Wealth International, Limited

Finance Digest for Week of April 23, 2007

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


On October 4, 2006, the Dow broke its old high of 11,750 set back on January 14, 2000, and from then on all you heard from the financial press was “Dow sets a new, all time, record high” ... at least that is all you heard until the correction on February 27, 2007. I just do not get it. How can anyone at this point in time (including the financial press) believe they are actually making gains being invested in general equities? On February 20th, the Dow hit its “brand new, all time, record high” of 12,795, and at the writing of this article hovers at 12,560, 6.9% above its 2000 high.

A 6.9% gain over the entire 7-year period ... has anyone heard of inflation? Do investors not know that if their portfolio fails to outpace inflation they are actually losing ground? The Dow is actually crashing, but if you have not yet educated yourself on the insidious ravages that inflation can have on your portfolio, you cannot see it. This is a blind spot investors must be mindful of, and guard against, if they are to prosper.

Anytime that it looks like everything is going up, stocks, bonds, real estate, commodities, and virtually every kind of investment there is, you have to stop and ask yourself, “why?”. The only reason the Dow looks like it is going up is because the Fed has pumped so many more dollars into the currency supply, that all asset classes are rising. Under these conditions, the only way to see where true value lies is to eliminate the dollar from the equation ... you have to measure each asset class, not with the dollar, but against another asset class.

Measured against any other asset, the Dow’s return has been lousy.

Now here is the story in pictures that proves beyond a shadow of a doubt that the stock markets are crashing. You have heard the saying “one picture is worth a thousand words”. Well, one chart is worth a million numbers, because a chart is simply a picture of at least two sets of numbers, in this case, the price of an item and the date that the item was at that price. Later, I use charts that are a picture of three sets of numbers, the date and the price of one item, divided into the price of another item. These “ratio” charts are my favorites because they reveal true value, and the true direction something is headed. I love charts.

So to get a picture of what is going on with stocks, I took the Dow as a proxy for stocks and measured it against everything else I could possibly think of. When I say buy or sell the Dow in this article, I am just talking about value. I know that you cannot actually buy or sell a share of the Dow. If you want to do that, you have got to use the Dow ETF (exchange traded fund) known as the Diamonds (DIA). In my opinion however, it is not a very good idea right now.

Here is the Dow Jones Industrial Average the way you are used to seeing it. It appears to have gone up because it is measured in dollars. However, it is up in price only – not value! And now I will prove it with the following charts. Since January 2002 the dollar has plummeted 31.25%, vs. other major currencies (chart here). This has caused money (gold) to rise measured in currency (dollars) as more and more investors move out of their currency and into real money.

In this chart I measure the Dow with money, not currency. It took almost 45 ounces of gold to buy 1 share of the Dow in 1999. Today it takes less than 19. Another way of saying it, if you sold 1 share of the Dow in 1999 you would have been able to buy 45 ounces of gold. Today if you sold 1 share of the Dow, the proceeds would only buy you 19 ounces of real money. So measured in real money, the Dow has crashed 58%. My favorite is the other real money: measured in silver, the Dow has crashed 65%. Measured in other currencies (fake money) the Dow has crashed 27% against the Euro, 31% against the Aussie dollar, 22.5% vs. the British pound, and measured against the Canadian Loonie (or Toonie) it has lost 18%.

I like this chart, because it shows you just how much real stuff (on the average) the Dow will buy you. It is the Dow divided by the Commodities Index. This chart is saying that you could buy twice as much stuff if you cashed out of the Dow in 1999 as the same number of shares will buy you today. This chart is also saying, “you can take your Dow and stuff it!” Measured against copper the Dow has plunged 76.5%. And if you sold 1 share of the Dow in early 1999 you could buy 800 barrels of oil, whereas today it will only buy you 200. Oil does not just go into the gas in your tank – it is the single most useful commodity there is. It is used to make medicines, fertilizers, plastics, the tar on our roads and the tires on your car.

Now here is a chart that is almost unfathomable. It is the Dow divided by, what is in my opinion, the worst investment you could possibly have in an environment of ever increasing inflation – what most investors believe to be, the safest (read stodgiest, slowest moving) investment one could possibly buy ... the 30-year U.S. Treasury Bond. Measured against the other investment class that is crashing, the Dow has crashed 13%.

But all comparisons heretofore have been using an unfair way to measure stocks vs. everything else ... because, by using the Dow I have overstated the value of stocks. The Dow is currently the best performing major stock index. The situation only gets worse if you use the S&P 500, because it is still down 7% from its 2000 high. The S&P is a much better proxy for the general economy than the Dow, because it is a measure of 500 of the countries largest companies instead of just 30. And if we used the Nasdaq, the charts would literally look twice as bad, because the Nasdaq is more than 50% below its previous high.

Why does everyone think the Dow is going up, when it is actually going down in value?

According to the Minneapolis Federal Reserve, total inflation from 2000 to 2007, using the Consumer Price Index, is just about 20%. This means the Dow would have to be at 14,100 just to break even. And that is if the CPI was not a made-up, hocus-pocus, voodoo fabrication – which it is. The Bureau of Labor Statistics (BLS) has become just another division of the governments “Ministry of Propaganda”. Its job is to manipulate the numbers, so as to paint smiley faces all over the economy. But John Williams, of Shadow Government Statistics, has made it his job to haunt our government and expose some of the financial malfeasance. He has painstakingly reconstructed the CPI data to more closely reflect reality. One look in your wallet, and you know that he is right. I urge you to go to his website and poke around, and if you want to learn how to see through the government’s propaganda, you may want to subscribe. Here is John’s chart of the CPI with the smiley faces removed.

The true definition of inflation is an expansion of the currency supply. Rising prices are not inflation, but the symptom of inflation. So, for a better measurement of inflation I took the last known M3 data published by the Fed. I say “last known” data because last year the Fed stopped publishing this data, which it had reported every month since January 1959. Their excuse for not publishing M3 was that it was too costly to compile and publish. But all they have to do is print a report and post it on the internet. It would cost them virtually nothing, and there is no excuse for discontinuing the disclosure of this data. My bet is that the Fed still wants to know how much currency is out there, but it does not want us, and more importantly, foreign buyers of U.S. Treasuries (like Japan and China) to know. There are several ways to inflate, but they all show up in M3, and if they embarked on a program of increased inflation, Japan and China would no longer buy our Treasuries.

I took the last known M3 data published by the Fed, $10.3 trillion dollars as of February, 2006, which was a whopping 58% increase from January of 2000 (when the Dow hit its previous peak). Where did all that currency come from? We borrowed it, of course, much of it from Japan and China. This 58% increase translates to an average annual increase of the currency supply of 7.82% compounded over the 6-year period. The U.S. needs a continuous flow of suckers lining up to buy U.S. Treasuries to fund our budget deficits. If these suckers ever did the math, they would figure out that if they buy a T-Bill yielding 4.82%, and the Fed inflates at a rate of 7.82%, they are actually losing 3% (paying the U.S. government 3% annually to loan it the currency). Now, if you use M2 you come up with only a 43% increase over the same period. This, my friends, is why the Fed is now only disclosing M2. We need to keep borrowing or the game will come crashing down.

On March 16th, 2007, Congress passed a bill to increase the ceiling on the national debt from $8.2 trillion to $9 trillion. We already owe $8.2 trillion? Yep. A baby that is born as a U.S. citizen today, comes into the world owing approximately $30,000. But that is only what the baby owes for our reckless deficit spending in the past (debt). What about all the reckless deficit spending promised into the future (liabilities)? Comptroller General David Walker, (chief auditor of the U.S.) says that the unfunded (deficit) liabilities now exceed $50 trillion. So if we add the debt to the liabilities, we end up with every man, woman, and child in the U.S. owing $194,000.00. Even a newborn baby. “Welcome to the world kid! Here’s the bill.”

In trying to extrapolate M3 from February 2006 to today, John Williams has come to the rescue again. His numbers show M3 inflating at a rate of about 9% for the first 7 months of 2006, and then rising to 11% by 2007. Even though there are at least 70% more dollars in existence vs. 2000, there are only 58.5% more dollars per person in existence than there were in January 2000. Thus, any investment that has returned less than 58.5% over this time period is under water, and that means that the Dow would be at the break even point if it were at 18,623 today.

The dollar is a smokescreen that obscures true value.

The reason I took the long way around to get to my point, instead of just saying it in the beginning, is that I wanted you to fully understand the subject. There are basically two kinds of tax, the kind the masses can see, and the kind they cannot. The inflation tax is of the second kind. Whenever a politician promises you more free stuff than the guy he is running against ... Whenever the masses think they are getting something for nothing ... Whenever our government does deficit spending ... Whenever we borrow the prosperity of tomorrow to spend today ... It comes back to haunt us as the inflation tax, insidiously, silently, invisibly, and deceitfully, confiscating our wealth. If I have done my job, you will be able to see it clearly from now on. This is a great advantage for an investor to have.

Just to drive the point home, here is the Dow from the year 1900 (blue line) showing the 1929 crash and the spectacular bull run from 1932 to today. And that other line? It is the Dow deflated by the CPI. The Dow was a breath away from 400 (381.17 actually) in 1929 (where the deflated data begins), and falls to a bottom of 40.22 in 1932. Then it began its bull run to 1966 where it topped at inflation adjusted 550 points, just 29% above its 29 high. Then the Dow began a long slow crash that would see it lose 70% of its value over the next 16 years. This was the raging price inflation of the 70s. It is called “The Invisible Crash” because investors never knew what hit them. The Dow had bumped its head on 1,000 points from 1966 to 1982. But due to inflation, if you had put $100,000 in the Dow in 1966, it would only buy you $30,000 worth of 1966 goods and services in 1982.

