Wealth International, Limited

Finance Digest for Week of June 25, 2007

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


Here is a good reason for believing that the bull market will continue: Journalists do not think it will.

Business commentators keep trying to see a peak or to imply that the market is high. Since this bull market began in 2003 they have been bearishly biased. And that is bullish. They have been looking back at 2000’s peak, clearly a deadly time, and making comparisons with now. They are fighting the last war.

Yes, the Dow Jones Industrial Average and Morgan Stanley World Index are at alltime highs, as we are constantly reminded. But many indexes are not – notably the Nasdaq, the Japanese markets and pretty much any growth stock index. And note that the headlines about new highs never mention inflation. Prices are up 20% from the spring of 2000, the last time records were being set, and so it would take an S&P at 1800 to set a real record.

Something else about that last war: Stocks were expensive seven years ago, compared with long-term borrowing costs. Now, on that metric, they are at near-record cheapness. Since 2000, S&P 500 earnings are up 57%. Should stock prices not be up, if not in tandem, at least by a good amount? Yet the media see earnings growth as bearish. It seems that earnings, as a fraction of economic output, are abnormally high and so due for a collapse.

Take the Wall Street Journal’s May 23 front-page story “Why Market Optimists Say This Bull Has Legs”. It is cast as a story about why optimists see more gains ahead but really spends much more ink on why gains are not ahead. The story suggests that regression to the mean from high earnings levels will drive this market lower. The experts saying this, however, have been saying this for several years. The day will come when profits shrink, yet there is no evidence for why this day is imminent. The WSJ article does not identify a trigger. My prediction is that before this bull dies we will see a Journal front-page piece on why it is different this time and the bull will buck for several more years.

While you are waiting for the bears to turn bullish, buy good stocks like these:

Link here.


Every year or so I update my views on technical approaches to the market. Inevitably the column precipitates a barrage of letters to the editor charging that I am incompetent and/or ignorant. The complainers, though, have never refuted the contentions in either of these columns or in a detailed study I published 11 years ago, “The Failure of Technical Analysis”.

Technicians, a.k.a. chartists, are somewhat in the news of late as both the DJIA and its companion Transportation average hit new highs. It is an axiom of chart-following investors that trends persist – that the market is not a random walk. The trend-following theory of Charles Dow, the original publisher of the Wall Street Journal, can be summed up this way: A bull or a bear trend is not established until the movement of one average is confirmed by the other. Would that life were so simple. On October 12, 1992 one technician noted in a prominent story in a certain business weekly that the Dow Theory was then saying that a bear market in stocks was under way. Over the next 12 months the DJIA gained 13%. And a bear market did not occur until 2000.

One of my issues with technicians (and other analysts) is that many forecasts are made with analysis that is perfunctory or nonexistent. At least, if you are going to make a pronouncement about market direction, you should collect lots of data. Perhaps the reason technicians often and regularly peruse small data sets is that seemingly foolproof trading formulas crumble when examined against a long historical backdrop.

Recently I was reading a book on the history of finance written by Leslie Gould (The Manipulators, published in 1966). Page 191 includes an amusing quote regarding the Dow Theory that appeared in the Wall Street Journal on August 13, 1929: “Stocks derived further powerful impetus on the upside yesterday from the establishment of simultaneous new highs in the Dow, Jones industrial and railroad averages at Monday’s close. According to the Dow Theory, this development reestablished the major upward trend.” So, 76 days before the stock market crash of 1929 this presumably surefire indicator was telling investors to buy.

For those chartists whose response might be (and has been), “Let’s see you do better,” I would point out that beginning in 1990 the old PBS program Wall Street Week undertook an experiment in which 10 Wall Streeters were asked to project the market for one-, three- and six-month periods. On May 21, 1995 Louis Rukeyser reported the results: “Since October 1990, when the index [the Wall Street Week elves index] in its present form began, the most consistently reliable elf has been Laszlo Birinyi.” Okay, I was guessing, as were the other elves, but the guesses were based on a thorough historical analysis. I did not make projections from head-and-shoulders formations, like the chartists.

Technical analysts have a hard time discerning cause from coincidence. Recently we have heard that the third year of a presidential cycle has a good record. These technicians conveniently ignore the fact that the second year of the cycle had a long historical pattern of ending down. Whoops, that theory did not work last year. Many technical tools are descriptive, not indicative. The fact that a lot of stocks are going up provides no insight into the next week or month and is descriptive. But the large net inflows into emerging market mutual funds is a plus for the stocks they own and is indicative.

While I am aware of successful investors who consider technical perspective, I have yet to see one who wholeheartedly endorses the approach. In any event, you should be wary of technicians, strategists and economists who are too sure of themselves. Like movie critics or restaurant reviewers, they know how it should be done but are not practitioners themselves.

My view of the market, based on flows of money into stocks (comparing dollar volume of trades to price changes), is optimistic. I continue to like Vornado Realty Trust (114, VNO), which keeps expanding earnings amid strong demand for office space, especially in Washington, D.C. and New York, where it is a big presence. A recent purchase of mine in the funds that I am responsible for is the New York Times (26, NYT). It is cheap, like all newspaper stocks these days, but the company will find ways to capitalize on the Internet and even to extract more profit from newsprint.

Link here.


Often the hardest thing for investors (and spectators) to do is to remember the plot. There are so many clowns on stage ... so many doors slamming ... so much greasepaint roaring ... such smelly crowds. So let us try to recall what has happened.

The U.S. stock market now stands at its highest level ever. By most measures, it is as pricey as 1929, 1968, or 2000. The correction that began in 2000 was washed away by huge new waves of liquidity, which now slosh over the globe and lift up everything – including a lot of trash and debris. Upon this sea of easy cash and credit, practically every stock market on the face of the planet floats higher and higher.

Meanwhile, the captains of the financial industry never had it so good. They are earning billions by doing deals – essentially transforming this huge flood of credit into debt, equity, property and consumer items for the rich, such as luxury yachts, sumptuous estates, snazzy airplanes, and various objects of ersatz art and genuine ridicule. At the Paris Air Show, for example, one of the Bass brothers is shopping around plans to build supersonic executive jets at $80 million a copy. Heck, why not? Think how much more productive an executive could be if he could get from New York to London two hours earlier. Think of all the deals he could do!

Of course, a supersonic jet is not a necessity. It is a vanity. But vanity plays an important role in this performance. Like a Greek tragedy, our protagonists are victims of their own vanity. They think they can get away with anything! And spectators and speculators cannot help themselves. They see our heroes – the hedge funds, the private equity funds, the bankers, the lawyers, the math geniuses and derivative impresarios – making fortunes. They see them in the newspapers, gloating over their billion-dollar paydays. They see them in Architectural Digest in front of their Greenwich mansions. They see them in the society pages, giving millions to charitable causes. And they see them at Christies and Sotheby’s holding up their hands to bid millions for some abject oeuvre by some no-talent hustler. Seeing all this, how can others not want to join them?

Even some of the greatest and most experienced market observers, and here we think of Richard Russell, have finally given up fighting ‘em. They have decided that this really is a New Era, and that this is the time to join ‘em. This worldwide bubble is more worldly and more bubbly than any in history, they say. It may get much, much bigger. And they have good reasons to think so. All those billions of Asians ... all those trillions of new money ... all those new hedge funds ... all those new investors ... all those reserves of dollars ... all those new financial instruments. How can they help but blow this bubble up even bigger – so big even the moon will have to get out of the way.

But wait ... what about the old market adage: The bull market is over when the last bear throws in the towel? Are there more bears still out there?

We don’t know. But there cannot be many of them.

Link here.

The New Capitalism

Things are seldom what they seem,
Skim milk masquerades as cream;
Highlows pass as patent leathers;
Jackdaws strut in peacock’s feathers ~~ Gilbert and Sullivan

“We are witnessing the transformation of mid-20th century managerial capitalism into global financial capitalism,” writes Martin Wolf in the Financial Times. Oh no! Not another New Era. We have seen so many already. Once we get the hang of one, along comes a new one and we have to start all over again.

Capitalism is prone to New Eras, as Wolf notes. Left to its own devices, it does to established institutions approximately what Sherman did to Atlanta. This New Capitalism, though, is different. It is unlike any other capitalism in every way – except the essential one. Like a drunken boat, it rocks and rolls on the great waves of money and politics. It drifts along with the market currents ... gets blown this way and that by heaving gusts from mobs, manias and monetary madness and then ... it sinks.

Mr. Wolf maintains that this New Capitalism is much more financial and much worldlier than the old one used to be. The old model of capitalism used to be focused on economic output. This new model concentrates on buying and selling the capital assets themselves. Today’s most successful capitalists tend to earn money not from producing things, but by financing capital transactions. Or, as Wolf says, “finance has become far more transactions-oriented.” Deals, deals, and more deals! There are more players in the financial world. They play harder. And they have more to play with – hedge funds and private equity funds, for one thing. And derivatives barely existed 20 years ago. In 1987, the total notional amount of interest rate and currency swaps was approximately zero. Today, including property derivatives, the total notional traded value is over $500 trillion – roughly 10 times global GDP.

