Wealth International, Limited

Finance Digest for Week of June 11, 2007

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


Once upon a time gold was the sanctuary of nonconformists, visionaries, contrarians, idolators and cranks. And the gold price moved accordingly. If stocks went up, bullion went down, and vice versa. As the financial theoreticians say, gold was an uncorrelated asset.

But the barbarous relic has moved ever closer to the investment mainstream. “Strength in commodity markets will be something we should see generally over the next 10 to 20 years,” said Russell Read, chief investment officer of the California Public Employees Retirement System. Read has lots of bullish company. In two years the market cap of the gold bullion exchange-traded fund StreetTracks Gold Shares, trading at $66 a share, has ballooned to $10 billion from nothing at all. Goldbugs rub their eyes. They feel like the starving artist who awakes one morning to discover that his neighborhood has gone upscale.

Actually, the goldbugs stopped starving some time ago. Since February 2000 the gold price has risen by 130% compared with the S&P 500’s 11% and the Nasdaq’s minus 45%. Adversity, of course, is the bullion market’s old, dear friend. Whether it was the 1987 crash or the 9-11 attacks, gold and stocks have tended to go their separate, uncorrelated ways.

If you sat close enough to the blackboard in business school, you may believe that uncorrelated returns are almost as good as just plain high returns. By diversifying into assets disconnected to stocks and bonds, theory has it, an investor can earn greater returns without assuming additional risk. Few assets have answered the call of disconnectedness better than gold. Between 1975 and April 2007 the correlation between weekly movements in gold and of the broad U.S. stock market was around zero.

But a funny thing happened earlier this year. One day the Shanghai stock market fell out of bed, and, in sympathy, so did other world stock markets. As did the price of gold, falling by $23 an ounce. In the 50 days leading up to the February 27 break, gold and stocks might as well have been ships in the night. But as the Dow Jones industrial average dropped by 416 points, equities and bullion set sail together. Their correlation rose to 0.6 and stayed there for the next 50 trading days. (At a reading of 1.0, gold and stocks would be in lockstep.)

It could be that this uncharacteristic joining of equities and bullion was a fluke that the safety-seeking gold buyer can safely ignore. But I doubt it. The stellar returns of the postmillennial metals markets have been lost on no one. Investors have chased them, and academics have rationalized them. The trouble I see is that the opportunists increasingly outnumber the goldbugs. Goldbugs are quick to buy their precious metal and slow to sell it. Opportunists are quick to buy it and quick to sell it. When gold goes down, or when its correlation characteristics change, the opportunist can be expected to dump it as unceremoniously as he would a sack of flour.

It follows that gold could be in for a rough patch. Insofar as it trades like the stock market (at least, on the days when stocks fall), it will tend to lose its newfound adherents. Even its old, grizzled, eccentric fans may despair of it. Why own a defective insurance policy?

That is the near-term risk. But I continue to believe in a sizable long-term reward. Yes, gold has had a nice 7-year run. But the monetary phase of the bull market has hardly begun. How could it have? People, for the most part, still trust the currencies in their wallets and the central bankers who print them. The day gold stops trading as a decorative asset, and begins trading as an alternative to Bernanke & Co., is the day that the gold bull run, part II, begins.

The U.S. this year will emit some $850 billion into the world’s payment stream. Most of this money will be absorbed not by profit-seeking individuals but rather by foreign central banks. The central banks of Russia, China and Brazil, for example, will acquire the dollars with currencies they print for the very purpose. This system of creating rubles, renminbi and reals with which to soak up redundant greenbacks might be characterized in many ways. But “bearish for gold over the intermediate to long run” is hardly one of them.

Link here.


The S&P 500 and the Dow Jones industrial average have hit new highs. Wonderful. But let us not get lulled into the false sense that what goes up must keep going up. Despite the occasional rough patch, we have been enjoying a bull market for the past 4 1/2 years. All good things must come to an end. For the rest of the year I am bearish. Now is the time to take money off the table. Why the gloom? Three things: (1) slowing earnings growth, (2) rising interest rates and (3) higher taxes.

Without any doubt, earnings are strong, for the moment. Companies that do a significant amount of business abroad have been performing particularly well. Some of this is due to vibrant foreign economies, but much of it stems from a weak dollar that makes overseas earnings look bigger on a U.S. profit-and-loss statement. Now look a little more closely at those fabulous earnings. Their growth is off the torrid pace of yore. And the growth in net earnings is significantly less than the growth in earnings per share, because of all the share buybacks going on. Corporations, no fools, know investors focus on EPS.

GDP growth has slowed considerably, and the most recent employment figures are disappointing. Results like these should make the Fed feel leery of a recession and thus more comfortable about easing. Still, we have learned in recent years that the Fed has little influence on the longer end of the yield curve. One reason: Energy prices are marching upward again. Higher gasoline and heating oil prices feed inflation, causing the yield on the 10-year Treasury note to rise. The 10-year serves as the benchmark for corporate loans, meaning that companies will be less willing to tap the capital markets to expand their activities.

Finally, there are taxes. I laugh when liberals rail against the Bush tax cuts. I really have not noticed any tax cuts. When you factor in my state and property taxes, which I cannot deduct on my federal return because of the alternative minimum tax, my taxes have risen quite a bit. All George Bush did was to make the situation less onerous than it otherwise would have been. Now that the Democrats control Congress, odds are heavy that federal taxes will not be going any lower. The tax increase built into the statute books for 2011 will take place as scheduled.

So why do stocks keep ascending? Blindly optimistic investor sentiment has a lot to do with it. Then there are hedge funds using lots of leverage, private equity firms buying public companies, the new merger wave and all those share buybacks. The stock market, though, is an instrument that reacts to where it thinks the trend will be. When the negative influences I just outlined start hitting, the market will get hurt. The economic slowdown will bite consumer-oriented companies first, since consumer spending makes up 70% of the GDP. A harbinger is Wal-Mart’s flat same-store sales.

But not all companies will see growth crimped. Through mergers AT&T (T) has become the world’s largest telecom. Its trailing P/E multiple of 21 is just a little higher than the S&P 500’s 17. AT&T’s scale is daunting. So is its new, exclusive deal to sell Apple’s iPhone. FEI (FEIC) makes gear for the burgeoning nanotech market. The 37 P/E may look high, but the growth rate justifies it. Church & Dwight (CHD), with a P/E of 23, makes two recession-proof products: detergent and condoms. Buy these three stocks.

Here are three stocks to short. Starbucks (29, SBUX) and Whole Foods Market (40, WFMI) are off their highs and have further to fall. Premium-price lattes and arugula will not move as fast in a slump. Absurdly overpriced Google (474, GOOG) lives off rising demand for its ads – but that demand will flag as consumers pull back. If you cannot stand the risk of a short position, buy at-the-money puts with at least five months to expiration.

Link here.


The pioneer is the one with the arrows in his back.

Remember the great first-mover movement of a few years back? The idea, which gained an intense following during the dot-com mania, was that you should expend any sum necessary to establish ownership of a field, then worry about profits later. It worked for Amazon. It did not work for a lot of other ventures.

Being the first to stake a claim in new territory does confer certain advantages, like setting industry standards and gaining economies of scale. But it does not guarantee success. It does not explain the majority of American blue chips. Consider that most famous industrial success story of a century ago, Henry Ford’s mass-produced Model T. By inventing the automated assembly line, he had a first-mover advantage that was so great that he scared England’s Charles Stewart Rolls and Sir Frederick Henry Royce, even though their luxury cars were at the other end of the spectrum. But Ford overstayed the Model T. Remember, he insisted that they all be painted black and in the late 1920s lost leadership to more innovative Chevrolet.

In most cases entrepreneurs are better off building the second or third version of the better mousetrap. Visicalc, the first desktop spreadsheet program, faded away as Lotus took over the field with 1-2-3. In time the Lotus software was itself crushed by Microsoft’s Excel. Microsoft has a history of succeeding by not being first. Digital Research developed the first desktop operating system, called CP/M. But Bill Gates upstaged it in the competition to supply an operating system for IBM’s PC. Gates did not even develop the original DOS. He bought the program from Seattle Computer Works for $50,000. His genius was not so much in coding as in marketing.

Getting in early on Web commerce was supposed to be a brilliant move. The business plan was to raise a gargantuan sum in an IPO and use it to construct an impregnable brand and Web presence. But roaring out of the starting gate did not help many of these dot-coms, or their stockholders. Financial news site TheStreet.com (TSCM) had a $19 initial offering price in 1999, and later leaped to $60. The shares were available at 99 cents in October 2001. Today they go for $11.

Prodigy Communications was a first mover in online connections. And it had powerful backers at its launch in 1984: IBM, Sears Roebuck and CBS. Prodigy’s focus was on electronic shopping, but two decades too early. Subscribers back then were more interested in chat rooms, e-mail and then Web surfing. The firm was sold in 1996 to an investor group for only $250 million. Dumont led the way in selling TV sets when they were new gadgets, but the company lost out to latecomers like RCA and Motorola. Chux was the leading disposable diaper yet succumbed to Procter & Gamble’s Pampers. Ampex had a commanding position in video recorders and tapes for two decades until Sony took over. Rheingold Brewery brought out Gablinger’s low-calorie beer in 1967, a cool summer with weak beer sales. So Rheingold lost interest and Miller Lite later mastered the field.