Then the Dow began what the uninformed call “the greatest bull market in history”. The Dow ran from 777 in 1982 to 12,795 on February 20, 2007 – a more than 1,500% gain, measured in dollars, of course. But, measured in purchasing power, the Dow only exceeded its previous 1966 high by 82%. But that is using the lying CPI. Adam Hamilton did an excellent job deflating the Dow in an essay aptly titled “Deflating the Dow”, written in 2001: “In M3 deflated terms, the Dow at 9000, after holding for over FORTY years, would have granted investors a real 1.2% average annual compounded LOSS on capital. At that rate, after holding for four decades, an investor would have seen his or her capital cut by over one third! ... Inflation IS real, it IS bad, it IS ugly, and it WILL chew investors up and spit them out.”

I think at this point I have proven my point beyond a shadow of a doubt. Time to pronounce it “case closed”. The general equities markets (a.k.a. stock markets) are crashing, and have been since 1999-2001, depending on how you measure it. Even though the Dow is going up in price, if everything else is going up in price faster than the Dow, then the Dow is crashing in relative terms. Oh, there is one other class of goods where the Dow will buy you more stuff today than it did seven years ago – consumer electronics made in Asia. So, if the only things you are going to buy with your proceeds are camcorders and plasma screen TVs, then you are ahead. On the other hand, you would be able to buy 2, 3, or 4 times as many of these do-dads, if you had invested in nearly any tangible asset.

What to do now?

To end my tirade on inflation I give you the following chart, again from John Williams, it is cumulative inflation from the year 1665. As you can see, before 1913, inflationary periods and deflationary periods pretty much netted out to zero, maintaining relative purchasing power for more than 250 years. But with the inception of the Federal Reserve in 1913 there was a change in the character of inflation. With the exception of the Great Depression, there are no longer deflations following the inflationary episodes, thus the purchasing power of the dollar has fallen to just 4% of the pre-1913 dollar. It now takes $100 to buy the same amount of stuff you would have gotten for just $4 in 1913, or for that matter, 1813. Then, with the end of the Bretton Woods system in 1971 and the severing of the dollars last linkage to gold, the inflation genie was unleashed. This is what has allowed our politicians to throw around money and spend like drunken sailors.

We have seen that there was an “invisible crash” in the stock market in the 1970s. An invisible crash is a product of a fiat currency system and/or rampant credit creation. It requires a rapidly expanding money supply to obscure the fact that an overvalued asset class is correcting and reverting back to fair value or less. It cannot happen on a gold standard with conservative fractional reserve banking practices. Therefore, it did not happen in the U.S. until the 1970s and today. But it has happened numerous times throughout history once a country leaves an asset backed currency standard. The stock of the Mississippi Company of John Law’s France, and the German stock market during the Weimar hyperinflation come to mind.

Can an investor prosper under these conditions? Is there a way to beat inflation? Absolutely! In fact, an investor can achieve superior results under these conditions. Why? Because anytime you find yourself in a situation where you are the informed investor and the masses do not yet know what is going on, you have the advantage. Once the cycle has changed and you have confirmation that the conditions have shifted, any investor that does reasonable due-diligence, takes a position early, waits for the masses to wake-up, and hangs on for the ride, has an extremely high probability of achieving extraordinary results.

The 70s were part of what is known as a commodities bull. This is a cycle that repeats and repeats, where first equities (paper assets like stocks) outperform commodities for 20 years or so, then the cycle reverses and commodities out perform equities. During a commodities cycle almost all commodities rise in price.

Other than the bull market for gold that we are currently in, the only other gold bull we can look at and analyze is the 1970s bull. Before that the dollar was backed by gold at a fixed price, so gold did not go up or down against the dollar. It was the dollar. The gold bull of the 70s was one of the greatest bull markets of all time, and precious metals were its top performer. Precious metals stocks took top honors in total returns, silver won the silver, gold got the bronze medal, and oil came in a distant forth with other commodities not far behind.

Almost all commodities rise during a commodities bull, but there comes a time, near the end of a commodities bull, when the public, the masses, the herd, awaken from their collective coma. They finally realize that their $100 is buying them fewer and fewer bags of groceries, and they look at their neighbor, who told them about gold and silver five years ago, and whose purchasing power is rising while theirs is falling, and they rush toward gold and silver. This is when gold and silver leave all other investments in the dust. It took nine years, from 1971 to 1979, for gold to go from $35 per ounce to $200 per ounce. But once the public woke up, it only took three more months to reach $850. This is why gold and silver were the top performers of the 70s. Gold and silver are money. All other commodities are just commodities. Thus, all commodities are usually good investments during a commodities bull, but gold and silver have been, and should continue to be, spectacular.

There have been 5 commodities bulls in the past 200 years and we have just begun the 6th. They are as natural as the coming of the tides. And while betting against it may be hazardous to your financial health, investing with the tide can bring you great wealth.

Link here.


Question on Message Board: EWI has kept its bearish stance for a few years now, as the market has rallied. Granted, your latest call for a crash on February 21 did result in an 850-point drop in the DJIA that came on February 27, kudos for that. Now the recent Elliott Wave Theorist and the Short Term Update tell us that we should expect flat-to-up markets throughout the remainder of 2007. (Which brings us to an election year in 2008 – which, historically, should be higher yet.) Still, your longer-term forecast with accompanying graphs insists on the DJIA going down to 400 over the years ahead. Is there a time when EWI plans to go long this market?

Answer, dated April 25, 2007: This question brings to mind the 1980-81 period. That is when, after a long bear market in stocks, Bob Prechter was one of the handful of market forecasters who had the guts to turn bullish on the DJIA. At the time, some subscribers were also wondering how he could possibly be making bullish calls in the face of all the “bearish evidence”.

Below is a quote from the November 2006 EWT. This is just one of many pieces of evidence that Bob has presented to subscribers recently that help explain why we at EWI still feel this market is very risky (emphasis added):

“Some people ask, ‘How high does the S&P have to go before you will turn bullish?’ If you understand our method, you can see why this is the wrong question. What would turn us bullish would be a change in the technical condition of the market. For example, stocks underwent a mild setback in 1994, and investors rapidly turned very cautious. That year saw 43 weeks (83% of the year) with more bears than bulls among advisors. The price setback was uncommonly mild, so the wave pattern did not signal the coming advance, but the background sentiment was there. In the past few years, nothing like this has happened. All the technical condition has done is get worse and worse. ...
Link here.


Last weekend, my wife and I went over to a friend’s home to watch “The Pursuit of Happyness”, starring Will Smith. During the opening scenes of the movie, Smith’s character sits in despair thinking about his own struggles in medical sales, during the recession of 1981, while the television blares in the background with the voice of President Reagan discussing the financial plight of our nation. In this snippet, we hear Reagan talk about the urgent need for our national leaders to face the $50 billion deficit. And like the swell of the bull market of the 80s and 90s, the movie goes on, drowning out Reagan’s words and numbers.

Recently David Walker, Comptroller General of the U.S., wrote, “The federal government’s financial condition and fiscal outlook are worse than many may understand. Despite an increase in revenues in fiscal year 2006 of about $255 billion, the federal government reported that it costs exceeded its revenues by $450 billion (i.e., net operating cost) and that its cash outlays exceeded its cash receipts by $248 billion (i.e., unified budget deficit). Further, as of September 30, 2006, the U.S. government reported that it owed (i.e., liabilities) more than it owned (i.e., assets) by almost $9 trillion. In addition, the present value of the government’s major reported long-term ‘fiscal exposures’ – liabilities (e.g., debt), contingencies (e.g., insurance) and social insurance and other commitments and promises (e.g., Social Security, Medicare) – rose from $20 trillion to about $50 trillion in the last 6 years.” (Parenthesis his)

So, we have seen large numbers grow astronomically larger, and as a society, we have learned to ignore the naysayers, who do not hold to our optimistic view of the financial markets. Not only does this happen in the investing public, but it also occurs at the very top of academia, in the writings of the Federal Reserve. In the July/August 2006 edition of the Federal Reserve Bank of St. Louis Review, the question “Is the United States Bankrupt?” was raised. The Editor’s Introduction to the article states that Laurence Kotlikoff, coauthor of the book, The Coming Generational Storm, “believes the question question of the bankruptcy of the U.S. government is not only worthy of serious discussion, but that the answer to the question is clearly ‘yes.’”

Lest we, who have not been schooled in the complexities of economic and monetary policy, look at Walker’s numbers and jump too quickly to side with Kotlikoff, we are quickly reminded that: “The government’s assets certainly are not in the process of being forcibly liquidated by creditors. For that matter, the notion of a formal bankruptcy process mediated by an outside party appears unrealistic, as well. After all, the vast majority of U.S. government’s liabilities to foreigners are denominated in U.S. dollars, which can be supplied virtually at will.”

