Wealth International, Limited

Finance Digest for Week of November 13, 2006

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


Perhaps hedge funds are simply accidents waiting to happen. That is the impression you get from reading the financial press. Either one has blown up like Amaranth Advisors, or is going out of business, or is underperforming the S&P 500. No surprise. With 8,000 U.S. hedge funds kicking around, genius and outsize returns obviously cannot bless all of them. But the truth remains that hedge funds are where the financial world’s best minds are gravitating. It is a simple matter of rewards. Hedge operators get paid better than anyone else – often with a yearly fee of 2% of assets and 20% of any profits. Beyond that, they enjoy a freedom to maneuver that they often lacked at traditional money management firms. One recent academic study found that mutual fund managers who also ran hedge funds had better results than those who did not. Hedge fund types increasingly are at the cutting edge and receptive to new ideas.

In years past the hedge fund pioneers, George Soros, Michael Steinhardt and Julian Robertson, made fortunes for themselves and their investors by thinking in new directions and taking big risks. Somewhere out there is a latter-day Soros. Can you find him? That is a difficult but not impossible task. If you regard hedge fund managers as reckless gunslingers, though, you are missing an important part of their culture. While they certainly seek to outdo the market, they also put strong emphasis on not losing clients’ money.

I wish I could say the same for mutual fund managers, who are entrusted with a vast amount of Americans’ investment capital, some $9.5 trillion vs. $1.2 trillion for hedge funds. Wealthy folks and institutions are the (usually) sophisticated clientele of hedge funds. The typical mutual fund customer is an average Joe or Jane, whose assets are smaller. The small investor has less room for error, and he or she tends to know little about investments. As the recent scandals showed, some mutual fund managers count on sticking it to the small investor. The vast majority of mutual funds lag behind the S&P. Some are way, way behind. At a time when the S&P is showing double-digit returns, large-cap growth funds are barely in the black. According to fund-tracker Lipper they had a total return of 0.2% for the year through Sept. 30. This category of funds controls one-fifth of mutual fund assets.

The complacency of the mutual fund industry is to blame. Funds are sold, not bought, and funds are, alas, marketing machines first and investing ones second. They typically preach the virtues of buying and holding to their customers. What that means is that it is okay for the fund manager to have a trigger finger but the fund investor should stay put, generating a steady stream of assets and fees, year in, year out. And what do you get for the fees you pay to your mutual fund manager? Herd investing. You do not have to pay a mutual fund manager a fee to follow the herd, and you do not have to give up 20% of your gains to a hedge fund manager, either. Be your own hedge fund manager. Buy stocks on your own.

Playing against the conventional wisdom is a good way to gain an edge. Housing is out of favor. During the last housing downturn the October 1, 1990 Newsweek cover read, “The Real Estate Bust”. Housing stocks bottomed later that month. The energy-service industry is attractive. Oil prices have fallen, yet exploration of new sources will continue, and energy-service stocks will be back. The exchange-traded fund holding a basket of such names is Oil Service Holdrs (133, OIH).

Link here.


Through late October the 30 big stocks of the Dow Jones Industrial Average have advanced through resistance point after resistance point to an alltime high over 12,000. The S&P 500 has risen 77% from its 2002 low of 777, to within striking distance of its March 2000 record high. And the widely followed Russell 2000 small-cap index is 29% above its March 2000 level. The $trillion question today is whether this is the last gasp of a 4-year-old bull market that has carried the Dow up 65%, or an upside breakout with a 1,000 points or more to come? My bet is that we are in a solid rally that could gain steam as 2007 progresses. But there will be speed bumps along the way.

First, it is impossible to get a good grip on how far the housing slump will go. The optimists state the decline in new home sales is almost over and home construction will bounce back vigorously both next year and in 2008. That is a hard story to buy because of the strong headwinds that await this important industry. Even if new construction is cut back fairly sharply, there is still a large inventory of new units to work off. With diving house sales, stocks of home builders look cheap today. However, proceed with caution. Fellow columnist Laszlo Birinyi [article above] finds several a buy, despite weakening earnings. I would wait a bit.

Will the slump in housing and commodity prices pressure the Federal Reserve to cut rates anytime soon? Probably not. The Fed is likely to stay on the sidelines for some time before cutting rates, which means that the yields on Treasurys are too low for current conditions. The risk here is what happens if oil, now trending downward, reverses and socks us with a huge price spike – whether through a terrorist action or a geopolitical crisis. The resulting surge in inflation would put the Fed in a box.

On the bullish side, corporate earnings continue to expand briskly and should be up better than 15% this year, and another 10% in 2007. Rapidly rising earnings since 2002 have cut the price/earnings multiple of the S&P to a little over 15 times, slightly below the average P/E over the last 100 years. The important stock indexes have not been so cheap on strong underlying earnings growth and other solid fundamentals since the mid-1990s. That is why, despite qualms about the fallout from housing, we should see a good market ahead. I would continue to buy large-company stocks available at low multiples and high yields. Here are several ideas to look at now.

Link here.


South of the border, home builders are hot. Shares of the dominant Mexican builders rose 50% on average over the past 12 months. That is a sharp contrast to the U.S., where a slowdown in housing has doused investors’ ardor for anything to do with real estate. But Mexican housing stocks will go higher. You should buy some.

Credit Mexico’s President Vicente Fox for rejuvenating the nation’s moribund mortgage market and boosting subsidies to low-income buyers, thereby permitting them to get home loans. While Fox was unable to get tax code and labor law reform passed, he did manage to streamline the bloated bureaucracies that were doing very little to deliver housing. His first step was to consolidate housing planning under one agency he created. Making mortgages easier to procure had a profound effect. The bottleneck to growth has been the availability of a mortgage rather than how many houses could be built. Unlike their counterparts in the U.S., Mexican developers will not build on spec.

In a country with a 50% poverty rate, the vast majority of mortgage credit comes from two government housing funds, known as Infonavit, for low-income workers in the private sector, and Fovisste, for those who work for the government. These organizations are funded with obligatory employer contributions equal to 5% of total salaries. Mexican lenders are protected from rising interest rates because all new mortgages are adjustable and indexed to inflation. Borrowers are protected by “negative amortization”, meaning that any rate hikes are tacked on to the principal and homeowners do not have to fork over extra cash for their monthly payments. In 2006 through September Infonavit originated 435,000 loans with an average balance of 230,000 pesos ($21,500), up 45% from 2004. Fovisste also saw its loan portfolio expand.

Fox’s successor, Felipe Calderón, who takes office in December, wants to increase the housing subsidy program. Home builders got the jitters earlier this year over the prospect that leftist candidate López Obrador might win the election, yet Calderón narrowly prevailed, in something of a replay of Florida 2000. This growth story is why I am interested in four excellent Mexican home builders with good to great managements, strong balance sheets and geographically diversified activities. Three are found on the Mexican exchange. One has ADRs traded on the NYSE. An equal dollar investment in each of the four is probably the best strategy.

Link here.


When you hear about a portfolio that goes up along with the stock market but cannot go down, your first question should be: Where is the catch?

The pitch is seductive, especially to those who remember the turn-of-the-century stock meltdown. How about a note that pays a return pegged to Standard & Poor’s 500 Index but guarantees your original investment back no matter what? Or, better yet, one that pays double or triple the index? They are called “structured retail products,” and, if you have not heard of them, you will.

Wildly popular in Europe and Asia, these derivatives for the average investor have been offered in the U.S. for at least two decades but were largely forgotten during the bull market at the end of the century. In the choppier markets since, the can’t-lose derivatives have come back with a vengeance. Sales so far this year are $33 billion in the U.S., according to Structuredretailproducts.com, a market research firm. Last year sales were $200 billion abroad.

Take Bank of America’s Minimum Return Eagles. The pitch: If stocks do well, you participate, but if they crash, you get all your money back with a little bit of interest. Reward without risk, it seems. Now look closely at the terms. The Eagle is a $1,000 5-year note that pays off at the greater of two amounts. One is $1,050 (your principal plus a 0.98% compound annual return). The other is what BofA cavalierly describes as the “index return” on the S&P 500. The “index return” includes dividends, but it is split out, quarter by quarter. In this calculation your account is fully charged for any losses in the stock market but is credited with a maximum positive return of only 7%.

At first blush this sounds pretty good. Why, 7% a quarter sounds pretty good, you say. But the fallacy is in thinking that the stock market climbs steadily, when in fact it lurches all around. Brokers are paid a 3% fee to sell these things, which comes out of the profits BofA makes by capping the returns. Say the market goes up 30% one quarter and down 30% the next. If you own the market, your return for the six months is a loss of 9%. The truncated return, however, delivers up a six-month loss of 25%.

There are two more twists to principal-protected notes that investors need to understand. First, they are unsecured obligations of the banks that issue them. And second, because of the principal guarantee, the IRS treats these like zero-coupon bonds, meaning you pay taxes on imputed interest of around 5% each year, at ordinary-income rates as high as 35%. If the market is up at the end of five years, you get a premium, also taxed as ordinary income. If not, you get a deduction for the “profit” you never earned.

