Wealth International, Limited

Finance Digest for Week of April 16, 2007

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


Was it only two months ago that market conditions could not have looked better? The DJIA ran to new peak after new peak, accompanied by 5-year highs for the S&P 500 and the Nasdaq. Then whammo, all three indexes were staggered following the Shanghai exchange’s 9% plunge in late February. Huge selloffs rocked Asian and European markets, as well. Many gurus have called this simply a blip, an overdue correction in a market destined to move strongly higher. And indeed, starting in March stocks regained some of their lost ground. So should you be nervous or not?

At first blush there is a real cause for concern. The nasty hit the subprime market took in March has continued, and the damage is frightening. Several subprime lenders are down 80% or more from their highs. Their loose underwriting standards suggest that more rot exists at these lenders than we know about. Investment and commercial banks have shut many of the subprime lenders off from fresh capital, which makes their survival questionable. The ripple effect from the subprime lenders has spread to their biggest Wall Street enablers. The stock of Morgan Stanley, Bear Stearns and Lehman Brothers suffered worse than the rest of the market, on fears that the firms’ ill-fated dealings with the subprime crowd will spawn bloody writeoffs. Just as bad, Morgan, Lehman and Bear’s own subprime lending units could be ripe for writeoffs on defaulted loans to weak-credit home buyers.

That said, the subprime fallout should be reasonably contained. Unjustifiably, subprime fears have weakened share prices at Freddie Mac and Fannie Mae. Freddie and Fannie, which also have trafficked in subprime loans, nevertheless screened out a lot of the really risky mortgages, so the two giants should encounter little pain. Given their enormous available capital, Freddie and Fannie could be big beneficiaries of the current panic, as other lenders pull back. The same is true for most of the nation’s large commercial banks, where subprime loans are a mere fraction of their loan portfolios.

Three other obstacles face the market. There are fears that (1) the slowing economy will sink into a recession, (2) corporate earnings growth will slow, and (3) the Federal Reserve will not cut rates anytime soon, because inflation shows signs of picking up. At this point, I think these fears are unfounded. Earnings growth could flatten through the rest of the year, but the economy is still working at a very high rate of capacity (82%), with unemployment near its lowest level in a half-decade. The economy does not need further Fed stimulation now. Although pockets of speculation do exist in private equity and hedge funds, not to mention subprime mortgage lending, they are small relative to the enormous speculation in the late 1990s.

Yes, 2007 should be a much more volatile year than we have seen for some time, but it should also provide some excellent opportunities if quality companies are sold at bargain basement prices. Stocks already are relatively cheap. The price/earnings multiples of the most-watched indexes, namely the S&P and the Dow, are near the lower ends of their ranges for the past 10 years. So wince and bear it. This is the type of market where big bucks can be made.

Link here.


Jesse Livermore, widely regarded as one of the greatest stock market operators of all-time, considered himself a humble student of the market until his last day in 1940. “I study the market, because it’s my business to trade. In the forty years which I have devoted to making speculation a successful business venture, I am still discovering new rules to apply to that business,” he once remarked. “Experience has taught me the way a market behaves is an excellent guide for an operator to follow. Observation gives you the best tips of all, and the behavior of a certain market is all you need at times. You observe, and then experience shows you how to profit by variations from the usual, that is to say, from the probable.”

Had Livermore been operating in today’s markets, he might have found it intriguing that the direction of the Japanese yen would become a key driver of the Dow Jones Industrial Average. Traditional indicators such as the health of the U.S. economy, company earnings, cash flow, and future sales forecasts are all taking a backseat to forecasting the direction of the heavily manipulated Japanese yen in the foreign exchange market, in order to predict the DJIA.

After closely tracking top U.S. mortgage lender Countrywide Financial’s (CFC: NYSE) in February and March, the dollar/yen exchange rate began to diverge from CFC in April, as currency traders bet on a rosy U.S. employment report on April 6th. “Observation, experience, and memory, are what a successful trader must depend on. He must not only observe accurately, but remember at all times, what he has observed,” said Livermore. “He cannot bet on the unreasonable or the unexpected. He must always bet on probabilities and try to anticipate them. Years of practice at the game, of constant study, of always remembering, enable the trader to act on the instant when the unexpected happens, as well as when the expected comes to pass.”

Jesse Livermore would have been intrigued by the Shanghai red chip market, which is reminiscent of the middle stages of the Nasdaq 1998-99 bubble. Left unchecked, the world is witnessing one of the greatest stock market rallies in history, ranked alongside Japan’s Nikkei-225 of 1986-90 and the Russian Trading System Index. The Shanghai Composite Index has gained 25% since its widely-reported 9% dive on February 27th. All lip service and tightening measures by Chinese authorities to keep Shanghai red chips from surging higher have not turned back the Asian stampede. It is highly doubtful that Livermore, who made $100 million during the 1929 stock market crash, would try to pick a top or start short selling this market. Foreign money is flooding into China, with its trade surplus doubling to $46.4 billion in the first quarter.

On April 6th, the Chinese central bank hiked bank reserve ratios by 0.5% to 10.5%, ordering lenders to set aside more money in reserve for the 6th time in less than a year. But unless the required reserve ratio is raised to more than 13%, which is not likely, the PBoC’s efforts to slow explosive loan growth and the money supply are just cosmetic overtures. China’s banks still have an average excess reserve deposit ratio of 3%, and its largest banks have the highest capital ratios, providing them with a sizeable cushion when they are ordered to increase reserves. Seeking to stay ahead of monetary inflation, Chinese investors are bidding up red-chips, and turnover in Shanghai A shares ballooned to a record $19.7 billion on April 10th.

Livermore used to say there is nothing new under the sun in the stock market. But the “yen carry” trade is turning some long held fundamental beliefs about investing upside down. The Shanghai bubble has been seen before in different clothing, and it is possible that it might never come back down to earth, much like the Brazilian and Russian stock markets.

Link here.


At the March 2000 stock market peak the S&P 500 traded at 33 times earnings and could do no wrong. The Bloomberg Real Estate Investment Trust Index, on the other hand, traded at a multiple that was 40% of the S&P’s and could do no right. Reading between the lines of these wildly disparate valuations, one could almost imagine a future without buildings. But a funny thing happened on the way to tomorrowland. REITs got hot, but the S&P did not. By so vast a margin did the REITs subsequently excel that the blue chips would have to quadruple tomorrow simply to close the gap. Can we agree that Mr. Market might have miscalculated seven years ago? Are we prepared to imagine that he could be in error again?

Income-producing property can be a superb investment. So, too, can REITs, which pay out 90% of the income they earn from the assets in which they invest, buildings or mortgages or both (the focus here is on buildings). Think of a bond with an upside. After all, rentals, unlike a fixed coupon, can be negotiated and renegotiated. You, the next Samuel Zell, could buy an undermanaged building, fix it up, boost its occupancy and raise its rent roll. In this way you could enjoy the best of all investment worlds, an appreciating asset with a strong and predictable cash flow.

But we reckon without the people, or the valuations. The tenants track mud on the carpets and scuff the woodwork. They stuff paper towels down the toilets and demand more heat or air-conditioning, according to the season. Some of the tenants go broke. They are an ordeal. It almost goes without saying that no investment asset is either inherently good or inherently bad. Valuation is the all in all. At the low March 2000 valuations REIT investors had that sleep-enhancing cushion known as a margin of safety. At the much, much higher prices now prevailing, they have no such protection, only the smug knowledge of past returns.

“Markets make opinions,” the sages taught. They were as right as rain. Just by going up, real estate has made believers of the former skeptics on America’s investment-policy committees. In the midst of the Internet frenzy, declared the real estate bears, people will work from their homes in their pajamas. They will shop from home, too. Because office buildings, bank branches and shopping malls had been rendered technologically obsolete, any price was too high to pay for them, or for the REITs that owned and managed them.

What a difference seven years make. Now, ostensibly, no price is too high, because rents will go up forever and private equity investors will buy up any REIT not nailed down. Never mind that the Bloomberg REIT index yields a mere 4%, a discount of 0.6 percentage points to the 10-year Treasury note. The REIT’s 8.1% yield in March 2000 was a 2-point premium to the 10-year note.

Yes, the bulls say, but only consider the glory of Blackstone’s recent $39 billion purchase of Zell’s Equity Office Properties Trust. Within two weeks of the February closing Blackstone had deftly unloaded $22 billion of the Equity Office portfolio to clamoring bulls, turning a $2 billion instant profit and proving beyond any possible doubt that there is lots more upside left for everyone.

But hold on: As the return on buildings pushes lower, the cost of financing them edges higher. Starry-eyed buyers think nothing these days of settling for 4% yields, or cap rates. And at the same time they are borrowing at 6% or more. In 2006 Equity Office itself paid a blended average of 6.5% on its (mostly) unsecured debt. Not to worry, the bulls insist. Real estate is not about the cash flow. It is about the price appreciation. An earlier generation of bulls once said the same thing about tech stocks.

But I do concur that Blackstone-Equity Office is a bellwether of sorts. One buyer of those hived-off Blackstone assets was McGuire Properties. It paid $3 billion for 24 office buildings in southern California, one of the county’s preeminent markets. But, the Wall Street Journal reported, 10% of the tenants in the EOP Orange County properties are subprime mortgage lenders. A great business is real estate – except for the tenants and, these days, the valuations. How to profit from that?