There you have it folks. David Walker and Laurence Kotlikoff are just getting people overly-concerned about our country’s ever-mounting debt for no real reason. After all, as long as the guys and gals at the Federal Reserve have the “dollars supplied at will” machine, what could possibly go wrong? The sad reality is that the two men at the Fed who wrote the Editor’s Introduction apparently represent the thoughts of many in government today. While there are some who have the courage to speak out against the travesty of our nation’s finances, most are a yes men, clinging to their jobs, and the average American has lost his or her bearings. We accept as normal that a new car that used to cost $3,000 now costs $30,000, or that a home that used to cost $40,000 now costs $200,000. The fact is that throughout our lifetime, the costs of stamps, milk, health care, auto repairs, and virtually anything else that we consider basic to the American way of life, has been propelled higher by this “dollars supplied at will” machine.

As “The Pursuit of Happyness” comes to an end, Will Smith’s character in the movie celebrates finally being the one broker chosen from the grueling program at Dean Witter. In the epilogue, we learn that in 2006, Gardner sold a minority interest in his company for millions. As inspiring as the story is, it took place over a 25-year period when to Dow went up 12-fold from just under 1000, in 1981. The reality is that this period also saw the greatest destruction of our currency and the largest rise of debt in our nation’s history. The next story is just not one that any of us would want to write or read. Debt will decline, prices will contract, and reality will set in. Inspirational stories will still be there, but they will not likely be of the rags to riches variety.

For those who doubt the destructive power of inflation, consider Keynes’ words in his book, The Economic Consequences of Peace: “Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. ... As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. ... Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

How well these words describe our current juncture is truly a shame. Today, our greatest obstacle is that we do not understand history because we do not understand financial history, and until we understand the role that fiat currency has played, and the power of money, our interpretation of history will be skewed because we are missing a critical component to all of our lives – money. In our society, “happyness” is synonymous with financial prosperity, so much so that many fail to see the true strength of Gardner was not found in his ultimate financial success. Rather, the enormous courage that Gardner displayed was in taking each day as it came, in his tenacity to daily move past his own pain, anger and frustration with his current circumstances, and in his resolve to never stop making decisions in his attempt to move forward, and in doing his best to provide for and protect his son.

As I reflect on the enormous sorrow of those trying to regroup from the brutal attack at Virginia Tech on April 16th, I am inspired by the actions of Liviu Librescu. Here was a man who had lived through the Holocaust and a brutal communist regime in Romania during the Cold War. He had spent the last two decades of his life as a college professor in a quiet idyllic campus, and may have attained little financially in his life. Yet, he blocked a door, holding it shut, paying the ultimate price to protect his students. The trait that we admire in Gardner and Librescu is called self-sacrifice. If we are going to get past this next chapter in our nation’s story, our leaders will have to be willing to place painful truths before individuals who are reluctant to accept such realities. They must be willing to place others’ lives above their own.

Link here.


In February, via an internal memo, the Carlyle Group said they see another 12 to 24 months or more of “excess liquidity”, which will drive further profits and growth. Also, that the current liquidity environment cannot go on forever, and the longer it lasts the more money the company’s investors will make. But also that the longer it lasts, the worse it will be when it ends. In the missive it was stated that Carlyle’s fabulous profits were not solely a function of their investment genius, but have resulted in large part from a great market and the availability of enormous amounts of cheap debt. In fact, there has been and is so much liquidity in the world financial system that lenders, even Carlyle’s own lenders, are making very risky credit decisions. This sea of money and credit has allowed deals to be done that could never have been done otherwise. They do not expect the Fed to reduce interest rates anytime soon.

What could bring this global liquidity to an end? Just that business would diminish their borrowing or could it be higher interest rates? Could it be a terrorist attack, $100 per barrel oil, trade protectionism, the absorption of excess skilled labor into the global economy, Russian energy policies, a multi-billion dollar bankruptcy, a tightening by the Bank of Japan and an end to the yen carry trade as a result, or perhaps the collapse of several hedge funds or a derivative collapse? All are possible and at least one is probable.

The strategy should be to take lower risk deals and earn lower returns rather than higher risk deals at only small incrementally higher returns. A redoubled focus on deals with downside protection, asset coverage, multiple and early exit paths, strategic partners, debt pay down, government protection, consumer needs, controllable capital expenditures, defensible market positions, etc., is deemed appropriate. Carlyle is being careful because they know what is coming. Carlyle is the insider. What we have been busy doing for years is figuring out what these elitists will do before they do it.

This is exactly what we have been forecasting. If we and Carlyle are correct, we can expect more than ample liquidity until February of 2009. During the year to 1-1/2 years that follow liquidity will decline and inflation will diminish. After three months of declining liquidity or declining use of liquidity we will know it is time to sell all assets except gold bullion coins, quality gold shares and for those of you who have to have some liquidity, Swiss francs.

This week the Supreme Court stepped into the subprime lending crisis with a potentially far-reaching ruling that limits the power of individual states to regulate mortgage lending. The elitists have to control everything in our lives. The Supreme Court is allowing banks to offer new terms on mortgages in violation of the law. This will have a big impact on the ability of states to act independently on predatory lending and throws the spotlight on federal authorities.

Link here.


The following commentary will describe the final sequence of events that will lead to the implosion of the global economy.

As U.S. real estate prices fall and depress U.S. economic growth, private foreign investors begin to withdraw their capital from the U.S. financial markets. This capital flow would by itself act to elevate the currency value of the country that it is returning to. In order to maintain fixed exchange rates, foreign central banks will print their own currency and exchange it for U.S. dollars (which are then invested into U.S. government debt). These central bank policies will act to artificially keep the value of the U.S. dollar elevated and artificially keep U.S. interest rates low.

The foreign central banks print much greater amounts of their own currency will act to boost their domestic money supply and cause their own economy and stock market to “overheat”. Additionally, the foreign central bank rapidly builds up the amount of foreign exchange reserves that they own. The increasingly large holdings of foreign exchange reserves represent a corresponding increasingly large risk of foreign exchange losses to the central bank (should the U.S. dollar fall in value in the future).

In the face of increasing private investment inflows (caused by a deteriorating U.S. economy), the foreign central bank is faced with a dilemma. Its economy begins to overheat, but increasing interest rates will only serve to worsen the situation. The only way to stop the rapid acceleration in domestic money supply growth is to finally abandon the fixed exchange rate regime altogether. This will negate the necessity of printing new currency with no control. When the fixed exchange rate regime is terminated, then newly minted funds from the foreign central bank no longer act to support the value of the U.S. dollar and maintain low U.S. interest rates. In effect, there is nothing left to support the U.S. consumer anymore. The value of the U.S. dollar collapses and U.S. interest rates skyrocket. The skyrocketing interest rates cause a real estate crash. The collapsing value of the U.S. dollar causes the price of gold to skyrocket. And needless to say, the stock market collapses.

At this time, the key foreign central bank that is artificially supporting the U.S. economy at present is the central bank of China. The Chinese stock market began to rise in value dramatically starting in November 2006. The run-up in the Chinese stock market and the acceleration in economic growth at the same time that China’s foreign exchange reserves rose sharply is no coincidence. The point is rapidly approaching when China’s central bank will be forced to abandon their fixed exchange rate regime. When the peg on China’s foreign exchange rate is dropped, the U.S. economy (as well as the global economy) will implode.

The global economy is critically dependent right now on what happens in the Chinese economy. To that extent, it is very important to focus on three elements going forward: (1) the growth of China’s foreign exchange reserves, (2) Chinese economic growth and (3) the Chinese stock market. In turn, what happens in China will depend on the rate of deterioration in the U.S. economy (which will determine the amount of private investment capital that returns back to China and causes their economy to overheat further). At this point, we are witnessing an extremely unusual relationship, whereby deterioration in U.S. economic growth actually causes an acceleration in Chinese economic growth.

Further deterioration in U.S. economic growth from this point onward will cause the U.S. Federal Reserve to consider cutting the U.S. short term interest rate. While many participants in the U.S. financial markets are conditioned to look at this outcome favorably, at this point such a decision would result in a repatriation of foreign capital (and rising longer term interest rates), because the interest rate differential versus other countries will become less favorable. An interest rate cut for a highly indebted country that is highly dependent on foreign capital will result in a completely opposite effect from that intended. The Fed is in a box. The Fed is now powerless to rescue the U.S. economy, because of the threat of foreign capital flight. The emperor has no clothes.

The tension in the world financial system will continue to build as the system is stretched from two opposite ends (the U.S. and China). Further acceleration in Chinese economic growth or further deterioration in U.S. economic growth will increase this tension to the point that the system literally breaks. Any further increases in the Chinese short term interest rate or decreases in the U.S. short term interest rate will amplify these stresses and cause the cracks in the dam to widen – until the dam bursts.

The wild card in this situation is Iran. Iran’s intent is clearly to escalate the conflict (in a “tit-for-tat” manner) to the point where a military conflict ensues. If Iran threatens in a more specific and tangible manner to attack the U.S. directly, then you can rest assured that private foreign capital with flee from the U.S. financial markets. When that capital flees back to China, the flow of capital will overwhelm their central bank and cause them to abandon their fixed exchange rate regime. As mentioned before, this in turn will cause the stream of money leaving the U.S. to turn into a flood. Given Iran’s deep hostility toward the U.S., they may very well recognize the acute vulnerability of their opponent and seek to exploit it by escalating the conflict (at least verbally) to the point of literally “scaring” foreign capital out of the U.S. and destroying their economy.

