Wealth International, Limited

Finance Digest for Week of May 21, 2007

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


Investing: art or science? Since it is, after all, based on numbers, some try to concoct market-beating formulas. Robert Colby has evolved a system that, while hardly foolproof, is pretty clever. The spring Investment Guide also offers the wisdom of Yale professor Robert Shiller on how to insulate yourself from oil-price unpleasantness.

Everybody knows you need fixed-income securities as ballast in a portfolio. The ins and outs of bond funds are explored. And many changes are buffeting the 401(k), the centerpiece of many people’s retirement stashes. See how to deal with them.

Stock buybacks are all the rage. When and why do the shares go up? An explanation. Condo fever may have subsided, but there are still cities where you can buy good units sporting a government subsidy. If you rent out residential property, learn how to maximize your tax savings.

Link here.

ETFs give the small investors an opportunity to ride the waves of hot money. But then you have to stomach the costs.

Most individual investors harbor a guilty secret. They know they should invest in sensible, low-fee index funds but cannot resist the lure of money managers who promise to beat the market. Go-go mutual funds are barely defensible on any level, yet investors chase after them.

Exchange-traded funds offer a way out of this guilty trap. Since they can be bought and sold throughout the trading day, unlike traditional mutual funds, investors can get carried away with them. And ETFs are among the favorite tools of fast-trading hedge funds, which can dart in and out of smaller overseas markets so quickly that market makers occasionally have trouble adjusting share prices in time. But all that trading means ETFs are among the most liquid issues on the big exchanges.

And ETFs offer an excellent window into the minute-by-minute flows of money among countries, industry groups and even investing styles. With a modest investment in time and data collection, investors can use ETFs to surf those waves of capital, taking advantage of a well-known phenomenon in the markets called “momentum”, or “relative strength”, in which rising shares tend to keep rising for three months to a year after they start their run.

This is not a cheap strategy, either in taxes or trading commissions. But for investors who find buy-and-hold hopelessly boring and index funds too plain to bear, ETFs offer a relatively safe alternative when used in moderation. Management fees for most of the bigger ETFs range from 0.7% to 0.25% of assets, versus 1% or more for actively managed funds. Here is one sensible approach: Robert W. Colby, an investment consultant and author of Encyclopedia of Technical Market Indicators, suggests ranking the 200 or so most-traded ETFs on relative strength and buying the top 10, refreshing frequently. He uses a simple ratio consisting of the stock’s current price divided by the price six months ago. That is it.

The strategy puts investors where the money is flowing. Over the past two years, that has been mostly into foreign stocks. And it tends to get them out before bubbles completely deflate. “Yeah, you are chasing the market, but the amazing thing is it works,” says Colby. Colby has been testing his stripped-down ETF strategy since mid-2004, updating the portfolio weekly. (He posts his picks on tradingeducation.com, a free Web site.) Over the two years ending Dec. 31, 2006 his portfolio, consisting of the top 10 ETFs out of more than 200 ranked each week, returned 18.2% a year compared with 8.24% for the S&P 500-tracking SPY ETF and 16.6% for the broader Dow Jones/Wilshire Global Total Market Index.

There are lots of ways to tweak Colby’s strategy, such as cutting back on trading frequency and restricting the list to North American stocks or certain industry groups. In an influential 1993 paper Narasimhan Jegadeesh, now a professor at Emory University, showed that a strategy of buying stocks with the best 6-month performance and shorting stocks with the worst 6-month performance returned 12% a year. And they were no riskier by measures such as beta. In subsequent research Jegadeesh found the same phenomenon with industry groups. “You buy the winning industry, the momentum tends to continue,” Jegadeesh says. Many mutual funds use relative strength as a basic component of their screens, and Value Line includes it in their secret ranking system for stocks.

Since ETFs consist of groups of stocks, they naturally cushion the volatility that makes momentum investing a hazardous game for most small investors. That does not mean they can overcome other problems, such as trading commissions and disparities between the trading price of an ETF and its underlying stocks. Stocks in thinly traded overseas markets can rise and fall so rapidly that ETFs have trouble keeping up. For example, China ETFs traded at discounts as wide as 9% on February 27, after hedge funds dumped shares on fears of economic slowing. Six-month relative strength also guarantees investors will miss the top in every market.

To replicate Colby’s results you would have to rebalance the portfolio regularly, so that consistent winners do not grow to dominate the fund. That means more trading commissions, which at $10 a trade could shave $60 a week off returns. And then come taxes. Since virtually all the trades in Colby’s portfolio would generate short-term gains taxable at as much as 35%, that could trim four percentage points a year or more off performance. Needless to say, if enough people pile into momentum investing, it will cease to work. Indeed, the Value Line magic was much more apparent in the stock-ranking system’s first two decades than in the last one.

Link here.

Bonds offer modest returns but also promise to lower your portfolio’s volatility. Here is how to buy them.

You will not get rich on bond funds. But nor will your nest egg yo-yo around. The annualized return over the 10 ten years of the Vanguard Total Bond Market Index fund is 6.1%. Nothing spectacular, especially with inflation typically eating up three percentage points of that return. But during the past decade the fund, which is built from the Lehman Aggregate Bond Index, never lost more than one point in a year.

Compare that with the S&P 500. That benchmark stock index gained 8% annually over the past decade but lost 22% in 2002. For the extra two points or so that stocks returned over bonds in 10 years, investors went through some jarring ups and downs. Volatility is only fun on the upside.

Conventional wisdom is to increase your percentage of bond holdings relative to stocks as you get older. A retired couple will not want to risk that 22% loss hitting their entire net worth, whereas a recent graduate has time to ride out the bumps to get that extra 2% over the long run. But even younger investors can lower their portfolio volatility with an allocation to bond funds. These are easier to buy than bonds themselves. Retail investors pay a significant price markup for individual bonds.

If you are buying U.S. paper, the cheapest method is to buy new issues directly from the government via Treasury Direct. What you are doing here is submitting a noncompetitive bid, meaning that you get a market average price at the next auction. Or, for a modest fee, you can have your broker handle the paperwork.

Treasurys will not default, but they are not riskless. The danger is that inflation – and with it, interest rates – may accelerate after you buy. Then the market value of your bond will crash. The sensitivity of a bond to interest rate fluctuations is measured by its duration, which is akin to, but not exactly the same as, the number of years until maturity.

If you want the somewhat higher yields that go with non-Treasury bonds, you need to think about both duration and a second peril, which is the risk of default. A bond from a large, blue-chip company like General Electric will get the highest rating, AAA, from Moody’s or Standard & Poor’s. Spectrum Brands, maker of Rayovac batteries and Remington shavers, gets a CCC rating because credit agencies think it has got a high chance of defaulting on its debt. Junk debt pays out a higher yield than safer debt in order to make up for the default risk its holders take on. At the moment the yield premiums on junk bonds are meager. You do not get particularly well compensated for the risk of losing principal. Besides the meager yield, another problem with junk is that its returns are too closely correlated with those of the stock market. Adding it to your stock portfolio does not accomplish quite the same reduction in volatility that you were aiming for in buying bonds.

Ordinarily, long-duration bonds pay higher coupons than short-duration bonds. There is more time for things to go wrong. But in the past year, the yield on 6-month Treasurys has been flat at 5%, while the yield on 10-year Treasurys has dropped from 5.1% to 4.7%. This is what Wall Street calls an inverted yield curve. Who would prefer the higher-risk Treasury with the crummier yield? Someone convinced that interest rates will fall. But it is hard to be so confident that inflation will not come back.

Other considerations: How good is the bond fund manager, and how much return can a good manager add or a bad manager take away? The higher the fund’s credit quality, the less impact a fund manager can have. Yet an actively managed fund will cost more in fees than an indexed fund. Vanguard’s bond index funds charge expenses of 0.2% or less. Pay more for an active bond fund only if there is persuasive evidence that its manager is doing better than other funds of similar duration. At the nether reaches of the credit-quality ladder, a good manager can make a higher expense ratio worthwhile.

Martin Fridson, who writes Leverage World for institutional investors, says that distressed debt, which is the lowest of the low when it comes to credit ratings, will add a lot to performance during bull years and subtract a lot during bear years. Being overweighted in distressed debt will make a fund manager look great one year and horrible the next. The best way, then, to gauge performance is to see who beat the index benchmark in both bull and bear years (see list).

Link here.

The U.S. new-issues market is on a pace to have one of its quietest years of the past decade. Probably good news for investors.

When the fish aren’t biting, Wall Street underwriters have to be choosy. Only the strongest prospects make it to market. Although there are several exceptions to the rule – and although 2007’s offerings are off to a terrible start – the general pattern is that lean years, like 2001 and 2002, deliver excellent returns. Busy years for the new-issues docket are bad years in which to speculate.

Link here.

Stock options are not for everyone, but a growing number of trading firms would like to convince you otherwise.

For the 34 years that options have been traded on an exchange, investors have dreamed of hitting the big score with them. Kevin Wakeem was one of those dreamers. He started buying options five years ago. He recalls winning big on one bet and losing big on the next. “I didn’t really know what I was doing,” Wakeem says.

Neither do a lot of individual investors, but they keep coming. Retail options trading accounts for some 40% of the total 675 million contracts traded a year on the Chicago Board Options Exchange. Discount brokerages like Charles Schwab, E-Trade, Fidelity and TD Ameritrade do a healthy traffic in these derivatives. Boutiques like Thinkorswim and OptionsXpress have been proselytizing amateurs, offering online accounts and seminars. “Customers run the gamut from yuppies to grandmas and everyone in between,” says Edward Provost, executive vice president for business development at the CBOE. “We think we're in the golden age of growth.”