Thomas Carter was a pioneer in competitive telecommunications services, one who lent his name to a famous legal case. He invented the Carterfone, a device that connected the telephone handpiece to an amateur radio transmitter or a mobile phone network. While only 4,000 Carterfones were ever installed, AT&T saw the device as a threat to its long-distance monopoly and its ownership of all telephone instruments. Then came the legal struggle. In 1968 the Supreme Court ruled in favor of Carter Electronics. It was a turning point in utility history, paving the way for MCI and other service competitors as well as hardware manufacturers. But Carter’s firm voluntarily dissolved in 1969.

Think twice about being first to invest in a new business, even if it boasts a 100% market share. Right now I would be wary of pioneers who offer emergency medical services, staffing and outsourcing, and environmentally safe home cleaning products, not to mention those involved in the Internet and other new tech areas. Often it is better to follow Alexander Pope’s advice: “Be not the first by whom the new are tried.”

Link here.


Americans spend approximately $6.2 billion on golf equipment and apparel each year. If we take the 7% of Americans that play golf regularly, we find that each golfer spends approximately $300 a year on new equipment in some form or another. The makers of the world’s best golf equipment know this all too well. Each year they seem to find some miraculous technological breakthrough. They seem find the one little tweak that will garner the ultimate club. THIS is the year their promise will be fulfilled. This is the year I will play like Phil Mickelson.

Equipment makers are playing the finest marketing game of all. Their greatest weapon: a mediocre swing. They know we strive for the quick fix. We are looking for a shortcut to superior returns. Instead of spending countless hours hitting buckets of range balls, we would rather you sell us $1,000 on a set of the latest Mizuno blades. That would sufficiently do the trick.

I fell prey to this very ploy. I had to buy a set of new golf clubs this last off-season. Not a full set, just irons. My old ones were too light for my taste, and it was time for a change. It came down to two sets of Titleist irons, one of which was brand new. The other was 15 years older. Below is a basic description of each. Tell me, which would you choose:

Option A:
These irons have an offset design that promotes ease in ball-striking, making it easier to square the clubface at impact, and helps create a more consistent ball flight.
Option B:
These irons have continuity in performance and aesthetics for a fluid transition from long to short irons.

Would you prefer a more consistent ball flight (Option A) or continuity in performance (Option B)? In my opinion, they are basically the same thing. The only thing that separates one club from the next is most likely the golfer holding it. I went with Option A – a used set of Titleist DCIs that cost $70. Though they were the older set, they were $1,000 cheaper.

To me, buying a brand new set of golf clubs makes about as much sense a buying a brand new car. The minute you take it off the lot, it loses a majority of its original value. Buying golf clubs and cars is no different than buying stocks. Before you spend a dime, you must formulate a ballpark idea of its intrinsic value. To me, new clubs are not much more than older clubs with inflated prices. Just because an equipment maker finds a new way to rephrase the term “consistent ball flight”, that does not necessarily equate into placing a $1,000 premium on a seemingly replicated asset.

Remember, whether you are in the market for golf clubs, stocks, or – for arguments sake, let’s say a 1967 metallic silver Porsche 912 that your wife has not properly warmed up to quite yet – it is not just about buying a great asset. It is about buying a great asset at a good price.

Link here.


In the past, at least for most of my 17-year career, the commodities markets have been a small part of the overall investment picture for most investors. The NYSE pooh-poohed the commodities exchanges as a form of gambling or worse. Average investors had little access to these markets, and those who did often came away feeling confused and disenchanted. Fast forward to today, and all of that is out the window. The electronic age has made global commodities futures and options accessible around the clock and much easier for the average investor to understand.

In the past, key commodities markets like gold and oil were the only ones you would hear mentioned in the mainstream press. Again, all of this has changed, as the commodities markets have evolved. One sector that was mainly reserved for farmers and professional speculators was the grain markets. With the resurgence of ethanol and biofuels, these markets have suddenly become more precious than gold. Let us take a look at a few grains, and show you how to use them to your advantage.

Corn’s explosive run will not stop anytime soon.

In the last few years, due to the ethanol craze, the grains everyone has heard about are corn and soybeans, and these grains are the most actively traded. Corn has absolutely been on an explosive run, and the cash and futures prices are soaring, allowing savvy investors to make a fortune playing corn directly. The main cause is the ethanol plants springing up right and left across the country. It is almost as though you cannot turn on the TV or pick up a magazine without hearing or reading about it. The demand for ethanol is real, and even though the science of ethanol is still questionable, the reality is that it is now the primary blending ingredient for gasoline. 10% ethanol is pretty much standard now at the gas pump, and in many states, E85 – 85% ethanol – is taking hold.

While the arguments rage on about whether or not ethanol is the answer to our fuel needs, the demand is already here. Until there is a viable alternative or a repeal of the 54-cent sugar tariff in the U.S., corn-based ethanol is here to stay, even though there are other alternative energy sources that are much more efficient. So clearly, corn and sugar are two commodities destined for much higher prices. In the rush for corn and soybeans, one grain that has being overlooked is wheat.

Can you really profit trading wheat? Yes!

Wheat is one of those commodities that is not sexy. But there is real money to be made in the wheat market right now. My readers have been able to make 62%, 68% and even 174% from the options I have recommended on wheat. Still, very few people are talking about wheat – at least for now – and that is good news.

Minneapolis boasts the largest cash grain market in the world. There is a small futures exchange and it trades wheat. Chicago also trades wheat and is where I usually suggest you trade. However, wheat is also traded in Kansas, and although the market is a bit thinner, it can sometimes work to your advantage. Some of the best markets to trade are the ones you never hear about in the mainstream. With the grain markets moving so fast even wheat is picking up steam and the trading action is like a tornado.

Kansas City wheat is the second most actively traded wheat contract after Chicago. KC wheat is special is the hard red winter wheat. This type of wheat accounts for about 45% of total wheat production in the U.S. and is a higher quality wheat that is more easily refined and milled. Last summer, the U.S. Department of Agriculture said 49% of the spring wheat crop was already harvested and only 32% of it was rated good to excellent. That is down from 67% a year ago. This year may be even worse, and demand is growing.

The situation gets even grimmer as the U.N. Food and Agriculture Organization is reporting that nearly two-thirds of the winter wheat crop in western and northern China has been wiped out by a prolonged drought. Some other areas have experienced a 40-50% cut in the winter wheat harvest. The rumbling in the pits is that red winter wheat, while volatile, is one of those crops that simply will go higher in the long term, due to increased demand and decreasing supply. Sounds like a good time to buy.

These forgotten grains could bring big gains.

Other than corn, sugar, soybeans and wheat, there are many other smaller grain markets for the more aggressive investors who want to do their research and take a little more risk. Canola, oats and a more mainstream commodity like rice are all more markets to take a look at. Personally, of the three, I would look at rough rice. The futures contract is pretty liquid, relatively speaking, and it can be a good-trending market. It certainly does not get as much attention as corn or soybeans, but that can be a good thing.

Corn and soybeans will remain the front-runners in the grain race, but the rush for profits and the ethanol hysteria (like the new gold rush) is far from over. I could list about 50 more reasons to buy grains right now, but the bottom line is that these markets are very strong and this trend is likely to continue. The grain charts have risen so fast they will give you a nosebleed if you look at them, but do not let that deter you as bull markets often have charts like that. As always, use protective stops and a strong defensive trading strategy in these markets. A correction is always possible.

Link here.


Oil and gas resources once thought completely out of reach have now arrived in the fuel tanks and furnaces of consumers around the world. Opinions differ about the future capabilities of oil field technology. Some argue that technology will allow us to unlock trillions of barrels worth of oil out of unconventional and not-yet-discovered resources. Others argue that every technology in use today was developed 20 or 30 years ago. Not only that, but growing service industry bottlenecks could halt several desperately needed development projects in their tracks.

While both sides of this debate have valid points, I think it is important to remain focused on the progress under way at major projects and depletion of large existing fields, and not argue about potential resources 30 years into the future. We want to profit from the decline of Peak Oil and its subsequent political instability now.

Since the advent of the oil business, scientists and engineers have developed a series of very remarkable technologies. Oil field technology tends to compound at a steady rate, extending the boundary of what was long considered the absolute limit of exploration and production. Resource owners usually want to produce a hydrocarbon reservoir as fast as safety and engineering limits allow, so it makes sense that most oil field technology was developed to accelerate the process.

This picture of working to beat the clock not only applies for newer discoveries, but it also applies for projects that strive to extend the lives of older fields. Oil field equipment and services have become very expensive and are likely to become even more expensive in the coming years. The free market is the driving force behind oil field technologies. If there is thought to be a few million more barrels of oil left in an old well, an operator will go ahead with an enhanced oil field recovery project if the return on investment is high enough. But if oil and gas prices fall and service prices remain high over the course of this project, this operator can lose a lot of money. So timing is of the essence.

Oil service stocks that can grow regardless of operator budgets are difficult to find. I recently discovered one that is fairly unique. It is fairly insulated from the booms and busts of the oil field investment cycle, yet has incredible growth potential. Its technology has proven to be very valuable for operators extending the lives of older wells, but it also plays a key role in unlocking the value of low-quality oil and gas. Its equipment and expertise will remain in very high demand by oil field operators around the globe for years to come.

How sour crude can lead to sweet profits.

Low-viscosity, or “sticky”, heavy crude and sour crude with high levels of impurities like sulfur require extra steps in both wellhead processing and refining. The initial step in crude oil refining really occurs at the wellhead, the site where it is first pulled from the ground. The trend toward heavier, sourer crude oil will directly benefit manufacturers of specialized wellhead equipment. These lower grades of crude make up a steadily rising share of global oil production because, as you would expect, the sweetest, lowest-hanging fruit in the oil patch tends to be picked and consumed first.