Now I would like to draw a very important parallel. Let us return to the sequence of events that led to the stock market crash of 1929 and the Great Depression in the 1930s. The two major players in the world financial system at that time were the U.S. and Great Britain. The U.S. was the emerging industrial power, whereas Great Britain was the mature and stagnating industrial power. The central bank of the emerging industrial power (the U.S.) printed money in an effort to prop up the economy of the mature industrial power (Britain). The inflation of the money supply resulted in the overheating of the economy and the stock market of the emerging industrial power. It was the crash in the stock market of the emerging industrial power (the U.S.) that brought about the crash in all the world’s stock markets and the Great Depression followed later.

Now fast forward to today, and what you see is China as the emerging industrial power and the U.S. as the mature and stagnating industrial power. China is printing money in an effort to prop up the economy of the mature industrial power (the U.S.). The inflation of the money supply is resulting in the overheating of the Chinese economy and stock market. Very interestingly, on February 27, 2007, it was the sharp 9% one-day drop in the Chinese stock market that led to the sharp drop in stock markets worldwide, including the U.S. People may be conditioned to think that economic events in developing countries pale in significance to economic events in the U.S., and may fail to see how what happens “way over there” in China would have any significant impact on their economic well-being. But how different the truth really is. I think most people even now after the February 27th turn of events, fail to grasp why the U.S. stock market sold off so sharply after the Chinese stock market sell off occurred first. A word of advice: you better get used to it, as there is much more of that to come. The crash is coming.

Link here.


China’s first quarter growth report of 11.5% and the market reaction thereto illustrated one market-forced dilemma faced by the world’s policymakers: in the long run, they can have cheap money or cheap commodities, but not both. China’s statistics are notoriously unreliable. However there is no reason to suppose they have become suddenly more unreliable. An acceleration in growth from 9-10% in 2005-06 to 11.5% in the first quarter of 2007 is still a substantial acceleration, even if the real figure is from 5-6% to 7.5%.

It is not surprising that acceleration would have taken place. China repatriated $42 billion from its international IPOs in the first quarter. Since several of the stock issues in the past year were for Chinese banks, you can be sure that the money has been on-lent, mostly to dodgy state-owned companies, thus increasing China’s rate of growth.

The People’s Bank of China has made several feeble gestures towards raising interest rates, but in a country where foreign exchange movements are restricted and most credit is allocated by government fiat, the Chinese economy is far from a market system and real restraint is a long way from happening. While excess Chinese liquidity has fed into the international system and inflated the rest of the world, any monetary tightening that affects the Chinese economy will have to come from the West. Only when real interest rates net of inflation are above 3% in China’s principal markets, the U.S., the EU and Japan will Chinese output growth begin to slow, and the breakneck expansion of Chinese consumption be reined in. At that point, of course, it is likely that the bad debt problems in the Chinese banking system, which have failed to manifest themselves for a decade as world liquidity has inexorably grown, will cause a crisis within the domestic Chinese economy that will retard its growth rate and halt its progress to becoming a major international wealthy economy for at least half a decade.

Rapid growth in China has major economic effects, apart from flooding the world with Chinese manufactured exports, because China has 1.3 billion inhabitants, 50% more then the U.S., the EU and Japan put together. Consequently a China that had a Western living standard would be a prodigious consumer of natural resources. This is already happening.

Oil, gold, copper and corn, as well as freight rates are all close to their all time highs, and showing no signs of retreating. The fall in commodity prices enjoyed by the world since last May has reversed itself, and those commodities which are not already at record levels are showing every sign of breaking through. Free market ideologues will proclaim that this is not a problem and that the high prices will call forth new supplies of the commodities concerned, so that prices will drop back down. If demand were rising only moderately, this would undoubtedly be true. World energy demand increasing by 1-2% per annum can be accommodated, provided there are no wars in crucial areas and the world’s consumers work together. But world demand increasing by 4-6% per annum is impossible to manage.

In this context, indeed, we need political as well as economic mechanisms. China’s need for energy and other resources is not going away. Telling the Chinese leadership that scarce resources such as oil and coal will be allocated by the free market through the price mechanism will not satisfy them. Their inclination is to use political influence to lock up their own sources of oil and minerals, notably in countries such as Iran, Venezuela and Sudan whose politicians are antagonistic to the U.S. This enriches and perpetuate some very unpleasant regimes, which might otherwise collapse of their incompetence, makes western efforts on human rights and democracy even more futile than usual, and endangers U.S. interests since one or other of these dictators will eventually decide to engage in some nuclear terrorism. However this all-out win for the bad guys is completely unnecessary. It is not in fact in China’s interests to depend for its resources entirely on the competence of assorted homicidal fruitcakes. China is rapidly becoming a wealthy country, so has an exponentially increasing stake in the world’s economic system.

In the world economy as a whole, the flood of cheap money over the last dozen years has caused uncontrolled economic expansion at a pace much faster than the world’s resource supplies can be expanded. While consumer price inflation has been suppressed for the last decade by the one-time communications revolution of the Internet and mobile telephony that has enabled global supply chains that were previously impossible, this effect will not last forever. In the 1880s, an equivalent communications revolution produced declining goods prices, as world money supply remained constant, bringing improving living standards for all except debt-ridden commodity producers. Today, with fiat money, its price-reducing effect has been swamped by printing money, so asset price inflation has resulted.

As the period of loose money has extended, its inflationary effect has increased, and is now beginning to swamp the effect of new technology. Rising commodity prices are today producing inflation that is always higher than expected, persistently breaking through central bank targets. It took 14 years and three election cycles for the inflationary impetus of President Lyndon Johnson’s attempt to provide “guns and butter” without raising taxes in 1965 to work its way through to consumer prices sufficiently to make the world’s monetary system cry “no mas” and appoint Paul Volcker Fed Chairman. It is now 12 years since Alan Greenspan began to increase M3 money supply by nearly 10% per annum in 1995. During that period the world has gone on a spending binge that has taken stock markets and house prices to unheard of heights while, unlike the 1880s price deflation, enriching nobody much in the West except speculators.

We seem to be approaching a crisis point, at which rising commodity demand overwhelms the market, producing a price spiral that overwhelms the world economy and bursts the stock market and asset price bubbles. This will produce a painful few years, but it will be good for us. When the world economy rebalances itself, after half a decade or so, Chinese growth will continue at a sustainable pace, while the rest of us will enjoy cheaper housing and higher yields on our investments. Only the speculators who failed to get out in time will lose money. One has limited sympathy.

Link here.


What is the difference between the last run to $700 and this one?

April is traditionally a quiet time in the gold market, but not this year. Suddenly, the gold market time bomb appears to be on a short fuse. When you contemplate the gold price nearing $700, the first question that comes to mind is whether or not the price is for real. In other words, what is behind the recent strength in the gold market? The second question is whether or not the price is sustainable. After all, we have been here before, my fellow goldmeisters, and from here we took quite a tumble just a little over a year ago – back to the $570 level. The short answer is “that was then and this is now.” The facts of economic life on the planet line up much differently in May 2007 than they did in May 2006.

The most profound change has been the wholesale run from the dollar led by Japan, China and various oil exporters. In December 2004 Japan held $690 billion in U.S. long and short term bonds. By December 2006, not only had the net Japanese position failed to increase, it had actually declined to $627 billion. Recently, China publicly joined Japan in shunning U.S. debt paper and so have several of the oil-exporting states. Though this troubling change of direction has been de-emphasized by the mainstream financial media, it has not been ignored by the foreign exchange and gold markets. It explains the $2 pound, the $1.35 euro and the near $700 gold price.

Altogether, the IMF recently reported that 80% of the annual U.S. fiscal deficit is now financed by foreign sources. Common sense begs the question “Who is going to fill the gaping hole left by the exit of America’s top creditors?” A prime candidate, and perhaps the only candidate, is the U.S. Federal Reserve itself with its magical ability to manufacture money.

When considering what is different between last May and now, and whether or not the gold rally can be sustained, the withdrawal of Japan, China and several oil exporting states from the Treasuries market, looms large. This amounts to a structural shift so profound that few really understand the full implications. The economists, politicians and Wall Street pundits who always believed that the dollar quid pro quo would go on forever are now suddenly forced with the prospect of its complete and imminent collapse. Whereas the run to $730 last May came as a final speculative blow off before the correction, this run to $700 looks more like the beginning of new leg up fueled by a fundamental break down in the operating international quid pro quo.

Goldman Sachs is rumored to be short 1000 tonnes. What does it mean for gold investors?

When Dennis Gartman, who publishes one of Wall Street’s most widely circulated insider newsletters, passed along the rumor that Goldman Sachs is sitting on a one thousand tonne gold short position, he reignited long-held suspicions in the gold market. Gartman also linked the short position to the 1999 Bank of England’s gold sales intimating that Goldman influenced that decision to sell over half its reserve. Biven the copycat behavior of the financial engineers these days, if Goldman has a problem it is likely that other bullion banks do as well. Thus Goldman’s problem could be the tip of a massive iceberg.

This tells us that in the future investors might be competing not only with each other for available physical gold, they could very well be competing with well-connected bullion banking institutions that have the inside track on gold supplies. Since the long term trends indicate a steady decline in mine production and official sector sales (the two largest sources of gold), covering shorts of this size could create an explosive mix.