Another thing that is different about this capitalism is that it is more cosmopolitan than its predecessors. Companies are often multi-national. Many hedge funds and private equity groups will take money from anyone, regardless of what passport they hold. Deals tend to cut across borders faster than illegal immigrants. And big investors are rarely flag wavers; they will go where the money is good. So, now, the whole world can get into the game. The Chinese won-ton vendor, the Indian sari merchant, the Colombian drug dealer – everyone can now enter the great casino.

But what is it, really, that makes this New Capitalism new? Mr. Wolf does not mention it, but the main new ingredient is new money itself. On August 15, 1971, Richard Nixon “closed the gold window” at the U.S. Treasury. Previously, the world’s money system rested on a foundation of gold. No currency could float too high, because the gravity of the gold in the basement would bring it back down. But after 1971, capitalists had a very new money system to work with. Henceforth, the nations of the world would look to the dollar as a reference. And the dollar, what would it look to? The dollar looked left and looked right. Seeing nothing to hold it back, it slowly took off!

With no gold to restrain it, the U.S. puts out, effectively, as much paper money as it can get away with. And it can get away with plenty because the last thing any nation wants is for its own currency to rise against the dollar. Americans, after all, are the biggest spenders in the world. If a nation’s currency rises against the dollar, the price of its goods and services will rise too. And then, the Americans will buy from someone else. So every foreign central bank wants to avoid a falling dollar in the worst possible way – by increasing the quantity of its own currency!

In no time at all, the whole world is awash with more cash and credit than it knows what to do with. More dollars, more yuan, more yen, more Swiss francs, more euros, more pounds! More credit. More bonds. More derivatives. More debt. More speculation. As long as foreigners continue to give each new dollar the same warm reception they gave to the last one, the dollars will keep turning up. And now, the whole world is bobbing in a sea of liquidity. Look at practically any stock market on the planet. You will see a sharp upward bend to it. Property – especially in major market centers, such as New York, Hong Kong, and London – has gone up too. Things like art, watches, yachts, and executive airplanes have shown even steeper increases.

While the few rich admire their Monets, the rest of us have to content ourselves with glossy prints, offered by The Daily Telegraph for free. Most people have no choice but to accept the paper’s generosity. New Capitalism has put them so deeply in debt, they have no free cash to buy anything. In the 10 years up to 2005, UK households increased their debts from 108% to 159% of GDP. Americans’ debts went from 92% of GDP to 135%.

That is the dark side of the financialized globe. But not to worry. One thing about the New Capitalism. It is no more permanent than the capitalism it replaced.

Link here (scroll down to piece by Bill Bonner).

The Worldwide Crack Up Boom

A kiss is still a kiss. A sigh is still a sigh. And a bubble is still a bubble.

All kisses end. And so do all bubbles – even sloppy mega-bubbles of liquidity. This one will be no exception. But of course, it is not the certainties that make life interesting ... it is the uncertainties – the known unknowns and the unknown unknowns, as Mr. Rumsfeld says. We are all born of woman and end up where all men born of women end up – dead. But that does not mean we cannot have some fun between baptism and last rites.

You will remember we said that this worldwide financial bubble is both worldlier, and more financial than any in history. And, for the moment, it is very much alive. So much alive that the media can hardly keep up with it. Forbes magazine, for example, tries to estimate the wealth of the world’s richest people. But the rich do not typically give out their balance sheets. So, there is a fair amount of guesswork in the calculations. But when it came to guesstimating the net worth of Stephen Schwarzman, founder of Blackstone, the Forbes crew wandered off into fiction. They put his wealth at about $2 billion. Recent filings in connection with the new Blackstone IPO show he earned that much in a single year!

In this phase of the bubble, it is as if your neighbors were throwing a wild party – and you were not invited. You detest them, envy them, and want to join them, all at once. A very small part of the population is having a ball. Everyone else is getting restless and wondering when the noise will stop. We wish we knew. And we have given up guessing.

Meanwhile, the experts, commentarists, kibitzers and analysts are saying that there is a whole new phase of the giant bubble about to unfold .Things could get a whole lot crazier. Even many of our respected colleagues are pointing to a text by the great Austrian economist, Ludwig von Mises, for a clue. What we have here, they say, is what Mises described as a “Crack-Up Boom”.

Before we go on, readers should be aware that the “Austrian school” of economics is probably the best theory about the way the world works. It is suspicious of efforts to control the natural workings of an economy, in general, and suspicious of central banking, in particular. The fact that it was a one-time “Austrian”, Alan Greenspan, who became the most celebrated central banker in history, only increases our suspicions. He was able to master central banking, we imagine, because he understood what it really is – a swindle. What is a “Crack-Up Boom?” Von Mises explains:

“This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

“But then, finally, the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

“It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last.”

Mises is describing the lunatic phases of a classic inflationary cycle. At first, no one can tell the difference between a real dollar – one that is earned, saved, invested or spent – and one that just came off the printing presses. They figure that the new dollar is as good as the old one. And then, prices rise, and people do not know what to make of it. Later, they begin to catch on, and all Hell breaks loose.

Von Mises died in 1973 – long before this boom really got going - let alone cracked up. He may never heard of a hedge fund, or even a derivative for that matter. A world money system without gold? He probably could not have imagined it. People spending millions of dollars for a Warhol? $20 million for a house in Mayfair? Chinese stocks at 40 times earnings? He would have chuckled in disbelief. He understood how national currency bubbles expand and how they pop, but he probably never would have imagined how insane things could get when you have a whole world monetary system in bubble mode.

He would have recognized the beginning of this bubble, and the end. But the middle, or the beginning of the end, would have dumbfounded him. During his lifetime he saw a Crack Up Boom in Germany in the ‘20s, and a few more here. But he never saw a worldwide Crack Up Boom. No, no one, anywhere, has ever seen a worldwide Crack Up Boom. We are the first, ever.

Pretty exciting, huh?

Link here.


“Granddad Benny, is it true that central bankers used to believe they could steer the global economy with quarter-point twitches in overnight rates?”

Granddad looked up from his GoogleSoft iSpreadsheet, where a flashing red “health care” box was blocking 2027’s planned expenditure from matching the income cell. “Yes, Joel. For about a decade we all believed central banks could ensure people had jobs, and could afford food and housing and such. That all changed after the Gigantic Global Bubble Burst of 2008.”

Joel put down his Mandarin dictionary. “That is what my socio-economics teacher says we will learn about next week. She called it the Giglobubu. What happened in 2008, Granddad?”

“We are still not sure, Joel,” Granddad said. “At the time, some accused the New Zealand central bank, some said it was the bond market, while others blamed the aftershocks of a slump in the U.S. housing market. If she is smart, your teacher will probably spend a lot of time talking about China. ... At the start of the century, China started to engage with the global economy. We were able to buy stuff like clothes and televisions really cheaply from China’s factories, making everyone feel wealthy enough to spend and borrow instead of putting something aside for a rainy day.

“All of that borrowed money had to come from somewhere, and most of it came from Asia. When China stopped turning up at bond auctions in 2007 and started investing directly in companies instead, alarm bells should have rung. They didn’t. What everyone failed to realize was that the billions of people in China, Vietnam and other Asian countries did not want to spend the rest of their lives living in huts in the countryside and working in factories for a pittance. They started to demand and get higher wages and a better standard of living, and went on a spending spree of their own. Their governments, meantime, built roads and hospitals and schools to keep people happy.

“Even though central bankers in the West had been puzzled by low bond yields and wage increases, they still took the credit for slow inflation! So when prices started to surge at the beginning of 2008, they were surprised when raising rates turned out to be powerless in the global economy. They were even more shocked when energy costs soared and they realized China controlled most of the world’s power-producing capacity.”

Joel whispered “2008 Giglobubu Causes” into his Apple iWatch, and watched as the holographic multimedia display scrolled into life six inches above his wrist. “Granddad, it says here that the New Zealand central bank made things worse?”

Granddad rubbed his beard. “Well, that is a bit unfair. They were quick to spot that prices were rising, and tried to curb inflation by driving up borrowing costs. Their mistake was trying to stop their currency, the New Zealand dollar, from rising. After the first two attempts failed, they should have given up. When the third attempt went wrong, people panicked because they started to realize how impotent the financial authorities were.”

“Granddad, it also says here that hedge funds and the derivatives market made things worse. What are hedge funds and the derivatives market?”

“Well, they are illegal now, Joel. As the global economy started to crumble under the weight of soaring raw material costs, financial markets melted down, with prices of stocks and bonds whipsawing. Hedge funds were supposed to be clever investors. It turned out that they had all made the same bet on the global economy staying wonderful for ever.

“Companies thought they had borrowed money from their bankers. Instead, hedge funds had bought up all of the IOUs. When companies started struggling to make their debt payments, instead of having a friendly chat with their bank managers, they found themselves eyeball-to-eyeball with the hedge funds’ lawyers, who were not interested in the survival of the companies and just wanted their money back.