More barrels of crude will require upgrading, particularly the abundant, yet barely accessible heavy crude from sources like the Orinoco Belt in Venezuela. Technology is what the Venezuelans, the Russians and the Saudis need, and they will pay up for it. Some of the biggest wealth-creating companies of the next generation will be those that can unlock the value of these politically unstable resources – without committing billions in capital to projects that can be seized overnight.

The odds are the next few years will look like the last few – a period of growing resource nationalization not unlike hoarding. Leaders of countries sitting on vast reserves are taking actions in the best interest of their people (or their personal bank accounts) and telling major oil companies to get out. Vladimir Putin and Hugo Chavez would not have kicked the big oil companies out if they had not planned on granting major development projects to big service companies like Schlumberger, Baker Hughes and Halliburton – because most of their countries’ remaining reserves are difficult to produce.

“Megaprojects” hampered by bottlenecks.

Yet despite having access to the best oil field technology in the world, most big projects still suffer from bottlenecks, delays, and cost overruns. This phenomenon is widespread enough that it supports the core ideas behind the Peak Oil theory - most notably that the “easy oil” has already been consumed. Chris Skrebowski, editor of Petroleum Review, became a leading Peak Oil theory proponent after initially setting out to prove that it was nothing more than worrywarts seeking to make headlines. With decades of international oil field consulting and research experience, he ran the numbers and concluded that data on both historical production and future projects were not precise enough to assume ample oil supply as far as the eye can see.

So Skrebowski started a “megaprojects” database to track the projects widely expected to satisfy growing demand. He has noticed an undeniable trend of delayed startups and shortages of everything from drilling rigs to qualified personnel. Assuming that the current backlog of projects proceeds without a hitch, he expects that “24.8 [million barrels per day] of new capacity [is] due to come onstream between January 2007 and December 2012.”

An extra 24.8 million barrels per day of new capacity represents a little over 4% annual growth over the next six years. But this ignores depletion of the existing base, the elephant in the room that most Peak Oil critics either overlook or avoid. Skrebowski warns that the data behind the existing base, especially from national oil companies like Saudi Aramco, are not transparent enough for us to make happy assumptions about long-term supply. If average global depletion is running a little over 4% per year – a fair estimate – the world is likely to have the same oil production capacity in 2012 as it has today. With relentless demand growth, flattening worldwide production would send oil prices well into the triple digits for good.

“The large volumes of new capacity being added between 2007-2012 may not translate into the sort of increased production flows the world economy needs to underpin economic growth,” says Skrebowski. Companies that play critical supporting roles in extending oil and gas production will be great investments over this 2007-2012 timeframe.

Link here.


Ever since Colonel Drake tapped the first commercially viable oil well in Titusville, Pennsylvania back in 1849, oil has reined the undisputed king of the energy industry. But this long reign, as with all others, will come to an end. The questions lie not in the “if”, but in the “how” and the “when”.

The world’s supply of crude oil may be enormous, but it is not infinite. Eventually, therefore, crude oil will abdicate its throne to an oligarchy of “alternative energy” sources like wind, solar, geothermal and liquefied coal. Up here in Scotland, the winds of change are already blowing. Last month, Talisman Energy (UK), in conjunction with Scottish and Southern Energy (SSE), announced that its Beatrice Wind Farm Project, located off the coast of Aberdeen in northeastern U.K., was online and operational. The project takes advantage of some of the highest wind speeds on the planet.

The demonstration deepwater offshore project is the largest of its kind in operation today. At a towering 85-meters (278 feet), the mammoth 5MW wind turbine will be powering the nearby Beatrice Oil Platform, some 25 kilometers off the eastern coast of Scotland. At first glance, it may seem relatively meaningless – or at least ironic – to use wind energy to power an oil platform. If you take a closer look at those funding the project, however, you begin to appreciate the importance of this landmark event for countries all across Europe. Aside from Talisman and SSE, enthusiastic contributions also came from the European Community, the Scottish Executive, and the UK Department for Trade and Industry.

Throughout the 1990s, the U.K. fostered a slow, but steady development of the wind power industry. But it was not until 2002, when the British government instituted the Renewables Obligation (RO) that things really started to take off. The RO aims to see the U.K. pass the 10% mark for energy derived from renewable sources. The nearby chart plots the near-exponential growth of the wind industry since the introduction of the RO. And this is just the beginning. The British Wind and Energy Association (BWEA) has set lofty targets.

For all the benefits of onshore wind farms, the typical problems still arise. Aside from governmental red tape, there is always a string of placard waving NIMBYs to contend with. But NIMBYs don’t swim. The Beatrice project is part of a larger, collective effort known as the DOWNViND Project (Distant Offshore Wind Farms No Visual Impact in Deepwater) that includes 18 organizations from six European countries. It represents a shift in focus away from the more conventional onshore wind farms and highlights the possibilities for rapid offshore growth. According to the European Wind Energy Association, offshore wind could provide up to 150GW if its full potential were harnessed – about the same amount of energy produced by 150 nuclear plants.

As the rest of Europe quickens its pace in the quest for energy independence, the U.K. is among those leading the charge. At a current offshore wind capacity of 300MW, they sit #2 only to Denmark (400MW) and in front of the Netherlands (140MW). Alongside the U.K., Denmark and the Netherlands, projects are also in development for offshore turbines in Germany, Sweden and France. Over in Spain, the current leader in onshore operations, some 31 projects are awaiting authorization mainly in the Galicia and Andalucía regions.

So how does the energy throne of Big Oil respond to the emerging alternative energy oligarchy? By joining the family. BP has purchased both Greenlight Energy and Orion Energy, while also forming a strategic alliance with Clipper Windpower. All three of these companies operate in the wind power industry. With two farms in the Netherlands and five projects at various stages of development in the U.S. this year, BP’s land bank of development projects now has the potential to generate some 15,000 MW of power. Similarly, Royal Dutch Shell has used its offshore oil and gas expertise to establish a formidable presence in the wind market.

There is little doubt that Big Oil will rein king for a while to come. With their support, so will the alternatives.

Link here (scroll down to piece by Joel Bowman).


Last week, the yield on the 10-year U.S. Treasury note recorded its biggest one-day jump in years and breached the 5% level for the first time since last July. Other fixed-income markets quickly followed suit, hurt not only by a nominal rise in rates but by a jump in risk spreads. One trader described the sell-off in the mortgage-backed securities market as “a good old-fashioned mortgage puke.”

The ostensible reason behind the sudden jitters, following a period when yields were already drifting higher, was the decision by European and New Zealand central banks to boost short-term interest rates. What is more, a smattering of positive economic data finally convinced some investors that the Federal Reserve meant business when it said rising inflation was its main concern.

The turmoil was not confined to fixed-income markets, however. Most U.S. and European stock markets were also rattled, after testing new highs only days earlier, and emerging equity and currency markets also got slammed by a bout of heavy selling. Precious metals prices slipped amid liquidation pressures and short-covering in the dollar, while options premiums rose, as the VIX index, or “fear gauge”, broke out from a multi-week base.

There was trouble in other quarters, too. The Wall Street Journal reported that some recent leveraged buyouts were starting to trigger alarm bells, noting that it was “striking how quickly a few of the deals have run into problems.” A Fed survey indicated that lenders were not only tightening standards on subprime loans, but were beginning to closely scrutinize some prime borrowers. Another recent poll noted that corporate chief financial officers had turned pessimistic on the U.S. economy. Elsewhere, a report revealed that analysts, in a rare move, had downgraded earnings forecasts for a number of investment banks, whose financial vitality is often seen as a leading indicator for markets as a whole.

On the political front, the immigration reform bill, apparently crafted with bipartisan support and announced to great fanfare only weeks ago, was suddenly dead in water. Overseas, the G8 meeting of leading nations not only failed to reach agreement on its loftier goals, but participants seemed to come out of it with relationships that were worse for wear. Tensions also flared up in hotspots around the world, and oil prices approached a record $70 a barrel. In Turkey, there were reports of troop incursions into Iraq and word that the Turks had declared martial law in the border area between the two countries. North Korea confirmed that it had recently tested short-range missiles, while Russia threatened to aim its missiles at Europe. In Pakistan, there were revolutionary stirrings as protests against the president swelled.

All of a sudden, it seems there is a great deal of anxiety around, not only in matters of money, but in a more general sense as well. Where once there was seemingly endless complacency, there is now growing pessimism and serious doubts about what the future may bring. In the financial markets and elsewhere, ties woven in an era of globalization and good times are being stretched thin, and some threads are beginning to unravel.

Perhaps it is nothing more than coincidence. Many analysts, for example, might view recent financial market turmoil as a knee-jerk response to global monetary policy changes. Even so, it is hard to believe that this abrupt and widespread change in mood, coursing as it has through the world of money, politics, social relations, and international affairs, is mere happenstance. Or that a wide range of catalysts with nary a common thread between them all seem to be causing events to turn in the same destabilizing direction.

Instead, it seems likely that we are on the periphery of a dramatic and potentially far-reaching transition to a new, more hostile environment – one that most people are both unfamiliar with and ill-prepared for. Odds are that it will be a dangerous, costly, divisive, and debilitating period, when all sorts of relationships and assumptions will be severely tested. Like it or not, it looks like it is time to say goodbye ... to the good old days.

