Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of January 14, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.


The always entertaining and usually instructive Bill Bonner sticks his neck out and ... well, let him speak for himself:

Don't tell me when I will die, says Woody Allen. Just tell me where ... I'll avoid the place.

In the year of our Lord 2008, there will be many places investors' money will die. Of course, if we really knew where the deaths would take place we would not be writing this column. It is not given to man to know his fate. Nor even the fate of his money. But this is the time of year when a financial columnist lets his well-deserved humility give way to brazen immodesty. He sticks his neck out ... and offers dear readers a peek at the upcoming year's financial obituaries.

But let us add an extenuating circumstance: The importance of an event is not merely the likelihood of it ... but the likelihood times the consequences. For example, it is not a good idea to drink heavily and then drive down U.S. I-95 to Miami. Most likely, you will get there in any case ... but the consequences of being wrong make it a bad choice. Likewise, we may have another year of rising equity prices, a strong currency, a new boom in house prices ... and a healthy, growing economy. But there are times -- such as after imbibing too deeply for too long from the cup of liquidity -- when betting on rising asset prices and prosperity is a bad wager; the risk of a crack-up is just too great to ignore.

Most home owners buy property insurance even if they consider the probability of a fire or storm damage very low. The likelihood times the consequences are high enough that it still makes sense to pay a modest insurance premium. Investors, however, often act as if they had failed to weigh the likelihood of outcomes with the consequences. For example, subprime mortgage investors reached for an extra percentage point or two of yield, but failed to appreciate they could lose almost everything if things went wrong. It brings to mind Keynes's crack that "a speculator is one who runs risks of which he is aware and an investor is one who runs risks of which he is unaware."

So let us turn to our guesses. The alert reader will see that they follow a pattern. We believe that the financial world stands between two more or less equal and opposite forces. On the one hand is the irresistible force of inflation. On the other is the immoveable object of deflation. Central bankers are busily trying to keep prices rising on one side; on the other, Mr. Market has plans of his own. The party is over, says the market. No, here is some more punch, say the central banks.

Just to complicate things, between the thesis of inflation and the antithesis of recession is the synthesis of stagflation. Not that we know what will happen, but with all this "flation" around, something is bound to blow up. The predictions that follow are just our way of taking cover.

Getting down to specifics, our guess is that this will be a better time to sell shares than to buy them. The U.S. economy depends on two big industries -- and both of them are menaced by "flation".

The travails and hardships of the financial industry are well known. No need to say more about them. But asset prices depend on finance. Wall Street takes money from the people who earn it, all over the world, and funnels it into asset prices. When credit contracts, asset prices fall.

That is an admirably pithy synopsis of the Wall Street racket.

Another major contributor to a share-price funk is the housing industry. Houses are not going up; they are going down. And in America, falling house prices squeeze house owners ... and reduce consumer spending. When consumers do not spend, businesses do not earn as much money. Falling earnings produce, ceteris paribus, falling share prices and an economic slump.

We have already let the cat out of the bag as far as house prices go. There are two things you can count on: both house prices and business earnings revert to the mean. Housing prices always go back to levels where people can afford them. And outstanding corporate earnings always get worn down by competition.

The dollar, too, is threatened by both inflation and deflation. Not that we have any direct or new information, but if we were writing a life insurance policy on the buck, we would want a thorough physical. Inflation hurts the value of the greenback directly. Things cost more, in dollar terms. But deflation hurts it too. Lowering asset prices and cutting consumer spending, deflation hits below the belt. The economy crumples over ... and the dollar falls.

Why? Because the dollar's handlers want to see it lose this fight anyway. As deflation threatens, they lower interest rates ... making the buck even less attractive to foreign (and domestic, for that matter) holders. The Fed, along with the Bank of England and the European Central Bank are all working the pumps -- trying to keep the inflationary boom going by reducing the values of their own currencies. We have little faith in the healing power of central banking; but when it comes to killing a patient, even a quack can do the job.

But if the dollar is to go down, what will it go down against? Ah, that is a good question. Against commodities? Maybe. Against housing and stocks ... as we have said, probably not. Against the pound or the euro? We cannot say; they are all in jeopardy. Against gold?

Back in January 2001, we announced our Trade of the Decade -- sell shares/buy gold. At the time, the ratio of share prices to gold was just coming off an all time high of 44 ounces to one Dow index. Gold had scarcely ever been lower and shares had scarcely ever been higher. Twenty years previously, the ratio had been as low as 1 to 1.

Since January 2001, the ratio of shares to gold has fallen in half. Not because shares have come down, but because gold has gone up. The trade has been a good one. Will it be good in the year ahead? Again, we can't say. But since we are guessing, our guess is that there is more juice in this trade. Gold is clearly in a bull market. If the force of inflation prevails, it is impossible that the bull market will come to an end with the price barely higher than the peak set 27 years ago. And, if gold does not go up, it will be because the force of deflation has the upper hand, which will almost certainly mean lower stock prices. One way or another, the Trade of the Decade still looks like a good one. Like a good marriage or a bad movie, we will stick with it to see how it turns out.

The Dow Jones Industrials to gold ratio has been in the 13-14 area of late. It was 1 to 1 in early 1980, but that was when gold was artificially pumped up by the Hunt Brothers' attempt to corner the silver market. The oft-cited 1980 gold price peak of $850 or so lasted only for the blink of an eye. The price collapsed forthwith. Later that year the Dow and gold had pretty nice bull runs. The DJIA/gold ratio got well above 1-1, but stayed below 2-1. (Long- and medium-term Dow/Gold ratio charts can be found on this page.)

Then gold went into a real bear market and the ratio embarked on a pretty-much nonstop 20-year rise. We recall seeing a presentation ca. 1990 showing how crazy the ratio had gotten, but it must have been only 6 or 7 at the time. Way short of 44. The presenter was right too soon. (10 years too soon is the same as wrong.) Now the trend has decisively reversed, and the ratio has been falling steadily for 7 years. If the ratio bottoms in the historically typical 2-3 range for bear market bottoms, that is still a long way down from 13.


Peak Oil expert Byron King, writing for Agora Financial's Whiskey and Gunpowder, shares his predictions on "what should be a very interesting New Year":

The economy of 2008 should be a bipolar one. There will be sectors in recession, if not depression. Yet some sectors will experience a boom.

