Wealth International, Limited

Finance Digest for Week of November 20, 2006

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


We are holding three Treasury-related ETFs: SHY for short-duration Treasuries, TIP for inflation-protected Treasuries, and TLT for long-duration Treasury bonds. These all carry a significant dividend yield, with TIP paying over 5.6% at current prices. The Treasury bond bull market is alive and well, having testing long-term trend lines at the highs (for yields) this summer. 30-year Treasury yields took three years to go from the bottom of their 26-year downtrend channel in 2003 up to the top of the channel this summer. The bottom line is that there has not been a long-term long-bond buying opportunity like this one since early 2000 – the last time yields touched the top of their channel. We entered TLT with this in mind, and if yields make their way down to the bottom of this channel over the next two-three years like we expect them to, we will be looking at a huge gain for this position.

We entered SHY in late September when we were reasonably sure the Fed was done hiking short-term interest rates. With that rate-hiking campaign in the rearview mirror, and with the strong likelihood that the Fed will be cutting rates before it hikes them again, short-term Treasuries held by this ETF will benefit. So while the Fed seems to be completely preoccupied with fighting inflation, we Survivors are well aware that the yield curve remains fully inverted, signaling the bond market believes there will be lower short-term rates in the near future. We believe the bond market over the Fed. Our position in TIP is much less volatile and pays out a much higher yield than either TLT or SHY. Bottom line is, if you are looking for a few safe positions to buy and hold over the next two years, these three Treasury ETFs are about the best opportunities out there.

We are holding three commodity-related long positions: GDX, OIH, and SJT. These positions are more speculative than our Treasury positions, but they are also in sectors that represent some of the best long-term opportunities out there. The GDX position is our endorsement of gold and silver mining stocks, often represented by the HUI and XAU indexes. After topping out in May at 401, the HUI index has since made two lows near 270. We waited for the second low in early October and bought GDX. It is likely that mining stocks have now embarked on a new bull run that will take them beyond the May high, but there is also the chance that the HUI could return to the 270 area one more time, so be prepared for that. Having said that, the weakness over the past few days is most likely the start of a correction of the recent rally from the 274 low in October to the recent high at 341. If we get a nice corrective decline over the next week or two, we will know the gold and silver bull is about to bust out in a major way.

Our recent purchase of OIH [oil services ETF] comes at a time when oil is continuing its decline to new 2006 lows. Yet the stocks are telling us a new upswing has begun within the ongoing bull market. It looks like the stocks are leading the commodity here. If, instead, the breakout in oil stocks turns out to be a fake-out, we will see a three-year bull market come to an end and take a small loss. Our position in SJT remains in good standing. It has earned a 3.7% yield in six months, and the shares look ready to break out of a 1½-year-long bear flag. There is the chance SJT could decline back to the low end of the flag near $32 again, but it looks more likely that it will head up from here. We will likely hold this one until oil stocks in general give us a definitive signal that the bull market from 2003 is over.

Bottom line: We are selectively adding positions to the commodities sector, under the assumption that the long-term bull market remains intact (especially in precious metals). 2006 has been a year of correction and consolidation for many commodities and related stocks, but much of the risk that was present earlier in the year appears to have been washed out. We will continue to add positions as the opportunities arise and hold our existing positions until the market proves to us the bull trend from 2003 is over.

While our positions in commodities and Treasuries are doing well, the rally in stocks over the past few months has taken its toll on our stock index positions – all of which are shorts. We have been highlighting the deteriorating economic backdrop this market finds itself in, but so far, it has ignored signs, such as the inverted yield curve and the troubled housing market, and focused instead on the decline in oil prices and the end of the Fed’s rate hike campaign. The other issue is the passing of the four-year cycle low this fall. The strong rally over the past few months could possibly be a 1994-like reaction to the 4-year cycle low, which would leave the door open to continued strength in 2007.

This outlook could not be more at odds with the fundamentals we are observing. However, the market does what the market wants to do, and if this rally from the July low is the first leg up from the 4-year cycle low, we will need to adjust. This chart shows the rally in its entirety. There have been three stages to the rally thus far, which is a common occurrence. And it now appears we are in the third and, likely, final stage: There are technical divergences in volume and breadth, which are usually seen at the end of a rally. This does not mean an end to the rally is imminent, but it does mean it is likely in its final stage. And when it does end, there will be a correction, the nature of which will give us a lot of information about what will be in store for 2007.

We are short high-beta markets that usually amplify the movement of the U.S. markets, which is why our short positions in EWG (Germany) and EEM (emerging markets) are currently showing the largest losses. Canada’s stock market has been lagging behind the U.S. and other world markets due to the fall in oil prices, and our EWC short position is showing a smaller loss, due to that and because the Canadian dollar has ended its four-year bull market against the U.S. dollar. Our four domestic short positions, IWM (small caps), IYT (Dow transports), SPY (S&P 500), and QQQQ (Nasdaq-100), are currently showing modest losses after being ahead at the summer lows.

Our stock indexes portfolio is geared for a bear market brought on by a weakening economy, and not much has improved on the fundamental side since this rally began. That leaves us with two possibilities: the market is either seeing better times ahead, or it is way behind the curve and being driven by other technical influences – which can reverse at any time. Whether or not we exit our stock index short positions in the next month will be determined by what we see the market projecting for 2007.

From most recent weekly Survival Report update.


Derivatives trading soars to $370 trillion – it will be the root cause for global depression.

An interesting data came out from the Bank for International Settlements. The global market for derivatives soared to a record $370 trillion in the first half of 2006. It is the highest ever and the bubble is bigger than any one can imagine.

The kind of euphoria in derivative trading has never been seen before. The amount of outstanding credit-default swaps contracts jumped by 60% at the end of last year. This year the rise is even faster. It is a typical pyramiding technique. Money is creating false concepts of money and that in turn is creating ever larger amounts of conceptual money. When the balloon bursts, the catastrophe will be unimaginable. The 1929 debacle and resulting depression will be miniscule compared to what is coming.

The derivatives were initially designed for hedging. It has now become the instruments of trade. As an example of what can happen, recently when Amaranth, the hedge fund, bet on the wrong side of the natural gas market, it lost $billions in days and went out of business – taking with it the capital of many investors. But something more sinister happened in the London credit swap market. On the news of Amaranth’s problem, the credit swaps based on Amaranth funds collapsed create a massive problem for the London credit instuments markets. Even that little hedge fund was able to bring the market to its knees. What about when many hedge funds collapse at the same time?

Remember 1987? Before the October crash, the public were arguing about the fact that the market would not give an inch on the down side. Finally, when the crash came, the brokers did not pick up their phones and Dow lost more than 20% in one day. Something much more serious is getting cooked here. The complacency level, the sentiment indicators and above all the fundamentals are all ready to make the market collapse big time.

Link here.

The dangerous games managements play.

It is an interesting term, risk management. It sounds so organized and reassuring. A risk that is managed is tamed, brought within well understood parameters and reduced to a level that shareholders can tolerate. Investment bankers and their tame economists constantly tell us that the derivatives market has reduced risk in the financial system and made corporate earnings stabler and more predictable, so it must be true, right?

So why has Ford had to restate its last 5 years’ earnings? Why has Fannie Mae still to produce a 10-K annual SEC filing for 2004, in the process of doing which it will wipe $11 billion off the earnings already reported for the years 2001-2004? What precisely is “managed” about an $11 billion write-off that takes 2 years to compute?

Derivatives trading totaled $370 trillion in the first half of 2006 and is still rising rapidly. That is almost 10 times Gross World Product, so even though derivatives volume is hugely overstated (because the value of a derivative – an option or a swap – is a small fraction of its nominal amount) and trading volume includes large amounts of Mickey Mouse round-tripping among the dealer community, it has clearly become a very large business indeed.

The derivatives business, in its modern large scale form, originated in the 1970s from two pretty well separate sources, stock options and currency options trading on the Chicago exchange and the parallel loan/swaps market in London. The separation between the two markets’ origins is reflected in the different rationales available for derivatives’ use. Options trading in Chicago was always primarily a speculative activity, whereas currency and interest rate swaps were initially used primarily for hedging. Thus derivatives today are often sold as hedging vehicles, but may in reality reflect buyers’ wish to speculate on their own superior intuition.

Traditionally, derivatives losses resulted from trading mistakes. In a classic ‘90s example, the German company Metallgesellschaft lost $1.5 billion in 1993 in the oil markets. That was a typical trader-driven loss, as were similar disasters at Barings (bankruptcy, from Japanese stock futures) and Orange County ($1.6 billion loss in Treasury bond futures) in 1994-95. These losses all had in common trading in excessively large amounts by improperly controlled traders motivated by the lure of short term personal profit.

The Long Term Capital Management hedge fund collapse of 1998 spotlighted a different problem. Again, excessive trading volume was partly at fault. LTCM’s risk management systems were state of the art, with two Nobel Prize winners on the Board of Directors to confirm that LTCM was managing its risks in line with the finest tenets of modern finance theory. It appears that the LTCM people were so convinced they were the cream of the intellectual crop that they failed to allow for the possibility that their models were rubbish. This should have caused an episode of deep risk-aversion in the derivatives markets, but 1998 being 1998, it did not.

