Finance Digest for Week of July 23, 2007

SPENDING LIKE A DRUNKEN SAILOR (USING OTHER PEOPLE’S MONEY)

History tells us that the first paper currencies were notes payable (redeemable) in gold or silver, or, mere warehouse receipts for stored gold. Over the years, it became obvious that it was easier to simply exchange the receipts after a transaction than go to the warehouse with the receipts to get the gold and silver. The receipts became currency in common usage, and the people began to think of the receipts (currency) as money all by itself, completely detached from any stored gold.

Then, as governments began to buy votes or finance wars, they yielded to the temptation to simply print more “receipts” than there was gold and silver to back them up (who would know?), each time triggering more and more inflation. The foundation for inflationary tactics was laid in America when Roosevelt created the New Deal, then Lyndon Johnson financed the War on Poverty and the Vietnam War at the same time (“guns and butter”), and the printing presses have had to step up the pace ever since. (Poverty won and so did North Vietnam, but that is another story.)

The process of currency destruction has been accelerating, with advances punctuated by retreats, since the 1930s. Throughout history, this has been the case over and over again ever since the birth of paper money. The critical moment in this era came when Nixon “closed the gold window” in 1971 – no longer allowing dollars to be exchanged for gold or silver to settle international accounts – at the Federal Reserve. This move finally admitted America’s irresponsible reality and permanently detached the paper dollars from gold or silver, and the money printers were off to the races.

In the last 10 years, the Fed has manufactured trillions of dollars out of nothing at the fastest pace in history by far, and it is now accelerating. The Fed has then loaned the dollars into circulation, or given them to politicians to spend. Since then, Congress has been spending like a drunken sailor. (The difference between Congress and a drunken sailor? A drunken sailor spends his own money!) This money expansion now dwarfs the monetary explosion which led to that historic metals bull market in the 1970s.

It is hard for me to exaggerate or overstate what is happening. Economists call this monetary-expansion process “inflation”. It really should be called “dilution”, that is, dilution of the money supply, and consequently its value. Inevitably, this sooner or later causes rising consumer prices, which laymen, and the media, and even Wall Street, will still mistakenly call “inflation”. Calling rising prices “inflation” is like calling falling trees “hurricanes”!

When will the masses catch on to this steadily progressing fact of life? Gold and silver prices are the true measure of public awareness. Sooner or later, awareness reaches critical mass, and the metals go through the stratosphere. One early-warning harbinger of inflation is the dollar losing exchange value against foreign currencies, which began in earnest in 2002 and 2003. A falling dollar is inflationary, as it takes more and more dollars to buy the increasing amounts of foreign-produced goods we are now buying. Gold and oil are quoted in dollars, so up they go. And now the metals are rising, not just against the dollar, but against nearly all currencies as the metals grow in strength, and virtually every country on Earth is inflating its currency. It is actually more accurate to say the dollar is falling in relation to gold, than to say gold is rising in relation to the dollar.

The falling dollar-exchange value explains the early strength of the metals, and there is a lot more to come, as we continue to flood the international money markets with dollars. Now we do not even have to print them. This is the age of cyber-money, when less than 5% of the dollars are minted or printed, and most are only computer entries at banks. We do not even know how many dollars there are!

22 years of low or falling gold and silver prices gave us a drop in production and exploration of epic proportions, as miners pulled in their horns to preserve their capital. It will take as long as 7 to 10 years to develop new mining and production, and falling supply and rising demand have made higher prices inevitable for the imminent future. Silver industrial applications have soared, and there are few satisfactory substitutes in sight. New silver mines are getting harder and more expensive to find, and supply is falling further and further short of demand. One expert claims that the deeper you go into the ground, the less silver there is.

Both metals are far rarer than most people know. All the gold ever mined since the dawn of history, including that in central banks, gold fillings and sunken shipwrecks in the Caribbean, would cover a football field about four feet deep. And, demand is now leaping past new supplies. China and India are enjoying a historic burst of capitalist prosperity, and their booming new middle class is enthusiastically buying gold and silver jewelry, creating soaring new demand. Government silver warehouses are now all empty, and COMEX futures positions, much of which must be covered eventually by deliveries or purchases, are estimated to be equal to or greater than all new production.

Silver is the poor man’s gold. Think of gold as large denomination money, and silver as small change. A one-ounce gold coin now costs only about $650, and you can buy a roll of pre-1965, 90%-silver dimes for close to $50 a roll. It is partly because it is so much cheaper that the potential silver buying pool is much larger. Along with industrial use being so much greater, silver will be more profitable than gold by at least 100%. And, there is more to come.

BERNANKE WARNS THAT U.S. SUB-PRIME LOAN LOSSES COULD BE AS MUCH AS $100 BILLION

In a second day of testimony to Congress, Mr. Bernanke said credit losses associated with sub-prime mortgage failures were “significant”. Wall Street is nervous about the exposure of banks and other lenders to the riskier sub-prime market. Earlier this month, Bear Stearns bailed out two sub-prime-focused hedge funds. It has since said one of them has “very little value” and the other is now worthless.

Fears have grown in recent weeks that the downturn in the housing market, prompted by more people’s inability to pay their mortgages, will cause instability and retrenchment in the wider economy. But the June minutes from the Federal Reserve’s rate-setting committee showed that despite the continued housing slump, inflation remained the central bank’s overriding concern. The decision to leave interest rates on hold at 5.25% was underpinned by fears that core inflation, stripping out volatile energy and food prices, would fail to recede. Economists now expect rates to stay at that level for the rest of the year.

In two days of testimony before U.S. legislators, Mr. Bernanke has sounded a persistently downbeat note on the state of the housing market and the woes of the sub-prime sector, which have led to the collapse of about 30 lenders. “The credit losses associated with sub-prime have come to light and they are fairly significant,” Mr. Bernanke told a Senate Committee. “Some estimates are in the order of between $50 billion and $100 billion of losses.”

The Fed’s handling of the sub-prime market, which it regulates, came under fire from senators, who argued it should have done more to protect vulnerable consumers from inappropriate and improper mortgage practices. Mr. Bernanke said the Fed was reviewing current regulations on lending practices in a “responsible” manner. The Fed remained “alert” for any signs that housing weakness may destabilize the economy as a whole, he added. It has already acknowledged the impact of reduced activity in the housing market on consumer spending, cutting its forecast for economic growth this year.

Worries over the economic outlook have not daunted investors, with the leading U.S. share index, the Dow Jones Industrial Average, closing above 14,000 for the first time.

Banks battle housing woes.

Increasingly, industry players may be judged on how well their mortgage businesses navigate a tricky housing market. With scores of banks reporting earnings last week, investors are learning how banks are doing against the backdrop of a slow housing market and worries about mortgage defaults. Many bank shares were falling slightly or barely moving higher despite good earnings figures. That may be a sign of rising worries about how well banks can navigate this tricky housing environment.

Investors are worried about the fallout from skyrocketing defaults on subprime mortgages, home loans to people with poor credit histories. There are signs defaults and delinquencies are spreading beyond subprime to other types of home loans. The problem is made worse by declining home prices in many parts of the country, which means residential loans’ collateral is not worth what it was a year or two ago.

How will all this affect banks? No one really knows. While residential lending is important to many banks, their profits also depend on credit cards, other kinds of lending and various fees. Interest rates also have a big effect on how much banks earn. Many mainstream banks stayed away from subprime entirely and only dabbled in other risky types of loans. But they are still vulnerable to defaults on residential mortgages. And, they are seeing slower growth in the new mortgages that provided big profits during the housing boom.

Despite housing’s problems, Standard & Poor’s equity analyst Erik Oja expects consumer and home equity loans to grow in the “low single digits” for the regional banks he covers. There is a real difference between banks in how well they avoid risky loans, Oja says. The best banks are willing to sacrifice earnings in the short term by carefully screening and reviewing their loans. Several banks have been hit by problems with residential loans, particularly loans to developers. Much of the devil is in the details: Analysts keep close eyes on what percentage of a bank’s loans are “non-performing”. So far, those numbers are not at alarming levels, though credit quality is deteriorating for many.

DOW 14,000: WHAT IS NOT IN A NUMBER

The market’s race to the 14,000 milestone (however brief) has the Wall Street pros waxing William Shakespeare-inspired poetics, with one popular news source asking, “What is in a number?” Well, we can tell you exactly what is NOT in that number, namely, a positive fundamental backdrop. On this, Bob Prechter makes the following observations in his July 13 Elliott Wave Theorist:

“Terrorism has increased dramatically; the President’s approval ratings have reached Nixonian levels (a new low this week of 29 percent); Congress’ popularity has plumbed record depths (24 percent in June); the conciliatory and apologetic tone of the dialogue among religious leaders has morphed into a tone of confrontation (radical Islam and the latest headline: ‘Other Christian denominations are not true churches, Pope reasserts,’ 7/11 Atlanta Journal Constitution); populations are demanding that authorities control immigration; governments are proposing protectionist measures; home prices have fallen for the longest time since the Great Depression; and bank credit instruments are under severe price pressure due to fears of default.”

Additionally, the global urge-to-merge is repellant in critical areas. China has responded to foreign criticism of the safety of its products with import bans and a high-profile execution. A fearful U.S. has suddenly realized the FDA cannot inspect the flood of imported food. The World Trade Organization is struggling to salvage stalled trade talks. Russia flexes oiled muscles and distances itself from the west. It has abandoned arms treaties and stated its intent to claim the North Pole and a large part of the Artic. Britain has expelled Russian diplomats over a radiation-poisoning murder.