There are a profusion of principal-protected investments on the market now, including “Index Powered” certificates of deposit sold in 60 rural banks across the Midwest that offer federal deposit insurance up to $100,000 and 90% of the S&P return. As derivatives go, these are not too bad. But reasonably sophisticated investors can create the same product themselves by purchasing a risk-free zero-coupon Treasury bond and call options on a stock index, such as XSP options traded on the Chicago Board Options Exchange. Tax treatment is a little better than with Eagles. And you do not have to worry that the bank goes bust.

What about an investment that pays triple the S&P or some other index? Merrill Lynch has sold more than $1.7 billion of Accelerated Return Notes this year, up from $568 million last year. Most offer a return over the life of the investment that is a multiple of the return on some index (or with its Bear Market Notes, the decline in that index). But your gains are capped at some level. The appeal is to investors who expect the market to go up, but only a little, explains Satch Chada, managing director in charge of retail structured products at Merrill Lynch. Again, there are ways for smart investors to structure such returns on their own, using traded indexes and options. There are more variations on the structured note theme, most of them complicated and some quite risky.

One reason structured notes are being issued at a rapid pace is the rise in interest rates in the past several years. In mathematically complicated ways, market interest rates are built into the pricing of derivatives like puts and calls, and with higher rates the terms of a structured note can be made more appealing to the naive investor. “When interest rates were very low, these things had to go away,” says Robert Gordon of Twenty-First Securities, a New York firm that advises wealthy families and executives on investment and tax strategy. “When interest rates start back up there will be a wave of them, and everybody should watch out.”

Link here.


Business school students are terrific indicators of what sectors were hot ... two years ago.

Looking for a clever way to predict which industries are heading for a fall? Just find out which ones are most avidly sought after by business school grads. In 2000, 17% of grads of the University of Pennsylvania’s Wharton School took Silicon Valley jobs, only to see technology collapse soon after. In 2001, 30% of Wharton job-seekers, more than ever before, took investment banking jobs. Wall Street laid off tens of thousands of bankers over the next two years. First-year investment banking associates’ pay did not recover until this year, when it hit $230,000 at top banks.

The hot job sector now for MBAs? Private equity, of course. In August nearly 400 Wharton students – half the class – attended a presentation on applying for a job at a private equity firm. The allure of becoming the next Henry Kravis has made private equity the fastest-growing career interest on campus, says Michelle Antonio, director of MBA career management at Wharton. It is a growing field with lots of opportunity, insists second-year Wharton student Prashant Kumar. He is president of the Wharton Venture Capital & Private Equity Club.

Goldman Sachs has plenty of openings for investment bankers and private-wealth managers this year, but the hot areas for MBA applicants are merchant banking (making investments with a firmwts own money) and trading. Sure, it may be sexier to play around with Goldman’s money. But in the quarter that ended in August Goldman’s trading and principal investments division saw its pretax earnings fall 17% over the prior year’s quarter. The investment banking unit nearly tripled its pretax earnings. Wharton’s Kumar laughs off the idea that MBAs tend to chase ships that have sailed. “There are always fields that are more in favor, but it’s for valid reasons,” he says.

Google hired 150 MBAs this year, bringing its total to 500, and got 3,500 more applications this summer. Sell signal?

Link here.


The European Central Bank last week concluded its two-day conference, “The Role of Money: Money and Monetary Policy in the Twenty-First Century.” Presenters included ECB President Jean-Claude Trichet, ECB Vice President Lucas Papademos, and Federal Reserve Chairman Bernanke. The discussion of “money” is too often technical in nature and almost always insufficiently assessable to non-economists. This is most unfortunate, and the scholarly presentations at this conference – at least the few I had the opportunity to read today – are typical in this regard. Nonetheless, I find the subject matter intellectually stimulating and the nuances intriguing. You see, the “old school” ECB remains firmly committed to Monetary Analysis. Meanwhile, the New Age Fed has abdicated the monetary aggregates and, in the process, carelessly tossed Monetary Analysis in the scrapheap.

“It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy since [1982], although policymakers continue to use monetary data as a source of information about the state of the economy,” said Chairman Bernanke. Mr. Papademos struck right at the heart of the issue in his opening comments: “Is it really possible for a policy described as ‘monetary’ to be formulated and implemented without money playing a central role in it? Indeed, the suggestion that monetary policy can be conducted without assigning a prominent role to money seems like an oxymoron.”

When it comes to “money”, Dr. Bernanke’s intellectual fixation remains with fashioning doctrine that ensures there will always be sufficient quantities of it – that there will never be a repeat of the post-1920s bubble Fed blunders that he believes unleashed deflation and the Great Depression. ECB analysis is forward-looking, focused on the complex role money and credit play in fostering asset bubbles, financial instability and future inflation. The Fed basically eschews comprehensive and forward-looking Monetary Analysis, choosing instead a shallow emphasis on core consumer price indices.

As long-time readers know all too well, Monetary Analysis is near and dear to my analytical heart. Perilous developments in contemporary “money” and credit today pose incredible risk to our future, yet they receive little attention. I applaud the ECB’s efforts, am appalled by the Fed, and generally believe that conventional thinking on “money” is so flawed that it would not be disadvantageous to wipe the slate clean and start from scratch. The traditional “quantity of money” approach to Monetary Analysis is an analytical dead end. The “transaction” role of “money” is today of minimal importance, while an ambiguous “store of value” attribute is absolutely paramount. No longer does the Fed even attempt to manage “money” and the Fed and banking system certainly no longer enjoy a monopoly on its creation.

The mystique of “Moneyness” is achieved when the marketplace perceives a financial claim’s superior liquidity and “store of nominal value” attributes. “Moneyness” is special because it basically fosters insatiable demand – which ensures powerful forces will evolve to issue it in increasing excess. If “moneyness” is confined to the narrow monetary aggregates – say, government-issued currency and bank created deposits – that is one (generally manageable) thing. The explosion of GSE debt and guarantees, MBS, ABS, Wall Street and securities Credit, myriad financial guarantees, “structured finance,” and mushrooming derivatives markets have thoroughly and radically altered Monetary Analysis. Today, in the euphoric late-stage of this historic Credit boom, the attribute of “The Moneyness of Credit” has created virtually insatiable demand for $trillions of credit instruments – top-rated and perceived highly liquid. And, as we are witnessing, the greater the degree of credit excess, the further the “Moneyness” attribute gravitates out the risk spectrum – and the greater the gulf between the perception of safety and liquidity and the reality of highly risky credits acutely vulnerable to a reversal in the credit cycle.

It is a very dangerous facet of contemporary derivatives markets that a large segment of a market can adopt a a seemingly rational strategy that preordains an eventual attempt to offload market risk to “the market”. The leveraged speculating community – having ballooned enormously since the days of the tech bubble – has gravitated to and is making a big fortune in various endeavors (i.e., credit default swaps, CDOs, and myriad credit derivatives) that are essentially writing credit “insurance”. The proliferation of speculators seeking to sell credit protection has profoundly reduced its price and increased its availability. This has encouraged many to speculate in risky credits while hedging in the derivatives market. Wall Street has certainly been emboldened to fashion sophisticated structures, pooling risky loans that are “insured” against credit loss through derivatives. Such an operation satisfies those clients wanting to borrow money, speculator clients wanting to write credit protection, and other clients wanting to speculate on “top-quality” but higher-yielding debt instruments.

The end result is the creation of coveted top-rated “money-like” securities that today enjoy almost insatiable demand – and with it an almost unlimited potential for issuance. Finding enough loans to pool and structure has been the limiting factor, but the corporate/M&A/ leveraged loan/junk/energy/resurgent telecom booms are quickly addressing this shortage. This dynamic has had a profound impact on general corporate credit availability, the cost and availability of credit “insurance,” credit creation, marketplace liquidity, and asset market speculation and inflation. And the more credit that becomes available and the greater the credit boom, the fewer corporate defaults and the more profits for those selling credit protection – writing flood insurance during a drought. The greater are speculative returns from writing credit insurance, the more players and finance that clamor for a piece of the action. This, then, incites a flurry of Wall Street innovation, crafting only more sophisticated (and leveraged) structures that somehow extract greater profits from shrinking “insurance” premiums. And reminiscent of the technology blow-off, those speculating on the end of the credit cycle – betting on widening credit spreads – have been forced to run for cover. This has only fanned the mania.

One upshot to this incredible dynamic is an issuance explosion of securities and instruments fashioned with the attributes of “Moneyness”, though backed by increasingly risky credits. A second is the dangerous marketplace perception of limitless inexpensive credit insurance. A third is the perception and extrapolation of endless liquidity, “money” to fuel permanent prosperity. The credit, insurance, and liquidity booms stoke the economy and inflate corporate revenues and earnings. They also flood the spectacular M&A boom with cheap finance, emboldening players to extrapolate both earnings growth and today’s backdrop of unlimited cheap finance. Inflating stock prices then create their own self-reinforcing speculation and liquidity bubbles, further deflating risk premiums and distorting market perceptions – creating only more intense speculative demand for corporate securities.

The explosion of credit derivatives and top-rated corporate securities issuance is a Monetary Development of historic proportions. I have written about the “Moneyness of Credit” issue over the past few years, but never did I imagine it would come to this. Marketplace perceptions of safety and liquidity are today being grossly distorted on a scale – multi-trillions of securities from one corner of the world to another – that overshadow the technology bubble, or anything previously experienced in the history of finance. Following in the footsteps of the technology derivatives bubble, the mania in credit “insurance” ensures a collapse. It today feeds a self-reinforcing boom, but when this cycle inevitably reverses, the scope of credit losses will quickly overwhelm the thinly capitalized speculators that have been more than happy to book premiums directly to profits. Undoubtedly, an unfolding bust will find this “insurance” market in complete disarray. As losses mount, the market will then face the harsh reality that minimal “insurance” reserves are actually available to make good on all the protection written. This will have a profoundly negative impact on both credit availability and marketplace liquidity – ruining the plans of many expecting – and requiring – that “money” always flow so freely.