UltraShort Real Estate ProShares (78, SRS) is an exchange-traded fund that seeks to deliver twice the inverse return of the Dow Jones U.S. Real Estate Index. So if the index were up or down by 10%, UltraShort would be up or down by approximately 20%. The source of this extra performance oomph is the use of futures, options, forwards, etc. These are techniques it is usually better not to try to implement at home.

Link here.


Kenneth Heebner, manager of the top-performing real-estate fund over the past decade, said U.S. home prices may plunge as much as 20% because of rising defaults on riskier mortgages. Subprime loans, made to borrowers with a history of missed payments or untested credit, and “Alt-A” loans, which require little or no documentation, account for about $2.5 trillion of the $10 trillion in outstanding mortgages, according to Economy.com. As much as 40% of these loans may default, flooding the real estate market, Heebner said.

“It will be the biggest housing-price decline since the Great Depression,” Heebner, 66, said in an interview in Boston. Prices may fall by a fifth in some markets, he said. That would leave home prices at levels last seen in 2003 and 2004, the middle of boom that lifted prices to a record in 2005. The damage from high-risk mortgages will slow the U.S. economy, though not enough to send it into a recession, Heebner said.

Heebner, who co-founded Capital Growth Management in 1990, manages the $1.6 billion CGM Realty Fund. The fund has gained an average of 20% a year in the past 10 years, the most of any real estate fund over that period, Bloomberg data show. Heebner said he has sold his shares of REITs that invest in apartments because they will face competition from single-family homes that have been converted into rentals. His fund had 35% of assets in apartment REITs at the end of last year.

He is buying shares of mining companies that benefit from growing infrastructure needs in India, China and Russia. CGM Realty Funds also holds shares of Las Vegas Sands, the casino operator that is developing real estate in Macau, and Mexican homebuilder Desarrolladora Homex SAB. Heebner is known for making concentrated investments in a few industries. He sold homebuilders after owning them from 2001 to 2005, record years for home sales. He bet against technology and telephone stocks in 2000, correctly timing their collapse.

Heebner, whose Capital Growth Management has more than $6 billion in assets, also manages the $2.3 billion CGM Focus Fund. The fund has advanced 13.5% this year, making it the top-ranked diversified U.S. stock fund, according to Morningstar.

Link here.

U.S. Supreme Court steps into subprime crisis.

The Supreme Court has made a potentially far-reaching ruling that limits the power of individual states to regulate mortgage lending. The ruling came as federal bank regulators responded to criticism that they had been slow to act over the crisis and cleared the way for lenders to offer relief to distressed homeowners. Regulators told banks they would “not face regulatory penalties” if they offered borrowers new terms.

The Supreme Court ruled 5-3 that banks regulated by the federal Office of the Comptroller of the Currency had a broad shield from additional state regulation. Though it did not directly involve subprime lending, it could have a big impact on the ability of states to act independently on predatory lending and throws the spotlight on federal authorities. Many consumer advocates had hoped that individual states would be able to step in more quickly than federal legislators or regulators.

Allen Fishbein, director of housing for the Consumer Federation of America, said after the court decision: “This is really disappointing news.” He said it could work to the detriment of consumers. The case, which tested whether Michigan could regulate the mortgage-lending subsidiaries of Wachovia, a national bank, split the court in an unusual way, with its most liberal member, John Paul Stevens, joining conservatives Chief Justice John Roberts and Antonin Scalia dissenting in defence of the right of states to regulate in this area.

Link here.
Subprime Ground Zero – Part I, Part II.

Real estate at altitude.

Bubbles burst with a sudden “pop”, right? Well, that depends on the size of the bubble. The process of inflating a hot air balloon is a slow one. You check lines, designate a chase crew, inspect fabric, test propane equipment and check the weather. You start the inflation with a big fan, then carefully shoot flame inside the envelope until it becomes ... a bubble. Then, whoopee, you fly away in it. It is a bit like “climbing a wall of worry.” Deflating the balloon is not instantaneous either. It too is a process. And if you land in an irate farmer’s field, you may have to keep the balloon inflated until you can walk it off his property.

If only the real estate credit bubble was that small and simple, and could be “walked” out of danger. But no, it must burst one layer, or “tranche” at a time. The deflation began with the little guys, the lower-income higher-risk borrowers. Now, like a Florida sinkhole, the collapse dissolves upward through strata of risk-ranked debt – bundled, “insured”, and sold by banks and hedge funds to limit their own risk. What began as a low-rent-rendezvous between Wall Street and the common man will probably end with some high rollers taking low dollar for their extravagant mansions. But not just yet. The rich are always the last to suffer the ill effects of a bursting bubble. Their mania is still rolling.

An article in the Wall Street Journal last week tells of a just-listed, 45,000-square-foot Los Angeles mansion modeled on Versailles: for $125 million, it’s yours. The article describes “Italian marble walls, French limestone floors, gold-embossed leather wall coverings and gold-leaf crowned moldings ...” The listing is in second place for pricy U.S. properties, just behind Saudi Prince Bandar’s Aspen ranch. The Versaille wannabe belongs to the recently divorced wife of a Texas millionaire.

Even in a balloon, looking down on the rooftops, its difficult to see the real estate boom for what it is. Are the millions of McMansions money-piles, or piles of debt? Can a nation go this far in debt and pour this much productivity into consumption and still maintain its place as leader of the world economy?

It is said that the three main causes of foreclosure are job loss, divorce, and major medical expenses. This trio of symptoms is always evident, but they appear more frequently in times of economic stress. They tend to snowball, and they always hit the common person harder than the rich.

Link here.


Sometimes big bad ideas are accepted because of ignorance, sometimes because they occur in the right social climate. For example, cigarette smoking was a bad idea, but during the 1940s, doctors recommended it in full-page, color ads in national magazines. One man’s idea to add lead to gasoline to prevent engine knock did not work and surely did not help the national IQ. Many bad ideas initially seem to be good ones, but even good ideas can look bad when the social climate encourages their abuse. After we wise up, the government that often allowed the foolishness has to step in and prevent it.

In 2002, the Congressional Black Caucus Foundation joined with Fannie Mae, Freddie Mac, the National Association of Realtors and others to promote increased minority homeownership. The plan was called the With Ownership, Wealth (WOW) initiative. In relatively normal times it is a good idea to expand home ownership, as happened in the productive optimism following World War II. But it is difficult to recognize “normal” times in an asset mania, such as we have been experiencing lately. A flood of credit in a lax regulatory environment has distorted the normally good idea of home ownership.

An article in USA Today this week, titled, “Subprime Lenders’ Big Gifts Helped Lawmakers”, tells the story of a lax regulatory environment: “The nation’s top subprime lenders, including New Century Financial, which has filed for Chapter 11, have lavished generous donations on homeownership programs sponsored by black or Hispanic members of Congress.” In short, the lenders paid for congressional access, special designations, chances to participate in advisory committees, and advertising at events and in caucus materials and websites. The caucus officials point to Fannie Mae and Freddie Mac as two of their largest sponsors.

Now Congress ponders a solution to the record number of foreclosures as they continue to accelerate. It will predictably tighten regulations, bail out some victims and hope for the mess to subside. The entire story is an excellent example of how social mood can sweep the majority into the boom and then require the bust. Congress just gets dragged along in the wake. It is an old, familiar pattern that still must be re-learned by every generation.

John Nofsinger is an academic economist who has studied the social forces behind the timing of investment legislation. The classic legislative cycle of “protect investors/repeal investor protection” can only be understood with socionomic insight that allows you to see that patterns of social mood occur first, and legislation is always a response.

The government continually tightens and loosens its laws regarding the investment industry just as it continually raises and lowers income taxes. After each major bear market or scandalous period, the government enacts new laws to protect investors. Unfortunately, the laws that are enacted to protect shareholders and investors are often repealed during times of economic strength and stock market euphoria.” (“Infectious Greed: Restoring Confidence in America’s Companies” by Dr. John Nofsinger and Kenneth Kim, published in Pioneering Studies in Socionomics)

If you at least know that we are in a pattern, you are at an advantage. If most of the time you know where we are in the pattern, that is a huge advantage. Socionomics and Elliott wave analysis can help you gain that advantage.

Link here.


Certain leveraged and short-exposure ETFs make the job easier.

Over a long enough period stocks always beat bonds. At least that has been true in the U.S. for the past two centuries or so. So why do I recommend that you include fixed-income holdings in your portfolio? Three reasons. One has to do with the psychology of investing, another with a matter of timing and the last with the tactical gain that can be derived from rebalancing.

There is a psychological benefit to diversifying across stocks and bonds. Bonds are ballast against bear markets in equities. When those bear markets come, you do not want to be panicked into selling. Having a portion of your portfolio in a class of investment that holds up (or at least is not damaged as badly) will give you the stamina to hang in there.

The second benefit is closely related. You may need to raise cash at an inopportune time. If all you own is stocks and you are in a bear market, you are forced to sell at the bottom. With some money in fixed income, you can get cash without disturbing your chance to recover in the stock market.

The third advantage to a balanced portfolio is the opportunity to rebalance. Say your target mix is 60% stocks, 40% bonds, preferreds and cash. After a bull market in stocks, the equities portion of your portfolio is overweighted. To bring the portfolio back into balance you have to sell stocks and buy fixed-income assets. Likewise, after a bear market in stocks you are impelled to buy more of them. This constant push and pull on your portfolio has the nice effect of causing you to buy low and sell high.

