline over the past four months has been swift, and a short-term correction of that decline is certainly under way. But as long as the yields remain in their long-term downtrend channels, we can expect a generally bullish environment for Treasury bonds over the next several years.

Since our first issue in March, we warned that an end to the commodities bull market – as defined by the CRB index – was near. After a continued rally through July, the CRB index dramatically broke down through its 5-year trendline in August. We have been showing the chart below for most of the year, and as you can see, the CRB has declined approximately 20% from its high in July.

Now it is time to assess where the pieces have fallen. The majority of the decline of the CRB can be attributed to oil and its related components. But the CRB index is not all oil related, and during this decline, some components have held up rather well. By recommending going long GDX, the ETF for mining stocks, over the past month, you may have guessed that we saw some opportunity in gold and silver. That is certainly the case, and now that the dust has settled somewhat, we are seeing a bigger distinction between the commodities that have been dragged down with oil and those that have not. What we are most interested in at the moment is how some of the base metals have held up. The oil charts are what you expect to see from a break of a 5-year trend – it has been a real washout. But the metals charts tell a different tale, one of consolidation. Copper, silver, and gold are now in tightly bound wedges. These formations can and do break either way. We got our short-term rally in the miner indexes, and it looks like we may see in the next month if this short-term rally is going to turn into a long-term rally. We will be looking for a break above $600 on gold and a break above $12.50 on silver. We will also be monitoring copper, aluminum, and other metals for confirmation of a broader metals rally.

Closely related to a possible rally in metals and mining stocks is the U.S. dollar. The trend of the dollar will not make or break a rally in metals, but it certainly would add a tail wind if the dollar declined or a head wind if it rallied significantly. A 10% rally in the dollar would certainly be a head wind for many commodities, gold and silver included. But despite plenty of time to get going, the dollar has only sputtered higher so far. The dollar index has been moving sideways between 84-87 for six months now. On long-term charts, there is a huge potential head-and-shoulders bottom, but the lack of progress on the upside so far would seem to discount the possible effect of that. Instead, we have two clear lines in the sand – resistance above at 87, and an upward sloping trendline now at 85.2. A break one way or the other should lead to a trend that lasts a year or more.

The direction of several other currencies will together have a big impact on whether the dollar rallies or not. The yen represents 13.6% of the U.S. dollar index, and its effect through the carry trade can be huge. If the yen future breaks down below 85, it will certainly provide some support to the dollar index, and if it instead bounces off support, it will be a drag on the dollar. The euro comprises 57.6% of the index. It is safe to say that knowing the trend of the euro is key to knowing where the dollar is headed. For almost three years, the euro has been moving sideways between 117-135. The euro has recently bounced off support at 125, which has been a significant support/resistance level during that entire stretch. The U.K. pound – which represents 11.9% of the dollar index – has also traded sideways versus the dollar over the past three years, and more recently has been consolidating above support at 185. As long as the euro remains above 125 and the pound remains above 185, there is almost no chance for a significant dollar rally, a decline in the dollar being more likely. These are the key levels to keep an eye on. With the Canadian dollar (composing 9.1% of the index), the story is very simple. After four years, and a 50% appreciation, the Canadian dollar has broken its trendline and ended its rally against the U.S. dollar. For those of you with assets in Canada or who hold Canadian investments, be on notice that the favorable trend of the Canadian dollar in all likelihood is over.

Link here.

Numbers Game

Q3 GDP increased at an annual rate of 1.6%, according to advance estimates from the Bureau of Economic Analysis. This was a slowdown from 2.6% in the second quarter. “Real” estimates are in chained (2000) dollars. Inquiring minds might be wondering whether or not we are headed for a Goldilocks landing or a recession, so let us dig a bit into the numbers.

Previously, I proposed changing the meaning of GDP from gross domestic product to “grossly distorted procedures”. If one discounts third-quarter motor vehicle output, and subtracts various hedonics and imputations, GDP was easily negative for Q3 (and perhaps substantially so). If one believes the published price deflators are off, GDP will look even worse.

In the meantime, I notice that almost no one is talking about the yield curve, the one set of numbers that someone can and should believe. The yield curve is what it is, and it is quite inverted, signaling a recession. Forget Goldilocks. The next recession will be an extremely hard affair, led by a falloff in consumer spending, rising unemployment, and a continued slowdown in housing.

Link here.


The most profitable stage of the gold rally – stage three – has not yet begun.