Nonprofessional options investors can be divided roughly into three groups. First are the gamblers. You make a lot of bets and hope for a few big wins. Options are, in effect, leveraged long or short bets on stocks. This kind of option buying is rather like betting on horse races, and probably as hard to succeed at. There are people who claim to have made a fortune doing this, but it is hard to know whether to believe them. The circumstantial evidence that it is next to impossible to succeed over a long period with this strategy is that you do not see mutual funds with terrific, long-term records that just buy options.

Second category: the risk avoiders. Say you retire from Wal-Mart, with shares of the company representing half your net worth. Maybe for tax reasons you do not want to sell. But you cannot afford the risk of a big loss. You could buy out-of-the-money protective puts – options that would make good some of your loss if the stock collapses. Risk avoiders do not expect to make money with their option trades any more than they expect to make money on their fire insurance. They are simply buying peace of mind.

The third category is yield enhancers. This is where Kevin Wakeem finds himself today. He does covered calls. With this approach you may be long-term bullish on a stock but do not think it will make a big move in the short term. So, for example, you buy Cisco at $27 and then write a call option at $35. If the option expires worthless, the option premium is extra money in your pocket. If the stock shoots up, on the other hand, you have some regrets, but you do not do badly. You make both an $8 capital gain and the money from the premium. Over the last two years Wakeem figures he has added 10% to his portfolio performance by trading options. He does the trading in a retirement account so as not to suffer a tax hit on short-term gains.

What is the catch? Much of the return on common stocks comes in short spurts. Giving away a big chunk of the upside in stocks during these rallies will damage your long-term return. During a bear market you suffer almost the same as a buy-and-hold investor – you ride the stock down with only a few bucks of option income to cushion the fall. Circumstantial evidence that what Wakeem is doing is much harder than it looks is the scarcity of market-beating mutual funds with covered-call strategies.

With options, timing is all. Buy and hold a set of stocks for ten years and there is a decent chance you will make money from capital gains and/or dividends. Go in and out of options and you will have to be lucky. Microsoft might take off just after your call expires.

Before jumping in, first educate yourself. One of the best primers is Michael Thomsett’s Getting Started in Options. Online, you can get some basics at either the CBOE Web site or here. The CBOE has a handy booklet on the tax treatment of options. You can get a feel for options trading without doing the real thing with Investopedia’s online Stock Simulator.

Shop around. To do one 40-contract trade (that is a bet on 4,000 shares of stock), your commission would be $40 at Schwab, $43 at E-Trade, $50 at Fidelity, $60 at OptionsXpress and $60 plus a percentage of the principal invested at a full-service broker like Merrill Lynch. New online options firms are springing up to cater to frequent traders by offering flat-rate commissions. OptionsHouse, founded in 2005, charges $10 a trade, with no charge per contract.

Link here.

There is a smart way to get in on the stock repurchase craze. And a not-so-smart way.

Cheap money and strong corporate earnings are fueling the share buyback fad on Wall Street. There is a way to get in on this bonanza: Buy shares of companies that have the means and the motives to do buybacks. Your prospects for capital gains should be good on these stocks.

Last year members of the S&P 500 spent $432 billion on stock repurchases. This method of disbursing profits has already surpassed in magnitude the conventional one of paying cash dividends ($224 billion last year at these blue chips). This year’s stock buybacks are on track to outpace last year’s, says Standard & Poor’s senior index analyst Howard Silverblatt.

Why now? First, we have cheap money. A company with a sound balance sheet and a decent rating from S&P can borrow in the bond market at an interest rate of 5.5%. Subtract taxes (since interest is deductible on corporate returns) and you have an aftertax cost of money in the neighborhood of 3.6%. Compare this with the earnings yield on stocks – the inverse of the P/E ratio. So the earnings yield on the S&P 500 is 6%. The average S&P 500 member can borrow $1,000 in the bond market and reduce the aftertax earnings of the company by $36; use that cash to extinguish shares with a claim on $60 of the company’s earnings. The net effect is to raise earnings per share on the shares that remain outstanding. The reasoning is about the same for the corporations that have so much loose cash that they do not need to borrow.

The other half of the picture is that corporations are so flush with profits that they can afford to disburse them to shareholders. As a percentage of national output, corporate earnings are near an alltime high. The profits turn into idle cash on the balance sheet and/or debt repayments that leave room for new borrowings. Of the nonfinancial companies in the S&P, 137 have more cash than debt on the balance sheet. That compares with 87 in 1999, analyst Silverblatt notes.

Money manager Ken Fisher has made much of the buyback wave and has used it to explain why he likes stocks. Two closely related phenomena are cash mergers and leveraged buyouts. In all three cases low-yielding cash is used to retire high-yielding equity. He also notes that in continental Europe and in Japan the spread of equity yields over aftertax bond yields is greater than here, by almost four percentage points. He is a cosmopolitan bull.

The earnings yield has been above the bond yield before, just not for very long, at least in recent decades. Spreads of this nature have recently lasted for only about a year, for example at market bottoms in 1974 and 1982. This time the spread has gone on for 55 months, hence yielding time for lots of companies to learn how to play the game, Fisher argues.

So investors should own equities being bought back. But which stocks to buy? And which ones to avoid? We found eight stocks for the buyback-minded investor. To get this list we screened for companies with strong balance sheets and comparatively low P/E ratios. With P/Es below 20, they have earnings yields over 5%. By “strong balance sheet” we mean having either excess cash on hand or a lot of untapped borrowing capacity (debt less than half of total capital). Next rule for the buy-in list: a high tax rate (at least 35%). This is key to making the aftertax cost of borrowed money (or aftertax yield on excess cash) very low. Then we have two criteria for growth. Both earnings per share and free cash flow (cash from operations minus capital expenditures) have grown more than 10% over the last three years. No sense buying in shares that earned $50 last year if those earnings are destined to collapse to $25 next year.

The stocks to avoid are those with opposite characteristics. They are repurchasing shares but have no business doing so. They are trading at rich multiples of 27 or more, they have got rickety balance sheets, and their credit ratings were pulverized by Moody’s. Moody’s says almost all are borrowing money for buybacks.

Link here.

Maybe REITs are burnt out, but there are other ways to get some real estate into your portfolio.

Some smart money says that the party is over for real estate investment trusts, closed-end funds that own portfolios of buildings. Samuel Zell, one of the geniuses of the field, just cashed out. The experts at Green Street Advisors are sounding caution bells. Our columnist James Grant says that REIT prices are way out of line with earnings.

Give up on real estate? No. Instead, find other stocks that give you exposure to land and buildings. Martin Whitman’s iconoclastic deep-value shop, Third Avenue Management, is not terribly keen on REITs, but it has a real estate fund nonetheless. The manager, Michael Winer, 51, much prefers real estate operating companies. His Third Avenue Real Estate Value Fund (with $3.5 billion in assets) has an annual total return over five years of 22%, roughly matching the MSCI U.S. REIT Index.

Winer notes that most U.S. REITs are trading at or above net asset value, while the operating companies he has invested in trade at discounts to what private buyers would be willing to pay for them. “They are not as widely known. And they don’t normally provide investors with dividends,” he says. His fund’s biggest wager is on Forest City Enterprises, whose shares have returned 50% over the past year. This company focuses on large, mixed-use urban developments. Another large holding is St. Joe Co., the largest private landowner in Florida. Back in the day, St. Joe had operations in paper, timber, sugar, phone systems and railroads. Now it is a developer, turning old timber stands to residential and commercial use. Its shares, recently at $57, are off by a third from their $85 high in July 2005. Florida is, for the moment, overbuilt. But someday that raw land will be valuable again. Buy 1,000 shares of this stock and you are the indirect owner of 11 acres.

Another land bank in the Winer portfolio is Tejon Ranch (NYSE: TRC), which owns 270,000 acres within 60 miles of Los Angeles. Environmentalists have serious concerns about its development. Winer is confident the plans will eventually proceed. Winer, who has been on Tejon’s board since 2001, notes that Third Avenue got into Tejon stock a decade ago and it may not see a big payoff on the investment for many years. “We are very patient investors,” he says.

He likes Brookfield Properties (NYSE: BPO). It owns, develops and manages North American office properties, but it is not a REIT. Earnings are not much, but it has strong, stable cash flow that keeps rising and a lot of hidden value in its assets waiting to be developed. Third Avenue also has a big stake in Brookfield Asset Management, which owns 50% of Brookfield Properties.

Winer has 13% of his invested assets in Hong Kong-listed developers, up from 1% two years ago. Companies there trade at substantial discounts to their probable liquidating value, operate in a territory that respects private property and issue reports in English. One, Henderson Land Development, owned by billionaire Lee Shau Kee, is focused on Hong Kong and mainland China. You can buy here via American Depositary Shares.

Link here.
Still got the nerve for investment real estate? Snatch a place with built-in tax breaks – link.

BDCs are closed-end funds akin to private equity funds, but liquid and available to the average investor.

Resentful about missing out on the private equity boom? You no longer have to sit on the sidelines and watch professional money managers and wealthy investors reap all the rewards – and take all the risks – with private equity. These creatures, called business development companies (BDCs), do much the same thing as private equity funds, but they are accessible to anyone with the means to open a brokerage account.

A BDC is a holding company that invests mostly in the debt or equity of operating companies, typically private businesses. As such, the net asset value of a BDC does not fluctuate as much as that of a closed-end stock fund that invests in publicly traded stocks. A BDC’s chief executive is more likely to be an investment manager than an operations type, and managers tend to run these businesses more like venture capital or private equity firms.

