Wealth International, Limited

Finance Digest for Week of January 29, 2007

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


When I last commented on the bond market (December 5), bond prices were inexplicably rallying, sending yields on 10-year Treasury bonds to 4.4%. At the time, Wall Street was offering a variety of half-baked explanations as to why the market had moved beyond the cause and effect stimuli that had ruled for generations. My advice to investors was simply to sell into the rally and ask questions later. Since then, bonds have reversed course, with 10-year treasury yields hitting 4.9%. Just as Wall Street’s explanation for falling rates was way off base then, so too is their explanation for rising rates now.

The consensus asserts that yields have turned around because new “evidence” of a bottom in the housing markets will keep the economy from tipping into recession, which in turn will diminish the likelihood of a Fed rate cut. The problem with this explanation is that there is no evidence of a bottom in the housing market. 2006 saw existing home sales decline by 8.4% (the biggest drop in 17 years) and new homes sales fall by a stunning 17.3% (the largest in 16 years). A drop in inventory in existing homes is most likely the result of discouraged sellers taking their homes off the market with the intention of relisting them in the spring. This is a common tactic among realtors. Also, my guess is that lots of other potential home sellers are planning on listing their homes for sale for the first time come spring, and many more would list their homes now if they thought they could actually get their “appraised” values. New home sales figures are even more misleading. Headlines trumpet that inventories dropped in December, but the figures ignore cancellations which are running at record highs. Also, while new home prices “officially” fell by a modest 1.8% in 2006, the real decline is likely far more substantial when sales incentives are incorporated. They are reflected in recent home builders’ earnings reports, which have been universally dismal.

The elephant in the living room is that the recent jump in bond rates suggests that things are about to get much worse for the housing market. Since January 5th, interest rates have risen by over 30 basis points and gold has risen by over $40 per ounce. When rates and gold prices rise together the most likely explanation is escalating inflation fears. Indeed, my guess is that bond investors around the world are beginning to appreciate the inflationary implications of a real estate crisis. The result of a substantial decline in real estate prices will likely be the Fed coming to the “rescue” with inflationary monetary policy. Inflation will push long-term rates even higher, causing more loans to default. With credit destroyed and home equity and jobs lost, foreign creditors will rush for the exits sending the dollar into a tailspin. The Fed will be forced to buy all of the paper foreign lenders no longer want and that savings-short Americans cannot afford. Domestic money supply will explode sending consumer prices soaring.

As is so often forgotten, interest rates are merely the price of money, which like any price is determined by supply and demand. In the U.S., where hardly anyone saves and almost everyone borrows, that price should be very high. Our low interest rates are a temporary fluke, once made possible by naïve foreign savers but now mainly a function of misguided foreign central banks. Instead of trying to fabricate benign explanations for why interest rates are rising, Wall Street should instead prepare investors for the unpleasant consequences to their portfolios should rates continue doing so. The true mystery is why long-term rates have remained this low for so long. Unfortunately by the time Wall Street solves the riddle many of their clients will be broke.

Link here.


Sequoia Capital is one of the most prestigious venture firms in the world. It backed Cisco Systems, Google, Oracle, Yahoo! and YouTube. Douglas M. Leone was Sequoia’s busiest partner last year. In 2006, Leone managed Sequoia’s moves into India and China and signed seven new deals, including a $48 million late-stage investment into Indian wireless provider Idea Cellular, a group of online stores that is headquartered in Omaha, Nebraska named NetShops, and Beijing outsourcing firm WorkSoft Creative Software Technology.

Leone, an industrial and mechanical engineer, broke into tech as a salesman at Sun Microsystems and Hewlett-Packard before joining Sequoia nearly 20 years ago. His exits include Hyperion Solutions, Sentient Networks (bought out by Cisco) and Telera (bought out by Alcatel-Lucent. In a rare media interview, Leone talks with Forbes about what constitutes a great company, how to harness violent growth and entrepreneurs who fold too early.

Some excepts: “A tremendous chief executive in a small market will never be great. All great companies start with great markets. ... The trick is, a market has to be nonexistent when you start. If the market is large early on, you will have too many competitors. You have to make it large. It is one of the reasons Sequoia went into India and China. Those domestic markets are very small now but will become very large.” ... “We like the kind of entrepreneurs who can see the future. When that happens, you get this. When the flywheel of a company that has created its own market gets going, it grows much faster than you expect. Then it becomes an almost violent growth. If you choose a market that already exists, say, networking equipment, you have to compete with an established company like Cisco. Even if your product is marginally better, Cisco can fudge it and outsell you.”

“I cannot think of one instance in my 20 years in venture capital in which I have wanted to sell a company before the entrepreneur. We are forced to go along with management. If management wants to sell and you don’t, you end up with a very unmotivated team. And that leads to failure. ... We know when something can become much more. ... Left to our own devices, we would have kept on going [with YouTube]. Maybe it’s long-term greed. But the public market voted. They must have agreed it has potential, because Google’s stock went up after the acquisition. ... All the most successful companies we have seen at Sequoia – Network Appliance, Cisco, Google, Yahoo! – in their private lives, someone put an offer in front of them. But they did not take it.”

“None of today’s wonderful companies planned to be very big. Not for a second did [Yahoo! founders] Yang or Filo understand the potential of an Internet portal when we funded them. Nor did [YouTube founders] Chad or Steve understand the potential of user-generated video growth. What they understood was a need. Being focused on solving one problem is a precursor to something big. We don’t see any big vision. We are just as blind as the entrepreneurs. ... We build structure around them. We give them an action plan. We tell them to just keep the business running, think about what their customer really needs, not what they think he needs. You cannot start looking into the future for a long time. All we can do is help the entrepreneur execute on a series of rapid, small steps. Later, it ends up becoming something greater.”

Link here.


Who is the next Google? for now, Google is. It slipped into second place on our list of the fastest-growing tech companies but still shows triple-digit annualized revenue growth over the past five years. The company cannot sustain its current growth rate for long, but last November it aided its fast-growth status by grabbing YouTube for $1.65 billion. In addition to Google, 11 technology overachievers returned to this year’s list, including three companies that have made the cut for each of the past five years. The 25 stocks listed here a year ago posted an average price gain of 16% versus an 8% rise in the Nasdaq Composite index.

Our selection process: We require at least $25 million in sales, 10% annual sales growth for five consecutive years, profitability over the past 12 months and 10% estimated annual profit growth for the next three to five years. We exclude firms with significant legal problems or other open-ended liabilities and also consider accounting and corporate governance scores in making our final cuts.

Link here.
Fast-tech growth at a reasonable price – link.


This time of year is typically filled with predictions for the upcoming 12 months. Sadly, very few of the “experts” who appear in print or on TV are required to review their efforts from the year before. Forbes, however, does not let us columnists off so easily, and we must render an accounting. For me, alas, 2006 was not as good as 2005. Had you bought all 30 of my 2006 selections you would have ended the year up 5.8%, assuming (as Forbes does) that you lost 1% in trading fees. Equal amounts invested at the same times in the S&P 500 (with no trading costs) would have returned you 10.7%. Both figures exclude dividends. I tend toward safer, conservative big companies, a category that did not shine in last year’s bull market. If you added in dividends, my results would obviously be better.

Among my losers were two Canadian royalty trusts, San Juan Basin Royalty Trust (SJT) and PrimeWest Energy (PWI). These are not taxed at the corporate level, but the Canadian government last year announced plans to scotch this advantage in 2011. Although that is a long time away, these stocks tanked, losing 22% and 38%. A lot can happen in four years. Stay with these trusts. Other dividend payers that I liked fared much better: Financial services house AllianceBernstein (AB) rose 42%, while tobacco purveyors Altria (MO) – the old Philip Morris – was up 15% and UST (UST) 46%. Keep them. UST sports a tidy 4% dividend. As always, my firm may have a position in the stocks I suggest to you.

Stick with Google (488, GOOG). It is the prime mover of the latest Web surge. If you are venturesome, also remain with New Century, a subprime mortgage lender. The stock is down 32% since last April when I recommended it. But the company has raised its dividend for each of the last eight quarters, and the stock yields 25%. Do not put your retirement funds here or take a large position, but at four times trailing earnings, it is cheap. And there has to be a bottom somewhere.

Now here are some new ideas. I am happy to recommend a few foreign stocks on the assumption that your portfolio is underweighted in overseas equities. I like the iShares ftse /Xinhua China 25 Index ( 105, FXI), an ETF that is a long-term play on a large and growing economy. Another longtime favorite of mine, traded in Paris, is Hermes International (119, RMS FP), whose ties, scarves and handbags are all the more sought-after because the prices are so high. Doubtful that its sales can stay aloft, 13 of the 18 analysts who follow the stock rate it a sell. Wrong. And if you lust after a BMW, do not forget the stock of the firm that makes it. At 10 times earnings – Audi’s P/E 28 – BMW (58, BMW GY), traded in Germany, might even qualify as cheap.

I am optimistic about 2007. Fundamentals are still supportive, stocks not expensive, and the Federal Reserve will likely cut rates, although its timing is uncertain. I like the fact that big investors – namely hedge funds, private equity firms and professional traders such as Goldman Sachs and Morgan Stanley – are cash rich. To them, there is a stigma about idle money lying around. That is why the private equity groups are out madly buying companies. Perhaps not always wisely, yet at least their frenetic activity buoys the market.