No surprise, but there will be much more bad news in banking and real estate. I foresee at least three large, well-known financial institutions being taken over by the federal banking regulators, if not filing for protection under bankruptcy law. The expression "too big to fail" will soon become "too big to bail." And with those takeovers or bankruptcy filings will come fire sales of bank assets, from commercial paper, to credit card and other debt-servicing businesses, to downtown office buildings.

You may find that the credit card in your wallet will no longer work, because its issuing institution will have shut down the transaction window. The FDIC will have to dip into the kitty to pay off many depositors who hold accounts at these institutions. But the FDIC has a limit of $100,000 per person. Some people will not be getting back their full deposit.

It behooves everyone to diversify their accounts among institutions and regions. I can see certificates of deposit backed by precious metals as something you will want to load up on this year. Our friends at EverBank should not experience the troubles that many other, less well run banks may encounter.

As for real estate, mortgage lending has dried up. This has certainly happened for jumbo amounts, defined as loans in excess of $417,000. Thus, the larger, more expensive homes of the nation are finding fewer buyers. Expect the froth to continue to blow off that mug of stale beer. But what affects the top of the market ripples, if not cascades, to the bottom. Therefore, expect to see a continued general tightening of home buying in the lower regions of the price range, as well.

After the subprime meltdown of 2007, we should expect any lender to demand more documentation of income and credit history than before. We should see higher down payments on any home purchases and the appraising community becoming utterly Prussian and inflexible in its collective correctness.

With that, the closing process will become highly detailed, with more paperwork and more costs to close. You may flip out if you expect to make money by flipping real estate. Enjoy your new home -- it will be yours for quite a while.

In the arena of commercial real estate, a banker buddy of mine -- who works for a large Midwest institution -- put it nicely: "All my clients who were going to build last year are now thinking of buying an existing structure. Everybody who was going to move to larger spaces is now planning to stay put, if not to downsize. Everybody is nervous about the future." Thus do ripples lap upon distant shores.

But another banker from the same Midwest institution also added, "My business clients are booming. Manufacturing is going great ... Aerospace, mining, and oil services are hitting on all cylinders. Those sectors are just fine. The main problem is bottlenecks in the supply chain. Exports are up."

His predictions for the oil industry include Mexican production trending downward at 8% or more, Iraqi oil production trending upward, a new great oil frontier region offshore Namibia, and stable Russian oil production. "Look for immense, new investment streams to flow into Russian oil services."

In 2008, China will experience increasing levels of pollution of every sort. We will read numerous reports about the increasing damage to human health -- in China and abroad -- due to Chinese industrial development. The dirty environment of China and its potential impact on Olympic athletes will become a cause similar to the Chinese toy scandal of the past year.

China will receive a lot of bad press on a worldwide basis and will pull all the stops to clean up the air and water near Beijing leading up to the Olympics. Vast swaths of heavy industry will be shut down, including coal-fired power plants in northern China. Electricity will also be diverted to Beijing from other regions.

This will cause a ripple effect throughout the Chinese economy as thousands of plants close and millions of workers are displaced from jobs. Overall Chinese economic output will be affected, and there will be a disruption in the Chinese demand for commodities.

This turbulence in the Chinese economy may also be the prelude to a major slowdown in Chinese economic activity after the Olympics. Chinese leaders are already looking for ways to get the breakneck pace of economic growth and price inflation under control, and post-Olympics will be a logical time for the Chinese economy to take a breather.

With the economic landscape around the world what it is today, these are just a handful of things we can expect to see in the upcoming year. As we all know, the world is a strange and unpredictable place where nearly anything can happen. By using sound judgment with an eye toward the future, you should be able to use this knowledge to prepare yourself and have the 2008 you hope for.


The title of Doug Noland's Credit Bubble Bulletin, hosted on PrudentBear.com, gives you a good idea of the publication's focus. He opens 2008 by highlighting "three of the major themes for what will surely be a tumultuous and historic 2008":

An ongoing bust in "Wall Street-backed" finance; mounting recessionary forces imperiling the U.S. bubble economy; and worsening Global Monetary Disorder. It is a confluence of extraordinary developments that will keep policymakers discombobulated and impotent, with financial market participants increasingly aghast at what they perceive as ineffectual policymaking. This year will fundamentally change the Greenspan/Bernanke Fed's (fallacious) doctrine that bubbles are to be ignored because of the confidence in the effectiveness of post-bubble "mopping up" measures. Going forward, an appropriate "risk management" approach to central banking will give much greater weight to restraining credit and speculative excess.

Last year was a watershed year for both U.S. and global finance. Spectacular breakdowns in the gigantic markets for Wall Street's "private label" mortgage securitizations and mortgage-related derivatives fundamentally and profoundly altered the financial and economic landscape -- for years to come. The loss of trust in "structured credit product" ratings, pricing, leveraging, financial guarantees, counterparties, and marketplace liquidity is an ongoing saga that will for some time significantly restrain both credit availability and marketplace liquidity. U.S. risk asset market (financing and speculating) dynamics have been altered and myriad bubbles are in now jeopardy. Resulting recessionary forces are so powerful I am confounded as to why the vast majority of analysts and strategists maintain ridiculously low probabilities for recession for 2008. It is upon us. And a key economic issue 2008 is how rapidly and deeply the bubble economy falters, a dynamic that will be greatly influenced by the performance of the financial markets.

As we begin 2008, I believe the U.S. bubble economy is unusually susceptible to stock market weakness. Consumer confidence has waned right along with home prices, yet I will suggest that equities market resiliency had worked to support the general view that U.S. economic fundamentals remained sound. Prolonging the equities market bubble also played a role in cushioning the credit market crisis. Faltering stock prices will now batter fragile consumer and debt market sentiment, creating a spiral of market weakness begetting and reinforcing economic weakness. Moreover, I expect negative sentiment to be reinforced by what will soon be a steady stream of headline-grabbing job cuts, especially in the financial and retail sectors. I would argue that, in the case of both the stock market and corporate America, last year's disregard for the true ramifications of the bursting credit bubble will make for a more problematic 2008 in the markets and otherwise.

Consumer spirits are certainly not being heartened by headlines of $100 crude oil. And while the bloated consumer sector of the economy will initially suffer the brunt of recessionary headwinds, other dimensions of economic activity (i.e., energy, alternative energy, agriculture, metal & mining, and exports in general) will be governed by powerful inflationary dynamics. Wall Street is keen to ridicule the Fed's attention to inflation risk. The reality of the situation is that global inflationary pressures have become the most robust in decades. In 2008, economies with weak currencies, huge trade deficits, and large imported energy requirements will face outsized inflationary risks.