Vernon Plack, a security analyst ranked best among his peers at forecasting earnings in the capital markets sector, follows BDCs for BB&T Capital Markets. Plack, 44, first noticed them in the early 1990s while covering banks and thrifts. He thought that investors who liked the bank stocks would also be interested in the BDCs, mostly for their yield.

Of the 22 BDCs currently trading on U.S. exchanges, 18 have gone public this decade. As the public appetite for all things private seems unlikely to wither, expect new BDC offerings to increase. We list the biggest ten by market cap. Over the past year almost all have delivered double-digit total returns (stock price appreciation plus reinvested dividends). The largest is American Capital Strategies (NASDAQ: ACAS). The best-returning BDC of the bunch is Capital Southwest (NASDAQ: CSWC), which has holdings in publicly held giants like AT&T and also in smaller, private outfits like PetSmart. Allied Capital (NYSE: ALD), the oldest of the BDCs (it went public in 1960), first attracted Plack. At the time Allied Capital was a one of a kind. Plack has seen the BDC business grow up from nothing to an industry with a market capitalization of $20 billion. While returns have been strong for most BDCs lately, Allied has suffered setbacks. Allied shares are basically flat compared with a year ago.

Though BDCs are not allowed to take on as much leverage, they are similar to REITs. A BDC is not taxed on corporate income as long as it distributes 90% of its profits to shareholders in the form of a dividend, though some BDC dividends are taxed at income levels. The BDC structure works best for companies that are issuing debt such as mezzanine loans and preferred stock that generates income, says Plack. The average BDC yields 6.4%. MCG Capital has the highest yield: 10%.

Currently Plack is recommending Technology Investment Capital (NASDAQ: TICC), which saw dividends rise 20% this year over last. It has a portfolio of 20 technology companies. TICC focuses on companies with less than $200 million in sales or enterprise values (market cap plus debt net of cash) below $300 million. Plack also likes Compass Diversified Trust (NASDAQ: CODI). He thinks it will nudge up its above-average 6.9% dividend yield next quarter. It has six companies in its portfolio, and unlike TICC, Compass seeks a controlling interest in all of its investments. It invests only in U.S.-based companies with cash flow of at least $5 million a year. Compass owns stakes in a medical-device maker, an industrial company and a promotional products firm, among others.

Smaller BDCs might not offer adequate liquidity. Equus Total Return, for example, which went public in 2000, has a market cap of just $73 million. The best liquidity can be found in BDCs with market caps of over $400 million.

Link here.

Want a nice dividend so you can cover your heating bill? You could buy a utility stock, or you could put the money into a geothermal system.

February was brutal in Chicago. Temperatures fell below zero on eight days. But Michael Yerke spent only $250 that month heating his 4,650-square-foot home in the tony Lincoln Park neighborhood. He got help from a heat pump stored in a utility closet in his basement and hooked up to a loop of pipes buried underneath his home. He figures the pump is saving him $2,000 a year, enough to recoup the installation cost in eight years.

Geothermal systems are quiet, long lasting and fashionably green. The 150-year-old technology is being rediscovered, inspiring more urbanites and suburbanites to tap into the power supply under their feet. But if you dig, avoid a few pitfalls. ...

Link here.

Owning gold can give peace of mind. Some ways are more bothersome or risky than others.

In the pantheon of commodities with nice price runs over the past several years, gold has a special shine. Gold is what investors turn to when they are scared. If you want to make money, buy stocks. If you are afraid of losing all your money, buy gold. That is because gold’s price is not correlated, positively or negatively, with stock market averages. It is more closely tied to how investors think the economy, inflation and the dollar are doing. Since the dollar has been weak recently, gold prices are up. Worries about international instability and oil shortages add to its allure.

The price of a troy ounce, $666 in early May, is considerably up from last year’s average $606. That is not as high as the alltime peak of $850 in 1980, when double-digit inflation was rampant and oil was, it seemed, headed to $100 a barrel. But that $850 in today’s dollars is $2,275. So by this yardstick, gold now has some catching up to do. Jeffrey Christian of CPM Group, a New York commodities research firm, is a gold bull. His case? “The things that caused investors to buy record amounts of gold have not gone away and will not go away anytime soon.”

More than a physical commodity, gold is a symbol, harking back to the times when the world’s monetary systems were based on it. Universally recognized as a store of value, gold can be bought and sold in any country. There are 4 billion ounces of gold in people’s hands, enough to fill a cube 60 feet on a side. Of this, investors own 1 billion and central banks another billion, with the remainder in jewelry and other baubles. Last year 79 million ounces were extracted. Two-thirds went to jewelry makers and the rest to bullion.

The uneasiness that has prompted higher gold prices can be found everywhere, but especially in the developed world. Since 2003, Christian notes, investors have been hoarding gold in Australia, Malaysia and Thailand, all places with no political risk – that is, their governments have historically not frozen private assets. If some economic disaster arises that prevents these investors from getting at their cash or getting value from it, they still have their gold.

If you want to own gold that you can touch, you can buy bullion, but you will pay a pretty price. There will be a markup when you buy it, a markdown when you sell it and fees to store and insure it. In some states, and certain cities, make you pay tax on purchases. You can also get one-ounce gold coins from dealers. The most popular are the American Eagle, the Canadian Maple Leaf and the South African Krugerrand. They all trade at a premium to their metal content. Whether it is in bar or coin form, you will need insurance for your gold, both while it is in transit from the dealer and when it is in your storage container. If you choose to keep it in your basement, be aware that your homeowner’s insurance probably will not cover it.

But do you need to touch your assets? Bruce Greenwald, a professor who heads Columbia Business School’s value-investing program, says it is dumb for individual investors to own commodities directly. One idea is to buy an intangible that tracks gold. The first gold bullion ETF StreetTracks Gold Shares, started trading on the Big Board in 2004. At 25 million shares traded per week and backed by 500 tons ($10 billion) of metal, this has the deepest liquidity of the gold-related ETFs. It and its twin, iShares Comex Gold Trust, which trades on the American Stock Exchange, run up annual expenses of 0.4% of assets. Both trade within 1% of their NAV. Another ETF is the Powershares DB Gold Fund, with net assets of $22 million and a 0.54% annual expense burden. This fund owns gold futures, not bullion. Because you simply own ETF shares, you are taxed in both cases on gains.

Or you could buy gold futures on your own. A 100-ounce contract on the Comex gives you the same exposure to the metal as a $67,500 investment in Powershares DB Gold. You can buy a contract with only 10% or 15% down, but it is not a good idea. Plunk down the whole $67,500 in your futures account and invest most of the collateral in Treasury bills. Advantage to direct purchase: Saving that 0.54% annual expense burden the ETF charges. Disadvantage is getting nicked by futures exchange floor trader. How far out should the future go? Comex trader Stephen Spivak recommends going out one month, known as the front month. You will pay capital gains rates on your futures gains, and your interest income from the Treasurys as your collateral will be taxed at ordinary income rates. Long-term capital gains are taxed at 15% and short term at your regular marginal tax rate.

Another way to get gold exposure is via mining stocks. These shares rise and fall as the price of gold does, but they tend to be three times as volatile. The main reason for volatility is operating leverage. If it costs a mine $400 to get an ounce, then a 10% move in the price of gold from $600 to $660 increases the gross profit by 30%. An ETF exists for mining stocks, too: Market Vectors Gold Miners. The $609 million fund has 36 stocks and runs up a 0.55% expense tab.

Among open-end funds, one of the hottest is the $175 million Midas Fund, with a 30% annual return over the last five years. Annual expenses are 1.96%. Two of the cheaper gold funds are American Century Global Gold Fund and Fidelity Select Gold Portfolio. If you want a piece of the gold business downstream, you always can buy stock in the nation’s largest gold merchant: Wal-Mart.

Link here.

Looking at investing in Asia but want to avoid the volatility? Add a dash of income-generating companies to your mix.

The Asian stock market yields the same 1.8% that you get on the S&P 500, but those Asian payouts have better prospects for growth. Dividends from Asian companies, excluding Japanese ones, have risen threefold during the last decade, while dividends from Japanese companies have doubled over the same period. The payout on the S&P 500 was $24.70 per share last year, up 66% from $14.90 per share a decade ago. “Sentiment is shifting. Investors are discovering that the emerging markets are also good dividend plays, with greater upside returns versus those in the developed markets,” says Joseph Quinlan, chief market strategist at Bank of America.

Countries like China, Taiwan, Singapore, Indonesia and Malaysia are all home to companies with high dividend yields and the underlying economic growth to expand them. Dividend-paying companies are perceived to be more mature, do not grow unsustainably fast and, as investors do not value them as growth stocks, are cheap. But, as in the U.S., you have to be wary of high yields built on unsustainable cyclical earnings.

One reason Asia has taken to the dividend is that share buybacks, now an accepted mechanism in the U.S. for distributing cash to investors, have not yet caught on there. U.S. managers have a cynical reason to prefer a share-boosting buyback regimen over a quarterly payout. It makes their options more valuable. Executive stock options are far less prevalent in Asia.

Several funds available to U.S. investors are dedicated to making money in Asia through dividend stocks. One of the newest is the Matthews Asia Pacific Equity Income Fund. The fund has $45 million under management, an expense ratio of 1.5% and net yield (after those expenses) that will probably be between 2% and 3%. Manager Andrew T. Foster says dividends put companies on a “capital diet”. A company has to stay lean to pay out income to shareholders. Foster has 18% of his portfolio in China and Hong Kong. One of his holdings is PetroChina, #41 on the Forbes Global 2000 ranking of blue chips. This oil company paid out $8.8 billion in dividends in 2006. The stock yields 3.1%. China’s average dividend yield of 2.1% is outclassed by Thailand’s 4.3%, Taiwan’s 4.1% and Singapore’s 3.4%.