Ordinarily, I would be worried by the high degree of bullishness in the air. Astonishingly, many otherwise intelligent investors rest their arguments on flaky notions like the third year of a president’s second term always being a good one for the market. A while back some strategists noted that years ending in five have done well. That was true ... until it wasn’t. There is a difference between coincidences and causal factors. The Super Bowl and market outcomes are coincidences. Fed rate hikes are causal.

Read fellow columnist Kenneth Fisher’s new book, The Only Three Questions That Count: Investing by Knowing What Others Don’t. One of his key points is to make sure you are not led by foolish beliefs. If your bullish – or bearish – conviction were argued before a court, would I win the case? My concern is that too many investors are bulls only because the market is doing well now. In 2006 it did well for all except one month (May). If during that month your bullish conviction wavered, then you were not a bull, you were a sheep following a herd. Not a good way to be a successful investor.

Link here.


I believe the current monetary disorder and resulting global boom are much the consequence of waning U.S. financial and economic supremacy, replete with all the geopolitical risks associated with such a historic development.” ~~ Doug Noland

Mr. El-Erian: “I think what is new is you have got a group of countries that have become systemically important in influencing growth, trade and, critically, capital flows. And they behave differently from what we have been used to. So the result is we are coming across all these aberrations in markets – in economic behavior – that we are all trying to explain. And unless we recognize that there are structural changes, we tend to get stuck on a debate between what is sustainable and what is less than sustainable, as opposed to what are the underlying factors that are now in play ...

“What we are in right now is bit of a journey; a journey where global growth is being supported by the coming on stream of these new economies. And where the decisions to allocate their wealth is helping countries maintain relatively low interest rates and relatively low borrowing costs overall. This is the journey and the journey feels better than most people expected. But the jury is still out as to what the destination looks like. And there are risks there both of the economic and geopolitical perspectives ...”

“We have had a dramatic revolution in financial instruments. The proliferation of derivative-based instruments – that tend to decouple trading from the underlying market – has allowed many investors to get involved in markets that otherwise would have been difficult to access. You see this here in the United States in terms of the exotic mortgage, which allows people to buy homes that they could not otherwise afford. You also see it in terms of capital flows, in terms of Credit default swaps, etc. If you step back and ask, ‘What is the major change?’ – is that the barriers to entry to these markets have come down, with the result that liquidity and velocity has gone up.”

Bloomberg’s Tom Keene: “Are you concerned about the complacency that we see here looking out this window – this gorgeous valley filled with CEO and executive complacency? Is it remarkable where spreads are?”

Mr. El-Erian: “It is totally remarkable where spreads are. I think that it would be wrong to think that spreads reflect the level of risk. They do not – they underestimate the level of risk. But they are there because of technical influences. So, the big message ... is that what we normally are used to looking at in terms of market signals – the shape of the yield curve, the level of volatility, the level of risk spreads – all that is being distorted during this transition. So, risks are not as low as risk spreads would suggest – volatility is not as low as volatility measures would suggest. But there is a good reason why these measures are distorted right now.”

From Mr. El-Erian’s FT article: “Complex Finance and the Brave New World Economy”: “Much of the discussion at the World Economic Forum in Davos has two themes. First, the continued robustness of the global economy as defined by sustained high growth and low inflation. Second, the steady rise in economic and financial risks. The tendency is to treat these themes as competing and engage in an interesting but inconclusive debate about their relative merits. A better approach is to recognise that these themes are consistent with structural changes in the world and seek to recalibrate the perspective used for defining the way forward. ...

The interaction of these economic and technical changes has altered market valuations, volatility, velocity and liquidity. No wonder various markets seem to be sending conflicting signals. No wonder market participants are having trouble predicting central bank policies, which are becoming more tentative. No wonder economists cannot resolve debates on the outlook for global payments imbalances ... We should view these themes not as competing but as part of a fundamental change in the global economy ...

I will begin with the caveat that taking exception to Mr. El-Erian’s analysis is risky business. He is an astute analyst and forward thinker on global financial and economic developments with few equals. And I certainly concur with his view that we have been witnessing “a fundamental change in the global economy.” I will, however, attempt to expand upon his thinking and to do so from a competing analytical framework. Yes, we now have a “group of countries that have become systemically important in influencing growth, trade and, critically, capital flows. And they behave differently from what we have been used to.” This is today a huge issue that goes way beyond derivatives and “barriers to entry”. The growing prominence of the “emerging” economies is only a subplot to the story, and to appreciate the nuances of the unfolding storyline one must reflect back upon the early chapters.

From my perspective, analyzing today’s extraordinary global environment must begin with the recognition of the profound role a weakened U.S. is playing in this Monumental Shift in Global Market and Economic Power from the “Core” to the “Periphery”. A previous chapter included the episode where the Greenspan Fed in the early-90s acquiesced to Wall Street, the GSEs and aggressive “financial innovation” in response to a severely impaired banking system. Part of the story would be how the U.S. economy consumed the “peace dividend” after the collapse of the Soviet Union and frittered away the bounty associated with the status as the only superpower and controller of the world’s reserve currency. There are, as well, the subplots of how the powerful Financial Sphere abused its new prominence and how each time the Fed and policymakers ignored the real issues and simply choose the inflation expedient to temporarily find their way out of trouble.

I would suggest that the unprecedented inflation of dollar-denominated credit instruments has been the decisive catalyst for the momentous financial and economic changes that the world is only now beginning to appreciate. The complete breakdown in U.S. monetary discipline – operating at the “Core” of the global financial system – has fostered a period of unlimited cheap global finance. The Chinese, Indian and Asian, Russian and oil producing nations, and other emerging economies would look a whole lot differently today were it not for this backdrop of endless liquidity that has inflated global commodities, real estate and securities markets, while promoting unprecedented (“Periphery”) capital investment.

The commanding role of “contemporary finance” cannot be overstated. But the key dynamic has been the massive credit and liquidity inflation at the “Core” – the upshot of booming domestic lending, securitizations, derivatives and securities finance/leveraging. The influence of “financial innovation” in fostering dollar liquidity inflation has been even more significant than its role in removing “barriers to entry” for the emerging economies. The “Core” versus “Periphery” analysis is especially critical when it comes to the issue of sustainability. Many analysts have presumed that the emerging economies were invariably at the brink of a 90s-style boom turned ugly bust. But the massive and unrelenting flood of liquidity emanating from the U.S. credit system (current account deficits, speculative financial flows, and investment flows) has to this point been more than adequate to finance ongoing booms at the “Periphery”. With this in mind, my analytical focus has been – and remains – our powerful but aged U.S. credit bubble. (On a side note, I find it curious that Mr. El-Erian’s analysis highlights the impact financial innovation has had on “liquidity” and “velocity” while maintaining a safe distance from the critical issues of credit availability and unrestrained credit growth.)

The divergence between the discernable escalation of global risks (financial, economic and geopolitical) and the market’s pricing of risk (i.e. overvaluation and meager spread/risk premiums) is receiving a fair amount of attention of late in Davos and elsewhere. From my perspective, spectacular global asset inflations transpire only during – are products of – periods of underlying monetary disorder – a circumstance today readily explained by Credit system dysfunction at the “Core”. Such a circumstance creates uncommon risks, as booming asset markets are seen as confirming bullish perceptions and expectations. Boom-time liquidity conditions and economic growth are then extrapolated far into the future. Festering geopolitical issues are easily disregarded. Lawrence Summers, commenting in Davos: “It’s worth remembering that markets were very upbeat in the early summer of 1914.” I believe the current monetary disorder and resulting global boom are much the consequence of waning U.S. financial and economic supremacy, replete with all the geopolitical risks associated with such a historic development.

Credit bubbles and their inevitable myriad inflationary effects are always a wealth-redistributing phenomenon – and, accordingly, inevitably quite problematic. Yet, for some period of time the liquidity and asset inflation effects do seductively stimulate investment, wealth creation and robust economic activity. However, the steep cost of the inflationary process begins to emerge later when inflation’s increasingly destabilizing effects promote myriad avenues of wealth destroying behavior (mal/over-investment, resource misallocation, waste, fraud, and profligacy). The growing divergence between waning wealth creation and the escalating expansion of financial claims then progressively heightens systemic risk. For awhile the major inflation in perceived financial wealth works to mask the underlying impairment to the economic structure, while booming liquidity and asset prices ensure most (including market professional and monetary policymakers) remain inattentive to risk dynamics.

Today we are in (and hoping to extend) the stage where the “Periphery” still readily accepts and accumulates our increasingly suspect financial claims. The deepening impairment to the U.S. economy is obscured by unrelenting credit expansion – the whirlwind of new financial claims that are accepted globally in exchange for needed goods/resources, as well domestically to sustain the finance/asset inflation/“services”-based U.S. economy. At the same time, inflating securities markets at home and abroad work to bolster confidence, self-reinforcing credit expansion, speculative excess, and continued income and spending growth. I continue to believe the probabilities are high that current dynamics are brought to a conclusion by some type of financial dislocation. I certainly recognize, however, that the weakened U.S. will act on every impulse to continue its current inflation, while the ascending “emerging” economies will remain steadfast in their pursuit of greater prosperity. So, for now, I will ponder ramifications for a continuation of an unstable status quo.