We could go on. Suffice to say, if news moves the markets (as the popular “experts” insist), then one must believe the DJIA is cycling to new highs on two flat tires, a busted chain and broken wheel bearings. Obviously, that makes no sense, UNTIL you consider the other detail that is missing from the 14,000 number – reality.

Here is the thing: The DJIA index presented in the mainstream financial press is denominated in terms of the U.S. dollar. The REAL Dow, however, as measured in terms of ounces of gold, tells quite a different story. An close-up of the Dow/Gold Index that shows prices more than 50% BELOW their 2000 peak. Which begs the question: Which Dow reflects the negative quality of social interaction that has taken the global front by storm – the one riding on a wave of leverage OR the one sinking beneath the weight of lower gold values?

A new twist on an old market-timing indicator?

You have probably heard of the “magazine cover indicator”, developed by the analyst Paul Montgomery some decades ago.The theory underlying this indicator is that by the time a financial market makes it to the cover of a magazine, the trend is near exhaustion. Perhaps the most famous example of the magazine cover indicator is Business Week’s “The Death Of Equities” cover in August 1979, right at the start of an historic, multi-decade rally in the DJIA.

Why does this indicator work? Because the mass media caters to the public, and when the public is obsessed with something, media outlets naturally choose that topic for their cover stories. What Paul Montgomery observed was that in the financial markets, the point of the public’s absolute obsession usually means that everybody is “all in”, and the trend is over. Well, here is a little twist on this old faithful indicator ...

Five reasons to sell, sell, sell.

U.S. stocks are at record levels. Earnings season is under way, with many expecting a modest rise in corporate profits. Unemployment is very low. So far problems with housing have not infected the rest of the economy, which seems poised to bounce back from slow growth in the first quarter.

So what is there to worry about? Plenty. No matter how wonderful things look, the good times will not last forever. Even as most market observers remain bullish, we asked them what could derail this bull market. Stocks could keep setting records for months or even years, but it pays for investors to know what dangers are lurking out there. This Five for the Money lists the five biggest threats to the stock market rally.

1. Earnings. Will any stocks and sectors step up to the plate to push the market even higher? Investors are closely watching corporate earnings for clues.
2. Consumer spending. Consumers drive the U.S. economy, and so far they have held up well despite housing problems and high gas prices. Watch closely for data later this summer on the back-to-school season, which is an important time for retailers.
3. Inflation. The faster prices rise, the more likely that Federal Reserve policymakers could decide to hike interest rates later this year. That would cool off the economy. The biggest worry is that the Fed is forced to raise rates while the economy is still growing only slowly, forcing the economy into a recession.
4. Subprime and housing. Many on Wall Street believe the problem with subprime mortgages is limited and under control. They may be right, but it is impossible for anyone to predict how many debtors will ultimately default on their obligations. Bill Larkin, portfolio manager of fixed income at Cabot Money Management, believes he is already seeing signs that subprime worries are spreading, rocking other areas of the credit market. “People are starting to get nervous,” Larkin adds, but it takes a while for these trends to show up.
   
   PIMCO bond guru Bill Gross has warned investors not to think subprime is only a problem for a few hedge funds or investment banks. The problem affects millions of home buyers who financed their houses with cheap money but are now seeing mortgage payments rise along with defaults. Gross wrote in his July investment outlook, “This problem – aided and abetted by Wall Street – ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address – Main Street.”
5. Shiny happy investors. As markets rise, the bulls’ success may be their biggest weakness. Too much optimism can derail a rally as quickly as too much gloom and doom. It is a cliché on Wall Street that markets like to climb a “wall of worry”. The more doubts about a rally, the more headwinds it faces on the way up, the more likely a bull market has a firm foundation.
   
   To gauge the amount of skepticism out there, investors can look at the amount of short-selling – trades betting stock prices will fall – or ratios between puts and calls. And be on the lookout for articles proclaiming “happy days are here again.” If the media is sounding too positive about stocks, it may be a sign that retail investors are jumping into the market. And if the average investor is buying again, you can bet the “smart money” is selling, and stock prices are near peak levels.

MIAMI CONDO GLUT PUSHES FLORIDA’S ECONOMY TO BRINK OF RECESSION

But the developers keep on building.

In the middle of the biggest glut of condominiums in more than 30 years, Miami developers keep on building. The oversupply will force prices down as much as 30%, the worst decline since the 1970s, and help push Florida’s economy into recession as early as October, said Mark Zandi, chief economist at Moody’s Economy.com, who owns a home in Vero Beach, Florida.

“Florida is the epicenter for all the problems that exist in the housing industry,” said Lewis Goodkin, president of Goodkin Consulting Corp. and a property adviser in Miami for the past 30 years, who also foresees a recession. “The problems we have now are unprecedented and a lot of people will get burnt.”

37 new high-rise condos and 20,000 new units are being built in Miami’s 1,040-acre downtown, where sales fell almost 50% in May, according to the Florida Association of Realtors. The new units will join the 22,924 existing condos in Miami-Dade County that were for sale in April, according to Jack McCabe, chief executive officer of McCabe Research & Consulting LLC in Deerfield Beach, Florida. That is the most unsold units since McCabe began tracking sales in 2002.

While the housing industry is responsible for 10.6% of the nation’s jobs, in Florida it accounts for 20%, Zandi said. The national housing industry’s weakness prompted Federal Reserve policy makers this week to cut their forecasts for U.S. economic growth for the next two years. Florida’s robust economy of 2001 to 2005 was driven by the thousands of well-paying jobs related to the real estate market and homeowners who used home-equity loans to pay for items such as boats and big-screen TVs, McCabe said. “All those jobs are going away now, and we are seeing the trickle-down effect in declining sales in big-box retailers and home-furnishing manufacturers,” McCabe said. “Florida is headed to a recession.”

A Florida recession could be averted and the state housing industry’s “serious problems” solved by an influx of American retirees and foreign buyers, said David Denslow, a University of Florida economist in Gainesville. “The wave of baby boomer retirees is gathering momentum, and the weaker dollar makes Florida seem like a bargain to Europeans,” Denslow said. “With any luck at all that will sustain us.”

Florida banks have already quit making loans to Miami condo developers, said Kenneth H. Thomas, a Miami bank consultant and a lecturer at the Wharton School at the University of Pennsylvania in Philadelphia. “South Florida lenders were the first to put money into the condo market, they were the first to see the oversupply and they were the first to get out,” Thomas said. Because of the lag time between making construction loans and closing sales on completed condos, loan problems showed up for Florida lenders in first-quarter bank statistics from the FDIC, Thomas said. Florida banks posted a 43% jump in the first quarter in loans no longer paying interest compared with the last three months of 2006, while the number for banks nationwide rose 13%, according to the FDIC.

Miami condo sales fell to 599 in May, a drop of 46% from a year earlier, according to the state realtors association. Condo sales in Orlando, home of Walt Disney World, have plummeted 80%, said Economy.com’s Zandi. “The statistics are scary,” said Michael Wohl, a partner in the Pinnacle Housing Group, a Miami developer that has stayed out of the condo market. “There is going to be a lot of blood in the water in the next 18 months.”

With prices falling, international investors, hedge funds, private equity firms and Wall Street banks are beginning to shop for deals, said Peter Zalewski of Condo Vultures Realty LLC, a consulting firm in Bal Harbour, Florida. Miami lags only New York in the number of foreign visitors to U.S. cities, according to the Greater Miami Convention & Visitors Bureau. “Bigger and bigger funds are coming to me wanting to buy,” Zalewski said. “Prices have yet to hit bottom because the bulk of Miami properties won’t come on the market for another six months.”

Since it can take up to four years for a condo project to travel from conception to completion, many of the towers rising from the coral rock of Miami were planned and financed during the Florida housing boom, which lasted from 2001 to 2005. Lenders typically require enough advance sales to cover the cost of a construction loan. Customers’ deposits, however, do not always mean the sales will close, said Ian Bruce Eichner, a developer whose latest Miami Beach condo tower is scheduled to open in November. “The market is as close to a depression as Miami has seen in 30 years,” Eichner said. “There is a gargantuan supply of homes and the overwhelming preponderance were built for speculators, not for people who are living there.”

As much as half of those putting down deposits for Miami condos are speculators looking to flip units, or sell them quickly for a profit without living in them, said McCabe of McCabe Research. With sale prices falling, McCabe said he expects up to 50% of them to walk away from their deposits in the next 18 months rather than complete the sales. “What is going to happen to all those units?” Eichner asked. “God only knows. You couldn’t give me a piece of property in Miami for nothing. I like sleeping at night.”

Condo developers encouraged short-term investors, whose deposits helped them secure funding, Goodkin said. “The developers didn’t get to start building until they had a certain number of contracts signed, so anyone putting down money was good for them,” Goodkin said. Many “flippers” closed on their units and now cannot sell them, said Michael Cannon of Integra Realty Resources-Miami Inc., leaving completed condo towers with floors of dark windows and empty balconies.

In the 1970s, when condos were a new product, Florida developers built 500,000 units and prices fell 50%, said Brad Hunter of MetroStudy, a research firm in West Palm Beach. “The difference is, back then they were two-story condo buildings that had $50,000 units,” Hunter said. “Nowadays they are $700,000 units in 20-story buildings. Instead of building too much stuff that people could afford like we did then, this time we built too much stuff that people can’t afford.”

A lot of the inventory 30 years ago was sold off and converted to rental apartments, Goodkin said. That solution will not work now because prices have soared and properties coming on the market will compete with existing condos whose prices have plummeted, he said. Goodkin said opportunistic investors will buy construction loans from banks at a discount of 30% or more. “The vultures are in the trees,” Goodkin said. “Reality has become the new pessimism.”