Another Matthews holding is Taiwan Semiconductor, an affordable stock at 14 times trailing earnings. The company started paying a dividend three years ago and now yields 4.3%. Foster says the once capital-hungry chipmaking industry is changing and will not need as much money for factory building. This company had $4.2 billion in the bank at last count and only $615 million in interest-bearing debt.

Edmund Harriss, portfolio manager of the $4 million Guinness Atkinson Asia Pacific Dividend Fund, says Asian companies in the last decade have gotten better at managing their cash, debt and capital expenditures. Before, he says, companies were too focused on expanding to keep up with their booming economies. Now they occasionally think about their responsibilities to investors. Harriss’s fund is so tiny and costly (expense ratio, 2%) that you probably do not want to own it. But you can crib from it.

Link here.
Asia’s new Silk Road – link (scroll down to piece by Chris Mayer).


Higher prices for commodities from coffee to soybeans and iron ore to crude oil, have brought new-found wealth to Brazil. Since the election of President Lula de Silva in 2003, Brazil has emerged as a major player in global trade, and its currency – the real, has climbed by 70% against the U.S. dollar, with a trade deficit shifting into a massive surplus. The Bovespa index on the Sao Paulo Stock Exchange reached a record high of 52,750 this week, and is up 18.2% so far in 2007.

Brazil economic output rose to $1.6 trillion last year, or half of South America’s GDP, and making it the 9th largest economy in the world. Brazil occupies half the South American continent, contains half of its population with 200 million, and is the 5th most populous country in the world. However, there are vast disparities in the distribution of the country’s land and wealth, and Brazil has the greatest number of people living in poverty in all of Latin America.

Still, Brazil’s arrival as a global economic power is linked to its vast mineral resources, particularly iron ore, which is highly prized by major steel makers in China, Europe, India, Korea, and Russia. Thanks to the development of Petrobras’s offshore oil fields, and the country’s extensive use of ethanol, Brazil has also become self-sufficient in energy, ending decades of dependence on foreign oil imports. Brazil is blessed with other valuable minerals such as chrome ore, copper, manganese, diamonds, gem stones, gold, nickel, tin, bauxite, uranium, platinum, and zinc. About a third of Brazil’s economy is linked to agriculture. It is the world’s largest exporter of coffee, sugar, cattle, orange juice, and surpassed the U.S. as the biggest exporter of soybeans in 2006. The rain forests of the Amazon River basin produce timber, rubber, and other forest products such as Brazilian nuts and pharmaceutical plants.

The emergence of the “Commodity Super Cycle”, combined with a global economy expanding at an annualized 5% rate for the past four years, helped to lift Brazil’s exports to a record $137 billion in 2006. Brazil’s trade surplus expanded to $47 billion last year, up from $2.6 billion just 4 years earlier. But beneath the glossy export figures are some worrisome trends. Higher export prices accounted for 72% of the increase in Brazilian exports last year, while foreign sales volume increased by only 5.3%, much less than the 11.6% growth in 2005 and the 17.6% in 2004. The unrelenting strength of the Brazilian real is starting to cut into exporter earnings, and would become more troublesome for exporters if global commodity prices flatten out or move lower in 2007.

Over the past 14-months, the Bank of Brazil (BoB) fought hard to prevent the real from appreciating against the currencies of its major trading partners in Europe (26% of trade) the (24%) and Asia (12%). Each day this year, the BoB intervened in the foreign currency market to mop-up the U.S. dollars flowing into the country, and tried to put an artificial floor under the greenback at 2.10-reals. Brazil’s finance minister Guido Mantega said the central bank’s foreign currency reserves soared to $120 billion in April, up from $52 billion in March 2006, during the bank’s 14-month defense of the U.S. dollar at 2.1-reals.

It is a 180 degree sea change from June 2002, when the Brazilian real had plunged to 2.84 against the dollar, and Brazil’s 8% Brady bond due 2014, yielded 21.1%. Today, traders are looking at with rose colored lenses, and its double-digit deposits rates of around 12.50%, are still acting as a powerful magnet for hot money flows from around the world. Global traders are snapping up many of the 50-companies listed in the blue-chip Bovespa stock index before Beijing goes on its buying spree for key assets in global markets.

On May 15th, Brazil’s central bank chief Henrique Meirelles signaled a shift in its intervention tactics by conceding that, “The central bank has no target for the exchange rate. At the same time, the central bank will not allow prices to be distorted or move in ways unrelated to economic fundamentals,” he said. Finance minister Guido Mantega also relented to a stronger real on April 27th.

The yield on Brazil’s dollar bond, due in 2040, fell to a record low of 5.50% last week, after Standard & Poor’s boosted its sovereign credit rating. “The efforts by the government to reduce vulnerability to interest rate and to foreign exchange rate fluctuations have been very positive,” said S&P, referring to the central bank’s massive build-up of foreign currency reserves. High commodity prices have boosted Brazil’s exports and trade surplus, which in turn, strengthened the real and allowed the central bank to build-up its foreign exchange reserves, which improves Brazil’s ability to service its outstanding debt, boosting its credit rating and lowering long-term bond yields. Coupled with a 16% growth rate of the M3 money supply, it is no wonder that the Bovespa index has gone ballistic.

Link here.


Driving a motorcycle to work is a risky proposition around here, especially since Autovantage.com has hipped us to the fact that Baltimoreans are amongst the top 15 rudest drivers in the nation. But that is not stopping scores of new motorcycle riders from risking road rash or worse just to enjoy 50 miles per gallon or more. Some cruisers even get well over that. It must be nice when a full tank of gas is only 4.8 gallons and costs about $14.40. But it really comes down to cost per mile. BMW motorcycles, for example, get outstanding fuel mileage, but have Sedan-like price tags. And the technology they carry easily rivals that found on their own 3-Series road cars. Look for 3-Series-like maintenance bills on occasion, too.

For most of us, motorcycles are not a viable option as daily transportation. And for areas where public transportation is almost equally unviable, we are stuck with moving at least a ton-and-a-half of steel, plastic and rubber between two points as fast as possible twice a day. AAA’s 2006 Driving Cost Guide says that it costs the average American driver $0.62 per mile to operate their car 10,000 miles a year. Now, there are a million ways to calculate that – you can include some expenses, eliminate others. But doing it the AAA way, we see a yearly expense that has been increasing some years much more than inflation. Following are the technologies most likely to keep driving costs at bay today and in the future.

Turbos – power in a small package. Once the domain of sports cars, Mercedes diesels and 18-wheelers, the turbocharger is making a big comeback. It allows engineers to use a smaller engine to achieve what a much larger, non-turbocharged engine could. A smaller engine is lighter, more fuel efficient when the turbo is not in use, and often times cheaper to produce.

Engine sizing on the fly. GM introduced this concept back in the early 1980s and it was not a success. The idea was to have a large V-8 engine that could electronically activate and deactivate cylinders as needed. So, when there was no acceleration needed, the car could run on four cylinders, and could go up to six or eight as your right foot commanded. The problem was it drove horribly. 30 years later, modern electronics make this cylinder deactivation idea viable. It is one way to gain greater fuel efficiency and decrease emissions.

Gears and gearlessness. Until recently, automatics were frequently 3- or 4-speeds. 5-speeds have now become common, 6-speeds are seen in more sporty and high-end luxury models, and now at least one manufacturer is boasting a 7-speed automatic transmission. Then there is the CVT (continuously variable transmission) that has virtually an infinite number of speeds. Big mileage gains are possible here.

But the above are only the beginning. Tires with lower coefficients of rolling friction could have a huge mileage and driving cost impact in years to come. And we could see steps that make running your car’s air condition systems cheaper as well. On that note, there is an interesting company in that field called Amerigon (ARGN). Amerigon produces a climate control seat for truck and car occupants. On the surface, the shares look pretty pricey at the moment, but this is one that we would take a closer look at a more attractive price.

Link here.


Does Bill Gross know about the former Fed chairman’s forecasting record?

As reported in Bloomberg on May 16: “Alan Greenspan will advise Pacific Investment Management Co. on strategy during quarterly economic forums ... Greenspan, 81, will join Bill Gross, Pimco’s chief investment officer who also manages [Pimco’s] $100 billion Total Return Fund ... ‘This engagement provides Pimco with unique access and insight from the former Fed chairman, whose perspective on financial markets, global economic trends, and investor behavior is truly special,’ [Pimco spokesman] Foong Hock Meng said.”

Bill Gross has admitted to confusion in recent months. Interest rates are not behaving as they should. In such a circumstance, employing an abysmal forecaster might add just the contrarian indicator that he needs. This is one possible duty for his new hire. On the other hand, Alan Greenspan’s generous press clippings may have led Pimco to a false reading of its recruit’s aptitude.

We might start with his earlier term in the federal bureaucracy. He served as President Ford’s chairman of the Council of Economic Advisers from 1974-1977. To read the press of the day, Greenspan was magnificent. By early 1975, a “top White House official” told BusinessWeek, “Greenspan has a unique personal relationship with the president.” The unnamed insider said that on “economic policy Alan is a heavyweight.” Confirmation of his skills flowed from all quarters. President Ford’s Chief of Staff Richard Cheney (known to us as “Dick”), claimed the president attached “more weight to Greenspan’s views than to those of any other economist.”