Then there was Enron. The thieving was actually minimal in the context of Enron’s overall size. The collapse resulted from sheer incompetence. Enron was running a huge energy trading operation from a company whose debt rating never exceeded BBB. When the market turned against it, Enron’s counterparties quickly required additional collateral to be posted and the house of cards collapsed. Enron’s energy trading operation was perfectly viable, as has been demonstrated by its subsequent success within UBS, but was far too big for anyone but a major international bank.

Unlike earlier derivatives catastrophes, Ford’s and Fannie Mae’s losses do not relate to poor trading, but from the difficulty in valuing a large portfolio of derivatives in financial statements. With derivatives valuation, companies are allowed to divide derivatives positions between trading, in which positions are marked to market and profits and losses taken and hedging, in which they are held for the long term against the asset being hedged. You are supposed to decide immediately when you buy the derivative which category it will go into. In the case of Fannie Mae, management had been holding new derivatives positions for several weeks to see which way the market went, and then recording them so as to book the profits and leave the losses as hedges, to accrue over the life of the instruments concerned. Needless to say, when this trick was discovered much later, after Fannie Mae management had collected several years of record bonuses, it was more or less impossible to determine what the correct position should have been – thus the accounting uncertainty and the two years of cleanup work.

Derivatives are sold by investment banks to corporations seeking to hedge risks in interest rates, currencies, equities or commodities. To the banks selling them, who make trading profits through their knowledge of the deal flow, they are a wonderful business. To corporate management, which can use them to create artificial profits in a quarter in which earnings are falling short of forecasts, they may also be attractive – any accounting restatements occur several years later, and pass almost unnoticed by the market. Trading credit derivatives is a huge distraction from management’s primary purpose of running their basic business. To corporate shareholders derivatives are all risk and no reward. In addition to the risk of a rogue trader, the risk of a hedging system that proves flawed and the risk of overtrading, shareholders also suffer the risk of corporate management dressing up earnings.

There are a number of partial solutions which shareholders can adopt to this problem. One is to reverse the organizational change, adopted in many companies in the 1980s, which made the finance function a profit center. It is much cheaper and safer for shareholders to insist on the finance function being headed by a Controller, make it responsible only for raising money, preparing budgets and controlling expenses, and return it to being a cost center. This will reduce enormously both risk and cost. If this does not work, shareholders need to change the company’s Articles of Incorporation, to prevent it entering into derivatives contracts at all. By eliminating the ability to create short term profits from “hedging” the company’s financial statements will become more transparent and its finance function much cheaper.

If companies adopt these approaches, Wall Street’s revenues from trading derivatives will be slashed – the investment banks will be reduced to gambling with each other in a perpetual zero sum roulette, which no doubt will produce for most traders a satisfactory flow of bonuses, at the cost of an occasional bankruptcy by the game’s losers. Eventually even the downtrodden investment bank shareholders will get tired of this activity – but at least Wall Street will no longer be able to feed itself from the misguided “hedging” of the corporate sector.

Link here.

Derivatives “insurance”.

A question from a journalist: “How does the Fed view this growing (derivatives) market and can we continue to grow at the rapid clip without causing systemic risks?”

Federal Reserve Bank of St. Louis President William Poole: “I’m not speaking for the Fed as a whole. My own position is that the derivatives market is a very fine extension of the depth of our financial markets, because it allows firms to lay off risks and to assume risks at a very measured and targeted way. ... I’m a big fan of the derivatives markets. I think that they perform a valuable service in our economy, and I would also say that the derivatives markets provide a lot of valuable information to the Federal Reserve ... I think that these markets are by and large inhabited by people who are very professionally competent in using those markets. Obviously there are some amateurs or people who after the fact will learn that they’re amateurs in these markets. But by and large these are competitive and very good markets. I applaud the development of these markets. I think it’s good for the economy and good for the Fed.”

Clearly, Mr. Poole and the Federal Reserve are oblivious to the precarious mania that has unfolded throughout the credit derivatives/“arbitrage” arena. This lack of responsible oversight is not surprising considering the Greenspan Fed’s role as vocal proponent for the burgeoning derivatives markets. Still, after the 1987 “portfolio insurance” melt-down, the 1994 mortgage derivatives fiasco, 1995 Orange County and Mexico debacles, the Southeast Asian dominos collapses, Russia, LTCM, NASDAQ, telecom debt, and Argentina – to list a few major derivative-related market dislocations – I find the Fed’s current complacency rather astonishing.

It is fair to assume the Fed’s sanguine view has been further hardened by the recent placid backdrop greasing interest-rate and currency derivatives markets, as well by the extended period of relative tranquility in the enormous markets that evolved to hedge mortgage and MBS risks. Currency and interest-rate derivatives expanded phenomenally, setting the stage, one would have thought, for major problems. Yet these marketplaces have been tested by a multiyear dollar decline and a 2-years plus interest-rate “tightening” cycle. However, the unfolding risks associated with the proliferation of strategies and resulting explosion of credit derivatives trading have characteristics that contrast materially to recent experience in currency and interest-rate markets.

Let me attempt an explanation, first with respect to the currency derivatives marketplace. Importantly, currency markets have benefited incalculably from the foreign central bank liquidity backstop. This has ensured that, despite the ongoing dollar bear market, derivatives “insurance” to protect against a dollar decline has remained inexpensive and readily available. In history’s greatest market intervention, foreign central bank (chiefly dollar) reserve holdings have since 2001 ballooned from about $2 trillion to today’s $4.7 trillion. On the back of virtually limitless central bank dollar support, market players – especially speculators writing derivative protection – have operated both with the confidence that markets would remain highly liquid and without the fear of abrupt marketplace dislocations (that cause bloody havoc for derivatives hedging strategies). The resulting cheap and readily available “insurance” has created a perception that fear of further dollar weakness is no cause to liquidate U.S. securities or assets. Instead, simply hedge with derivatives!

While there may be some justification for Dr. Poole’s and the Fed’s view, it is nonetheless a myth that derivatives reduce risk overall. Today it is quite the contrary. The booming derivatives markets are part and parcel to the explosion of global leveraged securities speculation. A mania in writing market “insurance” (interest-rate, currency, equities, credit, etc.) has grossly distorted the pricing of risk throughout the system – along with cultivating the perception of ongoing availability of cheap derivatives protection. The series of unprecedented interventions in the currency, mortgage, and interest-rate arenas over time nurtured what is now a proliferation of “credit arbitrage” speculations – derivatives that profoundly increase systemic risk through the expansion of volumes of risky credits at this late – exuberant – stage of the credit cycle. To make matters much worse, the speculators today writing derivatives “insurance” have little in the way of actual resources that could be made available in the event that this protection is called upon to mitigate losses. It is not at all clear who will step up to take the other side of ballooning credit “insurance” trades when a faltering credit cycle inevitably forces speculators to rush to hedge (i.e., sell the underlying bond) or liquidate their positions.

Fundamentally, credit losses are not even insurable – “insurance” denoting the payment of a premium for protection by the writer of loss protection against independent and random risks. Credit losses are categorically non-random and non-independent. During the upside of the credit cycle, abundant credit ensures seductively minimal defaults and losses. Profits from “writing flood ‘insurance’ during the drought” entice a reflexive boom in credit speculation, availability, and excess. The environment, however, is prone to turn on a dime. Unquestionably, data from the cycle’s upside will misrepresent downside risks, and the longer the cycle’s upside the greater the risk distortions. The cycle’s final “terminal” phase – replete with extraordinary credit availability, seemingly endless market liquidity, marketplace euphoria and resultant gross economic maladjustment – creates perilous distortions in the perception and pricing of myriad risks.

The problem as I see it today – a dangerous situation that goes largely unrecognized – is one of a freakish credit cycle that has been perpetuated by a series of interventions (Fed, GSEs, and foreign central banks) – significantly extending the “terminal” phase of perilous excess. In short, the greatest credit cycle ever has its finale in highly leveraged speculations and myriad derivative bets on the worthiness of risky credits, in the process inciting an issuance boom in the most susceptible loans.

Surely, the Fed today lacks the flexibility it enjoyed in 2001. Housing bubble vulnerability is keeping it from actually tightening financial conditions, leaving “terminal phase” credit excesses to run unchecked. At the same time, one would assume that speculative excess will hold Fed easing impulses at bay. I am left with the uncomfortable feeling that – with U.S. mortgage, government, corporate, financial sector and global credit bubbles now largely synchronized – the long-overdue initiation of the credit cycle’s downside will be systemic in nature and likely triggered by some market development.

Thinking back to Dr. Poole’s comment that “derivatives markets are an important source of information,” I believe that highly speculative derivatives markets at key junctures provide especially misleading pricing signals. These days, for example, a squeeze on those on the wrong side of the global collapse in credit spreads is only exacerbating the mis-pricing of derivatives “Insurance” and risk generally. At the same time, an unwind of speculations is distorting the energy and commodities markets. Meanwhile, a short squeeze is inflating the stock market value of scores of companies – many with questionable fundamentals – in the process encouraging a misallocation of resources reminiscent of the 1990s (but much more broad based). And the Treasury market gyrates daily on rumors of hedge fund liquidations and problems, while currency traders bet on the prospect of the dollar bears getting squeezed.