Keep all this in mind when you hear pronouncements about where the market is going. Pundits tell us, with a straight face: (1) the February downdraft was a “correction”, and (2) the market will finish the year above current levels. So ... what then was there to “correct”? Rather than becoming a victim of this periodic game, you can benefit from it by rebalancing. If a market “correction” brings your stock values down to where your 60-40 portfolio is 50-50, redeploy capital from fixed income to stocks. If you are doing that right now, first try to reduce any holdings of high-yield bonds, especially those rated single B and CCC.

Once the market recovery is in full swing and your portfolio starts to take on a 70-30 breakdown, sell off some of the appreciated stocks and return to your normal mix. Unless you are doing this within a tax-deferred account, you need to figure capital gains taxes into the equation. The fixed-income securities to buy are in my model portfolio.

When it is time to add to the stock portion, good vehicles for implementing this strategy are a series of exchange-traded funds, or ETFs, that aim for a rate of return twice that of the popular indexes to which they are tied. They do this through playing with derivatives, and thus far in their short (6-month) existence have managed to deliver. If everything goes right, your recovery is faster still. The risk is that, if things go wrong, you are in the hole even more. If your portfolio is more closely tied to the S&P 500, the Ultra S&P 500 ProShares (SSO) would be your vehicle of choice. If you are more of a blue-chip investor, buy the Ultra Dow 30 ProShares (82). But if you are heavily into tech stocks, look at the Ultra QQQ ProShares (QLD), which follows Nasdaq’s 100 largest stocks.

If you need to lighten your stock exposure, without tax effects, use another ProShares product, the Ultra Short ETFs for each of these indexes. Note also, these ultra shares also exist for specific industries and commodities as well as for small- and midcap stocks. This gives you the ability to hedge or reinforce specific portfolio exposures you have rather than the broad market. (“Short” here refers not to duration but to short-selling.)

Link here.


“You shall not press down upon the brow of labor this crown of thorns,” said William Jennings Bryan, on July 9, 1896, in the most famous political speech in American history. “You shall not crucify mankind upon a cross of gold.” The proximate target of this gush of oratory was the gold standard. But look deeper. Behind the scene were millions of farmers who had made an age-old mistake. They had gone too deeply into debt in order to increase production. In short, they had overdone it. The burden of today’s cogitation is that they overdo it regularly.

Judged as a businessman, the typical farmer would make a good veterinarian. Over and over, he walks into the same trap. When prices go up, he borrows in order to expand his holdings. He buys more equipment. He leases more land. And he plants more crops to take advantage of the high prices. The extra production soon causes prices to fall, naturally. Then, all of a sudden, he is ducking his creditors and running up the phone bill to his congressman. Save our farms ... Spare us from the evil bankers ... Give us subsidies, tariffs, he asks.

Farm products – especially corn – have played such a large role in American history that like the odor of lemon madeleines in Proust, they recall for us a whole series of debacles. When the farmer gets into a jam, the entire nation feels the pinch. The earliest settlers in the New World learned how to grow corn. It saved their lives. Then, farmers settled in the rich bottomlands, and planted corn. Soon, they were spreading out beyond the Appalachians growing corn everywhere they could turn the earth. The trouble in the early days was not growing the corn, but moving it. There were no roads, no canals, no railroads. So, the pioneers figured out that they could pack the energy of corn into a denser form that made it easier to store and easier to transport – corn whiskey.

After the American Revolution, the Founding Fathers attempted to pay off the nation’s war debts by imposing a tax on whiskey. But the 9-cents-a-gallon tax on small producers was enough to set off another revolution – the Whiskey Rebellion of 1794, centered in Monongahela, Pennsylvania. The insurgents got their hands on one tax collector, sheared his hair, and tarred him and feathered him. More comedy than tragedy, George Washington sent out 13,000 troops, who managed to round up 20 whiskey rebels. Two of them were convicted of insurrection, but soon pardoned.

With the rifles back over the fireplace mantles, farmers went back to making whiskey ... and produced so much that the price of the elixir collapsed. This was probably America’s golden era, when corn liquor was so cheap anyone could get drunk any time of day or night. The wild Irish slums of New York and Boston were soon blighted by booze. Out on the frontier, even Abraham Lincoln passed around a jug of “corn”. Then, a national epidemic of alcoholism gave way to a worse case of sobriety. The sour Temperance Movement arose – citing the many evils of Demon Rum and Cruel Corn Whiskey as Public Enemies No. 1 & 2. This infection of public improvement festered for nearly 100 years and finally broke out in a Constitutional Amendment completely outlawing alcoholic beverages in the United States of America. This was not without political consequences of its own. Rum-runners, mobsters, and the Kennedy family all got rich.

It was transportation that changed the lives of the corn farmers. In the mid-1800s, first canals, later railroads, made it possible to deliver undistilled corn all over the country. Suddenly, growing corn was more profitable than ever. The price of farmland west of the Mississippi soared. Kansas farmland went up four to six times between 1881 and 1887. Nature was rarely kinder to the Great Plains than in the years following the War Between the States. It rained out on the prairies, raising crop yields to levels rarely seen before or since. And the new railroads made it possible, for the first time ever, to ship a bushel of corn inexpensively to the major cities in the East. All over the Midwest, farmers planted corn, corn, and more corn.

What happened next could have been predicted by anyone, except for a farmer, an investor or a banker. The years that followed were dry. As the crops withered, so did the credit available to farmers. In the last three years of the decade, mortgage lending fell to only 10% of the previous three years’ activity. Land prices fell. And farmers went bust.

Today, it has been 35 years since a debtor was last crucified on a cross with any trace at all of gold content. But, in 2006, you could still go out to Kansas and buy an acre of farmland for only about $1,000. Adjusted to 1880 prices, that is only about $25, or barely 15% of the peak prices set 120 years ago.

But now, there is a new bubble out on the plains, and a new political scam to go with it. In Martin County, Minnesota, says Fortune, six new ethanol plants are either in operation or being built. In the last eight months, the price of corn has doubled, from $2 a bushel to $4. Corn is not just a crop in America. It is a currency. Corn is used to feed pigs and cattle. Corn syrup is a main ingredient in Coca Cola, candies, cakes, ice cream, hamburgers and many other products. When the price of corn changes, every calculation changes with it.

The price of land, for example. An average acre in the mid-west produces 180 bushels. At $2, that puts the gross yield per acre at only $360. After costs, farmers had little left over – only about $30, according to Fortune. But at $4 a bushel, corn farming becomes much more profitable, with net yields 10 times higher than they were two years ago. With that kind of money rolling over the plains, farmers grow bold. They begin to cast an eye over the “Property for Sale” section of the newspaper and stop in at the John Deere dealership.

In Martin County, Minnesota, an acre of farmland is already up to $4,000 – a price it has not seen in 25 years. What happened after the last peak? Corn went down, and farmers who had stretched to produce as much as they could, went broke. Land fell back to $1,500 per acre, where it stayed until the current boom.

Part of the trouble with this boom is that it depends on ethanol. 31 new ethanol plants have been built in the U.S. since 2005. When corn was $2 a bushel, and oil was $70, they could make more than a dollar per gallon. But at $4 a bushel, their profits have fallen to 3 cents per gallon, on average. And if corn continues to rise, or ethanol prices fall, even with their subsidies, they will be losing money.

Meanwhile, farmers are eager to take advantage of these high prices. They are doing what farmers always do – they are overdoing it again. As corn rises in price, farmers plant record amounts. And the biggest consumers – particularly ethanol plants, which are expected to take up more than a quarter of this year’s crop – cut back. Supplies increase. Demand falls. How long will it be before corn falls again? Of course, this time could be different. Ethanol may be a fraud, but it has got the U.S. Congress behind it. Corn-fed pork might not be good for you, but there are 3 billion Asians yearning for more of it. On those facts alone, we would not bet the farm. But at least we would be doing our sums on the subject. Could we sell forward enough corn to pay for a few more acres? Or how about a new air-conditioned tractor?

Whether corn will go down soon, we do not know. But even if the price continues to go up, many farmers will still find a way to over-do it ... and ruin themselves.

Link here.


The dollar is no longer responding to traditional stimulants. Despite the apparently “hawkish” tone in the recently released Fed minutes, and trade deficit figures that were slightly less horrific than expected, the dollar nevertheless declined against just about every currency on the planet. As a result, it now teeters dangerously close to the edge of a very large precipice. Looming large is the 80 level of the U.S. Dollar Index which has stood as long term support for almost 30 years. Last week, the Index broke below 82, and is sinking fast. When this critical level is breached, look out below. Without any support beneath it, the dollar could literally fall off a cliff.

The trajectory of the dollar is linked to America’s economic status in the world. Thanks in part to the strengthening euro the market capitalization of European shares now exceeds the market capitalization of American shares for the first time since before the First World War. At the current rate of appreciation, European shares will have a market cap 50% greater than American shares by the end of the decade. However, should the dollar decline turn into a free fall, this could happen much sooner.

For individual currencies, the British pound warrants particular attention as it approaches the significant two-to-one level against the dollar. The pound has not meaningfully breached $2.00 since the early 1980’s. The euro, currently trading above $1.35, is bumping against its all time high of just under $1.37 against the dollar. The Australian dollar has already hit a new 17-year high and is perhaps a harbinger of things to come. The sole laggard among major currencies has been the Japanese yen (and to a lesser extent the Swiss franc), which has been held down by the infamous carry trade. When it unwinds (which would clearly be evidenced by a break below the 110 level), buckle your seat belt as all that will stand between the dollar and oblivion will be the Bank of China. I can only imagine how low the dollar would already be were it not for the massive foreign aid provided by the Chinese.