Yet the public record calls Greenspan’s skills as an economist into question. On September 5, 1974, the day after he was sworn in as head of the CEA, Greenspan announced: “We are not about to get a dramatic decrease in economic activity.” With this knowledge, he urged President Ford to propose a tax surcharge – an effort to halt inflation. This was exactly the wrong time for such a tactic (which was passed into legislation). The economy contracted 5.8% from mid-1974 to mid-1975. In April of 1975, when BusinessWeek’s glowing profile was published, Greenspan warned a New York audience that the worst was yet to come. In fact, the worst had passed. In the fall of 1975, Greenspan coordinated the “Whip Inflation Now” conference in Washington, participants donning WIN buttons to battle a foe that had already, at least temporarily, diminished as the leading economic problem. If Greenspan did set President Ford’s economic policy, this may have made the difference in Ford’s slim 1976 loss to Jimmy Carter.

Alan Greenspan’s nomination hearing for Federal Reserve chairman provided another opportunity to review his skills. He appeared before the Senate Committee on Banking, Housing, and Urban Affairs on July 21, 1987. It was chaired by Sen. William Proxmire of Wisconsin. Proxmire chided the candidate for a “dismal forecasting record” when he was chairman of the CEA. Proxmire evaluated the forward projections made during Greenspan’s term for 1976, 1977, and 1978. In Proxmire’s words, the forecasts made by the candidate were “way off.”

Proxmire went on to ravage Greenspan’s record as a private forecaster. The repartee might be compared to the 1962 Yankees mowing down the 1962 Mets. (Proxmire and his staff must be commended for such a thorough search through the Greenspan archives. During the 18 years of Greenspan’s term, the press never exhibited such energy. Proxmire retired in 1988, so we will never know what might have been.) Proxmire, observing his fellow senators were not particularly interested in this tete-a-tete, drew to a close, told Greenspan, “I hope when you get to the Federal Reserve Board, everything will come up roses. You can’t always be wrong.”

If only it were true. He made, perhaps, the least timely forecast of his career on January 7, 1973. He told The New York Times that he was highly optimistic and announced: “It is rare that you can be as unqualifiedly bullish as you can now.” The DJIA peaked at 1,051 four days later and never looked up until it bottomed at 571 on December 12, 1974, a loss of 46%. The dollar lost 21% of its value against the consumer price index over that period.

Enough of the old days. We will skip to the end. A full listing can be dreary. However, to give the distinguished economist – that is, Proxmire – credit for all he feared, we drop in on a news conference on July 10, 1991. The Maestro spoke: “I think the evidence is increasing week by week that the bottom is passed and the economy is beginning to move up ... I think itq is a pretty safe bet at this stage to conclude that the decline is behind us and the outlook is continuing to improve.” The decline was still putting on its ski boots.

Greenspan topped out on February 23, 2004. The Fed chairman tried his best to convince Americans their best interests were served by grasping for the highest priced houses by means of the riskiest loans. He opened his pitch by noting, “American homeowners clearly like the certainty of fixed mortgage payments. ... This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common.” He informed his constituents the “traditional fixed-rate mortgage might be an expensive method of financing a loan.” He advised they refinance. Refinancing generally exploited two tendencies: (1) the lower monthly payment of a variable rate mortgage and (2) a higher valuation of the house. The combination of the two often took the form of refinancing at a higher level of principal.

Only a month later, Greenspan said that rates would rise at some point. On June 30, 2004, the Federal Reserve raised the federal funds rate. Once the Fed started to raise rates, the trusting adherents to the Book of Greenspan were doomed. On October 26, 2006, the retired chairman announced the housing slump is “likely past”. Notably, not a single mortgage lender had surrendered at the time of this upbeat forecast. In the wake of this reassurance, 66 mortgage lenders have entered bankruptcy. Last fall, “subprime” was a poor cut of meat to most Americans. Now, Congress investigates why no one at the Federal Reserve forewarned of this problem. The subprime market had received a rousing endorsement from Greenspan on April 8, 2005: “With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.”

An epitaph would try the patience of the reader. Pimco’s evaluation is correct in one respect. The former chairman’s perspectives are truly special.

Link here.


Chairman Bernanke last week provided a rather broad review of the subprime issue. Below are a few selected excerpts:

“Having emerged more than two decades ago, subprime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks.”
“The ongoing growth and development of the secondary mortgage market has reinforced the effect of these innovations. Whereas once most lenders held mortgages on their books until the loans were repaid, regulatory changes and other developments have permitted lenders to more easily sell mortgages to financial intermediaries, who in turn pool mortgages and sell the cash flows as structured securities ... The growth of the secondary market has thus given mortgage lenders greater access to the capital markets, lowered transaction costs, and spread risk more broadly, thereby increasing the supply of mortgage credit to all types of households.”
“The practices of some mortgage originators have also contributed to the problems in the subprime sector. As the underlying pace of mortgage originations began to slow, but with investor demand for securities with high yields still strong, some lenders evidently loosened underwriting standards. ... Incentive structures that tied originator revenue to the number of loans closed made increasing loan volume, rather than ensuring quality, the objective of some lenders.”
“Intense competition for subprime mortgage business--in part the result of the excess capacity in the lending industry left over from the refinancing boom earlier in the decade – may also have led to a weakening of standards. In sum, some misalignment of incentives, together with a highly competitive lending environment and, perhaps, the fact that industry experience with subprime mortgage lending is relatively short, likely compromised the quality of underwriting.”
Credit market innovations have expanded opportunities for many households. Markets can overshoot, but, ultimately, market forces also work to rein in excesses. For some, the self-correcting pullback may seem too late and too severe. But I believe that, in the long run, markets are better than regulators at allocating credit.

I appreciate Mr. Bernanke’s comprehensive approach in his discussion of the subprime debacle – the interplay of “technological advancement”, “financial innovation”, “the secondary mortgage market”, “investor demand for securities”, “incentive structures”, “intense competition”, and “excess capacity in the lending industry”. At the same time, his analysis avoids the critical issue with respect to the principal responsibility borne by unfettered “contemporary finance”. Fundamentally, the proliferation of securitizations, derivatives, leveraged speculation, and, in general, “structured finance” radically distorted both the availability of credit and the perception and pricing of risk throughout the marketplace. This mispricing fostered a recursive cycle of credit and speculative excess in the financial arena, concurrently fueling asset inflation, destabilizing speculation, and maladjustment in the real economy. This is elemental macro credit analysis that the Fed shuns at our peril.

So while the chairman’s analysis is in some aspects on the right track, his conclusion misses badly. For one, the issue is definitely not one of “market overshooting”. An argument can be made today that market forces are finally reining in subprime excesses. Unfortunately, rather than correcting or self-regulating (in response to an “overshoot”), it is much more a case of highly-adaptable Wall Street “structured finance” simply abandoning subprime for greener pastures. Today, the insatiable appetite for yield is more readily satisfied by (“subprime”) loans to support private-equity, LBOs, and the global M&A mania.

It should be obvious that over-liquefied and speculative global markets are these days doing an especially poor job of regulating and allocating credit. And from a systemic perspective, it is also clear that the amount and character of credit creation and financial flows deteriorate by the month.

Bill Gross capitulates?

Elsewhere, I found Bill Gross’s “PIMCO secular forum” article fascinating. The unrelenting global credit bubble is today forcing even the more circumspect investment professionals to fancy the glass half full, to presume that glass will hold liquid for the foreseeable future, and to concede that there is little alternative than to participate semi-blindly in the runaway boom. In this performance-based financial world in which we now operate, one can only sit gingerly on the sideline for so long before the strain of underperformance becomes too much to bear.

To be sure, we are witnessing in real time the propensity for unchecked credit bubbles to (more than) sustain themselves for significantly longer than discerning analysts ever imagined. Curiously, Mr. Gross and others continue to use the terminology “stable disequilibrium” to describe the global backdrop. Such commentary is detached from the reality of ongoing credit bubble excess. A semblance of “stability” is maintained only because, first of all, the global credit infrastructure has thus far succeeded in generally channeling global flows to the securities markets, while creating the requisite ever-increasing quantities of credit and marketplace liquidity.

The greatest credit, speculation, and prices effects remain largely contained in global asset markets, with speculators content for now to be crowded tightly together on the long side. Financial crisis it is not, but it does conspicuously fly in the face of claims of “price stability”. Indeed, global asset inflation has “gone parabolic”. It is worth noting that in just the past two years China’s Shanghai Composite index has surged 265%, India’s Sensex 122%, Russia’s RTS 187%, Mexico’s Bolsa 142%, and Brazil’s Bovespa 108%.

The gentlemen at PIMCO (and elsewhere) also cling to the fanciful notion that that the global financial apparatus and economies are buttressed by a “Bretton Woods II” “monetary regime”. I will cling to the view that this perspective is also not conducive to sound analysis. Monetary regimes are disciplining frameworks accepted by participants to ensure the promotion of stable credit, financial flows, currencies, trade and economic performance. The so-called “Bretton Woods II” – the ad hoc mechanism that evolved in the global central bank community for the purpose of recycling excess dollar liquidity back to U.S. securities markets – is in reality the anti-monetary regime. Its purpose – the only reason for existence – is to accommodate credit and liquidity excess, destabilizing financial flows, unprecedented trade imbalances, and unparalleled global financial and economic imbalances. And, as we have witnessed, to accommodate is to only invite greater excess. Financial scheme, perhaps, but this is no monetary regime.

Link here.
Gloom settles over housing market – link.


Fractional-reserves, the Fed and the bubble.

The classic 1963 slapstick comedy, It’s a Mad, Mad, Mad, Mad World, begins when the occupants of four vehicles learn about hidden treasure in a fictional town in California. According to a dying man’s last words, $350,000 (about $2.3 million in today’s dollars) is buried under a mysterious “big W”, less than a day’s drive away. When the strangers cannot agree on how to share the loot, a wild race for riches ensues.