Link here.


The latest Federal Reserve Z.1 Report provides its usual interesting and illuminating “read”. Total SAAR (Seasonally-Adjusted and Annualized Rates) Credit Market Borrowings remain enormous – although somewhat slower than Q4’s growth. The trend of accelerating credit expansion is unmistakable and, despite the housing slowdown, there is a legitimate possibility it runs through 2007.

Continuing last year’s trend, non-financial debt growth further moderated, while immoderate financial sector expansion gained additional momentum. Most analysts are focused on the former and its negative economic implications. I will instead suggest that the historic financial sector expansion is the predominant dynamic. At this point, sustaining this runaway credit expansion will be no easy feat. Yet, as long as it perseveres, unstable financial markets will be buffeted by liquidity overkill – and the bubble economy will be further contorted by these unwieldy inflationary forces.

Although slowing from last year’s blistering pace, broker/dealer assets expanded SAAR $540 billion, or about a 20% rate during the quarter. For perspective, the broker/dealers expanded $615 billion last year, $282 billion in 2005, $232 billion in 2004, $278 billion in 2003, declined $130 billion in 2002, and increased $244 billion in 2001 and $220 billion in 2000. The liability side of the broker/dealer balance sheet remains today a focal point of macro credit analysis. Wall Street-pioneered innovation has profoundly altered contemporary “money” and credit. Clearly, the traditional expansion of deposit liabilities – during the process of banking sector (loan) expansion – some time back lost its role as the primary source of system liquidity creation. As analysts, we must take a broad view of financial expansion and examine a wide range of financial sector liabilities created in the process lending as well as securities leveraging.

Despite the moderation of both non-financial debt and economic growth, there was little letup in the Rest of World accumulation of U.S. financial assets (not surprising, considering the boom in financial sector growth/liquidity creation). For the quarter, RoW increased U.S. asset holdings to the amazing tune of SAAR $1.316 trillion, to $12.931 trillion, down only slightly from Q4’s SAAR $1.327 trillion. In just 13 quarters, RoW holdings of U.S. financial assets ballooned $4.343 trillion, or 51%.

Household and government balance sheet expansion confirms ongoing global liquidy bubble.

As usual, we will attempt to glean credit bubble insights from the (ballooning) household (including non-profits) balance sheet. For the quarter, household assets increased $725 billion (4.2% annualized). Real estate assets increased $212 billion (a 3.7% rate) and financial assets jumped $463 billion (4.4% rate). And with liabilities increasing “only” $137 billion during the quarter, household net worth rose a respectable $587 billion to $56.2 trillion. For the year, household asset gains of $3.9 trillion (6.0%) were offset by liability increases of $1.0 trillion (8.1%), leaving a $2.9 trillion (5.5%) rise in net worth. Over four years, assets inflated $21.2 trillion (44%), liabilities $4.6 trillion (52%), and net worth $16.6 trillion (42%). We should not understate the ongoing influence on consumer behavior from the spectacular (4-year plus) inflationary windfall.

The windfall is also lining government coffers. Federal government first quarter receipts were up 6.9% from the year ago period, with state and local receipts gaining 4.6%. Q1 spending was up a robust 6.0% at the federal level and 7.6% locally. Despite booming tax receipts, federal government borrowings increased at a 6.6% rate during the quarter (after growing 3.9% during 2006). State and local debt expanded at an 8.6% rate (after 2006’s 8.2%).

Bond yields respond – finally – to global liquidity excess.

The ongoing excesses confirmed in the Q1 2007 Flow of Funds leave little confusion with regard to surging global bond yields. It is just surprising bonds ignored rampant global liquidity excess for so long. The abrupt nature of the yield spike is surely problematic for those highly leveraged players (and curve speculators) caught on the wrong side of the market. Clearly, scores of players had positioned for the imminent start of a Fed easing cycle. It is never a smooth process when the crowd rushes to the exit an unsuccessful “crowded trade”. But to what extent this unwind impacts liquidity (reduces gross excess) is difficult to assess at this point. The near-term market assumption will likely be that the jump in market yields is sufficient to keep the economy and inflationary pressures in check – holding the Fed at bay.

And while it was a painful week for fixed income, for the system as a whole it was anything but the worst case scenario (rates spiking, stocks collapsing, dollar sinking and spreads blowing out). The yen only rallied slightly, encouraging players that yen carry trade dynamics are still quite favorable. The dollar rallied and most spreads were only moderately wider for the week. Emerging market equities were OK. On a global basis, I doubt recent yield increases will have much influence on overheated credit systems.

But the week can be viewed as another body blow to a vulnerable marketplace weakened by subprime and heightened volatility. This yield spike certainly comes at an especially poor time for fragile housing markets and mortgages. Yet for global equities, securities finance and M&A – today’s prevailing booms and sources of new liquidity – the near-term outlook is anything but clear. I would be somewhat surprised if the current cost of funds meaningfully restrains the overheated M&A Bubble. I would also expect the equities bulls to play hardball, keen to keep the bears on their heels. But it should be increasingly obvious that this massive and unwieldy pool of global speculative finance is a serious problem.

As master of the obvious, I will predict we are in store for a long, hot summer of volatility and discontent. The bond market was content for some time to ignore unfolding fundamentals. The stock market has been gleefully disregarding reality. From Iraq to the entire Middle East to Russia – the disturbing geopolitical backdrop has curiously remained a non-issue. The enormous ongoing cost of national security and the global “war on terror” are brushed off as if they are inconsequential. But, then again, inflating financial markets create their own rationalizations, spin and reality. The latest round of bullish propaganda has really pushed the envelope, setting the stage for major disappointment and disillusionment. If history is any guide, expect a period of wild volatility leading to a financial accident.

Link here (scroll down).


There is an important context to the recent violent correction in sovereign bond markets. It is the defining feature of the second act of the great normalization saga. In the aftermath of the deflation scare of 2002-03, policy settings and markets were subjected to very unusual conditions. The restoration to normalcy has been a long and arduous process. Central banks led the first phase and are now being followed by a normalization of bond and stock markets. A third act is likely – one dominated by spread markets, such as corporate credit and emerging-market securities. Financial markets are more carefully scripted than you might think.

It has now been four years since the worst of the deflation scare. But the repercussions of this potentially devastating risk scenario are still very much in evidence today. Heeding the painful lessons of Japan, America’s central bank threw caution to the wind when a post-equity bubble shakeout pushed core inflation through the 1% threshold in early 2003. It was quick to take its policy rate down to the rarefied 1% zone and, in inflation-adjusted terms, held the real federal funds rate in negative territory for three years, from 2002 to 2004. While the Fed led the charge in this battle against deflation, similar efforts were undertaken by other major central banks during this period. The Bank of Japan augmented its zero interest policy with an extraordinary “quantitative easing”. And the European Central Bank took its policy rate down to “zero” in real terms and tolerated excess growth in Euroland M-3 for over three and a half years.

The medicine worked – or at least so it seemed on one level. Taking comfort that deflation risks were receding, beginning in June 2004, the Fed embarked on a 17-step policy normalization campaign – in effect, weaning the U.S. economy from the anti-deflationary treatment of über monetary accommodation. And then at 5.25% on the nominal federal funds rate in mid-2006, the Fed stopped – sending the markets a signal that something close to a 2.75% real policy rate was sufficient to cope with inflation risks. From this perspective, the normalization of U.S. monetary policy was largely complete. Similar efforts are now under way at the ECB, and at 4% on the nominal refi rate, our Euro team believes comparable normalization objectives will be achieved with another 50 basis points of monetary tightening by year-end 2007. The BoJ, of course, remains the exception. But with deflation risks a lingering concern, a full move to normalization would be premature. Excluding the BoJ, Act I of the post-deflation normalization campaign is now largely over.

Act II features the financial markets – in particular, the long end of the yield curve that has been pinned down by the so-called bond market conundrum. A number of explanations have been offered for the persistence of unusually low real long-term interest rates in the past several years – ranging from the excesses of the liquidity cycle and the so-called global saving glut, to policy-related dollar buying of Asian central banks and the persistent disinflationary headwinds of globalization. Whatever the reason(s), the slope of the yield curve – which had either been negative or flat for nearly two years – was certainly far from normal. That now appears to be changing. The 50 basis point back-up in 10-year U.S. Treasury yields over the past month is a major step on the road to bond-market normalization. From a relative valuation perspective, this also has important implications for equity markets. Last week, when the bond market sliced through the 5% yield threshold like a hot knife cutting butter, the equity market was forced to respond to the bond market’s normalization campaign – in effect, resyncing valuations with the emergence of a more traditional yield curve configuration. There could well be more to come in this act of the play.

A third act is likely in the great normalization saga – this one starring the spread markets. So far, credit spreads remain abnormally tight, as do those on emerging markets debt instruments. There is no inherent reason why these assets deserve special exemption from a financial market normalization scenario. As investors take their cue from the long end of government bond markets and begin to seek compensation for more of a two-way bet on the inflation trend, the risk on spread products should increase commensurately. The resulting increase in the funding costs of levered carry trades should also have an impact on spread-product normalization. Moreover, to the extent higher levels of both short- and long-term real rates begin to take a toll on expectations of real economic activity, expected default rates on domestic credits should rise. An analogous set of downside risks to export-dependent developing economies should also increase. In my opinion, the confluence of these developments should be more than sufficient to take a meaningful toll on heretofore high-flying spread markets. Risk assets need to be priced for risk. That realization could well be the principal feature of Act III in the high theater of financial market normalization.