I know of no other period marked by such pervasive market pricing distortions. Unlimited credit/“finance” and unchecked leveraged speculation are the bane of free market capitalism. Yet it’s amazing how recent monetary disorder (inflating stock markets) has the “free market” bullish crowd filling the airwaves with flawed analysis and wishful thinking.

Link here (scroll down to last subheading in left page column).
Derivatives tails are wagging corporate bond dogs – link.


The world is nervous about the implications of America’s stunning political upheaval. At least, that is the impression I have gleaned from a quick post-election spin around the globe that has taken me from our own conference in the Bahamas to Doha, Singapore, and Hong Kong. In a series of meetings with investors, business executives, and senior government officials, I detected growing concerns over Washington’s post-election posture toward geopolitical risks and trade policy. If these fears come to pass, liquidity-driven world financial markets could be taken by great surprise.

At my first stop in Doha, I had the opportunity to address a group of about 75 institutional investors from the Middle East. Doha, now emblematic of the failures of global trade liberalization, is another one of the Gulf region’s most rapidly growing cities. By Dubai standards, this capital of Qatar is a laggard, but considering what little was there just three years ago, the hyper-growth of Doha is nothing short of astonishing. This phenomenon is emblematic of a major difference in the Middle East when this oil shock is compared with the three that preceded it. Due to dollar-pegged currency regimes, dollar recycling still occurs in official channels. But private portfolio investors now have a considerably larger number of domestic options to consider than was the case during oil shocks of the past. Notwithstanding the region’s newfound prosperity, the Gulf States remain fiercely loyal to the Great Protector – the U.S. For what it is worth, this group of major Middle East institutional investors does not believe the political upheaval in the U.S. will lead to a breakthrough in the wrenching problems that continue to plague the region.

I could not resist asking the assembled Middle Eastern investors where they thought oil prices were headed over the next year. The largest chunk of the crowd – fully 36% of them – thought oil prices would fluctuate in the $50 to $59 range. The balance of the group thought the oil price outlook was skewed more to the upside than the downside. The results of this informal survey conducted in Doha were virtually identical to the readings we obtained from our U.S.-domiciled clients who attended last week’s Lyford Cay investment conference. Talk about an amazingly tight consensus – or a strong hint of the dreaded curse of a tightly bunched group of investors!

At my two stops in Asia, I drilled the assembled crowds on the outlook for U.S. trade policy. In my view, externally-dependent Asian economies have far more at stake than any other region in the world in the future of trade liberalization. By a margin of about 3 to 1, groups in Singapore and Hong Kong expressed fears of an increasingly ominous tilt toward trade protectionism by a Democratically controlled U.S. Congress over the next year. Needless to say, these fears were immediately borne out in the form of Congressional resistance to a U.S.-Vietnam free trade zone proposal on the eve of President Bush’s departure to APEC meetings in Hanoi. Meanwhile, protectionist fears or not, ever-frothy Asian equity markets were surging to new multi-year highs as I toured the region. We had record crowds at our Asian Summit in Singapore, and Hong Kong has a new swagger that several seasoned investors told me they have not seen since 1997. Go figure that.

In my in-depth meetings with Asian investors, business executives, and senior government officials, there was a fairly tight consensus of opinion that the U.S. economy would be just fine over the next year – thereby providing more than an ample offset to the recent shift in political winds. In particular, there was a strong belief that nothing would derail the American consumer. Post-housing bubble adjustments were viewed as largely over – and most assuredly containable. I took the other side of the debate on virtually all of those points, but my views were met with polite indifference as the multi-taskers present at my meetings checked their Blackberries for messages and market quotes as I spoke.

In Asia, long the land of some of the greatest boom-bust cycles in world financial markets, I sensed a gnawing suspicion that this boom may not last either. For now, however, there were virtually no concerns of what might lie on the other side. The buzz in Asia is as giddy as I have seen it in years. Meanwhile, the political winds have shifted in the region’s main engine of economic support – the U.S. I suspect a year from now the mood in Asia will be very different than it is today. Moreover, despite the sharp recent decline in oil prices, it is no different in the great new hubs in the Gulf region of the Middle East – especially Dubai and Doha. Euphoria over booming economic development masks any concerns evident elsewhere in this war-torn region. For now, economic triumphalism reigns supreme.

History teaches us to be mindful of the potentially potent interplay between economic and politics. The political winds are shifting in America. The Middle East gets it, and so does Asia. But in these liquidity-driven days of froth, the message rings on deaf ears in the markets ... at least, for now.

Link here.


The stock market has had a great run over the last few months, but as the holiday season begins, some analysts are worrying that the traditional year-end rally on Wall Street may have already come and nearly gone. Mary Ann Bartels, technical research analyst at Merrill Lynch, wondered in a note to investors whether the tendency for stocks to climb in the last couple of months of the year had been rescheduled this year for September and October. “We think yes,” she wrote. She then acknowleged feeling torn between what her charts have told her and what the calendar and history have led her to expect. “It is not our favored stance to be more toward the bear camp looking for a cyclical correction of 8 to 10 percent, but all of the market indicators suggest this is the more likely scenario over the coming weeks. What is surprising is that these readings are occurring at this time of year. Most years see a bullish year-end rally.”

She highlighted several exceptions that prove the rule, including three years in the 1990s when the S&P 500-stock index lost at least 6% at some point during the last two months of the year. What signs suggest that 2006 will play out as those three years – 1991, 1994 and 1996 – did? Trading volume has shrunk, something that often precedes a price decline, she noted, and several sentiment indicators, including opinion surveys of investment advisers and measures of market volatility, show the sort of complacency that typically occurs near market tops.

She also detected a “barbell strategy” among investors, favoring emerging markets on one end and defensive, high-quality American blue chips on the other while ignoring the moderately risky stuff in between. That is similar to the pattern last spring, just before the market took a tumble. These warning flags lead Ms. Bartels to forecast a decline in the S.& P. 500 to as low as 1,260 from its close on Friday of 1,401.20 “All technical signs are pointing to the markets nearing a consolidation period and not a blowoff to the upside,” she said. “We cannot rule out further upside, but the risk/reward warrants a more defensive stance.”

Link here.


Among the certain unalienable rights of finance in 2006 is that of successful hedge fund managers to make a lot of money. That right is embedded in the compensation structure of the funds: Most managers receive 2% of the assets they manage as a management fee and take home 20% of the profits as incentive pay. Many academics and certainly the managers themselves promote the “2 and 20” approach as a positive alignment of interests: The manager makes money if investors make money. But there are flaws to this compensation structure. If managers want to get paid every year, they might be encouraged to take risks to have those profits from which to take their 20%.

Getting paid annually does not always jibe with some styles of managing money, like value investing – the art of buying undervalued companies and waiting for them to be properly valued. If managers show poor returns, impatient investors might yank their money before the market recognizes the stock as undervalued. In investing parlance, that is called being dead before you are right. Lisa Rapuano, a longtime value investor, grappled with these issues and came up with a compensation structure based on the radical notion of delayed gratification. In January, she will start a value-oriented hedge fund that pays her a hefty incentive fee, but only every three years. Lane Five Capital Management charges a 1.5% management fee and takes 40% of any profits that exceed her hurdle rate (the Standard & Poor’s 1,500-stock index) every three years. If the fund has negative returns, she gets nothing.

Her reasoning, which she outlined at the Value Investing Congress in New York last week, was straightforward. She likes the hedge fund model of compensation because it is incentive-based. It is better than the traditional asset management model, which encourages mediocrity. Traditional managers get paid based on the amount of money they manage, not their performance. But she called the 12-month time horizon of hedge fund compensation “less than ideal” because it can cause people to “gun for performance and take undue risks at the end of the year.”

Not surprisingly, competitors loathe Rapuano’s compensation structure idea. If she becomes the industry norm, they make less money. She will pay taxes on money every year that she sees only every three years. She will have to explain to investors that she is different. And she will have to answer the obvious question of why she will not feel even more pressure to perform at the end of three years.

It is unclear whether investors will embrace Rapuano’s revolution of accountability or ignore it. One leader of a major alternative asset management group suggested to his partners that maybe they should charge lower fees to win more business, a well-worn business strategy. He was all but kicked out of the room.

Link here.


M&A worldwide rose to a record $3.1 trillion as leveraged buyouts almost tripled, surpassing the previous high set in 2000 during the peak of the dot-com boom. “M&A tends to follow the global cycle and there still may be about two years of growth ahead of us,” said Robert Jukes, an analyst at Credit Suisse Group in London. “Conditions for M&A are nearly perfect.”

Company CEOs are spending more on takeovers as rising earnings and stock prices make it easier to finance purchases. LBO firms, flush with record-sized new funds, have announced $616 billion of acquisitions, up from $222 billion a year earlier. Blackstone Group LP, manager of the world’s largest buyout fund, agreed to acquire Sam Zell’s Equity Office Properties Trust, the biggest U.S. owner of office buildings, for about $20 billion. Freeport-McMoRan Copper & Gold will buy Phelps Dodge Corp. for $25.9 billion in cash and stock to form the world’s largest publicly traded copper company. Europe is the hotbed for M&A for a second year, accounting for 47% of global takeovers. Financial services is the most active industry for takeovers, with $580 billion in announced deals, followed by telecommunications. The value of hostile takeovers has surged 60% to $241 billion.

