Wealth International, Limited

Finance Digest for Week of March 19, 2007

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


The yen is a piece of paper of no intrinsic value. Then again, so is every other currency under the sun. Each derives its value from the stamp of a government. What sets the yen apart is its tiny yield, five percentage points less than the money rates available in the U.S. and U.K., never mind the customarily higher-yielding currencies of Brazil, Turkey, Indonesia and other such subprime nations.

But the worst of it, for a yen bull, of which I am one, is the perceived certainty of things. At 121 to the dollar, the yen on February 26 stood at a 15-year low against the euro and its predecessor currencies, and a 21-year low in real trade-weighted terms. Before the worldwide selloff that began on February 27, there was supposedly nothing on the horizon to change things.

A little inflation would give the Bank of Japan the latitude to up its call rate. Because the so-called core CPI continues to sag, more increases seem unlikely. So sell the yen or avoid it, the consensus of expert opinion held. As an investor in Japanese equities, I will now talk my book. I believe that the yen is a worthwhile investment. It is a bargain in fundamental, purchasing-power terms, for one thing. And it provides low-cost disaster insurance, for another.

The yen is cheap for the merchandise it can buy today. It is also cheap for the corporate assets it could buy tomorrow, if only Japan’s famously shareholder-unfriendly corporate managements would wake up to the best practices of the 20th century, never mind those of the 21st. But more and more, they are. Late in February, for example, a Japanese fund manager did the heretofore impossible. Ichigo Asset Management, with all of $25 million under management, solicited more than 42% “no” votes to oppose the proposed acquisition of Tokyo Kohtetsu Co. by Osaka Steel, a union blessed by the two corporate managements and therefore, under the old rules, a done deal. But the rules have changed, and the merger is off.

Ichigo’s success in blocking this transaction represents a bell-ringing first. Scores of Japanese companies are commandingly cheap on an asset basis, but the assets are under lock and key. Pry the keys from management’s hands, and investors would beat a new path to Tokyo. Tradable merchandise is already cheap in yen terms. Japanese stocks will themselves appear cheaper as the reform in corporate governance continues to make quiet but substantive progress.

I mentioned disaster insurance. The yen, because it costs next to nothing to borrow and because it so reliably loses value against the dollar and euro, is the world’s favorite funding currency. People use it to finance investments in a host of higher-yielding assets. Japanese individuals sell the yen to buy Australian or New Zealand bonds. Sharpshooting hedge fund managers use the yen to finance their leveraged adventures in commodities, stocks, bonds and derivatives. The size of these borrowings – the “yen carry trade” – is nowhere precisely computed, but indications are that it is immense.

Because nothing is so unstable as a widespread belief in the certainty of peace and quiet, the buildup of yen short sales presents a risk to every investor, Japanese or otherwise. Without exactly knowing, it is a mortally certain that the world is more highly leveraged than even the fretful central bankers suspect. If so, a bear market in any of the popular classes of investment assets would likely turn today’s rush to borrow yen into an even faster race to repay it. Maybe it has already started.

If so, the yen-dollar exchange rate could soar. You may recall that in only three days during the crisis surrounding the 1998 crackup of Long-Term Capital Management, the yen rallied by 18%. One way to buy the yen is through a brand-new exchange-traded fund, CurrencyShares Japanese Yen Trust (FXY), traded on the Big Board. As the yen-dollar moves, so does the fund’s share price. The prospectus mentions some of the very good reasons not to speculate in foreign exchange. But there is no better time to take out flood insurance than when the sun is shining. The glare – until recently – was almost blinding.

Link here.

Japan land prices rise for first time in 16 years.

Land prices in Japan rose for the first time in 16 years as international and domestic investors competed to acquire properties in the three biggest cities. Gains in Tokyo, Osaka and Nagoya compensated for drops elsewhere in the country. Average commercial land prices in the three cities rose 8.9% in 2006 while residential land prices grew 2.8%, the Ministry of Land, Infrastructure and Transport said in a report released this week. The gains indicate Japan is “getting out from the deflationary era,” said Yuichi Chiguchi, at DLIBJ Asset Management in Tokyo.

Morgan Stanley and Goldman Sachs are among investors that have poured money into Japanese real estate, attracted by low interest rates, economic growth and new securitization deals. The investment rush has sparked concern of a new bubble, after a collapse in land prices in the early 1990s led to a decade of declines. The Bank of Japan said in its Financial System Report last week that it was “necessary to carefully watch future developments in the real estate markets and their effect on the financial system.” Japan's interest rates are still the lowest among developed economies after the bank raised the benchmark borrowing cost to 0.5% last month.

Commercial land in and around Tokyo, Osaka and Nagoya rose for a second straight year, after gaining 1 percent in 2005. Residential land prices in the cities increased for the first time in 16 years, up 2.8%. Commercial land values nationwide are still half of what they were at the height of Japan’s bubble economy in 1991, while residential land prices stand at half the peak. Commercial land prices in Tokyo’s central wards are at the same level they were in 1980.

Increasing land prices are a reflection of the economy and do not indicate an asset bubble, Vice Finance Minister Hideto Fujii said after the figures were released. But Tomohiro Makino, executive director of Nippon Commercial Investment, Japan’s 10th largest REIT, said, “Even prices for properties with low appeal are rising due to intensifying bidding. That is a very dangerous situation. You will fail if you make the wrong move.”

Link here.


The worldwide selloff after the Shanghai exchange’s overdue correction in late February is a reminder that investment risk is at a high level. Investors have been extraordinarily placid about the risk they are shouldering. Only following the China rout did VIX futures, which track expected volatility, nose up from recent lows. But at press time the March 2007 contract remained well below the level of last October, indicating people are still blasé about the threat.

There are pockets of risk you should definitely avoid. Two of the most dangerous are private equity and hedge funds. Despite their salesmen’s smooth PowerPoint presentations, many of these creatures have no clear-cut strategies of where to place the huge dollar flows they are receiving. They charge large fees for the privilege of accepting your money and often lock investors in for two to three years. If something goes wrong, then you have no way out.

Private equity works best when it finds very cheap companies – hard to do with so much competition from scores of other such funds. And then they must enlist operating geniuses who can dramatically improve company earnings where previous management failed. Next, they ladle on more risk by increasing the target company’s debt in the hope that earnings will balloon in the next few years. A heck of a tall order. Even the better-known funds like Blackstone Group are taking on immense new risk. Blackstone recently purchased Samuel Zell’s Equity Office Properties Trust for $39 billion. Zell is regarded as one of the shrewdest operators in the real estate world. When Zell sells, it is like a bell tolling for private equity’s peak. Good luck to Blackstone investors.

Hedge funds, on the faster track of daily trading, already have shown how things can come apart. Amaranth, a hedge fund with a sizzling record for some years, lost $6.6 billion last fall and collapsed. The fund allowed a young trader to make enormous directional bets in natural gas futures. This was the largest hedge fund failure since Long-Term Capital Management in 1998.

That is not all. Look at the subprime mortgage companies, which have both loose underwriting standards and a surprising appetite to hold a lot of the mortgages that they create. New Century Financial, the 2nd-largest subprime lender with $25 billion in assets, plummeted from a 12-month high of $52 to $15. NovaStar Financial, another large subprime entity (it also owns a passel of its own mortgages), is down 80% from its 12-month high.

Another measure of the disregard for risk is the equity risk premium, calculated by taking the S&P 500’s earnings yield – the inverse of its price/earnings ratio, now 18, which becomes 5.6% – and subtracting from it the 10-year Treasury bond’s yield. The difference is a mere percentage point, low by historical standards.

The lack of concern about risk also applies to the bond market. The spread between high-yield bonds and risk-free Treasurys is at its lowest level in five years. An even clearer indicator called the distress ratio measures the number of junk bonds that yield ten percentage points or more above long Treasurys. It is at its lowest level since 1994. Markets are much cheaper and have far stronger fundamentals than they had in the late-1990s bubble era, but any downdraft hurts. So improve the quality of your bond portfolio, keep maturities short and stay clear of junk. In equities, go for sound blue chips.

Link here.


4 1/2 years and still going strong. The bull market that began in late 2002 is far from over. Pessimists will tell you that the good times have to stop, that after four years the market just has to be due for a correction. But that is because the pessimists do not look at what is driving this market. The driver is the relationship between earnings yield (the inverse of a P/E ratio) and bond yields. When earnings yields are bigger than bond yields, institutional investors can make a profit by using borrowed money to acquire shares of stock. The process can continue for years, until equity prices are bid higher or the cost of money gets higher.

We are in the middle of such a process. The phenomenon can go on for quite a while. It did in the early 1960s, when a combination of cheap money and low stock prices gave rise to the conglomerate boom, personified by Harold Geneen of ITT. Who are today’s institutional buyers? They are of three kinds: (1) Private equity investors, firms like KKR and Blackstone, use mostly borrowed cash to buy whole companies outright, even, as we are now witnessing, a giant electric utility. (2) Publicly traded corporations using debt or a combination of debt and other financing to acquire competitors or related firms. An example is Tata Steel’s deal to buy British steelmaker Corus. In the lingo of analysts, the deal will be accretive – Tata’s earnings per share will go up as a result. (3) Finally, company heads who do not want their companies to be taken over can leverage up their own balance sheets in order to buy in shares. Done cheaply enough, the buy-in raises earnings per share and thus the share price, making the company less tempting to takeover artists. Two companies that have successfully undertaken large-scale buy-ins over the past several years are Avon Products and Texas Instruments.