Developer Tibor Hollo, for one, is not worried about Miami’s condo glut. Hollo, 80, was born in Hungary and spent his teenage years in two World War II-era Nazi extermination camps, Auschwitz and Matthausen. Hollo started building in Miami in 1956 and now his Florida East Coast Realty has two high-rises under construction, the $603 million, 787-unit Villa Magna, and the $120 million, 635-unit Opera Tower. “Residential buildings, if they are well-located and top of the line, they will sell,” Hollo said in an interview. Well-to-do Central and South Americans like Miami because of its Hispanic culture, while the dollar’s weakness against the euro has made Miami attractive to Europeans who seek second homes in the Florida sunshine, he said. “We sold 38 units of the Opera Tower's 635 units to Russians,” Hollo said, his eyes widening. “I would never have dreamed it. I would understand 38 Venezuelans, not 38 Russians.”

The skyline of Miami is visible from Key Biscayne, the barrier island where John Rosser lives. Some nights the real estate broker scans the new buildings and sees more dark windows than lighted. “This is dumbfounding to me,” Rosser said. “It is a building boom in the middle of a housing bust.”

Enough subprime, let’s talk housing debacle.

Troubles are surfacing with loans made to better-off U.S. homebuyers in a worrying trend that indicates what has been termed “the subprime crisis” may need to be rebadged “the housing crisis” and eventually maybe just “the crisis”. While signs are tentative so far, credit rating downgrades and payment delinquencies are happening more frequently in what is called the “Alt-A” mortgage loan market, the slice just above subprime in creditworthiness. The upshot is more pain for investors in mortgages, less appetite for other risky credits, such as leveraged buyouts, falling U.S. house prices, and the big one, a threat to consumption in the U.S.

In the past week, both Moody’s and S&P have announced downgrades and reviews for downgrades for securities backed by Alternative-A loans, which are typically made to borrowers with less proof of their finances than prime borrowers or who have small credit problems in their past. Delinquencies on Alt-A have been rising faster than for subprime, though at much lower levels. Between January and March, delinquencies for Alt-A rose by 17%, to 3.1% of loans, while subprime delinquencies rose by about 3.5%, to 14.8%. Fitch Ratings, too, has said it is “very concerned” about Alt-A loans, especially those with low early repayments which are not even sufficient to pay all of the interest.

The idea that problems in subprime were contained and would not spread to the general economy has been maintained by U.S. central bankers and policy makers. It has also been the market’s central assumption and underpinned the dizzying rise of stocks to new highs.

Virtuous cycle turned viscious.

If Alt-A follows the path of subprime, there will be more forced sellers of U.S. houses, less available finance to buy that increased supply and an ever-growing number of homeowners who will realize, even if they are “prime” borrowers, that their largest single asset is worth less than they thought. Even without a rise in unemployment, that could well prompt Americans to spend less, undermining in turn economic growth and employment.

The U.S. economy has been the beneficiary of a self-reinforcing cycle in recent years, as easy credit and rising house prices combined to fuel economic and consumer confidence, making lenders and borrowers alike think the tide would continue to rise and float everyone over the risks they had taken on.

Housing, as both an asset to tap and a reason to feel flush, has been a big factor behind the U.S. personal savings rate being negative since 2005. But signs of weakness in U.S. housing are weakening that trust, according to Robert Shiller, an economics professor at Yale, whose S&P/Case-Shiller Home Price index is showing a yearly loss of 2.1%.

U.S. Treasury Secretary Henry Paulson termed subprime problems “quite containable”, while St. Louis Fed President William Poole last week said that there was “a way to go” before subprime hit consumer spending and credit quality more generally. Fed Chairman Ben Bernanke told lawmakers last week he saw “no spillover so far” from the housing market to the broader economy.

But elements of the financial markets, notably higher risk corporate credit, seem not so sure, and the trickle of Alt-A worries has contributed to a sell-off. “Subprime may have been the first area to roll over, but pain has, is and will continue to spread to the Alt-A and Prime sectors of the U.S. housing market,” RBS credit strategist Bob Janjuah said in a research note. And while Alt-A losses are still modest in percentage terms, the overall numbers are huge, with estimates of Alt-A lending at $386 billion in 2006, as against $640 billion in subprime.

If, or perhaps when, this all translates into a retrenchment by the U.S. consumer, the damage could be very large.

“YOU ARE EITHER A CONTRARIAN OR A VICTIM”

So Rick Rule declared from the podium in Vancouver. “That is all you need to know about investing in resource stocks.” But during Tuesday’s brutal trading action north of the 49th parallel, even some of the contrarians must have felt victimized. The TSX Index of Canadian stocks tumbled nearly 400 points – its largest one-day drop in more than three years. Energy and mining stocks led the decline, assisted by a few swooning financials.

An X-treme contrarian would have enjoyed the devastation, of course. But only the most contrary (and nimble) of contrarians who could have maintained sufficient sanity and solvency to bet against the booming resource stocks ... or against any other facet of North America’s runaway stock markets. Meanwhile, down in the Lower 48, stocks also suffered a drubbing – especially energy and financial stocks. The shares of Countrywide Financial (NYSE: CFC), in particular, plummeted more than 10%.

“That is a pretty surprising drop,” a broker-friend remarked. “Yeah,” your editor replied, “but not nearly as surprising as the fact that this stock was not imploding last July instead of this July. I can’t believe how long it has taken for the mortgage market’s painfully obvious difficulties to begin imparting some pain to Countrywide shareholders.”

We have been annoying our readers for more than two years with ominous forebodings about the mortgage-lending industry and about Countrywide Financial in particular. To those readers who may have embraced a bearish perspective toward financial stocks before the stock market was prepared to reward it, we empathize with your pain.

Too often, the stock market does not permit a choice between being a contrarian OR a victim. It insists that you be both at the same time. But now that the winds are beginning to shift, the stock market is victimizing the bulls, rather than the bears ... and we would guess that the bulls will enjoy no immediate respite.

More than five months ago, we noted the curious strength of Countrywide Financial shares. And yet, CFC refused to yield to the weight of accurate skeptical analysis. For five long months (at least), the bears suffered for their prescient analysis. Should we be surprised, therefore, if the bulls now suffer for their delusional optimism?

DEBT MARKET IS SQUEEZING PRIVATE EQUITY

After two years of rapid-fire deal making, private equity firms are finding it harder to get the job done. Some 15 to 20 debt offerings – analysts’ estimates vary – have been modified or postponed as anxious investors have demanded better terms for high-yield loans and bonds, the lifeblood of the leveraged buyout. Private equity firms have had to raise interest rates and sweeten the repayment – or risk having to withdraw the offerings entirely.

Anxiety over securities backed by risky mortgage loans and rising interest rates has roiled the credit markets for several months. Now the contagion from those troubles seems to be spreading into other parts of the marketplace. The yields on 10-year Treasury notes fell below 5% last week, closing at 4.95 percent, in another sign that investors are looking for safe havens. The sale of loans meant to finance the buyouts of the Chrysler Group and the European retailers Alliance Boots and Maxeda have been sweetened or postponed. Bond sales have not fared much better: About $3.65 billion in offerings have been postponed since June 26, according to data from KDP.

If conditions do not improve, private equity firms and their bankers may face an even uglier situation. Some $235 billion in loans are waiting to be sold, nearly all for leveraged buyouts, according to Standard & Poor’s Leveraged Commentary and Data. Nearly all major debt offerings that were expected to take place next month have been pushed back. First Data, a credit card processor whose $22 billion sale of loans and bonds is widely seen as a bellwether for the high-yield credit markets, has pushed back its offering until after Labor Day. Bankers for other major buyouts, like TXU’s, may hold off their debt sales even longer.

In short order, one of the friendliest environments that private equity firms have ever seen in years has grown hostile. Once they could command extraordinarily lenient terms from investors, making the debt used to fuel leveraged buyouts quite cheap. So-called “covenant-lite” loans, which have few restrictions on repayment, blossomed, as did pay-in-kind toggles, bonds that could be repaid by issuing more debt. Now, analysts say, investors have shunned that easy debt, forcing buyout firms to pay more to get their deals done.

Chrysler raised the interest rates on $18 billion in loans meant to finance its buyout by Cerberus Capital Management, a private equity and hedge fund firm. The two sets of loans, earmarked for the carmaker itself and for its financing unit, may now cost the company millions more in interest payments. Two companies being acquired by the private equity giant KKR also postponed debt offerings amid the tougher market conditions. Alliance Boots, a British pharmacy chain, reportedly delayed £9 billion ($18.5 billion) in loans. The chain is also said to be considering raising the interest rates on those loans. Maxeda, a Dutch department store retailer, also canceled an offering of €1 billion ($1.4 billion). It is not clear when either company will reschedule those sales.

The troubles in the loan market have followed similar struggles to sell high-yield bonds. Over the last month, companies like U.S. Foodservice, a major provider of food to restaurants and school cafeterias, and ServiceMaster International, a lawn care and pest control services provider, have had to cancel bond offerings totaling almost $2 billion. To sell $1.175 billion in bonds to finance its buyout last month, Dollar General removed an additional $725 million in toggles.

Buyout firms are not the only ones suffering from the growing wave of caution. An increasingly popular practice among banks has been to assume part of the equity of these deals in what is known as an equity bridge. Banks normally turn around and sell off these portions to other investors. But at least two times over the past month, in the U.S. Foodservice and ServiceMaster deals, banks have been stuck on the bridge.