Markets are not worried about an inflation surge to the upside.

Inflation and inflationary expectations play the decisive role in driving the transition between these three acts. This is hardly a shocker. After all, it was the absence of inflation – and the risks of deflation – that sparked the unusual policy moves and market responses of the past five years. If inflation comes back with a vengeance, then the neutral settings of policy normalization are, of course, entirely inappropriate. If, on the other hand, inflation stays within the tolerance band of price-targeting central banks, then there is not much drama to the script laid out above. Moreover, given the ample liquidity that would probably still exist in such a “perfect scenario”, the curtain could go down early and there might not even be a third act involving the riskiest part of the return spectrum. But what if inflation flirts with the upper bound of central bank tolerance zones? That is precisely the case today in the U.S. and Euro-zone. However, since the inflation genie is far from out of the bottle in either economies, on a worst-case basis, it is hard to conceive that either the Fed or the ECB will have to take their policy rates much beyond those implied by the neutral settings of the normalization campaign described above.

That is pretty much the scenario markets are now currently pricing in. It was also the scenario endorsed by the consensus of clients at our just-concluded annual European investment seminar. While the pack saw inflation as the biggest macro risk over the next year, fully two-thirds of the conference participants expected the magnitude of any upside breakout in European inflation to be confined to the 2.5-4.0% zone. This is in broad alignment with market views in the U.S. Unlike the weak-economy, Fed-easing mindset that dominated market expectations in early 2007, futures markets are no longer discounting any Fed rate cuts through early 2008. Further out, medium-term expectations are centered on a snugging of no greater than 25 basis points through mid-2008. With the ECB slightly behind the Fed insofar as policy neutrality is concerned, markets are pricing in a couple of more policy tightenings by Trichet & Co. by early 2008. In both cases, market expectations are in broad alignment with the calls of our own teams of Fed and ECB watchers.

For what it is worth, I am still a broken-record advocate of the growth-relapse scenario – especially for the U.S., where I continue to look for a post-housing bubble retrenchment of the American consumer. Should those fears start to creep back into the markets, a bond-bullish rethinking of normalization risks cannot be ruled out. As was the case in the aftermath of the bursting of the equity bubble seven years ago, I would not be surprised if another growth scare was in the offing before the current post-bubble shakeout runs its course. Nor do I buy the inflation-fear scenario that gets bandied around the markets these days. To me, the globalization-induced headwinds to inflation remain mighty stiff – even in the face of Chinese and Indian wage inflation. With these pay rates still only about 5% of manufacturing wages in the West, the global labor arbitrage remains very much intact – as does its ability to continue to push world prices lower.

At the same time, I worry increasingly about the protectionist wildcard – in particular, an anti-China policy blunder by the U.S. Congress that could stoke inflationary expectations and leave the hopes and dreams of bond market normalization in tatters. I also continue to fear that central banks are far too smug about the effectiveness of their inflation-targeting tactics – especially in an era when the combination of low inflation and low interest rates is biased toward a steady string of asset bubbles. Normalization with respect to the narrow CPI target hardly guarantees a normalization of broader macro risks that might stem from boom-bust outcomes in major asset markets. The three-act normalization play presupposes an inherently stable macro climate that has changed very little in recent years. Such complacency could be the biggest risk of all.

Link here.


The failure (at least temporarily) of President George W. Bush’s immigration bill had one overwhelmingly powerful cause: the American people do not trust the Bush administration to enforce immigration laws, so the tough enforcement provisions in the new bill were nugatory. This atmosphere of distrust is partly generational but highly damaging, particularly in the economic sphere.

The mutual distrust that prevents compromise is rational. On the one side, the U.S. history of racial discrimination is sufficiently recent and widespread that a distrust of motives is natural. On the other side, the total failure of the enforcement provisions in the 1986 Simpson-Mazzoli legislation, and the laughable failure by the Clinton and Bush administrations to enforce laws against employing illegal immigrants, even after the 9-11 attacks had demonstrated that border control was a serious security problem, naturally destroy the credibility of new enforcement provisions. Had existing immigration provisions been enforced with reasonable rigor, there would be far fewer illegal immigrants – and far fewer empty and unnecessary McMansions, rotting in the sun as the housing downturn hits.

Trust is an essential to commerce. Throughout human life, transactions become more difficult and perilous if trust is not present. Even in personal interactions a propensity to fabrication can doom the most promising relationship. The commercial revolution of the 18th and 19th centuries was built largely on the ability of participants to trust one another. “My word is my bond,” the motto of the London Stock Exchange since 1801, was not simply a polite fiction, it was essential to dealings between participants who did not know each other well and whose transactions either did not follow well-established legal ground or in some cases (options dealings before 1822) were on the face of it unenforceable as gambling contracts.

The Victorian and Edwardian periods did not only introduce restrictive sexual morality, they also codified a commercial behavior pattern that involved very high levels of trust. J.P. Morgan testified to the Senate in 1913 that “a man I do not trust could not get money from me on all the bonds in Christendom.” Thus in the London market in particular but also in New York, by 1900 it was essential to be trusted by ones business associates, and lack of such trust was a generally fatal obstacle to business success. This pattern persisted until well after World War II. David Kynaston’s City of London has harsh words for the oligarchic City of the 1950s and 1960s, but the system worked very well, producing by 1980 most of the innovations of modern finance, at a cost in terms of GDP a small fraction of the bloated financial services sector of today.

After 1980 or so, things changed. A number of factors were responsible for this. Generationally, the cohort which had indulged in sexual and psychedelic experimentation in the 1960s, and had rejected the morality and lifestyle of its parents, began to control a major portion of the financial system. In London, the merchant banks were wiped out by the abolition of the Accepting Houses Committee in 1981 and by the Financial Services Act of 1986. Globalization brought companies much more closely into competition with entities from other cultures with different behavior standards. The rewards for success for CEOs soared, as did the penalties for failure (no mainstream CEO before Enron’s Jeff Skilling was given a 24 year jail sentence for going bankrupt).

Most important, financing became cheap and relatively easy for outsiders to obtain. No longer did old Pierpont have to trust you. If you had a plausible track record, however doctored the figures you had used to generate it, you could leverage yourself into a major corporate purchase. In 1987 the Washington Post published a cartoon of a hayseed explaining that with no qualifications and no credit he had previously been unable to get a loan, but now the bank would help him buy any major U.S. corporation he wanted. In 2007 that cartoon is not funny.

As Bush has just discovered, a world without trust is a pretty hostile place. In the long run, without adequate levels of trust, economic prosperity must inevitably disintegrate. So the questions arise: how quickly can trust be regenerated, at least in the business world? What factors will cause trust to regenerate, and how can we nurture it?

Generationally, we may have some hope of improvement. The 1960s are not going to happen again, thank God, and the generation that was nurtured by them is finally passing from the boardroom. Subsequent generations have shown themselves in youth far less prone to rebel against the political, social and ethical norms of society, as evidenced by declining crime, drug use, and illegitimacy. It is likely that as the current generation rises to power in the business world it will come to find itself less attracted by the quick wealth promised by hedge funds and the like, and more attracted by the chance of building something worthwhile in the long term.

This will not happen while cheap money remains, however. If starting salaries working for a hedge fund are three or four times starting salaries working for a conventional corporation, any reasonably able and ambitious graduate will gravitate towards the hedge fund. More than a third of the Harvard Business School Class of 2007 have accepted jobs at hedge funds and private equity funds. That is simply a reflection of the economics they face – it is, incidentally an almost perfect “sell” signal for those institutions.

Only once cheap money has gone, and the inevitable shake-out in the short term return businesses of Wall Street has occurred, will Harvard Business School and other well-qualified students make their choices based on their own underlying values and not on a huge immediate differential in earnings. At that point, the outcomes are likely to be very different. Contrary to the leftist dream, HBS students will not rush off to join charities, but major corporations that show signs of both stability and a high level of innovation will prove attractive destinations.

However, more than the end of cheap money will be needed for trust to return. For one thing, the end of cheap money is likely to lead initially to a surge in bankruptcies, which will inevitably be accompanied by innumerable toe-curling sagas of corporate malfeasance. For several years, very few people will trust the corporate sector at all, good, bad or indifferent. That, like the disruption caused by bankruptcy to the lives of innocent employees, is the inevitable denouement of an era of artificially cheap money and bubble-hood.

Corporations will regain their good name, and their ability to be trusted, by acting in a trustworthy manner. Stability will eventually return to the corporate structure, so that the median corporation exists for half a century and not half a decade. Top management must stop using accounting shenanigans to deceive shareholders about the excessive remuneration they are extracting – needless to say this will also require them to stop extracting excessive remuneration. Leverage must be cut back sharply – those corporations which do not do this will in any case not survive in an era of tight money. Business plans must be rationalized, and not become mere tools of empire building and corporate dealmaking. Consultancy usage must be cut back, and eliminated altogether from such areas as top executive compensation in which it is ethically inappropriate.

In a decade or so, the corporations emerging from the downturn will finally be trustworthy, and will in their business dealings put two-way trust relationships at the top of their objectives, where they belong. They will not look like the corporations of 1965. For one thing they will be far more multi-national, bound together by the marvels of modern communication, and they will manufacture primarily in locations where labor costs are much lower than the U.S., and yet quality is as good. However between their multinational workforces internally, and between the multinational workforces of corporations that do business together, trust will be established at an extremely high level.