In the 44 years since, the mad dash for wealth without work has been repeated throughout countless bubbles and manias. Witness the Japanese mania and U.S. takeover bubble of 1989, the biotech bubble of 1991, the 2000 tech bubble, and more recently the 2005 housing bubble – all ending in tears. Fittingly, in the movie’s finale the protagonists fall off a fire escape and all end up in the hospital. Was the film’s director, Stanley Kramer, prescient – metaphorically speaking – or have we evolved to the current state of perfection in which the investing masses are entitled to get rich simply by tuning in to Jim Cramer’s Mad Money?

Fractional reserve madness.

The lure of easy money begins with the government printing press. First, the central banker buys an asset – typically a government debt instrument – writes a check on itself and deposits it into the banking system. Since the bank never “redeems” the check, this is equivalent to creating money out of thin air. The banker, happy to receive fresh “reserves”, loans out all but a sliver. This new money ends up back with the banks, is counted again as “reserves”, mostly lent out, and so on and so on. Through this process of fractional reserve banking, credit is expanded at a multiple of the initial central bank deposit. Through such a system, the creation of money and credit (the promise to pay money) looks like an upside-down pyramid – essentially a pyramid scheme on top of a counterfeiting operation.

As James Grant has counseled, the inflation process gives a finite pool of capital the illusion of an endless sea of liquidity, in effect “turning all the traffic lights green.” Such a scheme is a concoction of government privilege (or mercantilism), not laissez faire. The so-called “capitalists” are no longer efficient allocators of capital to its most productive uses, but beneficiaries of and cheerleaders for a monetary fraud in which capital is debased, taken for granted, abused. As long as they remain chummy with their friendly liquidity provider of last resort, they can act recklessly without fear of having to bear the costs. And as long as the value of their collateral is constantly inflated, they never feel the need to worry about default.

Liberated from the gold standard straightjacket, the system has few restraints. For starters, the counterfeiter has an incentive not to draw attention to his racket. But the effectiveness of his ongoing propaganda campaign has weakened this deterrent. The real inflationary action, however, is in credit expansion. For example, in the last 6 years, the Fed has grown its balance sheet less than $300 billion while the nation’s money supply has expanded by $4.3 trillion. The central banker can bait the hook, but lenders and borrowers still have to take the bait.

This new money is never evenly distributed, but instead gets funneled into whatever narrow area happens to capture the public’s fascination. As prices and valuations soar, greater doses of credit are required to keep the game going. Either more marginal borrowers are drawn in at ever more precarious levels or greater leverage must be applied to existing borrowers. This is what ultimately doomed the housing bubble. In the end, nearly anyone who could fog a mirror was getting an invitation to join the party. Eventually, the number of willing dupes is exhausted. The same people who panicked late to get into the game are just as likely to panic when the music stops. The longer the music plays, the more leveraged and unstable the inverted credit pyramid becomes. As the late economist Hyman Minsky observed, “stability is unstable.”

The trouble with stability.

The current Federal Reserve experiment with stability began on January 3, 2001. With the Nasdaq Composite down 55% from its March 2000 peak and a bursting technology bubble threatening to plunge the economy into recession, the Fed began lowering rates. The impact was immediate. The Nasdaq rallied 14% that day and stood 24% higher four weeks later. But misplaced faith in central bankers is commonplace at major tops. In April, 1929 Financial World reassured its readers, “It may be well again to stress the all-important point that the Federal Reserve has it in its power to change interest rates downward any time it sees fit to do so and thus to stimulate business.”

Q1 2001 saw a spike in corporate bond offerings, including aggressively priced zero coupon convertible bonds by Enron and Tyco International. MCI WorldCom issued $10.8 billion in investment grade bonds – the second largest bond offering on record at the time. Within 18 months the company was bankrupt. For two years the Fed pounded the funds rate relentlessly from 6.40% to 1.24%. Regardless, the tech balloon continued to deflate, with the Nasdaq collapsing another 61% from its January 2001 high to its October 2002 low. The Fed was, however, successful in avoiding the bogeyman of deflation as cheap credit lit a fire under the housing market. From 2000 to 2005, homebuilding stocks leapt 9-fold. Lending standards eroded and, as home prices moved out of reach of the average American, “affordability products” such as interest-only and negative amortization loans became the rage. As it turns out, Time magazine pegged the top of the housing bubble with its June 13, 2005 cover, “Home $weet Home: Why we’re going gaga over real estate.” Time captured the zaniness of the times: “If home is where the heart is, it is now where ever more of your cash is. And when love and money collide, things can get a little crazy.”

As the new millennium unfolded, the engine of wealth creation shifted from technology to finance. In 2000, technology claimed 99 members of the Forbes 400 who accounted for 40% of the total wealth. By 2006, real estate, investments and finance boasted 140 members and a record 27% share of the billionaire market, while technology slipped to 17%. Another sign of the times (and hubris) is the naming rights on stadiums. From 2000 to 2007, the number of financial sector stadiums doubled from 12 to 24, while tech names slipped from 12 to 9. The Class of 2000 was notable for a number of corporate implosions such as PSINet Stadium, CMGI Field, MCI Center, and Enron Field. In fact, 19% of the sponsors eventually went bankrupt. The Class of 2007 includes Chase Field, Wachovia Center, and Quicken Loans Arena. 19% of today’s naming rights sponsors are banks. It appears the Fed experiment in monetary stimulus from 2001 to 2003 didn’t just ignite a housing bubble, but fomented a full-blown credit bubble.

Credit assembly line shifts into high gear.

More than in any previous cycle, a sophisticated assembly line has developed to facilitate the creation of credit and expansion of leverage. The days of the neighborhood banker on a first name basis with his customer are long gone. Loans are now originated, packaged into securities by Wall Street, endorsed by insurance companies and ratings agencies, and sold to investors. The assumption is that each of the gatekeepers is unbiased and financially sound. Yet commercial banks such as Citigroup have assets-to-equity of 12 times, investment banks are typically levered 25-to-1, and bond insurers like Ambac and MBIA guarantee 80 to 90 times their capital. If a chain is only as strong as its weakest link, there is plenty that could go wrong with the great intermediation of credit creation.

Investment banks have reveled in an elevated role during this credit cycle. In the past six years, the Fed grew its balance sheet 50%, money supply expanded 60%, and the Top Five investments banks increased total assets by 160%. In the latest quarter, the total assets of Goldman Sachs exceeded total bank credit at the Fed for the first time. Structured finance has become a lucrative business as nearly $500 billion in collateralized debt obligations (CDOs) were issued in 2006 alone, a 60% increase. To at least one cynic, Barron’s editor Thomas G. Donlan, “The work of Wall Street often is to introduce people who should not borrow to people who should not lend.”

The credit rating agencies not only sign off on the soundness of the gatekeepers (all investment grade, of course), but on the securitizations themselves. (They also designed the structures with the help of Wall Street.) Without their blessing, institutions such as insurance companies and pension funds would be restricted from investing. Yet the rating companies get paid by the credit issuers – a clear conflict. In fact, structured finance now accounts for over half of Moody’s ratings revenue.

The credit assembly line would not be complete without the end demand of the loan holder. In particular, many public pension funds which got addicted to the strong returns of the late 1990s bull market have been climbing the risk ladder in order to keep employer contribution rates low. Driven by the mantra that diversification into “alternative investments” can deliver the holy grail of higher returns with reduced risk, pensions have moved aggressively since 2000 to place funds with highly compensated managers who have the ability to add leverage and trade more actively.

Condo flipper passes torch to professional speculator.

From our perch, it appears the slowly deflating housing bubble has simply morphed into a massive professional speculator bubble, driven by commercial real estate, hedge funds, and private equity.

The number of real estate sector funds has doubled since 2000 and now exceeds the number of technology funds. Commercial mortgage-backed securities (CMBS) issuance is expected to exceed $350 billion this year, credit spreads are widening, and leverage is increasing. According to Moody’s estimates, the average loan-to-value on CMBS was 111.6% in the first quarter, up from 90% in 2003.

Signs of excess are everywhere with regard to hedge funds and private equity. More bells are ringing than at an Austrian downhill. Exhibit A: the highly successful IPO of Fortress Group and the proposed IPO of Blackstone Group. Steve Schwarzman, CEO of Blackstone, recently graced the cover of Fortune as “the new king of Wall Street.” U.S. private equity firms raised $160 billion in 2006 and are on pace to double that take this year. During the tech bubble, venture capital inflows went parabolic as well, peaking at $91 billion in the year 2000. The same investment banks who acquired tech underwriters in 2000 and subprime loan originators in 2006 are now busy snapping up hedge funds. According to Bridgewater Associates, hedge fund borrowings were $1.46 trillion last year, up from just $177 billion in 2002. In addition, investment banks are no longer content to play with other peoples’ money (“OPM”). They are putting record amounts of their own capital at risk. For example over two-thirds of Goldman Sachs’ net revenue now comes from trading and principal investments versus one-third five years ago.

Living on planet leverage.

On April 30th, The Wall Street Journal featured a cover article about the copious amounts of leverage employed by the professional speculator community. They quoted a senior credit analyst at Standard & Poor’s: “There’s leverage everywhere – whether at corporations or broker dealers or hedge funds or private equity funds. It sort of feels like something’s got to give.” The conclusion of the two WSJ journalists: “We’re living on planet leverage.”