“I hope they go the way of the dinosaur,” James Dimon, JPMorgan Chase’s CEO, said. Mr. Dimon has reason to sound alarmed. His bank is providing a $500 million bridge for TXU’s buyout by KKR and TPG Capital. Bank of America and Citigroup are also providing $500 million each. Later, Mr. Dimon sounded less worried. “There are some hung bridges, again nothing on our balance sheet we are particularly concerned about,” he said. But the consequences of being stuck on a bridge are serious. The more banks’ hands are tied with these loans, the less money they have to make additional loans to other deals.

One private equity firm that is particularly at risk if credit starts to dry up is KKR. It is exposed to at least six deals that have been delayed, modified or canceled in the last month. The firm filed to go public earlier this month. The tighter credit markets may not choke off deal making. But, analysts say, private equity must be willing to pay a higher price.

THE HAND OF FINANCE

Beginning in early-January, “It’s All About Finance” has been the underlying theme of almost every one of this year’s bulletins. For me, the important unanswered questions inevitably relate back to my December 2000 presentation “How Could Irving Fisher Have Been So Wrong?” Why are so many caught bullish – and completely oblivious to escalating risk – at major tops? And why is it that booms and bull markets cannot endure indefinitely? Clearly, the vast majority are today convinced they can and will. We are witnessing why they cannot and will not.

Well, booms inevitably falter at The Hand of Finance. In this distant past the post-Bubble post-mortem would simplify the state of things to “the money went bad.” People had lost confidence and “ran” from banks and the stock market. The credit wheels had ground to a halt and the abundant liquidity that seemed as if it would always be readily available instead abruptly evaporated. Jump forward to today and perceptions have it that the Fed and global central bankers are waiting to ensure that confidence is maintained and liquidity remains always bountiful. We are apparently so much more enlightened today, especially with our sophisticated risk monitoring and mitigating systems. We have derivatives!

I have my somewhat different take on why credit-induced booms are destined for bust. Bubbles are sustained only by increasing quantities of credit creation – a rather simplistic proposition encompassing highly complex processes. Inevitably, the dilemma evolves (sometime late in the cycle) to the point where the quantity of requisite additional credit turns enormous – and the rapid financial expansion accelerates to breakneck speed. At the same time, the risk profile of the marginal (late-cycle) new loan deteriorates, while the major financial intermediaries (right along with the vast majority of market participants) are caught reaching too aggressively for perceived easy profits. Too much credit is financing speculative endeavors, highly inflated assets values, and enterprises that, at best, are economic only as long as boom-time conditions exist.

Underlying credit risk eventually succumbs to parabolic growth tendencies – as we have witnessed this past year. Yet one critical upshot of this dynamic is the associated (credit-induced) surge in overall system liquidity, especially in wild securities markets inflation. Naturally, this “monetary disorder” unfolds some number of years into the prosperous boom – after an entrenched inflationary bias has taken firm hold in the securities markets and the economy generally. Irving Fisher was making a fortune at the top. He was intoxicated by his inflating wealth and was as emboldened as the naysayers were fully discredited. Almost by cruel design, the credit bubble’s “terminal phase” is guaranteed to entrap those willing to subscribe to New Eras.

The unappreciated predicament of 1929 and today is risk intermediation. Dr. Bernanke refers to the study of the Great Depression as the “Holy Grail of economics”. He blames the “bubble poppers” and the Fed’s subsequent failure to create enough money. Conventional thinking has it that had the Fed only created $5 billion and filled the hole in bank capital, the devastating downturn could have been avoided. But the issue at the time was not, as conventional monetary economist believe today, the few billions necessary to recapitalize the banking system – but the ongoing tens of billions that would be required to sustain unsustainable credit bubble-induced inflated asset prices, inflated corporate profits, inflated earnings, and myriad worsening economic maladjustments.

Citigroup expanded its balance sheet by $200 billion during the second quarter (to $2.22 TN). The four “broker/dealers” have combined for one-year growth surpassing $700 billion. The “good news” is that they have to this point succeeded in supplying the necessary credit to sustain global financial and economic booms. The bad news is that this credit deluge is wildly inflating global asset prices and feeding an historic worldwide speculative bubble in debt and equity instruments, real estate, and assets generally. We are witnessing in real time the dynamics of rapidly escalating late-cycle risk and the dilemma of how to intermediate it.

With few exceptions, the major financial firms have so far reported “better-than-expected” earnings. Almost without exception the market sold stock on the news. Citigroup’s Q2 Revenues were up 20% from a year ago. Citigroup is the poster child for a (struggling) major financial player responding to weakening profits and business fundamentals in its traditional lending business by pushing its capital markets activities to new extremes. Why not? All the other firms’ stocks – until recently – were amply rewarded for doing the same. Now they are all fully exposed to market risk with nowhere to go. And, for their efforts to support the boom, their stocks are now under liquidation.

July 18 – Financial Times (Ken Fisher): “Headlines herald a U.S. prime-time, subprime mortgage implosion leading to an upcoming credit-crunch crisis – destined to sink shares, raise interest rates and impale economies. But this is demonstrable nonsense. Yes, there have been media autopsies of the few notable subprime lenders that have gone belly up. More are certainly in the wings. But what makes this a systemic problem? If subprime is to ripple systemically into a crisis, it is a take-it-to-the-bank certainty that we will see vast credit-spread widening. Yet spreads between high quality and low quality debt of the same maturity – by any measure – are at near record lows, in spite of six months of subprime hand-wringing. ... Every true credit crisis in history had huge spikes in credit spreads early on and – while not always – usually well before equities implode. By contrast, wrong-headed credit fear babble blows through history like the wind without a ripple in credit spreads.”

I will assume that if Ken Fisher ever read my analysis he would pronounce me the “king of credit fear babble.” The title of Mr. Fisher’s FT article was a rather catchy “Be Bullish and Watch the Bears Impale Themselves”. Mr. Fisher did well to disregard previous credit fears, but I suspect he will regret his current complacency. It has been a long and profitable bull market. Too long.

July 20 – Financial Times (Michael Gordon): “Will the troubles in the U.S. subprime market pass by as a little local difficulty – or will they start a rout across capital markets and bring to an end the great bull run in a broad range of asset classes? ... Can history teach us anything on this score? Well, it’s certainly worth looking at the collapse of Long-Term Capital Management in September 1998. The near-demise of this mammoth hedge fund marked a turning-point for credit markets, hitting brokers and banks hard. The debacle is less than a decade ago, but banks were smaller and less diversified firms in those days and so less able to absorb large shocks. Also, their risk management systems were not as well developed as they are now ... Does the collapse of confidence in the U.S. subprime market have any similarities to the LTCM affair? Well, many of the weaknesses of the banks and brokers that emerged in 1998 have since been addressed. They are larger, more diversified institutions. They have also invested a great deal in risk management. Overall, the banks look far more resilient.”

Like Ken Fisher, Michael Gordon seems blind to today’s acute financial fragility. It is wishful thinking that “banks” are today “more resilient” than in 1998. The financial system today has unprecedented exposure to risky mortgage credit, highly leveraged and speculative financial markets, an M&A Bubble and global asset bubbles. The entire global credit system is one vulnerable Minskian “Ponzi Finance Unit”.

The near LTCM debacle had its roots in highly leveraged speculation across many markets. It was a credit issue only in the context of the impact of potential forced position position unwinds and systemic deleveraging. It was much more about the fear of contagious liquidations than of latent credit issues. The underlying credit instruments were not in and of themselves suspect. The market dislocation was (in hindsight, easily) resolved by ameliorating the fear of deleveraging and reinvigorating financial expansion.

Importantly, during the LTCM and other recent credit scares the marketplace’s faith in the evolving market in “structured finance” was not in question. Actually, it was a perceived strength. The GSEs were recognized as powerful pillars of strength (and willing and able to balloon assets holdings at a whim). Mortgage credit in general was solid in 1998. The credit derivatives market was small and a non-issue. There were, at the time, no festering domestic credit issues. The U.S. economy was not remotely as susceptible as it is today. The dollar was in the midst of a multi-year bull run. The current account deficit was running at about a $200 billion pace.

The issues today are more serious and deep-rooted. Confidence in the dollar is faltering in the face of untenable $800 billion annual current account deficits. The credit system is weakened by unprecedented impending subprime losses and acute vulnerability throughout “prime” mortgages. The GSEs are weak financially and extraordinarily vulnerable. The Wall Street firms and “money center banks” are heavily exposed to mortgage and capital market risk. The untested credit derivative marketplace has been shaken by the rapidity and severity of the subprime implosion. The CDO market was not a factor in 1998, let alone a vital facet of system credit creation and risk intermediation.

What appeared at the time (1998) a large leveraged speculating community today seems tiny by comparision. Today’s vast global pool of speculative finance was but a little puddle, and a dollar bullish one at that. Moreover, the coveted risk modeling and management systems are oblivious to end-of-cycle credit bubble dynamics. The most important difference between today and 1998 is that the credit system back then was not a full decade into problematic credit and economic bubble dynamics. The amount of credit necessary to support the economy and markets was a fraction of what it has become. Both the quantity and quality of risk to be intermediated was relatively small in comparison and, besides, there was a bevy of risk intermediators easily up to the task.

In stark contrast, today – and going forward – there will be an unrelenting torrent of risk that must be intermediated (risky credits transformed into palatable debt instruments), and it is not at all clear who is in a position to absorb significant risk. The leveraged speculators are more than likely keen to shed risk. The big “banks” and “brokers” are already fully-loaded. And the general marketplace, well, it is reeling with the realization that much of structured finance today suffers from pricing and liquidity issues and, worse yet, not even debt ratings can be trusted. “Ponzi Finance” dynamics are in full play and the U.S. bubble economy is incredibly exposed to a reversal in speculative finance and resulting liquidity crisis. These are very serious issues and indicative of the types of unavoidable risk intermediation problems that will stymie this historic credit bubble.