“You’ve got a healthy economy, lots of capital available, the stock market is very favorable to M&A activity, and companies still want to grow their top line and expand their markets around the world,” said Alan Alpert, who runs an M&A consulting group at Deloitte & Touche LLP in New York. “When you add that to the amount of money private equity firms have these days, that makes it a very, very favorable and robust M&A market.” The unprecedented volume of M&A is creating a windfall for investment bankers, who will receive record bonuses this year as revenue surges on Wall Street. Compensation will increase as much as 30% this year for merger advisers, private bankers and derivatives and commodities traders.

Link here.
Sam Zell a seller in biggest real estate deal on record – link.


Barclays Global Investors (BGI) has announced the launch of its second exchange-traded fund designed specifically for socially responsible institutional and individual investors. The iShares KLD 400 Social Index Fund seeks to maximize exposure to companies that have positive environmental, social and governance (ESG) characteristics. The Fund seeks to track the Domini 400 Social Index (DSI400) created and maintained by KLD Research & Analytics, a Boston-based independent investment research and index firm with expertise in socially responsible investing (SRI).

“The DSI provides investors with a cost-effective way to invest in a fund that tracks the highly-regarded Domini 400 Social Index, which identifies a universe of socially responsible companies and completely avoids others that derive a substantial portion of their revenues from certain industries such as alcohol and tobacco,” explained Lee Kranefuss, CEO of BGI’s Intermediary and ETF Business. “This new ETF complements iShares’s other SRI ETF, the iShares KLD Select Social Index Fund, which over-weights companies with higher environmental, social and governance (ESG) performance and under-weights companies with lower ESG performance. We believe that BGI is meeting the needs of most socially responsible investors with these two SRI Funds.”

The DSI400 consists of 400 companies drawn primarily from the universe of companies included in the S&P 500 and the Russell 3000 indexes. KLD seeks to include in the index companies with positive ESG performance relative to their industry and sector peers, and in relation to the broader market. Companies that KLD determines have revenues beyond specified thresholds in alcohol, tobacco, firearms, nuclear power, military weapons or gambling are not eligible for the DSI400. “The launch of DSI allows institutional and retail investors interested in issues such as climate change, treatment of overseas workers or executive compensation to gain exposure to the [DSI400],” noted Peter Kinder, President of KLD.

The iShares Funds are index funds that are bought and sold like common stocks on securities exchanges. Both individual and institutional investors are attracted to ETFs due to their their relatively low cost, tax efficiency and trading flexibility.

Link here.


As a general rule, many investors stay away from broken businesses. Companies with big problems do not see the attention demanded by the high-flying firms with soaring profits. After all, who wants to put their money behind a company with falling earnings and poor margins that is barely breaking even every year? Kian Ghazi would. He is the co-founder Hawkshaw Capital Management who uses investigative research to track down some of the best deals on the market. Ghazi has been keeping his eye on this $150 million broken businesses in the IT training field. And while other investors have run the other way, Ghazi’s scuttlebutt has led him to a terrific, overlooked deal.

The name of the company is Learning Tree (LTRE: NASDAQ). Many investors consider Learning Tree a failed computer-training center. However, Ghazi describes the business as a 30-year veteran in the IT training field with a strong reputation and tons of potential. Ghazi acknowledges that there are other people out there that probably know a particular business better than himself and his analysts. This is why he relies on scuttlebutt as a margin of safety. He admits that this type of research is difficult and time-intensive when it is done properly, but it helps him build conviction. With only 15 long positions, Hawkshaw’s portfolio proves this.

Ghazi describes Learning Tree as a “butts-in-seats” business. Right now Learning Tree classes are stuck with a problem: Too many seats and not enough butts. This is causing the company to barely break even. The big profit potential comes in because Learning Tree is poised to expand its training opportunities and reduce its excess infrastructure. But will it work and help increase its share price? Ghazi’s research tells him it will. This gives him the confidence to buy into a “broken” company that would frighten most investors. Here is what he found:

So while Learning Tree may still be “broken”, it appears a reasonable bet that the company is well on its way to being repaired and profitable once again.

Link here.


It is spend-it-or-lose-it time for millions of Americans who set aside funds for flex spending accounts. Any funds left in that account on December 31 will disappear because flex spending accounts, which allow taxpayers to use pretax dollars for out-of-pocket medical expenses, have a “use it or lose it” provision that requires them to use all of the money by the end of the year or watch it disappear. So with all of that extra spending going on, I have a new play that has a history of running at year’s end, Drugstore.com (DSCM: NASDAQ).

While flex account holders can spend the funds on medical expenses not covered by insurance – like laser eye surgery, dental expenses, psychiatric care, vaccinations, immunizations and dermatological services, etc. – they can also spend it on certain over-the-counter medications, thanks to a September 2003 announcement from the Treasury Department and the IRS. According to Forbes, “OTC products are reimbursable if they are used to alleviate or treat personal injuries or sickness and are generally accepted as falling within the category of medicine or drugs.” Regardless, there are millions of dollars still left in flex spending accounts that must be spent ... or they will disappear.

According to Forbes, Drugstore.com “called upon some of the largest U.S. benefits administrators to create a list of items that are eligible for reimbursement under most plans. On its Web site, Drugstore.com offers some 2,000 OTC items deemed likely to be eligible at its ‘FSA Store’. Shoppers can print a detailed receipt to submit to their FSA administrator for reimbursement, and all purchases made throughout the year on the site can be consolidated in a single FSA receipt.”

The company seems to have historically benefited from the spend-it-or-lose-it flex account trend. From December 2001 to January 2002, Drugstore.com ran from a low of about 90 cents to about $4.50. From December 2002 to January 2003, the company ran from about $1.75 to about $2.75. From December 2003 to January 2004, it ran from about $5.50 to about $8. From December 2004 to January 2005, it ran from about $3 to $3.75. And from December 2005 to January 2006, it ran from about $2.50 to $3.30. I am speculating that shares of DSCM could run again from December 2006 to January 2007. A good strategy would be to buy in mid- to late-December, holding until the second week of January.

Link here.


Inflation is not dead, despite the recent official government numbers. In fact, it is a bigger problem than the Federal Reserve admits publicly. Stagflation – high inflation and low growth – is still very much a possibility for 2007. How do I know? My bagel inflation index tells me so.

Here is what happened to me one recent morning. As usual, I stopped off for a bagel and schmear after I dropped off my daughter at school. As usual, I handed over $2 and waited for my change. But I did not get my usual 15 cents back, just a nickel. Before I squawked I looked up at the price list overhead. Sure enough, the bagel and schmear that had cost me $1.85 two days earlier was now $1.95. The man behind the counter noticed my look. “Everything’s up,” he said. With wheat prices up 50% in 2006 and projected by some commodity experts to go up 30% in 2007, I certainly understood where the squeeze was coming from. I have seen earnings reports recently for big baking companies that blamed lower-than-expected third-quarter earnings on a 35% increase in the cost of flour. No reason my local bagel shop should be able to escape the pain.

Thanks to the way inflation is reported in this country, that 10-cent increase, a 5.4% bagel inflation rate, is not figured into the most-watched measure of consumer price increases. The core CPI, which came in with an increase of just 0.1% for October and raised so much speculation about an end to worryingly high inflation, does not include changes in the price of food or energy, you see. The official numbers took the annual increase in the core CPI down to 2.7% from the 2.9% rate in September. That is still higher than the 2%-to-2.5% range that the Federal Reserve feels comfortable with, but you could argue – and the bond market did by rallying after the number came out – that inflation is headed in the right direction ... down.

But it is too soon to organize a parade or break out the confetti. My bagel-inflation index, at 5.4%, is telling us something important about future inflation, and the message is not comforting. Inflationary pressures, my bagel index says, are still working their way through the economy. Wheat prices, for example, have been climbing all year, but the increase has just now shown up in the price of my bagel. That tells me that past increases in the price of things like wheat, corn and oil are driving prices higher now and into 2007 – even if the prices of the commodities themselves have actually slumped in recent months, as is the case with oil.

It makes sense to me that inflationary pressures are still at work in the economy, despite 17 interest rate increases by the Fed since June 2004. Growth in the U.S. money supply as measured by M2, the broadest measure of money in the economy available now that the Fed no longer calculates M3, has started to climb again. M2 grew by 5.9% in the three months that ended in October, after growing by 4.6% in the 6-month period ending in October and by 4.8% in the 12-month period ending in October. The recent resurgence in money-supply growth is not just a U.S. phenomenon. Inflation in the prices of goods and assets such as real estate is a global phenomenon.

The bagel-inflation index also captures another feature that makes recent inflationary pressures so hard to stamp out. Global growth in demand for energy and for food has created a novel linkage between prices in these two sectors. With higher oil prices driving the development and production of alternative fuels based on agricultural commodities such as corn and wheat, energy consumers and grain consumers have become competitors bidding for limited stockpiles of these commodities. On November 16, crude oil prices hit a low for 2006, but corn prices were still near a 10-year high. Consumers may be paying less at the gasoline pump, but they are, or soon will be, paying more for chicken, beef – and bagels.