A major problem with the current monetary boom – the “Moneyness of Credit Bubble” – is the enormous and widening gulf between the market’s perception of safety and liquidity and the acute vulnerability of the actual underlying credits. Runaway booms invariably destroy the “money” – in whatever form it takes – whose inflationary expansion was responsible for fueling the bubble. This lesson should have been learned from the late-‘20s experience, or various other fiascos as far back as John Law. When current perceptions change – when$ trillions of credit instruments are reclassified and revalued as risky instruments as opposed to today’s coveted “money” – Dr. Bernanke will learn why a central bank’s monetary focus must be in restraining “money” and credit excesses during the boom. And the longer this destabilizing period of transforming risky credits into perceived “money” is allowed to run unchecked, the more impotent his little “mop-up” operations will appear in the face of widespread financial and economic dislocation – on a global scale.

Link here (scroll down to last subheading in left page column).


“Dear Sir/Madam, your details were provided by someone who is assuring me of your honesty and integrity for an Urgent Business Proposal in Confidence of the Strictest Nature. I am the sales director of the Democratic Republic of Derivatives. Unbeknownst to my colleagues, I have discovered millions of dollars hidden in an unexplored corner of the republic in the form of Constant Proportion Debt Obligations, or CPDOs. I seek your assistance in unlocking this value for the benefit of both of us.”

CPDOs are the credit-derivatives market’s latest alchemical wheeze to turn the lead of record-low yield premiums into the gold of market-beating returns. They have the distinct whiff of a Nigerian banking-scam e-mail, with the marketing literature suggesting the newfangled securities have found the holy grail of investing – heads you win, tails you don’t lose. The securities deliver as much as 2 percentage points more than money-market rates during their 10-year life. That is worth about 5.6% at current three-month rates, compared with the 3.7% annual yield on 10-year German government debt.

This remarkable rate of return is made possible by the magic of derivatives, which leverage the initial bet by a multiplier of 15. Performance is derived from the returns available on indexes of credit-default swaps, which in turn are tied to the creditworthiness of borrowers in the corporate-bond market. “CPDOs are susceptible to sudden shocks that result in severe mark-to-market losses,” Citigroup analysts said in a Nov. 10 report. “Jokingly, we have started calling the product a ‘hydra;’ almost every time we tried to kill it by subjecting it to severe stress, it seemed somehow to be able to recover par by maturity.”

Derivatives-based trading strategies rely on computer simulations to test their performance under different market scenarios. These simulations typically expect the future to be like the past. The collapse of Long-Term Capital Management LP in 1998 is proof of the danger of using inductive reasoning to extrapolate general laws from particular observable instances. A truism of financial markets is that everyone agrees there is no such thing as a free lunch – until they think they have spotted a buffet of risk-free basis points. CPDOs look too good to be true, so guess what? They probably are.

Link here.


A surfeit of liquidity in the financial markets is tempting bankers to underwrite and finance deals that may come back to haunt them, a top banker at Goldman Sachs said. Eugene Leouzon, the chief underwriting officer for Europe and Asia at Goldman who sits on the investment bank’s global credit committee, said the current conditions were unparalleled in his experience of investment banking. Leouzon also manages the firm’s underwriting and lending portfolio in Europe and Asia.

“The markets are really, really red hot,” said Leouzon, who approves new loans and debt deals to fund mergers and acquisitions. “The things we are seeing being done, both on the investment grade side and the non-investment grade side, are I would say borderline stupid. ... There is just too much capital going after too little by way of deals.” But Leouzon said the outlook was for a strong level of new deals going forward, led by lending money to fund leveraged buyouts and cash mergers and acquisitions.

Link here.


Warren Hellman, chairman of San Francisco private equity firm Hellman & Friedman, said he is concerned about the torrent of money flowing into private equity. Firms such as his are expected to raise a total of about $140 billion this year. Hellman’s firm is reportedly raising an $8 billion fund, more than double the size of the firm’s prior fund of $3.5 billion. The performance of the private equity industry is likely to fall as firms compete for good deals.

“We’re all going to struggle for returns,” Hellman told a meeting of about 300 people. Given the billions of dollars in the coffers of private equity firms, and bankers willing to lend billions more, Hellman said it is conceivable even a Ford or General Motors are buyout candidates. “It would surprise me, but it wouldn’t shock me,” he said. “There’s so much money sloshing around in institutional hands.”

Hellman said his firm recently passed on a deal that had bankers offering to lend at nine times cash flow. He said it was just a few years ago that it was difficult to get banks to finance at 3.5 times a company’s cash flow. He said the firm avoids deals that pencil out based on a significant portion of the returns come from paying off debt. “The amount of leverage available is just so strong, very scary, but very strong,” he said. But Hellman refrained from predicting when the private equity bubble might burst. “I have predicted 11 of the last two market crashes,” he said.

Link here.


Thomas Lee, the billionaire buyout executive, is postponing plans to raise $400 million in an initial public offering for a fund to invest in hedge funds, two people with knowledge of the sale said. Lee, known for making more than 10 times his money from the takeover of Snapple Beverage, is delaying the sale of shares in London for the Lee Diversified Opportunities Ltd. fund until next year, said the people, who declined to be identified because the decision is confidential. “They’re struggling to get these deals done,” said Jens Peers, who helps oversee about $3.5 billion at KBC Asset Management Ltd. in Dublin and invests in IPOs. “These investments don’t perform like regular IPOs.”

Lee was seeking to join companies including Goldman Sachs in tapping demand among individual investors for funds that seek to outperform stocks and bonds. The delay comes as London-based Marshall Wace LLP attempts to raise €1.5 billion ($1.9 billion) in the largest IPO of a hedge fund. Goldman Sachs Dynamic Opportunities Ltd. raised $507 million in an IPO in July. Its London-listed shares have dropped slightly by about 0.5%. Shares of Boussard & Gavaudan Holding Ltd., a hedge fund investment company run by ex-Goldman Sachs executives, have gained 1% since an IPO earlier this month. A spokesman for Lee declined to comment.

Link here.


Our current analysis of housing investment levels is summarized as: The current housing investment “bubble” has surpassed even the housing boom of the 1920s. It is now fading away into a very difficult housing market over the next 3 or more years.

In our 2005 analysis, we documented that the level of new residential investment exceeded population growth and traditional economic needs by a substantial amount. We also showed that personal financial obligations ratios were rising to historic levels. On the positive side, we discussed that price spreads between new and existing homes and interest rate levels remained highly supportive of continued investment.

Our 2006 analysis documents that the macroeconomic considerations are now taking precedence over the microeconomic considerations. Many microeconomic considerations still support the home building process. However, the accumulated overinvestment in residential housing is now so substantial that even strong microeconomic incentives are not sufficient to offset the macroeconomic weight of overinvestment.

Our analysis shows that over 2 years of excess investment has occurred in the last 10 years. Essentially, that means that we should invest only 60% of normal trend investment during the next 5 years in order to get back to normal. With financial obligation levels 20% to 30% higher than attractive, we expect 5 years of declining obligation ratios will be needed to produce a supportive environment for future housing investment. Our calculations show the potential for an average 40% to 50% decline in residential investment from the 2005 peak over the next 5 years. It is possible that we could experience a 60% to 80% drop from the 2005 peak in residential investment at some time in the next three years. If that were to occur, we would expect the trough in late 2008 or during 2009.

The only thing mitigating a potential housing market implosion is a real inflation level near 8%. If real inflation declines or real deflation occurs, then U.S. housing investment could implode in a manner similar to the housing market crater of the early 1930s. The soft landing that many prognosticators expect requires continuation of high real inflation and low interest rates. High real inflation would support the nominal dollar value of residential real estate even if its real value declined. Unfortunately, we do not see how increases in real inflation, the likely rise in interest rates, and the continuation of monetarily-supported overinvestment will significantly increase the future level of housing investment.

We believe that our analysis is robust. It indicates a very difficult housing market for many years to come.

Link here.

When the Home Equity Cookie Jar is empty.

My first experience with a mob of American children was a job I had working in my hometown park while in high school. At one summer party, my job was to hand out candy to the children. I grew impatient handing it out piece by piece so to speed up the process, I started throwing it by the handfuls to the kids. Their response was immediate and totally unexpected. I was soon chased through the park by a hungry mob of excited children who wanted their candy, and they wanted it now. This fond memory reminds me of the American consumer today because they continue to behave very much like those excited children.

Every day we are bombarded with advertisements and ads speaking to our inner child. We, as consumers, are so conditioned to buy that fancier car or bigger house because the auto dealerships and bankers are offering financing terms that have made it so easy. The loans being offered today are so flexible and, at first glance, appear affordable because they are interest-free, 40-year, no money down/no payment due, piggyback, adjustable-rate, etc. Alan Greenspan even encouraged “really sophisticated” consumers to take out ARM mortgages and extract equity from their homes.