Though such a brew could be a major positive for the gold price, there is a darker side to the story. At some point down the road, private investors could be squeezed out of the physical gold market by a pack of hungry bullion banks. If you do not own gold, or do not own enough, you run some serious risks by waiting. First, it is likely you will pay more later simply because the gold price will continue rising in response to the shortcovering. Second, there could come a breaking point where the premium on physical gold items goes through the roof. Last, you might find yourself unable to locate gold at all as the free supply dwindles to nothing.

For those who consider such thinking farfetched, keep in mind that in the late 1990s premiums on pre-1933 European coins shot up aggressively in response to the Asian contagion and ramp-up to year 2000. Relatively common items like the British sovereigns and Swiss 20 franc gold coins sold at premiums of 30% over the gold price and more. The gold market is relatively small compared to the high-volume stock and bond markets. The gold business in terms of manpower, item availability and infrastructure is simply ill-equipped for what might happen to it if even a minor gold panic should develop.

Why Gordon Brown’s calls for IMF gold sales have become a reliable indicator of an uptrend.

Recently, with gold pressing $700, Britain’s Chancellor of the Exchequer Gordon Brown, on cue, renewed his push for IMF gold sales. There was a time when Brown’s antics were cause for alarm in the gold market, but no more. As it turns out, one of the more reliable indicators of an impending spike in the gold price is Gordon Brown pressuring the IMF to sell its gold (see chart).

Brown’s latest attempt to persuade the IMF to sell gold suggests that the bullion banks are still having difficulty finding physical gold, and if that is the case, they are likely to bid up the price to meet whatever obligations are on the table. If the past is an indicator, Gordon Brown’s new call for IMF gold sales might be predicting another explosive move upward.

Link here.


It is still common for market commentators to denigrate gold as a relic of little value. They claim that since it offers no dividend its only appropriate use is for jewelry – never calling to mind the hubris it takes to ignore 5,000 years of civilization that viewed gold as money. Most market strategists still do not realize that gold is money and its value is as a store of wealth and it holds its value against fiat currencies better than any Treasury asset, including TIPS. So, I thought it may be enlightening to compare the returns of gold versus Treasury Inflation Protected Securities and determine which offers a better hedge against inflation.

A TIPS is a bond which increases its principal upwards by the same amount as the rate of inflation as reported by the CPI. Since their inception in 1997, the average issued yield on the 10 year TIPS has been 2.9%. Over that same period, the average rate for the CPI has been approximately 2.5%. Thus, the average annual return on TIPS since their inception 10 years ago has been about 5.4%. Currently, according to March inflation numbers the CPI increased by 2.8% compared to 2006 and the current yield on a 10 year TIP is 2.3%, suggesting a total return of only 5.1% despite today’s elevated CPI. However, the expected rate of inflation through the life of the security is only 2.4% as indicated through the TIP’s breakeven spread.

Comparing gold to the TIPS, we see the price of gold has risen from $300 to nearly $700 per ounce since 1997, for a compounded return of 8.7% per year. The same $300 invested in 10 year TIPS since 1997 would have compounded to only $536 at 5.4%, and that is before taxes on the income received.

This is no aberration. Many investors would be surprised to learn that gold has returned an average annual compounded rate of return of 8.65% since 1971 – the year Nixon broke the Bretton Woods agreement and severed all ties to the gold standard. For those who might say the history for TIPS is too short to draw any long term conclusions, we can also simply look back on the last 20 years of nominal Treasury yields, where we see an average yield of 6.21% before taxes. That yield is especially diminutive when compared to the average increase in M3 of 7.8% (which is closer to the actual rate of inflation) over the last 35 years. The CPI is flawed and will always understate the true rate of inflation, so adding such a CPI figure to the anemic nominal TIPS yield will never allow investors to get ahead in real terms. Unlike TIPS, gold offers no guaranteed rate of return, but I would rather have the millennia of history validating gold as an excellent hedge against inflation rather than a return benchmarked versus the CPI.

Link here.


Earnings season provides us a quarterly glimpse into the workings of the credit system. I was especially interested in the opportunity to examine how various institutions were responding to the subprime meltdown. Were lenders pulling back from home mortgage lending? Were they becoming more risk averse in the lending business generally? Any reverberations in securitizations or derivatives? Most important, are we seeing evidence of slowing financial sector growth – the lifeblood of market liquidity?

Results are inconclusive. Generally, moderately rising credit costs are putting only greater pressure on profitability for the more traditional banking businesses. Growth has slowed for some, while others are aggressively pursuing growth wherever it can be found. At this point, the more important dynamics remain the move by financial institutions into commercial lending and capital market activities. As Citigroup’s asset growth of $137 billion and JPMorgan’s $57 billion demonstrate, institutions can grow securities market-related assets these days much more readily than they can traditional loans. Need earnings to please Wall Street and support the stock price – go capital markets!

So, to answer a key question, when it comes to market liquidity there is little evidence that subprime problems have led to any restraint in financial sector expansion generally. Perhaps the opposite.

Reporting last month, Goldman Sachs, Lehman Brothers, Morgan Stanley, and Bear Stearns posted combined (fiscal) first quarter asset growth of an astounding $239 billion, or 34% annualized, to surpass $3.0 trillion. With the subprime collapse hitting at the end of February (little impact on fiscal Q1), all eyes were on Merrill Lynch’s report for quarter ended March 31. Well, Merrill enjoyed a blow-out quarter and was pleased to broadcast that it had taken full advantage of market turbulence (including record subprime originations!) during the period. It is at this point a reasonable assumption that the broker/dealers are well on their way to sustaining last year’s incredible 30% growth rate.

Financial sector quarterly revenues data provide evidence as to which businesses and what types of lending are driving system credit growth – all of them! Balance sheets – liabilities, in particular – help inform us as to the nature of financial sector liabilities being created in the process of financing the credit boom. Confirming record first quarter debt issuance data, the investment banking business has never been stronger. Despite slowing household mortgage debt growth, we are still likely on pace for record securitization issuance this year. And as far as funding financial institution asset growth, it is worth noting the aggressive expansion of “fed funds”, “repos” and other non-deposit liabilities. It is worth noting that the first quarter increase in “fed funds and repo” from the major investment banks alone ($201 billion) was larger than total M2 growth ($160 billion) during the period. While quarterly earnings leave many questions unanswered, the issue of a historic runaway increase in securities-based finance has been reconfirmed.

If only “Ponzi Finance Units” could live forever.

A commentator on CNBC today said that it was “obvious” that credit growth was slowing significantly. It appears obvious to me that rampant credit excess runs unabated. Household debt growth may be moderating, while corporate borrowings are likely expanding at low double-digit rates. But it is the growth in financial sector borrowings that holds the key to liquidity puzzle. The leveraging of existing securities – by hedge funds, in broker/dealer and bank “trading accounts” – is likely a major source of current liquidity excess.

As long as Credit expands at the current rapid pace the consumer will undoubtedly keep spending and asset markets will keep inflating. And as long as the credit bubble is sustained U.S. financial assets may appear sufficiently enticing to our foreign creditors (although they must not be that attractive or foreign central banks would not have been forced into accumulating about $1 trillion of reserves the past year. But this is Ponzi Finance at its most extreme. The U.S. financial sector must now balloon rapidly and incessantly to sustain over-consumption, to maintain inflated real estate and securities values, to support corporate earnings and income growth, and – importantly – to support the ever-growing pyramid of financial sector debt obligations. But as we have been witnessing of late, this kind of credit system expansion creates only more dollar liquidity to add to the global deluge. If only, in Minsky’s language, “Ponzi Finance Units” could live forever. There will, at some point, be a reversal of flows out of Wall Street “finance” that will likely coincide with a flight from the dollar.

Link here (scroll down).


Far away from the sun-kissed beaches and palm trees that make up southern California’s idyllic coastline, trouble is brewing in the Inland Empire. Two years ago the sprawling arid region that lies to the east of Los Angeles was one of California’s property hot spots. House buyers priced out of expensive Orange County and the more affluent neighborhoods of L.A. poured into towns such as Riverside, Moreno Valley and Perris. Limited housing stock and a relatively benign regulatory environment attracted developers, who built scores of new homes.

For a while, the Inland Empire rode the coattails of the California housing bubble as buyers, many of whom had limited financial means, took out subprime mortgages with low “teaser” rates. But with the subprime sector collapsing, the area is facing a looming crisis, with an increasing number of homeowners delinquent, or failing to make payments on their loans. Delinquency often leads to mortgage foreclosure, or the repossession of the house by the lender.

It is easy to see why towns in the region appeal to property buyers. In Moreno Valley, in the heart of Riverside County, residential streets are laid out in a grid system of predominantly low-rise homes, well maintained with large gardens and quiet, safe streets. Riverside County appears to have been most badly hit by the subprime collapse, with mortgage defaults in the first three months of the year up 168% on the same period of 2006.

Several factors have contributed to the region’s problems. “There is a lot of predatory lending going on,” says Gary Aguilar, vice-president of counseling services at Springboard, a national service for people struggling with debt. “I heard of one homeowner going through a divorce who ended up with a $115,000 mortgage on a $45,000 home.” When property prices were rising, buyers did not want to miss out, he says. “Everyone was jumping on board to buy a home. The majority of people did whatever they could do to have the American Dream and purchased homes they just couldn’t afford.”