ARCHRIVALS STORM STARBUCKS

Once the undisputed king of premium brew, the company is suddenly besieged by tough competitors.

Take a quick drive on a weekday morning through Needham, Massachusetts, a typical suburban community outside Boston, and you will see hordes of commuters queuing up for their morning joe. A Dunkin’ Donuts that opened a few years ago along the main drag is the busiest spot, followed by a McDonald’s that serves Paul Newman’s organic coffee for free to early risers. The least busy spot? A Starbucks across from one of the town’s four commuter rail stations.

McDonald’s, the $22 billion-a-year restaurant Goliath is probably the biggest threat to Starbucks. Then there are Dunkin’ Donuts, expanding under a trio of buyout companies that took the company private last year, and Canadian invader Tim Hortons, growing in the lower 48 thanks to a fresh capital infusion from its U.S. IPO in March 2006. As a result, 2007 is expected to be Starbucks’ third straight year of declining revenue growth. The company has bolstered earnings-per-share growth by spending almost $600 million to buy back 18 million shares of stock in the first half of the year. Yet the once high-flying stock has thudded to earth, dropping almost 30% since last November.

In the second quarter, the company reported that foot traffic at its U.S. stores had failed to grow for the first time ever. The 3 to 7% same-store sales growth that the company itself is projecting for 2007 would be the lowest ever. And a few weeks ago, Starbucks CFO Michael Casey said the company was finding it “very challenging in the current environment” to meet its earnings forecast for the year. He reiterated that Starbucks would stick with a reduced target of opening about 1,700 new U.S. stores for the next several years, in contrast to the rapid pace of increasing openings in past years.

Meanwhile, growth at the mature McDonald’s chain has taken off. Sales rose almost 13% in the month of June from a year ago, including a more than 8% increase at stores open at least a year. The company credits a powerful surge in its breakfast business, thanks in large part to the new coffee line. Mickey D’s java won a Consumer Reports blind taste test against Starbucks and other brands in February. McDonald’s coffee expansion kicked off with a TV ad campaign last year aimed squarely at Starbucks customers.

At the same time, Starbucks appears to be struggling, as founder and Chairman Howard Schultz admitted in an internal memo that found its way onto the Internet in February. “While the current state of affairs for the most part is self-induced, that has lead to competitors of all kinds, small and large coffee companies, fast food operators, and mom and pops, to position themselves in a way that creates awareness, trial and loyalty of people who previously have been Starbucks customers,” Schultz wrote. “This must be eradicated.”

Starbucks’ missteps have puzzled many ordinary investors who still admire the company’s caffeinated offerings. “Great companies do not always make great stocks,” says Alan Brochstein, principal at AB Analytical Services and an analyst with 20 years experience. “Consumers can get carried away.”

Along with the general investing public, most Wall Street analysts have been slow to catch on to the brewing battle. But now even they are starting to see the challenges mounting for Starbucks. Last month, analysts at Goldman Sachs and Deutsche Bank upgraded their ratings on McDonald’s while cutting targets for Starbucks. Both cited the growing coffee wars. Meanwhile, some of the smartest mutual fund investors have been unloading their Starbucks holdings.

THE VISIBLE HAND ON THE OIL TAP

When oil prices last approached $80 a barrel, a year ago, pundits put it down to the “fear factor”. Oil was not in short supply and stocks were increasing. But producers were pumping flat out, leaving little spare capacity. A nasty hurricane in the Gulf of Mexico or a political storm over Iran would, the theory ran, create a shortfall. When neither fear materialized and stocks continued to climb, the price quickly subsided. This time around, however, facts have replaced fears: the world is consuming more oil than it is producing.

Last summer, as stocks started to rise, Saudi Arabia began cutting back its production. These cuts were formalized, and extended, at subsequent OPEC summits. OPEC’s members are now producing roughly 1 million fewer barrels per day (mbpd) than they were this time last year. Meanwhile, global demand has risen by over 1 mbpd, to over 84 mbpd. The inevitable result is falling stocks, at a time when they would normally be rising. Since 1999, stocks have grown by 840,000 bpd on average in Q2, according to Leo Drollas of the Centre for Global Energy Studies. This year, however, they fell by 140,000 bpd.

Traders, fearful of shortages later in the year, are pushing up prices. On July 16th, a barrel of Brent, Europe’s benchmark crude, reached $78.40 – within a whisker of the nominal record set last year. (West Texas Intermediate, an American benchmark, lagged slightly thanks to diminished demand from refineries under repair.) The same day, Goldman Sachs issued a report arguing that prices could rise as high as $95 a barrel later in the year unless OPEC opened the taps. The International Energy Agency (IEA), a watchdog for oil-consuming countries, has also warned that supplies will be tight and prices high for several years to come. But this gloomy prospect rests on some rosy economic assumptions. The IEA reckons that oil consumption will accelerate this year and next, despite high prices. That calculation in turn presumes that the world economy will continue to grow smartly, shrugging off the cost of crude.

The grandees of OPEC presumably share the IEA’s confidence. It is not in their collective interest to derail economic growth or destroy demand for their wares. If they thought the oil price was high enough to do real damage, it would make sense for them to expand production. Unlike last year, they now have roughly 3 mbpd bpd of spare capacity they could tap. But such reasoning assumes the cartel is more predictable than the hurricane season or the politics of the Middle East.

Is $100 oil coming? $200, anyone?

Analysts at Goldman and CIBC say $100 oil may be just months away. If Bush is dumb enough to invade Iran, $200 could come in a hurry. But the idea that oil surges on a U.S. pullback from Iraq is debatable. The sooner we leave Iraq, the sooner Iraq will recover (just as Vietnam did, I might add), and the less jet fuel we will be wasting on needless missions. Could there be a short-term spike when we leave Iraq? Perhaps, but the long-term benefits of us getting the hell out will be enormous.

The weekly crude oil chart has had a few busted trendlines, but the monthly still looks great. Those watching crude may also be watching the U.S. dollar index and the yen versus the dollar. It is now do-or-die for both the U.S. dollar index and the yen versus the USD. Both currencies have been anemic lately, compared with anything else. The U.S. dollar is on the verge of collapse, and the yen is at lows compared with the British pound and the euro.

With trillions in carry trade bets riding on the outcome, the impact of a major breakdown in either currency could be very significant. Out and out disasters most often in the direction of the prevailing trend. Here, two competing losers also are going head to head. Resolution should come soon. The U.S. dollar is going to eventually break hard but one must be on the lookout for a major headfake with all the stops in too obvious places.

THE UNBEARABLE LIGHTNESS OF THE BUCK

It was the Chinese who invented paper “money” around the beginning of the ninth century A.D. Because it was so light it would blow out of their hands, they called it “flying money”. The ancient Chinese were right about the lack of substance of paper currency. The greenback seems to have less substance every day. But we do not wonder why the greenback seems to be dying. We wonder why it is not dead already.

In search of an answer, we look back, to a case brought by the First National Bank of Montgomery, Minnesota, against one Jerome Daly in 1969. The bank had lent Mr. Daly $14,000 in a mortgage loan. Then it tried to get its money back by foreclosing on Daly’s house. Daly took to the courts with a defense so ingenious even a Chinese banker might wish to emulate it. You cannot enforce a mortgage contract, said he, when there was no contractual obligation. And there was no valid obligation because no “consideration” had been given by the bank. Having gotten nothing from the bank, he had nothing to give back.

In support of his testimony, Mr. Daly, a lawyer, called the bank president to the stand and demanded to know if the bank had actually handed him a wad of $20 bills.

“Is it not true,” he began, or words to that effect, “that the bank did not actually give me a stack of $20 bills? In fact, the bank did not give me any bills of any sort, right?”

“Well, yes ... but ...” the bank president must have replied.

“Nor did the bank convey any property to me, or give me gold coins, or any other valuable, tangible thing ... right?”

“Well, yes ... but ...” came the next reply, also cut off by Mr. Daly’s next question.

“And is it not true that the bank did not go out and borrow extra money so it could lend it to me ... nor did it draw down its depositors’ accounts in order to give me money?”

“Yes, that is correct.”

“In fact, the so-called mortgage loan was, from your point of view, just a bookkeeping entry. Is that not right? And is it not true that the ‘money’ never existed at all, at least not in the sense that most people think of money, and that this ‘money’ was actually ‘created out of thin air’ as the economist John Maynard Keynes once described it?”

“Well, yes ... but ...”

By this time, both judge and jury were nodding their heads, sure that they had a combination of Charles Ponzi, John Law and Kenneth Lay on the witness stand. “Fraud!” concluded Justice Mahoney and went on to rule that the bank had given Daly no lawful consideration, had created $14,000 out of nothing, and had done so without the backing of any U.S. law or statute. Therefore, it followed, the bank was obliged to let Mr. Daly keep his house. And, thus it was that Mr. Daly kept his house.

Whether the reasoning behind this case was right or wrong is not at issue here. Our questions are more numerous but much simpler. We want to know why there are not more Dalys demanding to keep their houses today. And why there are not more Mahoneys around to let them. Why did one small court adopt this argument while it left no mark otherwise on American jurisprudence? Despite Justice Mahoney, U.S. courts have rejected every other attempt to argue that the U.S. dollar is not the lawful, valuable money everyone thinks it is. But just how valuable the U.S. dollar is, is a question not for the courts, but for the markets.