The first stage of the recent metals rally began in 2002. That is when the world lost faith in the U.S. dollar – the dominant currency of the world. Of course, it did not happen all of the sudden. Leading up to 2002, the stock market crashed, U.S. debt piled up to all time highs and the trade deficit swelled to epic proportions. Foreign central banks and a handful of shrewd investors questioned whether holding U.S. dollars was really a safe thing to do. A few brave souls decided it was not. So they sold their paper assets (dollars) and bought gold – a true store of value in uncertain times. For the first time since the 1970s, both demand and the price of gold increased significantly as the value of U.S. dollars fell in half. This marked the first phase of the metals rally.

Of course, not many people bought gold (or any precious metal) in 2001. The mainstream never catches an idea in its earliest stages. People are too afraid of being wrong and going against the herd. So they wait for confirmation from mainstream before they buy. That is exactly why noticeable buying did not occur in the gold markets until late 2004 and early 2005 – when the second stage of the gold rally began. By 2005, global demand for gold was large enough that spot prices actually rose no matter what the dollar did. This divergence from the U.S. dollar coupled with the first signs of retail interest in gold and silver as a legitimate investment opportunity marked the second phase of the metals boom.

Despite the interest that has been drummed up in the gold world to date, it is hardly indicative of a mainstream rally. The third stage (the “mainstream stage”) of this metals rally has yet to begin. But when it does, it will be quick, explosive and very lucrative. To understand what this mania phase will look like, we turn back to the 1970s. During the last metals boom, stocks rose fast and furiously in the final stages of the metals rally. Although many small-cap gold stocks have already risen hundreds of percent since 2001, we have not yet seen mania-buying like in the late 1970s. In fact, since May of this year, gold stocks have sold off to several year lows, despite better underlying fundamentals. Last year at this time, an ounce of gold traded in the $470 range. As I write this essay, the shiny metal is at $601 – 28% higher. Yet many gold companies are selling for less than they were 12 to 24 months ago.

While the price of gold has significantly increased in the last year, mining stocks have not followed suit. As investors, you have a choice to make. You can invest in gold stocks now – before the third stage of the rally begins (and while prices are trailing the overriding fundamentals). Or you can wait for confirmation from the herd. Those who buy now must have a stomach made of steel, patience and a thick skin. While it may be a rollercoaster in the short term, it will be these people that walk away with the largest profits in the end.

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


Bondholders worldwide are suffering a double whammy this year because more than 80 companies controlled by LBO firms have borrowed at the expense of workers and debt investors just so they can pay themselves dividends, according to data compiled by Bloomberg and Standard & Poor’s.

Firms such as Blackstone Group LP and Kohlberg Kravis Roberts completed $269 billion of LBOs this year by borrowing at least $166 billion in loans and bonds. Companies owned by the LBO groups sold an additional $30 billion of debt this year for dividends. The payments have helped the firms recoup 86% of their investments within two years. LBO firms, which typically borrow two-thirds of the money they pay for acquisitions, used to wait three to five years before profiting from selling shares in their companies. The debt of companies owned by buyout firms has risen to the equivalent to 5.4 times their cash flow, the most ever, S&P says.

Link here.


Judging by their body language, the U.S. authorities believe the roaring bull market this autumn is just a suckers’ rally before the inevitable storm hits. Hank Paulson, the market-wise Treasury Secretary who built a $700 mll fortune at Goldman Sachs, is reactivating the “plunge protection team” (PPT), a shadowy body with powers to support stock index, currency, and credit futures in a crash. Otherwise known as the working group on financial markets, it was created by Ronald Reagan to prevent a repeat of the Wall Street meltdown in October 1987.

Mr. Paulson says the group had been allowed to languish over the boom years. Henceforth, it will have a command center at the U.S. Treasury that will track global markets and serve as an operations base in the next crisis. The top brass will meet every six weeks, combining the heads of Treasury, Federal Reserve, SEC, and key exchanges. Mr. Paulson has asked the team to examine “systemic risk posed by hedge funds and derivatives, and the government’s ability to respond to a financial crisis.”

The PPT was once the stuff of dark legends, its existence long denied. But ex-White House strategist George Stephanopoulos admits openly that it was used to support the markets in the Russia/LTCM crisis under Bill Clinton, and almost certainly again after the 9-11 terrorist attacks. “They have an informal agreement among major banks to come in and start to buy stock if there appears to be a problem,” he said. The only question is whether it uses taxpayer money to bail out investors directly, or merely co-ordinates action by Wall Street banks as in 1929. The level of moral hazard is subtly different.