Vilma Mercado, home ownership centers manager with the Neighbourhood Housing Service of the Inland Empire, which promotes home ownership, says many buyers were not adequately prepared. “A lot of people moved into these areas thinking they were more affordable, but didn’t understand what they were getting into.” The increase in foreclosures in the region, she adds, is “absolutely overwhelming”.

The Inland Empire was one of the last parts of California to experience dramatic house price inflation, with the price of property in some towns doubling in five years. But last year the number of newly built houses coming on to the market reached its highest level in two decades. Prices fell and many of the buyers who had taken out subprime mortgages found themselves trapped. They could no longer rely on the equity in their homes to refinance their loans.

“Anything can turn that has doubled in five years,” says Dr. Christopher Cagan, director of research and analytics at First American Real Estate Solutions, which tracks real estate sales. “What we have [in the Inland Empire] is an explosion of building and an explosion of generous lending. There was no single villain: this was a market phenomenon characterised by 30 years of [house price] growth with very few defaults. There is no one person or company to point to.”

This has not stopped the California Department of Justice from pressing on with an investigation into predatory lending. It is unlikely that action will be taken imminently, though, as the state has been examining the issue for almost five years. Further, the U.S. Supreme Court appears to have curtailed California’s ambitions with a ruling that limits the power of individual states to regulate lending practices. However, any action that California or the federal government takes to resolve the subprime collapse is likely to come too late for the people currently facing foreclosure in the Inland Empire.

The increase in foreclosures has “come on strongly and quickly and none of us anticipated it,” says Ms. Mercado. “And it is nowhere near ending.”

Link here.

Subprime bondholders may lose $75 billion from slump.

Bond investors who financed the U.S. housing boom are starting to pay the price for slumping home values and record delinquencies in subprime loans. They will lose as much as $75 billion on securities made up of millions of mortgages to people with poor credit, says Pimco, manager of the world’s biggest bond fund. Some of the $450 billion in subprime mortgage-backed debt sold last year has lost 37%, according to Merrill Lynch.

Investors have replaced banks and thrifts as the primary source of money for U.S. mortgages. More than $6 trillion of mortgage bonds are outstanding, dwarfing the amount of U.S. government debt by about 50%. “Bond investors will be the ones who will take the losses,” not the banks, said Scott Simon, who oversees $250 billion in asset-backed securities at Pimco.

Investors are losing money because of places like Riverside County, California, where foreclosures almost tripled last quarter to 6,103 from a year earlier, the biggest increase in the U.S., according to Foreclosures.com. Lehman Brothers used Riverside loans as collateral for $1.5 billion of bonds sold in January 2006. Some of the lowest-rated portions of the securities trade at 63 cents on the dollar, down from more than 100 cents in October, according to Merrill Lynch. Investors in the Lehman bonds include New York-based BlackRock, which oversees $1 trillion of assets and AllianceBernstein, which manages $726 billion. Franklin Templeton also bought the bonds.

About two-thirds of mortgages get turned into bonds, up from 40% in 1990, when the market was $1.08 trillion and the country suffered its last real estate slump, according to data from the Federal Reserve and Fannie Mae.

Mortgage companies increased the amount of loans they provided when the economy was accelerating by accepting home buyers who previously could not obtain credit. “Underwriter standards have gotten progressively more lenient,” said Mark Tecotzky, chief investment officer at Ellington Management Group LLC, a $4 billion hedge fund that invests in mortgage bonds.

Bondholders are as much to blame as lenders, FDIA Chairwoman Sheila Bair says. “We should hold the servicers’ and the investors’ feet to the fire on this,” Bair said in testimony to the House Financial Services Committee last week. “We did not have good market discipline with investors buying all these mortgages.” Investors say more regulation may dry up financing for homes, causing more delinquencies and damaging the economy.

Link here.

Mortgage “meltdown” hits auto sales, says GM’s Lutz.

The crisis in the U.S. mortgage market has hurt U.S. auto sales this month, General Motors Vice Chairman Bob Lutz said. Lutz said he did not know how GM’s own sales had performed in April to date, but said he expected the whole sector would feel the impact of the stress on the housing finance market. “A lot of people are finding themselves in a position of reduced affordability and that has had an impact, not just on us, but across the industry,” he said.

GM, which has lost more than $12 billion in the past two years, has been struggling with high labor costs, stiff competition from Japanese automakers such as Toyota and Honda and slumping sales of profitable trucks and sport utility vehicles. GM in March said it expects results from finance company GMAC, in which it retains a 49% stake, to remain under pressure this year due to increased defaults in subprime mortgages or loans to borrowers with poor credit. Weak housing starts have also hurt sales of high-margin pickup trucks, typically bought by construction workers.

Link here.


It is a great time to be a Coca-Cola (KO: NYSE) investor. The soda-producing Warren Buffett mainstay has been performing beautifully lately. First quarter 2007 results were just released, with earnings beating what Wall Street had modeled and sales outdoing first quarter of last year. Give the credit to new products, like Coke Zero, and international markets.

But there is a black cloud hanging over Coke – its declining soda sales in North America. Q1 2007 brought a 3% drop in soda revenue in this key market, and fingers are being pointed at Americans’ tastes running toward healthier alternatives like bottled waters, drinks with vitamins and traditional hot beverages. Coke has warned that sales for the rest of this year will probably not reflect any major turnaround just yet in North America. But for small-cap investors, there are ways to play the soda industry, and ways to profit from the companies that are giving Coke some headaches.

So-called “gourmet soda” growth is the story here. Look no further than relative newcomers Jones Soda (JSDA: NASDAQ) and Hansen Natural (HANS: NASDAQ). The former is a small-cap, the latter is a bit bigger with a $3.5 billion market cap. A few years ago, you could only buy Jones Soda products at record stores, surf shops and tattoo parlors. Now, this maker of so-called “alternative” sodas with pure cane sugar has bottles in Starbucks, Target and 7-Eleven. The packaging is pretty distinctive. Customers send in personal photos to Jones, and the best get accepted on their sodas’ labels.

Hansen markets itself as a natural soda maker, and also markets bottled smoothies and various energy drinks. The company dates back to the 1930s when the Hansen family was a juice supplier to the Hollywood film industry. What these two companies have in common financially, though, is tremendous top- and bottom-line growth. Jones has averaged 20% revenue growth for the past seven years, with earnings making the turn to the plus side in 2003, and posting 254% net income growth just last year. All the while, Jones has been consistently expanding margins as well. Bigger brother Hansen has been even more impressive. Sales have grown on average 31% over the last seven years, with last year posting a 94% jump, while earnings have grown an average 53% for the last seven years.

The Beverage Marketing Corporation has the carbonated soda pop business pegged at $65.9 billion in total annual sales for last year. But traditional soda growth has been spotty and lackluster for much of this decade. While Jones and Hansen are called “sodas”, and are definitely competing for Coke and Pepsi consumer dollars, industry insiders refer to these niche drink companies as New Age beverages. This segment has not been sliding in recent years. The most recent data we have shows that this is an almost $17 billion industry at the wholesale level and growing.

Investors have noticed, too. Jones is up 103% in just the last two months alone. Hansen is up 281% since June 2005. Small-cap investors should look for the beverage company stocks that have a great product, but are not profitable at the moment, and do not have their distribution quite in place. When the stars finally align, a lot of the upside will already be gone.

Link here.


Why rob a company? Because that’s where the money is. ~~ paraphrase of famous Willie Sutton quote

After four years of rising stock prices a person might wonder how private equity investors can keep finding companies cheap enough to deliver decent returns on their investment. Private equity firms bought 654 U.S. companies last year. But were they bargains? Were they bought cheap enough to produce a decent return on their $375 billion cumulative price tag? Here is the answer: It does not matter.

That is the great thing about being a private equity investor. It does not have to be about the Return on Investment or the ROI. There is always the RFP, or Return From Pillage. So far, RFP has come in the form of “management” fees and “dividends” paid by recently-privatized companies to the privateers who privatized them.

Wall Street Journal reporters Greg Ip and Henny Sender described these innovative forms of compensation in a July 25, 2006 article using Burger King as an example. First, Burger King paid the private equity folks $22.4 million in “professional fees”, apparently for shepherding the company from the public wilderness into the loving arms of private equity owners. Then, after three years of restructuring and other voodoo, and three months before releasing Burger King back to the public, Burger King paid the investors a $367 million dividend. After reviewing such a transaction, a person might exclaim, “What a turn-around to be able to afford to pay yourself almost a gazillion dollars!” But that person would be exclaiming in the wrong direction. That person should be exclaiming, “You loaned money to Burger King to pay almost a gazillion dollars to their own owners?!” That is because Burger King borrowed the money for the dividend, the sort of thing that apparently is possible at the late stage of a credit bubble. Finally, as a parting gift of sorts, Burger King paid the investors $30 million to terminate their agreement, because after all, there is only such improvement an operating company can take.

All in, according to the Journal, the private equity investors squeezed $448 million in dividends and fees out of The King before the company went public again. The article went on to list Warner Music, Simmons Bedding and Remington Arms as other companies that paid big dividends to private equity investors that were largely funded with borrowed money. And, the Journal reminded readers that the parent of Hertz also borrowed money to pay its private equity a dividend, this one in the amount of $1 billion. As luck would have it, the dividend was paid about the same time the company was reporting a loss, due at least in part to the interest on the mountain of debt incurred in the buyout itself.