These opening salvos are a fair synopsis of Mr. Nolan's consistently expressed views: The U.S. "Ponzi/bubble economy" is artificially and unsustainably pumped up on credit, and is headed for a fall. Wall Street comes under ongoing and scathing criticism for its role in inflating credit via its alphabet soup of debt-backed securities and derivatives, and for pawning off so many bad credits on others while raking in nice fees in the bargain. The Fed is pilloried for abetting the credit bubble as it ballooned out of control, all the while disingenuously claiming there was nothing it could do to stop it. The credit bubble is now a worldwide phenomenon, with a crazy quilt of inflationary/deflationary dynamics an upshot.

Attempting to illuminate dynamics associated with today's problematic Global Monetary Disorder, I will use an analogy to the mortgage finance bubble. The GSE's [Fannie, Freddie et al] -- with their quasi-government status (hence market perceptions of superior debt quality) -- were for years instrumental in nurturing market distortions and powerful inflationary biases throughout American housing markets (homes and mortgages). By the time GSE accounting irregularities brought an abrupt halt to their ballooning credit expansion back in 2004, inflationary biases had become more than sufficiently powerful to accommodate the shift to massive issuance of Wall Street-backed "private-label" Mortage Backed Securities. This credit onslaught was, at least for awhile, sufficient to sustain the bubble. I have discussed how Wall Street grabbed the mortgage finance bubble "baton" from the GSEs (and ran like crazed lunatics).

Well, U.S. credit bubble excesses -- manifesting into asset bubbles, unprecedented spending and "investment" distortions, massive current account deficits, and highly leveraged speculation -- over a period of years nurtured increasingly robust global credit bubble dynamics. And just as mortgage/housing inflationary biases invited wild and destabilizing ("blow-off") credit excesses from an emboldened Wall Street, U.S. bubble-induced global inflationary forces (i.e., securities markets, energy, commodities, and economies) have encouraged domestic credit systems around the globe to partake in an unparalleled global credit boom. With few exceptions, double-digit credit growth has become the global norm, with "BRIC" (Brazil, Russia, India, and China) Credit expansion likely in the 20 to 30% range. To be sure, "Wall Street" Monetary Disorder evolved into an even more unwieldy strain of Global Monetary Disorder. Wall Street today wishes desperately that the Fed will completely disregard global issues and aggressively reflate. It is the nature of bubbles that such easy "money" policies would work to exacerbate bubble excess, with minimal impact on those that had already burst.

There are today great -- and apparently unappreciated - risks associated with aggressive Fed rates cuts further aggravating global liquidity, financial flows, and currency market excesses and instabilities. This is not 2001/02 or 1998, and the current backdrop is the antithesis of the early-'90s global "disinflationary" backdrop that provided the Greenspan Federal Reserve the flexibility to orchestrate a historic banking system recapitalization and economic reflation.

For one, the Fed today risks inciting a crisis of confidence for our degraded dollar and currency market dislocation more generally. Second, there are the enormous financial, economic and geopolitical risks associated with the continuation of rampant energy and commodities inflation. Third, aggressive Fed rate cuts risk exacerbating increasingly destabilizing financial flows (teaming with now rampant domestically-induced excesses) to Asia and the emerging markets (Brazil, Russia, India and China -- in particular). The last thing an increasingly unstable Chinese bubble needs is another year of massive financial inflows. Fourth, with Monetary Disorder and general inflationary pressures mounting rapidly across the globe, reflationary policies here at home today have a much greater propensity for feeding into traditional measures of consumer price inflation than they have had in decades.

Another consistent theme: The spillover effects of the U.S. credit bubble into world markets, including "rampant" energy/commodities inflation and the out-of-control economic bubbles in other countries that import U.S. inflation, risk disorders that go well beyond simple economic contractions. When the financial imbalances spawned rebalance, the rebalancing could be politically cataclysmic as well.

Returning to my credit bubble "baton" analogy, it is instructive to contemplate how precarious it became when Wall Street-backed credit supplanted (quasi-government) GSE credit at the ("terminal") blow-off phase of mortgage finance bubble excess. This period of Acute Monetary Disorder was fueled by unfettered inflation (issuance) of Wall Street securitizations conjoining with manic speculative impulses. Inflating home prices, market euphoria and accompanying economic distortions masked the fundamental fragility of the underlying credit instruments, debt structures and asset prices.

"Wall Street finance" was the flip side of the real estate/stock market bubbles. Each needed the other, and reinforced the other. The financial and real economies became massively distorted in the process. Note also that to keep game going, it was necessary that someone pick of the credit expansion "baton", as descibed in last week's "Primer on Fed Interventions" entry. When Fannie Mae and Freddie Mac faltered, Wall Street securitizations were used as an alternative debt issuance channel.

Today, similar dynamics enshroud acute asset market, credit system, and economic vulnerabilities on a global basis. The U.S. credit system handed the global credit bubble baton to domestic financial systems the likes of China, Russia, India, Brazil, the oil/commodity producing economies, and the emerging markets more generally. These immature and unsound "contemporary" financial systems are today perpetrating a credit fiasco paralleling U.S. subprime but on a much grander scale. Keep in mind that only deep-seated underlying U.S. systemic weakness (manifesting into massive financial outflows and a depreciating currency) could have engendered the profligate backdrop where (fundamentally deficient) credit systems across the globe could inflate with such reckless abandon. The bottom line is that credit bubble and "Ponzi" dynamics are working their seductive and disastrous effects now on an unprecedented international scale. To those arguing that aggressive Fed rates cuts pose inconsequential risk, I have the following retort: "Only if you exclude the risk of global financial and economic collapse."

The claim is that not only would further rate cuts by the Fed lead to further dollar weakness and inflation, but that it could push the other economies around the world over the edge.