“Lots of the banks had sold insurance on those IOUs and on a bunch of other stuff that they bundled together into derivatives called collateralized debt obligations. When those investments started to blow up, we all realized that nobody knew who owed what to whom. And banks and hedge funds had become such a big part of the global economy that they dragged everything else down with them.”

“I’ve been meaning to ask you, Granddad: What are all those funny little rectangles of green paper in that big frame on the wall next to your desk?”

“They are called dollars. We used them to buy things in the olden days. In 2015, a group called the Single Global Currency Association convinced the Bank for International Settlements, which by then was running the world’s financial systems, that everyone should switch to one type of money.”

“And they didn’t choose the dollar, Granddad?”

“No, Joel. There was a global referendum to make the decision on which currency people wanted. Which is why we now use the yuan all around the world. Anyway, it is getting late. Back to your Mandarin homework, young Master Bernanke.”

Link here.


A prominent hedge fund’s implosion revives fears about the poisonous influence in America’s subprime-mortgage market.

“They kept pointing to the juicy yield, but our guys soon saw the paper for what it was: nuclear.” Thus one chief executive, recounting his investment firm’s decision to spurn an offer of securities backed by subprime (low-quality) mortgages from Bear Stearns, a large investment bank. The radiation appears to have seeped out at its source, leaving two of Bear’s own hedge funds terminally sick. Coming less than two months after UBS, a Swiss bank, closed a fund that had lost over $120 million as the subprime market crumbled, the incident is a clear sign that concern is shifting from small, specialist lenders – dozens of which have gone bust – to the supposedly more sophisticated Wall Street firms that package, distribute and trade bonds tied to home loans.

Of the big securities houses, Bear is the most exposed to subprime. So no one was shocked when it announced a 10% fall in underlying profits for the latest quarter. But the fate of its year-old, unfortunately named High-Grade Structured Credit Strategies Enhanced Leverage Fund and its sister fund, the High-Grade Structured Credit Strategies Fund, has raised eyebrows. Run by Ralph Cioffi, an industry veteran, they were thought to be among the shrewdest actors in the mortgage-debt markets. Their downfall suggests that hedging at the highest levels is not as adept as it might be.

The enhanced-leverage fund lost 23% of its value in the first four months of the year as the subprime market collapsed, then stabilized, then fell again. The fund’s problems were compounded by its borrowings, which were 10 times bigger than its $600 million in capital. This made it more vulnerable when things went wrong. Last week Bear’s funds, besieged by disgruntled investors, offloaded securities with a face value of at least $4 billion to free up capital. This fire sale was not enough for one creditor, Merrill Lynch, which seized collateral and threatened to auction it off to cover its losses.

Bear persuaded Merrill to stay its hand by agreeing to negotiate a rescue with a consortium of banks. But the plan fell apart. On June 20th Merrill began hawking some of the funds’ assets to other hedge funds, while other creditors worked with Bear to unwind their positions. But there were few buyers for the bank’s subprime-backed debt, even the highest-rated paper. The sale weighed on the shares of homebuilders and mortgage insurers as well as lenders. It raises the prospect of a wave of repricings, as banks and funds take a fresh look at their asset-backed holdings. Many of these are illiquid and still booked at their original, inflated prices. Assigning new values to them will be tricky, not to mention bad for banks’ share prices.

This week an index that tracks bonds consisting of subprime loans made in 2006 dipped below 60 for the first time, down from 97 in January (see chart). One cause was the continuing deterioration of loan performance as mortgage rates have risen: almost one in five subprime mortgages are now delinquent by more than 30 days or in foreclosure. The index also reflects fears that other large funds will suffer the same ignominy as Bear’s. The number of hedge funds focusing on mortgage debt ballooned along with the underlying market in 2005-06.

Other squabbles are adding to the drama. A group of hedge funds recently urged regulators to investigate banks, including Bear, for alleged manipulation of the market for mortgage bonds and the booming derivatives linked to them, such as collateralised debt obligations (CDOs). The funds accuse the banks of protecting their own positions in derivatives trades – in which hedge funds are often counterparties – by propping up the prices of dodgy mortgages bought under the pretext of helping struggling borrowers.

The recriminations are likely to grow as rating agencies, slow to act at first, bow to the inevitable and revise their opinions. In the first of what is expected to be a wave of downgrades, Moody’s has cut the rating of 131 subprime bonds because of higher-than-expected defaults. It is reviewing hundreds more. Meanwhile, as more loans turn bad, it is dawning on the banks, hedge funds, insurers and pension funds that hold “senior” (highly rated) portions of CDOs that their investments may not be as bullet-proof as they thought. CDOs offer higher yields than similarly rated mortgage-backed bonds, but are more susceptible to losses if the underlying loans decay.

With some $100 billion of adjustable-rate subprime mortgages due to reset to higher rates by October, investors are likely to remain twitchy. Moreover, lenders have tightened underwriting standards across the board for both prime and subprime mortgages, making it harder for borrowers to refinance loans. And as regulators debate the merits of new rules on abusive lending, some politicians in Washington are pushing the notion of “assignee liability”, which would hold secondary-market investors responsible for homeowners’ losses. Never mind that the most forceful attempt to introduce this so far, in Georgia in 2002, ended in disaster. As securitization dried up, so did the primary-lending market. The law was amended in 2003.

But perhaps the most worrying thing for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger one to which they are also exposed: leveraged loans to companies. As Daniel Arbess of Xerion Capital Partners points out, corporate lending’s giddy leverage echoes the high loan-to-value ratios in subprime. The explosion of “covenant-lite” deals and payment-in-kind notes mirrors that of interest-only and negative-amortization mortgages. And LBOs have their own form of mortgage refinancing in the so-called dividend recapitalization. Subprime, says Mr. Arbess, might well be “a dress rehearsal for something bigger and scarier.”

Link here.
Bear Stearns plans $3.2 billion hedge fund bailout – link.
Deadly ripples threaten subprime funds – link.
Subprime mortgage losses may be the “tip of the iceberg” – link.

Does it all add up?

As head of the financial stability unit at the Banque de France, Imène Rahmouni-Rousseau traveled to America this month to look at the current turmoil in the U.S. subprime mortgage world. Although initially that had seemed an all-American saga, Ms. Rahmouni suspected that French and other European investors also held assets linked to subprime securities. So on behalf of her central bank she wanted to assess the risks.

What she discovered surprised her. There was little confidence about how to value the holdings. “Pricing data are difficult to obtain,” she says. It is a discovery being shared by numerous other policymakers and investors around the world as the fallout widens from a subprime lending boom, in which U.S. banks provided vast amounts in home loans to financially stretched borrowers who put little money down and gave no proof of income. Among the casualties have been two hedge funds run by Bear Stearns.

Until recently, when late payments and defaults on these mortgages spiked higher, the problem drew little attention. This was because, through the magic of so-called structured finance, risky assets such as subprime mortgages could be packaged into attractive investment products. These elaborately constructed securities, called collateralised debt obligations (CDOs), are designed to yield juicy returns while also carrying high credit ratings. They have proved popular with hedge funds as well as with longer-term investors such as pension funds and insurance companies, many of which have bought billions of dollars of such securities in recent years – thus providing the liquidity that was then channeled into mortgage loans.

But heavy losses incurred at the two Bear Stearns hedge funds as a result of such financial haute couture have prompted fears that the CDO emperor may turn out to have no clothes. Such a revelation could threaten the value of investor portfolios around the globe – not just in the mortgage sector but in the way many sorts of company fund themselves.

This is because unlike stocks or U.S. Treasury bonds, CDOs are rarely traded. Indeed, a distinct irony of the 21st-century financial world is that, while many bankers hail them as the epitome of modern capitalism, many of these new-fangled instruments have never been priced through market trading. Instead, products such as CDOs, which are designed to be held until they mature, have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. In addition, fund managers and bankers often have broad discretion as to what kind of model they use – and thus what value is attached to their assets.

So when Wall Street creditors last week threatened fire sales of CDOs seized from the stricken Bear Stearns funds, thus creating a market price for them for the first time, they also threatened to create a wider shock for the system. Fire sales rarely realize anything close to the previously expected value of assets. But if these deals went ahead, they would provide a legitimate trading level that would challenge current portfolio valuations.

In the event, Bear Stearns’s creditors sold only a fraction of the assets put up for auction. Market participants suggest that this was in part because bids fell far below expectations, with traders increasingly reluctant to take on CDOs tainted with subprime exposure. But the crisis at Bear’s funds has left investors, brokers and regulators asking an uncomfortable question: can the pricing models that have provided the foundations for this new financial edifice really be trusted? Or will valuations turn out to be over-optimistic and result in further investor losses? “Investors are slightly more cautious, becoming more picky and asking more questions,” says Michael Ridley, co-head of high-grade debt capital markets at JPMorgan. “They want us to lift the lid off the box a bit more.”

Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough. Behind the scenes, the Bear Stearns hedge fund problems are prompting bankers and investment managers to reexamine their valuation techniques.

However, history also shows that large-scale structural dislocations – such as a serious mispricing of assets – are rarely corrected in an orderly manner. “If every CDO [manager] was forced to mark to market their subprime holdings, it would be – well, I cannot think of a strong enough word to describe what it would be,” confesses a U.S. policymaker.