Some chief executives are either slow to figure out what is going on or else too conservative to want more debt on their balance sheets. I will cite two companies that ought to be buying in their own shares. My purpose is not to scold management into acting but to tip you off to shares you can still buy cheap. By the time the companies in question (or hostile acquirers or Blackstone) get around to buying, you should be looking at a nice capital gain.

The first is Lone Star Technologies (NYSE: LSS, 47), which makes the steel pipe used to drill oil and gas wells. It is a perfect takeover target in a naturally consolidating field. One plausible buyer (pending any antitrust concern) is Tenaris S.A.), an Argentinean firm in the same field that recently announced takeovers of two Lone Star competitors, Maverick Tube and Hydril. Lone Star trades at 12 times its likely earnings this year. Tenaris or another acquirer could pay a 25% premium to get Lone Star, pay the tab with BBB-rated bonds paying 5.8% (which would cost only 3.8% aftertax) and pocket an earnings increment of $45 million a year. Lone Star’s boss, Rhys J. Best, is about the best guy you could get to run an oilfield steel firm like this. But he is simply too conservative financially. Buy now, before he reads this column.

Another steel man I admire is Keith Busse. He was a protégé of the late steel industry genius Kenneth Iverson of Nucor Corp. But Keith must not know finance or he would get his stock up more. He is the founder and chief executive of Steel Dynamics (NASDAQ: STLD, 38), which is a smaller version (4.7 million tons a year) of Nucor, a low-cost minimill operator. Steel Dynamics trades at 10 times likely earnings for 2007. An acquirer paying a 25% premium using borrowed funds should be able to boost its own aftertax earnings by $175 million a year. The steel industry is globally fragmented. Takeovers are accelerating as firms strive for share. Cross-border takeovers are common now. Anticipating a hostile tender offer, Keith Busse should have his company borrow money and use the proceeds to buy in shares. Keith has been doing just the reverse: paying down debt, a bad strategy for 2007. Keith Busse is as courageous as anyone you will ever meet and fears no fight, but if he does not get his stock up he will have a fight he cannot win. Buy that stock before the fighting starts.

Link here.


Five breakup possibilities examined.

Breaking up is hard to do. but it can be the best thing for shareholders. Temple-Inland was a sleepy Austin, Texas producer of beer packaging and particleboard with banking and timberland management divisions, before interventionist investor Carl Icahn built a 7% stake in January. Within two months – at Icahn’s insistence – Temple-Inland’s management got religion. CEO Kenneth Jastrow last month announced that Temple-Inland would split itself into three companies (manufacturing, financial services and real estate). That plan sent the shares up 16% to an alltime high the same day.

Over the years Icahn, ranked 42 on the Forbes rich list, with a net worth of $13 billion, has made killings buying stakes in underperforming companies like Texaco, American Real Estate Partners and Time Warner. Interestingly, Temple-Inland was itself spun out of then Time Inc., now part of Time Warner, in 1983. There is more capital where Icahn’s came from, ready to be put to work either taking over companies and dismantling them or else browbeating companies into doing their own restructuring. This is a large part of what the private equity movement is all about, employing investment pools managed by the Blackstone Group, the Texas Pacific Group and Kohlberg Kravis Roberts, among others. Tribune Co. and Dow Chemical are among targets drawing attention from investors looking for lucrative breakup deals. But shares of both have been propped up by speculation and could suffer should plans fail to progress.

In earlier installments of our Beyond the Balance Sheet series we looked at such matters as hidden real estate values, intellectual capital and earnings quality. This time we focus on companies that look like good prospects for breakup schemes. The idea is that you can get in before Icahn or someone like him makes himself felt and causes the share price to move. To find suitable targets, we looked for companies with poor stock performance in recent years relative to peers and at least two reported segments. Our breakup value estimates come from segment-by-segment appraisals. Each piece of the whole is valued at a multiple of either operating income (in the EBITDA sense) or sales, using multiples typical for the industry in question. Where both methods produced reasonable valuations, we averaged them. For moneylosing segments we used only the sales multiple.

We then compared the combined segment value with the company’s enterprise value, that being defined as the market value of common stock, plus debt, minus cash. All five of our target companies have apparent breakup values at least 25% higher than their enterprise value. Of course this “breakup premium” will probably not be fully realized by a public shareholder. The dealmakers who bust companies up capture some of the gain.

Shares of Kentucky’s Ashland have underperformed the oil sector during the past year as the company shifted its strategic focus to chemicals. The obvious restructuring would be to hive off its moneylosing $1.4 billion (sales) Valvoline motor oil business. Using a price/sales multiple of 1.2, a median for three publicly traded engine lubricant and additives companies, we estimate Valvoline could fetch close to $1 billion. Include Ashland’s other business segments and the company has a breakup value of $6.1 billion – 49% more than Ashland’s enterprise value.

For General Dynamics, spinning off its Gulfstream business would capitalize on a booming private-jet industry. What is that business worth? Goldman Sachs is partnering with Onex to acquire rival Raytheon’s private aircraft manufacturing unit for 1.2 times sales and 14.5 times operating income (the deal is due to close in the first half of 2007). Applying those valuations to Gulfstream’s sales and operating income yields a blended estimate of $7.4 billion. General Dynamics has three other lines of business. One builds tanks and armored vehicles like the wheel-driven Strykers currently deployed in Iraq. Another designs and manufactures naval submarines. The last provides global surveillance technology like GPS units for soldiers. Slap valuations on each to get a breakup value for the company of 27% more than its current enterprise value.

A tender offer is not the only way to get a piece of this hypothetical premium. Another possibility is simply spinning off Gulfstream. The two parts of the company wind up with a better valuation on Wall Street than the whole had. Better still: the parent sells Gulfstream for cash and uses the proceeds to either buy in some of its own shares or raise its dividend.

Link here.


“You cannot believe how bad it’s going to get before it gets any better,” he says.

Commodities investment guru Jim Rogers has stepped into the U.S. subprime fray, predicting a real estate crash that would trigger defaults and spread contagion to emerging markets. “You cannot believe how bad it’s going to get before it gets any better,” the prominent U.S. fund manager told Reuters by telephone from New York. “It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops. Rogers has put his $15 million belle epoque mansion on Manhattan’s Upper West Side on the market and is planning to move to Asia.

Some investors fear the problems of lenders who make subprime loans to people with weak credit histories are spreading to mainstream financial firms and will worsen the U.S. housing slowdown. “Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we have not had this kind of speculative buying in U.S. history,” Rogers said. “When markets turn from bubble to reality, a lot of people get burned.”

The fund manager has focused on commodities since 1998, said the crisis would spread to emerging markets which he said now faced a prolonged bear run. “When you have a financial crisis, it reverberates in other financial markets, especially in those with speculative excess,” he said. “Right now, there is huge speculative excess in emerging markets around the world. There will be a lot of money coming out of emerging markets. ... I have sold out of emerging markets except for China.” Even in China Rogers said stocks were overvalued and could go down 30-40%. But, “China is one of the few countries in the world where I am willing to sit out a 30-40 percent decline.”

The last stock market bubble to burst was the dot-com craze which sparked a crash from March 2000 to October 2002. When the last bubble burst in Japan, said Rogers, stock prices went down 85% despite the country’s high savings rate and huge balance of payment surplus. “This is the end of the liquidity party. Some emerging markets will go down 80 percent, some will go down 50 percent. Some will most probably collapse.”

Link here.


The Federal Reserve helped create a “perfect storm” in the U.S. subprime mortgage market that could expose up to 2.2 million more Americans to the threat of home foreclosure, Chris Dodd, chairman of the Senate Banking committee, said. Mr. Dodd, who is also a Democratic Party candidate for the 2008 presidential nomination, alleged the Fed had failed in its oversight role when the growth in high-risk “adjustable rate mortgages (ARM”q to risky borrowers was exploding.

While questioning leading mortgage lenders and federal banking regulators, Mr Dodd also promised legislation to crack down on predatory lending in the U.S. mortgage market, where a rising level of repayment delinquency has caused global market jitters during the past month. Dodd said that U.S. regulators had relaxed guidelines on mortgage lending at precisely the point in 2004 and 2005 when the riskiest ARM loans were increasing most rapidly. That also coincided with the start of the Fed’s 17-stage rise in rates. “Despite those warning signals the leadership of the Federal Reserve seemed to encourage the development and use of ARMs that, today, are defaulting and going into foreclosure at record rates,” he said.

Thursday’s hearing could mark the start of a backlash against leading subprime mortgage lenders. Senior executives from four of the leading lenders – HSBC, Countrywide, WMC Mortgage, First Franklin – testified. Of those invited, only New Century, the largest subprime lender, declined to send a witness. Mr. Dodd said the lenders had engaged in “unconscionable and deceptive” practices. But he also admitted that it would be hard to pass a stricter law. Mr. Dodd said lenders had engaged in “unconscionable and deceptive” practices.

Links here and here.
Comptroller says abusive loans fueled subprime crisis – link.


The mortgage finance bubble should have burst last year, taking the lead from housing market dynamics. But the extraordinary dynamism associated with global credit, speculative and liquidity excesses proved overpowering. The global leveraged speculating community was in aggressive expansion mode. Bubble excesses were going to reckless extremes throughout “credit arbitrage”, the M&A and corporate debt bubbles were in full bloom, and securities leveraging was taking the entire world by storm.