For the most part, analysts have missed key dynamics. The prevailing view has been one of sanguine global integration of “emerging” economies’ cheap labor and manufacturing capacity, within the context of an ongoing technology and productivity-induced boom in the developed world – the confluence of these powerful forces pointing to a further secular decline in inflationary pressures. This “disinflationary” backdrop, as the thinking goes, will pacify U.S. and global central bankers and engender lower global market yields (and rising global securities prices!) for some time to come.

The flaw in this line of thinking lies in its disregard for underlying credit inflation and bubble dynamics, as well as a complete lack of appreciation with regard to the inflationary ramifications of waning U.S. financial and economic supremacy. In reality, there has been no secular ebbing of inflation, but instead an alluring secular shift in inflationary effects. The bullish optimists were snared by the inflationary boom’s captivating initial facets, including asset price inflation, muted CPI, generally robust growth, strong profits, etc. Additionally, the marketplace’s perception of a “disinflationary” backdrop and the Fed’s likely course of accommodation, in conjunction with a historic bout of financial innovation, played a decisive role in fomenting the global credit bubble and unparalleled financial excess the world over.

As we now proceed to a much more problematic phase of a runaway global boom, analysts and market operators are being forced to begin reexamining previous assumptions. The structural increase in global credit availability and marketplace liquidity will necessitate tighter-than-anticipated monetary policies by global central bankers – in particular the Fed. Until some development impedes the global credit boom, monetary policy will be dictated more by the need to lean against loose credit conditions and global liquidity than any by any measure or index of consumer prices.

The increasing awareness by holders of inflating quantities of suspect dollar credit instruments that they are being shortchanged should weigh on U.S. markets, and keep in mind that strong U.S. markets have provided major support for our faltering currency. And as the bubble’s inequitable (re)distribution of wealth gains greater recognition, the strains between the “haves” and the “have nots” – between debtor and creditor – between the U.S. and its highly liquefied competitors for global resources – will surely intensify. The global grab for limited resources should be expected to at some point turn more hostile, providing greater incentive for the U.S. to inflate and for others to aggressively exchange dollar liquidity for more attractive stores of wealth/value.

As Mr. El-Erian states, “the jury is still out as to what the destination” of this “journey” will look like. A black tide of protectionism, nationalism, radicalism, trade frictions, capital controls, and militarism certainly cannot be ruled out as the ugly outgrowth of this historic inflationary boom. And, from this perspective, the growing divide between the over-liquefied markets’ mispricing of risk and escalating financial and geopolitical risk is no conundrum.

Link here.


Act now before it is too late. That may sound like a pitch from a cheesy TV ad, but the fact is that a number of good mutual funds appear poised, by our estimation, to slam the doors on new investors in the coming year. So we have assembled a roster of portfolios likely to close. The seven on our list, according to the Forbes fund scoring system, rate mostly A’s and B’s in up or down markets. Closings occur when a fund company believes a portfolio is getting unwieldy and will not be able to effectively allocate the torrents of fresh cash sluicing in.

Fund closings happen during bull markets, and more than a few took place during the 1990s (Fidelity Magellan, for instance). In the early part of this decade, when the market was crashing and customers fleeing, there was little need to chase away new ones coming in the door. Now closings are on the agenda once again. In 2006, 98 funds locked their doors, up from 40 the year before. Last April Fidelity Investments decided to give Contrafund, the popular large-cap growth fund, a curtain call before its sterling performance succumbed to asset bloat. In the prior 12 months the total return was a princely 21.3% – and $8.5 billion in new money flowed into what is now a $69 billion fund. Other notable funds that closed last year: Royce Premier, Third Avenue Small-Cap Value and William Blair Small Cap Growth.

Asset bloat gets to be a big problem very quickly at a small-company fund. If the portfolio reaches $5 billion, its manager must purchase a 10% stake in a $500 million company just for it to encompass 1% of his fund’s portfolio. Getting in and out of a position equal to 10% of a company’s outstanding shares without pushing the price is a tricky matter.

To be sure, the mere fact that a fund is playing hard to get is not proof that you should buy in. The tech-laden Janus fund closed in September 2000, just as the tech bubble was bursting. Performance collapsed, and money drained out. The fund reopened to investors in December 2002, which was not a bad time to invest since Janus is now doing fine. Fidelity Magellan closed in 1997 after a decade in which it bested the market, albeit not by much. In the not-quite-decade since, the fund has turned in subpar results.

Still, given the same management and no large-scale intervening events, like a market slump, there is every reason to believe that most closing funds will continue their winning ways, says Russel Kinnel, director of fund research at fund tracker Morningstar. In a recent study he found that, after barring new investments, closed funds’ performance did cool down somewhat, but they still outpaced their peers.

Fund watchers look for an obvious telltale sign to discern the next ones to haul up the drawbridge: Funds with a flood of new money – say, 30% of current assets in the past three years – are prime suspects. Funds in hot categories – lately small cap and international – are where closing is most prevalent. Monitor Web sites like Morningstar’s to get an idea of what funds are popular. Roy Weitz, head of watchdog FundAlarm, Morningstar’s Kinnel and other savants helped us pick our 7-fund list of likely upcoming closings in the next year or so, based on the above metric and old-fashioned scuttlebutt. All the funds deny having any current intention to close their doors, except one which did not comment.

Our picks include the midcap Calamos Growth, which reigned for three years at the top of the Forbes Honor Roll, then fell off our golden list in 2006. Asset bloat may be partly to blame, as was betting wrong on computer hardware. At Dodge & Cox, which is in the habit of closing funds, the $28 billion International Stock fund (97% of that cash arriving in the last three years) is likely to follow. Real estate funds have blown past the broad market for a while.

What to do if the door has already shut at a good fund? Existing investors and those whose 401(k) plans already offer closed funds often can continue to put money in it. Or you can buy an open fund similar to a sterling closed portfolio. We assembled five such matches, whose performances tracked the closed stars over five years. We assembled our picks using Lipper research data, screening for funds with similarities to the stars, based on a metric called R-squared. Unfortunately, the average investor cannot do the exercise himself without subscribing to a costly service like Lipper’s. Missing from our table of celebrated closed funds is Sequoia, which is extremely concentrated (only 22 holdings, 84% in its top 10) and lacking in close substitutes. Nonetheless, given the fund’s low turnover (8% a year), you can probably do a fair job of knocking it off yourself.

Link here.


The GM era is over. This year Toyota will overtake it as the world’s largest manufacturer of autos, selling something more than 9 million, probably half a million more than GM. This seems certain. It is even plausible that in, say, 2011, when Toyota has built more factories and hired more dealers as GM sales keep falling, the Japanese Godzilla will outsell GM in the U.S. I am not predicting this, just saying it is possible with present trends.

The psychological effect of GM’s fall to the #2 position will be enormous. Sure, there is maybe one good side to it. People will stop blaming General Motors for everything that goes wrong in the world. The company will not be blamed for destroying the air we breathe, for not doing enough for safety or diversity, for not saving the polar bears. Look at the nonsense about blaming GM for killing the electric car. GM really tried to build one, with a unique power system. Toyota stuck a few batteries in an old RAV4 and then quit on it. But nobody made a movie charging Toyota with killing the electric car.

That is the only good thing about losing that I can think of. The bad things are many. The auto business tends to follow the leader. GM takes off the side vent windows (remember them?), everyone has to remove them or their cars look old-fashioned. If Toyota, when it is #1, puts back the side vent windows (not that it will), GM would have to follow or its cars would seem dated. This will be a painful adjustment. At first GM will try to prove that it has not lost. We call that denial. When GM ruled, it led in technology. But this preeminence has been fading for decades. GM will reach – trying to prove it is still in the technological game. GM people will come up with new cars that they dream will retake the leadership. I call that desperation.

Ford was first in the world in the early days but lost that title late in the 1920s. It was never the same after GM passed it. Ford built some fine cars, but was always the #2 company. At first the company seemed to crawl into a shell. Then founder Henry died; his grandson Henry II took over and hired a team of GM fireballs to retake the title. “Beat GM” was the motto, but that grand crusade died with the failure of the Edsel in 1958. From then on Ford was like a mouse in an exercise cage. No matter how fast it ran, it got nowhere.

This does not mean the end of GM. Outgunned armies can still fight, hold ground and win battles. But they do not win the war. GM was on top for three-quarters of a century, and that is impressive. Toyota will not do that. The world moves faster now. In 15 years maybe the Koreans (Hyundai) or the Chinese (Shanghai Auto) will overtake it. I might be wrong about GM never regaining the leadership. After all GM still is a power, outselling Toyota in North America, Brazil, Europe and China. But Toyota is closing the gap everywhere and leads GM in Japan by millions of sales. And Toyota wins in Africa, the Near East and Asia outside of China. GM 2007 is not Ford Motor 1929. The battle is not always to the strongest – but the bookies say it is still the way to bet.

Link here.