That is the problem with owning an operating company, the demands of running the company can detract from all that creative financing. Take Intelsat Global Services. Private equity investors paid $513 million for the company in 2005 according to a Business Week cover story published last year. Within a year the “investors” scored $576 billion in fees and dividends. Sadly, the owners had to deal with operating details like credit rating cuts as the company’s debt load doubled. Then it had to lay off 194 people for “operational” reasons. No wonder private equity owners often take their companies public again. Who needs the headaches?

New York Times columnist Floyd Norris recently put a number on the private equity dividend mania, and that number – the amount of money companies borrowed to pay dividends to their owners – was $26.9 billion in the first quarter of this year. At that rate, RFP this year will easily surpass last year’s $56 billion, a figure that towers over the less than $20 billion borrowed for dividends as recently as 2003.

The beauty of RFP, as Mr. Norris points out, is that the private equity investors can make money even if the company itself goes under, or has to layoff scads of employees. But who would loan money to a company that borrows money at one end and pays it to its owners out the other? Sophisticated institutions and hedge funds, of course. Banks and other entities simply pool their money, divvy up the loans into pieces, and sit back to reflect upon their own sophistication. For these “leveraged loans” to be paid off, all that has to happen is that things have to continue to go swimmingly: Operating companies must make enough money to service the debt over time, or a happy event must make it possible to service the debt all at once.

As long as happy events, like IPOs and leverage loans are possible, non-public companies can continue to generate a huge RFP for the private equity owners. No wonder the most important question in the private equity world is no longer is “What is our ROI?” But rather, “What would Willie Sutton do?”

Link here.


No business start-up idea seemed too outlandish during the dot-com bubble (Kozmo.com, Boo.com, etc.), when the phrase “burn rate” described how rapidly a new venture could exhaust the hundreds of millions of dollars raised in an IPO. But back then, investors at least knew what the idea was that burned up their capital.

Today, on the other hand, we are bearing witness to the rise of new ventures called special purpose acquisition corporations, or SPACs. If that sounds like it could mean anything, well, it does – literally. SPACs raise capital based upon the following premise: “Investors do not actually know what their money is going to be spent on when they buy shares.” Maybe you have even heard about it, given that this “low-profile” way of raising venture capital dates has been around at least since the South Sea trading bubble of 1720.

This topic would not be worth discussing if it amounted to a handful of obscure deals. But the New York Times explains that SPACs represented 26% of the 73 IPOs so far this year, and 15% of the money raised on public markets. Not that the NYT finds this any more objectionable that does Wall Street itself. The article appeared not in the investment part of the business pages, but in “Media & Advertising”. The tidbits of skepticism were greatly outweighed by the resumes of the executives in the various SPACs and the dollar amounts they have raised. “It’s not a fad,” gushed one such executive, “The only question is: how large can the market get?”

Question like that are more pleasant to report than, say, “How much do investors stand to lose, and how angry will they be?” Pleasant questions about risk are always what the crowd wants – and gets – near a peak.

Link here.


Oil ended 2006 roughly where it began, at just over $60 a barrel. This reassured the public that all talk about Peak Oil was hysterical blather from a lunatic fringe. It was reinforced by the publication of the mendacious Cambridge Energy Research Associates (CERA) report issued this fall – a tragic document put out by a giant public relations firm representing the oil industry – with the mission of staving off windfall profits taxes and other regulatory moves that a true resource emergency might recommend.

But beyond this debate, in the background, another ominous trend can account for the stalling of oil prices in 2006 – totally unrecognized by the public and ignored by the news media: Prices on the oil futures market leveled off because the Third World has effectively dropped out of bidding for it. And using it. They cannot afford it at $60 a barrel. The Third World has entered an era of energy destitution and it is manifesting itself in symptoms like local resource wars, genocides, falling life expectancies, and in many places a near-total unraveling of the sociopolitical order. American mall-walkers and theme park visitors are oblivious to this tragic process, but it is perhaps the major reason why we are not now suffering from $100 a barrel (or greater) oil prices (with the consequent unraveling of our sociopolitical and economic order).

The major trend on the oil scene for the past 12 months has been the apparent inability of the world to lift total production above 85 million barrels a day – with demand now rising above that line. It is unclear how much more demand destruction will come out of the Third World before bidding intensifies between the developed nations.

One commentator in particular, Dallas geologist Jeffrey Brown – a frequent contributor on the Web’s best oil debate site, TheOilDrum.com – is advancing the idea that we are entering an oil export crisis that will presage a more general permanent world-wide oil emergency. Brown holds that the major oil exporting nations are using so much of their own product, because of rising populations, that their net exports are falling at an alarming rate, perhaps as much as 9% annually. This trend combines with general depletion rates now said to be around 3% a year.

The question of total oil reserves around the world remains somewhat murky, but Brown, Kenneth Deffeyes of Princeton, and others using a straightforward mathematical model, have stated that the world is roughly at the same point in all-time production as the lower-48 U.S. was in 1970, when America passed its all-time production peak. Discovery of new oil to replace the production from declining fields remains paltry. Meanwhile, companies developing tar sand production in Alberta announced that their costs of production were rising substantially, while a reckoning lay ahead as to how much of Canada’s fast-disappearing natural gas reserves will be squandered in melting tar. The oil shale project is going nowhere. American corporate farmers have entered into a racket with congress to subsidize ethanol production from corn and biodiesel fuel from soybeans. This project depends on oil-and-gas “inputs” to keep the crop yields up and ultimately is a net energy “loser”. As the world crosses into the uncharted territory of “The Long Emergency”, Americans will find themselves having to choose between eating food and making fuel to keep the car engines running.

The bottom line for oil in 2007: Expect the bidding on the futures markets to regain intensity between the U.S., China, Europe, and Japan. A contracting U.S. economy could take some demand out of the picture, but the sad truth is that we burn up most of the oil we use in cars, and American life is now so hopelessly based on incessant motoring that citizens cannot even go down to the unemployment office without driving. Geopolitical events can only make the oil supply situation worse and probably will.

We are probably also in the early stages of a natural gas crisis in the U.S. Over the next decade, the gap between U.S. demand for natural gas and dwindling supply may amount to one-and-a-half times the current equivalent of our oil imports. This is a staggering deficit. Natural gas is used for heating in more than half the houses in the U.S. and accounts for just under 20% of our total electricity production. Domestic supply is crashing. To make matters worse, the means of gas delivery, through a vast web of pipeline networks around the nation, makes “just-in-time” delivery the norm and, tragically, also makes “just-in-time” pricing normal, too. Thus, gas prices are responding only to the shortest-term signals - for instance, unusually mild winter weather - rather than to the catastrophic long-term reserve picture.

Finally, we are unlikely to solve our natural gas problems with imports for technical reasons having to do with the cost and difficulty of moving the stuff by means other than pipelines and for geopolitical reasons, namely that most of the remaining gas in the world is in Asia.

Link here (scroll down to piece by James Howard Kunstler).
Bakhtiari’s event of the century – link.


The majority of companies that have outsourced IT operations would have saved more money had they kept the services in-house, according to a study of contracts worth more than £3 billion. The outsourcing industry is facing a mid-life crisis with some “high-profile outsourcing deals being taken back in-house” and employers starting to question the value of long-term savings, research by Compass Management Consulting found.

The consultants, which advise businesses in 35 countries on efficiency savings, compared the cost of 240 outsourced contracts with what employers would have paid had work been kept in-house. Compass concluded that savings of up to 18% were achieved in the first year of outsourcing, but by the final years of a typical 5-year or 7-year contract most prime contractors were charging an average of 30%, and sometimes as high as 45%, above the comparable internal market rate.

A separate study of FTSE 350 companies found that a third of companies had taken back in-house, or intended to bring back under their control, operations which had been out-sourced. Failure to deliver cost savings was cited by 40% of dissatisfied clients. Compass said that computer equipment and software prices had fallen faster, making in-house costs cheaper than had been expected when the contracts had been let.

Simon Scarrott, head of business development at Compass, warned that companies that had outsourced IT and other operations had found it difficult to bring work back in-house as they no longer had staff with experience to do the work. “Outsourcing is not alchemy and is failing to achieve cost savings,” he said. “We are seeing up to 65% of all outsourcing contracts worth over £20 million unravelling before running their full term. The costs to both parties of failure are high and legal and advisory costs can quickly escalate.”

More recently employers had been seeking to achieve better benefits by seeking shorter three year deals. Even so, contractors would remain under strain if they were to out-perform in-house operations, said Mr. Scarrott. Compass calculated that contractors would have to be at least 20% better than the in-house operation they replaced just to cover the costs of winning and break even. On top of this they had to make a profit, cover overheads and leave margin for any unseen risks.

Link here.


Obvious prospects for physical growth in a business do not translate into obvious profits for investors.

This may be the single greatest piece of investing advice I have ever received. The author of this quote is Benjamin Graham, mentor to Warren Buffett, and undeniably one of the greatest investors who ever lived. Graham emphasized the importance of understanding the underlying value supporting a company’s stock. He recognized the fundamental mischaracterization of the term investor. For Graham, many so-called “investors” were truly nothing more than speculators – individuals looking for a “shortcut” to superior returns. Graham understood that the majority of individuals lacked the patience and discipline required to succeed in the world of investing. Investing is much more than an end in itself. It is the means to an end that make all the difference.