The resulting global liquidity cataclysm ensured insatiable demand for higher-yielding instruments, in large part satisfied by Wall Street’s unprecedented CDO (collateralized debt obligations) issuance boom. Despite the turn in U.S. housing, the unprecedented deluge in speculative finance created rapacious demand for riskier loans, certainly including subprime mortgages – vulnerable housing markets notwithstanding. Readily available mortgage finance empowered subprime originators to accommodate throngs of simply terrible credits (many borrowers content to submit fraudulent loan applications) desperate to refinance problematic mortgages with payments about to reset significantly higher. When Wall Street pool operators recognized the unfolding disaster – and began rigorously scouring portfolios for problem loans and imperfect applications to return to the originators – the subprime Bubble was brought to a screeching halt.

That the mortgage finance bubble did not succumb last year only ensured the peril associated with a protracted period of terminal blow-off excesses. Excesses included unprecedented speculation in credit derivatives (including a trillion or two of new CDOs), equities bubbles spanning the globe, and only greater bubble distortions and imbalances in U.S. and global economies. The exponential growth in risky lending, in the leveraged speculating community, in the derivatives markets, and in speculative flows to global asset markets were accommodated another year. Wall Street finance became an only more imposing source of global “money”, credit and marketplace liquidity, operating with the type of power and control central banks could only dream of.

Everyone thinks they are “hedged”.

Reading through this week’s Wall Street earnings releases and listening to their conference calls left me with the sense that these firms and their clients are especially poorly positioned for an abrupt change in the market environment. Everyone is quick to state that their subprime exposure is small and that they have successfully “hedged”. We are also told that market tumult has been isolated in the subprime marketplace, and that marketplace liquidity remains extraordinarily abundant. All of this may be true for now, but it does not alter the reality that the subprime collapse may very well mark a key (historic?) inflection point for the U.S. mortgage finance bubble and intertwined global risk markets generally.

Clearly, the subprime collapse has quickly imposed dramatically tighter credit standards and availability for risky borrowers. I would expect this to speed housing price declines in some areas, with mounting credit losses ushering in the ugly downside of credit cycle. In many ways, Subprime is a microcosm of U.S. credit system and economic fragility.

The bulls argue that subprime amounts to only a small portion of mortgage debt, and thus will have only minimal economic impact. More discerning analysis would instead focus on the financial sphere ramifications associated with the hasty reversal of speculative flows from risky mortgage instruments. Is the flight out of subprime mortgages, securitizations and other derivatives a harbinger of things to come for the entire mortgage marketplace? And does the move toward risk aversion in this sector mark a momentous marketplace shift from risk embracement to risk aversion?

In analyzing potential subprime contagion effects, we must begin with a critical question: Is the general backdrop characterized by soundness and stability or is it more a case of excess, weak debt structures, and general fragility. Again, subprime collapsed so abruptly because of the acute fragility associated with Ponzi Finance. Unfortunately, analysis of general mortgage market vulnerability leaves me quite uneasy.

The entire mortgage finance bubble is today especially susceptible to subprime contagion effects. For starters, lending standards should be expected to tightened significantly throughout the “Alt-A”, “jumbo”, and prime “exotic” mortgage marketplace. This will likely pose a greater dilemma than subprime restraint for vulnerable high-priced housing across the country, with all eyes on California. Going forward, I fully expect California to lead the nation in credit losses and mortgage/housing angst.

Throughout the boom, the securitization of mortgage credit provided endless finance for homebuyers and speculators, as well as endless profits for the holders of these instruments. As long as home prices were inflating, there was little concern whether the underlying collateral was reasonably valued. Now, with credit conditions beginning to tighten, I expect holders to take a more keen interest in the type and location of underlying collateral. This contagion effect will spur risk reassessment and a consequential reversal in speculative flows from the mortgage arena.

For some time it has been my belief that a California housing bust would bring an end to the GSEs as we presently know them. Never in my wildest imagination did I contemplate the median price for the entire state inflating to $560,000. A bust would now likely take down the GSEs, the mortgage insurers, scores of banks, and wreak bloody havoc throughout the entire securitization and derivatives marketplaces. While few will today subscribe to such a scenario, I certainly expect the marketplace to begin contemplating and gravitating away from such risks. And I do not believe it will take that much for the marketplace to start nervously totaling up the capital and reserves available for future credit losses from the thinly capitalized guarantors of the “AAA” agency securities marketplace. Again, there are now reasons to ponder various contagion effects that together could foster a major and self-reinforcing reversal of speculative flows and risk-taking generally. While marketplace liquidity generally remains quite abundant today, a reversal of speculative flows and a problematic unwinding of positions in the highly leveraged mortgage arena now pose a serious threat to a liquidity backdrop that for too long has been taken for granted.

Ominously, renewed dollar weakness has been an early subprime contagion effect. Sure, the market now perceives the Fed will in the not too distant future cut rates and narrow rate differentials. But I also believe more may be at work. The transformation of risky credits into perceived “money-like” instruments – that foreigners have been happy to accumulate – has lent great support to the dollar over these past few years of massive current account deficits. A bursting mortgage finance bubble and what it could mean for the securitization markets, risk intermediaries and leveraged speculating community create the potential for subprime contagion effects to precipitate a serious problem for the dollar.

Link here.
Pimco says subprime woes may spread to Alt-A, jumbo mortgages – link.
Subprime meltdown snares borrowers with better credit – link.

Housing, especially in California, is dead money for many years to come.

I am going to get right to the point. Housing, especially in California, is dead money for many years to come. Game over. It is that simple.

In March 2005, I stated that anyone buying a house in Orange County should have a 10-year horizon and be comfortable with having lost paper wealth during that period of time. Virtually every investment boom/bubble has the same characteristics: The perception that easy money can be made with little risk is reinforced by the media and “cocktail chatter” which serves to suck in the public (the “dumb money”). Those that believe they are very smart want to display their intelligence by sharing with others how well their investments are doing. Those not in the game feel like they are stupid and not keeping up with their neighbors who are on the path to the American Dream. Other characteristics of an investment mania are a lot of borrowing, fraud at the tail end of the boom, questionable quality supply of whatever is in high demand, and then a crash.

Prior to the housing boom, the most recent financial bubble was the dot com/telecom craze of 1995-2000. Let us compare the two:

Public Participation: Enormous numbers of day traders.
Borrowing: Huge margin debt and massive corporate spending on technology.
Fraud: Illegal IPO allocation, fraudulent accounting, and now back-dating of stock options.
Questionable Supply: Junk companies going public in which most of them failed.
Crash: NASDAQ dropped 80%

Public Participation: Large numbers of condo flippers and investor/speculators.
Borrowing: Extraordinary amount of mortgage lending much of which is highly risky given the repayment terms and interest rate risk.
Fraud: Widespread appraisal fraud and false information provided on loan applications encouraged by shady mortgage brokers. Massive accounting irregularities by Fannie Mae and Freddie Mac.
Questionable Supply: Massive numbers of condo conversions of basic apartments and a large amount of new condo construction.
Crash: Housing prices are falling rapidly in areas that have experienced great appreciation, inventory is exploding, and new home sales have dropped 25% from its peak.

Supply and demand are out of balance. Second home buyers and speculators are no longer buying. In many cases they are selling. Inventory of new and existing homes for sale is at a record level and it is taking longer and longer to sell homes. According to basic economic laws, the only way to clear the market is by lowering prices. Major builders have been very aggressive.

My firm had an extensive history in the manufactured housing industry and we have learned valuable lessons during past markets that can be applied to the current market. Like today’s home builders, we were faced with the formidable challenge of selling new homes in a soft market that were competing with lower priced resales. We reduced our prices and individual home sellers were often forced to follow. As their equity and financial security began to dissipate, many sought litigation to recoup their losses and assuage their fears. With similar circumstances prevailing in this market, I predict a rash of lawsuits against builders, particularly condo developers and apartment converters in communities that only sold a portion of the units and rented the remaining units.

Another important lesson relates to lending. In 1999, with the lending spigot turned on full blast, [manufactured housing] lending peaked at $13.5 billion. Shortly thereafter, the insidiousness of poor lending practices and outright fraud materialized. Wall Street investors recoiled. Lending dried up. Home prices fell.

According to the Federal Reserve, total outstanding home loans increased from $5.1 trillion in 2000 to $9.8 trillion in 2006. This explosive growth has been fueled over the last six years by an exotic array of repayment and interest rate options that have been created to assure every living and breathing individual could buy a home, whether or not they were financially and emotionally prepared. From 1970-1981, the U.S. homeownership rate was between 64.3% and 66.0%. From 1982-1994, it ranged from 63.5% to 64.4%. Since 1995, however it has gone from 64.2% to 69.2% – an enormous increase in market share for owner-occupied housing.

My assertion is that all investment manias have the common characteristics of the perception of easy profits with little or no risk, loose lending standards, and outright fraud and deceit. This housing boom has been fueled by a mortgage finance bubble on an unprecedented scale that will have enormous economic implications as it unwinds. With Fed Chairman Ben Bernanke acknowledging the risk of an economic slowdown due to a deflating housing market, long-term interest rates have very little risk of moving much higher.

When you read my article in 2015 do not be surprised if the value of Southern California homes has not changed from where they were at the peak in 2005. Meanwhile, enjoy your home. Remember that its primary purpose is for shelter and satisfaction and not necessarily a source of wealth creation. On the other hand, it may be hard to find an apartment over the next decade as the allure of home ownership begins to fade and financing tightens up.