I received a phone call from a professor of an esteemed university offering to teach a class on relationship management right here on Whiskey & Gunpowder. I was initially skeptical, and it took a bit of persuasion on his part, but once I heard a synopsis of the lessons, I agreed the topic was fine. Still, everything on Whiskey is free, I insisted. Eventually we came to terms, and the professor agreed to teach a few lessons at the bargain-basement price of nothing. Without further ado, here is professor Hardious Knocks of the prestigious School of Hard Knocks, teaching Relationship Management 101. Each lesson in this series is based on current events. There will be a written assignment after each lesson. Class is now in session.

Lesson 1
Relationship Management by the Book.

“The stalled real estate market turned Stoneybrook at Venice into a very different community than its residents paid for: a half-built subdivision dotted with slow-moving construction sites and ‘For Sale’ signs. Many residents of the 560-acre east Venice subdivision said they are willing to weather those inconveniences. But the latest news – that mega-developer Lennar will dump more than $6 million in costs on homeowners – has Stoneybrook residents crying foul and preparing a lawsuit. ...

“Residents said they were under the impression they would only have to pay for future maintenance through their homeowners dues. But commissioners ruled the developer did everything by the book. ... Lennar attorney Dan Bailey called the residents’ claims ‘reckless allegations.’ He said Lennar made clear there would be more costs when it started selling homes in Stoneybrook. ... Today, the complex is about 43% sold, which county staff said is less than two-thirds as far along as Lennar hoped. County staff said Lennar will fall almost $8 million short of its revenue goals for its first two years if the sales trend keeps up.”

Homework Assignment 1

Lesson 2
You Are No Longer Needed. Goodbye.

“Centex Corp. chief executive Tim Eller ... said the homebuilder’s head count is down 17% since the beginning of its fiscal year. ‘There will be more reductions in the [fiscal] fourth quarter,’ the CEO said. ‘We’re taking the necessary steps to get our balance sheet and our organization to their fighting weight,’ he added.”

Homework Assignment 2

Lesson 3
Blame the Auctioneer

“One Cape Coral (Florida) homeowner left an auction sponsored by the Miloff Aubuchon Realty Group Inc. elated her home fetched a $400,000 bid. Then, the bottom fell out. ... ‘The bid came over the Internet. They said there was a computer glitch,’ said Rosemarie Leibert, 79. ‘They put it back on auction and the bid was $250,000.’ "Leibert declined to take the bid. Leibert ... believes the bids were too low and the auction did not deliver serious bidders.

“Calling the effort a learning experience, Jeff Miloff, the realty group’s sales manager, said another auction planned for March could have different rules. The bids were so unrealistic the auction showed people didn’t do their homework, Miloff said. ... ‘People had no sense of what they were bidding. It made no sense.’”

Homework Assignment 3

Lesson 4
We are All in This Together

“If you think you are paying more to live in your condo, townhouse, or gated community, consider this: It may get worse before it gets better. Experts fear that with homes selling slowly, owners who can no longer afford payments may soon abandon them. If that happens, those left behind in communities run by associations must make up the missing share of money to maintain roofs, roads, landscaping, and pools. ...

“‘We’re seeing a 100% increase in the number of files turned over to us [by associations] for lien and foreclosure,’ said Gary Poliakoff, whose Fort Lauderdale-based law firm, Becker & Poliakoff, represents 4,200 associations in Florida.”

Homework Assignment 4

Lesson 5
Who Do You Believe?

“The 0.8% drop in (home) sales in December came after two straight months of improving sales, the first back-to-back sales gains since the spring of 2005. David Lereah, chief economist for the Realtors, said that even with the December setback, he still believes that sales of existing homes have hit bottom and will start to gradually improve. ‘With fingers and toes crossed, it appears that we have hit bottom in the existing home market,’ he said. ...

“In other economic news, the number of Americans filing applications for unemployment benefits shot up last week by the largest amount in 16 months, reversing two weeks of big declines. ... But economists said they believe the low point for housing has been reached and they are forecasting a slow rebound in 2007. Because of that optimism, analysts don’t believe the slump in housing will drag the overall economy into a recession.”

Homework Assignment 5

Extra Credit Assignment
Lower Your Costs or You are Fired

“Faced with a $195.6 million loss in the fourth quarter, [Lennar] is telling subcontractors that it wants further cost cuts (by 5% or more) or they will be excluded for six months from future bidding. ... ‘As our customers continue to pay us a lower price for our homes, we must in turn pay you a lower price for your services,’ said a letter circulated to subcontractors in Lennar’s Orange Coast, Corona, Temecula, and Palm Springs divisions. [Lennar’s Southwestern U.S. regional Vice President Jeff] Roos, said similar requests are being made of Lennar subcontractors nationally. ... ‘Every builder is doing the same thing,” added Roos ... [who] said 90% of the subcontractors in the region had a positive response to the letters.”

Extra Credit Homework

Hmmm. There seem to be some questions for professor Hardious Knocks about this extra credit assignment.

Mr. Plumber: I can’t cut my costs, I have bills to pay.

Professor Knocks: It seems you have a relationship problem with your bills. We cover that in Relationship Management 102. The first two lessons are “How to avoid paying your creditors” and “How to terminate expensive relationships.”

Mr. Carpenter: This sounds like extortion. My inventory is stacking up, and if I cut prices, I will lose money on the bid.

Professor Knocks: It does not matter what your costs are. You can lower your prices and lose money, or not lower them and do no business.

Mr. Economist: You cannot fool me. This extra credit assignment is really about deflation.

Professor Knocks: Don’t confuse falling prices with deflation or rising prices with inflation. I highly recommend that you take Deflation 101. The first lesson is how to put the horse in front of the cart. But if the carpenters and plumbers of the world go bankrupt, or if too many of those new relationships at the unemployment line end up in bankruptcy court, then yes, we are talking deflation. I look forward to seeing you in class next semester.

Link here.

When realtors become waiters.

Home sales volumes in California are sliding sharply. Ironically, the population of real estate agents in the state continues to set new records. One in 70 Californians now holds a real estate license. Why should we care what happens in California?

We should care because California epitomized the excesses of the late great housing bubble. It was California where quirky, high-risk mortgages flourished, where the median home became unaffordable to 84% of the average residents, and where actors became waiters, then became real estate agents ... only to become waiters again. What happens in the California real estate market, therefore, might anticipate what will happen in the rest of the country ... and that is probably not good news.

If you were to ask most Wall Street analysts about the condition of the nation’s housing market, they would probably say that it is “bottoming out” or “stabilizing”. But if you were to pose the identical question to most CEOs of major homebuilding companies, they would probably say, “We have not yet seen tangible evidence of a market recovery.” We find the first-hand accounts from the homebuilders themselves to be much more persuasive. Furthermore, the rapidly imploding subprime mortgage industry persuades us that homebuilding CEOs will not be heralding a recovery any time soon.

“Subprime” refers to borrowers with relatively poor credit, i.e., borrowers who cannot qualify for a traditional “prime” or “conforming” mortgage. Not so long ago, subprime borrowers represented a small sliver of the overall mortgage market. But during the recently ended housing boom, these borrowers came to represent a whopping 23% of the total share of new loans. What is bad for subprime borrowers, therefore, is bad for the entire housing market. And what is beginning to happen to subprime borrowers – and their lenders – is bad indeed. They are defaulting in large numbers, while their lenders are going bankrupt in large numbers.

During previous housing booms, a buyer who could not qualify for a conventional loan could not buy a house, plain and simple. But during the boom that just ended, a relaxed, new set of lending standards emerged. Borrowers who could not qualify for a traditional loan could still obtain a non-traditional loan, a sub-prime loan. Unfortunately, the mortgages they got usually contained toxic features like “adjustable” interest rates that would adjust higher whenever short-term interest rates moved higher – possibly raising mortgage payments to unaffordable levels. Since rates have been moving higher at the very same time that home prices have been moving lower, many subprime borrowers are finding themselves with no way out ... except to default.

Nationwide, foreclosure filings jumped 51% last year. In California, the epicenter of the housing bubble-cum-bust, default notices jumped 145% in the last three months of 2006. Therefore, as James Grant explains in a recent issue of Grant’s Interest Rate Observer, “It’s a fact of macro as well as micro significance that roughly 25% of the U.S. home-buying population can be classified as ‘subprime.’” It is significant, says Grant, because this large contingent of marginal buyers played a major role in the powering the housing boom. If, as it now appears, these marginal buyers are disappearing, the housing market will miss them dearly.

Meanwhile, subprime lenders are disappearing rapidly. In early December, Ownit Mortgage Solutions, a California-based lender, went out of business. Ownit was the nation’s 11th largest subprime lender. The Mortgage Lender Implode-O-Meter is reporting “Twelve lenders have now gone caput since December 2006.” This number has been increasing at a rate of 1-2 a week since December.

Some subprime lenders continue to operate, of course. But the surviving lenders are issuing fewer mortgages than they used to issue. The new and improved subprime lending environment requires borrowers to have higher credit scores, make larger down payments, and possess larger reserves of savings. But even though the lenders have closed their proverbial barn doors, the subprime horses are still running wild. And many of these wild horses will straggle back to the stable as delinquents.

In short, the increasingly dire conditions of the mortgage industry suggest that a genuine recovery remains a delusional hope. The willingness to lend and the willingness to borrow are both in retreat. This is how cascades start.