Back in 2000, when homes were worth $11.4 trillion, there were only $4.8 trillion in mortgages against them. And now? In Q2 2006, that mortgage debt increased to a whopping $9.3 trillion. Even with the increases in housing prices over the last few years, the percentage of equity in homes has actually fallen from 58% in 2000, to 54% today.

If you read the financial press, you will know that new home prices have already been marked down almost 10%. The markdowns do not even include incentives being offered such as free swimming pools, granite counter tops, or free maintenance for a year. It would be a miracle if the prices of old existing homes did not follow the same path down in price. Some of our clients who work in the distressed arena and buy crappy mortgages have reviewed large nationwide portfolios of existing homes that are up for sale because of mortgage default. Their findings indicate that prices are already down 8-20% on average across the country! Remember, based on actual history of past real estate bubbles, the housing price drop is almost certain to take 2 to 3 years before it hits bottom.

Home values have bubbled up almost 80% in just a few short years. Speculators and flippers bought a few million homes they now cannot sell. $1 trillion of adjustable-rate mortgages are scheduled to adjust upward in 2007. Lenders permitted sub-prime borrowers to buy homes with no credit and no real money down. There are currently 10 million homes in this country that if they were sold today, they would sell for less than the existing mortgage balance. Foreclosures have just started rising, and sellers of existing homes are watching as builders are dumping inventory, driving down prices across the board. New home construction is running far higher than new home sales, and inventories are bulging while buyers are on strike. The good news is that mortgage lenders have begun verifying home appraisals and borrower income (long overdue). The bad news is that home equity is evaporating quickly and you cannot borrow against negative equity.

Americans will need a wage increase of about 20% to make up for a loss of purchasing power if home equity extraction goes away. I must humbly admit that I cannot be certain what is going to happen. However, I do know that specialty retailers cannot get sales up, the auto makers cannot figure out how to sell cars, and auto production needs to be scaled back. Home Depot is starting to sell general household goods because home owners are scaling back on home improvements. Wal-Mart’s sales are off and they have declared a major price war with Target and Best Buy (and any other retailer that wants to sell to mid-America) this Christmas season.

Do the arithmetic yourself. Companies that either sell to the consumer or manufacture goods will be left scratching their heads as they scramble to find ways to get the consumer to spend. They will be hiring fewer people and cutting back on production and investment. Home builders have already halted new home construction in an over-saturated market. Less spending means fewer jobs. Even after taking $250 billion out of the house in the 3rd quarter, GDP was only up 1.6% so when the home equity extraction ends, GDP will go negative. When this happens, we will all have to sit back and see how the childish consumer reacts when the Home Equity Cookie Jar is empty.

Link here.

It takes a vision.

Vision. That is what separates the men from the boys or at least the men from the men with Aspen condos and watches that can keep perfect time even if strapped to a rock and dropped into the Mariana Trench. Somehow they have it – that ability to see what remains invisible to those of us more focused on the “low fuel” warning light on the dashboard than investment opportunities that appear before our very eyes.

Take Elkcorp. The company is a Dallas-based maker of shingles (Premium Roofing Products they call them) and some other stuff. But 90% of sales comes from shingles. As you might expect with the housing market falling off the cliff like Wile E. Coyote holding an anvil, Elkcorp sales were not up much in the quarter ending Sept. 30. Not only that, the stock price had been drifting lower for much of the year. So what does Elkcorp do? Does it take the traditional corporate approach by, say, sending the employees through a ropes course to learn about teamwork? Does it come up with a China strategy? Does it design a new logo? No. In what may prove to be a visionary move, Elkcorp, is putting itself up for sale. At least management said that it is mulling it over and they have hired an investment bank to sniff out buyers.

But surely the real visionaries are the ones showing interest in Elkcorp even after the pop in the stock from the mid-20s to the mid-30s. They are the ones who see beyond the obvious, like a valuation of 16 times earnings for a (Premium!) shingle company so soon after the peak of a housing mania. Deal doers will argue that much of Elkcorp’s shingle sales are from replacement business, and that should help insulate the company from a bear market in housing. Still, it takes a visionary to see that the time to buy such a company is soon after a refi boom, a cash out refi boom, a home improvement boom, a home equity loan boom and an “I’m sick of my house looking dumpy compared to my neighbor’s” boom. That is why they call them visionaries.

There are, of course, those who say that rather than just beginning, the housing bust is nearly over. That means the visionaries are playing the next housing boom rather than worrying about surviving the ongoing collapse. Thanks to Paul Kasriel we know that among those who thinks the worst is behind us is Federal Reserve Governor Susan Bies. She shared that very thought in a recent speech. And apparently Governor Bies has better eyes than Robert Toll, the CEO of fancy homebuilder Toll Brothers. Mr. Toll himself said he could see no end to the slump in homebuilding. Visibility is also cloudy over on the more modest side of town. Beazer just reported new home orders down 58% vs. prior year. In his conference call, CEO Ian McCarthy said he has yet to see “any meaningful evidence to suggest that a rebound in the housing market is imminent.” Molly Boesel, an economist for Fannie Mae may also be cursed with myopia. She thinks that new home construction needs to decline for “an extended period” in order to work off housing inventory and set stage for an upturn.

But it takes a visionary to think that the country’s biggest and best housing boom could retreat and reinvigorate itself so quickly and with so little pain. Paul Kasriel, who apparently gets car sick wearing rose colored glasses, has produced a chart of housing starts (PDF file) going back to 1959. Mr. Kasriel has noticed that housing starts have declined an average 47% over the seven cycles since 1959. But from the February 2005 peak through August starts are down “just” 25%. Kasriel’s chart also shows that housing starts have behaved strangely over the past 16 years. Rather than tracing an inverted “V” as in prior cycles, housing starts moved higher and higher, and higher, resembling only the left half of a “V”. Finally, starts fell back a bit in 2000, but then resumed their climb, moving higher still. In other words, for a decade and a half, there has been a lot of “up” and hardly any “down”. That is why the housing starts chart looks strangely incomplete. In the other cycles, starts quickly retraced all of their gains. But in the current cycle, the jagged line appears to have miles to go before bottoming and starting all over again.

Only a true visionary knows how low that level will be.

Link here.

Lies, Deceit, Greed

I have been listening to the spin by the National Association of REALTORS (NAR) spokesman David Lereah. The contradictions are nothing short of amazing. ...

Link here.

Home equity loan growth is rapidly decelerating.

Not many people pay attention to bank credit and the money supply, but the Federal Reserve sure does. M1, M2, M3, Aggregate Reserves of Depository Institutions and the Monetary Base, Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks ... and more, so very much more. Now, the Fed goes to these lengths, because it is supposed to “control” the money supply. Yet this control is simply a means to a greater end for the Fed – namely, to expand credit.

A growing money supply normally means growing deposits for financial institutions, which means more lending and borrowing, i.e. the expansion of credit. And there has been borrowing aplenty, notwithstanding the unstable economy in recent years. Consider home equity. Fed data shows that July 1997 was the first time the total amount of home equity loans reached $100 billion. And it took more than five years for that figure to double, reaching $200 billion until September 2002. How long do you think it took to double again? Oops, if you blinked you missed it when it happened – homeowners had converted $400 billion of assets into debts in the final week of 2004.

What does it mean? Well, it reflected – after the fact – the acceleration of the trend toward reckless levels of debt. Here is another view. The dollar amount of home equity loans increased by 30% during 2003, by 35% in 2004, by 10% in 2005, and by 4% in 2006 through October. What does the rapid reversal of this trend mean for the economy and consumer spending in 2007? Stay tuned. It is a question that could answer itself sooner than (almost) anyone expects.

Link here.

The Moon Also Rises

The housing bust is over, according to Alan Greenspan, former Fed Chairman and asset-bubble connoisseur. “Most of the negatives in housing are probably behind us,” he assures. “The fourth quarter should be reasonably good, certainly better than the third quarter.”

If Greenspan is not worried, we probably should be. However literate the former Fed chairman may be, he cannot read tomorrow’s paper. In fact, he sometimes seems to have trouble reading today’s newspapers ... or at least understanding what they mean. “A lot of people are going to lose their homes,” he says. “It’s a family tragedy. It’s not an economic – or macroeconomic – tragedy.” Perhaps, but neither is it a comedy. Let us call it an unfolding drama ... with a surprise ending. This particular drama will likely feature declining home sales and falling prices. Will home prices tumble low enough to qualify as a Greenspan-defined “macro-economic tragedy?” We do not know, but we would not rule out the possibility. Bursting bubbles tend to produce more tears than belly laughs.

We were terrified about the housing market, even before Greenspan tried to calm us down. But we are more terrified now, thanks to Greenspan’s well-documented history as a contrarian indicator. The former chairman is not ALWAYS wrong, of course. But who could forget his infamous “Irrational exuberance” remark of December 5, 1996, when he fretted aloud about the frothy stock market. Over the ensuing three years, the Nasdaq quadrupled. But instead of worrying even more about the frothy stock market, the Chairman started worrying LESS.

Then, on March 6, 2000, Greenspan informed a conference on the “New Economy” that the Internet-based economy would continue to foster productivity, technology innovation and enduring wealth creation. Alas, the Nasdaq topped out almost immediately after Greenspan stepped away from the podium. Greenspan’s calm assurances about the housing market, therefore, impart neither calm nor assurance.