My bagel index says that as we go into 2007, not much has changed on the inflation front. The Fed is still fervently hoping that either (1) its policy of increasing interest rates has failed and both the economy and inflation are growing too rapidly, or (2) its policy of increasing interest rates has slowed both the economy and inflation. And frankly, I think there are even a few Fed members who privately would be willing to take #2 further and send the economy into a recession if it brought inflation down to within their comfort zone, near 2%. The reason for being willing to accept even an outright policy failure or a recession is that a third alternative, stagflation, is just too dismal to contemplate.

Link here.


Not so long ago, companies that borrowed lots of money were considered risky, appropriate only for daredevil stock pickers. Those with lots of cash on hand and few outstanding debts might be dull stocks, but they were at least safe bets for bondholders. That view has now been turned on its head. With Wall Street caught up in a wave of acquisitions, normally cautious bond investors are living like Las Vegas high rollers, and stock speculators are behaving like worrywarts. And for some companies, the more they borrow, the safer they are deemed.

Consider the case of Freeport-McMoRan Copper and Gold, which announced this week that it would spend $25.9 billion to acquire Phelps Dodge, the giant copper producer. Much of the purchase will be financed with debt, which at one time would have been expected to hit Freeport’s bonds. “The combined companies will go from having no net debt to having a staggering $15 billion in net debt,” Carol Levenson, an analyst with Gimme Credit, wrote in a research note. “The combined company will definitely be of speculative-grade credit quality,” or in other words, riskier for bondholders. Instead, Moody’s announced that it would probably upgrade Freeport’s credit rating. Bond ratings for Phelps Dodge, a company with no debt that was consistently criticized for its underperforming stock, are expected to fall. The cost of insuring against either company defaulting on debt obligations ended the day essentially unchanged. Put another way, Freeport borrowed $15 billion, and the market said the company was more stable because of what they would buy with all that debt.

It is a pattern that has been repeated for many companies acquired during the buyout boom, where stock and debt holders have seemed to view the same companies very differently. For much of this year, the stock prices of companies like the radio giant Clear Channel Communications and the magazine publisher Reader’s Digest stagnated, signaling that investors thought their futures were dim. But when private equity groups swooped in last week to purchase the companies, bondholders opened their wallets to finance the deals. The wave of recent purchases by private equity groups has pushed issuance of high-risk debt to record levels.

And yet, instead of worrying that defaults will increase, debt prices are signaling that bondholders believe the companies will have few problems paying off new loans. “The message here is that managers need to work hard to get stock prices up to where they reflect the bright future,” said Kenneth Fisher, chief executive of Fisher Investments, a $32 billion fund that owns about 2.5 million shares of Phelps Dodge. “Because if management can’t get the stock price up, someone else will do it for them with the enthusiastic support of the debt markets.”

For many acquirers, debt has never been easier to get. Global issuance of risky high-yield bonds has reached record levels. High-yield issuances this year are expected to exceed $230 billion, vs. the $210.8 billion record set in 2004, said Scott MacDonald, director of research at the hedge fund Aladdin Capital Management. Many of those issuances offer surprisingly low yields, suggesting that despite the glut of new debt, demand is still outpacing supply and investors are betting companies will not default on their new, risky loans.

A further sign that borrowers, rather than investors, are calling the shots is the growth of pay-in-kind notes, which allow a company to pay a bond’s interest with more debt rather than with cash. “There’s a huge amount of money out there looking for a place to go,” said MacDonald. “So private equity groups are buying companies and debt investors are pouring money into risky bonds to chase returns.”

That explains why Freeport’s huge new debt only makes the company more attractive: Investors are flocking to companies that seem poised to grow. So although Phelps Dodge was larger and had more cash on hand than Freeport, stockholders refused to believe the company could expand significantly. Now the bond market is in essence betting that Freeport will be able to revive its larger cousin, and giving managers the money needed to make it happen. “As long as there is liquidity in these markets, investors are going to chase whatever stories are in town, and Freeport is one of the sexiest stories out there,” MacDonald said.

Indeed, investors have said the debt market’s enthusiasm for new loans is fueling the acquisition spree consuming Wall Street. For many companies, the cost of debt is small compared with how much acquiring a company will add to their bottom line, so in some ways it is less risky to borrow and acquire than to go it alone, particularly as industries like mining consolidate. “Right now, debt is so cheap that you can borrow and buy another company for less than it would cost to build something yourself,” Fisher said. “And that’s not going to change until the stock market goes up significantly, or bond rates increase. ... As long as bond buyers think the future is rosier than stock buyers, there’s going to be lots of deals.”

Link here.


Recently, at a party in New York, I mentioned that I had been talking to various groups in the U.S. and Europe about investment opportunities in commodities. Before I could get out one more word, a woman interrupted me. “Commodities!” she exclaimed, with the kind of incredulity in her voice that Manhattanites reserve for people moving to Los Angeles. “But my brother invested in pork bellies and lost his shirt. And he’s an economist!” Everyone seems to have a relative who took a beating in the commodities market, and this fact (or fiction) is considered sufficient reason that no sane person would ever risk playing around with such dangerous things. That this particular victim was also a professional economist makes the warning seem even more ominous. I, however, could not help laughing.

Billions of dollars are invested in commodities every day. Without the commodity futures markets, many of the things that you depend on in life, from that first cup of coffee in the morning to the aluminum in your storm door to the wool in your new suit, would be either scarce or nonexistent, and certainly more expensive. To be sure, investing in anything has its risks. A lot of Ph.D.s in economics lost money in the dot-com debacle, too. There are several other bromides out there for why “ordinary people” should not invest in commodities, and I want to lay these myths to rest, once and for all, so that we can get on with the more interesting business of how you can begin to make some money investing in the next-generation asset class.

About that relative of yours who got wiped out – he was inexperienced. You can learn. Most likely, he was buying on thin margin and when the market went against him he lost big-time. You can buy $100 worth of soybeans for $5. If soybeans go up to $105, you have doubled your money. Beautiful. But if soybeans go down $5, you are wiped out. Not so beautiful. Experienced, smart speculators can make tons of money buying on margin. They also know that they can lose tons, too. Your relative was in over his head. If he had bought $100 worth of soybeans in the same way that he can buy IBM – for $100 (or maybe even $50) – he would be happy when it goes up $5 and a lot less sad should it go down $5.

“But what about technology?” Whenever I mention commodities in public, someone always points out that we now live in a high-tech world where natural resources will never be as valuable as they were when we had a smokestack economy. But if you read your history you will discover that technological advances are as old as history itself. The introduction of the sleek and beautiful Yankee clipper ship dazzled the world in the mid-19th century. Within a decade, the clippers had been replaced by the steamship, no faster but not dependent on wind power. And before long the next big thing in transport had taken over, the railroad, which, of course, was the original Internet – and prices in commodities still went up. In the 20th century came electricity, the telephone, and radio (three more Internets) and then television (a fourth Internet). There was also the automobile, the airplane, the semiconductor – and in the midst of all of these truly revolutionary technological breakthroughs came periodic, multiyear commodity bull markets.

Wven a revolutionary technological breakthrough in a particular commodity-related industry will not necessarily lower prices. For decades, drilling for oil below 5,000 feet or offshore was virtually impossible. Then in the 1960s the Hughes diamond drill bit was invented and an explosion of technological advances in oil drilling and exploration followed. Soon there were wells 25,000 feet deep and offshore oilrigs multiplied around the world. Yet oil prices went up more than 10-fold in the 15-year period between 1965 and 1980. When the supply and demand in raw materials is seriously out of whack, the emergence of new technology will not necessarily restore the balance quickly. To be sure, changes in technology, for example, have made the economy less dependent on oil. But we still use plenty of it, and whenever there is not enough prices will rise. Computers or robots may do amazing things, but they cannot find oil or copper where there is none or make sugar, cotton, coffee, or livestock grow faster than nature allows. Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear.

“But isn’t it only speculation and the lower dollar that are inflating prices?” Certainly, speculators who jump in and out of commodities can push up prices. And the dollar has been a pale remnant of itself. Since commodities are traded in dollars, a weak dollar will make prices appear higher. While crude oil prices were rising 64% in dollars they rose only 16% in euros. But when the dollar strengthened a funny thing happened. Commodity prices kept going up. The global recovery, particularly in Asia, was for real. We are now watching a fundamental structural shift in commodities markets, and it is called “supply” ... and “China”, a nation that will be consuming extraordinary supplies of all kinds of commodities for years to come. Here is the story: dwindling supplies and increasing demand. And the dollar has nothing to do with either.

We are talking another long-term bull market in commodities, and neither speculators nor a weak dollar can make that happen. Speculators can have a short-term effect only. For example, if they drive up the price of oil artificially, oil producers with excess supplies will gleefully dump their oil on the market driving the price back down. Both the dollar and speculation can have a marginal effect, but the market itself is bigger than they are.