Link here.
Housing threatened by defaults in sub-prime mortgage market – link.


The Pentagon recently reported that it now spends roughly $8.4 billion per month waging the war in Iraq, while the additional cost of our engagement in Afghanistan brings the monthly total to a staggering $10 billion. Since 2001, Congress has spent more than $500 billion on specific appropriations for Iraq. This sum is not reflected in official budget and deficit figures. Congress has funded the war by passing a series of so-called “supplemental” spending bills, which are passed outside of the normal appropriations process and thus deemed off-budget. This is fundamentally dishonest. If we are going to have a war, let us face the costs – both human and economic – squarely. Congress has no business hiding the costs of war through accounting tricks.

As the war in Iraq surges forward, and the administration ponders military action against Iran, it is important to ask ourselves an overlooked question: Can we really afford it? If every American taxpayer had to submit an extra $5-10,000 to the IRS this April to pay for the war, I am quite certain it would end very quickly. The problem is that government finances war by borrowing and printing money, rather than presenting a bill directly in the form of higher taxes. When the costs are obscured, the question of whether any war is worth it becomes distorted.

Congress and the Federal Reserve Bank have a cozy, unspoken arrangement that makes war easier to finance. Congress has an insatiable appetite for new spending, but raising taxes is politically unpopular. The Fed, however, is happy to accommodate deficit spending by creating new money through the Treasury Department. In exchange, Congress leaves the Fed alone to operate free of pesky oversight and free of political scrutiny. Monetary policy is utterly ignored in Washington, even though the Federal Reserve System is a creation of Congress. The result of this arrangement is inflation. And inflation finances war.

Economist Lawrence Parks has explained how the creation of the Federal Reserve Bank in 1913 made possible our involvement in World War I. Without the ability to create new money, the federal government never could have afforded the enormous mobilization of men and material. Prior to that, American wars were financed through taxes and borrowing, both of which have limits. But government printing presses, at least in theory, have no limits. That is why the money supply has nearly tripled just since 1990.

Link here.


A recent Associated Press headline read “Signs Point to Good Year for Investing in Large-Cap Stocks”. I could not help but wonder what signs these people are reading. The gist of the article is that it might be time for small-cap investors to rethink their investment strategy. The author thinks that this year, the best bet for anyone with a dime in his pocket will be the big-name stocks that can ride out any bumps in the economy. His logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000’s returns. I am sure some are eagerly anticipating this event as if it will somehow restore order to the stock market and promote world peace.

But as much as we humans enjoy synchronizing our watches and measuring significant events by calendar year, we tend to miss out on the bigger picture attempting to predict the unpredictable. The AP article posed the question as to whether an investor should alter his strategy to focus on larger stocks since they are “poised to outperform” smaller ones. The Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and romped the Russell 2000 for the second half of 2006. Ever since the Russell 2000 took a hit in May 2006, a lot of money has been flowing into large-cap stocks. The Dow Jones Industrial has soared while the Russell 2000 and the NASDAQ have lagged behind. Now we have the Dow squeaking out record highs seemingly every week. So what are investors to do?

Well, there is a group of small-caps that are very attractive, but you must be selective. A few months ago, our former value guru James Boric wrote that average investors are, in fact, buying garbage stocks, even in the small-cap arena. He searched for all small-cap companies traded on the NYSE at the 15 times earnings level or less, 1.5 times book value or less, 1.5 times sales or less, with positive free cash flow, revenue growth, and net income growth. This group would represent attractive small-cap value stocks. This group only appreciated 6.1% over the prior year – not much at all.

These stocks with good fundamentals are what investors should be clamoring for. But it was another group of stocks that got all the attention: Small caps on the NYSE that had negligible sales growth, no free cash flow, were trading at two times book value or more and had no earnings to speak of. The 19 stocks that made this list climbed 51% over the previous year. Do you think that these stocks with rotten fundamentals will continue to rise? Well, we cannot tell you when they will stop, but we can tell you where we would put our money.

Link here.


This past week, a 77-square-foot London flat sans electricity hit the market for $335,000. Apparently, the rather intimate proximity to Harrods and Hyde Park will reap an impressive $4,350 per square foot. So in case you desire something more generous than a glorified walk-in closet, say, a 500-square-foot studio, perhaps, be prepared to surrender something along the lines of $2.1 million. Exclusive properties around town, assuming you need something more advanced than an Afghani cave, have been nudging the $5,900-per-square-foot mark. That figure graciously elevates the asking price for our dream flat to a respectable $3 million. Amazing.

Despite the fact that sales of new homes in the U.S. were down 17.3% from their all-time high in 2005 (sales of existing homes fell by 8.4%), London residential property keeps heating up. Broad-based values have experienced a 22.4% gain this year. Home prices in the more exclusive neighborhoods have shot up more than 60%. London is not alone. Similar properties in New York can garner roughly $5,300 per square foot. But what caught my attention was that comparable properties in Hong Kong were selling at a 25% discount to the country’s respective financial peers. Exclusive properties there sell at around $3,950 per square foot.

Hong Kong is only six times the size of Washington, D.C., with an annual GDP on par with both Argentina and Portugal. More importantly, Asian financial centers like Hong Kong lack the expansive terra firma we in the West find so readily abundant. Land is and always will be the most valuable asset in places like Shanghai, Tokyo, Taipei, Hong Kong and Singapore. These Asian cities lack the land for urban sprawl we in the U.S. see in places like Chicago, Washington, Houston, Los Angeles, Charlotte and Atlanta.

So I am a little baffled that high-end Hong Kong real estate trades at such a noticeable discount to similar properties in New York and London. Hong Kong is the land of the rich. 21 billionaires now call this city home. Money will flow to where it is treated best. And I think you will be hard-pressed to find another place in the world that treats money better than Hong Kong. Since 1970, Hong Kong has held top honors as the world’s freest economy. Hong Kong stands as the world’s 11th largest trading entity and 13th largest banking center. Hong Kong produces a GDP per capita that ranks No. 1 among all economies on the Asian continent.

The highest tax bracket comes in at 17%. Individuals are assessed on only annual employment income. Dividends and capital gains are not taxed. Like many progressive tax systems, Hong Kong grants allowances for certain deductions like charitable contributions. When you consider that Hong Kong provides perhaps the world’s greatest municipal services in a relatively crime-free environment, good luck finding a more favorable tax policy anywhere in the world. And like the low personal tax rates, Hong Kong’s estate tax holds a maximum rate of 15% on assets exceeding $1.35 million. When Li Ka-shing, the world’s 10th richest man, looks to pass on his $18.8 billion-plus, he will do so under very favorable circumstances.

And here is the kicker. Hong Kong recently repealed its inheritance tax on property. Consequently, many Hong Kong property owners (U.S. citizens who own Hong Kong property are still taxed under inheritance laws) are now able to pass down real estate assets without any tax liability whatsoever. Hong Kong will become a tax haven for the new class of the super-rich. Its skyline competes with Manhattan’s, its weather compares to Miami’s and public safety and infrastructure outclass anything you will see here in the U.S. Disney has just moved in across the harbor on Lantau Island, and Macau, the Las Vegas of Asia, is just a 45-minute boat ride away. What is not to love?

Prime locations in Central, Admiralty and Causeway Bay, the heart of Hong Kong, will continue to command premium prices for years to come. Hong Kong property stocks should prosper. And right now, property development companies like Cheung Kong (CHEUY: Pink Sheets) and Sun Hung Kai (SUHJY: Pink Sheets) are both trading at very attractive prices.

Investors with direct access to the Hang Seng Index may also want to check out the Guoco Group (HK: 0053). Guoco is an investment holding management company based in Hong Kong. Its subsidiary companies and investment activities are principally located in Hong Kong, China, Singapore, Malaysia and the U.K. Guoco has four core businesses, namely, proprietary asset management, property development and investment, hospitality and leisure business and financial services. It currently trades at 5 times earnings and has a 5% yield. Better yet, it has three times the cash on the balance sheet than total liabilities. Operating margins are consistent and strong. That is something to consider.

Link here.


It was half-past five before Holmes returned. He was bright, eager and in excellent spirits, a mood which in his case alternated with fits of the blackest depression.

“There is no great mystery in this matter,” he said, taking the cup of tea which I had poured out for him; “the facts appear to admit of only one explanation.”

“What! You have solved it already?”

“Well, that would be too much to say. I have discovered a suggestive fact, that is all. It is, however, very suggestive.” ~~ Sir Arthur Conan Doyle, The Sign of the Four

The greatest investment ideas often turn on a simple insight. Yet the simple insights are hard to find, which makes them rare and special. Useless information and noise often obscure them. The origin of a good investment idea often begins when an investor has filtered out what does not matter and has found what remains. A simple “suggestive fact”, as Sherlock Holmes would say. The search for suggestive facts is worldwide and crosses many boundaries.

A hardscrabble camel dealer with 20 years in the business knows a few very good things about camels. He is easily able to separate what really matters from what is not so important. He is hard to fool with predictions and fancy talk. He knows what he is looking for and he knows what he will pay for it – or sell it for. One of my favorite “suggestive facts” is when you find a big difference between what private buyers are paying for whole companies versus what people are paying in the public markets for shares of these same companies. I have found many such disparities, and they have often become recommendations for my readers.