Even if it is always darkest before the dawn, it is also pretty dark around midnight. Differentiating between shades of black is more guesswork than science. Alan Greenspan says the dawn of recovering will soon pierce the darkness enshrouding the U.S. housing market. But we are not so sure. We are still hunkering down for a long night. Did the sun not just set on the nation’s majestic housing bubble? And didn’t the long shadows of falling home prices just begin stretching across the nation’s real estate market? How then could the sun be rising already?

In a recent meeting, many of your editor’s colleagues discussed the likelihood of a “second wave” of the housing bust. “A second wave is coming,” warned Mike “Mish” Shedlock, contributing editor of Whiskey and Gunpowder, “and it’s gonna be a lot worse than the first wave. The second wave will wash over the entire economy. We won’t just see home prices falling; we’ll see lots of people losing their jobs and lots of empty shopping malls and lots of bankruptcies. It’ll be bad.”

“But haven’t the housing stocks been rallying?” another editor protested. “Yeah,” Mish continued, “that’s because investors are already looking for a bottom in this sector, but they’ll be disappointed. This kind of thing always happens when booms go bust. People assume the worst is over, even when the worst hasn’t even begun. … The housing bust is far from over, and its gonna get ugly.”

Ironically, Mish uttered these words at the identical hour that Greenspan was uttered the remark, “Most of the negatives in housing are probably behind us.” We do not know if Mish is right, but we fear the Greenspan is close to being entirely wrong. A terrific report by two analysts at JMP Securities makes the case that the housing “recovery” is no better than a faint hope. “Based on our field work,” write analysts Alex Barron and James F. Wilson, “we do not believe the worst news [on housing] is out yet.” The prognosis for the housing market remains very poor, they contend, and it remains particularly grim for the builders of new homes.

Despite cautious remarks from homebuilding industry leaders Robert Toll and D.R. Horton CEO Donald Tomnitz, investors are throwing caution to the wind. Homebuilding stocks bounced nearly 6% on Tuesday – punctuating a rally that has lifted the sector more than 20% since mid-July. But analysts Barron and Wilson would advise against bottom-fishing among the homebuilding stocks. “Historically, we see that speculative excesses generally take longer than one year to work themselves off. So far, the housing stocks seem to be closely tracking the Nasdaq decline after it peaked in March 2000. ... The Nasdaq eventually bottomed out three years from the peak in March 2003, 75% below its all-time high. ... We believe the housing stocks are likely to re-test their lows in the coming months and perhaps go below them before we see the ultimate bottom.”

Our advice? Wait for rays of sunshine to appear before heralding the dawn.

Link here.


Last week, we highlighted that the stock market may have given an early warning signal that the rally was near an end, but this week, it decided to make another quick run-up. Some indexes made new highs this week (Dow industrials, Nasdaq-100) and some did not (Transports, Russell 2000). If you notice, the S&P 500 has been having trouble making any sustained progress above 1,385 – an area it first reached a month ago in October. There is a very important technical reason for this resistance that is related to the 2000-02 bear market, and we will outline it in detail in a later issue.

Our position in gold stocks has been rallying hard. The rally in GDX is feeding off a broader rally in commodities that is now reaching into the one area that has been the biggest drag on the entire sector – oil. Oil has been attempting to carve out a bottom over the past seven weeks. Will this recent low hold? If oil stocks have anything to say about it, the answer is yes. Since we already have a direct play on oil and natural gas in our San Juan Basin Royalty Trust (SJT: NYSE) position, we are going to add an ETF that is somewhat of a leveraged play on oil. The Oil Services HOLDRs ETF (OIH:AMEX) is a basket of some of the largest oil services companies in the world. Since topping out in May at $169, it declined all the way down to $118 in October – a 30% drop. However, during a nasty fight with its long-term uptrend line in September and October, it appears to have put in a low that has left the long-term bullish trend intact. OIH has now broken out of its downtrend from May and could now be ready to move significantly higher. It is time for us to add to our oil exposure with this ETF.

The recent strength of the precious metals and most other commodities seems to be signaling something big is about to happen. We wonder if this market action is anticipating a breakdown in the dollar. The U.S. dollar index is now right on the edge, and a move much lower below 85 could start a renewed decline. The immediate target if we get a breakdown is 80, after a brief stop at 84. If the dollar were to break down below 85, it would likely be the start of at least a short-term decline. But there is also the chance that after two years of sideways action, the dollar index is ready to continue its decline below its December 2004 low near 80.

Even though the losses in some gold mining stocks were severe from their May highs, on many long-term charts, this year’s decline looks like a normal correction in an ongoing bull market. That is why we entered long last month, and it is why we are adding to our oil exposure this week. If these sectors are anticipating another significant decline in the dollar, we will want to be there when the sparks start flying.

From most recent weekly Survival Report update.


The market, fueled for nearly three years by rising oil prices, had become a national obsession that was as close to gambling as one can get in a kingdom that bans it. But a sudden downward spiral in the market in March wiped out gains for thousands of Saudis, and recently, things have only gotten worse. In the past couple of weeks, the index has tumbled about 3,000 points – close to 2004 levels.

The downturn, which saw the market’s index drop from a record peak of 20,634 in late February to a recent 8,019, has been disastrous for many Saudis. People collapsed in trading halls while witnessing their money evaporate. At least four investors died of heart attacks, according to the Saudi media. Saudis who quit jobs to focus on playing the market are now jobless and in debt. Grooms who had hoped their investments would cover their wedding expenses were left with a fraction of their savings. Fathers who sought to double their daughters’ dowries are now penniless.

The collapse took many Saudis by surprise. Until February, the market was growing by almost 100% annually, leading many Saudis to predict a new boom similar to that fueled by oil in the 1970s. The stock market run began in 1999 when the number of companies going public increased sharply. But it really took off in 2003 when oil prices started climbing to over $70 a barrel. Experts say the reason for the crash is simple. The market went up too far too fast and now it is come back to earth.

Link here.


Remember the infamous comic book villain The Scarecrow? In the 2005 blockbuster Batman Returns, he sprayed a lethal fear toxin into the air that caused all who breathed it in to imagine their worst fears coming to life before them. Hypothetically speaking – Julius Caesar would see cats, Johnny Depp clowns, and Jenny Craig complex carbohydrates. But take that terror-sol can to the mainstream financial streets and chances are, the nightmare to emerge would be one and the same: The evil specter of inflation materializing out of thin air AND increasing the price of all it touched.

The good news is, in the real world, we can see that the bogey of inflation is a complete hallucination. We could use the November 14 Labor Department report, which said that October’s Producer Price Index matched the biggest monthly decline on record. That the core PPI, which excludes energy and food, experienced the sharpest one-month plunge in 13 years and pushed the year-over-year rate of unfinished goods prices into negative territory for the first time in four years. We could use this “literally unbelievable” figure, as one DJ MarketWatch analyst describes it, as proof that inflation is about as real as Bozo, the bloodthirsty buffoon.

U.S. stocks initially found the November 14 PPI figure quite unsettling: Blue-chips “head lower as plunging PPI data suggests growth may be slowing too much.” (Bloomberg) By mid-day however, the Dow Industrials soared to a fresh, all-time high, the previously “disturbing” data turned into “definitive” proof that “inflationary pressures are easing.” With that kind of unpredictability, who needs a fear toxin?

Now, PPI, CPI, CPA, SOS aside – one fact remains both clear and consistent. Everything from energy prices to third-quarter economic growth has been FALLING, the exact opposite condition of inflation. Crude oil prices are down 25% since July alongside a 10-month low in prices at the pump. Wal-Mart saw same store sales growth drop by the sharpest amount in 10 years this October, in conjunction with the “weakest nominal growth in national retails sales since 2004.” In order to combat the slump, in fact, the King of Cheap is planning to “cut prices to drive traffic” this Holiday season, including an unprecedented promotion of $4 prescription drugs. And let us not forget the drop in new home prices this October by the largest amount in 35 years.

FYI: The across-the-board slowdown got underway LONG BEFORE the Federal Reserve put the brakes on its 2-year cycle of raising interest rates. As early as July 2005 we saw the downtrend “take up residence in real estate.” The specter of inflation IS not real. A reversal in mass social mood is. So, stop running from imaginary adversaries AND face the actual, long-term trend changes underway.

Elliott Wave International November lead article.

Pieces of the deflation puzzle continue to fit into place.

Today’s news reports are that wholesale prices fell 1.6% in October, equaling the record set in October of 2001. Core inflation (excludes energy and food) showed the biggest one-month fall in 13 years. Some speculated that the Fed will welcome the price decline as evidence that its 17 consecutive interest rate hikes have slowed the economy just enough to reduce “inflation pressures”. This is highly ironic, viewed in light of the historic reflation attempted by the Fed in 2000-2003 when it cut rates to 1% – the lowest level since 1961 – funneling credit, foie gras style, into consumer pockets via real estate refinancing.

Anyone who welcomes signs of deflation during an unequaled inflationary asset mania betrays ignorance of the available 300+ years of stock market data and the accompanying social phenomena. Homeowners are not welcoming declining property values, for example. Inflation is only a boogyman, but to see that, you have to take the lampshade off your head.

Link here.