Mr. Paulson is not the only one preparing for trouble. Days earlier, the SEC said it aims to slash margin requirements for institutions and hedge funds on stocks, options, and futures to as low as 15%, down from a range of 25% to 50%. The ostensible reason is to lure back hedge funds from London, but it is odd policy to license extra leverage just as the Dow hits an all-time high and the VIX “fear” index nears an all-time low – signaling a worrying level of risk appetite. The normal practice across the world is to tighten margins to cool over-heated asset markets.

The move is so odd that conspiracy buffs are already accusing SEC chief Chris Cox of juicing the markets to help stop the implosion of the Bush presidency. One is at least tempted to ask if Mr. Paulson and Mr. Cox know something that we do not. Are other hedge funds are in the same sinking boat as Amaranth Advisers and Vega Asset Management, keel-hauled by bets on natural gas and bonds? Are currency traders with record short positions on the Japanese yen and the Swiss franc are about to learn the perils of the Carry Trade, a high-stakes game of chicken where you bet against fundamentals with high leverage to make a quick profit? Everybody knows it will blow up if the dollar goes into free fall.

Link here.

Curious change in margin requirements.

Through the SEC, the Fed controls margin requirements and a recent announcement was described by the deputy director of the SEC as “a very significant change”. Remember that this is essentially the same Fed and SEC that argued that no increases were needed during the late 1990s tech mania. Now they are talking about lowering margin requirements for institutions on stocks, options, and futures. Now ranging from 25% to 50%, the proposal is to drop them to 15%.

Of course, prevailing margin requirements were imposed by panicked policymakers in the 1930s contraction in order to prevent another 1929 blowout. This was understandable as, at the time, most knew that the bust was caused by the preceding boom. Propaganda since by a few generations of interventionist economists insist that the depression was “caused” by the hike in administered rates from 5% to 6% in August 1929. This conclusion, of course, was contrived to retrospectively protect the infallibility of the Fed as an institution by shifting the blame to the functionary that hiked the discount rate – a classic example of the left’s chronic resort to ad homenum argument. As with a senior central bank in any great financial mania, it followed the course of short-dated market rates of interest – typically by a few months.

Traditionally, the Fed raised margin requirements as a stock boom matured and then lowered them near the end of the inevitable contraction. Despite the remarkable intensity of the 2000 mania, margin requirements were not increased. Perhaps the Fed rationalized this non-action as not wanting to be seen doing anything that could be construed as breaking the mania – a curious abandonment of touted contra-cyclical genius. Why then the “significant change” in margin requirements now?

An answer could be found in reviewing the last time a senior central bank lowered margin requirements close to the peak of a boom, and that was in early 1990. At the peak of the Tokyo mania, the Japan Times headline “Economists Believe The coming Decade Will Be A Golden Era” (December 26, 1989). Our May 1, 1990 edition reviewed the initial decline as follows: “The main problem is that everyone has always expected the Japanese government to support the stock market. With the first break in Tokyo, the authorities lowered margin requirements and margin accounts bought. So far as we can tell, most sharp breaks at the end of a Bull market are caused by the liquidation of speculative positions. Usually with this, there is a reduction in margin debt. In Tokyo’s case, the market sold off 20% with a substantial rise in margin debt. This is a very vulnerable stock market.” Obviously, on the initial break, pain to big players was sufficient to prompt concerned policymakers to lower margin requirements. As noted at the time, this was a grave error and yet another example of naïve policymakers exacerbating natural market forces.

In looking at the senior indexes and credit spreads, the conviction is that nothing can go wrong. Beneath the ebullient veneer is a serious problem in the housing market which, with a huge 50% of their assets committed to mortgages, will feed into commercial banks. The other problem is the threat of more blowups in hedge-fund-land. Possibly these two threatening conditions have prompted the discussion about reducing margin requirements, which would likely be as impractical as the one at the end of the Tokyo bubble.

Link here.


The federal government slapped a levy on income trusts – which pay little or no corporate tax – on October 31 to stem a growing revenue bleed and curb the growth of a vehicle it says threatens Canada’s economy. The surprise move breaks a major Conservative campaign promise to avoid taxing trusts. Finance Minister Jim Flaherty said he had no choice because he feared that increasing numbers of corporations were preparing to convert to trusts – a trend he said threatened Ottawa’s tax base. In 2006 alone, the market value of companies converting to trusts was approaching C$70 billion. Federal officials said they were also concerned about the prospect of financial institutions such as banks, or portions of bank assets, converting to trusts.