The technology would be incomprehensible to J.P. Morgan. However if Morgan returned to 2027 he would see, as in 2007 he would not, that the central principles of trust in which he believed were alive and well.

Link here.

Bear Market: Polarization and Conflict

The fate of the immigration bill in the U.S. Senate has emphasized the two polarized sides of the issue: a majority of Americans who think it is a good idea to have an immigration bill – even one that is poorly executed – and the vocal minority who think that any bill that allows illegal aliens to become U.S. citizens is an unmitigated disaster. And this brouhaha is just a taste of what social conflict will look like during a full-blown bear market and accompanying depression. Bob Prechter describes how polarization and conflict will touch everyone’s lives in this excerpt from his best-selling business book, Conquer the Crash (2004).

The main social influence of a bear market is to cause society to polarize in countless ways. That polarity shows up in every imaginable context – social, religious, political, racial, corporate, by class and otherwise.

In a bear market, people in whatever way are impelled to identify themselves as belonging to a smaller social unit than they did before and to belong more passionately. It is probably a product of the anger that accompanies bear markets, because each social unit seems invariably to find reasons to be angry with and to attack its opposing unit. In the 1930s bear market, communists and fascists challenged political institutions. In the 1970s bear market, students challenged police, and blacks challenged whites. In both cases, labor challenged management, and third parties challenged the status quo.

In bear markets, separatism becomes a force as territories polarize. Populism becomes a force as classes polarize. In the area of personal behavior, part of the population gets more conservative, and part gets more hedonistic, and each side describes the other as something that needs reform. One reason that conflicts gain such scope in depressions is that much of the middle class gets wiped out by the financial debacle, increasing the number of people with little or nothing to lose and anger to spare.

Link here.


William H. Gross, the bond investor and chief investment officer of PIMCO, confirmed his prowess in another area when his collection of 19th- and early 20th-century British stamps was auctioned in New York for $9.1 million. The proceeds were donated to Doctors Without Borders, the international humanitarian charity.

Shortly after the auction ended, Mr. Gross said that he was gratified by the amount raised. He said that he had acquired some of the stamps within the past decade for as little as 1/10 to 1/4 the amounts they brought. The top item – a reconstructed mint block of 24 of the world’s first stamp, the Penny Black of Britain, issued in 1840 – sold for $1 million. Another item – an envelope mailed from England to Malta in 1841, bearing 5 Penny Blacks and 3 Two-Penny Blues – sold for $650,000 to a buyer from Britain.

It brought the highest amount ever bid over the Internet for a philatelic item, according to Charles Shreve, the president of Shreves Philatelic Galleries, which handled the auction. Mr. Shreve and his wife, Tracy, had assisted Mr. Gross in building the collection. Mr. Gross said that he intended to continue building and exhibiting his collections of stamps.

Dr. Darin Portnoy, president of the U.S. section of Doctors Without Borders, said that the donation was the largest from the U.S. in the charity’s 36-year history, and would be used to improve rapid response around the world. He said priorities were in areas like Jordan and the Kurdish area of northern Iraq, where war refugees with drastic injuries needed urgent and extensive surgery, and Chad and Sudan, where refugees from fighting in Darfur and related conflicts suffered from serious malnutrition.

Link here.


An old friend brought up another old friend. “You remember Catherine?” he asked. “You know, she collects photographs. I mean, photographs from well-known people. Well, guess what? The market for photographs has gone crazy. Actually, all the collectibles have gone crazy. There is just so much money around, it’s stirring everything up. She had a few photos that she had paid $4,000 for, a few years ago. They are going on the auction block at Christie’s this week. Guess what the guide price is? A half a million. It’s really unbelievable.”

See how easy it is to get rich, dear reader? Just buy something. Then, you wait a respectable interval, and then you sell it to someone. It is so easy an idiot could to it. In fact, many of the people who are doing it are idiots. They are dumb enough to believe that asset prices always go up. And they are getting rich because they do not know any better. Oh, to be an idiot.

But what kind of wealth is that you get without working or saving? “The best kind,” say most people. But to us, it seems more like a case of false pretenses. It is like a man who marries a rich widow ... and then discovers that she is as penniless as he is. Maybe it will work out. But, maybe it won’t.

We confess that we are too rich to steal, too dumb to lie, and too humble to profit from a credit bubble. To get rich in today’s wacky markets, you have to believe wacky things. We do not mind believing wacky things, but the problem is the wacky things you need to believe today, scratch uncomfortably against our sense of humility.

Today, you have to believe not only that over-priced financial assets are going up, but that you alone know which ones will go up most. And you also have to believe that you know better than Mr. Market. Because, when you buy at the market price, you are wagering that Mr. Market has made a mistake and missed something. And then, you have to believe that when he gets around to noticing what he has missed, the asset you just bought will have gone up in price.

The staggering arrogance of it is too much for us. We do not buy things because we think Mr. Market has bungled. We only buy things we think are of real value. But right now, where can you find a real value? In the stock market? In the property market?

How about Paraguay? That is where the Bush clan has bought a ranch. We think perhaps they were looking ahead to the time when they would have to flee an angry American mob. They have probably made a deal with the Paraguayan government, letting them skulk down there after people get wise to what they are up to here. Or, maybe they were just looking at values. According to International Living’s reports, there is no place where you can get more for your money than in Paraguay. Who wants to live in Paraguay, you ask? We do not know, but we will check it out.

But let us return to the world’s first Worldwide Bubble. We notice one other thing – in addition to gold – that did not bounce up last Friday. That was the 10-year U.S. Treasury note. It is going down. Which means, the price of credit is going up – despite the glorious gush of cash and credit from central banks, CDO investors and others. Now, if the cost of debt goes up enough, of course, the credit bubble will blow up.

According to classical economic theory, an expanding credit bubble takes more and more credit to expand and keep output increasing. That is what we have seen for the last few years – higher debt/GDP. Economists now warn that the housing slump may have a longer-lasting effect on GDP growth than previously thought and (according to the most recent reading), actual GDP growth has fallen below the rate of population growth. As a credit bubble goes on, it becomes less effective at producing wealth – and more effective at producing what was most lacking in the first place – humility.

That means that if this book keeps at this rate, Americans will eventually be sneaking across the Rio Grande, to look for work. Maybe the Mexicans will build that wall before us.

Link here.


Over on RealMoney, Barry Ritholtz opined that the U.S. government is probably underestimating inflation because it is focusing on the wrong type of inflation. I would agree with that, having identified no less than five different types of inflation: commodity inflation, wage inflation, monetary inflation, fiscal inflation, and foreign exchange inflation. Before discussing “inflation”, it helps to identify which form of inflation is being talked about. Failure to do so may have caused some of the confusion that often surrounds this topic.

The inflation that most American economists remember best is wage inflation, otherwise known as demand-pull inflation. Workers observe rising prices and demand compensation in the form of higher wages, which creates a vicious cycle of more inflation and more wage demands. There has been a long absence of this in the United States, due to the absence of labor unions, and to what Karl Marx called the “reserve army of the unemployed” in “offshore” markets. This appears to be the form of inflation that the Fed and other U.S. government authorities are focusing on, and it has indeed been benign up to now.

A less common, but more volatile form of inflation is commodity inflation, better known as cost-push inflation. We can see it today in commodity prices such as energy and metals. Energy and food price changes are excluded from “core” inflation because of their period-to-period volatility. But over time, oil price rises have averaged 6% a year – higher than other forms of inflation – and assuming that they do not cause inflation is really assuming away the problem. Other commodities such as timber rise at 3% a year in so-called “real” (above the rate of calculated inflation) terms.

Another form of commodity inflation that is excluded from the official statistics has been the parabolic rise in housing prices. The government instead uses a calculation of “owner equivalent rents”, which are basically tied to the benign wage numbers. Commodity inflation is the most obvious form of inflation today (after having been quiescent in the 1990s), as reflected in higher food, gasoline and gas bills, but is severely understated.

Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the German government went crazy with the printing presses. This wiped out the savings of the middle class, most members of which were compensated with worthless “million mark” notes, and eventually led to the rise of Hitler. Nothing of this sort has happened in the western world since, but it is a worry when the U.S. has a chairman of the Fed who has talked (hopefully facetiously) of dropping money out of helicopters.

Fiscal inflation is due to excess government spending, for which the budget deficit is a reasonably good proxy. It originated in the “guns and butter” spending of President Lyndon Johnson in the 1960s, and similar spending of today’s President Bush. We have war spending without a “war economy”, e.g., rationing or wage and price controls. If the 1960s are any guide, we will be paying the price later this decade and in the 2010s.

The last type of inflation, foreign exchange inflation, is particularly scary to me, as someone who lived in Mexico before and during the peso crisis in 1994. This happens when the local currency (pesos in that case) falls dramatically against other world currencies, thereby sharply raising the price of imported goods, and hence the overall price level. This is a real worry for the U.S. when the latest annual trade deficit is somewhere over $760 billion. I am not looking for anything like the two-thirds fall of the Mexican peso in 1994-95 as a result, but even a 20% across the board drop of the U.S. dollar against the Euro, yen and yuan would be a severe shock stateside.

Link here (scroll down to piece by Tom Au).

Rampant Inflation

Caroline Baum is asking, “Is Inflation Coming Back or Just Filling a Void?” When it comes to prices, I happen to agree with her overall theme, which I take to be “don’t uncork the [inflation-is-coming] champagne just yet.” But ... Before we can say whether inflation is coming or going or ever left in the first place (and before I get blasted with hate mail, like she did), we must first agree on what inflation is. Of course, this gets into religious arguments, and some prefer to leave the bruise marks from such debates to others.