Analysts of the bullish persuasion have been trumpeting the U.S. economy's resiliency in the face of the "subprime" crisis. As I have addressed over the past few months, our bubble economy has been bolstered by significant ongoing credit creation -- even in the face of the bust in Wall Street-backed finance. Importantly, the liabilities of some key sectors have retained their "moneyness" [i.e., liabilities are still perceived to be safe, and thus are still liquid] throughout the crisis, spurring a rapid expansion of the thus far immune debt instruments. Bank credit has expanded at a 16.1% rate over the past 23 weeks and finished 2007 with one-year growth of 11.6% to $964 billion (2-year growth of 23.4%!). Money fund assets ballooned at a 46% rate over this same 23-week period, with one-year growth of 30.2% (to $3.1 trillion). Fannie and Freddie's combined Books of Business (BofB) expanded on average almost $55 billion monthly between March and November, in what will be a record year of BofB growth. The Federal Home Loan Bank System likely expanded credit at a 30 to 40% annualized rate during the second half, capping off what will also be record annual growth.

These are astounding rates of credit growth in the sectors where the confidence required to support the growth remains. This compares with the credit contraction in areas where confidence has been shattered:

The ongoing bust in Wall Street-backed finance will undoubtedly be a major issue for 2008. No amount of Fed rate cutting can reverse this spectacular debt collapse. The fallacies of so many aspects of "contemporary finance" have been exposed. Going forward, the viability of many firms involved in Wall Street risk intermediation will be in doubt. The financial guarantors are in serious trouble. The credit default marketplace will attempt to forestall implosion. Problems that will beset the colossal leveraged speculating community have only begun to emerge.

What impact Fed "reflationary" policies have on the ballooning bubbles in the "money-like" credit sectors is a less obvious but major issue 2008. With Wall Street risk intermediation now virtually out of the equation, the ballooning bank, GSE, and money fund complexes are left in a perilous position as the prominent risk intermediators (of last resort) for a U.S. bubble economy at the precipice. Delaying the inevitable (arduous) financial and economic adjustment period through aggressive Greenspan-style cuts only exacerbates the unmanageable risks accumulating in institutions issuing enormous quantities of perceived safe and liquid liabilities ("money-like" debt instruments). The difference between a deep recession and a devastating depression hinges -- as it has historically -- on maintaining market faith and confidence in "money." A serious issue 2008 has the perceived soundness of "money" today in the most serious jeopardy in almost 80 years.

If confidence falls too far then many credits which today serve as a medium of exchange, i.e., are "money-like", will lose that quality. The quantity and velocity of money will plunge, and we have credit deflation.

It will be another year of fascinating tests for macro credit theory and analysis. Is it possible for our Bubble Economy to persevere through 2008 without ever increasing quantities of system credit growth? Assuming such massive credit creation is in the offing (a major assumption today), how does the credit system pull off such a feat and what will be the consequences? Well, it would certainly necessitate ongoing bubbles in "money" market instruments, including Treasuries, "repos," and agencies. It would also require a massive issuance of agency MBS, along with another year of double-digit ($trillion plus!) bank credit expansion. And we must also hope that our foreign creditors will not completely back away from our risk markets.

Today, ongoing credit excess, current account deficits and financial outflows inundate the world with dollar balances -- that are then recycled back to a limited supply of perceived safe Treasuries and (to a somewhat lesser extent) agencies. This ... has severely distorted the fixed income marketplace, creating one more facet to the unfolding financial crisis and dislocation. The first three trading sessions saw stocks in virtual freefall, Treasuries in melt-up mode, the yen rallying strongly, and many spreads widening meaningfully.

2008 has commenced with some key hallmarks of impending financial dislocation -- not a huge surprise since we have for some time now been in the midst of an unfolding financial crisis. The stock market is in some serious trouble, and the U.S. bubble economy is in serious jeopardy. Myriad global bubbles are accidents waiting to happen. Worse yet, we are now officially in what will be a decisively unbullish political campaign season. There is also increased talk of Wall Street investigations -- of which there will be plenty. Disconcertingly, the public mood is turning increasingly sour at home and the geopolitical backdrop more problematic abroad. Get ready for one of the consequence of bursting bubbles -- a public less trusting in "capitalism," a world increasingly lured to "protectionism," and a federal government much more intrusive in our financial lives.

This particular reverberation of an imploding financial market and economy is one that we have been warning about practically since day one of W.I.L.'s existence. The federal government intrusion into our financial lives will no doubt be accompanied by restrictions of moving capital abroad.

As for Issues 2008, there are obviously many and they are unusually varied -- a wide spectrum of financial, economic, political, environmental and geopolitical risks. I really fear a major California bust has commenced. But what worries me most at the present is the possibility of a "run" on the leveraged speculating community, a circumstance that could potentially precipitate a "seizing up" of even the more "money-like" debt markets at home and abroad. I foresee chaotic markets. As always, I can only hope my fears prove unfounded.

Welcome to 2008. See all that we have to look forward to?

Ambac Insurance Loses AAA Ranking at Fitch Ratings

Another of the "Wall Street-backed finance" dominos falls.

Ambac Assurance Corp. was lowered two levels to AA and may be reduced further ... Fitch said today in a statement. The downgrade "reflects the significant uncertainty with respect to the company's franchise, business model and strategic direction," Fitch said.

Without its AAA rating ... Ambac may be unable to write the top-ranked bond insurance that makes up 74% of its revenue. Ambac may quit the business or sell itself, said Robert Haines, an analyst at CreditSights Inc., a bond research firm in New York. The downgrade throws doubt on the ratings of $556 billion in municipal and structured finance debt guaranteed by Ambac.

"This makes Ambac insurance toxic," said Matt Fabian, senior analyst and managing director at Municipal Market Advisors ... "The market has no tolerance for a ratings-deprived insurer." ...

"The likelihood is quite high the others will follow," said John Tierney, credit market strategist at Deutsche Bank AG in New York. "Barring some significant development on new capital, it's just a matter of time before S&P and Moody's act on MBIA and Ambac."

The seven AAA rated bond insurers place their stamp on $2.4 trillion of debt. Losing those rankings may cost borrowers and investors as much as $200 billion, according to data compiled by Bloomberg. The industry guaranteed $100 billion of collateralized debt obligations linked to subprime mortgages, $22 billion of non-prime auto loans and $1.2 trillion of municipal debt.

New York-based Merrill Lynch ... yesterday took $3.1 billion of writedowns on the value of default protection from bond insurers.


It is ever thus: After a bubble pops, the frauds that were nurtured by or actually contributed actively to its expansion get exposed. As the mortgage finance/real estate bubble kept getting bigger, home appraisers got lax -- after all, rising values would always bail out an optimistic appraisal -- and then took it further by purposely inflating their assessments, if that would help make a deal happen. They had plenty of encouragement from nominally adverse parties as well. Note the different parties that appear in this story.