Link here.


This should be an easy Bulletin to write: The apparent collapse of two hedge funds – highly leveraged (at least 10 to 1) in illiquid collateralized debt obligations (CDOs) and other “structured” instruments. Escalating losses induce the fund’s (“repo”) lenders to hit The Street with bid lists of CDO collateral apparently loaded with subprime exposure. The dearth of buyers willing to pay anything close to (“marked to”) “market” prices then forces the specter of revaluation and downgrades of similar securities and a possible contagion deleveraging of CDO exposures throughout. Smelling blood, scores of enterprising speculators of various stripes move to place assorted bets seeking profits from the expected forced liquidations, generally widening credit spreads, and the potential snowball unwind of leveraged speculations. The Wall Street firm that sponsored the funds is forced to step up and loan the funds $3.2 billion, increasing its risk profile in an increasingly uncertain marketplace. And with the CDO market having evolved into a critical source of system credit and liquidity creation, the potentially dire credit ramifications certainly could have rocked U.S. and global markets.

Yet, the Dow is only about 2% off its record high and the S&P 500 only a few percent below its own. The NASDAQ100 is within a percent or so of its 6-year high. The emerging equities boom has not missed a beat, with Brazil’s Bovespa index up 22% y-t-d, Mexico’s Bolsa almost 20%, and China’s Shanghai Composite up 52%. Emerging debt spreads remain near record lows. Junk spreads are not far off recent lows.

It would be easy this week to just stick with the obvious: marketplace complacency has become deeply ingrained. I will shoot for something a bit more thought-provoking, delving deeper into possible reasons behind the markets’ nonchalance. First of all, market participants have become conditioned to seek added risk during these occasional periods of “risk” market tumult. Buying stocks and bonds back in the dark days of the 1994 MBS/bond/interest-rate derivatives rout worked wonderfully. Ditto for the LTCM debacle in October 1998, the corporate credit dislocation in 2002, the auto bond/derivatives dislocation in 2005, last year’s Amaranth collapse, or even the February subprime implosion. It has been a case of each “profit opportunity” emboldening a little deeper. “Resiliency” is today’s watchword.

But there is certainly more to market behavior than a simple Pavlovian response. After all, the global economy is booming and inflationary biases proliferate at home and abroad. So far, the historic global M&A boom has not missed a beat. Despite subprime and housing angst, U.S. and global debt issuance runs at or near record pace. Junk issuance was robust again this week. Even CDO issuance remains strongly above last year’s unprecedented level. The bulls are comfortable that the U.S. economy is in decent shape, that the global economic boom has a powerful head of steam, and that liquidity remains abundant. Naturally, they would expect powerful Wall Street to fix problems as they arise.

Yet below the surface of mostly impressive market performance there are troubling signs. Notably, recent risk market turbulence has been noteworthy for failing to ignite aggressive Treasury purchases. For years, the credit market has been bolstered by the awareness that any indication of heightened systemic stress would be met with an immediate rally in Treasuries, agencies, MBS and other “top-tier” securities. I have always seen this predictable drop in yields as a key dynamic supporting leveraging and risk-taking generally. A change in this dynamic would be a significant credit bubble and market development.

Clearly, U.S. markets are coming to the realization that global forces these days play a much more prominent role than ever before. Robust credit systems globally, general liquidity overabundance, and increasingly determined international central bankers are pressuring global as well as U.S. bond yields. Importantly, this is forcing participants to rethink how quickly and freely the Fed might respond to heightened financial stress.

I can imagine the manager of Bear Stearns’s troubled hedge funds – and most speculators in risky assets – have for some time built into their thinking the presumption that any meaningful stress in asset markets would quickly impel lower Fed funds rates and sinking market yields. Today’s scenario of a subprime implosion, faltering U.S. housing markets, an unparalleled global M&A boom, record debt issuance, an escalating global economic boom, $70 crude, heightened inflation pressures, and rising bond yields would have been considered a remote possibility not many months ago. But things these days move so quickly and unpredictably. Issues that were not even on the radar screen six months ago are now front and center.

The subprime implosion, CDO problems, faltering hedge funds, China bubble worries, the global M&A and securities bubbles, prospering hedge funds and leveraged speculators, ballooning Wall Street, “tax the rich”, enterprising sovereign wealth funds, wildly inflating global asset markets and heightened uncertainty are anything but random and independent developments. I hope readers will contemplate that the world economy, financial flows, and markets have been commandeered by precarious global credit bubble dynamics – and the pursuit of free-flowing but highly inequitable financial riches. At its core, to sustain U.S. financial and economic bubbles requires ever increasing amounts of already colossal credit creation. The global effects emanating from this global inundation become more pronounced and unwieldy by the month.

In relation to subprime, CDOs, derivatives, and highly leveraged hedge funds, keep in mind that the task of transforming ever-rising quantities of increasingly risky debt instruments into palatable securities has become quite a challenging endeavor. This process, whether in relation to mortgage finance or corporate M&A, implies greater system leveraging, risk-taking, and the implementation of more sophisticated risk instruments and strategies. Contemporary credit booms work too magically on the upside, but the enigmatic world of derivatives and aggressive speculative leveraging ensure great uncertainty at some (turning) point.

How secure is the collateral supporting Bear Stearns’s hedge fund loan? How great is the risk of an unwind and contagion collapse of leveraged CDO and risky MBS/ABS holdings? How quickly could tumult in the CDO marketplace spread the fear of risky mortgages to fear for risky corporate credits and a faltering M&A bubble? To what extent will the global “leveraged speculating community” hedge against or speculate on widening spreads and heightened credit system stress?

On several fronts, the credit bubble and U.S. current account deficit-induced ballooning pool of global finance was inevitably going to lead to major market uncertainties. That day has arrived – the comforting and dependable flow (deluge) of finance into U.S. debt securities cannot now be so mindlessly taken for granted. Not uncharacteristically, over-zealous financiers and speculators have greatly exacerbated late-stage bubble risk and Uncertainty. The M&A boom, global stock, real estate and assets markets turned too hot. The Chinese, Asian and general global economy became too hot. Billions were made too effortlessly. The CDO game was too easy. And robust economies and myriad spectacular asset and debt bubbles are by their nature gluttons for additional credit and marketplace liquidity. Inevitably, things turn tenuous, and the line between runaway boom and unwinding bubble turns troublingly thin. For the semblance of order is maintained only as long as speculation and leverage-induced demand for risky debt instruments meets the ever escalating supply.

Most of the ingredients for credit crisis are within reach, yet heightened volatility is likely still the best short-term bet. I would expect the gigantic pool of speculative finance to be increasingly keen to short securities and bet on/hedge against systemic stress. This is a notably unbullish dynamic, one that likely alters that nature of speculative flows – and that could at any point initiate a rush for the exits, market dislocation and panic. Big down days seem inevitable, the kind that really shake confidence and instill fears that the “wheels are coming off.” But there will almost surely also be days of panicked short covering and euphoric buying. And those days will reinvigorate notions of goldilocks, new eras and unlimited finance. There will be days when the hedge funds and sovereign wealth funds are perceived as bull market friendly and days when their supporting role is seriously questioned. Uncertainty reigns supreme.

Link here (scroll down).


Back in February, Elliott Wave International showed an exponential rise in the Shanghai Composite Index and asserted, “If the top is not yet in for Chinese shares, it should be close.” It was not. After a brief downturn in late February, China went back into its vertical ascent. But the higher it goes, the more certain we are of its eventual crash, as its further rise creates an even more extreme representation of a mania. One key characteristic is something EWT dubbed “The Insidiousness of a Mania” back in 1997. This refers to investors’ maddening facility for separating price from any principle of valuation. At such times, EWT said, “a knowledge of history and value is eventually judged an impediment to success,” and market wizardry is ascribed to investors of lower and lower levels of sophistication. In April 2000, for instance, when a Saudi Prince greeted the dot.com meltdown by publishing a list of all the Internet stocks he was rushing into, EWFF called his status as one of the “new market wizards” a bearish signal that spoke “volumes about the current stock market juncture.” (A stronger version of the same signal is evident in the same prince’s latest project – a public offering of his firm on the Saudi stock market.)

In this respect, however, everything pales in comparison to what is taking place in China. China will likely be remembered as the place where the Great Asset Mania breathed its last gasp because it is the place where the most naïve investors have become convinced of their financial genius. It has certainly produced the largest mass of unseasoned investors on record. Investment accounts are now being opened at a rate of more than 300,000 a day. About 10% of Shanghai maids resigned in recent weeks “because they make more money trading shares.” China’s latest hero investor is Shi Changxing, a 50-year-old monk who made headlines by simply opening an account to trade stocks. We are pretty sure that praying over a stock trade is not the path to riches or enlightenment. The accounts are owned almost exclusively by individuals. “People are buying stocks to boost their retirement funds, students are speculating to pay for their education and housewives are borrowing from banks to expand their families’ share portfolios.” Debt, once again, is a major factor.