The American consumer has been living on planet leverage for quite some time, having taken on another $5.5 trillion in debt just the past six years – an 85% increase. Despite generation-low interest rates and a housing boom for the ages, homeowners’ equity is at all-time lows and the consumer’s balance sheet has never been more stretched.

Cracks are already appearing in the credit façade. Year-to-date, the Bearing Credit Bubble Index (a proprietary composite of 22 credit-related stocks) has underperformed the S&P 500 by over 10%. Sub-indices closest to the mortgage finance bubble are particularly weak, with homebuilders –16.3% and subprime lenders –54.8%. It appears the Fed experiment in monetary stimulus from 2001 to 2003 did not just ignite a housing bubble, but fomented a full-blown credit bubble.

The trouble with liquidity.

Liquidity remains the rallying cry of the bulls, just as it has at the top of every bubble. But they confuse cash on the sidelines with ready access to credit. As BlackRock CEO Laurence Fink recently warned, “Probably the greatest issue that is confronting the world’s investors is we are trading liquidity for illiquidity.” With mutual fund balances and mutual fund cash levels at record lows, the fuel to power stock prices higher is depleted. The strain of liquidity that has financial markets on steroids is cheap credit, a fair weather friend who will turn tail at the first sign of trouble.

Perhaps the ultimate contrary indicator of this credit cycle will be BusinessWeek’s February 19, 2007 cover story, “It’s a Low, Low, Low, Low-Rate World”. BW’s authors gushed, “Borrowers, of course, are deliriously happy. Even the shakiest companies are seeing their debt costs plunge ... Most remarkably, the craziness isn’t likely to stop anytime soon.” Sound familiar? Simply substitute “home buyers” for “companies” and this quote could have easily appeared two years ago at the top of the housing bubble.

As the actors in this madcap movie continue to chase that illusive pot of gold buried under the “big W”, we cannot help but be reminded of the advice of InvesTech Research editor James Stack: “Never confuse an economic miracle with a liquidity bubble”. As the great Austrian economist Ludwig von Mises warned, “There is no means of avoiding the final collapse of a boom brought about by credit expansion.”

Link here.
Make that a Cheap Money Bubble to go – link.


Recent news reports highlight the difficulties some troubled borrowers are facing when trying to renegotiate payment and other terms with lenders. In many instances, the problems stem from the fact that the loans have been sliced, diced, and repackaged into mortgage-backed securities, which have then been sold to investors in the U.S. and around the world. Aside from stymieing efforts to interact with final decision-makers, the shift to a securitization-based financing model has also reduced the flexibility and “human element” associated with the old-fashioned approach. Nowadays, lenders are much less interested and have little incentive to work with any one borrower – out of the hundreds or more in an MBS “pool”, for example – than previously.

Unfortunately, these are not the only unintended – and unwelcome – consequences of the spectacular boom in securitized lending. The more serious downside threat stems from the systemic dangers this risk-shifting mechanism has introduced into the global financial framework. Few would argue with the notion that sharing risk helps to cushion the blow from small “shocks”. Unfortunately, shoveling layers and layers of myriad risks into every nook and cranny of the global financial system also boosts the odds that a “black swan event” – an unexpected economic or financial rupture – could bring down the entire house of cards. Some policymakers argue, in fact, that securitization ensures that large-scale upheavals will be anything but contained.

Some of the dangers emanating from the vast expansion in securitized lending derive from the incentives inherent to the current structure. Unlike with traditional financing arrangements, where profits accrue over the life of a loan, lenders nowadays expect to garner the bulk of their profits up front, in the form of fees and net proceeds from the sale of the obligations. This has spurred a widespread emphasis on short-term profits at the expense of longer-term stability. Naturally, banks and other lenders focus on quantity rather than quality – i.e., the volume of loans they can originate and the amount of money they can realize up front, rather than borrowers’ willingness and ability to repay the debt, long-term potential, or the broad banking relationship.

Distorted incentives have also promulgated “moral hazard”, especially during a time of easy money. Strong demand from yield-hungry investors and an aggressive push by bankers to come up with the goods has caused standards to fall sharply. Together with the fact that risk is quickly passed along to others, the modern approach to lending has boosted bad credit-granting decisions to an unprecedented degree. Consequently, when the credit cycle turns negative and the economy rolls over into recession – if it has not done so already – a far greater portion of outstanding loans will turn sour at a much faster pace than in the past, kick-starting a swirling snowball of defaults that will have a devastating knock-on effect throughout the economy and the financial system.

Moreover, cheap financing, seemingly unlimited opportunities to garner high fees and short-term profits, a significant increase in global trading and arbitrage, and the complacency that normally accompanies periods of unusual stability have all helped to nurture the illusion that there will always be a market for any sort of tradable instrument. That, in turn, has encouraged investors and speculators to buy and sell with near reckless abandon, concentrating in areas that seem to offer the juiciest returns, and following the herd into ever riskier investments – with little regard for the downside. Believing that they will always have an “out”, money managers have become entranced by securitization alchemy, buying any sort of rubbish as long as it has been sprayed with “eau de liquidity”.

Compounding matters, many are unwilling to sell before the “top”, or to take any defensive measures in advance of potential bad news. That means, naturally, that everyone will be looking to do the same thing, at the same time, with the same sense of urgency when circumstances turn for the worse. That guarantees that markets will lock up and losses will accelerate at an alarming rate. For all the so-called disadvantages of owning “illiquid” investments, as when lenders made loans and held them until maturity, managers took at least some steps to prepare in case things went horribly wrong. They knew, unlike the highly leveraged and asymmetrically rewarded financiers of today, that bad decisions would almost certainly have painful consequences.

Ironically, the absence of a visible market also dampens the angst and panic that results from seeing values evaporate on a computer screen. When volume dries up, spreads widen, and bids disappear altogether, many of today’s New Age investors will wish they had the luxury of known illiquidity, rather than being stuck with the ball-and-chain of illusory liquidity.

Historically, investors and policymakers have relied on the level of interest rates, risk spreads, and credit availability to gauge the pulse of Wall Street and Main Street. Securitization has distorted those signals, not least because the monetary policies of nations around the world, whether good or bad, flow readily from market to market, muddying the economic waters.

It would be hard to argue that securitized lending has not benefited society by boosting efficiency and enabling risks to be shared in a way that was not really possible before. Even so, the phenomenal expansion of the modern risk-shifting approach has had numerous unforeseen consequences. Experience suggests that too much of a good thing – sunlight, fine wine, rich food, or, in this case, eau de liquidity – usually turns out to be pretty bad.

Link here.


The immigration bill brought forward and apparently likely to pass demonstrates an unattractive new political trend in the U.S.: the end of the classless society for which the U.S. has been famous and the opening of yawning political as well as economic gaps between rich and poor. Traditionally, the U.S. has been economically unequal, but without a sharp divide between rich and poor in the political arena. Democrats represented the South, minorities and unionized labor, while Republicans represented small business and the professional classes. The truly rich have always been more or less evenly divided between the parties. Thus, except for a brief period in 1932-46, the U.S. never had a real class-based politics.

One economic force was always likely to change this – the steady increase in inequality seen in the U.S. since about 1969. The household Gini coefficient of income inequality has risen from 39.7 in that year to 46.9 in 2005 – extrapolating that trend would suggest a figure of 47.3 by today.

At around 40, the Gini coefficient was close to the optimal level. Unlike in egalitarian Scandinavia it left enough incentive in the society to ensure that entrepreneurship and hard work were fostered, but yet it did not cause divisions between classes. At 47, it is approaching the level prevalent in Latin America, (Argentina 52, Mexico 55, Brazil 60) which has historically exhibited a politics characterized by deep alienation between classes, producing as rulers an unpleasant collection of corrupt oligarchs and irresponsible leftists.

The counterproductive Latin American politics appears to result from excessively high inequality. The important driver is that the conditions of the classes are so radically separated, and the likelihood of poor people working themselves into the middle class so distant, that politics ceases to be a process of attempting to produce a better society and instead becomes a corrupt search for rents. The elite control the system for most of the time, diverting public resources to their own use and securing reelection by offering state handouts to the impoverished masses. The masses in turn have no incentive to vote for a party that might allow them to better themselves, so regard politics only as a process by which handouts are produced. The "Christian Democrat" parties so common in Europe, to some extent represented historically in both major parties in the U.S., never really appeared in Latin America.

This does not appear to be purely a cultural problem. Similar pathologies appear in Africa, when the society gets rich enough to have wide divisions of wealth, in the Middle East, to the extent democracy exists there, and in certain Asian societies such as the Philippines, with the highest Gini in Southeast Asia at about 48. It is particularly worrying that there are no recorded cases of a middle-income or wealthy country with a democratic government successfully emerging from a Latin American income distribution. Once such a distribution is entrenched, economic growth slows to a crawl and the pathological social system becomes permanent.

H.G. Wells postulated in his 1895 Time Machine the ultimate destination of a Latin American-style social system. In his future 800,000 years hence the human race has divided into two species, the eloi, who do no work and live only for trivial aesthetic pleasures and the morlocks, sub-men who work underground keeping the mechanical civilization running. Wells’s fantasy seemed far-fetched after 1920, as equality increased and the working classes became both educated and comfortably off. However the fantasy looks a lot closer to reality in 2007 than it did in 1957, when the movie was made.

In the U.S., one would expect political activity to begin showing Latin American characteristics, including a breakdown in social cohesion, as Gini rises towards Latin American levels. This appears to be happening. One example is the doubling since 2000 of the number of Washington lobbyists, whose objective is primarily to divert public resources to private uses. A second is the growth of earmarking in legislation, up 10-fold in the decade to 2005. Earmarks are generally inserted in order to benefit some private interest at the expense of the general good. U.S. politics has always been corrupt, and was especially so during the 1870-96 Gilded Age, the previous high point for inequality, but the increase in the proportion of GDP spent on lobbyists, on corrupt government spending, and indeed on elections themselves suggests that systemic corruption is rapidly increasing.