So far the Dollar Index has tested the 80 level five times in the past: 1978, 1990, 1992, 1995, and 2004. On several of those occasions it took massive, coordinated interventions by all the world’s central banks to rescue the dollar. However, given the enormity of today’s imbalances and the sheer number of dollars in foreign hands, such a bailout seems unlikely. Perhaps the most significant warning sign is the break out in the price of gold. This is the first time the Dollar Index has hit this level with gold trading above $400 per ounce (although it might have been slightly above that level in 2004). Currently, spot gold is trading at about $680 per ounce.

The strength in gold is also a good indication that this time around the U.S. dollar can count on little help from its friends. Rising gold prices reveal the suspicion with which many now view fiat currencies and central bankers’ resolve to keep them sound. Therefore, foreign central banks will be reluctant to take actions to further weaken their own currencies, ushering in greater domestic inflation and calling into question the soundness of their own respective monetary policies. Low gold prices gave cover to such inflationary interventions in the past, but today’s rising prices urge caution. As a result, the chances that the dollar can dodge another bullet are increasingly remote.

Despite the impending gravity of this situation, few show any worry. Perhaps the dollar will bounce from these levels and will buy us a little more time, but how much? When the support ultimately gives way all hell will break loose. A sharp decline in the Dollar Index below the 80 level will likely take down the bond, stock, and real estate markets as well. Since a lower dollar will exert additional upward pressure on already rising consumer prices, the ensuing combination of rising inflation, higher interest rates and lower asset prices will be a toxic mix.

Link here.

Dollar Doom Redux

When it comes to the nature of action-adventure films, it is safe to say that if you have seen one chase scene, you have seen them all. To wit: Good guy runs after bad guy across busy highway, through crowded byway, over barbed wire fence, into abandoned warehouse, and up a gazillion flights of stairs to rooftop ... only to get there right as bad guy parachutes onto the ground below. Good guy maneuvers his way back down only to reach bad guy right before he hooks himself onto dangling harness attached to helicopter overhead AND is lifted skyward into safety. And cut.

Thing is, you can see the same scene play out on the mainstream financial Big Screen everyday as the hired “guns” pursue the major market trends, only to reach them right BEFORE prices take off in the opposite direction. Plus, these guys do all their own stunts.

In case you have forgotten the late 2004 stockbuster smash “The Disappearing Dollar”, allow us to replay some of its most memorable scenes. The plot: the greenback has plunged over 30% in value against a basket of the world’s key currencies, including an all-time record low versus the Euro. And, according to the popular press, the only things the U.S. note would be pushing UP in the near-term future were daisies. From glossy magazine cover stories in The Economist to Newsweek spouting the end of days for “the incredibly shrinking dollar” – to bossy moguls like Bill Gates and Warren Buffet predicting “further decline ahead for the dollar,” including a $21.4 billion short position against the currency by the Oracle of Omaha on December 12, 2004 (versus $0 in 2002) – the good guys had caught up to the speeding bear bandwagon. Right BEFORE said wagon jumped tracks and bid adieu on a bull train speeding north – a 180-degree turn that left nearly everyone in the dust.

Nearly. See, in the December 2004 Elliott Wave Financial Forecast, our analysts chased the only measures that offer objective insight into the long-term trend changes in store for the U.S. Dollar: wave patterns and sentiment. In EWFF’s own words: “For the first time ever, we start with the US Dollar because the case for a bottom is an extraordinarily compelling one. ... We are strongly bullish on the dollar. The upside reversal should be measured in months, not weeks.” Starting on December 30, 2004, the U.S. dollar staged a 12-month long rally that tacked 15% onto its value before reversing.

Flash ahead to April 2007 and we have the mainstream release of “The Disappearing Dollar” Part II, a Dollar Doom Redux with all the same characters firmly in place: The U.S. Dollar has plunged to a 2-year low against the Euro and New Zealand Kiwi, a 15-year low against the British Pound, a 17-year low against the Australian Dollar, and on and on from the ringgit to the rupee, the “greenback assault returns.”

It is “doomsday for the US currency,” writes the Associated Press. “There’s really no way of knowing how far prices will plunge.” Add support from the U.S. Congress to create legislation that would put a stop to the Yen carry trade, decrease foreign reserves of the buck, and prevent “manipulation” on the part of particular governments to devalue their currency – and we would say the usual suspects are awfully close to catching up to the dollar bear trend. In the words of the April 13 Short Term Update, “These are the conditions which create” one kind of move in the markets. Don’t get caught in a cat-and-mouse chase with the mainstream crowd.

Elliott Wave International lead article.

The $2 British Pound.

“Savings income normally has 20 per cent tax taken off before you get it,” the British government notes on its Direct Government website. Anyone trying to save money today will also know that inflation is also deducted at source.

10 years ago this May, the current administration –New Labour – swept to power with the greatest electoral majority since the end of World War II. And the first announcement made by Gordon Brown, the new finance minister, gave full operational independence to the UK’s central bank, the Bank of England. By way of thank you, the Bank has given the nation record price stability. Or so you might think. The Old Lady has tweaked interest rates and twiddled the knobs of monetary policy so deftly, she has abolished the risk of runaway inflation, but also steered clear of the dreaded deflation, too.

Hence the Two-Dollar Pound hit on the news that Consumer Price inflation (CPI) in March 2007 rose to 3.1%. Forex traders the world over expect higher Sterling interest rates to counter this higher cost of living. Inflation running at a 16-year high makes better yields on the Pound a slam-dunk. But peer through the other end of the telescope for a moment. With the Pound so strong, how come inflation in the UK is rising so quickly? And rather than speculative flows being a mere by-product of tackling inflation with higher rates, is a stronger Pound not the only way to prevent inflation – already at a 16-year high – from running ahead faster still?

Since gaining independence, the BoE has built itself a fantastic reputation for inflation-busting – despite presiding over the greatest flood of money growth in the UK since the huge bubble-top that preceded the collapse of its housing market, and the collapse of Sterling that followed, at the end of the 1980s. Under Mervyn King, the current governor of the Bank, the Pound was the first of the world’s top 5 currencies to gain higher interest rates after the “Deflation Scare” of 2003. The BoE jumped to raise its rates seven months before the U.S. Fed started hiking dollar rates off their half-century floor of 1%. (The European Central Bank took until December 2005; the Japanese and Swiss have only just got round to it.)

King also loves to talk the talk of “zero tolerance” in the fashion of Bundesbank heads during the 1970s, repeatedly warning that he is not afraid of higher rates ahead if necessary. He even makes occasional reference to “rapid money and credit growth” – so at least he knows there is a problem.

Despite gaining kudos from the forex markets, all the BoE has really given British voters during the last decade – as this week’s awful cost-of-living data prove – is a collapse in the real rewards paid on cash savings. That, plus a bubble in property prices to surpass even the top of 1989. Over the last 10 years, real Sterling interest rates have shrunk to their lowest level since the late 1970s. Even ignoring the deduction of basic-rate tax, real returns in March paid to cash savers fell to just 0.45% – their lowest level since the “Deflation Scare” of mid-2003. The BoE cut its base rate to a half-century low and real interest rates dropped to a 2-decade low of 0.40%.

The stock market leapt higher. House prices rose at their fastest pace in history. Household savings rates shrank towards zero. And no wonder. You now have to go back to May 1981 to find British savers enduring a worse rate of return on cash-in-the-bank post inflation. Now the BoE is expected to raise base rates to 5.50% at its May meeting. Unless inflation falls away dramatically, however – an unlikely event – then holding cash on deposit will continue to teeter on the verge of costing British citizens money. After tax, that other government-inspired deduction at source, British savers are already under water. And if Mervyn King fails to make good on the currency market’s expectations of higher rates, the Pound looks fated to fall – fast – pushing the rate of inflation yet higher again.

Link here.
Pound For Pound – link.


The Morgan Stanley Cyclical index is up 9.4% y-t-d. The Dow Transports have jumped 10.4% and the Morgan Stanley Retail index has gained 7.9% (52-week gain of 18.6%). Clearly, the stock market is not overly burdened by the prospect of subprime mortgage problems impacting the general economy. With some justification, the bulls at this stage have attained great confidence in the resiliency of the U.S. consumer, stock market, credit system and economy. The bears, on the other hand, continuously scratch their heads attempting to comprehend the amazing nine lives demonstrated by this protracted boom. When the financial and economic worlds are in such a state of crosscurrents and complexities, I instinctively fall back upon an analytical framework heavily influenced by the work of the great Hyman Minsky.

“An understanding of the American economy requires an understanding of how the financial structure is affected by and affects the behavior of the economy over time. The time path of the economy depends upon the financial structure.” ~~ Minsky, Inflation, Recession and Economic Policy, 1982. (page xxiii)

Minsky’s analyses fixated on the “complex, ever evolving financial institutions and structures.” Finance drives the economy – not vice versa – and the interplay of financial and economic evolution and attendant uncertainty and instability are all inherent to capitalistic systems. The complexities of his day – including the advent of the Eurodollar market, commercial paper, money market funds, REITs and “bought” deposits – seem rather rudimentary in our age of “repos”, multifarious CDOs, credit default swaps, global 24/7 derivatives markets, proliferating hedge funds and sophisticated market-based leveraged trading strategies. At the minimum, we should remain leery of superficial and simplistic analysis of the workings of the U.S. and global economies.