Among the preferred stock picking strategies are ticker codes containing a double eight. “Numerology is a basic trading strategy in China,” reports the Wall Street Journal. Trading tips include wearing red cloths because they “are representative of a hot market, eating beef to sustain the ‘bull’ run and avoiding references to ‘dad’ since the word in Chinese is a homonym for ‘drop’.” To an unprecedented degree, the Chinese bubble is fueled by “get-rich-quick stories and accounts of the extremes to which investors are willing to go to finance trading.” Can there be a better way to celebrate the final vestiges of a Grand Supercycle peak than to let loose a mania on a society that is less than a generation removed from peasantry?

Another key trait that accounts for the similarities between the technology bubble antics in the U.S. in 2000 and China today is that bubbles can cool in one area and migrate into new ones. In 1719-20 when John Law’s Mississippi Scheme petered out, the South Sea Bubble was ramping up into its most extreme phase of price acceleration. According to the book Millionaire, an account of John Law’s role in the bubble, Mississippi Company shares peaked in late 1719 and created a run on hard assets. A drive into gold and silver as the demand for shares declined should sound familiar. It happened here in the form of the all-the-same-market phenomenon which has sent investors scurrying into gold, silver and various other “alternative” assets. Just as share speculation leapt across the English Channel to London in 1720, the fiery core of the mania is now burning itself out on the other side of the Pacific.

The legacy of 1719-20 is borne out by the latest flare-up in the veneration of millionaires. Recall that EWFF has tracked the phenomenon back through the Mississippi scheme itself. In fact, the word “millionaire” was first used there to describe the nouveau riche that the bubble created. The fascination with the term regained its grip over the public imagination in 1929 and 2000. In September, EWFF noted a return to a societal interest in “millionaire-ness” but found the obsession muted by comparison to the Who Wants To Be A Millionaire frenzy of 2000. This may not be the case in Asia where a million goes a lot further. The latest lifestyle magazine, MillionaireAsia, was launched with a lavish May 13 bash. It is truly amazing how thoroughly the tapestry of the Great Asset Mania weaves the threads of past bubbles into its framework. There is, of course, one missing piece, which is the most important element of all. Every mania is followed by a decline that ends below the starting point of the advance. The advance is exciting, but the decline should be even more compelling human drama. While the bubble markets flare in succession, the move below the starting point should culminate in unison.

One of the biggest reasons cited for the continuation of the uptrend is the belief that way too many people are worried about what will happen if things go wrong. Recent weeks have brought a loud chorus of warnings about derivatives, debt and high share prices. China is probably the biggest worry. The Chinese central bank raised interest rates while Chinese securities regulators issued public warnings against investment risks. Chinese bank regulators also launched a “campaign to prevent people or companies from channeling bank loans illegally into the equity markets.” Here again, we see an unmistakable parallel to the Mississippi Scheme crack-down in 1720. Not to mention the U.S., where worries of overheating accompanied a similar effort to slam on the brakes with interest rate increases in 1929 and 2000.

In fact, the architect of the U.S. government’s effort to stem the tide in 2000, Alan Greenspan, is among the latest financial heavyweight to weigh in against Chinese shares. The Chinese market ignored Greenspan’s warning, just as the Dow did back in January 2000. In February 2000, EWFF said, “In finally succeeding to tune out the sincere concerns of Alan Greenspan, the foremost financial hero of the bull market, the public has signaled that its potential to experience tragedy is now fully formed.” The Dow completed its last burst shortly thereafter. In China today, the response, is much the same. The more authorities worry, the more convinced investors become that the market will not crash. “Wen Jiabao [the prime minister] will not let it drop. He is afraid of that,” says a Chinese investor. Here too, China’s mania is exhibiting a highly developed version of the “uh-oh effect” that typically appears in the final phase of a bubble. With China’s history of reliance on social engineering, the effort to stem the tide may be more pronounced than in other countries. Any such action will magnify the effect of the eventual decline.

Link here.
China’s Monetary Tiger – link.


Hans F. Sennholz is one of the handful of economists who dared defend free markets and sound money during the dark years before the Misesian revival, and to do so with eloquence, precision, and brilliance. From his post at Grove City College, and his lectures around the world, he has produced untold numbers of students who look to him as the formative influence in their lives. He has been a leading public voice for freedom in times when such voices have been exceedingly rare.

This much is well known about him. But there are other aspects to his life and career you may not know. Sennholz was the first student in the U.S. to write a dissertation and receive a PhD under the guidance of Ludwig von Mises. Mises had only recently completed Human Action. Imagine how having such an outstanding student, and a native German speaker no less, must have affected Mises’s life, how it must have encouraged him to know that his work could continue through outstanding thinkers such as this.

When Mises arrived in New York, determined to make a new life for himself after having first fled Austria and then sensing the need to leave Geneva too, he had no academic position waiting for him. He had no students and no prospects for students. But then came Sennholz. Here was living proof that ideas know no national boundaries, that even in the darkest hour there was hope for a new generation of economic scientists who cherished freedom, and were not fooled by the promise of government planning.

And think of the crucial time in which he entered the Austrian picture. Mises was by now carrying the school by himself. Most of his students had moved on to other things, whether Keynesian economics or social theory. For the Austrian School to survive in a profession now fully dominated by interventionists, it needed economists. The School desperately needed the new life that only new faces, names, books, and ideas provide.

When Sennholz began studying with Mises, it would still be another 12 years before Rothbard’s Man, Economy, and State would appear, and nearly a quarter century before Kirzner’s Competition and Entrepreneurship would be published. Sennholz provided exactly what was needed: that crucial bridge from the prewar School to the postwar School in America, where the Austrian School would now make its home.

Though an outstanding theoretician, Sennholz placed a strong emphasis on the application of Austrian theory to the timing of business cycle, and to explaining the current state of affairs. This is, by itself, highly unusual in the economics profession. If you know anything about academic economists, you know that they are the last people you want to ask about the state of the economy. But Sennholz made it his job to explain the world around him, a trait which drew many to his thought.

Sennholz was never shy about insisting on the centrality of ethics in the study of economics. He has decried the welfare state as confiscatory and immoral. He has called inflation a form of theft. He has identified government intervention as coercion contrary to the true spirit of cooperation. He did this at a time when saying such things was taboo in the profession. Here again, he was keeping alive the spirit of Mises, and the spirit of truth.

Nobody can ever gauge the full impact of a great intellectual in the development of culture. His influence spreads like waves in a lake. By the time the waves hit the shore, few are in a position to remember the source. But this much I am sure of. We are in Hans Sennholz’s debt far more than we know.

Link here.


Crash Proof: How to Profit from the Coming Economic Collapse reviewed.

Many writers of investment books approach the topic of saving and investing without any clear economic theory. Value investors often share the sentiments of fund manager Peter Lynch, who said, “If you spend 13 minutes a year on economics, you have wasted 10 minutes.” From the other end of the methodological spectrum, MBAs trained in efficient portfolio theory look disdainfully on any suggestion that investors should at times be entirely in cash as “market timing”.

In contrast to both schools, author and investor Peter Schiff approaches the issue from a top-down macro-economic view. Schiff believe that the most important issue facing investors over the next few years is a series of macro-economic crises that will impoverish most Americans. Schiff’s book Crash Proof: How to Profit from the Coming Economic Collapse is really two books in one. The first is Peter Schiff’s analysis of the U.S. economy, incorporating both theory and historical examples. The second consists of his strategies for surviving and even prospering.

It is not possible to approach macro-economic questions without an economic theory. A sound economic theory may not yield any useful insights for investors, but a false one is almost certain to mislead. A problem with macro investment literature is the generally poor economic foundations of most of their authors. Harry Dent, for example, shares the Keynesian-macro belief that consumption, not savings, drives economic wealth. Louis-Vincent Gave, Charles Gave, and Anatole Kaletsky believe that capital accumulation is a money-losing proposition for firms. The reader of Crash Proof is fortunate that Schiff incorporates Austrian economics in his approach. The Further Reading section contains titles by Rothbard, Mises, Hayek, Hazlitt and J.B. Say. And unlike some authors who cite these thinkers without understanding them, Schiff displays a grasp of their thought and its application to investing.

This review will focus on Schiff’s economics. I will not say much about his investment advice. While his advice could be implemented through the investment firm of your choice, Schiff is the founder of a brokerage firm offering investment accounts following the book’s recommendations. Schiff believes that his firm provides advantages in executing these strategies. After reading the book, I believe that his investment recommendations follow from his economics (right or wrong) and not the other way around. And by publishing his ideas in a book, an investor could implement these strategies with or without Schiff’s help.