The euro, the pound, the Canadian dollar, oil and gold have been pronouncing a judgment of their own – all have soared against the dollar. And yet not a whimper is to be heard from the great American masses. The dollar may be in trouble abroad, but at home its reputation is still spotless. Gas may cost more, heating bills may be higher, but so far milk, eggs, and beer have not soared beyond the budget of the masses. The people may have mortgaged their futures for the roof over their heads and sold their souls for a mess of credit, but with home prices still holding up and stocks pushing at all time highs, the devil has not come around for repayment yet.

Helping to postpone the day he does, the government also quietly stopped reporting M3 money in March 2006. M3 is the broadest measure of the “money supply” in the U.S. economy. As the supply of money increases, typically, consumer prices go up. Independent analysts who keep an eye on these things tell us that the green stuff is being pumped in at one of the highest rates ever – 12% per year, or four times the rate of GDP growth.

Why has it not gone to swell the prices of groceries yet? Because the people with the most money are spreading it around in places far distant from the local Superfresh. The ersatz money is circulating these days in art houses and auctions, in exotic vacation houses and rental properties, in retirement funds and pensions. Securitized and derivatized, packaged and repackaged, it is lent from one end of the globe to the other, forcing central bankers all over the world to work their own printing presses night and day to keep up with it. The resulting global “liquidity” is the bilge upon which asset prices float and make this boom so great for asset owners.

But this liquidity is no different from the non-existent “consideration” that Mr. Daly received from the First National Bank of Montgomery. It was this shaky credit that was packaged into new debt instruments like CDOs that are so intricate that teams of mathematicians cannot fathom all the ramifications and complications thereof. Then these oily pretzels of debt were twisted into Triple A rated bonds and sold to pension funds and institutional investors. Now the buyers are finding that the grease has turned rancid. The three leading rating agencies downgraded debt linked to the shakiest part of the housing market – the subprime loans. And following swiftly, one hedge fund at Bear Stearns took ill and passed away altogether while a third gave up 91% of its returns.

Ben Bernanke would like to boost rates to support the dollar and help American tourists, but faced with a liquidity crisis in the $500 trillion derivatives market, he will have to think thrice before doing so. But rates are going up with or without him. Lenders are finally growing wary. Afraid of the poisonous debt packages, buyers are passing up another helping. Offers for CDOs are said to be going “no bid”. And several major debt offerings had to be withdrawn or rescheduled as promoters were afraid that they, too, would go “no bid”.

We do not know if the First National Bank of Montgomery still exists. But if it does, we would not be surprised to learn that it is growing more cautious about lending. And dollar holders all over the world are tightening their grip, fearing that their flying money might fly away.

An inconvenient truth: Independent analysts say that M3 is increasing at 12% per year.

M3 is the inconvenient truth that the Labor Department no longer reports. It is the fullest measure of the U.S. money supply, and it is going up 3-4 times faster than GDP itself. Mr. Bernanke assures us inflation is under control. Excluding food and energy, he says, the cost of living is not going up too much. We will get to that in a second. But in an effort to thwart our ever-declining purchasing power, thanks to the prodigal magic of fiat money, your editors have tried to wean our nasty addiction to food and energy. It is harder than one may think.

So we are a little concerned that monetary officials keep dismissing the “food and energy” effect. We certainly understand their motivation. Our friends at the Cleveland Fed just reported that energy prices have risen at an average annualized monthly rate of roughly 30% during the first four months of the year and soared nearly 90% in May.

To make matters worse, the World Food Program reports that purchasing costs have risen roughly 50% in the last five years. Corn prices alone have jumped 120% in the last six months. But the Fed assures us there is nothing to fear. The CPI excluding food and energy was up a modest 1.8% (annualized) in May, and the median CPI fell to 1%, its slowest monthly growth rate in over four years. Reason to cheer, right?

We are not so sure. If the CPI were measured by the same standards used in the 1970s, today’s inflation rate would soar well above the 2.7% stated rate. How can this happen? Well, for one, the Bureau of Labor Statistics (BLS) has significantly modified the way we calculate the number. Take a look at this one adjustment. In 1983, the BLS dramatically changed the way we account for rising house prices, a figure that makes up 28.4% of the CPI. It no longer measures the actual price change of the tangible asset itself (in this case, the house). Instead, it measures rising house prices through a method called “owners’ equivalent rent”. When demand for rental properties drops, so does the price a homeowner could earn from renting. We believe this approach dramatically understates housing price inflation.

So when you exclude energy, food and housing, Mr. Bernanke may have a point: The cost of living is not going up too much. But our cynicism toward American monetary policy over the past 100 years is not directed toward Mr. Bernanke himself. In fact, we commend his concerted effort to address inflation. He did not get us here. The bankers and big government spenders before him brought us to this point. They are the Keynesian disciples who sat back, spent and soaked up the champagne. Unfortunately for Big Ben, he is stuck nursing the hangover.

American lawyer, lecturer and author Rene A. Wormser once wrote: “No government can operate with a monetary system consisting only of fiat money without sustaining gross economic turmoil and eventually facing a tragic day of reckoning. A fiat money system prompts legislative profligacy and inevitably produces inflation.” He has a point. Deficit financing and government intervention have taken their toll. A 1940 dollar is worth only roughly 5 cents today.

Eventually, the consequence of eternal credit expansion will rear its ugly head. Maybe not today, maybe not tomorrow, but someday the gentle breeze of a butterfly’s wings will shake the thin-veiled foundations on which this fragile house of cards auspiciously rests. The question is, will you be the one left holding the mighty greenback?

GOLDEN PROFITS FROM THE CHINESE TRADE DEFICIT

A quick chat about trade deficits seems timely. Starting with the notion that they are inflationary, right? Well, technically, they do not have to be. In the absence of government intervention, all a trade deficit should mean is that the people of one country are willing to trade their money for something on offer by the people of another country. In the 1800s, the U.S. ran big deficits and did quite well because our country was full of opportunity and promise, so foreigners invested here, more than we invested there.

The problem comes when a government, say China, steps into the picture and deliberately suppresses its currency to attract businesses to certain sectors of its economy – for instance, city dwellers. That causes an aberration, the result being a lot of U.S. dollars shipping out to China in exchange for all manner of consumer goods – dollars that the Chinese have then turned around and invested in U.S. Treasuries. More on that momentarily.

The massive deficits with China are unstable because, rather than being the result of open trade, they are based largely on political decisions made by a handful of people in the Chinese government. In time, those people – or their successors – may decide that there is more advantage to spending the dollars. Or they will be forced to do it, say, to appease other segments of the economy now penalized by the higher cost of foreign goods. Or they might have to spend the dollars to pay the cost of a war or to bail the country out of a financial crisis.

Regardless of the reason, at some point the political advantage of spending those dollars, rather than hoarding them – which the Japanese did to their detriment in recent decades – will reach a tipping point after which those greenbacks will come flooding back to the market, devastating the value of the dollar on foreign exchange markets. The dollar has already, since 2002, lost about 26% of its value. Of course, a good deal of the pain that depreciation has caused to the wallets of foreigners has been offset by the interest they earned on their Treasuries. But treading water is one thing, and standing by while your pile of cash starts to go up in the flames of a monetary crisis is another.

Viewed from another angle, over time it is not the trade deficit that is inflationary. Rather, the trade deficit is effectively a subsidy provided to the U.S. by China ... a subsidy that comes from the Chinese having used the river of dollars provided by U.S. consumers to buy the unbacked paper of the U.S. government. That has allowed U.S. interest rates to remain artificially low and forestalled inflation in the U.S. It is as if China is building up a big bank of inflation points. Sooner or later, they are going to spend those inflation points.

Make no mistake, we are in uncharted water. It is unprecedented that the claims represented by the fiat currency of one government – that of the U.S. – have been accumulated in such massive quantities for the reserves of other governments. And we are not just talking China but virtually the world. And the world is getting nervous. To quote Thai Finance Minister Chalongphob Sussangkarn in his recent address to the annual meeting of the Asian Development Bank in Kyot: “Should the financial markets lose confidence in the U.S. dollar, huge capital outflows from the U.S. could lead to a rapid depreciation of the U.S. dollar, and thus dramatic appreciation of other currencies.”

The whole matter of trade deficits is, unfortunately for investors not paying attention, just one of far too many aerosol cans now roasting in the fire. When they start exploding, you will want to be safely hiding behind a wall of gold and silver. In the final analysis, every day the price of gold goes up and gold goes down. To avoid being panicked one way or the other, a long-term perspective is required to see these fluctuations in their proper perspective. And, despite all the jagged fits and starts these past few years, and all the nay saying along the way, three years ago, gold was trading for $393 an ounce – 40% lower than it is today. And the better gold shares have offered exponentially higher returns than that.

While now is the time to begin accumulating your gold and gold share positions, if you have not already started doing so, how will you know when things are about to get really “interesting”? My partner Doug Casey recently made the observation that it is not when the trade deficit is rising that you should be concerned, but when it starts to contract. Because that is a sign that the flood of greenbacks is starting to return home.

WHAT MORNINGSTAR REALLY DOES NOT WANT YOU TO KNOW

I am sure you have heard people say that Wall Street never gives you the whole story. That it is not in the Streetwts best interests to tell you about the market's biggest opportunities. That they keep you in the dark about all the money over-the-counter and bulletin board stocks can deliver. It might sound cliché ... but I have found tangible proof that there is some truth to those stories. At least one of Wall Street’s most trusted companies is pulling the wool over your eyes. It is everything short of a deliberate attempt to steer you away from the stocks they do not approve of.