The resiliency of the U.S. consumption-based economy is readily explained by the unrelenting expansion of finance.

When stocks faltered early in the decade, double-digit mortgage credit growth and consequent housing inflation lifted household balance sheets – and animal spirits. Stagnant real wage growth became only a minor issue as mortgage finance and housing gains flowed freely. Now, with the mortgage financial bubble faltering, corporate and financial sector credit excesses engender the strongest income and securities market gains in years. The Wall Street credit infrastructure simply switches gears. And while the process of extending inflated purchasing power to the household sector evolves over time, the end result is about the same – more spending.

“In our economy, money is created as bankers acquire assets and is destroyed as debtors to banks fulfill their obligations. ... The performance of our economy at any date is closely related to the current success of debtors in fulfilling their commitments and to current views of the ability of today’s borrowers to fulfill commitments.” (page 17)

In this age of non-bank, securities-based credit creation, we will replace Minsky’s “money” with (an equally and inescapably ambiguous) “liquidity”. And instead of “money” being primarily created by banks financing tangible (“capital”) asset investment, the creation of liquidity through the expansion of financial asset holdings is today’s prevailing monetary dynamic. In Minsky’s day, the creation of new finance through business borrowing for real investment was the defining monetary process. Today, it is the expansion of leveraged securities speculation by a highly diverse cadre of players.

Real economy business profits were Minsky’s primary focus (although attention was certainly paid to bank earnings). The massive expansion in the Financial Sphere since his 1996 passing has relegated non-financial corporate profits to a virtual side show, at least in terms of the driving force of credit creation and economic performance. These days, financial profits overwhelmingly dictate system behavior, a circumstance that goes far in explaining the proclaimed economic resiliency – as well as delusions of the nullification of the business cycle. And this is no mere academic debate.

Minky focused on the crucial role of the “level, stability, and prospects of profits.” Profits drove business investment, but the vagaries of financing capital assets were at the heart of inherent system instability. As profits grew and finance expanded, disequilibrating forces destabilized the profit picture, especially for booming sectors. I argue that today’s Financial Sphere profits boom is different in kind from the traditional Economic Sphere profit cycle. For one, the capacity to finance and speculate in (unbounded) new financial assets creates dynamics distinct from those typically at play in (resource constrained) capital assets. Ponder the variability of profits during the (relatively short) life of the technology boom and bust, and contrast it to the ongoing Wall Street profits bonanza. In the former, massive overinvestment distorted and eventually destroyed industry profitability. In the latter, at least so far, escalating excesses have created ever increasing profitability: More finance, more financial profits.

Outsized Financial Sphere profits will basically be sustained for as long as sufficient financial sector growth is forthcoming. Importantly, the capacity for the contemporary credit system to bankroll its own profits boom has engendered a momentous transformation in the “level, stability, and prospects” – critical facets of system profits. With financial profits the key driver of economic performance and the expansive financial sector commanding its own profitability, system “resiliency” is no enigma. In no way, however, has the business cycle been repealed, although it definitely has been grossly distorted and extended.

Stabilizing effect of big government has destabilizing implications down the line.

“It should be noted that this stabilizing effect of big government has destabilizing implications in that once borrowers and lenders recognize that the downside instability of profits has decreased there will be an increase in the willingness and ability of business and bankers to debt-finance. If the cash flows to validate debt are virtually guaranteed by the profit implications of big government then debt-financing of positions in capital assets is encouraged. An inflationary consequence follows from the way the downside variability of aggregate profits is constrained by deficits.” (page 43)

Minsky believed that large federal deficits worked to stabilize (business) profits, while buttressing the debt markets with relatively robust government debt. He was at the same time quite cognizant of the reality that Federal Reserve efforts to stabilize the economy would over time prove destabilizing (embolden risky behavior). I argue that the Fed’s efforts to stabilize system profits are a profoundly riskier proposition in today’s environment where profits are largely dictated by financial sector expansion (as opposed to capital investment). With corporate profits, household income, asset prices and economic growth now all dependent on ongoing leveraged speculation and rampant financial sector ballooning, sophisticated market players aggressively seek their outsized share of profits with comfort knowing the Fed has no alternative than to sustain the boom.

Today’s global economy is built on a castle of paper.

“Looking at the economy from a Wall Street board room, we see a paper world – a world of commitments to pay cash today and in the future. These cash flows are a legacy of past contracts in which money today was exchanged for money in the future. In addition, we see deals being made in which commitments to pay cash in the future are exchanged for cash today. The viability of this paper world rests upon the cash flows that business organizations, households, and governmental bodies, such as states and municipalities, receive as a result of the income-generating process.” (page 63)

Minsky was known for his conception of the American economic system’s evolution from Commercial Capitalism to Money-Manager Capitalism. I have humbly updated “Minskian” evolution analysis to include Financial Arbitrage Capitalism. This step I deemed justified by the radical departure in the character and outcomes engendered by contemporary credit systems dictated by leveraged securities (“spread trade”) speculation. The securitization, “repo”, credit insurance, and derivatives markets have profoundly changed finance, as well as the underlying economic structure. Inflation dynamics have been decisively altered, as has the interplay between finance and monetary policymaking. Today, myriad global players – incorporating financial instruments, structures, funding sources and leverage to their liking, while operating outside the purview of central banks and other financial regulators – dictate the general financial and economic backdrop like never before.

“Ponzi financing units cannot carry on too long. Feedbacks from revealed financial weakness of some units affect the willingness of bankers and businessmen to debt finance a wide variety of organizations.” (page 67)

I will wrap this up – as tornado warning sirens blare in the background - with the thesis that Financial Arbitrage Capitalism (FAC) has radically extended the life expectancy of Ponzi Finance Units. Actually, FAC is itself ultimately one massive Ponzi Finance Unit. This system is dependent upon continuous credit excess, expanding leveraged speculation, and asset inflation. Ironically, when financial weakness is revealed in one sector – as it was recently in mortgage finance – the expectation of imminent Fed easing actually bolsters Ponzi finance dynamics elsewhere. I surmise that when this Ponzi scheme eventually succumbs, it will take a slug of Wall Street finance down with it.

Link here (scroll down).

Recession 2007

One can never be completely sure of the future, of course, as one does not have full information about all factors shaping future events. Thus, it is possible that the following prediction will go wrong if the U.S. experiences some future positive shock, such as for example a significant decline in oil prices. Australia seemed poised for a recession in 2005 after its housing market busted, but this was averted as the prices of Australia’s commodity exports soared because of increased demand from China. However, barring such an unexpected positive shock, it seems increasingly clear that we will see a U.S. recession this year. The main reason for this is that the housing bubble that fueled the recovery of the last few years has essentially burst.

While mortgage debt continues to climb, albeit at a slower rate than before, and while housing prices have flattened rather than declined so far, other housing market indicators point to a housing recession. New home sales have reached multi-year lows and the inventory of unsold homes reached multi-year highs. Meanwhile, residential investment has declined significantly from its peak in late 2005. From 6.3% of GDP in Q3 2005 to 5.3% in the Q4 2006. However, that is still above the 4% average of the 1980s and 1990s, and also significantly above the 3.3-3.4% level of the recessions of 1982 and 1991.

So far, the economy has seemingly handled this fairly well and experienced what one might call a “soft landing”, with growth being slow but still well above zero. Yet there are increasing signs that the worst is yet to come. Much of the housing bubble was financed by so-called subprime mortgages, mortgages to people with a low credit rating. Subprime mortgages were encouraged greatly by the government, with the Federal Reserve providing a cheap source of credit. But after the Fed was forced to raise interest rates again, and as the introductory teaser offers expired, the cost of borrowing for the subprime borrowers increased sharply. And as subprime lenders almost by definition have weak personal finances, many have proven unable to handle that.

And so we now see how the default rate has increased sharply. This will mean two things: first, new subprime loans will decline sharply. So far this year, subprime loans have declined 37% from last year. This will not only mean lower demand for new houses, but also increased supply as an increasing number of subprime borrowers are forced to leave their homes. This fact, as well as the fact that construction spending is still at historically high levels, means that it is likely to decline a lot more. And if this causes outright decline in housing prices, it will have a very adverse effect on consumer spending.

The current spending pattern is dependent upon a continued rapid increase in asset prices, from levels, which are historically already extremely high. Household real estate values have historically ranged from 135% to 150% of disposable income. In Q4 2006 they had risen to 213% of disposable income. Thus there is certainly a high risk of falling prices – which, given the negative savings rate and the record high level of household debt, would imply that consumer spending will have to fall.

With residential investments likely to continue to fall and with consumer spending likely to be weak as well, the one thing that could save the U.S. economy would be business investments. Business investments are still at a relatively moderate level, and in relation to corporate profits they are in fact historically low. However, there are signs that corporate profits have peaked. Profits at domestic non-financial industries (the sector that invests) have started to decline. What matters for business leaders is not so much current profits, but expected future profits – or to be more precise, if businesses think additional investments will generate even higher profits. And with the pessimism generated by the decline in profits and the trouble in the housing market, an increasing number of business leaders seem to think that the days of high profits will be over soon. Business investments fell during Q4 2006, and judging by the weak data for non-defense, non-aircraft durable goods orders, the outlook for 2007 is not particularly good.