Schiff disputes common economic fallacies, such as that we do not need to save because our assets are going up in value and that Americans provide the “engine of growth” in the world economy by consuming what others produce:

“It is important to remember that in market economies living standards rise as a result of capital accumulation, which allows labor to be more productive, which in turn results in greater output per worker, allowing for increased consumption and leisure. However, capital investment can be increased only if adequate savings are available to finance it. Savings, of course can come into existence only as a result of [consuming less than one earns] and self-sacrifice.” [pp. 6–7]
“The world no more depends on U.S. consumption than medieval serfs depended on the consumption of their lords, who typically took 25 percent of what they produced. What a disaster it would have been for the serfs had their lords not exacted this tribute. Think of all the unemployment the serfs would have suffered had they not had to toil so hard for the benefit of their lords.
“The way modern economists look at things, had the lords increased their take from 25 percent to 35 percent, it would have been an economic boon for the serfs because they would have had 10 percent more work. Too bad the serfs didn’t have economic advisers or central bankers to urge such progressive policies.” [p. 14]

One area where Schiff may be on less firm ground is in his analysis of the U.S. trade deficit, which he sees as evidence that Americans are living beyond their means and making up the difference by borrowing from foreigners. All that a trade deficit means is that the deficit country is importing capital. If the imported capital is used to fund the development of the productive structure within the country, then the resulting financial claims are supported by production. Schiff’s view of the trade deficit could be correct but it does not follow from the mere existence of a trade deficit. To prove this, he would need to provide more evidence than he does that the imported capital is wasted. Economic historian Sudha Shenoy has broken down some of the data to arrive at the conclusion that U.S. trade in the private sector was balanced up to 2002, and that the trade deficit results entirely from government over-consumption.

Schiff shares the skepticism of most Austrians toward central banking and inflation. How many investment books contain a section called “Fiat Money: Why it is the Root of our Economic Plight”? His discussion “How the Government Obfuscates the Reality of Inflation” is excellent. Schiff is particularly good on the deflation issue. According to Wall Street’s way of thinking, deflation is supposedly even worse than inflation, and we should be thankful that we have the Fed to artfully charting a course between the two terrors. Schiff dismisses this nonsense. His discussion of the business cycle is clearly Austrian: “According to the classical economists ... recessions should not be resisted but embraced. Not that recessions are any fun, but they are necessary to correct conditions caused by the real problem, which is the artificial booms that precede them.”

Schiff forecasts a stock market crash, the bursting of the real estate bubble, and the collapse of the dollar. For the first two of these, his reasons are the over-valuations of these asset classes, runaway credit expansion and the moral hazard created by bailouts. His argument for the collapse of the dollar is tied very closely to his view of the trade deficit, which I have called into question above.

His investment recommendations consist largely of foreign stocks, which have higher earnings yields and pay better dividends than U.S. stocks; gold and gold mining; and cash or liquid short-term bonds to preserve purchasing power until after bubbles have burst, when the money can be put to work at much more favorable valuations. The book falls in a long line of gloom-and-doom forecasts offering advice on how to profit from them. Many of these books even have titles containing the words “How to profit from the coming ‘X’”, e.g., Y2K meltdown, hyperinflation (1985), currency recall (1988).

While it is possible to see unsustainable trends playing out, some of them take many years to reach the breaking point, and in the meanwhile, there can be very long counter-trend movements. While bubbles burst, getting the timing right is difficult. It is possible to be right but wrong about the timing for a long period. While there were a number of bears in the late ‘90s who correctly called the stock market bubble, many of them were wrong for several years until being vindicated.

Crises do happen. In recent years, a number of countries have had their currency collapse or defaulted on foreign debt. Recall the Asian contagion, the Mexican peso crisis, the Russian ruble crisis in 1998, and the Argentine banking crisis. America is not inherently immune from such a crisis. The laws of economics so ably demonstrated by Schiff apply to America as well as to other places. And I believe that Schiff does as good a job as anyone making the case that the trends that he examines are unsustainable, excepting possibly the trade deficit.

I enjoyed the book and it is one of the better examples of economic writing among investment books. I recommend it for anyone who wants an analysis of current economic and investment trends from an Austrian viewpoint. While I am in general agreement with Schiff’s forecasts, time will tell whether the crises are imminent, or whether we are due for an extended period of grinding sideways.

Book review here.


To be honest, I am scared and I think you should be also. It all started with something we are all accustomed to and dabble in from time to time. Revenge. eBay was upset about something Google did – the details are not important, but it is related to the heightening competition between Google Checkout and PayPal.

Basically, Google was throwing a party in Boston for users of Google Checkout while eBay was having a conference, eBay Live, for its users. It was like two squabbling teenagers. Consequently, eBay, which is Google’s largest customer, decided to have some fun. The online auction company pulled all of its ads for a week from Google.

What were those ads, and why is this important? Well, if you search right now for “Beanie Baby”, you will see an ad on the right that takes you to eBay. eBay served up 188 million ads for Google in 2006. That was almost double the #2 advertiser Target. eBay then claimed that its traffic actually went up on the week that it had no ads. In other words, eBay implied that the ads were meaningless to their business. eBay then stated it would reinstate “limited” ads on Google. A spokesperson for eBay told USA Today, “I will tell you it will be in a much more limited way than it was before.”

So what does this mean? Something like 99% of Google’s revenue and earnings come from search. Google dominates search advertising, with somewhere between 56% and 65% (depending on which data service you believe) of all searches done using Google’s search engine. All of Google’s other fine products – Gmail, Google Maps, Google Finance, even YouTube – are like a drop in the bucket compared with search.

I believe there are three other factors that could be affecting Google’s core business and analyst estimates:

  1. Keyword inflation is coming to an end. Across the board, the prices of keywords have been steadily rising since Google’s inception. I think as more companies start putting money toward natural search marketing (figuring out how to get higher on search engines rather than paying for ranking), the keyword prices will go down.
  2. Anecdotally, a lot of keyword advertising was being done by mortgage brokers. It remains to be seen how the housing bust has affected this end of the business.
  3. There is a huge arbitrage game that has been played for years with keyword pricing, and it is done right now by hundreds of thousands – maybe millions – of domains. Basically, you get a domain, you slap a bunch of links on the domain where all the links are related to a very expensive keyword category (for instance, mortgage brokers) and you buy cheaper keywords to drive the traffic to your domain. Here is a great example. This is called “parking” a domain. Marchex (MCHX)is the master of this. Like any arbitrage, this is going to run out as the spread between the expensive keyword prices and the cheaper ones goes away.

I do think that the so-called holistic approach to online advertising is the direction to follow in the next five years. Search defined the last five, but now with Google buying DoubleClick, Yahoo! buying Right Media (and this past weekend consolidating its banner and search-ad sales forces), Microsoft buying aQuantive, and AOL having successfully integrated Advertising.com, we are going to see a lot more interaction between the banner side of things and the search side.

Will GOOG go to $0? Certainly not. It has a continually growing business and the smartest people in the world working for it. Google’s other products, while not generating a lot in revenue, are generating a lot of mind-share and are being taken seriously by the competition (hence the lawsuit by Viacom against YouTube). Despite all the attempts by InterActiveCorp, Yahoo! and Microsoft to get share in search, Google keeps dominating this area, without any real moat other than brand value. (Arguably, Ask.com’s results are better right now, thanks to the integration of Teoma.)

But is 100% of Google’s revenue in question? Do people really need to pay so much for search ads? About nine out of 10 Web sites I visit can easily improve their natural search results with very simple techniques. Many of these same companies are ignoring this and just spending money on keywords. This is like using diet pills instead of exercising. First see what you can do naturally – then take the medicine.

Link here.


Ethanol was the choice fuel for some of the first combustion engines. In the 1820s, Samuel Morey used an ethanol blend in his experimental internal combustion engine. Due to the rise of steam power, ethanol remained an obscure fuel until 40 years later, when the internal combustion engine took off thanks to a more efficient design by German inventor Nikolaus Otto. But also around that time, America discovered a cheap, domestic oil supply, which would compete with ethanol and later become our preferred fuel despite ethanol’s early success. Even Henry Ford thought ethanol would withstand the test of time. He designed his Model T to run on ethanol, going so far as to call it “the fuel of the future.”

Now, 100 years after the first Model T took to the roads, our leaders are spouting the same tired slogans. Our reliance on oil has not been clipped. Instead, we are faced with new debates over ethanol’s true energy output and its overall effectiveness as a cheap, efficient alternative to gasoline.

While technology cannot always help these old ideas become modern-day miracle cures for oil fever, there is one ancient technology that could provide clean, renewable energy for the planet’s 6.6 billion people. Geothermal energy has been used for centuries. It helped provide the Vikings with heat and hot water when they settled in Iceland, and it is still a widely used energy source. Geothermal energy produces more than 25% of the power in Iceland, and is used to heat a majority of the homes in the Scandinavian nation.

But that is in Iceland. For the rest of the world, it will take a little innovation. A 2006 report issued by M.I.T. claims that it would be possible to affordably generate 100 gigawatts of electricity or more by 2050 with a $1 billion investment. But it will take a technological boost to make this possible. Where volcanic activity is minimal, there are two options to extract steam from the earth: water pumping and drilling.

Water mixed with chemicals can be pumped into the ground to enlarge the natural cracks and passageways, creating big enough steamholes to effectively run large turbines. Then there is drilling. Thanks in part to our never-ending quest for oil, drillers have developed the equipment and techniques to drill farther into the Earth’s crust than ever before. If we can tap into the deep geothermal wells all over the world, the result will be clean, cheap, reliable power. And that is an old technology we can live with.