As an investor, you need to recognize that emotion should yield to reason. But more often than not, we confuse emotion (i.e., greed) for logic. We act like sheep anxious for the slaughter. We repeatedly choose the path too often taken. The Dutch tulip bulb mania of the 17th century offers us the perfect example. At its peak, the market bubble drove the price for a single Dutch tulip bulb to an astounding $76,000. Before long, people began to see the error of their ways. They began to exercise reason in place of greed. They realized the price for tulips centered on speculation and nothing more. In the end, a bulb produced nothing more than a single flower. Well you know the story. Markets adjusted and speculators lost everything.

But speculation can come in many different forms. Irrational decision-making does not require extreme illustrations like tulip bulbs or even cash-burning dot-coms for that matter. Investor traps can lie in some of the greatest growth stories of all time. And that is the point of the opening quote. A great growth story does not necessarily equate to a great business.

Graham calls attention to the fervent demand for air transport stocks in the 1940s and ‘50s. Everyone knew (and rightly so) that air transportation was here to stay. It did not take an expert to forecast the enormous long-term growth rates for air travel in the second half of the 20th century. Consequently, air transport stocks were the hot investment. But the airline business has horrible margins. Fuel costs, fierce competition and labor disputes have hindered the industry since its very inception. Even though predictions on passenger growth rates proved true, the business itself never offered significant returns. As Graham wrote in The Intelligent Investor, “In 1970, for example, despite a new high in traffic figures, the airlines sustained a loss of some $200 million for their shareholders.”

Airlines certainly are not the only great growth stories that proved to be entirely unprofitable. They are not even the most recent example, less we forget the 1990s. So before you sink Junior’s college fund into the greatest hyped small-cap since Microsoft went public in 1986, make sure there is more to the story than 1.3 billion depraved consumers eager to spend that 40+% annual savings rate they have parked away in low-yielding Chinese savings accounts over the years.

Link here.


Get out your peanuts and Cracker Jack. Baseball season is ba-ack. Still, if you go see the New York Mets play at Shea Stadium anytime soon, you might notice a few changes around the field from last year: There are the old ball caps AND hard hats? Pitches AND ditch witches? Stolen bases AND mobile cranes? The gist? The construction of a brand-new arena for baseball’s NYC Mets is underway in the old parking lot just beyond the current Shea Stadium.

When complete (set for 2009), location will not be the only thing thats different about the Mets new dome home. After 43 years, Shea Stadium will be renamed “Citifield” as part of a 20-year sponsorship deal between the base ball team and the world’s largest investment bank Citigroup Inc. – reportedly worth more than $20 million annually. Strange match, maybe. But according to the popular press, the marriage of America’s favorite pastime TO the leading sport of Corporate America’s future is quite fitting. It is no secret that over the past year, Wall Street’s biggest banks have built themselves up to be bigger and better and lo and behold, the deals they hath come.

CEO’s are “dancing on Wall Street,” writes a recent news source, as financial firms have hit their profit margins out of the park: The Q1 2007 saw $428 billion worth of deals take place, a 21% surge from last year’s all-time record. The “experts” throw reason after reason after reason to explain why the banking sector will continue to grow strong – without breaking a sweat. Yet from where we sit, the industry itself continues to swing, swing, swing, and miss:

Pitch ONE: “Corporate executives are confident enough in their outlook to embark on brave merger and acquisition deals [and IPOs] that boost the share price of company’s taken over” AND listed – Except nearly every financial exchange under the sun as the NASDAQ, NYSE, CME, ICE, and NYBMEX all peaked between November and February, with the CBOT widely expected to follow the post-issuance downtrend.

Pitch TWO: The market is “awash with liquidity. Wall Street banks are raking in more money than ever before.” Well, actually. One out of every four deals made in Q1 2007 were from private equity firms. As we all know, private equity is not parlance for “cash”, but rather “credit”. To wit: Loans for leveraged buyouts soared 65% last year to $1.4 trillion. Meaning: Banks are not raising their profits internally, but via advising fees AND by investing in the LBO deals themselves.

Pitch THREE: “Fear of contagion from the subprime market meltdown” was overblown. “Giant banks have promised that their exposure is limited.” Washington Mutual’s subprime segment lost $164 million in the first quarter of 2007. So goes the song, “For it’s one, two, three strikes you’re out.” Still, optimism prevails, as this April 25 article in the UK Independent makes plain: “Hang out the bunting, prepare the sandwiches and the fizzy pop, get ready for a party. A Wall Street party.”

Heck, you need only look at the blueprint for the new Citifield Stadium to see how entrenched the bullish enthusiasm is for the future of financials. The new stadium will be both “more intimate, and more opulent,” reports the Associated Press. The capacity of regular seats will drop from the current 57,333 to 45,000, in part to make room for more “luxury boxes”.

In February 2007, our analysts turned back the clock to show the last time the business world united with the world of baseball: It is called “Enron Field”.

Elliott Wave International lead article.


Almost any person of reasonable intelligence has the potential capacity to master the fine art of living.” ~~ J. Paul Getty

Last month I started my own weekly e-letter, “The Worldly Philosophers”, wherein I highlight each week a worldly wise business leader or teacher, and what lessons we can learn from them. One of my favorite worldly philosophers is America’s first billionaire, J. Paul Getty (1872-1976). He was a 20th century icon. His classic book, How to BE Rich, is far different from Donald Trump’s ramshackle alternative, How to GET Rich. In J. Paul Getty’s refined world, there is a big difference between “being” rich and “getting” rich. (I suspect Getty’s book will be in print long after Trump’s.)

For Getty, life is much more than simply working for a living. Far too many Americans are too busy and do not take the time to enjoy all that life has to offer. As the wise old Chinese philosopher Lin Yutang says, “Those who are wise won’t be busy, and those who are too busy can’t be wise.” I made the mistake of writing this statement on the blackboard on the first day of class as a professor at Columbia Business School. A third of the students left and dropped the class immediately.

If you too busy in your work, you do not have time to learn new ideas, to discover new truths, to enjoy life’s little pleasures, or perhaps to pick a winning stock! Beating the market requires you to look in untroddened paths, and you need the free time to do it. Getty wrote a whole book, The Golden Age, on the need for workaholic Americans to diversify into other gainful pursuits. In Getty’s case, he developed a taste for paintings and other collectibles. He states, “I began developing other, non-business interests and engaging in a reasonably broad range of ‘extracurricular’ activities early in my career. These have all had a profound salutary effect, for each helped generate enthusiasm for the next, and all added zest to life and, what is more, helped me be a better, more energetic and efficient businessman and a much more content and happy person.”

But in How to Be Rich, Getty confesses that for much of his life was he was workaholic. His nonstop schedule led to serious personal and family problems. Despite tremendous monetary success, J. Paul Getty had one failure. He was married five times. “I deeply regret these marital failures,” he said, “but a woman doesn’t feel secure, contended or happy when she finds that her husband is thinking of his business interest first and foremost, and that she comes next – almost as an afterthought.” Sounds like Getty needed to read his own book, The Golden Age, about the need to spend more time with his wife and children and less time at the office.

Make your money first – then think about spending it.

Like most of us, Getty focused fearlessly on making money and building a fortune early in his career. He lived the life of Ebenezer Scrooge, working overtime and saving every penny. Getty was famous for installing a pay telephone in his Sutton Place manor in England.

Still, there is much to admire in Getty. He was a risk taker extraordinaire. He started out as a wildcatter in Oklahoma in 1915. He was never interested in joining the big oil companies. One of Getty’s leases proved lucky, and he was on the road to prosperity. But it was not just luck that made him successful. Unlike the other wildcatters, he relied on geologists to find oil, an uncommon approach in those days. Getty also bought oil stocks in the depths of the 1930s, another unpopular but shrewd move. Finally, in the 1940s, Getty bought oil concessions in the Middle East: “Instinct, hunch, luck – call it what you will,” he said.

Yes, Getty was a Wall Street investor too. He warns, “Get-rich-quick schemes just don’t work. Making money in the stock market can’t be done overnight or by haphazard buying and selling. The big profits go to the intelligent, careful and patient investor, not to the reckless and over-eager speculator.” He recommended buying relatively low-priced stocks in “industries that cannot help but burgeon as time goes buy.” Getty’s chapter on the stock market in How to Be Rich is the best 12 pages you will ever read. I made it required reading in my investment class at Rollins College and at Columbia Business School.

As a libertarian, I liked Getty’s politics. He favored lower, less complex taxes. He would not be a fan of Sarbanes-Oxley! He also favored greater freedom in international trade.

Getty liked to travel and live abroad. He moved to England, in part to manage and get a better view of his international financial affairs. He knew the value of diversifying abroad. In the early 1980s, my family and I moved to the Bahamas to get away from the rat race, and our two years in the Bahamas, and later London, were life changing. It was life in living color! (To read my account, see “Easy Living: My Two Years in the Bahamas”.)

I have followed Getty’s advice in taking some time off to learn and have fun with my family and friends. Each year I produce a private conference for worldly philosophers called FreedomFest. John Mackey, CEO of Whole Foods Market (worth $7 billion), is a busy executive. He takes off six weeks (!) each year to go hiking somewhere in the world – to get away, think and take a break from work. He is a better entrepreneur because of it. He feels the same way about FreedomFest. John told me he is bringing three friends with him. If John Mackey and his worldly wise friends can take 3 days out of their schedule to come to FreedomFest, how about you?

Link here (scroll down to piece by Dr. Mark Skousen).
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