But what about the Federal Reserve? The Fed has always saved the day by cutting interest rates. And they will do so again – or so many people on Wall Street seem to think. And of course, Ben Bernanke would certainly be willing to provide “liquidity” – with or without helicopters – if he thought a recession was coming. However, the fact that commodity prices continue to soar and the dollar is falling means that Bernanke will have limited scope to cut interest rates, particularly in the aggressive way that Greenspan did after the tech stock bubble burst. With businesses being reluctant to invest, and with subprime mortgages discredited, one has to wonder: where is Bernanke going to create the next bubble, the one that will mask the hangover from the housing bubble in the same way that the housing bubble masked the hangover from the tech stock bubble?

Link here.


Most manager performance can be replicated with indexes, he claims.

Merrill Lynch managing director Heiko Ebens had an awkward message for hedge fund managers and investors attending the 2007 MARHedge conference in San Francisco. “Alpha has essentially disappeared” from the hedge fund industry, said Ebens, who heads equity derivatives strategy for Merrill in the U.S. Alpha is industry parlance for the extra return, above what is offered by the market, that is generated by the skill of the hedge fund manager. Ebens argued, in front of a stonily silent audience, that most hedge fund returns come from the broader markets and can be replicated by indexes constructed, coincidentally, by Merrill.

One of those so-called synthetic hedge fund products – the Merrill Lynch Factor Index – outperformed widely followed investable hedge fund indexes run by Hedge Fund Research, Morgan Stanley Capital International, Credit Suisse and Tremont, over the past three years, he noted. Ebens touched on a sensitive subject for the hedge fund industry. As assets have ballooned and more managers have entered the business, some argue that increased competition for a finite number of trading opportunities has dented returns. If that is true, the high fees levied by hedge fund managers may no longer be worth paying.

Investors using Merrill’s Factor Index are charged roughly 50 to 100 basis points a year. Another index, which replicates a hedge fund strategy called volatility arbitrage, charges similar fees, Ebens noted. In contrast, hedge funds usually charge a 2% annual management fee (200 basis points) and take 20% of any profit each year.

Rather than being hostile to this synthetic, low-fee approach, Ebens said a lot of hedge funds have shown interest in using the Merrill products themselves. By letting Merrill to take care of the returns that are generated by the market, hedge fund managers can in theory focus on trying to generate gains above and beyond that – the apparently elusive “alpha”, he explained. Hedge fund managers have been particularly interested in Merrill synthetic products that replicate short selling, Ebens said.

Link here.
Hedge fund inflows top $60 billion in quarter – link.

Hedge fund traders’ pay hits stratosphere, with some salaries now topping $1 billion.

The ballooning pay packets of the world’s top hedge fund traders have hit the stratosphere with some salaries now topping $1 billion, but fears are mounting about an industry bubble. Snapping at the heels of the elite are dozens of money managers working in New York and London who banked hundreds of million of dollars in pay, according to an annual survey by Trader Monthly magazine published last week.

The identities of those who have gained entree to the billion-dollar club through running a hedge fund, in essence a secretive capital pool, are not household names, and many members prefer it that way. The top five hedge fund managers earned 10-digit packages in 2006 while 93 other traders banked an average of $241 million dollars, the survey found.

“Compensation for hedge fund managers has exploded as more investors have invested in hedge funds,” observed Rea Hederman, an economics expert and senior policy analyst at The Heritage Foundation. Hederman said investors do not seem to mind the huge salaries taken by managers of funds that perform well, but said some “hedge funds have not delivered the returns that the investors might have wanted.”

Despite the perception that hedge fund investors reap lucrative returns, market data appears to show that stock market investors can fare just as well in the financial jungle. In 2006, the average hedge fund return to investors was 11.99%, according to the HedgeFund.net website while the broad-market Standard and Poor’s 500 index posted a gain of 13.62%, according to Thomson Financial.

“This is only one more indicator of how far the bubble has expanded, how investors have rushed into hedge funds and private equity and other equity products,” said Alan Johnson, a director of Johnson Associates. “It’s exactly reminiscent of the tech bubble of the late 1990s, early 2000s. To some degree, it’s madness. ... We believe the bubble is going to burst at some point.”

But for now top earners cited in the survey, such as 33-year-old former Enron trader John Arnold who runs the Texas-based Centaurus Energy fund, are sitting pretty on mountains of cash. Arnold, who grabbed the top spot in the rankings, received an estimated $1.5 to $2 billion dollars last year, the magazine said. He has reportedly overseen staggering returns of 317%, largely due to massive bets on the price direction of natural gas.

As seasoned Las Vegas gamblers well know, a player can be up one minute and down the next. Brian Hunter, a former high-earning hedge fund trader who previously made Trader Monthly’s list, was missing from this year’s table. Hunter was largely responsible for the implosion of the Connecticut-based Amaranth hedge fund in September tied to a series of disastrous energy trading bets, which resulted in $6 billion in losses. Hunter is now reportedly trying to set up a new hedge fund.

Link here.


Yahoo! shares tumbled mid-week after the Net giant disappointed investors yet again. The company beat so-called adjusted profit targets and offered guidance that was in line with Wall Street targets. But shares slipped more than 11% to $28.41 in early Wednesday trading, giving back roughly half of this year’s gains as investors mulled over a weak revenue performance. CEO Terry Semel also warned of reduced expectations in the Net giant’s key display advertising business. Back in January, Semel promised that Yahoo! intended to “outpace the industry” in 2007 on display-ad growth. But this week, Semel said the company expects merely to keep pace with rivals. The shift marks yet another black eye for Yahoo!, which disappointed Wall Street serially last year, earning its shares a nearly 40% drop.

Yahoo! shares had risen 26% this year going into this week, as the company appears to have finally gotten a handle on its much-discussed Project Panama advertising project. Strong reviews for the Panama ad-ranking system, which debuted in February, had led to increasingly bullish sentiment. And while Yahoo! management has said that it does not expect the financial impact from Panama to be felt until the second half of 2007, investors seemed to be lining up in anticipation.

CEO Terry Semel remains on the hot seat following last year’s nearly 40% plunge, which came amid repeated financial shortfalls and various other setbacks, many to hard-charging rival Google. During 2006, the company also saw a steady exodus of top executives from its ranks. And in the fourth quarter, the company announced a dramatic restructuring of its top ranks and a reorganization into three new business units.

Adding to the pressure on Yahoo!’s stock is the premium value it continues to fetch in spite of the company’s competitive problems against Google. Yahoo! shares trade at 44 times earnings estimates, a rich multiple indeed for a company whose latest quarter showed single-digit revenue growth across the board. When asked about Google’s recent acquisition of ad technology firm DoubleClick, Yahoo! Semel said that it lent credence to Yahoo!’s approach. The move is intended to make Google a player in the display ad market where Yahoo! is dominant.

Link here.


“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

Although I read and collect information and ideas every day, whenever the day comes each month when I actually have to start writing this report, the words of Gene Fowler (an extremely successful screenplay, sports, and humorous writer) come to mind: “Writing is easy. All you do is stare at a blank sheet of paper until drops of blood form on your forehead.” On these occasions, I then usually turn to works of science, politics, history, or philosophy in the hope of calming down and finding some inspiration. Since so many investors look to investment advisers such as myself, whom they often call “gurus”, for guidance on the future of the markets, I think it is appropriate to remind my readers of these words of Lao Tzu (the 6th-century Chinese sage): “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”

I have mentioned this because I was recently invited by my friend Manish Chokhani, of Enam Financial Consultants in Mumbai (the most successful investment bank in India), to give a presentation. The founder of the company, Vallabh Bhanshali, introduced me by saying that his staff consider me to be a hero for having correctly predicted the bull market in Indian equities in 2002, and for having called in 2006 for the 30% May/June sell-off. I felt deeply embarrassed by this, as I know only too well that I have made just as many, or even more, poor and erroneous market calls as correct ones in the course of my life, and not only about economics and asset markets but also about people. Moreover, I know people who are far more knowledgeable about the financial markets than I am – people such as Henry Kaufman and Peter L. Bernstein – who focus on presenting well-researched facts in their excellent papers, publications, and presentations, and refrain from making predictions.

In fact, addressing large audiences makes me feel uncomfortable – because, as a contrarian, it is not desirable for my views to be popular and because assets that I consider will perform well in the future seldom attract large crowds. The managers of the India Capital and Vietnamese Dragon Funds used to have tiny audiences when they presented at investors’ conferences. But as their markets more than doubled in size, so did their audiences. In 1981, I was invited to speak about bonds at a gold conference that had attracted over 500 participants. Just one person came to my presentation. (September 1981 saw the end of the bond bear market, which had begun in 1942.) As an investor looking for guidance from newsletters, blogs, financial publications, and conferences, I would also be mindful of Ralph Waldo Emerson’s words, “Do not go where the path may lead; go instead where there is no path and leave a trail.”

There is nothing to be contrarian about these days.

Unfortunately, in today’s high-liquidity driven global investment environment, I find it hard to identify an asset class “where there is no path”. There are far too many smart – and not so smart – treasure hunters who have bid up every imaginable investment class right around the world. It is only in the most unusual places that I can find true value (often, however, in assets that are difficult to invest in), as opposed to relative values, which certainly do exist. It will become increasingly important for investors not only to decide which asset class in which to invest, but also, and even more importantly, whether they want invest any asset class.