A little background is in order. The story starts with a man named Phillip Fisher. A stock analyst who survived the market crash of 1929, Fisher made his mark with a landmark book, Common Stocks and Uncommon Profits. And while most people like to associate Warren Buffet’s investment style with Benjamin Graham’s, the Oracle of Omaha admits that Fisher inspired him as well. That is partially because Fisher was a strong advocate of buying and holding. He once said the best time to sell was “almost never.” Of course, he did not mean blindly hold on to losing stocks ... he meant that if you did your research right before you bought – and paid attention thereafter – you would never have to worry about selling.

So it is pretty amazing when you realize that Fisher was primarily a growth investor. He did not care about a company’s fundamentals. He cared about its business. He loved companies that were “highly speculative and beneath the notice of conservative investors or big institutions.” In fact, he famously bought Texas Instruments and Motorola long before they were household names – and even held Motorola until his death.

In Common Stocks and Uncommon Profits, Fisher spelled out 15 questions he used to evaluate a company. They were pretty open-ended and could be subject to interpretation. They were not, as he put it, “determined by cloistered mathematical calculation.” They were:

1. Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?
2. Does the management have a determination to continue to develop products or processes that will further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
3. How effective are the company’s research and development efforts in relation to its size?
4. Does the company have an above-average sales organization?
5. Does the company have a worthwhile profit margin?
6. What is the company doing to maintain or improve profit margins?
7. Does the company have outstanding labor and personnel relations?
8. Does the company have outstanding executive relations?
9. Does the company have depth to its management?
10. How good are the company’s cost analysis and accounting controls?
11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
12. Does the company have a short-range or long-range outlook in regard to profits?
13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholder’s benefit from this anticipated growth?
14. Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointments occur?
15. Does the company have a management of unquestionable integrity?

I will admit there is nothing groundbreaking here. Fisher’s 15 questions are fairly well-known, and you can find them or slight variations all over the Internet. But I recently discovered that some of Fisher’s wisdom has been purposefully been withheld from investors. In fact, one of Wall Street’s most trusted Web site glosses over some of what Fisher had to say. Fisher also listed 5 “don’ts for investors”:

1. Do not buy into promotional companies.
2. Do not ignore a good stock just because it is traded “over-the-counter”.
3. Do not buy a stock just because you like the “tone” of its annual report.
4. Do not assume that the high price at which a stock may be selling in relation to its earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price. (Or, put simply, price-to-earnings is not everything)
5. Do not quibble over eighths and quarters. (That is, do not stress over a few cents difference in price.)

Please pay attention to #2, where a man hailed as one of the greatest investors says there is nothing wrong with trading Bulletin Board and Pink Sheet stocks. But the folks at Morningstar.com think you should not know that rule. Its Website has an “Investor Classroom”, which includes a profile of Phillip Fisher. The article patiently explains his love of growth stocks. His 15 points are spelled out in detail. And then it goes on to paraphrase Fisher’s “don’ts” ... all 3 of them. Not 5 ... 3.

Any bets to which ones are missing? They are the ones that have nothing to do with fundamental analysis or exchange-traded stocks. See for yourself here. Now, I know – Morningstar can easily claim it is concealing parts of Fisher’s message in order to protect investors. That over-the-counter stocks can be risky, and that discounting fundamental analysis may encourage bad research.

But whatever their reasons, one thing is clear: Morningstar.com is not giving you the whole story on Phillip Fisher’s investment philosophy. Yet if it worked for him, why should it not work for others?

SEEING SOLAR FROM NEW ANGLES

A new approach to solar power has people looking at it, quite literally, in a new light. While the ultimate source of solar power may be solar power satellites (SPS) – a source quite capable of single-handedly supplying all the power humanity could ever want – MIT Technology Review reports that a new Earth-bound approach is causing quite a stir.

The silicon used to make most solar photovoltaic (PV) cells is costly. Researchers have attempted to reduce the use of silicon via solar concentrators. However, being large and conspicuous, these are hard to integrate into housing designs. Prism Solar Technologies has figured out how to use holograms to concentrate light. This should reduce the silicon required by up to 85%, thereby making solar panels cost-competitive with fossil fuels. That is at today’s prices – as India and China rocket upwards in their demand for oil and related products, solar will begin to look cheap by comparison.

Instead of large concentrators, the Prism systems use flat panels that contain holograms. Not only do they fit on rooftops, but they also can even be built into windows and glass doors. Also, they are beautiful, giving off pleasant shifting rainbows of color when viewed. Unlike conventional solar panels, the PV material is arranged in rows. Specially designed holograms capture the sunlight and redirect it until it reaches a strip of photovoltaics. Researchers estimate this will reduce costs from about $4 per watt to $1.50. The company seeks $6 million from venture capitalists this year, and plans to start manufacturing first-generation products before 2008. It will sell them at $2.40 per watt.

At least two more opportunities to strengthen this product offering exist. First, I am aware of a VC-backed startup that has developed PV material that sprays on like paint. This material, while probably not as durable as the Prism approach, could supplement it by capturing sunlight in odd locations and on curved surfaces. Second, holograms are not as powerful as conventional concentrators. They currently multiply the light reaching solar cells up to 10-fold. Lens-based concentrators have been demonstrated to be up to 100 times more effective. I believe it is just a matter of time before researchers devise ways to make holograms more closely approach the efficacy of concentrators. That will drop the cost of solar even further.

It is fascinating to watch recent developments in solar power. Just a few years ago, I heard scientists and engineers decrying attempts to milk more power from photovoltaics. They simply did not think the technology was amenable to major improvement. We now know that view was wrong. Solar power is coming. On the business side, companies are figuring out newer and better ways to make the return on an investment in solar arrays viable.

INVESTING IN THE ALCOHOLIC BEVERAGE INDUSTRY

Sometimes, certain industries seem to be made for small-cap investors. When this happens, Wall Street analysts would kill to be in our position. They cannot write about certain ideas, no matter how good they are, because their audience consists mostly of big mutual fund managers who cannot invest in these companies.

A perfect example of this is the craft/micro beer industry. By definition, it does not ever include large beer producers. You will never find an Anheuser-Busch or a SAB-Miller on the list. A craft brewer is a small, independent and traditional brewer, producing less than two million barrels of beer a year. The brewing industry, as a whole, has been suffering lately. People are drinking a lot more wine and distilled alcohols. But what is not necessarily common knowledge is how well this small section of beer producers is doing. Craft/micro beer sales grew 17.8% in U.S. supermarkets in 2006 compared to the entire beer industry, which only sold 2.4% more beer than in 2005 (see chart).

According to the Brewer’s Association, the beer industry went through a massive consolidation in the 1970s. In fact, it was predicted that there would only be five breweries in the U.S. Not only this, but all of these large companies were only producing light beer. Imported beer was not nearly as common as it is today. So, what did people do to get European style beer? They made it. Tiny microbreweries sprung up all over the country by the early ‘80s, including the Boston Beer Company, maker of Samuel Adams Boston Lager, amongst hundreds of other types over the years.

As public companies, these craft beer companies have had an extremely short life. The first and only mainstream public company is Boston Beer (NYSE: SAM). That company went public in 1995 and really struck it big in the past six years, making over 368% profits for its investors. Unfortunately, only a handful of these other 1,400 craft breweries are public. Of these, all of them are sold over the counter. Not one has made it to a major U.S. exchange.

These companies are just too small for Wall Street to discuss, but not for long. One way these brewers will make it mainstream is through the form of consolidation, just like the ‘70s. Anheuser-Busch has a stake in Redhook Breweries. Miller Brewing owns Jacob Leinenkugel Brewing Company. These big brewing companies are even introducing “craft-like” products of their own to get in on this trend. This desperate attempt to regain respect amongst many new beer drinkers may work. But either way, it is a great opportunity to get in on the small craft beer companies who are not sucked into the mega-brewers’ net just yet.

SMALL-CAP BOOK PUBLISHERS

Amazon.com (AMZN: NASDAQ) just released its 2Q earnings report and the results were shocking. Net income more than tripled over last year’s 2Q, soundly beating what analysts told everyone to expect. Amazon jumped over 27% from its pre-earnings release price.

Amazon’s management tells us to chalk these results up to strong sales around the world for books, music and electronics – plain and simple. On the heels of that, we have the climax to the greatest series in publishing history in the form of final chapter of Harry Potter hitting store shelves. That franchise alone has been a huge boon for Scholastic (SCHL: NASDAQ) and Bloomsbury (BMBYF.PK: Other OTC), but leaves them with a huge void to fill.

Literacy, whether it has been sparked by the need to use the Internet, the need to secure better jobs, or simply because more people want to read, is on the rise. Back in the year 2000, there were an estimated 860 million illiterate adults around the world, according to the U.N. Educational, Scientific, and Cultural Organization (UNESCO). It forecast by 2015 literacy will increase around the globe by 7%. So how do you play a secular trend like literacy with small-caps?

One way to play it is through an interesting small-cap publisher that has been around since 1824, Courier Publishing (CRRC: NASDAQ). Courier is technically both a publisher and an actual book manufacturer. It is the 5th-largest book manufacturer in America with a dominant share of the Northeast. In fact, 82% of its total sales come from book manufacturing. Of those, educational texts, religious titles and specialty trade titles make up the bulk of sales.