Home appraiser Julian "Tony" Perez conjured $7.5 million out of thin air in the first six months of 2001 by overvaluing 33 condominiums in the Atlanta area. Perez valued eight unfinished properties at the Deere Lofts development on April 2. Some were missing ceilings, cabinets or sinks. Each had been bought the previous week for $90,000 to $167,000. Perez said they were worth $177,000 to $330,000, according to the U.S. Attorney's Office in Atlanta.

"These are the worst condos ever," Perez said ... during testimony at the federal trial in Atlanta of developer Phillip Hill, who used the appraisals to resell the properties. "Those values are super over-inflated, probably double what the amount of that property is probably worth."

The Fed guns the credit supply and starts a world-class bubble in housing prices, then waxes indignation when some small time outsiders try to horn in on the action. This is virtually entrapment.

Perez and appraisers like him helped exaggerate U.S. mortgage values by as much as 10%, or $135 billion, in 2006, according to Susan Wachter, a real estate professor at the University of Pennsylvania's Wharton School ... Such appraisals artificially inflated the value of collateral supporting mortgage-backed securities and are contributing to record foreclosures because borrowers end up owing more than their houses are worth.

Lenders and investors in mortgage-backed securities depend on independent appraisals to value their collateral. Buyers use them to make sure they are not overpaying.

Except none of them asked too many questions during the boom, which they figured would bail them out.

Mortgage lenders, eager to make bigger loans and win market share during the five-year housing boom, relied on both higher appraisals and the proliferation of subprime and adjustable-rate mortgages, said Wachter ...

Lenders and mortgage brokers routinely pressured appraisers to boost values, said Jonathan Miller, a New York property appraiser for more than two decades who writes a blog about the problem. ... The system was further corrupted when lenders began moving mortgage applications to third-party brokers who only got paid if a loan closed, he said. ...

90% of appraisers surveyed in a study published last year by ... October Research Corp. said they felt pressure to make bogus valuations. Five years ago, that figure was 55%. Almost three-quarters of the appraisers said that mortgage brokers asked them to bend the rules. ...

Appraisers who resist pressure to inflate values said they may be blacklisted. Paul Bodeving saw his business dry up after he was hired by an appraisal management company to evaluate a four-bedroom, 3,500-square-foot house in Grants Pass, Oregon, last February.

After examining the value of comparable homes, Bodeving determined the property was worth $837,000. The appraisal management firm asked him to "squeeze another $20-$25,000" in value so the lender could close the loan, Bodeving said. He refused and rarely gets work from the company anymore. "It's absolutely horrible," he said. "We've never had the pressure we have now." ...

The problem became so severe in Florida that appraiser Pamela Crowley said she started an e-mail distribution list in 2003 for real estate appraisers to report suspicious sales and refinancing deals.

Crowley said she was forced out of the appraisal business because she refused to report property values that were higher than the actual worth. She has turned the e-mail list into a Web site, and says she now works with a snub-nosed .38-caliber pistol at hand because she is afraid of retribution.

"There are a lot of people who made a lot of money on this whole game and I was hurting them," Crowley said. ...

Even before Perez pleaded guilty, he paid for bucking the system, said his lawyer, Page Pate. "He liked the steady stream of business," said Pate. "My client refused to inflate a few appraisals and they cut him off for a long time."

A lot of illegal and unethical business is still going on. By the time the real estate market hits bottom, the crooks will have moved elsewhere. There will not be enough hot money floating around to be worth the effort to grab a piece of it.


"An economist's guess is liable to be as good as anybody else's." ~~ Will Rogers

Ambrose Evans-Pritchard writes:

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of U.S. Federal Reserve policy by Professor Anna Schwartz.

The high priestess of U.S. monetarism -- a revered figure at the Fed -- says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

"They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence," she told The Sunday Telegraph. "There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for," she says.

Schwartz remains defiantly lucid at 92. She still works every day at the National Bureau of Economic Research in New York, where she has toiled since 1941.

Her fame comes from a joint opus with Nobel laureate Milton Friedman: A Monetary History of the United States. It revolutionized thinking on the causes of the Great Depression when published in 1965. The book blamed the Fed for causing the slump. The bank failed to use its full bag of tricks to stop the implosion of the money stock, and turned a bust into calamity by raising rates.

"The book was a bombshell," says British monetarist Tim Congdon. "Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression."

Ben Bernanke, among others, readily takes to the idea of making the Fed the fall guy for the Great Depression. "Yes, we did it, we're very sorry, we won't do it again," he said at the late Milton Friedman's 90th birthday party a couple of years back.

On the other hand there are many of us who find Ms. Schwartz's assessment -- and Bernanke's concurrence -- wanting. To turn what Talleyrand said of Napolean's execution of the Duc d'Enghien on its head: "It is worse than a blunder, it is a crime." We unreservedly join the ranks of the critics of the Fed for its (non-exclusive) role in stimulating the artificial 1920s boom, whose comeuppance devolved into the 1930s disaster. But claiming the Fed could have single-handedly reversed the effects of that and all the other policy errors (Smoot-Hawley tariffs, basically the whole New Deal) made at the time is simplistic, and also a little too convenient.

Assigning all responsibility to the Fed provides a handy cover for inflating the money/credit supply still further: "We have to do it in order to prevent a recurrence of the Great Depression, which, all reasonable people (government employees, paid-off/bought-in academics and policy wonks, other esteemed members of our coterie -- people like that) agree, happened because of the incompetent bureaucrats at the Fed failing to dump enough money into the system." And since the Fed acting alone can stave off the worst, why everyone else can just go on borrowing and spending, and legislating and regulating as they please. Convenient indeed.

"It had an enormous impact in revitalizing free-market conservatism, and it broke the Keynesian stranglehold over policy," [Mr. Congdon] says. Keynes himself was a formidable monetarist. He became a "Keynesian" big spender only once all else seemed to fail.

Granting the good effects that Friedman and Schwartz's book had on the economics profession, we nevertheless take note of this: The "free-market conservatism" that was allegely revived (post-1965) was hardly a return to the ideals of the Enlightenment, or even of free markets. Only in comparison with the various dominant central planning ideologies of the day did the Chicago School of Milton Friedman seem either conservative or free-market advocating.