Income trusts pay little or no corporate tax, instead shoveling out the bulk of earnings to investors, who are taxed individually. Critics said Ottawa and the provinces never recouped all the lost revenue and ended up losing hundreds of millions of dollars in revenue each year. Mr. Flaherty announced that Ottawa will start taxing trusts in the same manner as corporations, effective immediately for new trusts and starting in the 2011 tax year for existing trusts. The tax rate on trust distributions will start at 34% – mirroring federal and provincial taxes on companies – and will drop to 31.5% by 2011. This effectively ends any tax advantages for investors in trusts over corporations. Finance watchers said they expect the measure to stop almost all corporate conversions to trusts – and may encourage some that have already converted to rethink the move. Real-estate investment trusts will be exempted, as in the U.S.

Mr. Flaherty said this will restrain a wave of conversions that he said threatens corporate productivity, because pressure on trusts to distribute all profits cramps Canadian productivity by eroding trusts' ability to reinvest and innovate. The trust tax is certain to hammer the retirement savings of millions of Canadians who have come to rely on trusts for hefty returns, including many seniors, whom the Tories consider a key voting group. Liberal finance critic John McCallum accused the Conservative Party yesterday of hurting Canadians’ retirement savings by breaking their campaign pledge. The New Democrats, however, praised the Tories for closing the tax gap between income trusts and corporations.

Link here.

Canadian stocks have worst drop since June on income-trust tax.

Canadian stocks had their biggest decline in almost five months after the government unexpectedly said it will begin taxing income trusts, whose securities make up about 10% of the country’s main equity benchmark. The Standard & Poor’s/TSX Composite Index slid 2.4% in Toronto for its biggest decline since June 13. The income trust sub-index, which makes up about 10% of the country’s main equity benchmark, slid 12%. About C$19 billion in trust capitalization was wiped out.

Link here.


A couple of years ago, Robert E. Rubin – éminence grise at Citigroup and the Democratic Party’s economic wise man – decided that the U.S. dollar was headed for a fall. This view put Mr. Rubin in good company. Nearly everyone who spends time thinking about the American economy believes that the value of the dollar has to fall at some point. The U.S. has been borrowing enormous sums of money from other countries, largely so that American consumers can turn around and buy the computers, clothing and other goods those countries make. Like all borrowing booms, this one will eventually subside. When it does – and foreign investors stop buying so many dollars to lend back to us – the dollar will drop.

With this chain of events in mind, a former colleague of Mr. Rubin’s at Goldman Sachs had been whispering in his ear that anybody who did not have 20 or 30% of his holdings tied to other currencies was “out of his mind.” Yet as Mr. Rubin told me last week, his finances at the time were “totally dollar-based.” (As are yours, in all likelihood.) So he decided to bet against the dollar by buying options on other currencies. It turned out to be a very bad bet. Mr. Rubin’s logic made perfect sense – it still does, in fact – yet most people who have made similar bets in recent years have taken a bath.

The fate of the dollar, to be blunt, often seems like one of the most boring economic subjects around. But it really is worth trying to understand what is going on. In the end, the value of the dollar will go a long way toward determining how well Americans live. The simplest way to explain the problem is to say that the U.S. has been living beyond its means. Both the federal government and American families have been spending more money than they take in, leaving both in debt. To close the gap between our resources and our spending habits, we have borrowed from abroad. It is the only option.

The net amount of money leaving the U.S. is “just stunning,” said Kenneth S. Rogoff, former chief economist of the IMF. “It’s unprecedented.” The big question now is how will the situation reverse itself. It could happen gradually, with other countries slowly reducing their purchase of dollars. This would not be horrible, but most of us would be worse off. The other possibility is that foreign investors could cut their dollar purchases sharply, bringing all sorts of economic havoc. The other possibility is that an unexpected event — a spike in oil prices, say — could cause foreign investors to cut their dollar purchases sharply, bringing all sorts of economic havoc. Paul A. Volcker, the Fed chairman who whipped inflation in the ‘80s, has become sufficiently worried to call the circumstances as “dangerous and intractable” as any he can remember.

Whatever the outcome, a decline in the dollar will probably be part of it. That is why Mr. Rubin made his bet. But the dollar did not cooperate. While no longer at the highs it reached in 2002, it has stayed strong. “I think I was right, probabilistically,” he said recently. “But I don’t know. I really don’t. I don’t think anyone does. It’s also possible that none of this could happen. It’s possible that for reasons none of us can see that this will work itself out in a very copacetic way.” Mr. Rubin and the other dollar bears look a little like the skeptics of the real estate boom back in 2005. For years, those skeptics warned that things had gotten out of hand and that reality would soon reassert itself. And for years, they were wrong. The longer they were wrong, the more out of touch they sound.