“But my stock broker tells me that investing in commodities is risky.” Tell me again about all those Cisco shares you owned back in 2000. Or JDS Uniphase, or Global Crossing? So many risky stocks made the turning of the new millennium a not so happy time for many, who watched their portfolios evaporate. If you do your homework and remain rational and responsible, you can invest in commodities with perhaps less risk than playing the stock market. Let me point out something that you might not have realized: There has been more volatility in the NASDAQ in recent years than in any commodities index. Cisco, Yahoo!, and even Microsoft have been much more volatile than soybeans, sugar, or metals. Compared with the risk record of most tech stocks, commodities look safe enough to be part of any organization’s “widows and orphans fund”.

According to a Yale study, “Facts and Fantasies About Commodity Futures”, the “high risk” of investing in commodities does not square with the facts. Comparing returns for stocks, commodities, and bonds between 1959 and 2004, the authors found that the average annual return on their commodities index has been comparable to the return on the S&P 500. The returns from commodities and the S&P 500 beat those from corporate bonds during that same period. They found that the volatility of the commodities futures under analysis was slightly below that of the stock in the S&P 500. They also found evidence that “equities have more downside risk relative to commodities.”

How about buying shares in commodity-producing companies instead of buying commodities themselves? That is about as far as some financial advisers will go in the direction of commodities. But investing in commodity-producing companies can turn out to be an even riskier bet than sticking with buying the things outright. Supply and demand will move the price of a commodity while the share price of its producer can depend on such less predictable factors as the overall condition of the stock market, the company’s balance sheet, its executive team, labor problems, environmental issues, and so on. Oil skyrocketed in the 1970s, but some oil stocks did not do that well. The Yale study found that investing in commodities companies is not necessarily a substitute for commodities futures. The authors found that from 1962 to 2003, “the cumulative performance of futures has been triple the cumulative performance of ‘matching’ equities.”

And let me remind you of one more important difference between commodities and stocks: Commodities cannot go to zero, while shares in Enron can (and did).

Link here.

Time to go shopping for commodities.

The past couple of quarters were traumatic for the commodities investor. After a huge advance, the natural resources’ bull came to a grinding halt before falling off the proverbial cliff. The carnage that followed yet again reminded investors not to chase “hot” assets after a big rally. So, what caused this sudden reversal ... and is the commodities bull dead?

In my view, the recent decline was a classic correction or consolidation within the context of the primary bull-market and was caused by fears of monetary tightening. Back in May, everyone was worried about rising interest-rates. Even the Bank of Japan had joined in the party by declaring an end to its zero-interest rate policy. As fear grew among the investment community, leveraged positions got unwound, causing a sharp reversal in commodities prices. So, what will the future bring? (1) Rapid industrialization and urbanization of Asia (led by China and India). (2) Consumption-growth in Asia. (3) Global monetary inflation.

Based on these factors, and considering that the public has not even really started investing in commodities, I conclude that the natural resources bull is alive and well. The recent correction in this sector seems to be over and now is the time to load up on precious metals, base metals and energy.

Link here (scroll down to piece by Puru Saxena).


These days, there are two sets of statistics to monitor if you are trying to avoid losing money, let alone trying to make money. The first set is the monetary statistics: the adjusted monetary base, M-2, and MZM (money of zero maturity). (M-3 is no longer published.) The second statistic is the inverted yield curve, which is the most effective herald of a recession. How inverted is it? What is the spread between the 90-day T-bill rate and the 30-year T-note rate? The larger the spread, the more likely the recession.

The average American has never heard of any of this. Most people go through life in a kind of fog. Even among those more sophisticated groups of investors, few people actually monitor these statistics on a regular basis. Both are confident that experts at the FED know what they are doing. But what if this confidence is misplaced?

These days, there is also considerable confusion about the direction of interest rates. Rates are falling. Long-term rates have fallen more than short-term rates have, which is a rare occurrence. Money is tight. The monetary base is actually shrinking slightly. Yet short-term T-bill rates and long-term T-bond rates have fallen in 2006. If we look at monetary policy from early 2001 until mid-2003, monetary inflation expanded. Yet both short-term rates and long-term Treasury rates fell. What is going on? If today’s tight monetary policy produces falling rates, but loose monetary policy produced falling rates, what produces rising rates? What constitutes cause and effect in interest rates?

A free market rate of interest is a composite of three factors: the originary rate of interest, the risk premium, and the price inflation or deflation (rare since 1933) premium. The originary rate of interest is most important most of the time. It is the discount that all people apply to the future. The risk premium is the compensation we demand because the borrower may default, disappear, or break the item. We may not be fully repaid at the end of the loan period. The more likely the default, the higher the market rate of interest. Finally, there is the price inflation or price deflation premium. Ever since the creation of the Federal Reserve System in December, 1913, it has been mostly an inflation premium.

When the central bank expands reserves for the commercial banking system by purchasing debt, the newly created money winds up as deposits in fractional reserve banks. The banks then lend out money. The new money appears to be the result of greater thrift by lenders. It is not. It is the result of greater inflation. Prices do not immediately rise. The mentality from the preceding recession is pervasive. Demand for business loans is slow to respond to new money. The rising supply of loanable funds is met be weak demand. So, interest rates fall or remain low.

As new projects are launched, employment rises. The recession mentality fades. People start spending money and borrowing money to buy things. Slowly, the rate of price inflation begins to approach the rate of monetary inflation. At this point, the price inflation premium reappears. If the central bank’s policy of monetary inflation continues, long-term loans – bonds, mortgages – rise. So do short-term rates, but long-term rates remain higher. The risk of loss through rising prices increases as the maturity date recedes. Eventually, in order to keep prices and long-term rates from rising, the central bank must cease inflating so rapidly. It must cease buying government debt. If policy is not reversed, the currency’s value will collapse.

Before the bust, there is a transition period. Borrowers are still borrowing. They do not perceive the threat. Like frantic buyers in an auction for new homes in the final days of a housing bubble, so are borrowers at the end of a boom. Interest rates shoot upward for one last move. Then reality sinks in. Debtors find themselves facing an economic slowdown. High rates are strangling economic growth. Fear takes over. We can see this in the rate decline from 1929 to 1936. Prime bankers’ acceptances (90 days) reached 5% in 1929. The rate hit 0.15% in 1936. Price deflation and the fear of stock market losses combined to reduce the demand for loans. Lenders wanted safety, so they were willing to lend short-term. They saw this market as less risky than anything else out there.

Falling rates occur during recessions. They begin to fall before the recession appears. Long-term rates fall more than short-term rates. Lenders want to lock in high returns. They think that short-term rates will fall, which is common in recessions. When it comes time to roll over the loan, lenders will receive lower interest on short-term loans. So, they buy bonds. Long rates fall faster. In the preliminary phase of the boom, the fear of falling short-term rates recedes. The boom will raise short-term rates. So, lenders stop buying bonds and start buying short-term debt. They expect to be able to roll over the loans at a higher rate in 90 days. At this point, the inverted yield curve disappears. The boom will raise long rates faster than short rates because lenders fear currency depreciation. They ask for a higher rate. Borrowers are will to agree to this.

This is why it is not sufficient to look at the direction of interest rates as a way to forecast the economy. You must look at the money supply, too. When long rates are falling faster than short rates, and where the money supply is increasing at a lower rate than a year ago, you can safely conclude that the next phase of the economy will be recessionary. In the transition phase from boom to bust, which does not last long, prices are rising faster than the money supply is. The stock market is still climbing in anticipation of rising consumer demand and rising corporate profits. This is the last hurrah of the boom phase. Bond market investors see what is coming before stock market investors do – they grow pessimistic first. They lock in high long-term rates.

So, it is not enough to look at the direction of interest rates and conclude that the Federal Reserve is pursuing hard money or soft money. The tendency is to interpret a falling Federal Funds rate as a sign of monetary loosening. To see which cause is dominant – inflation or deflation – you must look at the money supply figures. They are important for revealing which phase of the economy we are in. Falling short-term rates do not tell us. Falling rates in general do whisper “recession ahead”, and long-term T-bond rates that are below short-term T-bill rates are not whispering. They are raising their collective voices. You would be wise to listen.

Link here.


Though the secular force of globalization and the urbanization of large parts of the world in what some have called a “second industrial revolution” seems set fair to continue issuing its increasing call on the basic raw materials needed to build the necessary infrastructure, those calling for a largely uninterrupted rise in raw materials prices are overlooking the fact that our present day financial structure is almost guaranteed to introduce a significant cyclical element into their trajectory. This instability is fundamentally rooted in the artificial stimulus to growth which originates in credit expansion and which results in that alternation of booms and busts we call the business cycle.

Despite the long passage of time since the pathology of this affliction was first teased out by the great Austrians, the phenomenon is still widely misunderstood, its causes misidentified, and its progression mischaracterised, so another treatise on this virulent, if entirely self-inflicted, the disease is perhaps warranted.

At its most basic, the foundation of all the associated woes were first explained by Richard Cantillon – the father of modern economics and one of history’s great traders – nearly three centuries ago when he was making his own, considerable fortune amid the twin manias of the Mississippi and South Sea bubbles. His theory relied, at root, on the insight that the process of money creation can never be “neutral” since somebody, somewhere has to have the new money first. In other words, the famous Friedmanite-Bernankean “money helicopter” is not some indiscriminate crop-duster, but a Hellfire-spitting Apache with very specific targets in its sights.