I have taken up the cause (and I have the bruises to prove it). So have many others. But even among those taking up the cause, there are violent disagreements about the endgame. No, I am not going to rehash where we are headed. I have stated the case for deflation dozens of times, and I am not going to repeat it. Instead, let us focus specifically on what inflation is.

Gary North is writing about “Ben Bernanke’s Post-Horse Barn Door-Locking Strategy for Real Estate”:

“Ben Bernanke’s June 5, 2007, speech on the real estate market was an exercise in futility. He did not refer to the obvious: his predecessor’s monetary policy, which created a real estate bubble. ... He admitted that the present economic slowdown was heavily dependent on the fall in the real estate market: about one percentage point ...

“‘As expected, we have also seen a gradual ebbing of core inflation, although its level remains somewhat elevated ... However, although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside. In particular, the continuing high rate of resource utilization suggests that the level of final demand may still be high relative to the underlying productive capacity of the economy.

“But what is causing this price inflation? He did not say. That is because price inflation is a monetary phenomenon, and the Fed controls the monetary base.”

There you have it. Two people who could not possibly disagree more about the final outcome (the author and Gary North) are at least in agreement about the problem (presuming I can throw in the expansion of credit into Gary North’s statement about the monetary base). Gary, are you with me on this? Even if not, let us proceed.

Inquiring minds might also want to consider “Marc Faber Shatters Prevailing Market Myths”:

“Q: How important is it to understand the role of the Federal Reserve to understand the world economy?

“A: I think it is very important to understand the fact that we have a central banking system where the central banks can indicate, theoretically drop dollar bills from helicopters. You will not be able to do that because all American helicopters are in Iraq. But they can print money, that is a fact, and they can flood the system with liquidity.

“Then you have to find a measurement of inflation. We measure inflation by rise in money supply. It would be wrong to think that the inflation is just consumer price increases. Inflation is a loss of purchasing power of your currency, dollar, or rupee. It can manifest itself by rise in consumer price, but it can also manifest itself by a loss of purchasing power of money against real estate, or against stocks and real estate.

“Q: What is the public enemy No. 1 in your book, would it be inflation or deflation?

“A: In my book public enemy No. 1 are the central banks. I think the world will be much better off under a gold standard. Other than that, I think the asset inflation is much more dangerous than consumer price inflation because asset inflation is driven by a huge credit bubble.”

Interview With Paul Kasriel – Economist, The Northern Trust:

“Does that mean you believe that inflation is a monetary phenomenon related to increases in money supply and credit, as opposed to rising prices?

“Kasriel: Yes, and that is exactly why Greenspan was so lucky. Inflation was masked by the factors we just mentioned ...

“How does inflation start and end?

“Kasriel: Inflation starts with expansion of money and credit. Inflation ends when the central bank is no longer able or willing to extend credit and/or when consumers and businesses are no longer willing to borrow because further expansion and/or speculation no longer makes any economic sense.”

Gary H. Stern, President of the Federal Reserve Bank of Minneapolis, 1995, in “Formulating a Consistent Approach to Monetary Policy”: “One of the few topics about which most macroeconomists agree is that inflation is first and foremost a monetary phenomenon. It results from a long-term pattern of money creation which is excessive relative to the economy’s ability to produce real goods and services. Further, there is widespread agreement that the supply of money is determined by the central bank in the long run.”

My own thoughts on what it is can be found in “Inflation: What the Heck Is it?” On the basis of the agreed-upon definition from those listed above (that inflation is an expansion of money and credit), one can look at M3 and clearly see that inflation is soaring. (I have never said otherwise and my deflation outlook is about endgame expectations.) Although the cork of the credit bubble bottle popped long ago, that magic bottle of credit supply seems endless. It is not endless, of course, but as promised, I am not going down that path in this post.

Caroline Baum makes the case that price inflation is decelerating. One can believe that or not, but regardless, the Fed is amazingly disingenuous to be harping about inflation just as its own measures show that its preferred measure of inflation is heading south. That is a major thesis of her article, and few seem to have caught it.

Interestingly enough, it was not that long ago when it was widely understood that inflation was about money as opposed to prices. Those who believe inflation is about monetary policy now happen to be in the minority. What happened to the definition? Was the change happenstance, or constant, purposeful chipping away at the truth?

The meaning of inflation has evolved significantly over the past 100-plus years, but the original meaning is the proper one. But it is in the interest of the bubble-blowing Fed and the government that people not understand what inflation is. That way, they can always give some BS answer as to what they are doing and why, and that also helps explain the change in the meaning of the word in the first place.

It is virtually impossible to know why prices are rising or falling. Is oil rising because of Peak Oil or the inflationary policies at the Fed? Are food prices rising because of idiotic governmental policies on ethanol from corn or from inflationary policies at the Fed? The current fixation on prices allows the Fed to blow asset bubble after asset bubble, given that asset prices are not included in the mix of prices monitored. Whether or not anyone objects, the Fed has set itself up to be the sole arbiter as to why prices are rising or falling. This lets the Fed do what it wants when it wants ... as long as the market will cut it slack. That is a BIG reliance on the market, and will ultimately be the Fed’s undoing.

With nearly everyone fooled about what inflation really is (by the way, add Ron Paul to the list of those NOT fooled), the Fed can and does talk complete nonsense about capacity utilization, jobs, trade deficits, oil, productivity, inflation expectations, etc., and comes to any conclusion that it wants. The Fed never talks about the expansion of money and credit, runaway borrowing to fund IPOs, debt-financed share buybacks, the war deficit, or the fact that government is spending far more money than it takes in year in and year out. In other words, the Fed talks about anything and everything but inflation!

The current sad state of affairs can be condensed down to the fact that the Fed sets U.S. monetary policy but never mentions credit or money supply itself. Nonetheless, if you read between the lines, reckless expansion of credit has to be what has the Fed spooked, because as Caroline Baum points out, none of the other story lines seem to fit.

Link here.


There must be some kind of tried and true sit-com formula involving a 20-year look back. Happy Days was one of the most popular sit-coms airing in the 1970s and ran 11 seasons. Happy Days was set in the 1950s and revolved around a group of teenage friends, their mishaps, and their coming of age, in Milwaukee suburbia.

That ‘70s Show, set in the era of Led Zeppelin 8-tracks, Tab cola and Farrah Fawcett posters, debuted on the Fox Television Network in August 1998. This sit-com revolved around a group of teenage friends, their mishaps, and their coming of age, set in 1970s, coincidentally, in Milwaukee suburbia. An 8-year run in a prime time slot is a testament to the show’s popularity.

That ‘70s Show was obviously targeted to late-stage baby boomers like me. My memories of the decade are generally positive – Cub Scouts, trips to grandma’s house, school band, going on dates (well, at least trying to). Of course, my memories are from the perspective of a relatively care-free teenage boy. I did not have to deal with some of the harsher realities of the times. Vietnam, gas rationing, Watergate, leisure suits ... I suspect people my parents’ age may have less pleasant memories. That ‘70s Show in the U.S. economy was one that most folks would prefer to forget. Unfortunately, this show might be making a comeback in 2007.

From an investment standpoint, the decade of the 70s was one of the worst of the 20th century. Even though the S&P 500 more than doubled between 1970 and the middle of 1982, the CPI had soared more than 150%. The S&P 500 produced a negative inflation-adjusted rate, also known as the real, of return of -1% per year during 1970-79. The only worse decade for stocks was 1910-1919, when the market averaged a -2.6% annual real return.

Sucking in the Seventies is the name of a Rolling Stones “Greatest Hits” album released in March 1981. The title aptly describes the performance of the U.S. economy during that period. And if Mick Jagger had finished his studies at the London School of Economics before fronting for the Stones, he might have penned a song titled “Stagflation”. What exactly is the phenomenon economists call stagflation?

Stagflation is a term that originated in the early 1970s to identify the simultaneous occurrence of recession and inflation. According to Sean Corrigan, the Chief Investment Strategist of Diapason Commodities Management, in the early 1970s the business cycle had peaked. Corporate profitability was “caught in the grinder between heightened costs ... and less rapidly rising output prices and sales.”

So across the whole economy, costs are rising at a faster clip than sales. Profits are getting squeezed. Can’t we fix this? Surely the government has a solution to the current state of the economy ... French economist Nicolas Bouzou writes “in theory, recessions (and the unemployment implied by them) are cured by inflation, while inflations are cured by recessions. When both occur at once, the theory is not only seriously challenged, but fiscal and money managers are at a loss concerning what to do next.” So why won’t inflation solve the stagflation dilemma? Corrigan examines the economy of the early 70s for some answers.

Central banks attempted to mitigate the stagnating economic condition of the early 1970s by loosening monetary policy. Easy money did eventually drive the price of goods higher, but did not stimulate the overall economy. Corporations became reluctant to keep their expensive workers, let alone hire more. In spite of rising nominal prices and wages, the labor market continued to weaken.

Stock investors in the stagflation of the 1970s as shown in this chart above, did not fare well. Neither did bond investors. Even CDs and T-bills, despite offering double-digit yields, failed to keep pace with inflation. Corrigan: “Under stagflation conditions, nominal bond yields may be rising, even as real returns are falling ... Equities may find that a nominal earnings slowdown (and probably a real earnings decline) is compounded by a contraction of the multiples thereto attached.” In summary, stagflation creates a toxic brew for financial asset prices.