How is that housing boom going, anyway?

Link here.


Less than 20 years from now ExxonMobil could be flat broke. Imagine that. One of the biggest, most outrageously profitable corporations in the history of markets ... an awe-inspiring behemoth that rakes in tens of billions per quarter in pure profit ... broke. Busted. Kaput. Tapped out. This is not some whacked-out, nearly impossible prediction. It is based on the analysis of Charley Maxwell, a veteran analyst with Weeden & Co. In addition to being one of the most respected energy analysts on the Street, Maxwell has had nearly 50 years of experience in the oil and gas industry. He got his start with Mobil Corp. – since merged with Exxon – way back in 1957.

After 11 years in the field, Maxwell headed for the canyons of Wall Street in 1968. He quickly established a reputation as the top oil analyst in the business, dominating the rankings for decades. Now he works with institutional traders, meets with top industry execs and OPEC officials twice a year and routinely advises the top dogs in the energy and hedge fund world. In other words, the guy’s opinion is probably worth listening to.

In a recent interview with Barron’s, Maxwell marveled at the utter folly of Exxon’s decisions. To understand his line of thinking – and to see why Exxon is in major trouble – we first need to consider the energy industry from a big-picture perspective. By conservative estimate, 75% of the world’s oil supply is produced by national oil companies, or NOCs. This is not good news, according to Maxwell. Imagine the U.S. Postal Service in charge of America’s energy supply. The efficient, well-run oil majors are like FedEx and UPS – they do a good job, but handle a very small portion of the job overall. Now expand this analogy to a global energy scale.

The situation with NOCs is ugly for multiple reasons. On one side of the coin, you have leaders like Hugo Chavez, who turn their countries’ oil and gas operations into political fronts and largesse-distribution programs. On the other side of the coin, you have leaders like Vladimir Putin, who see the strategic value of energy as a weapon. Witness Russia’s recent belligerence regarding its Sakhalin and Shtokman fields. Russia rejected all Western partnership offers for development of its massive Shtokman gas field, on grounds that the spoils are simply too valuable to share. Cynics have their own interpretation of the golden rule: He who holds the gold makes the rules. This is doubly true for energy reserves.

As Russia demonstrates, oil majors in future will have two choices: They will have to pay through the nose for access to new reserves, or be left out in the cold. The first option could eventually disappear altogether. And when the world clamors for a refuge from paper, even as the developing world bursts at the seams, NOCs will be all the more aggressive about keeping the goods to themselves.

Exxon puts on a confident face, but seems to have no plan ... other than assuming things will just work out somehow. If Exxon’s management is confident that cheap oil will be readily available anytime soon, they are deluded. Then what about expensive oil? Energy optimists just assume that technology will save the day, by giving us access to the more expensive, harder-to-reach stuff. Chevron’s deep-water drilling is just such an example of technological triumph. So is Exxon confidently betting on technology, then? Will the great behemoth save itself with skillful application of technology? Apparently not. Maxwell outlines his belief that Exxon is taking a huge gamble, on the assumption that oil will go back to $30 and none of this high-tech foofaraw will be necessary. He thinks Exxon is “dead wrong”. I completely agree.

Optimism is good when logic and reason support it. Optimism sans logic is foolhardy and dangerous. I agree with the energy optimists that technology will eventually pull us through ... the key word being “eventually”. Exxon is an excellent company, with a history of excellent management. How could it make such a boneheaded mistake? It makes sense if one considers that Exxon is steeped in a rigid, old-school culture that does not respond well to change. It fits in terms of seeing Exxon as a gigantic, tradition-steeped company with a history of dogmatic authority at the top of the pyramid. In sum, Exxon has become entombed by its own success and its own culture. This in itself is not surprising. It has happened plenty of times before, to companies and empires alike.

Mr. Maxwell: “I estimate Exxon will peak in 2011. BP will peak in 2012. Total in 2012. ConocoPhillips in 2013. Marathon Oil in 2009. Royal Dutch in 2009 and Hess in 2010. But a company like Suncor Energy (SU: NYSE), which operates in the Canadian tar sands, will peak around 2045. It is a completely different world. EnCana (ECA: NYSE), the big Canadian gas and tar sands producer, will peak around 2020.” We own Suncor and EnCana. Now, just imagine the valuation boost these companies will get when the Street wakes up to the fact that Exxon and its ilk are set to peak within the next five years and find themselves on a path to oblivion thereafter? The Suncors and EnCanas are indeed in a “different world” ... they are deep in the oil sands, investing in the future, doing it right.