Once he has had his bank account credited, the fortunate, early recipient of the new monies can immediately exercise claims upon existing resources far beyond those he has earned through his prior productive contribution – just like the quartermaster of an occupying army can fill his supply train simply by issuing the expropriated locals with requisition chits, rather than having to render them honest payment in exchange. In this way, a borrower can hope to buy now, on the cheap – before his counterparty realizes the tendered money has just been debauched – while potentially reselling more expensively later, enjoying windfall gains, once the effects of the dilution have begun to manifest themselves. Whatever the majority of today’s policy makers may think, even if prices in general remain unchanged this cannot fail to distort and gradually to weaken the economic structure, while merely transferring – rather than increasing – wealth, in a manner that is both unfair and unsustainable, to boot. Albert Hahn once referred to the phenomenon of “inflation without inflation” as being the most dangerous type of all, since it was almost guaranteed to lull policy makers and financiers into the most enormous of errors.

But, of course, despite the fundamental lack of equity involved, the masses have been taught to clamour ceaselessly for a regime of easy money, for this gives rise to the illusion of “making bread from stones” – as Keynes, the most persuasive modern advocate of this fateful ruse, once put it. Even Hayek, in his early days, once dismissed the idea of halting credit expansion so as not to have to forego a more rapid rate of achieving technological progress. He spent the rest of his long and intellectually prosperous life demonstrating the full extent of this youthful error. When money is easy, many more undertakings can be launched than are strictly warranted by the resources available. This gives rise to the intoxication of a boom for so long as we can defer the crucial question of how all this will be funded – that is, supplied with the necessary real resources – as opposed to merely being financed – that is, furnished with the extra, fraudulent credit needed to contend for an unaugmented pool of such scarce resources.

A great part of the appeal is that, with no-one having to undergo the rigours of conscious abstinence today in order to provide for a greater plenty tomorrow, inflation is a means of burning the candle at both ends. Inevitably, what is consumed in the flames which illuminate the revelry is nothing less than hard-won capital. It is only later, when the taper gutters and goes out, that the true extent of the impoverishment which has paid for such a Bacchanal is fully revealed.

Frustratingly, the date of that day of reckoning cannot ever be predetermined – a fact which makes Cassandras of those of us who tend to fret about its inevitability. Late in life, Hayek himself regretted that he had tended to underestimate the ability of the great institutional change to universally elastic credit and floating currencies to add greatly to the longevity of the upswing. However, the fact that we humans cannot predict the date of our own demise makes its arrival no less fore-ordained. Similarly, the discontinuities which accompany such a boom must one day come to threaten its very continuance, even if we cannot say when or even exactly how.

Whenever this juncture does arrive, however, the central banks will finally be forced to face the dilemma inherent in their whole flawed policy, for they will now be confronted by the stark choice that to belatedly jam on the brakes is to instantly derail the runaway train, while to shovel even more paper money into its firebox will only delay the wreck, not avert it. If they do choose the first course it will primarily hit those businesses whose false profitability has come to depend only on the continuation of inflation (and perhaps on its intensification, if the process comes to be better and better anticipated by buyers and sellers). Those disrupted in this manner will find their margins suffer horribly at the moment the credit expansion begins to decelerate. Then, as their own income falls, their suppliers (especially those of deferrable investment goods), creditors, shareholders, and workers will, in turn, have the squeeze transmitted to them.

An inverted yield often presages a crisis, since the exigent demand for money which twists time rates in this fashion is, in effect, a signal of a generalized scarcity of present goods: to borrow a term from commodity markets, it is akin to a widespread “backwardation” of circulating capital, of a dire lack of the needed complements to all too many misconceived productive plans. It is also why such an occurrence should be disregarded when, as today, it is not accompanied by elevated real short rates, falling profits, rising risk premia, and direct evidence of credit restriction.

No, sir, today’s inverted curve can in no way be construed as a characteristic sign that extraordinary numbers of producers are forlornly trying to salvage something from the wreckage of their plans even as the financial system has finally become more wary of accommodating them in the attempt. Rather, the present inversion is only an artefact of three, highly idiosyncratic influences:

  1. The prodigious, leveraged purchases of longer-dated securities which are being conducted by the speculative horde – in good part by using the lowest cost global currency to the purpose in a manner which begs the entire question of whether the “global” yield curve is effectively negative at all.
  2. The vast, concerted, governmental program of foreign exchange intervention, enacted through the same medium of the bond market, but in a largely price-insensitive fashion.
  3. The post-Tech Bubble shift in the regulatory environment for pension funds, et al, which has conveniently given these supposed stewards of the small man’s savings a perverse incentive to devote an increasing share of them to finance the present squanderings of the welfare-warfare state by buying its longest dated bonds, regardless of the vanishingly small real yields which they offer.

To sum up, as Hayek again put it, the truly ominous aspect of a negative yield curve is that which arises in a situation where “investment raises the demand for capital” and not when inflation itself – properly defined – is boosting the price of riskier financial assets and thus suppressing long bond yields in a highly artificial manner.

To return to our theme, despite all the inescapably malign side-effects of credit expansion we have detailed above, it is nevertheless true that, while the Pan pipes still play, all manner of businesses can appear to thrive. The rising incomes of those who work for, or speculate in, such concerns will therefore tend to boost all manner of spurious economic activity until the music finally stops. The political attractions of all this are not to be underestimated, especially since there are, these days, no dynasties to be preserved through the ages, only the briefest of incumbencies to be exploited as shamelessly as possible by each succeeding crop of elected dictators.

During the boom, not only is tallow burned to light the merry makers’ wild carousing, but concrete is poured, copper is wound, chrome is plated, and thrifty sub-compacts are traded in, en masse, for thirsty SUVs. As this happens, it is of little immediate consequence to the producer of the commodity being more rapidly used up than it otherwise might – or whether it is helping construct yet another grand architectural folly. Indeed, to the extent that the producer suspects that things are running just a little too well – and so resists taking a full participation in the boom – such a period of heightened appetite may well not elicit much at all in the way of a supply response. Instead, he may forego the hard slog of finding and developing his own reserves in favour of using his newly-buoyant share price and his lately-enhanced creditworthiness to try to gain control over those of his peers. In order to lessen the chances that he will himself become the target of an unwanted bid, he may be tempted to apportion a sizeable proportion of his swollen income stream not to delivering more material to the market, but to putting more cash in his shareholders’ pockets.

Even if he does finally succumb to the urge to expand, he may well find that most of his peers have reached the same decision along with him, meaning our man will soon be confronted by the very same forces of overstretch on which his own forecasts are based – forces which we have highlighted as a major feature of every boom. If so, he will find that such matters as a shortage of truck tires, a lack of specialist steels, waiting lists for capital equipment, rising energy costs, an ageing workforce lacking replacement cadres with suitable skill and experience – and many more such operational difficulties – may greatly limit his own ability to react. Far from being an academic construct, these very phases of caution giving way to cupidity should be familiar to anyone who has been following the boardroom manoeuvrings of the miners and drillers through the course of this current cycle. Each of them has, in its different way, served only to intensify the impact of the secular upswing on the prices of the resources involved.

An excess of easy money can give the post-hoc appearance of too many savings chasing too few outlets – a “global savings glut”, as our esteemed Fed Chairman fatuously termed it, early last year. Risk premia fall; multiples expand; a “search for yield” begins. Leverage rises; a credit-collateral vortex starts to form, and analysts go back to the old Amazon/Google game of making headlines, not through any dispassionate reckoning, but by competing to be the most raucous cheer leader of the boom and issuing ludicrously ascending “targets”, like roosters bragging on a dunghill.

In such a phase – like the one witnessed as recently as this spring – it almost does not matter which asset you borrow money to buy, it is almost guaranteed to go up. Conversely, of course, the greater the superstructure of unstable positions which have been built up, the more violent the downdraft when the margin calls can no longer be met, as anyone familiar with this year’s debacle in the natural gas market can attest.

Taken together, all of these malign monetary influences mean that one must always temper one’s enthusiasm for the so-called “fundamental” reasons why commodity prices should tend to rise for some time yet, namely, to recap, that producers – themselves victims of an earlier entrepreneurial error of underinvestment – are struggling to catch up to the largely unforeseen and immensely magnified demands of an industrializing world. However, “fundamentals” alone are never sufficient in an investment process, for this is another realm where subjectivity reigns. Consumer sovereignty is no less absolute in financial markets than in the retail marketplace, and it is the investor himself, in all his folie d’amour, who comprises the consumer who matters.

Thus, however solidly-grounded we may believe the secular trend to be (“More” will almost certainly be required: that same “More” may not easily be forthcoming), the more transient manifestation of periods of significant decline can never be ruled out, particularly when a previous outbreak of financial market euphoria evaporates, or when a cyclical overextension in the real economy intrudes and a period of recuperation and rebalancing has to ensue.

It is hardly a novel concept that, amid such turmoil, the canny investor’s task is to try to identify and thence to exploit such oscillations – and not to act so as to magnify their amplitude by blindly following a peer group often bereft of any real intellectual understanding of the forces at work in the market, but whose every member implicitly trusts in his individual ability to jump off his log raft just before the stream’s momentum carries him over the cataract with all the others.

Link here.