If we look at the economic and financial history of capitalism, we can see that over periods of 5 to 10 years there were always some assets that performed well. But there were times, such as in the early 1930s and the 1970s, when very few assets appreciated. Gold and gold shares performed well in the early 1930s. And in the 1970s, precious metals, and energy and energy-related shares, appreciated dramatically. But what were the chances that, in 1929, an investor would have had all his assets in gold, or, in the 1970s, in energy and precious metals-related investments? Moreover, in both cases, these investments had to be liquidated at some point because, as is always the case, “over-staying” eventually leads to huge losses. And this is where I see the biggest problem in the current investment environment. At the beginning of a bull market in an asset class, there are very few participants. But by the tail end of the boom the vast majority of market participants have become convinced that the boom will last forever or that a greater fool will soon emerge and take them out at a higher price. (This is likely to be the thinking among private equity fund managers.) So, in every boom, the majority of investors eventually get caught when the investment bubble bursts, as was the case in 2000 with high-tech stocks and in 2006 with U.S. housing.

A peculiar feature of the bull market in asset prices since 2002 has been that all asset prices around the world have appreciated in concert as a result of highly expansionary monetary policies, which has led to excessive credit growth and a credit bubble of historic proportions. Therefore, if my theory of slower credit growth in future holds, it is conceivable that, for a while at least, all asset markets (with the exception of bonds and cash) could come under pressure, albeit with different intensities. Asset markets would come under pressure if credit growth merely continued at the present rate and did not accelerate. In this instance, investors would be better staying loaded up with cash. (However, they would still have to decide what kind of cash to hold.)

U.S. household debt growth is slowing.

The first signs of credit tightening would be visible in the performance of U.S. brokerage stocks. Recent pronounced weakness not only of brokerage shares, but also of other financial stocks and, in particular, sub-prime lenders, would seem to confirm that the “irreparable cracks in the financial system”, about which we wrote in January, are now spreading. These cracks are now causing some “illiquidity”, not only in the household sector but elsewhere in the system as well. First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. Declining home prices and tighter lending standards have brought about a slowdown not only in mortgage debt growth but also in overall debt growth. It is likely that mortgage debt growth will decline even more given the problems in the sub-prime lending industry and the tight lending standards.

In the meantime, household debt growth in the U.S. has declined from a peak of 11.9% in the Q3 2005 to 6.6% annual rate in Q4 2006. According to David Rosenberg, the Q4 2006 annual credit growth was the slowest since the third quarter of 1998 and the 6th consecutive quarterly deceleration, which has not happened since 1956. This significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in U.S. consumption were it not for the stock market rally in Q4 2006 having increased equity wealth by 4.2%.

David Rosenberg further notes, “just as households are beginning to curb their appetite for debt, the once-dormant corporate sector stepped up its borrowing sharply in Q4 ... You have to go all the way back to the cashburn era of 2000 Q2 to see the last time that the corporate sector outdid the household sector in terms of debt buildup.” Corporate borrowings have been rising along with M&A activity. But corporate borrowings are far smaller than household debt. While corporate debt growth has increased by around $100 billion since Q2 2006, household borrowing has grown since then by around $300 billion.

This deterioration in household debt growth has not yet led to a consumer spending decline. But, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in Q4 2006/Q1 2007, than by the continuation of an increase in household wealth and the selling of U.S. equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down or stops their spending. Slower consumption growth, as a result of tighter lending standards and flat or declining equity prices, should have the following consequences. The U.S. trade and current account deficit will no longer expand at an accelerating rate. This should lead to a relative tightening of global liquidity, which would likely be unfavorable for asset prices but could temporarily strengthen the U.S. dollar and even more so the Yen.

Poor financial stocks performance a leading indicator?

The full extent of the sub-prime lending problems is not known. However, since at least 12% of the mortgage market – whose total size is over $1.2 trillion – is comprised of sub-prime loans, the fall-out could be considerably worse than expected. This certainly seems to be indicated by the recent poor performance of banking stocks and, as indicated above, brokerage shares. Gerard Minack of Morgan Stanley recently published a figure showing how financial sector earnings have exploded in recent years. As can be seen, the financial sector’s earnings rose 14-fold since 1990 to an annualized $251 billion, whereas the rest of corporate earnings experienced only a 4-fold increase, to $636 billion. If we included in the financial sector’s earnings financial profits from speculating in all kinds of derivatives and financial products by industrial and multinational companies, the profit contribution from financial earnings to S&P 500 total earnings would be more like 45%. Also, the recent contribution to profit growth would amount to around 70%. Therefore, I suppose that if asset markets failed to appreciate further, financial earnings would begin to decline and likely pressure S&P 500 earnings. (Aside from the financial sector, the energy and material sectors have in recent years also boosted S&P earnings. Never before have energy and financials contributed so much to the S&P profit pool.)

In the past, poor performance of financial stocks has always been an unfavorable indicator for the entire stock market. In an economy that has become addicted to credit growth, this should be even more so! The other point to remember is that if corporate profits no longer expand, the ammunition used by the corporate sector to take over other companies and to buy back their own shares is likely to diminish. Any reduction in activity in 2007, when simultaneously the increasingly illiquid household sector is likely to diminish its equity purchases further, is going to have an unfavorable impact on the stock market. And sooner or later, private equity funds will place the acquired companies back on the stock market and so increase the supply of equities via IPOs.

If the assumption is correct that global liquidity is tightening – at least relatively – as a result of a stagnating U.S. trade and current account deficit, the asset markets that benefited the most from surplus liquidity should come under some pressure. I am thinking here in particular of the extended emerging stock markets, which in this scenario could be vulnerable to corrections of between 20% and 40%. In turn, a decline in these peripheral markets should have an impact on Japan and, in particular, on the Yen.

Link here.


A year ago, the average choice grading steer fetched around $85.50 per cwt to the meat packer. (The abbreviation “cwt” stands for hundredweight. Hundredweight simply means “per 100 pounds specified weight”. It is always qualified as the type of weight used for cattle.) Two weeks ago, the average was $94.44 cwt, an increase of $3.32 over the previous week. Translation: Prices for cattle in the cash market are climbing fast and they will most likely continue to do so. Demand is the driver. As more countries reopen their markets to U.S. beef, demand will increase. Meat packer margins are hovering at break-even levels. Right now, tight cattle supplies and plentiful inexpensive feed will likely result in a firming up of the cattle price. This holds true especially for cattle producers and feedlot operators.

What mad cow? Typically, market participants have a short memory, so it is important to act on fear while it is still in full swing. The cattle and meat markets in general are the butt of many jokes in the investment world – Hillary Clinton’s infamous cattle trade comes to mind. Truth be told, the meats are a good agricultural market with solid fundamentals and can be a great learning market for the novice trader. Just make sure no one knows you are a novice. The cattle market is a volatile one and relatively illiquid, so it can be a difficult market if you are just starting out. You may want to avoid it until you get some experience.

The coffee, sugar, and cocoa markets are near and dear to my heart. These three commodities are also known as the tropicals or softs. These are some of the best performing and least understood or talked about markets. I spent much of my early career running between the pits of the coffee, cocoa, OJ, and sugar markets, and these are markets that trade like no others. Gold and oil may get the lion’s share of the sound bites and headlines, but if excitement is what you are looking for, these markets have it.

Sugar is one of my favorites. It is growing exponentially in demand as a result of ethanol production and being widely used in foodstuffs. Meanwhile the supply is shrinking due to factors such as European subsidies being curtailed. Sugar is likely to double in a couple of years, in my opinion, and the writing is already on the wall.

Much the same can be said for markets like cocoa and coffee. Worldwide demand is sucking up supplies faster then these commodities can be harvested. I know the coffee market very well – it is one of the first markets I traded when I started out in commodities 18 years ago. It is also one of the fastest-moving and most volatile markets, which means it is loaded with opportunity for you to make a lot of money. One of the best features of trading commodities is the ability to short a market just as easily as going long. A market like coffee is particularly important because of its volatility but also because a new Starbucks pops up on every corner from Maine to China and every farmer who could possibly grow coffee beans is doing so, resulting in a glut of beans on the market. Even Juan Valdez, from the TV commercials, hung up his sombrero in 2006. Coffee is thus one of those markets you can play from both directions to get maximum profits.

Cotton gave this maniac trader his start. My first full seat was on the New York Cotton Exchange (now the New York Board of Trade). Cotton is an “old boy” market, much like cattle or the grains – old in that it has been around a very long time and the people who trade it have been doing it a very, very long time. Cotton is a great market to trade, but you must understand the fundamentals at work and the differences between old crop and new crop. This simply means that two different cotton crops are produced each year in cotton, and you must make sure you know which crop you are looking at and then make your decisions based on that. Cotton is one market that is crucial not to underestimate and, much like the ocean, never turn your back on.

Right next door is another very active market, especially in the winter and during hurricane season: orange juice. Orange juice is a perfect market for learning about fundamentals the hard way. Many of you have seen the movie Trading Places, with Eddie Murphy and Dan Aykroyd. The movie was filmed on the old World Trade Center trading floor and was about trading OJ, but the reality stops there (or does it?). The OJ market is tightly controlled by supply and demand and is certainly ruled by weather factors, and not just winter hard freezes. It may surprise you to know that hurricanes in Florida are the biggest factor influencing this market, not only before the hurricane hits but after, too. The main concern is citrus canker. After the winds and rain die down, this fungus can develop on the crop. Fundamental information like this is important to know and take into consideration when initiating a position.