Let us dig a little deeper still, and attempt to unmask some of the silent presumptions behind the dialog of the day. Friedman and Schwartz's opus is in a real sense a de facto apologia for big government. The book says the Fed blew it, but having helpfully identified the errors made, the implication is that the Fed will do better next time. The book fails to demur on the presumption that the Fed ever deserved to see the light of day in the first place. "Money for nothing, bankers' kicks for free" should be the Fed's motto ... but we digress.

Milton "Free to Choose" Friedman spent his whole career saying the Fed could be rendered effective by binding it down with the chains of Milton's encoded wisdom. But he never said get rid of it entirely. He never said we should all to be "free to choose" who provides what we use for money. "There are a thousand hacking at the branches of evil to one who is striking at the root," said Henry David Thoreau. Friedman was a branch hacker. (Our fair and balanced alter ego notes that Friedman undoubted inspired more than his share of root strikers.) Anyone who gardens knows that intelligent pruning actually strengthens the plant. Returning to Anna Schwartz's current-day pillorying of the Fed:

According to Schwartz the original sin of the Bernanke-Greenspan Fed was to hold rates at 1% from 2003 to June 2004, long after the dot-com bubble was over. "It is clear that monetary policy was too accommodative. Rates of 1% were bound to encourage all kinds of risky behavior," says Schwartz.

She is scornful of Greenspan's campaign to clear his name by blaming the bubble on an Asian saving glut, which purportedly created stimulus beyond the control of the Fed by driving down global bond rates. "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can't be blamed on global events," she says.

That mistake is behind us now. The lesson of the 1930s is that swift action is needed once the credit system starts to implode: when banks hoard money, refusing to pass on funds. The Fed must tear up the rule-book. Yet it has been hesitant for three months, relying on lubricants -- not shock therapy.

"Liquidity doesn't do anything in this situation. It cannot deal with the underlying fear that lots of firms are going bankrupt," she says. Her view is fast spreading. Goldman Sachs issued a full-recession alert [last] Wednesday, predicting rates of 2.5% by the third quarter. "Ben Bernanke should be making stronger statements and then backing them up with decisive easing," says Jan Hatzius, the bank's U.S. economist.

Many were critical of "Easy Al" Greenspan's super-accommodative monetary policy and failure to confront the obvious bubble as it was happening. If Ms. Schwartz's voice had been added then it would have been borderline sensational. It is still noteworthy coming after the fact from "the high priestess of U.S. monetarism." And her admonition that only "shock therapy" will be effective now -- forget about the "lubricants" heretofore administered -- is more than welcome dose of applied intellect amidst a hue and cry for more of same of what has been ineffective: rate cuts.

When banks refuse to lend to anyone, even creditworthy entities, that we have a situation where lack of confidence threatens the whole system. Schwartz repeats a point raised last week in this entry -- which cited an article written by Antal Fekete -- that liquidity will not help such a situation. Here is the relevant passage:

For electronic dollars to work they have to trickle down through the banking system. The trouble is that when bad debt in the economy reaches critical mass, it will start playing hide-and-seek. All of a sudden banks become suspicious of one another. Is the other guy trying to pass his bad penny on to me? In extremis, one bank may refuse to take an overnight draft from the other and will insist on spot payment. A field day for Brink's. ...

Goldman Sachs mouthpiece Jan Hatzius's plea for "decisive easing" -- as if the easing to date has been indecisive -- would appear to fall under the more useless liquidity category. Ms. Schwartz says this will not help with the fear thing. But we imagine it will help with the boost-whatever-Goldman-is-long thing.


To be a successful speculator one needs a statistical edge and a sound approach to managing risk. The edge has to overcome frictional trading costs and taxes as well as better all the competitors that are trying to do to you what you are trying to do to them. Even with an edge that delivers "on average", you will encounter losing streaks. Risk management is required to keep you from losing a fatally large piece of your stake during such streaks.

Most people get mesmerized by all the news and information out there. They overtrade, burdening their results with the large transaction costs thereby incurred. They do not even have an trading methodology worthy of the name. And they tell themselves they are "investing", not realizing they are speculating, writes Michael Rozeff. They come up to the plate with two strikes against them -- maybe three -- before the first pitch has been thrown. The chance of this approach working out in the long run is immeasurably small.

There are many sound approaches to speculating available, e.g., the Benjamin Graham/Warren Buffett fundamental value methodology, or various implementations of the related contrarian/go-where-the-crowd-ain't path. They do not necessarily involve much in the way of trading. Many are actually simple to follow in principle -- too simple for overactive minds. People say they want to make money, but they also want excitement and that sinful but delightful feeling of getting something for nothing. Watch what people do, not what they say.

Michael Rozeff explains what investing is as compared with speculating, and offers some advice for implementing a sound investment plan. It is as good an investment primer short of a book that we have seen in a long while. It sounds pretty dull, which in investing is usually a Good Thing™.

Whenever I write on anything remotely connected to securities, people ask me many questions. Why is M1 flat and gold rising? Should I follow M1 or M2? Why did the Fed discontinue M3? When will the housing market recover? What is a good investment during a recession? They are more than curious. They want to know what to do with their money.

I think that most of these people are making a basic mistake. They are seeking information in an attempt to speculate. I think they would be better off if they became passive investors and left the speculating to speculators (or traders). Most traders lose money.

How should one invest? The textbooks on investing run almost 1,000 pages. Such a mass of material overwhelms and confuses many people. For example, these texts distinguish between active and passive investing. They use the term active investing to avoid using the term speculation. But active investing, which is an attempt to beat the market, is speculation. To my way of thinking, investment is passive investment.

This article provides counsel on investing viewed solely as passive investing. In this way, I answer many of those individuals whose queries I have not answered. Naturally, no matter what I say, it will not be enough.

Investment and speculation in securities are two different things. They require very different fundamental principles. One should not confuse them. The investment and speculation I discuss here both involve placing funds into securities or asset-related securities. That is about all they have in common.

Speculation is an attempt to profit, that is, earn an above-average rate of return, by forecasting the future price movements of specific securities. ... Speculation is a business and a very difficult business. The number of people who make a profit by starting and running businesses is relatively small, especially in lines of business that are highly competitive. Speculation is a highly competitive business. There are very few highly successful people in any field of endeavor. The average person who attempts to speculate is very likely to fail at it. Studies of brokerage and commodity trading accounts show that upwards of 80% of traders who speculate lose money.

The reason for this is that most amateur speculators do not follow sound fundamental principles of speculation. They do not know what these principles are. ...