The barbarians are amassing along the Canadian border. But these barbarians do not wear bearskins and wield clubs. They wear Armani and wield wads of cash. Foreign investors are preparing to sweep into the beaten-down investment trust sector, to plunder the valuables and return the booty to their native lands. Canadians will not enjoy this plundering very much. Individual investors, however, would stand to benefit if they purchased selected investment trusts before the barbarians arrived. The aptly titled Barbarians at the Gate is a famous book-turned-movie about one of the biggest private equity deals in history. In the late ‘80s, private equity firm Kohlberg Kravis Roberts bought out RJR Nabisco for $25 billion, a staggering sum that was only recently topped. (And still has not been topped in inflation-adjusted terms.)

The global economy is still awash in a sea of cash and private equity firms have literally tens of billions to throw around. They are bigger, badder and hungrier than ever before. What are a private equity guy’s favorite two words in the world? “Cash flow.” What do Canada’s income trusts have in spades? Cash flow. Put the two together and it is not hard to see: The barbarians are coming.

Private equity guys recently bought Freescale Semiconductor for $17.6 billion. They bought HCA for $33 billion – the largest deal ever in noninflation-adjusted terms. KKR was recently in the hunt to break its own record. The proposed deal price? A cool $50 billion. All the Canadian energy trusts put together have a market value of $60-80 billion – a drop in the bucket by today’s standards. The barbarians are sitting on so much investor cash that they are literally desperate to deploy it. They are no doubt drooling over the situation Flaherty created.

“So what?” You might ask. “What does it matter if the barbarians take over? Is it not all the same?” Well, no. When an energy trust goes private, instead of enriching Canadian citizens and other small-scale investors, the cash flows to bigwigs in L.A. and New York. More importantly, the “hollowing out” problem is still there ... and arguably gets worse under a barbarian regime. Private equity firms used to take pride in shaping the companies they acquired. The old way was to really clean up a company, improve its efficiency and make a mint by way of genuine value creation. That still happens, but it is more and more rare these days. The new model is more akin to strip-mining: load the target with debt, extract as much cash as you can and flip it back to the public as quickly as possible. Under the old-fashioned way, polishing up a company took years. Not any more. The new record for a private equity strip ‘n’ flip is an astonishing three weeks.

Private equity guys do not care about the world’s energy future. The name of the game is fees and cash flow, end of story. They view their acquisitions in the same way credit card companies view subprime borrowers – as assets to be leveraged and exploited. If you thought Exxon and BP were stingy on the capex side, you ain’t seen nothing yet. Flaherty’s proposal not only produced a sweet opportunity for foreigner buyers, it also created bitter opportunity for domestic sellers. A lot of Canadian executives now feel they have been betrayed and abused; this makes the trusts all the more susceptible to selling out. If the business you love has been trashed by your government, and your net worth just took a sizable hit, why not cash out with your wealth and your dignity intact?

At the end of the day, I can see why Flaherty did what he did. But I think all his talk of “fairness” and “doing what is best for Canadians” is probably a bunch of hooey. Bottom line: If Canada’s energy trusts are taken private en masse, that could hurt Canadian investors and workers alike, as cash flows are diverted and capex is cut. If Flaherty decides to block the barbarians with restrictive legislation, then he will be responsible for demoralizing and shrinking an industry that has less lifeblood and less expansion capability than before.

But we individual investors need not trouble ourselves with such issues. We need merely assess the situation as it currently exists and respond. The situation as it currently exists offers compelling value. The high-yielding investment trusts will continue to pay their high-yields without taxation until 2011 ... assuming the barbarians do not swoop in to take them private in the meantime. Net-net, seek out the values that would attract a barbarian.

Link here (scroll down to piece by Justice Litle).


Back in 2000, at the climax of the telecom bubble, I went to the National Fiber Optic Engineers Conference in Denver. It was as if they were trying to turn geeks into veal. About 5,000 people shared 4,000 seats. Muscles atrophied. People who a year earlier could not have discerned fiber strands from pasta piled in, smelling money. Within weeks, the telecom bust kicked in. The conference slid back into the realm of Ph.D.s in Birkenstocks. Hard to imagine 5,000 people interested in paying to hear fiber-optic engineering presentations for three days anymore. In fact, the conference has combined with another, the Optical Fiber Communication Conference & Exposition, just to keep going.

After experiencing last week’s Web 2.0 Summit in San Francisco, a lot of tech types are feeling like they have seen this movie before. Once again, there we were, jamming 3,000 tech entrepreneurs, investors and executives into about 2,000 seats in a downtown hotel ballroom. This is a bad sign going forward. Web 2.0 was the same dance all over again – this tech bubble, boomy, exuberant thing that happens when money hangs like a bumper crop in an orchard. At the conference, I swear there was a ka-ching sound in every techie’s step.

It is not necessarily Google’s $1.7 billion purchase of YouTube that accounts for Web 2.0 fever. Creating a YouTube-style social phenomenon that sells for billions of dollars certainly takes smarts, but it also takes a heaping portion of luck and fortunate timing. More likely, stories like the one about JotSpot flush out every would-be entrepreneur from their basement offices. Google bought JotSpot earlier this month for a reported $50 million. What is JotSpot? Who knows! Has anyone you know ever used it? Probably not! So, see, Google will pay millions of dollars for ANYTHING! Let’s start a company! Yay! That is what Web 2.0 seems to mean, a second wave of people who choose not to remember how badly things ended the last time around.

The parallels to Ye Olde Bubbles of previous eras could not be ignored. Heck, they were in your face. In his opening remarks, conference co-founder John Battelle noted that he had changed the name this year from the Web 2.0 Conference to the Web 2.0 Summit. This is because he turned 5,000 people away who wanted to come but who, apparently, are not summit-worthy. They will now have to go in April to a sister conference, Web 2.0 Expo. The people who get turned away from that might have to go to a Web 2.0 County Fair. Battelle explained that he chose the word “summit” because, “I used to have a conference called Internet Summit.” I attended one of those. The Internet summits were, basically, the Roman orgies of the dot-com bubble. Not that there were any actual naked people or anything, but there were chocolate fountains and giant martinis and surfing expeditions at a beach-side resort. Keep in mind that the most feverish Internet Summit turned out to be the last Internet Summit. The bubble burst. Industry Standard collapsed. Internet Summit became a memory that its attendees recall the way Imelda Marcos must think of her palace shoe collection.

Did I tell you that last week’s Web 2.0 had chocolate fountains, too? And Yahootinis? They tasted and looked like automatic transmission fluid. But they were free, so people drank them. Oh yes, there were lots of presentations on stage. And as seems to happen at peak bubble moments, some of these strayed far and wide. Japanese investor Joichi Ito gave a detailed talk on how to play the globally popular online game World of Warcraft, which looks as complex as manning the derivatives trading desk at Goldman Sachs but with the goal of killing a cartoon dragon instead of making millions of dollars. Imagine the total drag the game has on the world economy. Debra Chrapaty, an intense woman from Microsoft, excitedly showed images of a giant data center under construction amid a withering barrage of tech-speak. I had the same feeling I used to get when Aunt Eve would show slides of her plastic surgery.

At such moments, a lot of people were glad for one huge difference between now and the previous bubble: Wi-Fi. Lots of attendees had their laptops open, doing who-knows-what. We each had enough space to type with our elbows glued to our sides, while trying not to look at our neighbors’ screens – which would seem to be a breach of etiquette, like staring in the locker room.

Wonder if we will all be back next year?

Link here.


The brakes just might have been slammed on U.S. defense spending. Voters in the U.S. made their feelings known about the Iraq War and seemingly swept aside as much Republican influence as they could last week. Political pundits did not see this coming. Equity analysts were shocked, too. And markets always love to react to changes in expectations ...

In March 2006, the Department of Defense published details of the defense budget President Bush took to Congress. It projected a U.S. defense budget for 2007 about $28.8 billion less than the one for this year. It also estimated that we would not see defense spending on par with 2005 levels for at least the next three years. With a lull in budget growth already expected even before last week’s Democratic sweeps, defense stocks would seem like a place you would not want to have money. In fact, over the last week, that sector has seen some bloodshed – with the minnows of the group taking it the worst. Our scan of performance in the aerospace and defense sector over the last week shows that eight of the top 10 losers since the November 7 elections have been small-cap and micro-cap names.

The major defense companies, like Lockheed Martin and Northrop Grumman, held up well to the Democratic win. The reason is most likely because the 2007 defense budget will still be the largest portion of the total Federal budget. Another major reason is that no political party would want to be seen denying troops of their necessities while they are on the ground in a combat theater. So until the Democrats engineer a troop withdraw, adequate funding should remain in place. Not all defense stocks took this shift in power badly, though. One of the big winners of the week was small-cap Hi-Shear Technology (HSR: AMEX). This is a diversified company that makes many aeronautical components, but one of the more interesting military products it makes is laser ordnance for the U.S. Army. So the big question is: Are defense stocks a good play these days or should investors now stay away? The answer is, you need to be selective, as always.