Link here.


Reviewing the data from Friday, CPI (consumer price inflation) ticked upward, thus keeping the Fed Reserve wedged in between the rock ... and well ... another rock. I do not agree with the results of this data due to the moving goal posts inside the data configuration. And furthermore, I do not care what “core” inflation is. Give me the whole picture, because that is what I have to live with every day!

Industrial production for February rebounded from the previous month’s awful showing ... but average them out, and you have still got some tepid industrial production. One of my favorite stats, capacity utilization, rebounded to 82% from the revised 81.4% rate in January. Still far below the go-go days of the late 1990’s, but better. That is a good sign for the economy. However, there are just not enough of them! I think consumers are beginning to feel the pinch too. The University of Michigan consumer confidence showed some souring of consumers’ confidence in the early part of this month. The index slipped to a six-month low of 88.8 from 91.3 in February. The dip was larger than the “experts’” estimate for a 1.3 point reduction to 90.

So with inflation edging up, along with industrial production, the markets should have been excited and all lathered up over the prospects for strong growth. The dollar especially should have had a spotlight affixed on it. But NOOOOOO! The markets have become very myopic on this subprime mortgage meltdown. If they are going to focus on it, we had better do so too.

My friend, John Mauldin, has been on top of this meltdown with some great insight and data, so let us take a look at what John had to say in his Friday letter last week: “Subprime mortgages were about 20% of the market in 2005-2006. Already almost 12% of those mortgages are in some part of the foreclosure process, with anecdotal evidence that the number is going to increase. The prediction late last year by the Center for Responsible Lending that as many as 20% of the subprime loans made in the last two years would end in foreclosure does not look as Cassandra-like when it first was made. The CLR study suggests that as many as 2.2 million people will lose their homes.”

There are reports out that up to 60% of subprime loans that were made in the past few years were done with “no documentation”. That means the borrowers were most likely overstating their incomes so that they would qualify for a larger loan. When the re-pricing is done on the subprime ARMS, these borrowers then cannot make their payments.

This causes two problems to the economy. (1) All these houses go back on the selling blocks, thus bringing down the values of everyone else’s homes, thus causing problems with the ability of these borrowers to obtain Mortgage Equity Withdrawals (MEW’s). (2) Lenders are going to, if they have not already begun to do so, tighten down the hatches on the “easy credit”, thus closing the door on borrowers who would have qualified for a loan previously, thus keeping those homes that just got put back on the selling blocks unoccupied. The tentacles of this subprime mortgage meltdown will go deep into the fabric of this economy, and most likely will be the key master for a recession.

But do not look for any help from the Fed. They cannot raise rates to fight rising inflation, because of the housing mess, and they cannot cut rates to help the housing mess, because of the rising inflation. They made this bed. They can now sleep in it!

Meanwhile in Asia, China raised interest rates again in an attempt to cool the economy. I know the Chinese have been banking longer than us ... so why are they following the Fed’s small rate hikes practice that did not work here? The renminbi hit another record high since the dropping of the peg versus the dollar in the overnight session. The Singapore dollar continues to move higher versus the dollar along side the renminbi, as I thought it would do. The killer in Asia has been the Thai baht. Up over 15% this year, even after the military government placed currency controls on the baht, and locked us out of the market.

The Nordic currencies of Sweden and Norway are both back to gaining versus the dollar, stealth-like. Interest rate hikes here have put these two currencies in a position to compete with Swiss francs as “euro alternatives”.

Link here.


Behind the recent, gut-clenching stock market volatility in China is a disquieting reality: China’s rotten accounting. If you thought the Shanghai index’s 8.8% drop in late February was bad, wait until a bunch of rickety Chinese companies collapse. That is the dour outlook from ace China-watcher Brian Hamilton, who runs stock research firm Sageworks in Research Triangle Park, N.C. “Investors in China tend to buy and sell according to price movements, not fundamentals,” Hamilton says. “But too often with China’s stocks, there are no fundamentals to be found.”

Stocks are a big fad in China – a worrisome situation. The old warning holds true: Once the shoeshine guy is playing the market, it is time to step out. The stock-buying frenzy began early last year, when the Chinese government converted $250 billion in nontradable shares in mostly state-owned enterprises into tradable ones. Since then investors have been pouring into China’s Shanghai and Shenzhen stock markets. With price gains and new issues the combined market value of these exchanges climbed from $400 billion at the end of 2005 to $1.5 trillion on March 4. The average price/earnings ratio in China is 63.

All this has spooked government officials. To drain liquidity out of the market, China has been moving to reduce its banks’ lending capacity by forcing them to keep more capital in reserve, as investors opened 50,000 retail brokerage accounts a day in December, and mutual funds raised a record $50 million last year, quadruple the 2005 amount. But Hamilton thinks that move still will not stop market swings, because investors are about to see much more detail on China’s corporate earnings, and the picture may not be pretty.

China decreed January 1 that its listed companies must book their profits under a new set of accounting rules. What is eventually unearthed just might set off panics among small investors. The new rules are based on, but not identical to, the international accounting standards increasingly used in most markets. Now companies will have to do things like quickly write off obsolete inventory and uncollectible receivables. That is a novel concept there.

Financial fraud has been plaguing China’s effort to mingle freewheeling capitalism with its murky centrally planned economy. The country’s police recently announced that they have uncovered 400,000 cases of economic crimes and arrested 370,000 suspects over the past seven years, recovering $12.9 billion. A former branch president of China Construction Bank and an accountant will be executed for filching $25 million.

Given the radical shift that the new rules call for, compliance will hardly be perfect. Since the 1949 revolution China generally has not had an objective accounting profession because it discourages dissent. Accountants were routinely packed off to reeducation camps in the 1960s. Would a place that still jails reporters for revealing corruption really protect accountants who are just doing their job?

Hamilton, now 44, founded a firm to oversee the financial work of small companies. Then he started up Sageworks, which sells financial research to the likes of Citigroup. In 2003 it tackled the enigmatic world of Chinese investing. To rate the shares traded in Shanghai and Shenzhen, Hamilton uses software to assess 26 metrics like profit margins, debt and assets. Despite his qualms about the accounting, Hamilton still thinks fast-growing China is a good investment opportunity. He has a list of five such stocks, and another quintet to avoid or sell (see table). Most of them are available as ADRs and generally reconcile their numbers according to U.S. accounting rules.

The good five show increasing sales, an average net margin of 38%, a low ratio of accounts payable to sales and a high ratio of sales to assets, among other things. And the bad? Hamilton singles out China TechFaith Wireless Communication Technology (NASDAQ: CNTF), a telecom company that dipped into the red last year. It cannot get a grip on costs. For 2006 its cost of goods sold rose 57% to $55 million while its top line decreased 10% to $81 million in 2006. For a company struggling with costs, tougher accounting rules can only bring bad news.

Link here.


Over the last few years, emerging market investment has been overwhelmingly centered around the concept of the “BRIC” group of emerging economies – Brazil, Russia, India and China. These countries were supposed to be the giants of 2050 and the only emerging markets that a truly important institutional investor should consider, because of their liquidity. Like most ideas spawned by investment banks (truly original minds are weeded out by the banks’ Darwinian appraisal systems pretty rapidly) this idea was vapid and silly at the time. More interestingly, it is now a recipe for gigantic investment losses. There are economies in the world with excellent medium term prospects, but none of the BRICs qualify.

Brazil does not qualify as an exceptional market.

Brazil, first, was always included in the BRIC group because it made the acronym euphonious and avoided a too obvious snubbing of the infinitesimal growth prospects of Latin America. For a couple of years after the invention of the BRIC acronym, Brazil appeared to be justifying its inclusion, at least in relation to Latin America, though its long term productivity growth remained below 1% per annum, pathetic by any non-Latin American standards. However since the departure of the cautious Antonio Palocci as finance minister in March 2006 and the reelection of President Luis Inacio “Lula” da Silva in October, Brazil’s prospects have taken a significant turn for the worse.

Brazil’s growth rate was only 2.8% in 2006, or 1.7% net of its 1.1% population growth, in a period of unprecedented economic liquidity and synchronized world boom. That is not going to make the country an economic giant of 2050, or a political one. Brazil now has $83 billion of reserves – but it has more than $100 billion of foreign portfolio investment in the stock market, all of which can leave at a moment’s notice – or rather, would not be able to, since if any outflow became apparent, Brazil would instantly impose exchange controls. So even though Brazil indeed has a more intelligent ethanol program than the U.S., it does not qualify as an exceptional market, either through rapid growth or enlightened government policy.

If you must invest in Latin America, try Colombia, which has never been securely on investors’ radar screens but where the economy grew 5.4% (4.0% net of population growth) in 2006 and where President Alvaro Uribe is genuinely committed to free trade, pro-U.S. foreign policy and free market economics. It is less corrupt than Brazil, too – 59th as against 70th on Transparency International’s Corruption Perceptions Index.

Russia is an economic and political disaster waiting to happen.

Russia is an economic and political disaster waiting to happen. It is currently propped up by high oil prices, and has enjoyed half a decade of stellar economic and productivity growth. However, foreign investors have been ripped off over and over again, while domestic entrepreneurs are subject to being sent to Siberia or poisoned by little-known radioactive substances. President Putin in March 2008 has the choice of either violating what remains of Russia’s constitution by running for a 3rd presidential term, or handing the country over to one of his cronies, none of whom he trusts and all of whom are at loggerheads with each other. Russia is #121 on Transparency International’s corruption list, level with Benin and Gambia. Actually I would suggest that that ranking is rather too high.