Link here (scroll down to piece by Justice Litle).
2006 U.S. Association for the Study of Peak Oil & Gas: Global Warming – link.
Renewable Energy Sources – link.


Enter what is called the “sell-side” firm. It is like any other brokerage firm, but its analysts cover stocks as ideas primarily for institutions, mutual funds and hedge funds – the buy side. The buy side guys are the managers who are pulling triggers on large share positions each and every day. Traditionally, the buy side has its own analysts, but the workload is usually too great for them to cover all of the stocks they need to, so fund managers utilize sell-side analysts to come up with additional, fresh investment ideas. If a manager likes what a particular sell-side analyst provides him, he repays him by directing a certain amount of trades through that analyst’s trading desk. Frequently, trading desks make only pennies per share on institutional trades, but in sizable volume it can be a lucrative business.

That is where the aversion to small-caps comes in. If sell-side firms make a sizable portion of their money based on how many shares they trade, a small-cap stock trading 30,000 shares a day will not be too attractive to them. They will not want their analysts to waste time covering it ... unless there is a lucrative banking deal attached to it, at which point you might question that analyst’s objectivity.

Let us look at a sample of small-cap stocks and large caps. The list of small-caps at the top has companies with market caps of around $250 million. Only one trades more than a million shares a day, but most of them trade less than 100,000 shares daily. The list of large-caps includes the largest companies traded on U.S. exchanges. The market caps of theses companies are in the hundreds of billions of dollars, and average trading volumes are many millions of shares a day. As you can see, more sell-side analysts are covering the bigger names. The large-caps have more transactional value and greater banking needs. In short, there is more money to make off of them than the minnows.

But how much value can one analyst in a sea of 34 others add about Microsoft? How much additional insight can be gleaned about Wal-Mart with 22 analysts already scrapping over every bit of information? How much time can any of the large-cap CFOs devote to speaking to any of these analysts? The answer to all of these questions is: Not much. That is one of the main reasons why I love small-caps. There are a lot of truly undiscovered, or under-discovered gems, in this space. There are lots of opportunities for us to add value through our research.

There is also the tendency for small-caps to outperform large-caps over long periods of time. But forget about history for a moment. Just look back year-to-date at the top performing stocks so far in 2006. Of the top 10 performing stocks so far this year, 9 of them are small-caps. And half of them have no sell-side analyst coverage! So, when you see little or no analyst coverage on a small-cap you really like, do not be scared away necessarily. It just could be the best opportunity around.

Link here.


We are still not sure that the great bull market in U.S. residential real estate has come to an end. What we are sure of, on the other hand, is that it is not at the beginning. The great housing bubble may be dead, but it already has a certain corpse-like stink to it. The relatives are gathered in the parlor. The silver has already been packed up. The local priest is already on the scene, administering last rites. True, we still do not know exactly how the story will turn out. But it is time to begin preparing the obituary.

We begin, like all good requiems, in the middle of it ... or at least at one of its many comic high points. In the fall of 2006, the news appeared that Donald Trump had put his Palm Beach mansion on the market for $120 million. He had bought the place less than 10 years before, for less than $50 million. If he were to get his price, the profit would be about $7 million for every year he held it. Which is good work if you can get it – earning more than half a million dollars per month – just for owning one of America es greatest beach houses. But pity the poor next owner. He will have carrying costs of $6 million per year ($120 million at 5% interest), plus property taxes, plus upkeep, plus staff costs and other expenses. Instead of earning money, he will probably be out of pocket more than a million dollars per month. And here, we let the fellow in on a little secret: Houses do not go up every year, especially those that rose $70 million in the last decade.

We thought The Donald had set the pace for extravagantly-priced houses when, only a few weeks later, came news that Saudi Arabia’s former ambassador to the United States, Prince Bandar bin Sultan, put his ranch near Aspen, Colorado, on the market for $135 million – making it the most expensive private house ever offered for sale in America ... perhaps in the whole world. But that was the charm of the housing bubble – one absurdity always seems to lead to an even bigger one later on.

And all over the world, the rich were on a spending spree. They bought ranches in South America. Even the Bush family bought one – a 98,000-acre estancia in Paraguay. Rich people pulled out their fat wallets and bought diamonds, art, apartments in Mayfair, on the Place Vendome, and at the Puerto del Sol. Prices soared, as the cost of living it up headed for the moon. But down at the other end of the income spectrum, the lower and middle classes were having a rough time. In the 10 years leading up to 2006, they had added $5.2 trillion to their debts – most of it on mortgages. This was nothing to worry about, said the experts, because their net worth had also gone up. The price of the average house in America rose approximately 60% in the period. Compared to the type of gains the rich were getting in Malibu, Manhattan and Miami, a 60% gain was peanuts. But it was enough to lift the spirits of millions of ordinary people. Besides, in the preceding 100 years nothing like it had ever happened. Normally, house prices merely followed income and GDP gains.