The new immigration bill is above all an example of class legislation. The Immigration Act of 1924, which largely restricted immigration to the richer countries of northwest Europe, produced the greatest social leveling the U.S. has ever seen, with the Gini coefficient declining by around 10 points between 1920 and 1965, the years of its salience. After 1965, immigration policy was reversed, to encourage a larger flow of immigrants, primarily from developing countries. Initially, this had only a modest economic effect. Then the 1986 amnesty encouraged low skill immigrants, allegedly now numbering 12 million, to try their luck with the overstretched immigration bureaucracy.

Whatever the economic effect of moderate amounts of skilled immigrant labor, almost certainly positive, the economic effect of large amounts of unskilled immigrant labor is very clear: it drives wage rates down to rock bottom levels, particularly in personal service sectors where training is minimal and employment informal. It is why even modest middle class households now have a cleaner and a gardener, and it is why enormous numbers of dubiously-constructed houses appeared when finance became available in 2002-06.

For the elite, the eloi of the HG Wells future we appear to be entering, this is all very attractive. The servant problem, butt of jokes ever since equality began to increase after World War I, has suddenly gone away – the rich can and do have as many servants as they want, provided they speak Spanish. Those who employ low skill labor no longer need make any pretence of paying union wage rates; they can simply hire illegal immigrants to fill any gaps that may appear. Corporate profits are at record high levels and service sector inflation, a bane in the 1970s and 1980s, has more or less disappeared.

The claim by eloi pro-immigration forces that the U.S. economy has a massive new “need” for unskilled labor is of course pure bunkum. If there are 12 million illegal immigrant workers in the economy, about 8% of the working population, then since we know the value of output, productivity is in reality about 8% lower than we thought it was. That means that productivity growth, far from accelerating in the mid 1990s as Wall Street fatuously claimed, in fact slowed, as more and more bodies were required to achieve the same output. GDP may have continued to increase, but GDP per capita is also 8% less than we thought, and hence has shown little growth. It is this that has caused the curious phenomenon of an apparent rapid increase in GDP that in practice makes nobody any better off.

However attractive illegal immigration is to the eloi, it is hell for the morlocks. Instead of the well paid factory jobs their fathers had, making physical products in which they could take pride, they are now reduced to competing with infinite numbers of illegal immigrants for personal service, retail and construction jobs that have not been mechanized or outsourced. The inability of the morlock element to achieve the modest comfort of their fathers brings other social pathologies. Since the morlocks are unable to “settle down” to marital bliss and a decent standard of living, illegitimacy and crime increase – only partly from the immigrants, legal or illegal, but also from the impoverished population as a whole. Political activity no longer offers hope of assistance, so they cease to vote or participate in politics, either directly or indirectly through unions and fraternal organizations. There is little point in saving, so they run up gigantic credit card debts. The eloi in turn withdraw themselves to gated communities, and Wells’s dystopia grows ever closer.

The new immigration bill, with its ineffectual enforcement provisions and its enthusiastically inserted loopholes through which even more immigrants can arrive, is perhaps the most socially divisive policy since the taille of the French ancien regime, a tax that was exacted from the poor and the middle class but not from the nobility. It stems from the same cause as the taille, a desire by the political class and its financial backers to entrench their superiority over the common herd.

Our choice of future is thus clear: Wellsian dystopia, or the Terror.

Link here.


Beating the S&P 500 has become like a golf handicap, expressed in a number that gets bandied about, and maybe embellished a point or two, to impress any financial “mind” polite enough to listen. The goal is simple, But for many, the attempt is futile and childish, grossly naïve in its fundamental premise. Most try, but few succeed.

50 years ago, keeping your head above water meant saving a dollar. Now, squeaking by has become the 13% annual return that nearly ruins a manager’s financial career and reputation by narrowly clearing the S&P by a mere 50 basis points. But there is a new American generation ... an entitlement class of children playing children’s games, weaned on the bottle of instant gratification. They expect more for less. They have been assured that it is OK to spend more than they make, because in the end, the government will be there to brace their fall.

Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite that the consumer savings rate for all of 2006 remained a negative 1%. 2005-6 produced the most reckless lack of savings since the negative 1.5% savings rate in 1933, during the Great Depression. So while most Americans woefully stare at double-digit APRs as they cut another check for the minimum monthly payment, the debt continues to rise. It will not be long before the notion of keeping your financial head above water will require more effort than signing your name on the back of yet another new credit card.

Hardly anyone beats the market for more than a few years, so why do we waste so much time and money trying? And more importantly, why do we deem our investing success relative to what a bunch of strangers are doing? As Jason Zweig cleverly points out in Ben Graham’s The Intelligent Investor, no one’s gravestone reads, “HE BEAT THE MARKET!” Expectations today shun returns below double digits.

That type of thinking negates what Warren Buffett calls the very first rule of investing: “Don’t lose money.” As investors, we are looking for a margin of safety – companies trading near or below their intrinsic value with an established earning power. That is basically it. So here are four basic criteria you can expect from Free Market Investor. You may recognize the thinking. Warren Buffett coined the parameters. It is a bit cliché, but we will humbly concede that if it ain’t broke ... well, you know the rest. We always ask ourselves these four things:

  1. Is the business easy to understand?
  2. Does the business sell at a fair price?
  3. Does the business operate with a long-term competitive advantage?
  4. Does the foreign stock trade on a U.S. exchange?

We will lump the first two rules together in the following example. Is the business easy to understand and does it sell for a fair price? This is a fictional story of a small biotech company, “CureAll Pharmaceuticals”. CureAll currently holds patents on two mildly significant drugs that treat a rare blood disorder. Proceeds from those sales pay the rent, but the company continues to operate in the red. The company’s immediate future rests on a breakthrough pipeline drug capable of curing prostate cancer. The breakthrough of such a drug would mean a great deal to a great many people. There is no way to quantify the benefits.

Even before Phase III clinical trials begin, the company’s stock takes off. Investors are willing to forego 120 years of future earnings for a single share. Who could blame them? This is the miracle cancer drug we have all been hoping for. Two years pass, and FDA approval looms even closer. The stock price continues to climb. The atmosphere around CureAll’s stock feels strikingly similar to the sentiment for Internet search engines in the early 1990s.

Back in 1994, Yahoo’s search engine started as a simple directory for the then-small universe of Web sites. The stock price rose side by side with the market all the way to its peak in 2000. On the last day before the new millennium, Yahoo closed at $432.69. Its diluted earnings per share that year were 6 cents. Investors and pundits were predicting that Yahoo was set to go even higher. We termed the 1990s the “new economy”. Times had changed. Many considered earnings to be irrelevant. We all know how that story ends. By the end of 2000, Yahoo closed at $25, down 94% in less than a year.

But it is now 2007. Times have changed. Investors argue CureAll maintains a tangible revenue-producing product. The dot-com companies had nothing like this, they said. That is why speculators got burned. “It’s different this time,” they claim.

CNBC and the financial press jump on board. Even pundits left of the far left begin cheering capitalism’s conquest. The greatest minds in medicine start making public statements. CureAll’s management discloses final FDA approval. Wall Street wholeheartedly jumps on board. CureAll’s shares are now going for 250 times future earnings.

Here is where our story takes a turn. In all the hype, investors confused the tangible benefits of the drug for the tangible benefits of the stock. Unfortunately for investors, the costs of producing this innovative drug are astronomical. Gross margins are less than 5%. Operating margins are then even half of that. Critical inputs come from shaky supply sources. To make matters worse, CureAll’s current blood disorder drugs are about to go off patent. The future pipeline contains the only high-margin, cash cow product that could effectively put the company firmly in the black. But FDA approval for that drug requires successful DNA rebuilding in the Jensen sarcoma as well as full atomic models with sugar phosphate nucleic acid structures of 25 different lab rats. That is tough to read, much less to comprehend.

Like Yahoo, the hysteria surrounding CureAll’s drug eventually surrenders to the financing and fundamental earning power behind it. Although cancer patients are rewarded, investors suffer. The stock falls 94% by the end of 2007. The story of CureAll demonstrates two common traps readers are encouraged to avoid: First, steer clear of businesses you do not fundamentally understand. And second, never pay too much for an asset, regardless of how great that asset may be.

You see, all market bubbles eventually come to an end. There is no telling what triggers the retraction. Some average investor woke up one day and realized that he would probably not recoup his investment on a company with an earnings multiple well above 200. It is really common sense. Value investors like Benjamin Graham and Warren Buffett know that throughout history, the average price-to-earnings ratio of the stock market has been 15.3 – which means investors have traditionally been willing to pay $150,000 or so for $10,000 in earnings.

Today’s Yahoo appears to be Google. Growth projections are large, and they are built on a very fragile assumption. They assume Google will be the leading search engine for years to come. They assume a competing programmer will fail to construct a better algorithm. They assume real competition will not enter the market. In an industry with little to no switching costs, that is a pretty risky assumption.

There is nothing wrong with owning a great business that grows at fantastic rates. It is a matter of paying the right price for that business. Investors should determine an intrinsic value, wait for someone to overreact or under-react to news and buy the stock when the market prices the shares for less than they are worth.

Google is just another name for the same story. It is a story whose message is focused on hubris and greed. Regardless, investors today are singing the same historical tune: “It’s different this time.”

It’s never different this time.

Link here (scroll down to piece by Christopher Hancock).
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