There is some compelling evidence that the U.S. might be entering another stagflationary period. The U.S. economy appears to be slowing down. Interest rates in the U.S. and around the world are slowly moving higher. John Williams, of Shadow Government Statistics, provides even more damning evidence. Williams writes a monthly electronic newsletter that exposes and analyzes the flaws in current U.S. government data and reporting. According to Williams, changes to the CPI made during the Clinton years drastically underestimate the true rate of inflation. Williams’s estimate of inflation is 6.2% versus the official CPI of 2.6%. Even if his adjustments to CPI are only half right, it still indicates that real economic growth in the U.S. is negative. Chris Mayer wrote a more detailed report on Williams – see Figures Don’t Lie, Liars Figure.

Marc Faber, editor of the Gloom, Boom, and Doom Report, believes the U.S. has reached the stagflation phase already. Faber cites weakness in the utilities and real estate indices (prior to the Dowqts recent sell-off) as evidence of market expectation of rising interest rates. If stocks, bonds and cash did so poorly in the stagflation of the 1970s, what might the humble investor do to best weather the storm?

Look no farther than the Rolling Stones’ 1978 release, “Everything Is Turning to Gold” – a song that appeared on the flip side of “Shattered”. While stocks and bonds were, um, sucking in the 70s, gold was “Hot Stuff”. We should not be surprised if the timeless monetary metal becomes hot stuff again very soon.

Link here.


Richie Rich was the sweet little rich kid that appeared in comic books from the 1950s through the 1980s, and later in an animated TV series. Despite being the richest kid in the world, Richie was not conceited, and his family and friends were the most important things in his life. He was wholesomely, appealingly rich, and he affected the attitudes of a generation of children.

Compare that vision of the rich with 1906, when the top 1% of Americans owned as much as 60% of all U.S. wealth. The heyday of Rockefeller and Morgan yielded to Teddy Roosevelt, who said the only kinds of rich were the criminal rich and the foolish rich. By 1912 rich was something you tried to hide. In 1920, a bomb exploded outside J.P. Morgan’s bank killing 38 and wounding 200. That was terrorism on U.S. soil, directed at the rich.

The Roaring Twenties smoothed the wealth gap somewhat, until the 1929 crash exposed the fraud that comes with financial mania. Then came some of the worst riots in U.S. history, gold was confiscated and tax rates for the richest rose above 90%. Most people do not remember that these rates lasted through the 1960s.

A certain level of wealth disparity in any society seems to trigger backlash against the wealthy, because the middle and lower income people suffer more than the rich in a downturn. This does not happen overnight. The progress from reverence to revilement has stages and leading indicators. First comes ridicule, a waning of society’s respect for and emulation of the rich. The hatred is later.

An article in the New York Times last week reviewed a new book, Richistan, which describes how the rich are dealing with the chronic shortage of trained butlers to perform the perfectly synchronized “Ballet of Service”, a deft dance while juggling silver platters. At the same time the article celebrates our emulation and envy of the rich, it sounds undertones of ridicule of excess.

You can see a mixture of attitudes toward the rich in articles about shortages of trained yacht crew, CNBC’s new High Net Worth program that “speaks to the ultra-affluent,” and Steven Colbert’s new segment, “Colbert Platinum”, in which he heaps sarcastic praise on the very rich. There is still a mix of feelings out there, but the point is the leading indicator. When the media ceases to portray the rich as worthy of envy and emulation and begins in earnest to show them as foolish and ridiculous, what comes next?

Link here.


Almost everyone, probably including yourself, gets held back by inertia at one time or another. Inertia weighs on an investor, trapping him in a state of paralysis and freezing his portfolio, almost forcing him to hold on to whatever he already owns – for no better reason than that he already owns it. He hopes that every one of his old shoes will go up, even if the reason for the purchase is long forgotten or the environment in which the investment might have prospered has vanished. People who substitute hope for cold-blooded analysis almost inevitably wind up losing money.

So, for the sake of argument, let us look at where you might best put your money for the rest of the year 2007. To keep things simple, say you start by liquidating all the cats and dogs populating your portfolio, so that you have just a pile of cash. But then you are going to start wondering which of the securities you own really are cats and dogs. You might get bogged down. And then inertia will creep back in, and you will throw your hands up and do nothing. So instead say you sell everything, in true going-out-of-business style. Now, where are the smartest places to put that money? Let’s look at the alternatives.

Bonds? A disastrous sucker bet. Bonds, at the moment, are a triple threat to your capital. First, you have a huge risk with interest rates, which are still near historic lows. As they go up, the market value of your bonds drops proportionately. Second, no matter which of the fiat currencies you choose, you have a big currency risk. While the U.S. dollar is on the fast train to zero, virtually every other currency in the world is being inflated along with it and is heading toward eventual oblivion. Third, you have credit risk. General Motors is not the only large company whose bonds may go into default.

Stocks? The general market is yielding less than 2% in dividends, less than 1/3 of what you typically see at major market bottoms. And selling for more than 18 times earnings – 25+% higher than its norm. The bull market of the century started in 1982 and, in inflation-adjusted terms, ended in 2000. Stocks are almost certainly early into a bear market that could last another 5 or 10 years. By all traditional measures, chances are much better that stocks will drop 50% from here than gain 50%.

Cash? T-bills currently yield only 5%, before taxes. Inflation (notwithstanding the highly imaginary official figures) is probably running around 6% and likely to head higher.

Real estate? At the present, at least in the U.S., this is probably the worst choice of all. The speculative boom crested last year, and the market, burdened by an immense amount of debt and overleveraged speculation, is likely to head down for years to come. Of course, there are places in the world – two of our favorites being Argentina and Uruguay, where there is not much of a mortgage market, so the properties are not overleveraged and values are still available. But unless you are looking to pick up cheap land in undeveloped, exotic countries that have avoided the credit-driven bubble, real estate should be last on your list of investments.

Mutual funds are just a way of buying one of the investments we have already dismissed. Paying all those fees and expenses that come with a mutual fund just makes the bet that much worse.

So what should you do? Since 2001, we have been in a natural resources bull market. If you were one of the few who positioned yourself in gold, silver or pretty much any of the metals or energy commodities – either directly or through the shares in smaller resource companies, which is the preferred vehicle we have been recommending to subscribers of our International Speculator – you have already made the easy money. At least to us, before the bull market kicked off, the opportunity in the sector seemed obvious, with many resource companies selling for less than the cash they had in the bank. Few people even knew the sector existed, and most of them thought it was a dead duck after the 20-year-long bear market it had suffered since 1980.

The easy-money stage of the resource bull ended in 2003, at which time we entered the second stage, where the market climbs a “wall of worry”. In even the most formidable of bull markets, this phase comes with inevitable corrections and scary downdrafts. Per its moniker, with each short-term setback in price, investors who were shrewd enough to get positioned early on into the long bull market fret that they might be wrong. Some are shaken out, but the smart ones buy even more on the dips.

But now, in my opinion, we are about to enter the third, and most important, stage of the classic bull market: the mania stage. This will resemble the tail-end of the Internet stock bull market. It will very likely be rising expectations for inflation. Fear will drive the foreigners who hold about $6 trillion to sell the greenback, and they will be joined by savvy Americans. Some will buy other paper currencies, like the euro or the yen. But those units are just backed by U.S. dollars themselves, so they really are not much in the way of an escape pod. Inevitably, much of the money now sloshing through the world will try to get into gold. While no one can say with certainty, I expect the metal to hit $1,000 within the next 12 months and go much, much higher by the end of the decade.

Is this an unreasonable prediction? No. Most casual investors mistakenly look at gold and think it has been a leader in this bull market, when it is actually a laggard compared to the industrial metals that have been bidden up to extraordinary highs by soaring demand from China, India and other emerging markets. In the last five years, copper has been up 330%, nickel 560%, uranium 1150%, zinc 460%, molybdenum 450%, and even lowly lead, the most basic of base metals, is up 425%. Gold is up only 100%. That will change. Although gold has many and growing industrial uses, its main use is as money. It will dawn on the herd that the world is drowning in a flood of increasingly worthless paper currency, and they are going to stampede into gold. The metal is not just going through the roof – it’s going to the moon.

When gold really starts to move, the mining exploration stocks are going to howl. Gold exploration stocks are not just highly leveraged plays on the price of gold. They are capable of providing you with triple-digit gains based on exploration success alone. The last mining share boom from 1993-96, which occurred at the tail-end of gold’s 20-year bear market and carried hundreds of stocks with it, was driven entirely by a handful of discoveries. Since gold prices turned up, starting in 2001, a lot of money has been spent on exploration, and that work will inevitably lead to major discoveries and market excitement. Confirmation of a major discovery could well ignite a mania in the market.

While most other investments, such as bonds, industrial stocks, real estate and broad mutual funds are likely to be serious losers over the coming years, the bull market in gold and gold exploration stocks has still barely entered the public’s consciousness. Although the easy money has been made, the big money is waiting to be picked up.

Nothing in the investing world is ever a sure thing, but today the exploration stocks look to be as close as it gets. As for the inevitable corrections during this “wall of worry” phase, remember that the time to be timid is when everyone else is bold, and the time to be bold is when everyone else is timid. Selloffs in the gold and gold mining sector are, to our way of thinking, gift-wrapped opportunities to buy.

Link here.
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