Rising property prices were caused by a lie – that the feds could increase the world’s purchasing power by introducing additional “money” into the economy. Then, the lie led to a humbug ... after which followed a delusion trailed by a hallucination. At the center of all these swindles was the idea that houses actually can go up in value. Readers may be taken aback. Everybody in America now knows that houses always go up in value. But it is not true. For 100 years – from 1896 to 1996 – houses went nowhere at all, merely keeping up with GDP, inflation and income growth. Then, in the following 10 years they rose remarkably.

The homeowner did not know what to think. Predictably, he made the wrong thing of it. He came to believe that his pile of blocks, bricks, 2-by-4s and faded paint had somehow grown in real worth – like a fine wine that had aged or a bond that had matured. This sentiment was extraordinary because it was completely at odds with the evidence before his very eyes. He had only to open them to realize that his house was not, in fact, becoming a better thing. Instead, with each passing day it became a worse thing. He knew damned well that the wooden floor joists rotted and warped. The concrete foundation cracked. The aluminum windows corroded. The shingles on the roof wore away. The pipes rusted. The carpet matted down and stained. Every item – big and small – about the house actually lost value as it aged. How was it possible that the ensemble of them went up?

But out came the theorists, the economists, and the real estate salesmen. Property was rising, the homeowner was told, because there were so many new people coming in. But how could it be that houses were rising everywhere – throughout the 50 states? Where were all these new people coming from? And it was rising, they said, because the country was running out of buildable land and building codes were more restrictive. New houses were actually becoming rare ... that is why older houses were so sought after. But here too, he opened his eyes and saw it was not so. Everywhere he looked, houses were going up. There was clearly a house-building boom, not merely a house price boom. In some areas, every available lot was under construction. Single-family homes went up in former cow-fields and old auto lots. In other areas, single-family homes were knocked down to make room for condominiums. Acres of previously empty land were being converted to housing. How was it possible – with all this new supply – that prices would go up? The very idea of it contradicted his intuition if not also his instruction. Rising supplies drive prices down, not up. What is more, the new houses were bigger, cleaner, brighter ... more modern. How was it possible, in face of this competition that his hulk of a house was going up in price? It should go down.

He might have asked himself, what was a house really worth? What is it, after all? It is shelter. It is a place to hang our hats. It is home sweet home. But who ever heard of home sweet home making anyone rich? Then, his mind working on the problem like a gorilla trying to do long division, he realized that he had to look upon his house, not as a dwelling, but as an investment! Thus did another brick in the lunatic wall of the great housing bubble get laid in place. Between 2002 and 2006, in many areas of the country, residential housing rose at 20% per year or more. As an investment, it was actually a superb one, he noticed. What stock would do that? And what stock had granite countertops in the kitchen?

The more he looked at it as an investment, the more attractive it became. He could buy a house with no money down. But let us imagine that he acted as a conservative, prudent investor. He could buy a $200,000 home with a 20% down payment. So, he put down $40,000. Then, he got two forms of pay-off. Like a stock or a bond, he got a “dividend” – in the form of a place to live. A $200,000 house might rent for $2,000 a month. So, he figured he got $24,000 there. Plus, he got a capital gain, when the house went up in price. At 20% per year, this came to another $40,000. Whoa. What a bonanza! His $40,000 initial investment was throwing off $64,000 in “profit” every year. All he had to do was pay a mortgage of say, $1,000 a month and, of course, property taxes and expenses.

One absurdity led to another. The householder began to see that not only was his house a great investment, but that he must be an investment genius for taking advantage of it. The average wage in the U.S. in 2000 was only $37,565. He was making much more than that just by living in his own house. A thoughtful man might have wondered how it was possible. “How is money made?” he might have asked himself. By working. By saving. He knew the answers. And he knew he was doing neither. Ah, by investing! “Yes, that’s it,” he said to himself. “I am an investor ... like George Soros or Warren Buffett.” Only smarter. Buffett still lived in the same house he bought 40 years ago, he noticed. What a dolt! He should have traded up, flipped, and refinanced.