For example, take a look at Pioneer Companies (PONR: NASDAQ). Pioneer emerged from bankruptcy in 2002, a victim of the last downcycle. New management took over in autumn 2002. So began a process of cost cutting and selling off non-core assets. The company dramatically paid back debt such that it is essentially debt-free. It is a new company. Pioneer is the 6th largest producer of chlor-alkali products in the U.S., with 5% of the North American market (which makes up about a quarter of the global total). It has productive capacity of 725,000 electrochemical units (ECU).

In Pioneer’s capacity of 725,000 ECU is where you find the disconnect between the public markets and the private markets. It costs about $1,000 to create one ECU of capacity. If you were going to build Pioneer’s chlor-alkali production from scratch, it would cost you about $725 million. The whole enterprise value of Pioneer right now (stock market capitalization plus debt less cash) is about $340 million – a 47% discount to replacement value. If you wanted 725,000 ECU of chlor-alkali capacity you could build your own factories from scratch for $725 million. Plus, you know it would take time and ramp-up costs to get the whole thing running. You would need to find workers and managers and all that. Or you could go buy Pioneer. You would not be able to buy Pioneer for $340 million. But you could pay $500 million for Pioneer. That would make Pioneer shareholders happy. You have saved $225 million in the process. And Pioneer can start producing for you right away.

That is the most compelling reason to buy some shares of Pioneer. Even if the industry tanks, you have still got a lot of productive capacity that someone will want for when the market gets good again. Players like Dow Chemcical could write the check tomorrow without batting an eye. So you have got definite downside protection to help you stomach the stock market volatility. You own a real asset here which, unless chlor-alkali products somehow go out of style, is worth something.

The second reason to own Pioneer is that it is so cheap compared with peers. There does not seem to be a lot of justification for a 40% discount from peers based on cash flow and earnings, but that is what we have. Pioneer sells for less than three times trailing EBITDA. So it seems the bearishness on Pioneer is overdone. Some discount may be warranted because Pioneer is small and there are advantages of scale. But Pioneer has decent advantages of its own. As an aside, more than 75% of the North American production for chlor-alkali comes from the Gulf Coast region. So if another hurricane rumbles up that way, expect chlor-alkali prices to shoot up. Finally, about a third of sales are directly tied to water treatment. These sales get the benefit of the whole water emerging crisis I have talked about many times in other places.

For 2007, Pioneer could generate $4 per share in free cash flow. That is a 13% cash flow yield based on a $30 stock price. This cash flow could be used to pay a dividend or buy back stock – either of which would boost the stock price. That also makes it a target for the bigger fish. And if the consensus is wrong and the current chlor-alkali cycle has legs yet, this company is going to generate a lot more cash.

These are the kinds of suggestive facts (as Holmes would say) I spend countless hours searching for. These little nuggets form a compelling portrait of a potentially great investment.

Link here.


Capital markets powered ahead in 2006. As expected, the big winners were the emerging stock markets led by Peru, Vietnam, Venezuela, China and Russia. The laggards, however, were the stock markets of the “developed” world – no surprises here. Over in the commodities arena, several base metals (zinc, copper and nickel), precious metals (silver, palladium and gold) and grains appreciated significantly. So, how can we explain the simultaneous rise of so many uncorrelated markets?

During the past 12 months, the ongoing monetary-inflation, credit-growth and expanding liquidity environment drove up prices in various markets. Apart from rising interest rates and unrest in the Middle East, we did not get any major negative developments on the economic front, which also helped the global markets. Finally, the U.S. housing slowdown did not curb borrowing and affect consumer spending, thereby preventing a recession. So, what can we expect in 2007 from the various asset classes?

Going forward, I expect the liquidity environment to remain supportive of asset prices resulting in another good year for stocks. If my assessment is correct, emerging market equities and commodities should (once again) be the biggest beneficiaries in 2007. Even the U.S. stock market may surprise to the upside. This is a pre-election year, and history has shown that during pre-election years, American stocks have done well. Moreover, each mid-term election year in the United States since 1950 has provided investors with an opportunity to profit from a significant rally.

The U.S. economy is currently undergoing a mid-cycle slowdown, and the chances of a full-blown recession are slim. Over the coming months, I expect U.S. housing to deteriorate further, but a crash is highly unlikely. In other words, I anticipate a soft-landing in the U.S. economy. For sure, the world’s largest economy has severe problems. However, as long as other nations want to sell their merchandise to the U.S. and are willing to finance its deficits, its economy should be able to live on borrowed time.

I am of the opinion that despite a slowing U.S. economy, growth in other parts of the world may remain unharmed. Asia is advancing at a blistering pace, Latin America has turned around and Eastern Europe is developing rapidly. Accordingly, our managed-accounts are invested in the fastest-growing regions of the world. My current preferred stock markets are Brazil, China, Mexico and Russia. I expect commodities to resume their bull-market and make headlines all over the world. Despite all the negative news surrounding natural resources, the fundamental factors have not changed. In fact, the recent consolidation has made commodities even more attractive. Global demand for “things” is rising, supplies are tight and monetary-inflation continues worldwide.

It is interesting to note that roughly 60% of China’s population and 70% of Indians still live in rural areas. Back in 1980, over 80% of China’s population resided in rural areas (versus 60% today). This number is expected to decline further to 40% by 2030. People in cities generally earn more money when compared to those in rural areas. Once the millions of Asians move to urban centers and become wealthier over the coming years, they will demand a better quality of life and all the “creature-comforts”. Unless you are a central banker and have the ability to create something out of thin air, it is safe to assume that the demand for all these goods will require an immense quantity of raw materials such as cement, steel, copper, rubber, zinc and energy.

Throughout the 1980’s and 1990’s, prices of commodities were caught in a vicious bear-market. The devastation was so severe that the majority of the commodity-producers did not invest in spare capacity. When the demand for commodities suddenly began to rise 4-5 years ago, nobody was prepared for it. Even today, despite the surge in the prices of raw materials, spare capacity and stockpiles are extremely low. These days there is a lot of noise about the copper “bubble”. It is my observation that asset-bubbles are usually accompanied by an oversupply of the item in question and buildup of its inventories. Yet, the level of copper inventories on the London Metals Exchange indicates that the “bubble-talk” is totally absurd! And Bolivia plans to “industrialize” a river that supplies water to Chile’s Atacama Desert, thereby threatening the world’s largest copper-mining district.

I suspect copper – like many other commodities – is simply consolidating within its ongoing bull-market and its price in real (inflation-adjusted) terms is still way below its all-time high recorded in the 1970’s. Once the correction is over, I anticipate copper will resume its uptrend. Utilize any weakness in the near future as an opportunity and consider investing in copper-mining companies that have huge reserves and cash flows.

Furthermore, it seems to me that the multi-month consolidation in precious metals is now almost complete and we are likely to see upward moves over the coming weeks. Both gold and silver have built a huge base and they have recently shown strength in the face of a strong U.S. dollar – impressive action. It is my belief that this maybe the final opportunity for investors to buy precious metals and quality mining stocks at these depressed levels. It always pays to buy when the sentiment is negative.

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


It feels as if it was years ago when I was in the Baltimore suburbs, baking in the hot summer sun as I waited in line at a gas station. It was just a few days after Hurricane Katrina shredded much of southern Louisiana and Mississippi. Along with the human suffering came economic woes, as many people presumed that our refineries along the Gulf Coast had been blown away as well. A gallon of regular unleaded was going for $3.05 at the cheapest place in town, and people were piling their cars into the small parking lot. Some of the eager motorists even spilled out onto the main road, backing up traffic for almost a mile. But today, it is off our collective radar screen. Gas is cheap – crude has even traded as low as $50 a barrel. And for the past couple of months, some consumers have been filling their tanks for less than $2 a gallon. How quickly we forget. ...

By looking at the performance of oil companies over the past several months, it is quite evident that the average investor has become almost completely oblivious of one of the world’s most profitable businesses. The current P/E ratio of the independent oil and gas industry is 12.6. Major oil companies have an average P/E of only 9.8. The P/E of the S&P 500 is 20.7. And the break we are experiencing in higher oil prices probably will not last too much longer. OPEC recently announced that it might decrease oil production. President Bush has said that he wants to double the strategic petroleum reserves. Winter’s biting cold finally arrived. And let us not forget the Summer driving season is not too far away.

While these events might not send gas prices back through the roof, the demand is there. And $50 oil will not stop the energy dealers from turning a profit. With that in mind, I present you with these three independent oil companies. All three of them have price-to-earnings ratios of less than 10. Two are trading below $10 a share. Keep your eye on these deals.

Link here.


We will take a look at the Brave New World of derivatives, what the Fed and central bankers are saying about that world, and what the world believes they both can do. Let us start off with a look at the GSEs.

Bloomberg reported, “Sallie Mae 4th-Quarter Net Falls on Derivatives Losses”: “SLM Corp., the nation’s largest provider of college-student loans, said fourth-quarter profit tumbled 96% because of a decline in the value of financial contracts it uses to protect against swings in interest rates. Net income fell to ... 2 cents a share ... from ... 96 cents ... a year earlier ... Earnings excluding the derivatives rose 15%, less than analysts expected.”