Every market is different, so you must study the fundamentals for all of them. For example, you must understand what soybean meal is used for as opposed to soybean oil. Soybeans are used for biofuel, among many other things, so nowadays soybean prices more closely parallel those of crude oil and heating oil than those of the regular crop reports. Right now, the demand for soybeans is picking up in a big way due to biofuel consumption, which in turn relates to how high heating oil prices are.

It is not hard to connect the dots to identify what affects a specific commodity, but sometimes you have got to do a little research first. Biofuel is used primarily for home heating, and as ethanol is derived from corn, biofuel is derived from soy. The bottom line is that you must know, inside and out, the basics about whatever commodity you choose to trade, whether it is rough rice or natural gas. More importantly, you need to know new factors that may affect a particular market – and these can change.

Link here (scroll down to piece by Kevin Kerr).


“Stagflation” makes a renewed appearance.

It is with a certain sense of déjà vu that we greet the renewed appearance of the term “stagflation” in the financial press and in brokers’ reports – a phrase of which we have not heard much since it was last dusted off (prematurely, as it turned out) for an airing in the summer of 2004. It is also a source of sardonic amusement that a prominent bond bull at one of the Bulge Bracket heavies has even gone so far as to argue that this means you should now invest in gold – Yes, in the “barbarous relic” itself! – since he thinks it might hit $1,500 at the end of a 5-year rally from here!

Of course, what the mainstream means by “stagflation” is simply a circumstance where prices are rising faster than we are able to increase our output of “stuff”. Since this is not an uncommon occurrence, the only significance to such a statistical event is that it complicates the central bank’s job of interfering with the free market by stripping it of the convenient fiction that it is not, in fact, its true role to act as the engine of chronic Keynesian inflationism.

By contrast, true stagflation really requires that, as was the case in the 1970s, when the business cycle reaches its peak and profitability is caught in the grinder between heightened costs and scarcer inputs, on the one hand, and less rapidly rising output prices and sales, on the other, the monetary assistance by which the central bank seeks to combat this is largely dissipated in higher wages, not in increased output. Such an occurrence means that the renewed inflation cannot therefore prevent the labor market from weakening, even as it drives final goods prices continually higher.

Our man, the Johnny-come-lately gold bug, is not wholly wrong, therefore, when he suggests that this tends to be a poisonous brew for financial asset prices. Under such conditions, nominal bond yields may be rising, even as real returns are falling; credit spreads may be widening as profit margins shrink; equities may find a nominal dollar, earnings slowdown (and probably a real earnings decline) is compounded by a contraction of the multiples thereto attached.

Meanwhile, there is the risk that not only do traditionally elastic commodity prices rise rapidly under the impetus of the ongoing, if slackened, physical demand (particularly if worried governments tend to subsidize their end use for fear of exciting popular unrest), but that they also become a vehicle for those trying to escape a depreciation of their money, yet rightly fearful of the ability of paper assets to accomplish this in such trying times. In these circumstances, gold might indeed be as good a bet as is offered.

“Globalization” may not be able to provide a counterforce.

Even “Globalization” is not to be taken absolutely for granted as a remedial force. As but the most pressing current threat it faces, if those giants of narrow constituency politics – Messrs Graham and Schumer – have their way, the U.S. could be about to send the worldwide division of labor crashing bloodily into its hastily-erected barricades of tariff and quota and so bring about both a financial bloodbath as well as a very tangible slump in productive economic activity. If a self-inflicted harm of such enormity were to be committed, the cancer of “stagflation” would probably come some way down the list of medical priorities to be addressed, given the anaphylactic shock such a move would provoke. Hence, gold might suffer just as much in the resulting systemic rout as any other asset (though it might outdo the dollar if its frustrated Asian holders were to find that shoring up their collapsing domestic economies were to take precedence over financing, on continued easy terms, their truculent, erstwhile customers).

Beyond the specific question of the gold price, the fate of those mountains of foreign exchange reserves piling up, especially in the world’s Oriental treasuries, is a very pertinent one to all investors – not least those of us for whom commodities are the main focus. For one thing, the sheer scale of the cash engaged in what Jacques Rueff scathingly described as a “childish game of marbles” is impressive, even to a mind jaundiced by the endless mantra of millions and billions routinely invoked in financial markets. This is because, by the IMF’s latest reckoning, 2006 saw the total of this most high-powered of monies exceed the $5 trillion mark, having doubled in less than four years.

We can see what has been behind this phenomenon when we note that in this doubling – which has added $56 billion a month to the pot of hot money since the recovery began in March 2003 – 80% of the increase has come from “developing” countries, a proportion which rose to 7/8s of the extra $850 billion, $70 billion-a-month, heaped up last year alone. On the other side of the coin, we can confirm our suspicions as to the motive force behind the acquisition when we see that the cumulative U.S. current account gap for this same period came to a broadly comparable $2.8 trillion.

Although perhaps no more than two-thirds of the reserves’ total addition (say, $1.6 trillion, or 56% of the sum needed) was directly returned thence to the voracious, American “spender of last resort”, even those amounts stacked up in euros and sterling, for example, still served to take pressure off world capital markets, lowered yields, and so made ancillary private purchases of U.S. debt seem much more palatable than they would if the whole deficit had had to be found voluntarily out of savings.

Dollar hegemony’s salad days may already be behind us.

The salad days of effortless dollar hegemony may already be behind us, as a few minutes’ Googling will reveal, for there will be found a growing listing of stories about people desperately trying to cut their dependency either on the dollar itself or on the passive, unimaginative holdings of U.S. Treasury and Agency paper into which their hard-earned surpluses are transformed. Rumblings abound about how Iran might now be billing for oil in yen and euros, or about how some of the smaller Gulf states are seeking to change from a greenback monopoly to a basket of currencies, but of more import are hints of what the likes of the Indians and the Chinese are up to.

The former, somewhat laughably, seem to think that they can bear down upon rising inflationary pressures (i.e., too lax a monetary and fiscal mix) in what is a desperately overheated economy by spending some greater portion of their existing reserves on infrastructure. While it is true that anything which enhances the supply of goods will help in the long run, it would seem that the last thing a country suffering from elevated resource prices and surging wage rates needs right now is a government-driven burst of ill-directed, “investment” spending – but then again, this is a country where the ruling coalition is possessed of such profound economic understanding that it thought it could alleviate a shortage of foodstuffs by banning futures trading!

As for the Chinese, they are still making no more than the occasional, Washington-appeasing headline moves. When and if they do make good on their stated intention to divert something of the order of $200-300 billion out of their existing $1 trillion war-chest – plus (one presumes) the bulk of the future inflow of dollars (another $200 billion a year at present) – into a vehicle, the better with which to buy stakes in Guinean bauxite mines, Siberian oil pipelines, and technology and engineering firms anywhere they can find them, this will make a twofold difference.

At present, the dollars earned by a Chinese exporter are bought by the PBoC for yuan and then lent straight back to the U.S., financing – albeit very indirectly – the original purchase of goods (imagine, for example, that the U.S. Treasury were to spend the proceeds of a Chinese-bought bond issue in paying the salaries of the bureaucrats who bought the original imports). Back home, if the new yuan are simply left in the system, there is a direct inflationary impetus in China – goods went out, whereas only money came in – but not one of equal magnitude abroad where, though money was also created anew, it also elicited a new supply of goods to match it.

What is worse, however, is that if the PBoC buys the dollars from the exporters’ commercial bank by simply writing a check on itself, it has not only added the original external receipt to the supply of domestic money, it has also furnished the bank with the means to multiply the accretion, right up to the inverse of the prevailing reserve ratio. The PBoC can limit this to a single unitary addition by selling the bank T-bills, thereby absorbing (or “sterilizing”) it. Or, it can remove the new money completely by selling the bills directly to the non-bank sector since, in this last way, a Chinese under-consumer (a saver) has now effectively been induced to fund a U.S. over-consumer (a borrower), converting his demand deposit (his money) into a term loan as he does.

Commodities stand to benefit from Chinese redeployment of foreign exchange reserves.

However, these latter options are not entirely devoid of adverse side-effects, either, so the authorities may finally decide no longer passively to recycle their excess dollar receipts into U.S. government paper, but instead to use them actively to buy assets and goods abroad. Now, even as the domestic impact is reversed, they will institute a grand round of pass-the-parcel which is likely to drive the dollar down both against the value of the purchased goods and assets (i.e., it will raise their price) and vs. that of any other currencies in which those goods and assets were denominated. Exactly this sort of process is what no less an august body than the Asian Development Bank is, in fact, recommending – even to the point of salivating about what could be achieved if an extra 500 basis points of return were to accrue to the new fund; a visualisation which, we could read more as an incitement to engage in an aggressive “search for yield” rather than as a counsel of prudent stewardship over the nation’s patrimony.

While sanity may prevail and the crafty Chinese may therefore act with a little more due caution than the overexcited comments of an unaccountable academic might suggest, two propositions will hold: all such investments as will be made are likely to be used to fuel China’s commodity-intensive urban and industrial growth and most of the natural resources for which it will be scouring the earth will be priced in what will by then be once-more depreciating dollars. Either way, by throwing $200 billion a year into the pot, China can hardly fail to further the cause of commodities. Assuming sufficient crumbs are thrown the way of certain key industrial sponsors of the Democratic Party when overseas procurement decisions are being made – neither will it hurt in the urgent task of laying the unquiet ghosts of Messrs Smoot and Hawley and thus in forestalling a dangerous threat to the very life-force of the present economic organism.

Link here.
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