The publishing business is highly competitive. It is estimated that there are 43,000 printing companies in existence, and that does not even take into account all the newspaper companies that dot the U.S. Book and magazine manufacturers are an interesting group. One day, they might be churning out 10,000 copies of a top children’s book, and the next day that very same firm might be cranking out a contract for the most lurid, adult publication imaginable. But that is where Courier has traditionally had an advantage over the competition. Our sources in the industry tell us that Courier has refused to take on adult publication contracts, which gives them a huge boost when negotiating for religious book deals and other morally sensitive clients. Courier’s reputation sets it above the bulk of its competition.

And that “above the board” approach to the book business, over the last five years, has brought it returns that outpace the two public companies on either side of the Atlantic that largely control the Harry Potter series. CRRC stock is trading at 16.5x earnings, 2.5x book, and 1.6x sales. All of these multiples are slightly below CRRC’s 5-year average, and its earnings and book multiples are below industry averages at the moment. And it has a dividend yield of 1.7%. This is an interesting way to play rising literacy around the world without the exposure to publishers desperately seeking the next Potter.

WHY APPLE’S iPHONE CANNOT CHANGE ANYTHING

It was touted as the second coming ... the next major innovation in mobile phone technology that would revolutionize the way we do all of those time-wasting activities we do. Listening to music, looking at a map, or arguing with your wife on the phone have become oh so simple and fun, thanks to the handy new Apple iPhone.

Unfortunately, every cell phone owner in America did not agree. AT&T – the iPhone’s exclusive carrier – announced disappointing activation data. As it turns out, customers only activated 146,000 iPhones during the first weekend of its release. Plenty of Wall Street cheerleaders were expecting activations coming in around 500,000.

Apple stock has tumbled nearly 8% since the news. Now, Apple diehards and some analysts are coming up with plenty of excuses. People had activation problems, they said. And then there is that whole problem with the phone getting over-hyped. The stock shot up on great expectations, and is getting grounded now that the actual news is out there.

But what people are forgetting is that the iPhone is not revolutionary. Sure, it looks nice. It is an interesting novelty, but it is not going to change anything. It is a fashion accessory for the hip and the wanna-be hip. The network running its web browser is reportedly slow, the touch keyboard is difficult to type with and, at the Apple store, I noticed that the screen becomes completely smudged after heavy use. It is not a business phone, so you will not see many professionals checking their iPhone instead of their Blackberry. And the phone’s biggest potential customers, high school and college students, probably would have trouble digging up $500 for a phone.

But the biggest disclaimer I can attach to this phone is that it is not the most advanced smart phone you can buy. In countries like Japan, the iPhone is old news. Companies like Nokia have introduced more versatile smart phones like the N95 that have been a hit overseas and among the more tech-savvy crowd here in the U.S. Next generation mobile phones are slow in coming to the U.S. They are much more popular in Europe, Japan and even China. That is why you should be looking at small, overseas companies that are helping make the smart phone revolution a reality.

Take KongZhong Corp. (KONG: NASDAQ), for instance. Kong is a Chinese company that provides multimedia content to mobile phone users. The company’s ADR has been crushed in 2007 (see chart). Shares are down nearly 50% since January 1. However, the company just announced a strategic partnership with Opera to offer its customers a branded KongZhong Opera web browser. And since the KongZhong site will be the default homepage, the company will be able to generate revenue through increased traffic and advertising. It is an interesting company that is worth adding to your watch list.

HOW TO PROTECT YOUR PORTFOLIO FROM PLUMMETING STOCK PRICES

Investing with trailing stops.

Ben Hogan said, “Reverse every natural instinct and do the opposite of what you are inclined to do, and you will probably come very close to having a perfect golf swing.” Investing sometimes feels as counter intuitive as that perfect drive you some how luck into when there are only two holes left to play. But the two endeavors have two very important keys in common if you are to be successful at either: Minimize your errors and maximize the things you do right.

In golf, hitting balls into lakes or beyond the out-of-bounds markers are akin to sitting idly by as your stocks drop to zero. Very few portfolios can weather catastrophic losses and still provide attractive overall returns. You will hear some brokers, fund managers, and analysts proclaim that they just aim to be right 51% of the time. That might work out for them – as long as the 49% of the time they are wrong does not bankrupt them (or you).

In investing it is not about how often you are right or wrong, but by how much. The magnitude of your triumphs and defeats are of paramount importance. Michael Mauboussin, chief investment strategist at Legg Mason Capital Markets, calls this the “Babe Ruth Effect”. In his book More Than You Know, Mauboussin says that Ruth was one of baseball’s greatest hitters, as we all know, despite the fact that he did strike out a lot. He magnified his triumphs, however, by hitting 714 home runs.

Minimizing the magnitude of your mistakes within your own portfolio, and allowing your winners to dominate your results, is easier to achieve than you might think. In fact, it can be an almost automated process. I am talking about trailing stops – the emotionless selling of stocks in your portfolio when they drop a predetermined percentage from their highs. By placing, say, a 25% trailing stop on each stock in your portfolio and only allowing yourself to invest a maximum of 4% in any one stock, you are limiting yourself to a maximum loss of only 1% of your investment capital for each stock that stops out. That is pretty good protection. Several 1% losses, while nothing to jump up and celebrate, are acceptable as you allow your winning positions to climb.

Here is an example of exactly what I am describing. This is a worst-case scenario. You have a few winning positions and many more losers that plummet the moment you buy them. The portfolio illustrates that if you limit your position sizes to a maximum of 4% of you investment capital (here we assume that to be $100,000), and use trailing stops on all of your stocks, you can actually have a lot more losers in your portfolio than winners and still make money. In fact, this portfolio contains only 40% of stocks that actually rose compared to 60% that stopped out. Despite that, the portfolio is up 7.02%.

I know your next comment: “But those fictitious winners are up unrealistically high.” Well, I actually chose those positive returns from actual results in the Small-Cap Strategy Report’s recommended list. The only difference between that list and the above portfolio is that since the beginning of 2006 our recommendations have ended up rising 65% of the time, and the average returns of those gainers has been 35.4%.

RISK AVERSION SWEEPS MARKETS AS CREDIT FEARS GROW

A wave of risk aversion swept across financial markets on Thursday as investors worried about instability in world credit markets, leaving stocks sharply lower and driving demand for safe-haven government bonds. Risky currency trades looked subject to unwinding as the Japanese yen rose across the board. The euro fell to a 2 1/2 week low below $1.37 and the dollar hit a two-month low of 119.64 yen. Emerging sovereign bond spreads widened to 205 basis points over U.S. Treasuries, the highest in almost eight months. The iTraxx Crossover index, the most widely watched indicator of European credit markets, blew out 35 basis points on the day to 400 basis points, its highest level this year.

“The market has started to see the risk of contagion growing,” said RBC Capital Markets senior currency strategist Adam Cole. “There has been a general assumption that the subprime issue was ring-fenced and that has been questionable in the past few days.”

Problems in the U.S. subprime mortgage market have been stalking investors for the past few weeks, rattling stocks, widening credit spreads and driving money into safe havens. The fear is both that the financial system could come under threat and that borrowing costs for companies will rise, hurting earnings. News over the past 24 hours has exacerbated the worries. Sydney-based Absolute Capital, a hedge fund half-owned by Dutch bank ABN AMRO, said it temporarily closed two funds because it was tough to offload investments in collateralized debt obligations (CDOs).

At the same time, adverse credit market conditions are spilling over into the financing of corporate deals, a backbone of many equity market gains this year. Britain’s Alliance Boots postponed syndication of £5.05 billion ($10.4 billion) of senior debt backing its leveraged buyout. Similarly, DaimlerChrysler AG’s $7.4 billion deal to spin off Chrysler hit a speed bump on Wednesday when bankers were forced to postpone a $12 billion syndicated loan to finance the transaction.

THE COLLAPSE OF COLLAPSE

Gloom and doom ain’t what it used to be. Our old friend Dr. Gary North was – and still is – a master of the Armageddon genre. The turning of the millennium seemed to cry out for some kind of catastrophe. Gary came up with what seemed like a suitably disastrous scenario – Y2K. Remember that? It sounds like a joke now, but it was no joke then. But then the big day came and nothing happened. As far as we know, not a single computer-controlled system in the entire world failed because of a date-related malfunction.

You know, the life of a financial advisor is not easy. We have been in the business of publishing financial analysts and advisors for nearly 30 years. We have seen plenty of them come and go. And many have gone under very unpleasant circumstances. One whom we knew was shot dead on the beach. One went to jail. Another one went crazy.

But the trouble with this modern world of ours is that there is not enough trouble in it. There used to be more. Which is what made the good old days so good. Back then, people had real trouble and they really appreciated it. Now, they just toss it off. They are not worried about it because they do not know what it really is.

As long as the generation that had lived through the Depression and World War II were in charge of things, America was in pretty good shape. But in the 1980’s, a new generation – our generation – took over. And there were three key events during that period that caused trouble as we had known it to take a holiday.

First, there was the Crash of ‘87. Stocks fell hard. But then, they got right back up again, as though nothing ever happened. People began to think that crashes were no trouble. Books began to appear such as Stocks for the Long Run. Second, in 1989, the Berlin Wall was dismantled. Suddenly, we no longer had any enemy worthy of the name. Third, Ronald Reagan and the neo-cons transformed the Republican Party. After the ‘80s there was no longer any organized political party in favor of fiscal and monetary conservativism.

Trouble could take a holiday. Since then, every warning has turned out to be a false alarm. But when you do not have enough trouble, you have to go looking for it. That is probably what drew Britain and America into Iraq. And it is the lack of financial trouble that is drawing people all over the world to do strange and troubling things. What is a subprime ARM but an invitation to rumble? And who would buy a package of these CDOs but a moron ... or a man looking for trouble? People looking for trouble are bound to find it.