Take HEICO (HEI: NYSE), for example. It is a $1 billion, small-cap aerospace and defense company that provides engine parts and services for commercial aircraft, and an extensive suite of test systems for military applications. And with the specter of a falling defense budget in the near term, the company is actually prospering. On August 30, the company reported Q3 2006 results, which included record net sales and record operating income. This was the sixth consecutive quarter in which they did so. And in the last six months, its stock has gone up 25%. Insiders have been making many purchases recently of HEI shares – many of which represented substantial percentage increases to their HEI holdings. HEICO’s debt-to-total capital is a very attractive 12%. But HEICO’s strong performances over the last several years have attached a premium to its shares – and the stock is now pretty pricey. This is a stock, though, that I would consider recommending if its price pulls back.

Link here.


On the surface, it seems that there are diametrically different views at work in the markets. While the rising bond prices and the falling commodity prices apparently suggest underlying distinct economic bearishness, the sudden surge in stock prices and persistent record-low credit spreads appear to reflect very optimistic expectations about the economy.

Considering that the rate of decline of long-term rates has occurred against the backdrop of a firmly inverted yield curve, implying that expenses of carry trade exceed current yields, the strength of the move in bonds seems a bit surprising. The quick capital gains, though, have richly offset the interest expenses ... for the time being. But to maintain these highly leveraged positions, it will need at least one of two things: either a further sharp fall in long-term rates providing new capital gains or rate cuts by the Fed reducing the costs of carry trade.

More surprising is the new bull run of the stock market in the face of an economic slowdown. Approaching recessions have always tended to depress stock markets in expectation of falling profits. Well, there is a tremendous difference between past and present experience. Past recessions were all triggered by true monetary tightening, hitting both the economy and the markets. The current economic downturn is unfolding against the backdrop of unmitigated monetary looseness. While the Fed has raised credit costs from unusually low levels, it has done nothing to tighten credit. Its expansion has kept accelerating. Credit demand has been running wild for consumption, housing and financial speculation. Ominously, however, corporate credit demand for fixed investment remains zero. Corporations have been borrowing heavily, but for mergers, acquisitions and stock buybacks, not for productive investment.

It is certainly reasonable to regard the strong trend of corporate stock purchases as an early negative indicator of investment intentions. The old-fashioned way of organic growth is via creating new plant and equipment. The alternative is to purchase growth and higher earnings through mergers and acquisitions by going more deeply into debt. What, then, has been happening more lately to mergers and acquisitions? In short, they have gone crazy. This compares with continuously weak capital investment. This tendency towards “purchasing” growth and earnings started in the 1980s, strongly intensified during the 1990s, and has gone to extremes during the last few years.

Stating this, we primarily have the long-term development in mind. But in the same vein, we are pondering what is going to happen to business investment in the short run, when consumer spending slows, or even slumps, in the wake of the bursting housing bubble. Generally highly optimistic expectations and forecasts about investment spending taking over from consumption as the driver of the economy greatly puzzle us. To stress one important point, which appears to be generally overlooked: Some rise in capital spending is not enough. Given its much smaller share of GDP, it takes a very strong rise to offset even a minor decline in consumer spending.

While the markets seem to reflect highly conflicting views about the U.S. economy’s outlook, we nevertheless presume one underlying common view, and that is the perception of very little risk of a possible recession because the Fed would, in any case, swiftly act to head off any gathering weakness. What matters from this perspective both in the bond and stock markets are impending rate cuts. In essence, this is in line with the conventional thinking that the U.S. Great Depression of the 1930s and Japan’s prolonged malaise since the early 1990s could have been avoided by prompter monetary easing. Whoever believes in this is entitled to be bullish both on stocks and bonds.

U.S. stock prices received their lift since June/July mainly from lower oil prices and lower long-term interest rates. To keep heading higher, it will now need sufficient earnings growth. If you look at the profit development of U.S. corporations over the last 10 years, you will see that it is an awkward picture. Profits fared very poorly during the “New Paradigm” years of the late 1990s, presumably a time of excellent economic performance. While “New Paradigm” ballyhoo and stock prices flourished after 1997, business profits, as officially measured, suddenly slumped.

No less astounding is their sudden steep rise in the course of 2005, from $624.2 billion in the Q4 2004 to $1,027.7 billion in Q1 2006, happening while the economy distinctly slowed. Coming to the recent recovery years, we must point to some irritating observations. From recession year 2001 to 2005, profits of businesses in the nonfinancial sector have more than tripled, from $322 billion to almost $1,100 billion – the best profit performance of all time. However, this good-looking total consisted of two extremely different parts. It was in the first quarter of 2004 that profits exceeded their peak of 1997 for the first time. From there, they shot up almost vertically. Typically, it has been inverse that the very first years of recovery were best for profits.

Link here.


I just finished two new books about investing. One, written by a capable analyst, tackled global investing directly. The other, penned by a famed money manager, did so only indirectly. But the message behind both books was simply this: investors need to look abroad.

We will start with the indirect first. Christopher Browne of Tweedy, Browne fame just published a book called The Little Book of Value Investing. In it, he lays out some basic thoughts and ideas on how the aspiring investor may add to his financial breadbasket. The book is in the Graham and Dodd tradition – espousing simple verities about the virtues of buying cheap stocks. It is like a little country store. But instead of polished apples and sweet corn, the shelves hold bags of polished wisdom and sweet dollops of moneymaking advice. But what struck me, buried among the homespun maxims, was his emphasis on global investing.

Browne gleefully tells readers of his exploits kicking around in faraway markets. Like an eager traveler returning from his first look at the pyramids of Egypt, Browne talks about the glories of picking up cheap stocks in Japan, South Korea and Switzerland. In the late 1990s, free-spirited investors could find Japanese homebuilders, media companies and textile mills selling for less than the cash on their books. In 2003, Browne uncovered a Swiss conglomerate loaded with valuable assets whose stock traded for only one-half of an understated book value. In two years, the stock doubled. He writes about Dae Han Flour Mills of South Korea, which he picked up for one-third of book value. Browne spends considerable ink on the rationale behind global investing, understanding foreign accounting, what to make of foreign currencies and more.

But for all the convoluted reasons others often offer up for investing in foreign stocks, Browne offers one that is crystal clear: “If you expand your horizons to all the developed countries of the world,” he writes, “you can double your chances of finding cheap stocks.” Browne also offers another basic, yet compelling, observation. When you rank the top 20 companies in the world by sales, you find 12 of them maintain headquarters in Europe or Asia. What holds true at the top also holds true in the middle and at the bottom. There are good mid-size and small companies tucked away in places other than the U.S. Stateside investors ignoring these other opportunities have restricted their choices unnecessarily – and they do not know what they are missing. Today, of the $14 billion in assets Tweedy, Browne manages, about 70% is in international stocks. And about a third of that is in small companies with market caps of $5 billion or less. Among his current favorites spots are South Korea, Japan and Mexico.

The second book tackles global investing directly. Finding the Hot Spots is the title of David Riedel’s new book. A former Salomon Smith Barney farmhand, Riedel now heads up his own independent research firm. Riedel opens his book with several myth-slaying pages. To the charge that investing overseas is too risky, Riedel turns the microscope on U.S. markets. Corporate mischief and thievery pepper American companies as well. Investors also have a way of looking down at foreign firms because they believe the information they are getting is not reliable. Again, Riedel points out that unreliability is not unique to overseas markets. In my personal experience, the disclosures can sometimes be even more thorough overseas than at home. Foreign firms know they have an extra hurdle to clear.

The most interesting aspect of Riedel’s book is the numerous profiles of foreign firms. Many of these are companies you have never heard of before. And they trade on U.S. exchanges. Riedel discusses China Yuchai, for example, which makes diesel fuel engines. Another interesting China play is Bodisen Biotech. Despite its name, Bodisen is simply a producer of fertilizer in China. This one looks interesting. As I write, the stock is about $9 and trades for only 12 times trailing earnings. The company has no debt and nearly a dollar a share in cash. Riedel’s book gives plenty of interesting ideas like these.

Another good reason to invest abroad is to give you some exposure to a currency other than the frail and waning dollar. Last year, Brazil’s market rose about 30%. Moreover, the Brazilian real also rose against the dollar by about 14%. So all told, U.S.-based investors in Brazilian stocks turned a 30% market gain into a 50% gain in dollar terms. Not that you will always get that extra wind behind your back. But it shows you an unappreciated force in global investing.

In summary, plenty of options lay before investors these days. Consider the opening up of Eastern Europe or the booming economies of Asia. Or look at the brightening prospects in parts of Africa. Or easily overlooked South America. Both Browne and Riedel remind us of the potential in these markets. They nudge us on to take a look beyond the fringe of trees on the horizon and explore other lands under the big open sky.

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


Our concentration at the moment, is mining. It has not always been that way, nor will it be in the future. But it has been the best possible place to be for the last five years, and I expect that will remain the case for about the same time going forward. Simply, the trend is our friend, for a number of reasons. Among those is the well-established progression of market phases: Stealth, Wall of Worry, and Mania.

The mining market was in a stealth bull market from about 2000 to 2003, a time when most people did not even know, much less care, that the sector even existed. The stealth phase is when the easy and lower-risk profits are made. In those days a good number of companies we recommended were selling for less than cash, giving us all their other assets for free. Back at the time, there were very few people who had the knowledge, or courage, to buy shares in an industry that had been in a generation-long bear market.