Whatever the sound fundamental principles of speculation are, they are based upon a knowledge of those factors that provide an accurate guide to future stock price movements. Knowledge always is the basis of true basic principles. You will not find revealed here the fundamental principles of speculation. If you search for them yourself, you will find many competing claims and little evidence to back up most of them.

Warren Buffet has sound principles. His wealth and success prove that. Is Warren Buffet engaging in speculation, investment, or something else? Should we look to what he does in order to find basic principles that we can apply? Buffet is in large measure a businessman. He buys whole companies after meeting the owners and managers. His holding company has a structure for managing these purchased enterprises. This part of Buffet's procedure is not security investment. It is investing in real assets. This is not our subject, which is investing in securities.

Buffet also buys individual securities. His usual strategy is to buy first-rate companies at prices that are at a discount to the values he perceives them to have. Buffet concentrates wealth in a few of these securities that he likes a great deal. This is a variant of what is called value-investing, which ... is actually not investment. It is active investment, which is speculation. ...

One need not be too concerned over this. Properly executed, value-investing is a good way to speculate. My only reason for explaining it and calling it speculation is to steer the average investors toward passive investment and not let them detour to any of these alluring side streets. If you insist on detours, then what you should do is divide your money into two piles. One pile will be for passive investment, the other for speculation. One will be for money you do not want to lose, the other for money you can afford to lose. Keep them absolutely separate and you will have fewer regrets. Mix up the two and you will find yourself getting nowhere as the years pass.

What then is involved in investment? Various states-of-the-world can happen in the future, in fact, an infinite number of possibilities. The investor makes no effort to discern what these will be and which ones are more likely to occur. He makes no attempt to speculate on the future. The first sound fundamental principle of investment is not to speculate in any way, shape, manner, or form. The investor swears off trying to forecast the future. This means he pays no attention to the investment markets, to changing prices, to the news, to economic data, to political events, etc. ... He will not be constantly on edge about the markets. He will not constantly be in a state of confusion wondering why stocks fell when he thinks they should have risen.

An old John Denver song (confession time ...) goes: "Blow up the TV, throw away the papers ..." Good advice for investing, not to mention sanity.

The second sound fundamental principle of investment is to buy and hold a value-weighted, highly diversified or market portfolio. One may rebalance that portfolio on occasion as new securities become available, but low turnover will be a hallmark of a portfolio that is following sound fundamental principles. Investing will be a boring sideline, requiring very little of one's time and effort. One will not be doing much buying and selling, and this will keep both transactions costs and taxes low. The effort will go into finding out what one's asset allocation should be, that is, finding appropriate value-weights and diversifying properly. Diversifying properly means really diversifying. This goes well beyond merely buying the major stock index of one's country.

Those two principles are the main ones that you need to get you into the investment ball game in good shape. A third sound fundamental principle is to start investing as early in life as possible. This means saving and not consuming. It means not going into debt.

If there is one thing that the finance literature shows definitively, it is that diversification pays. ... You may disregard those who laugh at diversification because it is merely average investing. These giants of active investing all claim that by focusing on a few well-chosen securities, they can do far better than average. They are speculating, however. That is for your other pile of money, the money that most people lose. ...

How shall you diversify? Very, very, very broadly; the more broadly the better. There are many asset classes. The ones that provide most of the market value are domestic securities, foreign securities, stocks, bonds, real estate, and real assets. These are the mainstream investments. Stay with them. There are some potentially attractive classes that the average investor will find it difficult to get into, such as venture capital. There are some securities that one should simply avoid, like hedge funds. One may avoid abstruse derivative-based securities.

I will explain next the basic idea. ... The basic idea is to buy a value-weighted market portfolio of these assets. The reason for the value-weighting is as follows. There are many thousands of securities that investors and speculators are valuing. Their valuations are better than yours. They have more information and more money that they are hazarding. You cannot possibly keep up with all the new information and how it affects security values. The market will sometimes be valuing various securities too richly and others too poorly, but you don't know which is which and neither does the market. But it is doing the best that it can, and its valuations are reflecting huge amounts of information that you have no access to or knowledge of. The market's valuations across all these securities are more likely to be accurate than for any one security. If you buy the entire market in value-weighted proportions, you will be mimicking the actions of all investors collectively in all their assessments, using all the available information. You cannot do better than that if you tried. If you try, do so with your speculative pile.

The reason for the market portfolio is that it, by definition, includes every existing security in the world. This gives the maximum diversification and the maximum gain/loss ratio. ... The problem of passive investing comes down to determining appropriate market-value weights and then determining appropriate securities that match the asset classes. Obviously one cannot buy every single security everywhere, so one must find index funds that mimic these assets. The passive investor of today is extremely fortunate! There is an ample number of exchange-traded and mutual funds that provide very low-cost access to a portfolio that approximates the world value-weighted market portfolio.

Harry Browne in his little book Fail-Safe Investing explains and justifies a similar passive investment approach. If it will make you feel more comfortable, read his book. It will supplement what I am saying even though it is saying different things. Browne ends up recommending a four portfolio worry-less investment policy. He has equal proportions in long-term bonds, short-term bonds, gold, and stocks.

No one knows, including me, what the world market portfolio's asset proportions are. You can search the internet as well as I can. I believe that the proportions are roughly 40% real estate, 25%, and 25%. Gold and other real assets such as timber may account for 5–10% of total assets at most. Hence, one might think about a portfolio like 25%, 25%, 40% real estate, and 10%. If one alters these proportions, it will not make much difference.

The main idea is to apply sound fundamental investment principles. They are: do not speculate, and buy and hold a highly diversified value-weighted portfolio. ... Within the relevant categories, one should diversify further. Suppose one has 30% stocks. Find out how much market value that American stocks have compared to foreign stocks. Then adjust the portfolio to those proportions. One might split the portfolio as 20% American stocks and 10% foreign stocks. Similarly, one can diversify the bond and real estate portions over domestic and international securities.

This kind of portfolio will be as worry-free as one can make it. It will have the lowest risk for the highest return. In absolute terms, its return will probably be something like 6–8% a year. The bond and real estate portions will cause its return to be lower than if you held an all-stock portfolio, but the risk will be a lot less. You will not endure the sharp fluctuations that stocks quite often deliver.