Link here.


The construction and building materials industries have been in trouble. From the moment when people realized that their home prices would not go up forever, these industries have plummeted. And as you probably already know, when Wall Street reacts to something, they go overboard and bring down the wrong companies. This is the case here. But first, let us look at the problem.

In 1956, President Dwight Eisenhower signed the Federal-Aid Highway Act, which authorized a plan to build 40,000 miles of Interstate highways to be built. Since then, more than 20,000 miles of highways – maintained mostly by the Federal government, but with assistance from the states – have been added. But this amount is obviously not enough. In about 13 years, 90% of urban Interstates will be at or exceeding capacity, according to the American Association of State Highway and Transportation Officials’ February 2007 report. Also, the demand of new vehicle miles traveled will go from 690 billion in 2002 to 1.3 trillion by 2026.

At the rate this is going, this means that our current road capacity will have to be doubled in the next 20 years. Billions of dollars will be spent over the next 20 to 30 years to repair, update and build new roads and bridges – the estimated total is $155 billion. This money is not going to go into the same old road technologies that are leaving us with constant repairs and construction like the current ones do. New technologies, coupled with new materials, give way to things such as quieter highway noise and better drainage of rain and snow. Highway barriers, both in and out of construction zones, use billions of tons of cement. The barriers are also built using steel rebar for support, in case a car hits them.

This new street-making technology also impacts these highway barriers. Now construction companies are finding a cheaper and more durable material to replace rebar. It is called engineered structural mesh (ESM). ESM is pre-stressed and pre-tensioned steel bars used to support concrete structures such as road medians. Approximately 38.4 tons of ESM are used for every mile of median. Even if half of the required new roads use a concrete median like this, that is 1.9 million tons of ESM. And there is only one company that can handle that load. In fact, this $330 million company has the market cornered.

The company is called Insteel Industries, Inc. (IIIN: NASDAQ). It produces the steel that reinforces just about any type of concrete structure, everything from road medians, to bridges, parking decks and concrete pipe. IIIN produces the ESMs for highway medians and makes the steel used in bridges. Insteel makes all the concrete reinforcement for these massive structures. According to Insteel’s annual report, over 30% of all bridges in this country are either structurally deficient or functionally obsolete. That, along with the construction of new bridges, will give Insteel a lot of work.

But for whatever reason, Wall Street has completely ignored this company. No one wants to invest in anything to do with building or construction because of its association to the current housing bust. This is simply a mistake. Only 20% of Insteel’s business comes from residential building materials. The other 80% of Insteel’s business is from nonresidential customers such as pipe manufacturers and bridge builders. These businesses are untouched by the falling residential-construction industry.

It is always nice to find a beauty like this when Wall Street forgets to look at what a company actually does instead of what it assumes.

Link here.


One more step towards the “Holy Grail” of electricity management.

The promise of superconductors is a world in which our power supplies are managed more efficiently. Transmission lines lose almost a third of the electricity they carry. Electrical circuits of all kinds waste a certain percentage of the power due to “resistance”, a phenomenon whereby electricity is wasted as heat. Superconductors carry electricity without loss or resistance.

Currently, the only working superconductors require a tremendous investment in cooling to liquid nitrogen like temperatures. This renders them impractical for most real-world applications. Now, researchers at Duke University have identified a “metal sandwich” that is expected to be a superior superconductor. The material is called lithium monoboride (LiB). It is made by sandwiching a lithium metal “filling” between two layers of boron. Though lithium monoboride has not yet been made in the real world, the modeling results were sufficiently impressive that the paper was accepted for publication in a professional journal.

Dr. Stefano Curtarolo, a member of the team at Duke said, “It should superconduct at a higher temperature, perhaps more than 10 percent greater, than any other binary alloy superconductor.” He said that once a new superconductive material is identified, scientists can usually modify the molecular structure and find even better variants. Among the exciting potential uses of a high-temperature superconductor are trains that levitate above their tracks traveling a tremendous speed without any friction.

The major breakthrough in 1986 and subsequent years involved so-called high temperature superconductors (HiTC). All of these have been ceramic. However, recently the substance magnesium diboride was found to have superconducting properties, and works at a relatively toasty 39 degrees Kelvin (still more than 300 degrees below zero in Fahrenheit terms). It has the advantage of being manufacturable from two simple abundant elements.

The Duke scientists used a physical modeling software package they developed to evaluate properties of potential materials. The new material was a serendipitous discovery in this process. “It was like spotting a $100 bill on the street,” Curtarolo said of the finding. “It seemed impossible that this could be real and that no one had seen it before.” Now, they will use the Supercomputer Center at the University of California, San Diego to perform further calculations and refine the process. Also, they sell to manufacture the material which they stress will be no easy task.

Overall, the progress toward room temperature superconductors is proceeding in fits and starts. Nevertheless, with each breakthrough scientists become more optimistic that this “Holy Grail” of electricity management will finally be achieved. In the mid-1980s, I co-founded a well-regarded publication called Superconductor World Report. With hindsight, we were premature. However, the time of the superconductor industry is approaching and I will be watching to see who licenses the crucial technology.

Link here.


Hardline Islamists released six Chinese female hostages and one man last weekend after a 17-hour kidnapping in Pakistan. The issue: The Chinese were running a brothel. The point is this: The Financial Times quotes: “The incident threatened to dent Pakistan’s relations with China, its closest ally, and the Islamists later claimed to have freed the captives to preserve the bilateral relations with Beijing.”

So when exactly did China become Pakista–rs closest ally? Did we miss something? And more importantly, when on God’s green Earth did radical Islamists embrace sensitivity training in the realm of diplomatic relations? This rather inexplicable turn of events comes off our discussion last week regarding oil negotiations between Iraq and China.

You may recall that Iraqi President Jalal Talabani flew off to Beijing last week to revive a $1.2 billion dollar oil deal originally established between the two countries before the war. China certainly seems to be making a great name for itself in that part of the world. And other than not hardlining Iran for being naughty by playing with uranium, they are not really doing much to garner all this attention.

This trend highlights something uniquely Chinese. Chinese diplomacy is, and will always remain, strictly business. They do not swoop in with the flag of moral superiority. They do not care what type of government Country X adopts (excluding Taiwan, of course). And it seems to be working. Iraq, Iran and Pakistan are all courting China like the belle of the ball. I am sure they see a Chinese alliance as the natural balance to U.S. imperialism. Or maybe they just like to cozy up to the new guy on the block sporting all the cash.

Who knows? But one thing is sure: There are a few mainland companies whose long-term success is one of Beijing’s top priorities. One such company being PetroChina. Controlling China’s domestic market will be one of Beijing’s very top priorities. Oil is much more than the commodity that fuels our cars. Petroleum-based products undoubtedly serve as the most important commodity driving domestic economies.

Domestic stability rests on its relative availability. Consequently, Beijing will certainly protect the vested interests of the two large energy companies in which it holds significant stakes, PetroChina (NYSE: PTR) and Sinopec (NYSE: SNP). The Chinese government will never relinquish control of its domestic industry to foreign competition or market forces.

When the China National Offshore Oil Corporation (CNOOC) attempted to buy the Union Oil Company of California (UNOCAL), Washington went up in arms. It is one thing to buy America’s first major computer maker, but any attempts to buy one of America’s most strategic oil companies would not be tolerated.

I guess that is the way the world turns. You could call this piece a soft push for Chinese oil companies. But I think the bigger picture is this. In politics, it is the economy that matters. Every capital around the globe knows this. Most get it right. Others get by. But in the end, companies that drive domestic economies, blue chips like PetroChina, Yanzhou Coal or even Cheung Kong will do well over the long haul. They may not make the best story, but the best companies rarely ever do.

Link here.


We recently wrote about the very encouraging results of this year’s Wall Street Journal’s “Best on the Street” for 2007 competition. It has direct implications for small-cap stocks.

The annual tournament of sorts is one of the purest competitions in the investment world. It ranks the analysts whose Buy ratings had the biggest gains and whose Sell ratings had the biggest blow-ups. For 2006, The Journal looked at 45 industries and ranked the top five analysts in each, based on their skill of knowing when to buy a particular stock and when to sell it. It does not get any purer than that. Contestants were largely unrestricted when it came to which of their stocks would be eligible for honors. Just about any stock above $2 a share that traded on a major U.S. exchange was fair game.

How everyone was ranked is not as easy a process as you might think. First, every eligible research department’s rating scale was converted to the standard scale used by financial data company Thomson Financial. For instance, a Strong Buy rating was given a 1, a Buy a 2 and on down to a 5, a Strong Sell. (Some firms have less than 5-tier ratings scales, some have more. This must have been a nightmare.) The next step was to take all of those numbers and convert them to a 1-2-3 scale – Buy, Hold and Sell. On a 5-point scale, the two most bullish ratings became Buys, the two most bearish became Sells and the middle one became a Hold. Basically, for each Buy-rated stock an analyst covered, the total return it accumulated while he had it rated a Buy gave him points. The analyst also got points for Sell-rated stocks that had negative total returns.