On Jan, 17, 2007, William Poole, president of the Federal Reserve Bank of St. Louis, gave a speech on the topic “The GSEs: Where Do We Stand?”:

Not long after coming to the St. Louis Fed in 1998, I became interested in government-sponsored enterprises, or GSEs. My interest arose when I began digging into aggregate data on the financial markets and discovered how large these firms are. The bulk of all GSE assets are in the housing GSEs – Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks. Using information as of Sept. 30, 2006 ... these 14 firms have total assets of $2.67 trillion; given their thin capital positions, their total liabilities are only a little smaller. ... Fannie Mae and Freddie Mac .. account for ... 62% of all housing GSE assets. Moreover, Fannie Mae and Freddie Mac have guaranteed mortgage-backed securities outstanding of $2.82 trillion. Thus, the housing GSE liabilities on their balance sheets and guaranteed obligations off their balance sheets are about $4.47 trillion, which may be compared with U.S. government debt in the hands of the public of $4.83 trillion. ...

My initial curiosity about the GSEs was stoked simply by the size of these firms. As I investigated further, I became concerned about their thin capital positions and the realization that if any of them got into financial trouble, the markets and the federal government would look to the Federal Reserve to deal with the problem. ...

I believe that many risk managers simply accept that GSEs are effectively backstopped by the Federal Reserve and the federal government without ever thinking through how such implicit guarantees would actually work in a crisis. The view seems to be that someone, somehow, would do what is necessary in a crisis. Good risk management requires that the “someone” be identified and the “somehow” be specified. I have emphasized before that if you are thinking about the Federal Reserve as the “someone,” you should understand that the Fed can provide liquidity support, but not capital. As for the “somehow,” I urge you to be sure you understand the extent of the president's powers to provide emergency aid, the likely speed of congressional action and the possibility that political disputes would slow resolution of the situation. ...

At present, there is no process and no one knows what would happen if a GSE is unable to meet its obligations. ...

I do not believe that a GSE crisis is imminent. However, for those who believe that a GSE crisis is unthinkable in the future, I suggest a course in economic history.

Key points made on the GSEs:

Let us review one key excerpt: “The Fed can provide liquidity support, but not capital.” For all this talk of “helicopter drops”, Poole seems to be calling Bernanke’s bluff. I have pointed out many times before that the Fed has no authority to do “a drop”, and probably would not even if it could. No doubt it would act to slash interest rates in a crisis, but depending on the exact nature of Fannie Mae’s hedges, it is conceivable that the opposite play might be needed. Is this what has the Fed spooked over Fannie Mae?

In the panel on government-sponsored enterprises, Poole spoke on the emergency powers of the Fed: “I am acutely aware that should there be a market crisis, the Federal Reserve will have the responsibility to manage the problem. Just as many market participants apparently believe that GSE obligations have the implicit backing of the federal government, they may also believe that the Federal Reserve has all the powers necessary to manage a crisis. ... The Federal Reserve has ample power to deal with a liquidity problem, by making collateralized loans as authorized by the Federal Reserve Act. The Fed does not have power to deal with a solvency problem. Should a solvency problem arise with any of the GSEs, the solution will have to be found elsewhere than through the Federal Reserve.”

Because of all the past Fed interventions, no one believes the Fed. Is this the case of the boy who cried wolf one time too many? Is the Fed finally issuing a legitimate warning that no one believes? Let’s go across the Atlantic and check out things in Europe.

The Financial Times reports, “Prepare for Asset Repricing, Warns Trichet: Current conditions in global financial markets look potentially ‘unstable,’ suggesting that investors need to prepare themselves for a significant ‘repricing’ of some assets, Jean-Claude Trichet, president of the European Central Bank, warned at the weekend in Davos. ... ‘We are currently seeing elements in global financial markets which are not necessarily stable,’ he said, pointing to the ‘low level of rates, spreads, and risk premiums’ as factors that could trigger a repricing.”

Did anyone care about Trichet’s warning? I think not. The following news headline says it all: “Davos Elite Rebuffs Risk Warnings From Policymakers”. The body of the article reported: “Bankers, investors, and executives last week arrived at the Swiss resort of Davos giddy about record profits and bonuses. After five days of hectoring by policymakers that they are too complacent, they left just as happy. ... ‘The consensus here in Davos is everybody is thinking it will be another booming year,’ Morgan Stanley chief global economist Stephen Roach said.”

On January 26, Bloomberg reported, “ECB’s Weber Says Markets Shouldn’t Expect Central Bank Bailouts: European Central Bank council member Axel Weber said investors shouldn’t expect central banks to bail them out in the event of an ‘abrupt’ drop in financial markets. ... ‘If you misprice risk, don’t come looking to us for liquidity assistance,’ Weber said in an interview ... ‘The longer this goes on and the more risky positions are built up over time, the more luck you need’ ...”

Is this the case of the Fed that cried wolf one time too many? Oddly enough, I do not believe Trichet or Weber, or Poole, either. Like everyone else, I think the Fed will be there and willing to lend a hand to attempt to bail out the speculators. But unlike everyone else, I think that credit expansion and risk taking have reached such astronomical proportions that when it all implodes, the central bankers will be powerless to stop it.

I am not sure what will pop this global credit bubble, but I suspect it will not be higher U.S. interest rates or a rising yen. More than likely, it will be either pure exhaustion, something totally off everyone’s radar, or simply the reverse of some scenario that everyone expects. In 1980, it took $1 of new debt to create $1 of GDP; in 2000, it took $4; and today, it takes $7. All of that extra credit is serving no productive means. It is pure speculation and it will be unwound. Nonetheless, the sheep are still grazing.

There is a lot of unjustified faith in this Fed for what little power it has relative to where things stand in the current credit expansion cycle. Whether or not the central bankers are purposely crying wolf is now irrelevant.

Link here.


With some consternation, we have been reading that Fed officials think the U.S. economy is a lot sounder today than it was at the end of 2000 and in early 2001, when the Fed abruptly reversed course and began a string of rapid interest rate cuts. One can only wonder about its reasoning. What we see is a doubling of the U.S. trade deficit, the complete collapse of personal and national saving and an unprecedented borrowing deluge that created the most anemic GDP growth in the whole postwar period. During the five years 1995-2000, nonfinancial debt growth by 32.4% went together with 22.2% real GDP growth. In the following five years 2000-05, nonfinancial debt grew by 47.3% and real GDP by 13.4%. There has been an atrocious deterioration in the relationship between debt growth and economic growth.

In his speech on the Economic Outlook last November, Chairman Ben S. Bernanke said: “A reasonable projection is that economic growth will be modestly below trend in the near term but that, over the course of the coming year, it will return to a rate that is roughly in line with the growth rate of the economy”s underlying productive capacity.” To everybody’s surprise, Mr. Bernanke indicated he was more afraid of inflation than of an economic slowdown. What, actually, would happen if he expressed some fears about an economic slowdown? He would unleash an undesirable torrent of speculation anticipating the coming rate cuts. It is one of the many bad ideas of Mr. Greenspan that central banks should foreshadow to the public their next policy moves. It only plays into the hands of speculators.

Pondering the U.S. economy’s performance in 2007 ultimately boils down to two main questions: (1) whether the housing downturn will seriously hurt consumer spending, and (2) whether capital spending by Corporate America will promptly come to the rescue when consumer spending slows.

In our view, the first eventuality is highly probable, and the second is highly improbable. The housing bubble over the last few years has been the economy’s main driving motor, against pronounced weakness in business capital investment. Sharply rising house prices provided the collateral, which enabled private households to embark on their greatest borrowing-and-spending binge of all time. Those “wealth effects” from house price inflation, manifestly, played the key role in fueling the soaring home equity withdrawals. But the thing to see now is that to stop this easy credit source, it is enough for house prices to flatten.

The curb to this borrowing-and-spending binge has started with a vengeance. Private households have drastically curbed their mortgage borrowing, to $672.7 billion in Q3 2006, vs. $1,223.6 billion in the same quarter of 2005. That is, consumer borrowing almost halved. It amazes us how little attention this fact finds. It means that the most important credit source for spending in the economy is rapidly drying up, even though money and credit remain, in general, as loose as ever. This lever is not under the control of the Federal Reserve. Mortgage equity withdrawal peaked at an annual rate of about $730 billion, or 8.1% of GDP, in the Q3 2005. One year later, it was sharply down to $214 billion.

This, too, represents a pretty steep decline. Yet it seems to have had little effect on consumer spending, which rose 3.9% in 2004, 3.5% in 2005 and 2.9% in Q3 2006. For the bullish consensus, this is instant proof of its prior assumption that the downturn in the housing market will not spill over more broadly to consumer spending or aggregate employment. The truth is that consumer spending has been squarely hit. To see this, it is necessary to look at total spending by the consumer on consumption and residential investment. The latter was down 11.1% in the second quarter and 18% in the third quarter 2006, both at annual rate. Combined, the two components of consumer spending in the third quarter had slowed to an annual rate of 2%, the slowest growth rate since the past recession, against a 3.8% increase in 2005. Less than one-third of the rise in consumer spending was funded by current income growth and more than two-thirds was derived from additional borrowing. To us, this seems an unsustainable pattern.