We transitioned into the Wall of Worry stage in 2003. At that point, metals prices were perking up, and some observers realized that early investors had already made a killing. As is typical for this stage, over the past few years we have seen a smattering of reports out of major brokerage firms talking about the sector from a “pros and cons” point of view. You have heard the arguments. But all the while, the mining stocks keep moving higher. And because of their immense internal leverage, many are quite underpriced relative to the metals they produce (or hope to produce). So, we are still in the Wall of Worry phase. When will it end? Hard to say. But my guess is fairly soon. Then we should enter the Mania phase.

All great bull markets end in a mania. It is interesting to contemplate why this is. Books have been written on it. In essence, however, it is a matter of psychology and economics. Psychologically, when people see others making a killing, they cannot help but join the party. Especially if there is a credible reason why it is a good idea. The nice thing about this gold bull market is that the story of why gold is going up not only tells very well, but very few investors (in today’s world) have actually heard it. That means almost nobody owns gold. And that is good, because it means the only thing they can do is buy it.

The coming mania for gold stocks will, I suspect, be extraordinary for a number of reasons. One is that, due to the huge bull market in common stocks from 1982 to 2000, absolutely everyone who has any spare capital at all has opened a brokerage account. They all got involved in the Internet and tech frenzy and saw that it was possible to make money in the stock market (even though very few actually did). They are primed for another go at getting rich quick. Meanwhile, economically, the conditions are right for a mania in gold stocks. The government has no option but to continue a massive inflation of the dollar. And inflation inevitably does two things, among others: (1) create a speculative psychology among the public, as they search for some way to beat the debasement of the currency, and (2) direct people’s attention towards hard assets.

And in terms of market value today, most mining stocks are not even micro-caps. They are nano-caps. The world’s total market valuation of publicly traded gold equities adds up to only about $150 billion, or just 0.33% of the $45 trillion combined value of the world’s equities. When – not if – even a fraction of the bigger investment pie starts to shift toward gold stocks, these stocks should move at least as explosively as the tech stocks did. My feeling is that what we will see in mining stocks over the next few years will be something for the record books.

Link here.


I just recently read Marc Faber’s October Gloom, Boom & Doom Report. Faber’s contrarian financial views often appear in various media outlets. His latest issue included an interesting little piece on grains written by Mark McLornan, of Agro Terra Ltd. The piece opens with a question that is right up my alley: “Where in the world can you buy real assets that are cheap, uncorrelated to economic cycles, and independent of interest rates? What asset class can take advantage of the major cyclical forces of China/India development, global warming, and depleting water resources?”

I spend a considerable amount of time thinking about where to find cheap tangible assets. More than just finding cheap assets, I also like to see that the investment somehow cashes in on some bigger trend or idea. I have forged a good track record finding just these kinds of opportunities. And in the last few months I have also added some nice investments loaded with tangible assets and wealth creating businesses. McLornan, not to leave us hanging, gives us his own investment candidate – grains. “The agricultural grains market has been totally uncorrelated to economic cycles for at least the past 50 years. The main factors driving grain prices are a combination of population growth, increases in standards of living, and production capacity.”

I also like the grains. I recommended Agrium (NYSE: AGU) in January 2005. It has nearly doubled over that time. Saskatchewan Wheat Pool (TSE: SWP) is a little below my entry price as I write, but a good story is unfolding there. Here are some of the key points McLornan mentions:

Net-net, McLornan’s observations all add up to a bullish outlook for grains. That is a good backdrop, too, when you think of Saskatchewan Wheat Pool. The Pool announced an offer to buy Agricore, the other leading Canadian grain handler. “We are attempting to create a significant agri-business with decades of expertise, superior assets and a truly unique home grown Canadian advantage,” said SWP president and CEO, Mayo Schmidt. “By combining operations we will create the scale and scope of operations to enhance Western Canada’s position in a global environment.” I love the deal. Whether it will happen or not is another matter. Regulators will have to approve it and given Canada’s rather hostile turn on business lately, maybe we should not count on that.

In any event, with their rock-solid finances Pool is in good shape to position itself as a global player in the coming boom in agricultural markets – in particular, the grains. Saskatchewan Wheat Pool is a buy.

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


Robert Rubin, Treasury Secretary under President Bill Clinton, of the famous line “a strong dollar is in the best interest of the [United States]” (and what is funny is that it is now reported that Rubin has taken on some huge option positions in currencies! Ha ha ha.) and my favorite Fed Chairman Paul Volcker sat on a panel yesterday. Basically, I would think these two to be on opposite ends of the earth regarding economics, but suddenly they turned into a choir, singing from the same song sheet. Rubin and Volcker (who has said that there is a 75% chance of a currency crisis) are in agreement. Over what, you ask? Ahhh grasshopper ... come sit, and hear this one!

Rubin and Volcker said “foreign investors probably will not keep increasing dollar holdings, raising the risk of a slump in the currency.” Rubin said, “Failure by the U.S. government to shrink its budget deficit may spook the central banks, hedge funds and others who have been buying Treasury notes.” Volcker said, “The U.S. borrowing requirements raise the risk of a ‘crisis’ in the dollar as soon as the next two and a half years.”

WOW! See why I do not understand why traders did not pick up on this and send the dollar to the woodshed immediately? Wait ... I think we need to wait on this one. I will bet that this will get regurgitated at some time in the near future, and everyone will point to it as “the reason the dollar is falling again.” When in reality, the reason the dollar will begin to fall again is already in place ... fundamentals.

Link here.
China’s central bank has been buying yen – link.


Thank you for contacting me regarding fiscal responsibility and tax reform. I appreciate hearing from you, and I noted your suggestion to read the book Empire of Debt.

I agree with you that our debt is extremely troubling, and I am disturbed that some in Washington seem to regard the debt as a mere inconvenience rather than the actual threat it represents. Over the last four years, the country has experienced the worst fiscal reversal in history, which is not a temporary deficit due to the economic slowdown or the costs on the war on terrorism. Instead, the $5.6 trillion 10-year surplus the President inherited is now a deficit of $2.8 trillion, creating a total fiscal reversal of almost $8.4 trillion. That amounts to over $25,000 of debt for every man, woman, and child in the United States and threatens to leave our children and grandchildren in debt for a generation.

This massive debt will have a serious and damaging effect on our economy.

In order to attract enough buyers to soak up all this debt, long-term interest rates are likely to be higher than they otherwise would be.

Additionally, as government debt eats up a growing share of investment dollars, the private sector will have less and less access to capital.

Businesses will not expand and create new jobs at the pace they otherwise might have. That means that, not only will our children have to shoulder the burden of paying back this massive debt, they will also have to contend with a job market and an economy weakened by irresponsible budgeting.

The budget surpluses that we achieved in the late 1990s and early 2000 resulted from a strong economy and some hard choices by President Clinton and Congress. I supported these budgets, but I have been unable to support the recent budgets, awash in red ink. These deals have eroded our country’s surplus and its economic security. Please be assured that I take this issue very seriously and will continue to fight for a renewed commitment to fiscal responsibility.

I also noted your concerns about tax reform. ... Throughout my career in Congress, I have been a strong advocate of tax reform. My leading concern when considering any proposal to change the tax structure is to ensure that no change places an unfair burden upon any particular segment of the population. We must also ensure that any tax changes spur job creation and encourage saving and investment. When Congress considers the panel’s recommendations for reforming our tax code, you may be certain that I will keep your thoughts in mind.

Again, thank you for taking the time to contact me. I look forward to hearing from you in the near future.

My best wishes to you.



United States Senator

Link here.


One of the biggest scams ever perpetrated is the idea that the stock market has made people rich over the past 80 years. Almost the entire gain in the Dow is due to debasement of the currency. The first chart below shows the DJIA (reconstructed prior to 1890) priced in dollars, and the second chart shows the Dow price in real money, gold, since the founding of the Republic. If you look closely, you can see that both charts are identical for well over a century, through 1933. Then they utterly diverge.

Now look at the bullets in the second chart. The Dow today buys less gold, and by extension less in the way of goods and basic services, than it did in 1929. Because gold was fixed at $20.67 per oz. until January 1934, we may take the first three decades of the century as the nominal Dow’s benchmark, because during those years the nominal Dow and the Dow/gold ratio moved precisely together. Had the dollar remained worth 1/20.67 of an ounce of gold, then today the Dow would sell at 340 – not 11,700. That is what it does sell for today when it is denominated in constant, gold-valued dollars. The entire net gain from 1929 today is an illusion.

The real price should be no surprise. Our railroads are rusted out, the auto companies are failing, and except for computers American industry in general is so crippled by regulation that it cannot compete successfully in the global marketplace. This is the legacy of 93 years of expanding indebtedness, fostered by a wave of runaway optimism and fueled by a paper money monopoly in the form of the Federal Reserve System.

The illusion of the Dow’s value since 2000 hardly pales by comparison. Investors have broken out party hats in anticipation of celebrating a new Dow high, but in terms of real money, the Dow has crashed since 2000. At the May 2006 low, the Dow in terms of gold was down 64.28% from its 2000 high! In other words, you can buy 1/3 the amount of gold now with your 30 Dow shares than you could have in 2000. You can buy even less oil and copper. Yet people think the Dow is unchanged. If we normalize the Dow to its 1999 peak in gold terms, it would be in the 4000s today.

If deflation occurs as we expect, these values will fall substantially back in line, and the Dow will decline in dollar terms as well. Credit bubbles always lead to collapses. We hear from many quarters – both from bulls and bears – that “this time it’s different.” Time will tell.

Link here.
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