For an alternative Slavic investment, why not try Bulgaria? It has lower wages than Russia, a equally good education system, a fully functioning democracy and it is in NATO and the EU. It is a lot less corrupt, just above Colombia. We are used to thinking of Bulgaria as a corrupt, Mafia-ridden cesspit, but its corruption level is today closer to Scandinavia than to Russia, and it far more deserves the name of emerging market than the R of the ridiculous BRIC.

Unless the Indian electorate comes to its senses in 2009, forget about it as a growth economy.

India does deserve the reputation of a growth market, but not with its current government. Prime Minister Manmohan Singh is perfectly adequately committed to economically sound policies, but he is not in control. India’s new Five Year Plan works on the assumption that economic growth will magically average 9% per annum for the next 5 years, faster than it has ever grown before. The government as a whole is determined to spend more than its full share of that growth – and will do so whether or not the growth happens. If the Indian electorate comes to its senses in 2009, it may once again be worth ranking as a growth economy. Meanwhile, it is a liquidity crisis waiting to happen and at over 20 times earnings, its stock market is thoroughly overpriced.

As an alternative to India, try Indonesia. With 245 million people, it is a decent size even by BRIC standards. Its growth rate was only 5.4% in 2006 – 4% after deducting population growth. On the other hand it had a budget deficit of only 1.5% of GDP vs. India’s 8%. Its corruption is appalling, at #130 on Transparency International’s list, but is improving fairly rapidly under the current government of Susilo Bambang Yudhoyono. The stock market is on about 17 times 2006 earnings.

In the very long run, China bulls may be right.

China has grown so rapidly for so long that it has become the icon of emerging markets, untouchable because not understood. In 2006 it again posted a growth rate of more than 10% (on dodgy official figures), at least some of its people appear to be sharing in the new found prosperity, and its problems of bad debts and inefficient state industries have been decried so often that nobody believes the nay-sayers any more.

So central is Chinese growth to emerging market investors’ optimism that a 9% drop in the Chinese stock market the other week caused a chill to reverberate around the investment world, even though foreigners could not have been significantly affected by the drop as the market is closed to them. China has benefited enormously from the last few years of globalization and high world liquidity, particularly as it has allowed the country to build a $1 trillion hoard of foreign exchange reserves and tempt greedy and careless foreigners to prop up its tottering banking system.

In the very long run, China bulls may be right. The decision by the National People’s Congress last week to adopt a property law that gives private property the same protections as state property is immensely important. It offers the possibility that rural China will join the much smaller urban China in increasing prosperity. It will not be clear whether the change is genuine however until implementation has occurred. The stated intention of the Congress to prevent land seizure for development by corrupt rural bureaucrats needs to be proved on the ground. If that happens, then for the first time since the late Song Dynasty Chinese property rights will have become secure. That will bring its worryingly growing inequality, approaching Latin American levels, once again within bounds consistent with rapid and stable growth.

Meanwhile tighter world liquidity, combined with a slowdown in the U.S. market, will cause more trouble in China than in anywhere else in the world. Foreign speculators have been propping up Chinese banks. They will cease doing so. Domestic liquidity will tighten, causing a slowdown in the Chinese economy and producing negative cash flow in all the office buildings and speculative apartment developments that have sprung up. Foreign demand for Chinese manufactured goods will drop, and a protectionist backlash in the West will squeeze Chinese profitability still further as its major export markets are blocked. Probably the Chinese banks will run out of money. That will liquidate the $1.8 trillion of Chinese domestic savings and cause a massive run on confidence, depressing economic activity for a decade to follow.

Imagine the decline in Japan after 1990, only without the cushion of Japan’s overall wealth and sound economic structure. Japan’s downturn lasted a decade. China’s could last at least as long. The only saving grace is that there is effectively no political downside risk, because the country is already a Communist dictatorship! For this we pay 35 times earnings?

Contrast that with Taiwan, at about 16 times earnings. Taiwan has a 5% economic growth rate, which with 0.6% population growth that figure works through to 4.4% per capita (its national statistics are much more reliable than China’s). Taiwan had land reform in 1949-53; since then private property has been sacrosanct. Taiwan is as rich as Europe, but works a hell of a lot harder. All this is available from a freely functioning international market for less than half the price of Chinese investments.

Thus each of the four BRIC economies is economically and/or politically in severe danger, and is distinctly less attractive than a neighboring economy whose asset prices have been far less run up by international speculators. The BRIC concept, dubious when it was introduced, has become thoroughly counterproductive to those international investors who want to make a profit, as distinct from merely charging clients a fat fee plus performance bonuses for losing their money. Face it: the BRICs are broken!

Link here.


Hope and hype are again triumphing over reality. The primary preoccupation in economics worldwide is the U.S. economy’s “recovery”, presently hyping the markets. We note three different views: (1) A cocksure bullish consensus. (2) Doubtful voices, among them the Federal Reserve, stressing the lack of conclusive evidence. And (3), a few lonely voices, ours among them, who flatly repudiate the possibility of a full-scale, self-sustaining economic recovery in the U.S. We see years of Japanese-style sluggish growth for America, if not worse.

Yet, the latest American Association of Individual Investors poll showed 71.4% bulls and a miniscule 8.6% bears. The gap between the two is the highest since August 1987, just weeks before the crash. Merrill Lynch surveys show institutional investors more fully invested than at any time in the past two years, and heavily overweighted in high tech.

The case of the bullish community rests crucially on the assumption that the U.S. economy is basically in excellent shape. Fed Chairman Alan Greenspan, and with him the large bullish community, have actually never seen anything seriously wrong with it. In their view, its failure to return to normal economic growth is mainly due to a series of exogenous shocks inflicted one after the other on the economy – the stock market crash, the September 11 terrorist attack, the corporate governance scandals and the Iraq war. Rather, they consider it a sign of health that the economy has not weakened more in the face of this unusual sequence of shocks.

Yet compared to the extraordinary exuberance prevailing in the markets, the Fed has been remarkably hesitant in declaring the economy’s impending recovery. In our own opinion, after careful analysis both of recent economic data and also of basic micro- and macroeconomic conditions for the resumption of strong economic growth, we have come to two conclusions:

  1. The U.S. economy neither improved nor accelerated in the second quarter. The reported GDP growth of 2.4% is grossly misleading. From the perspective of quality, it has distinctly deteriorated.
  2. The crucial macro- and microeconomic conditions for a self-sustaining and self-reinforcing economic recovery remain flatly missing. Necessary economic and financial adjustments of past economic and financial excesses implicitly involve pain. But pain is not accepted in the U.S. In essence, policymakers are trying to cure past borrowing excesses by more of the same and new excesses.

Trying to assess the U.S. economy’s prospects, the first thing to realize is that past cyclical experience offers no guidance to the present downturn because it has completely different causes and also a completely different pattern. All past recessions had their main cause in monetary tightening. As soon as the Fed loosened its shackles, the economy promptly took off again, propelled by pent-up demand. For the first time in history, the U.S. economy went into recession against the backdrop of most rampant money and credit growth.

The typical, major imbalance in post-war business cycles has usually been in inventories. To correct it, retailers and manufacturers temporarily sold from stock, depressing production. Once the stocks were down to desired levels, production came into its right again. At the heart of the regular V-shaped business cycles was the inventory cycle.

In contrast, the present downturn has its brunt in the combination of a profit and capital-spending crisis. At the same time, there has accumulated an array of economic and financial dislocations that tend to depress the economy in many ways, such as extremely poor profits, badly ravaged balance sheets, a variety of asset bubbles in different stages of development, excessive leverage in the whole financial system and shrinking cash flow. There is nothing normal anymore in the U.S. economy and its financial system.

For the old economists, investment in tangible assets – factories, commercial buildings and machinery – was paramount in creating both economic growth and wealth. The U.S. has always been a low-savings and low-investment economy, i.e., a high-consumption economy. But all three went to unprecedented extremes over the past several years. Savings and investment have been run down to atrociously low levels that are typical for underdeveloped countries. Given the low levels of saving and investment, American policymakers and economists in recent years have elevated productivity growth to the single most important achievement of an economy. But just by itself, productivity growth creates only unemployment. It is the normally associated capital spending that makes for the necessary, simultaneous demand and employment growth.

This simple recognition – gross lack of saving and capital formation – is really at the root of our controversial and highly critical view of the U.S. economy’s sanity and vitality. True, its growth rate has been the highest among the industrial countries for years. But it has all the time been economic growth of the most miserable quality. The striking hallmarks of this extremely poor quality were collapsing savings, low rates of business fixed investment, a profit carnage that began at the height of the boom, exploding consumer and business debts and an exploding trade deficit.

Today’s economists have at their disposal information in quantity and speed as never before. But reading numerous reports, we have the impression that very few are making use of it. Particularly shocking in this respect were the immediate euphoric reports about growth acceleration in the second quarter. Plainly, Greenspan’s policy has collapsed into uncontrolled money and debt creation that has rapidly diminishing returns on economic activity. The late economist Hyman P. Mynsky would call this a Ponzi economy, where debt payments on outstanding and soaring indebtedness are no longer met out of current income, but through new borrowing. Soaring unpaid interests become capitalized.