Then, another monstrous delusion developed. The homeowner came to believe that he had the equivalent of an ATM machine in his bedroom. If his house was making him so much money, he said to himself, surely he could take some of that money out and spend it? Using home equity lines and refinancing money, homeowners found that they could make regular withdrawals from the Bank of Their Own Homes. Borrowing against the house was easy. Lenders saw little risk. And interest rates were low. It seemed like a no-brainer. A house that was bringing $60,000 a year in wealth to a family could easily provide $10,000 to help the family live better. Heck, the family was still $50,000 ahead of the game. And so the money flowed. And what began as a trickle soon became an Amazon ... a great river of no return. In 2004 and 2005, homeowners “took out” more than $1 trillion from their houses.

Experts told them they were being very prudent. They were shrewdly “managing their household wealth,” it was said. Mortgage credit was cheap credit, so better to borrow from a home equity line than a credit card. And besides, with their houses rising in price, how could they go wrong? Except was not the price of the house that counted. It was the ability of the homeowner to repay the loan. Yes, he could sell his house to get cash. But then where would he live? It was not as if his was the only house in America going up in price. The only way he could actually realize the inflated value of his house was by dying, or moving out of the country. Not many householders were ready to do that. Short of that, he had to service his loan, just like any other borrower. And as the weight of his borrowing increased, his legs began to wobble ... and buckle. Nor did it help that his house was pricier – his insurance, his maintenance costs, and his property taxes were rising, too!

By 2002, houses were clearly going up in price – faster than they ever had before. And the homeowner was about to swallow his next big absurdity. The rise in housing prices between 2002 and 2006 in certain markets – San Francisco, San Diego, Miami, Las Vegas, Washington, D.C., Manhattan – was breathtaking. By 2005, the average house in San Francisco was selling for $820,482. In the Washington suburbs, ordinary split-levels and colonials had doubled in price in five years’ time. And along the California coast even trailers passed the $1 million mark.

Link here.

Housing vampires walk streets after Halloween.

Does the back of your neck not stand up when you hear the stories about blood-sucking CEOs who backdated their stock option grant dates to take home millions more with no extra effort? There they were in their offices late at night. The clock struck midnight, and out came their fangs. In the dead of night, these CEO vampires roamed their headquarters, searching for the document that listed their stock options. Once they found it, they sucked the blood from shareholders by changing the grant dates to more favorable ones when the company stock was at a low point for the year.

The more serious threats to the economy and life as we know it, though, will come from the undead who will still roam the streets well after this year’s Halloween candy has been eaten. They will be those folks who overextended themselves to buy a handsome Gothic mansion in a friendly subdivision. And they will have one thing on their minds – needing more cash to make their monthly mortgage payments, particularly after their adjustable-rate mortgages are reset. One estimate suggests that 2007 will be the Year of the Vampire, as $1 trillion worth of ARMs (or 12% of all U.S. mortgage debt) will be readjusted upward, increasing monthly payments and adding to homeowners’ burdens. The mortgage companies will want more blood from their mortgagees, yet these homeowners have already been bled white. Where will they find the cash to make the payments?

Link here.


U.S. corporate credit quality has been on a 25-year decline toward junk status, with almost half of all companies now rated below investment grade, Standard & Poor’s said. Liquid financial markets, downgrades in the auto and airline sectors, a spate of takeovers and global competition have contributed to the credit quality erosion, the rating agency said in two reports. “An aggressive financial posture is necessary for survival in a stiff globally competitive environment,” S&P said. “The same dynamics are unfolding in Europe, albeit at a slower pace.”

As of September, junk, or speculative-rated issuers, defined as those rated “BB+” or below, stood at a record high of 49%, up from 48% at the end of 2005 and a low of 28% in 1992, S&P said. Downgrades and mergers have taken an even higher toll on U.S. nonfinancial, or industrial companies, with 61% carrying junk ratings. In Europe, where investors are less receptive to high-yield issuers, just 17% of all borrowers are rated junk. While U.S. junk ratings have climbed, the number of top “AAA” ratings has dropped to 18 from a peak of 24 in 1998. In the industrial sector, only six parent companies have “AAA” ratings: Automatic Data Processing, Pfizer, Johnson & Johnson, United Parcel Service, Exxon Mobil, and General Electric. “Maintaining an ‘AAA’ status does not yield the payoff it once did,” S&P said. Borrowing costs are only about 5 basis points lower for an “AAA” 10-year bond than for an “AA” bond of that maturity, the rating agency said.

Some strategists have cautioned that the slump in credit quality could end badly. Given the present ratings mix, the default rate could exceed 15%, the highest since the Great Depression, if the economy goes into a recession, according to Martin Fridson, publisher of independent research service Leverage World.

Link here.
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