So what did we learn? The best-performing stocks of the top 10 all-stars this year were ... small-caps. We define stocks valued from $50 million-$1.5 billion (sometimes to $2 billion) as small-caps. Typically, we recommend stocks with values greater than $300 million or so, but on occasion, we will go lower to find a great value. The all-stars in 2006 went low. Very low.

When Thomson Financial tallied the results, 8 of the 10 top-moving stocks were small-caps. STEC, the flash and DRAM maker, was the big winner, having climbed 236% during the time Pierre Maccagno at Needham had it rated a Buy last year. On the flip side, Rod Lache at Deutsche Bank called the drop in auto-parts supplier Dana perfectly, as it dropped 91% while he screamed Sell. Nice work. Small-caps continue to do well as we speak. As of May 31, the benchmark small-cap index, the Russell 2000, was up more than 8% year to date.

Something that we also monitor closely is the ratio of small-caps to larger-cap stocks amongst the top-50 best performing stocks year-to-date. Small-caps are dominating, as usual, by a ratio of 11.5 to 1. And some of those small-cap winners so far this year are posting massive returns, like Celsion (CLN: AMEX) up 270%, Transcend Services (TRCR: NASDAQ) up 435%, and Terra Nitrogen (TNH: NYSE) climbing 234%.

Link here.


Just because the bull-market in equities and commodities is five years old does not mean it must stop immediately.

Cash is trash! Today, currencies continue to perform their function as a medium of exchange, but they certainly are not a genuine store of value, i.e., a guardian of purchasing power. Thanks to the ongoing unprecedented money supply and credit growth (inflation) on a global scale, currencies have stopped fulfilling this crucial function, thereby robbing the masses of their hard-earned savings.

The major world currencies have lost between 25% and 75% of their purchasing power through inflation since 1980! For this system to work however, this solitary bear-market in “money” must remain concealed from the public for the fear that the masses may stop accepting these currencies as a medium of exchange. In order to proliferate this fraud, the officials keep up with the “inflation-fighting” propaganda through their totally bogus and meaningless “inflation” figures that are constantly spewed out by the media.

Taking into account the course of action chosen by the various central banks, I am convinced that the various currencies will continue to depreciate in value against assets. In other words, I expect that the stealth confiscation of savings will continue through inflation. For sure, they may be temporary setbacks or corrections in asset-prices, but the major trend is up. Before you disagree with my assessment, take into account the fact that despite an average economic backdrop (sky-high deficits and debt-levels in the developed nations), over the past four years, all assets appreciated at the same time. Despite rising interest-rates and geo-political tensions, even property and bond prices managed to stay strong together with equities, commodities and collectibles.

At the beginning of this decade, if I had told you that seven years later crude oil would be trading above $60 per barrel, gold would be close to $700 per ounce, food prices would be at multi-year highs and the Dow Jones would be trading around 13,500, you would have pronounced me crazy! However, this is exactly what has happened, and there is nothing in the works to suggest that this major trend is about to change in the near future.

In other words, I anticipate that barring short or medium-term corrections, asset-prices will continue to trend higher in nominal terms UNLESS the central-banks change their expansionary monetary policies and decide to rapidly raise interest-rates. In all likelihood, this scenario may not unfold for a few more years and until such time, investors should be able to protect their savings through the returns generated from the capital markets.

In the world of investing, it all comes down to supply and demand. The money supply is rising by roughly 10% per annum in several countries and the supply of assets is not keeping pace. Hence the bull-market in asset-prices when measured in terms of currencies. Now, I am not saying that the explosive growth in the supply of currencies cannot and will not be reversed in the future, thereby causing sharp contractions in asset-prices. It could easily reverse. But for that to happen, we would have to see genuine monetary-tightening through significantly higher interest-rates and a sharp increase in the banks’ minimum reserve requirements. The central banks know fully well that given the high debt levels, such drastic measures would probably cause a global depression, widespread unemployment and social unrest. So, they will try and avoid or delay this outcome as much as possible, thereby further assisting the bull-market in asset-prices and the death spiral for your cash savings.

Recently, several well-regarded economists and analysts have issued compelling reports explaining why the end is nigh. I tend to agree with their assessment that some assets are over-stretched and ripe for a correction (Chinese A-shares come to mind). However, I do not buy into the thesis that just because the bull-market in equities and commodities is five years old, it must stop immediately. History has shown that since the abandonment of gold in the early 1970’s, bull-markets have lasted for very long periods of time. Taking into account the strong money-supply growth and the rapid transformation of Asia and Latin America, I am inclined to think that the global boom in stocks and commodities will continue for several more years.

There can be no disputing the fact that the global expansion is now five years old and well advertised, accordingly the “low-hanging fruit” may not come by so easily. Furthermore, I envisage that in the future, investors will have to become more selective when making decisions and deploying their capital. For maximum success and safety, I would urge you to invest your capital during pullbacks while avoiding overstretched markets. Despite all the talk of “doom and gloom”, this strategy should continue to deliver reasonable returns in the period ahead.

Link here (scroll down to piece by Puru Saxena).


Some of what makes a great investor is baked-in natural talent, beyond imitation in the same way countless hours of golf practice will not turn you into Tiger Woods. But some things you can copy. In fact, a few things are very easy to copy. Three of them include: (1) discipline in the price you pay for an investment, (2) keeping your turnover low (sticking with your investments longer) and (3) focusing on your best ideas.

What follows is some shoptalk gathered at a recent investment conference in Hollywood that reinforces these three principles. Let us start with lessons from the Great Depression. The Great Depression was a terrible time to own stocks. During the entire span from 1929 to 1939, stocks delivered a negative return. Small-cap stocks were hit the hardest, losing more than 5% a year on average. Bonds were the only place to hide, scratching out a relatively robust 4.7% per year. Or maybe not.

Two great investors, Robert Rodriguez and Steve Romick, both money managers at First Pacific Advisors (FPA), show that a little discipline – a little attention to prices paid – would have given you good returns, even in the Great Depression. They show that waiting just two years – until 1931, instead of 1929 – turns negative returns to positive ones. Suddenly, small caps beat out the alternatives. Between the market lows of 1931 and 1939, small cap stocks outpaced bonds. And if you factor in the deflation that occurred during the 1930s, small caps delivered an even more impressive result. A dollar in 1939 bought more than a dollar in 1929. If you factor that in, the real return on small-cap stocks was 9.2% annually during the Great Depression.

Rodriguez and Romick are not market-timers. They are stock-pickers. They buy stocks when they are cheap. They hold onto them. So their basic message is simply this: Stick with buying cheap stocks. You can still earn good returns even in a lousy market. If you could buy all small-cap stocks and get a 9% annual real return during the Great Depression, think what a stock-picker could have done by just sticking with the cheapest stocks in a friendlier investment environment. Stock-pickers are a minority these days. James Montier, a researcher at Dresdner Kleinwort, recently observed, “Stock-picking has become a minority occupation. But if no one else wants to be a stock picker, then this is, most likely, where the opportunity lies.”

The second part of Rodriquez and Romick’s presentation had to do with patience. Investors, as a group, are not patient. They flip stocks too often. They sell when prices fall and buy when prices rise. The fund flows into (and out of) Rodriguez’s own fund offers a classic example of how most investors behave. The FPA Capital Fund, run by Rodriguez, was the best-performing mutual fund over the past 20 years, beating the market by a sizable margin. In 2006, the fund slipped a bit and lagged the market. Despite Rodriguez’s two-decade-long performance history, some investors actually pulled money out of the fund. The fund lost 8.6% of its money under management to redemptions in the first quarter of 2007 alone. This has happened before. When the fund lagged the market in 1999 the fund lost 15% of its assets due to redemptions. In the following year, it lost a whopping 25% of its assets from redemptions. The Fund subsequently beat the market by 35 points in 2001.

The FPA Capital Fund’s experience illustrates a classic case of investor impatience. There are several studies out there that show the average investor actually earns returns less than what mutual funds report. Why? Because the average investor tends to take his money out at bottoms and invest it near tops. Montier, commenting on empirical research exploring the link between turnover and performance, wrote, “Unsurprisingly, those funds with the highest turnover deliver the worst performance, while those funds with the lowest turnover do the least damage to net risk-adjusted returns.”

So pay attention to the price you pay and you can make good returns, even in a bad market. And do not chase past returns. Instead, be patient with your investments and give them time to bear fruit. Lastly, focus on your best ideas.

Zeke Ashton is on nobody’s list of great investors – at least not yet. But he is a rising young star. Research supports the idea that the best-performing investors concentrate on their best ideas. The average mutual fund owns 128 stocks. Among the top 25% of all funds, the average is only 63 stocks. The bottom 75% own over 140 stocks. In short, the best investors own fewer stocks. Ashton said, “The goal for all investors should be to get the most value out of your best ideas without risking significant capital loss if you are wrong.”

What makes a great investor is endlessly fascinating to me. I love to study how great investors play the game. Doing so also helps reinforce good investing habits. Sometimes, these habits are relatively easy to copy: pay attention to price, trade less and focus on your best ideas.

Link here (scroll down to piece by Chris Mayer).
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