We keep asking whether American economists are they providing deliberate misinformation or simply performing slipshod work? In our view the latter rings true. The whole economic discussion today is fixated on the next economic data with one single question in mind: is it better than expected? Careful, more detailed analysis with a longer-term perspective is completely missing.

Link here.


It’s the dollar, stupid!

Why do gold and silver usually decline along with the stock market these days when it should work the other way around? The dollar is the key. Currently, they move heaven and earth to keep it above 84.0. That keeps gas cheap, the stock market inflated and people thinking that it is just another day. They push the dollar up by manipulating precious metals (PM) and stock index futures markets.

Friday is their favored manipulation day because (1) so many traders take 3-day weekends, (2) there is no overseas market until Sunday (because it already is tomorrow in Japan, due to the International Date Line) and (3) the lesson of a drop in the price of gold and silver is best imprinted on the minds of an off-work, Internet-surfing, hand-wringing public that must live with their precious metals losses until the markets open again on Monday.

Eventually, the dollar’s floor-at-any-cost will have to drop to 83.0, then 82.0 and so on. Gold and silver will plateau upward in lockstep with the dollar’s stair-step controlled descent. How far can it go? How deep is the ocean? Can you say Z-E-R-O, boys and girls? To keep the dollar Ponzi scheme afloat, they keep increasing the money supply. It is a juggling act where the juggler keeps throwing another ball into the air to add to the in-progress performance, else the audience begins to lose interest. Logic demands that, eventually, he will start dropping balls – probably all of them because he will try to save the first one he misses, then the second, then ...

The dean of Wall Street, Richard Russell, has said, “The best measure of the dollar is that number of dollars it requires to purchase a measure of pure wealth – an ounce of gold. Gold is both the unit and the messenger. The government and the central bank fear the messenger. The reason why they fear the messenger is obvious – they are frightened of the message.” The message? The dollar is doomed and hyperinflation can be seen just over the horizon. Yet another reason for war, upon which they will blame it all.

It’s the dollar, stupid. Yes, it is just that simple.

Link here.


For quite some time, complacency and fuel economy have gone hand in hand. Admittedly, vehicles have become more attractive, faster and more technologically advanced. But when it comes to fuel efficiency, it just never seemed to matter. Gas was cheap and always would be cheap, so what was the point?

But now we have this triple threat: Oil prices are high (and probably going higher soon), a global-warming scare, and Middle East tensions. And what have the big car manufacturers done for us lately? “To these circumstances, automakers have responded with a fleet of cars that averages 21 miles per gallon, about 4 mpg worse than the Model T,” according to a recent Popular Science article.

Major automakers sit on their hands, producing vehicles that only slightly improve on gas mileage. It is the smaller companies that are taking the lead in building concepts that will break the 100 miles per gallon (mpg) milestone. According to the Popular Science article, the X Prize Foundation is set to announce a prize for the first car that breaks 100 mpg and sells a certain number of units. You may recall this is the same group that sponsored the $10 million competition for the first group to invent a private spaceship. Reportedly, the winner will receive upwards of $25 million.

A fascinating small company that is working on this task is StarRotor Corp. The company is attempting to improve engine efficiency by recovering some of the heat it produces and turning it back into energy to power the vehicle. This cannot be done with a regular four-cylinder, so the company is in the process of developing an engine using jet technology. Unlike hydrogen fuel cell technology, this engine would be cheap enough to mass-produce. As an added bonus, this engine concept would minimize pollution, since the combustion process is more advanced.

And what about the potential fuel economy? The inventors predict that the StarRotor engine will be at least 45% to 60% efficient. Your car’s conventional engine is only about 15% to 20% efficient. Therefore, a regular economy car that now gets 40 miles per gallon could get approximately 120 with a perfected StarRotor.

StarRotor is not a public company, and is just now starting to generate interest and a few orders for its compressors. Keep in mind, this is still very early in the game for StarRotor. No venture capital money has been announced for this infant company, and very little in the way of news is available. You can check out StarRotor’s website here. Stay tuned ...

Link here.


In New Jersey, the state pension plan for teachers is badly underfunded, to the tune of $10 billion. We are coming off the biggest housing boom in history, with property taxes soaring, tax revenues up, and four good years in the stock market and the N.J. teachers’ pension plan is still $10 billion short. To top it off, Gov. Corzine wants to fund only half of the state’s pension obligations this year, which will put the plan further in the hole. Exactly how do they expect to fund this if we have an 18-month recession, and falling stock prices on top of it? Either taxpayers are going to foot the bill or plan promises made to 220,000 teachers will not be met, or some combination thereof.

As bad as New Jersey looks, Illinois looks worse. Illinois comptroller Daniel Hynes says, “Illinois’ state pension systems continue to be seriously underfunded, with the latest calculations placing the unfunded liability at over $40 billion.” Once again, I see a state deep in the hole having failed on a 15-year plan established in 1995 to get out of that hole. One of the problems pension plans faced was the stock market decline between 2000-2003. The same problem is about to hit again. Illinois, as well as every other state, likely has pension returns and revenue growth assumptions that are way too high headed into a recession. The likelihood of negative returns and falling revenues simply is not being planned for by anyone at any level.

In Massachusetts, The Boston Globe is reporting, “The assets of 35 pension systems, including those of Plymouth County, the Essex Regional Retirement Board, Newton, and Andover, would come under the control of a state trust in a proposal by the (Governor) Patrick administration to boost returns, improve pension management, and provide fiscal relief to cities and towns, according to a new analysis prepared by the state retirement commission ...” Massachusetts is taking a different approach to the problem. Their plan has an alias name of “Chasing Yields”.

As we have seen with subprime lending, chasing yields works until it doesn’t. And somehow, in just a few short years, the memories of 2000-2001 have faded away. The current consensus is that subprime woes will not spread, housing has bottomed, there will be no recession, and any pullback in the stock market will be temporary. I guess everyone is listening to Mr. Bubble (Greenspan) when he says that if home prices “would go up 10%, the subprime mortgage problem would disappear.”

If home prices would go up 10%, the problem would not go away. The problem is people bought houses they cannot afford at prices that were ridiculous. If home prices rose 10%, there would still be no one able or willing to afford them. It is comments like those from Greenspan that seriously make me wonder if he is senile. But then he actually says something that makes some sense: “On another matter, Greenspan repeated a warning about the massive strain on the U.S. budget and the economy in the future from the looming retirement of 78 million baby boomers, who will draw benefits from Social Security and Medicare. ... ‘There is a significant probability that under existing law, we have overpromised what will be available to Medicare recipients,’ he said.”

Yes, we have not only overpromised, but we have also underbudgeted, and pension plans are starting to chase yields in a foolish attempt to catch up. I find it amazing how quickly even recent lessons are forgotten and current lessons (subprime) are dismissed outright.

Here is some practical advice from someone who goes by the name of “PolymerMom” posting on my board on TheMarketTraders about the risks of chasing yields. It seems a pension plan change where she works caught her by surprise:

“Earlier this year, I received a note saying the core bond fund in my 401(k) was changing to a new bond fund this year. They nicely transferred the old holdings to the new fund without any cause for action on my part.

“The return looked impressive: ~4.5% vs. ~1.6%. Both were int. term (2.5-5 years duration).

“They finally got around to posting the new fund’s top 10 holdings and percent asset categories. The new fund is almost 37% invested in mortgage securities. The old was only a tad over 1%.

“So I moved my holdings to a money market fund from the new bond fund today. Imagine my surprise when the value of the [new] fund had dropped almost 13% from Friday to today! [March 2-5]

“The HR analysts were chasing yields without a thought as to risk. I wonder how many will even realize what is happening ...”

Unfortunately, those in state pension plans do not have the luxury of spotting mistakes like that. If someone managing a government plan decides to chase yields, invest in swaps or emerging markets or real estate, or even if the state chooses not to fund the plan at all, there is little one can do about it. This adds up to yet another huge problem that is coming our way as returns over the next few years are unlikely to be anywhere near as good as those plans expect.

Link here.


Pointing out the errors of conventional wisdom (CW) may be like shooting fish in a barrel, but that does not mean you should not pull the trigger. The financial news alone keeps the fish barrel full each day. And if you look for the influence of CW in a broader sense – current events, social commentary, cultural trends – the barrel grows to ocean-sized proportions. But I am not going to do any shooting today. Instead, I would like to offer a three-sentence explanation of why the CW is so often so mistaken. Here goes:

Virtually everyone believes that “events” produce the trends and turns in social mood. This is backwards. Instead, social mood drives the trends and turns that produce “events”. Just three sentences. Yet this idea should obviously inspire a much deeper discussion. In fact, it has.

The notion that social mood drives events is extraordinary indeed. It means that journalism, news reporting, and even the traditional record of history itself, all include an assumption that is fatally flawed. So I will cut to the chase: an extraordinary idea deserves an extraordinary explanation. With a simple click and about an hour of your time, you can watch and listen to something you will remember for a very long time. There is nothing to buy, there are no strings attached.

If you are a long-time Elliott Wave reader, you have probably guessed that I am talking about History’s Hidden Engine, the documentary from award-winning filmmaker David Edmond Moore. But, if you have come here only recently, you are in for a treat. You can watch History’s Hidden Engine on your computer via streaming download in Windows Media Player or QuickTime (you can also download and share all 59 minutes of the documentary). The link to the documentary is here.

Link here.

Speed limit? In Germany?!