I have been reading many claims in many places lately that “the Fed is pumping M3.” Others claim that Fed open market operations (repos and coupon passes) are purposely being used by the Fed to fuel the stock market. Others still point to manipulation in gold. This post attempts to look at those claims.

Let us start with An Examination of Interest Rate Targeting (PDF), a 108-page study of open market operations in Australia by Liam J. O’Hara which applies equally to the FOMC. Not only does the article by O’Hara debunk myths about open market operations, it also debunks myths about “the Fed pumping M3,” a statement I have seen at least twice a week for months on end. The Fed is not really in control of credit at all, and that is an idea that few seem willing to accept.

The key point is that the Fed can only target one variable at a time. This Fed has chosen to target interest rates, and thus money supply and the price of gold will do what they want to at that rate. If the Fed chose to target money supply instead, the market would then determine the interest rate. If the Fed chose to target the price of gold, the market would then set the other variables. Thus the Fed is not really “pumping M3”. It is merely supplying the demand for money at the artificial rate it has targeted (emphasis on artificial). This, indeed, is part of the problem, but it is important to state the problem correctly.

Remember that the Fed cannot force anyone to borrow who does not want to, nor can the Fed force banks to lend. Regardless of whether the Fed targets money supply or interest rates or the price of gold, the Fed is NOT in control of bankruptcies, foreclosures, job hiring, or the velocity of money. Those last two sentences are crucial to the deflationary argument. Bankruptcies and foreclosures are soaring, consumer spending is sinking, and jobs will follow housing with a lag. The current setup is essentially the liquidity trap that Japan fell into. Japan’s national debt went from nowhere to 150% of GDP, and Japan is still battling the aftermath of deflation after at least 18 years.

Please note that the idea of a “liquidity trap” essentially flows from a Keynesian approach to economic/monetary policy in the belief that there is not enough money in the system and things would somehow be better if more money could be forced into the system. Unfortunately, the Fed simply does not know the correct amount of money or the correct interest rate on it, either, anymore than it knows how to set the correct price of orange juice or TVs. The liquidity trap develops because there eventually comes a point at which the central bank simply cannot force additional credit down the throats of prospective borrowers. Practice has shown that although central banks will attempt to fight the resultant deflationary tide, they will not resort to “helicopter drops”. In this regard, the Fed has far less power than anyone realizes, in spite of possessing vast power in theory.

It should be clear from the above that the Fed must take a big share of the blame for the mess we are in. The Fed has no real idea where interest rates should be, and thus has no business setting them. If credit exploded out of control to the upside, then it is simply because the Fed kept interest rates too low too long. The problem is what to do about it. Bernanke is absolutely scared to death of a credit contraction here (and he should be). But the Fed also has to be spooked by the leveraged buyouts, merger mania, stock buybacks, and derivative madness fueling the stock market. Consumer credit and housing will dictate what happens next.

The dice have been cast and the latest result was snake eyes. First, we saw consumer credit plunge, with the other die showing a massive decline in housing permits and starts. The box the Fed is in is of its own making, and that box keeps getting smaller and smaller. Eventually, overall credit will start contracting, regardless of what the Fed says or does, and the wizards behind the curtain will be exposed for the frauds that they are. This means that the Fed is going to be as out of control of the upcoming credit contraction as it was of the preceding credit expansion. It is the end of the line for the Fed, and contrary to popular belief, open market operations are not going to hold things together.

Link here.


We stand before you a profoundly ignorant man. What we do not know is almost everything. We do not know which investments will go up. We do not know what will happen in the world. We do not know if global warming is a farce or a fact. We do not know if Peak Oil is something to worry about or something to ignore. As Donald Rumsfeld put it, there are known unknowns, and there are unknown unknowns, and then there are things about which we do not have a clue.

Still, that did not stop the Bush Administration from launching the biggest foreign policy blunder in U.S. history ... nor does it stop us from having opinions and ideas about things. In fact, as we get older, the less sure we are that we know about anything. And there are people who think we already know nothing at all. But the less we know for sure ... the more important it is to have rules and principles you can follow. So as we become more ignorant about what is going on, we become more stubborn in our opinions about things.

Now, imagine that there were no Barron’s ... no Dow ... no financial commentators ... and no one writing books such as Dow 36,000. If that happened, you would have to rely only on your own eyes and ears ... and your own ability to put two and two together. Investing would become a private matter. The public spectacle of the whole thing – where you get Abby Cohen telling people how much “The Market” is going up – would disappear, because there would not be any public market – just millions of private transactions, each one made on its own merits.

In our private lives, by the way, that is the way we tend to do things anyway. For example, if you were in the publishing business, as we are, you would look around to see how to invest your money without much thought to “The Market”. You know you can get about 5% risk-free by buying U.S. Treasury obligations. And you know you can borrow at about 7% or 8%. So, in everything you do, you have to be sure that it will give you a return of more than that. Otherwise, it is not worth doing. But when we look for acquisitions in the publishing field that fit this objective we see that they are hard to find. We have to spend a lot of time looking at a lot of publishing projects in order to find the one or two that make sense for us. And rarely are these investments available to the public. They tend not to be listed on the public markets. Out there in the public – where stocks are quoted on Wall Street – publishing businesses tend to be just too expensive.

In fact, in only one case did we find a publicly traded company that was cheap enough to consider – the case of TheStreet.com, but only after it crashed. And even then it was only interesting to us and to a small handful of other investors from the industry who thought they knew what to do with it. In other words, even though it was available to the public, and even though it looked cheap enough to meet our criteria, a regular public-market investor probably still should have stayed away from it, because he would not have known what to do with it to make it profitable. Well, as it turned out, TheStreet.com figured that out for themselves too, and their share price rose to the point where it was no longer a good investment for us.

But how could it be that a stock could be too expensive for those of us in the industry who best understand it? Why is it that public market investors believe they know more about our industry than we do and are willing to pay higher prices than we are? We have been in the business for 30 years. How does the casual, public-market investor think he can do better with this company than we can?

We just bring it up to be provocative. We all know there is a big difference between what goes on in public and what goes on in private life. A guy can make a fool of himself – most do – but it takes a crowd to make a real public spectacle. Because in public ... in a crowd ... in a stock market, for example, a guy will do what he would never do on his own. This includes paying more for a company than it is really worth. In private, he looks at the situation as we do when we are making an acquisition. He figures out what it will cost and what it should be worth to him. But in public, he gets pushed along by slogans, headlines, collective fears and impossible dreams that he would not possibly take seriously in his private life.

So, we give you our first general rule: You will do better investing privately than you will investing along with the public. A private investor is more likely to know what he knows and what he does not. By getting close to his investments – by really knowing the industry and the business – he is able to eliminate some of the unknowns and make a better decision. Generally, that means he pays less for his investments and works harder to get them.

And now, another rule: The further you get from the facts and from the consequences of any action, the worse the results. This is true for individuals as it is for groups. In politics it is obvious that a town meeting in New England is a long way from the U.S. Congress. The folks voting on where to put the new town dump are acting on information that is very close at hand. They know the area. And they do not want to put the dump in the wrong place, because they are the ones who will have to live with it. And they will be very attentive to the costs, too, because they are the ones that will have to pay for it.

The U.S. Congress, on the other hand, is usually far removed from both facts and consequences. Members of Congress routinely vote on legislation that they have not even read. Recently, they went along with a war in a country they had never been to, for reasons they did not understand, paid for with money they did not have, and fought by soldiers who were not their own sons and daughters. In ancient Rome, engineers were forced to stand under the arches they had designed when the scaffolding was removed. And in ancient Greece, not only did the sons of the assemblymen go out to fight, so did the leaders themselves. Not only that, the oldest veterans were put on the front lines! If Americans wanted to make their government more responsible, they would force congressmen to put all their wealth in U.S. dollar bonds ... and serve in every war they start.

Our general rule works for investments too. The further you get away from them and the less you suffer the consequences the worse your investments will be. That is why “collective” investments are usually so bad. The investor himself does not take the responsibility for making decisions and managers do not suffer the consequences. Index-linked funds, mutual funds, and hedge funds are just ways of being “in The Market”, not ways of making serious investments. And since the rate of returns you will get are always reduced by the managers’ fees, you'll always – over time and on the average – get less than the market itself. And as we pointed out, getting “The Market” is not getting much. Stocks go up and down. You go through a complete cycle – paying fees, taxes, commissions and adjusting for inflation – and you are usually about where you began.

Hedge-funds are a special case. Their “I win, You lose” fee structures are so aggressive that the average hedge fund investor is almost bound to lose money. Felix Dennis, publisher of Maxim magazine among other things, has a house on St. Barts. The luxury island is a playground for the rich and famous. Felix says that when he got to know his neighbors, he found that they were almost all hedge fund managers. “Where are the hedge fund customers?” he wanted to know.

Our old friend, John Mauldin corrected us, “You are all wrong about hedge funds. Some of them do make a lot of money. But they are like stocks. The best ones are not available to you. And as you pointed out, you would have to work pretty hard to find the ones that will do well. The average hedge fund is no different from the average stock. On a good day, it will probably lose money for its owners. On a bad one, it will wipe them out.”

Link here (scroll down to piece by Bill Bonner).
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