Considering the dramatic reversal in the housing bubble, a virtual collapse of consumer borrowing is definitely in the cards for the U.S. Compensating for this big loss in spending power will require a sharp surge in employment and income growth. Some recent employment numbers have been somewhat better than expected. But they are not nearly as good as would be necessary to offset the impending further sharp decline in consumer borrowing. The median price of a new single-family home fell 9.7% year over year in September – the largest percentage decline since December 1970. The median price of an existing single-family home fell 2.5% year over year – the largest decline in the history of the series.

How likely is it that this housing downturn will be milder than average, as the consensus assumes? A rule of thumb says that the fierceness of a downturn tends to be rather proportionate to that of the prior upturn. By any measure, this was America’s wildest housing boom. The dollar volume of single-family home sales to GDP reached a record high of 16.3% in 2005, almost double the median percentage of the entire series dating back to 1968. Between 2000 and Q3 2006, the mortgage debt of U.S. private households soared from $4,801.7 billion to $9,497.4 billion. In barely six years, it has, thus, almost doubled.

We have been reading with utter amazement that stronger employment and income growth will offset the negative effects of the downturn in homebuilding. By available official numbers, the housing bubble – including directly related businesses such as furniture, mortgage finance and real estate – has created about 850,000 new jobs, about 30% of total job growth. Most of these jobs are sure to disappear.

Link here (scroll down to piece by Dr. Kurt Richebächer).


I read with interest a recent debate between Doug Kass and Michael Comeau on TheStreet.com. As a bear second only to Doug, I see the potential for a major drop in stock prices. But I would agree with Michael that “sounding ‘last call’ now seems premature,” mainly because of timing issues. My best guess it that a combination of the U.S. presidential election cycle and the Chinese preparations for the 2008 Olympics will keep the wolf at bay for one more year. These and other positive drivers listed in the next paragraph will not carry as much force next year, so I will have to revisit the bear case then. My views could best be summed up by saying, “stocks will soon fall, but not this year.”

Things are still good for now, but it is also hard not to see the handwriting on the wall. Earnings growth still appears to be strong, but it figures to weaken during the course of 2007. The Fed is probably done tightening, although other central banks may have just begun. The U.S. housing market appears to have stabilized for now, but the ARM resets are beginning in large numbers this year.

There are two mean reversion arguments regarding valuations. U.S. stocks are fairly valued today, or, as Comeau put it, “stocks today are not terribly overvalued,” relative to trend, and that stocks are well above trend. The first applies in comparison to the past 10 years or so. The second, and “Kassian” argument applies over a whole “long cycle” of 30+ years.

What has happened in past bear markets is that there is a catalyst that yanks stock prices out of their 10+ year trend, and toward (and even below) their 30-year trend line. Kass’s call for lumpy, mediocre growth, 1970s style (which I endorse), is a bearish argument, but one that does not cut it in a pre-Presidential election year. 1967, 1971, 1975, and 1979, the analogous years of the last secular bear market, were all up. The real bear argument is that 2007 will shortly become the modern 1931, in which case the market will go down this year, pre-election year or not.

Major market reversals usually start in the banking system. The bear case is that an Asian banking crisis (perhaps driven by a commodity bust) will put a kibosh on the global growth story. The scariest piece of global economic news I have read recently is that Korean banks were taking a hit on bad construction loans. This could have a ripple effect on the banks of a much larger country, China, whose banks are equally shaky.

So I have answered the three key questions of when (after 2007, perhaps 2008 or 2009), why (a catalyst such as an Asian banking crisis) and how (a reversion to, or through the 30 year mean valuation pulling stocks out of the 10 year trend line). The timing of these events is anybody’s guess, but the more important thing to know is what to look for.

Link here.


The insight that people can pursue their own interests, and in so doing improve the lot of everyone is the central insight of modern economists, at least those who are not idiots. The theory is simple enough. A man bakes bread not to put bread on others’ table, but to put it on his own. That others have bread to eat too is merely the happy consequence of a virtuous system. Likewise, the electrician does not fix your wiring because he likes to see sparks fly. He has to earn a living too, and he does it by providing something useful to others.

The symmetry of it is elegant. The morality of it is appealing. Do unto others, and they will do unto you. And the more you do for others, the more you can expect them to do for you. That is why a properly functioning economy does seem to deliver something close to rough justice. Henry Ford brought the benefits of automobile transportation to the masses. He deserved to make a lot of money. Andrew Carnegie provided the nation with steel. John D. Rockefeller rolled up and rationalized an early market in oil. Who can say these tycoons of yesteryear did not deserve what they got?

Just look along the “Gold Coast” of Connecticut. By the early 20th century, you could find the mansions built by the kings of industry and commerce of the period. Greenwich was home to the Simmons family, who made a fortune in mattresses ... the Phelps Stokes family, who made their money in copper products ... the Milbanks of Borden Condensed Milk ... and “Sugar King” Henry O. Havemeyer. Their grand houses were testament to their grand contributions. They were the people who built the wealth of America. The rich got their money honestly back then – at least most of it. They put their family names on their products and spent their loot grandly. Fancy clothes, limousines with chauffeurs ... grand balls with orchestras and servants dressed in proper outfits.

But now, what is this? A new bunch of kings have taken its place in Greenwich, dressed in perma-pressed khaki pants with blue, open-collared shirts. They are richer and busier than any group of bees the honey-pot nation has every produced. Still, do not bother to look for their last names on your refrigerator, or on your armchair, or even on your liquor bottles. Paul Tudor Jones, who lives in a house in Greenwich that resembles the mansion in Gone with the Wind, is a very rich man. But what did he do for the money? He is not a king of industry. He does not bring milk to the masses, nor does he provide copper pipes for their water systems, nor mattresses to rest their weary bones. Mr. Jones is a Bubble King, who manages a $15 billion hedge fund.

In another little town favored by the new moneyed classes, Norwalk, the granite mansion of steamship magnate and head of U.S. Steel, James Augustus Farrell, has fallen into the hands of another Bubble King – Graham Capital Management, a hedge fund with $5 billion in assets and only 150 employees. Graham’s chief financial officer lives on the other side of Long Island Sound and is said to commute to work by boat. We wonder why. At this point in the credit cycle we are convinced that bubble kings can walk on water!

We have previously argued that the present boom is a “fraud”. Now we look at those whom the fraud is rewarding so generously. If they are so richly paid, says the theory of modern capitalism, they must richly provide. But what? Take Lloyd Blankfein. The Goldman Sachs man took the wheel at the firm after Hank Paulsen went on to greater glory at the Treasury Department. In the six months from the time he took the job until the end of the year, he is reported to have earned $53.4 million ... or about $400,000 every working day.

And here ... our eyes roll up to heaven as we wonder: What hath this man done? This is where the theory of meritocratic markets begins to pinch the common man like a starched shirt at a summer wedding. There is no better system than free and unfettered capitalism, he tells himself. He loathes the thought of mobs at Mr. Blankfein’s door, and thinks he is clever enough to resist the meddlers who want to put a limit on how much a man can earn. Still, he senses that there is something not quite right.

How is it that in a free market system, where people are supposed to be rewarded according to how much they provide to others, today’s biggest prizes go to those who provide so little? Mr. Jenkins and Mr. Blankfein do not add in any appreciable way to the world’s wealth. Instead, they merely move it around. From middle and lower class taxpayers to the super-rich. From householders to speculators. And, by loading up the world with debt, from the future to the present. The answer is to be found in the details of modern finance.

Since 1995, the U.S. money supply has risen at about 10% per annum. The world’s supply of goods and services only about 3%. A free market presumes that money itself is an honest measure. Otherwise, all the “information” that free prices give is distorted and untrustworthy. “The introduction of a non-market driven money controller into the financial system invalidates the assumptions on which free-market economic theory is based,” writes Martin Hutchinson. Central authorities have kept money too loose, deceived a whole generation, and redistributed more wealth than ever in history. Like a cosmetic surgeon moving fat around, they have fashioned a financial world so lumpy and lop-sided, its own mother would not recognize it.

Hutchinson adds: “Lax monetary policy has continued for far longer than would normally have been possible, fully 12 years, a period of monetary ease and low real interest rates entirely without precedent. For more than a decade price signals have been distorted and resources have flowed in artificial directions ...” The U.S. and world economic system have been distorted for more than a decade in favor IPO-insiders, those with excessively large homes, the managers of hedge funds and private equity funds, and above all the gatekeepers such as Goldman Sachs, who control access to the overwhelming flood of liquidity. The wealth of the world has been artificially redistributed into their pockets. “They have come to expect such benefits; the Goldman Sachs participation in the Initial Public Offering for the Industrial and Commercial Bank of China, in which the firm and its partners, mostly the latter individually, made a $6 billion profit due entirely to its insider position in the world financial markets, might have landed them in jail for insider trading in a more stringent environment but in this market only further fattened their bonus pool.”

Neither central bankers nor bank robbers create wealth. They merely redistribute it. The mob idolizes holdup men. Then, often, it lynches them. What they will do to the central bankers and their accomplices in the financial industry, we wait to find out.

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