Yes, you heard right. The world famous, bullet-fast, no-speed-limit German autobahns may soon become just like every other highway ... boring. “The EU’s environment commissioner,” reports Reuters, “has called for a maximum speed limit on German highways to slow down the notoriously swift traffic on the car-loving nation’s autobahns.” Why? Because fast driving “senselessly wastes energy and harms the climate.”

It is not the first attempt to slow down Germany’s autobahns. A similar proposal came out back in 2004, when Germans said they “would welcome the introduction of a sweeping speed limit” of 130 km/h. Which hardly came as a surprise for students of Elliott wave and socionomics, the science of social prediction based on the Principle. You see, over the years, we have noticed a remarkable correlation between speed limits and the position of the stock market. Speed limits usually get introduced during bear markets and repealed when bullish times return.

Why? The Elliott Wave Principle teaches that the stock market is the best indicator of the society’s overall level of optimism. When people are happy, stocks are up. When they get depressed, stocks go down. And, it seems, so do speed limits. In 1974, for example, after the DJIA (read: social mood) had been on a losing streak for several years, the U.S. lowered its speed limit to 55 mph nationwide – a move that “institutionalized the nation’s depressed pace,” as we put it later. The limit was only lifted in 1995, after two decades of rising social mood, stock market and the economy.

In 2000-2003, when the DAX, Germany’s main stock index, lost over 70%, Germany was clearly Europe’s bear market leader. So the 2004 push to set a federal 130-km/h speed limit was only logical, from an Elliott wave point of view. But what about now? The DAX, after all, has been rallying strongly for four full years, indicating improving collective mood and rising levels of optimism among Germans. Recent business and consumer confidence numbers confirm that. So why the call for a lower speed limit again?

Well, notice that it did not come from Germans themselves – it came from the EU’s “environment commissioner”. So it may or may not represent “the will of the people,” so to speak. Time will tell how this plays out, but all I can say is that if this proposal gets support, this could be the end of an era for everyone who has ever dreamed of someday “opening it up” on the famous German autobahn.

Link here.


The effort to measure financial risk is a good thing, in that it is an exercise in humility. This humility appears first in recognizing that you may well lose money when investing; second, it takes humility to rely on objective analysis in assessing risk, instead of trusting your instinct and emotion.

There is nothing new about measuring financial risk – gifted mathematicians have done theoretical studies of the problem for more than a century, particularly over the past 40 years. Yet the unending irony comes when the theoretical work spawns formulas that show promise in the real world of markets. Even a small degree of success in quantifying risk often becomes the worst thing that could happen to the person(s) using the formula. They relive the paradox Ben Franklin captured with the phrase, “proud of my humility.” In other words, a successful effort to be humble leads not to deeper humility, but to self-destructive arrogance.

The past decade has seen two of the most catastrophic examples of this on record. In 1998, Long Term Capital Management leveraged $4.72 billion of equity into derivative positions totaling $1.25 trillion. When LTCM imploded, fears of a ripple effect were so great that the Federal Reserve had to help sort out the mess. Nobel Laureate Myron Scholes was an active partner in LTCM, and was famous as the brains behind the Black-Scholes model, which was the recognized standard on Wall Street for valuing derivatives. The best book about the fiasco is appropriately titled, When Genius Failed.

Enron is the other recent and more famous example. The company successfully used arbitrage and derivatives to mitigate risk in the natural gas market in the 1980s. Eventually Enron tried to duplicate that success by making markets for more than 800 different products. Its collapse and bankruptcy came at the expense of $70 billion in market valuation, the jobs of 21,000 employees, and the virtual dissolution of the Arthur Andersen account firm and its 28,000 employees. “Smartest Guys in the Room” indeed.

All this and more came to mind when I read a page one story in the Wall Street Journal about a math professor in Paris who teaches the “skills required to create and price derivatives, the complex financial instruments based on stocks, bonds or loans.” Graduates of this professor’s courses are in extraordinarily high demand, as “banks are hiring an increasing number of recruits who understand derivatives. Inside banks, they are known as ‘quantitative analysts’”.

The Parisian math professor is apprehensive about the trend in derivatives, and “is perturbed that an instrument that began primarily as a hedge for banks and financial firms against market risk is increasingly being used as a way to make a profit.” How large a risk has “quantifying the risk” become? Too large to quantify, probably, though NOT too large for wise individuals to protect themselves from.

Link here.

Hedge funds: A world apart?

In the last few months, the world’s monetary powers-that-be have been trying their darndest to cool down the red-hot – and risen 200% in the last five years to $1.5 trillion – hedge fund sector. First, every region from Shanghai to Singapore to Sydney has tried “talking” hedgies down. “The growing influence of hedge funds has exaggerated market movements in Asian equity markets. [We} have not seen this kind of selling intensity since the height of the Asian crisis in 1997 and 1998,” remarked one interested party. “If not contained, hedge funds are going to create more unpredictable gyrations in the future.”

On March 15, Germany’s finance minister went on the record to say, “Highly leveraged hedge funds pose the most serious threat to a generally positive global outlook. No expert I have met up to now could exclude a potential financial crisis caused by” the sector. As for tranquilizer guns – well – capital controls to shut out foreign investors have already been imposed by regulators in Vietnam, with many Asian economies expected to follow.

But while those across the globe are devising ways to restrain and regulate the hedge fund fire, U.S. monetary officials say now is the time relax, relent and release. In their professional opinion, the best way to prevent the booming hedge fund industry from ka-booming is to let it burn, and it will eventually burn out. On February 24, the Plunge Protection Team (comprised of the heads of the SEC, Treasury Department, Federal Reserve, and the Commodity Futures Trading Commissions) voted “NO” on enforcing tighter restrictions for hedge fund creations and credit. In their words, “The current system for preventing market collapse and widespread investor losses is working well.”

Cough, Amaranth. Cough, cough, “The largest case of insider trading in 20 years” hits UBS Securities AND Morgan Stanley. The way we see it, when U.S. policymakers prefer to the hedge fund market operate with undue meddling from overseers, one kind of trend is locked in place. Whether it will prevent hedgies from going up in smoke is another matter.

Elliott Wave International lead article.


Blackstone Group LP’s plan to raise $4 billion in an IPO is giving investors a first look at the moneymaking power of the firm that manages the world’s biggest leveraged buyout fund. Documents filed with the U.S. S.E.C. show Blackstone earned $2.27 billion in 2006, 71% more than a year earlier. Money-management fees were $1.12 billion and investment gains totaled $7.59 billion, as the firm’s private-equity funds returned more than 20% and its real estate investments almost doubled.

Not only did Blackstone make more than Bear Stearns last year, each of the company’s 770 employees produced an average of $2.95 million in net income, almost nine times the average of Goldman Sachs, Wall Street’s most-profitable firm. “Blackstone is an amazing story,” said Jonathan Insull, a New York-based managing director at TCW Asset Management, which runs almost $4 billion in bank loans. “They have built up a terrific franchise in private equity.”

The company, founded in 1985 by Stephen Schwarzman and Pete Peterson, will sell a minority stake in the largest-ever IPO by a U.S. buyout firm. Blackstone said the offering will give it capital to expand into new, unspecified businesses or buy out partners as they leave. Should Blackstone fetch the same valuation as Fortress Investment Group LLC, the private-equity and hedge-fund manager that went public on February 8, it would trade at 37% of its $78.7 billion in assets under management, or about $29 billion. If investors value it like Goldman, at 10 times earnings, its market capitalization would be $23 billion.

The lowest borrowing costs in a decade have allowed LBO firms like Blackstone to do deals faster than ever. The $144.7 billion of private-equity deals and management buyouts announced this year is ahead of 2006’s record pace by 14%, data compiled by Bloomberg show. Now, Blackstone is raising $20 billion for a new fund, the industry’s largest ever, and as of March 1 had $18.1 billion in commitments, according to the IPO filing.

LBO firms typically use a mix of cash from investors plus their own money and debt secured on the targets they buy to finance deals, then generate a return for investors by selling the assets to other funds or public investors within five years. Blackstone said its private-equity funds have returned an average 23% a year, after fees, and its real estate investments have gained 29%. Blackstone entered private equity in 1987 and broadened into real estate in 1991. Since it has expanded into hedge-fund investing, private debt and mutual funds. Private equity remains the firm’s top moneymaker, with $1.01 billion of pretax profit in 2006. Real estate produced $902.7 million, followed by investment banking at $194 million and alternative-asset management at $192 million. The diversification push has made Blackstone look increasingly like Wall Street firms such as New York-based Goldman.

“This is yet another example of how the markets have taken over banking functions,” said Martin Mayer, a guest scholar at the Brookings Institution and author of The Bankers (1975). Blackstone is “a sort of pirate’s monastery,” he said. New unit-holders will not elect the general partner or directors, a right the founders will keep. “I don’t think there is any benefit to anybody except the people who are partners in this firm who will be able to cash out,” said Mayer.

Link here.

If Blackstone is selling, why are you buying?

One by one, the big companies of the alternative investment industry are selling. Blackstone Group LP, the leveraged buyout firm that has spent $160 billion taking companies private in the past two decades, has just announced its IPO. Fortress Investment Group LLC, which manages hedge and privat–equity funds, listed its shares in February and the stock almost doubled on the first day it was traded. In Europe, booming hedge funds are queuing up to go public.

If Blackstone, Fortress and other alternative-investment managers are selling their shares, should you be buying? Probably not. The managers of those firms are better at calling the top of the market than most of us. The rush of share sales suggests the boom in alternative investments may be ending. It would be better to sit out the IPOs, wait for the share prices to drop, and then buy them. “There is a fin-de-siecle feel to many of the IPOs,” Tim Price, investment strategist at Union Bancaire Privee in London, said in a telephone interview. “These worlds are mashing into each other at extreme speed. Alternative investments are not really alternative anymore.”

Nobody would argue that alternative investments have been the favorite sector of the financial markets for almost 10 years. Money has poured into private-equity and hedge funds as investors sought to diversify away from traditional stocks and bonds, and to boost returns with sophisticated financial engineering. Now, there are good reasons for thinking the boom is running out of steam.

First, investors are starting to rebel against the high fees and profits generated for the managers of alternative investments. In hedge funds, Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System, recently attacked the excessive fees charged by many managers, often for quite ordinary performance. No doubt, he struck a chord with many investors.

Likewise, private-equity funds exist to buy out public companies from institutional investors – and then sell the same business back to the same people a few years later for a lot more money. It cannot be long before those investors start wondering why they are giving away so much.

Next, the growing size of the alternative-investment industry will inevitably generate calls for more regulation. The private-equity industry is feeling the heat, both in the U.S. and in Europe. The U.S. Justice Department is already investigating whether private-equity firms are colluding to set prices for companies, while U.K. trade unions have been campaigning to change the tax rules on buyout funds. That matters. One of the reasons private equity has been so successful is because it has been beyond public scrutiny. It has quietly overhauled businesses without anyone monitoring the day-to-day decisions. The chances are that private-equity firms will not get away with that in the future.

Lastly, alternative investments are not really alternative anymore. Once Blackstone has listed its shares, it is hard to see what will be so private about the private-equity firm. Its investments would be subject to the same scrutiny as any other listed company – and certainly its own performance will be. In effect, Blackstone will turn itself into an old-style company with interests in various industries. There is nothing wrong with that, so long as it is well managed, but there is nothing alternative about it.

Likewise, many hedge funds have become indistinguishable from standard mutual funds. That may be good or bad, depending on how smart the managers are at calling the market, but it does not make them an alternative to dozens of other investment vehicles. The alternative investment industry is not about to vanish. Yet it may be entering a period of restrained growth. In that case, many of the IPOs will soon look overpriced.

Fortress’s shares have indeed dropped from $31 in February to $24 this month. So let the alternative investment firms stage their IPOs, then you can wait for the shares to drop once investors realize this is an industry with its days of turbocharged growth behind it. Pick up the shares when they are more reasonably priced. That is what the hedge-fund and private-equity managers would do.

Link here.


On January 2nd of 1900, the Dow Jones Industrial Average closed at 68. If you had told those living at that time that in one generation Americans would be driving automobiles and that the world would be looking back on a war in which the Allied Forces consumed 12,000 barrels of oil a day, who would have believed you? On September 3rd of 1929, the Dow closed at 381. If you had told those living at that time that on July 6th of 1932, the Dow would close at 44 – lower than its value on January 2nd of 1900 – who would have believed you?

After hitting 991 in January of 1966, 13 years later, in August of 1979, the Dow closed at 885, and Business Week wrote a piece titled, “The Death of Equities”. If you had told those living at that time that the next generation would be surfing the web from their personal computers, who would have believed you? Who would have believed that median U.S. home prices would go from $64,000, in 1979, to $257,000, in March of 2006?

On February 20th, 2007, the Dow closed at an all time high of 12,786. One week later, the Dow saw its worst one-day loss in 7 years, outside of 9-11. So, was February 27th a worldwide wakeup call for investors or just one more bump on the road to higher markets? While we wait to see what happens, we must contend with the fact that, collectively, we have a poor track record of foreseeing substantial changes in the future. Time and again, history shows the circumstances that have led to manias and the attendant aftermath of these episodes. In fact, the record is so replete, that we must consider how large of a role denial has played in financial history. The headlines and media coverage after Tuesday, February 27th, only serve to exemplify this trend.

In 2005, I dedicated five months to a topic that I think will be a historically significant in the near future and in generations to come. Though it has been around since the 1640s, little has been written on this topic. And, while many institutional players have had access to this tool through the hedge fund world, few people actually understand its value to investors. The topic? Short selling. As recent events have caused some to consider the possibility that markets have a downside, I have decided to take this opportunity to revisit one of the managers that I interviewed for Riders on the Storm: Short Selling in Contrary Winds. As attested to by the Strunk Short Index, Robert B. Lang, Chairman and CEO of Lang Asset Management, is one of seven dedicated short-only managers in the U.S. at this time. I recently had the opportunity to ask Mr. Lang the following three questions.

(1) Dedicated short-sellers are extremely rare in our financial markets. Can you share some of your background and perhaps some of the experiences that led you to establish a short-only strategy?

Bob Lang: I started in the business in 1959, have managed portfolios since 1964, and started my own firm in 1980. I remember when the markets were bottoming in the mid-70s ... I remember calling prospects and telling them P/E (price-to-earnings) ratios were down to 7 or 8, dividend yields were better than 6%, and that the market had likely bottomed so I thought it was a good time to start buying. There was absolutely no interest. Well, times have certainly changed.

Though, I have historically operated on the long side of the markets, during the latter part of the 1990s, I could tell that the activities on Wall Street were becoming much more speculative. Security analysts were no longer performing their traditional roles as independent thinkers. They would just take the information given to them by the companies they covered and parrot it. Wall Street lost its way in a bullish tsunami. Since I had experienced multiple investment cycles, it became apparent that a significant opportunity was developing for contrarians ... it was time to move to the short side of the markets.

Since most participants have only experienced stocks going up, a bearish view was, and is, extremely unpopular. Only a handful of investors understand the bigger picture. Stocks are subject to cycles. One generation grows up with the understanding that stocks always rise. Finally, the market declines and a lot of people get hurt and the next generation look at stocks with contempt. So unless an individual investor is made aware of this pattern, they are inclined to go along with the current prevailing opinion. After the fact, that is once a decline unfolds, that decline becomes obvious in hindsight. But until then, most find it extremely difficult to “fight the crowd.”

(2) Since most investors have no experience with short selling, can you give us some basic lessons on how short selling works?

Bob Lang: Most investors buy stocks hoping that the price will rise. Short sellers, like Lang Asset Management, anticipate making a profit from declining prices. Expecting a drop in price, we sell the stock, and buy it back later at a lower price. The difference is our profit. How can you sell a stock that you do not own? When you sell a stock short, the broker lends you the shares from a buyer, who previously approved such an arrangement, and “delivers” them to you. As a short seller, you immediately sell the borrowed 100 shares. Later, when you buy the stock back (otherwise called covering), the broker returns the shares to the buyer, and all is settled.

Of course the stock could go up after you sell it, instead of down as you were expecting. You decide to buy the stock back (“cover” your short) in order to minimize your losses. You buy the shares back, and you have lost the difference between you sale and your purchase. The net result is not all that different from a situation where you had bought the stock, watched it decline, and then sold it. Unless the broker “calls” the stock back because he must return the borrowed shares to the owner for some reason, there is no limit on the amount of time you may remain short. But, having a stock called away is a highly unusual situation which usually only occurs with stocks that have a low level of liquidity. There are a few stocks that the broker cannot obtain, and in such cases, you may not short that particular stock.

There are only a very few pure short sellers, probably measured in the single digits, vs. many thousands of mutual funds and hedge funds. In my opinion, this endeavor requires a special aptitude, which is not easily transferable from the long side (without considerable experience).

(3) How does the client benefit?

Bob Lang: The same way one benefits if a stock rises. Most investors buy stocks hoping they will increase. The short seller makes a profit when the stock declines. When an overvalued market turns down, by definition most stocks decline, and portfolios that are short, increase in value. So, not only does the client not lose money, but by implementing this “hedging” strategy, he or she actually profits. Typically, as a measure of diversification, short selling is only done with a portion of a client’s total assets.

Unfortunately, millions of investors will never heed the words of Bob Lang or an article like this one. They continue to see warnings in their everyday lives, but take comfort in the fact that their friends and advisors are all doing the same thing. They ignore reality and trust theories that have worked well (for the last 3 decades) in an ever-expanding sea of credit. So why do most individuals, maybe even those reading this article, never take steps to protect their capital from a bear market?

In answering this question, I turn to a professor of geology at UCLA. As an evolutionary biologist, biogeographer, and Pulitzer Prize winning author, Dr. Jared Diamond addresses the “it can’t break” mindset in a story about individuals who live below a dam. According to Diamond, attitude pollsters ask people who live downstream from the dam how concerned they are about the possibility of the dam bursting. Naturally, those that live further away from the dam are less concerned about the dam breaking that those that live closer to it. But shockingly, from a few miles below the dam, where one would assume the fear would be the greatest, as we approach the dam, the concern about the dam breaking falls off to zero. Why?

Diamond notes that those that live closest to the dam, who are sure to drown if the dam breaks, must believe that the dam could not break in order to preserve their own sanity. This ability to suppress or deny thoughts that cause us great pain is known as psychological denial. Diamond suggests that this behavior, common to individuals, could apply to groups as well. The only way that investors will be able to take constructive financial steps before this credit cycle contracts, is to step outside of the powerful forces of the herd. From here, they can begin to address the unpleasant reality of that which is currently unfolding and how we got here. Denial will only lead to unnecessary losses and increased pain.

Link here.
Previous Finance Digest Home Next
Back to top