The risk of investing is not always easily observed until it is too late and the investor discovers to his dismay, after his stocks or bonds have fallen drastically, that his investment portfolio was risky. I cannot too strongly stress that a highly diversified portfolio of this kind has far lower risk than investing in any single asset class and far, far lower risk than investing in a handful of securities as speculators do. The goal of such a portfolio is to preserve and grow capital, earning an average return, with a minimum of risk.

Stocks in a major downtrend. Speculators should sell.

Michael Rozeff follows up his advice for investors above with advice for speculators:

In case you have not noticed, the major uptrend is over that began back in mid-2003. The stock market is now in a major downtrend. In some sectors, such as real estate investment trusts, the downtrend began months ago. In others, it is just now taking hold. Any knowing speculator does not need to be told this fact; he or she already knows it and has already adjusted his stock position.

For those of you who have not, be advised that in a major downtrend the vast majority of stocks go down. If you stay long of stocks, you are running against a strong headwind. Be advised that the first loss is the smallest loss. Taking a 7-8% loss now is far preferable to looking at 20-50% losses later on. Cutting losses is one rule of speculation that holds for almost all methods of speculating. Be advised that stocks that resist the decline may subsequently catch up with the market and fall. Patience is a virtue in speculating. Markets do not turn on a dime. Wait. The decline will take time. Making a new bottom will take time. The next major uptrend will take time to get going. A major downtrend like this is a good time to do one's homework, to be looking for stocks that might be shaping up to be leaders in the next uptrend market.

No one knows how deep prices will fall or for how long the downtrend will last. One must wait until the market itself tells us that the downtrend is over by its own price and volume action. That is why it is absolutely essential for speculators to cut their losses at the earliest possible time.


Forbes columnist and money manager Ken Fisher has been steadfastly bullish, and steadfastly right for the most part, for a long time. We at W.I.L. are dyed-in-the-wool gloom and doomers: "It may be sunny out, but look at that tropical depression on the radar map on the Web." We find ourselves wishing we could be as optimistic sometimes as he is always.

One day Fisher may end up wishing he had listened more closely to us. Meanwhile, Fisher's style -- sometimes wrong but never in doubt -- has certainly worked for him. Moreover, his approach of looking for value, with an international angle and few small macroeconomic calls mixed in, is sound enough to our way of thinking. His current counsel is to look beyond the scary news, take a chill pill, and get back to the business of looking for value in the stock market. Same old song and dance, but a that is OK.

Let me make you a solemn promise for 2008. This year, and for the rest of your life, the U.S. market and economy will not head markedly one way while the foreign world collectively goes the other. We are too intertwined globally. Since the foreign economy is twice America's size, and is strong, America should do well in 2008 -- better, at any rate, than people expect.

Yes, we have heard all the problems. Over and over again. They are well broadcast. And that led to a weak stock market in 2007. In my January 29, 2007 column I predicted that the market (as measured by the Morgan Stanley World Index) would be up 10% to 40% for the year and that "the S&P 500 will be up, but by a lesser amount." The world was up a shy 9%. My Forbes stock picks, which were chosen expecting a more vibrant market, did not do well.

2007 was not a great year for Mr. Fisher, mostly due to a "very wrong decision in February to jump into housing stocks." Another sad chapter in the book: What Happens When You Ignore the Old Trader's Advice and Try to Catch a Falling Knife (Rather than Let it Stick in the Ground and Start Vibrating First). His best performing pick was Agrium, up 100%, as agricultural stocks did well. He advises clearing the decks of 2007 deadwood, winners and losers alike.

I am still bullish. Why? The larger non-U.S. economy is doing great. America is not doing badly. In each quarter we get a gross domestic product stronger than expected, followed by new expectations of terrible results for the next quarter.

This is basically bullish. We are not likely to get much gloomier. Eventually we will come around. So 2008 is more likely to be a robust market than a bust one. Stocks are cheap, particularly compared with long-term interest rates globally, as I have said for years.

We have had only three negative 4th years of a President's term in the S&P 500's history: in 1932 as the Great Depression bottomed, in 1940 as World War II began heating up in Europe and in 2000 as the tech sector disintegrated and we had the first constitutionally challenged presidential election in a century. Indeed, the 2000 market was positive until shortly before the election and was positive for the year if you exclude the technology sector. Nothing so severe is likely in 2008.

Fear a Democrat this year? We have elected them many times before. And stocks were almost always positive then. I am betting so for 2008, although foreign stocks could beat domestic ones. My advice is to stay fully invested on a global basis, with stocks like these ...

He goes on the recommend Australia & New Zealand Banking (120, ANZBY), Germany's Fresenius Medical Care (54, FMS), Brazil eucalyptus pulp producer Aracruz Celulose (74, ARA), Swiss eye care conglomerate Alcon (141, ACL), and U.S. insurance giant AIG (57, AIG). AIG was once a "Nifty 50" type institutional favorite. Now its stock trades at a lower price than it did 8 years ago and sells at 8 times earnings and 1.2 times book value.

Hazzarding a summary of Fisher's principal points: The performance of U.S. and overseas stock markets will be highly correlated. A lot of the bad news in circulation has already been incorporated into stock prices. Stocks are cheap. The 4th year of a U.S. President's term is almost always a good year for stocks. (Unless there is a major war, a depression, or a popping bubble. Wait. Isn't that what us alarmists are fearing? ... Oh, never mind!)


Forbes columnist and money manager John W. Rogers Jr. picks stocks using a fundamental value approach. His search universe consists largely of higher quality small- to mid-capitalization U.S. stocks. His portfolio turnover rate is quite low on average. We tend not to find his column recommendations all that exciting, because they usually do not appear to be all that cheap. But he is always worth listening to. He summarizes his 2007 results, and looks ahead to 2008:

In last year's January column I predicted the market would correct in 2007. It did and it didn't. For the year the S&P 500 was up 3.5%. But in November both the Dow Jones industrial average and the S&P 500 fell 10% from their early October highs. The pain is not over.

A 10% drop is not steep. This one came after a 5-year run that pushed the S&P 500 up 105%. Smaller stocks like the ones I follow did even better: The Russell 2000 Value Index rose 135%. Extended bull runs and brief selloffs have lulled investors into a false sense of security.

It pays to have some historical perspective. On February 9, 1966 the Dow peaked at 995, yet the index did not reach 1000 until 6 1/2 years later, on November 14, 1972. And crossing that milestone did not portend good times. Two years later the Dow closed at 577. It did not cross 1000 for good until 1982.

If you are young, the 1970s seem like ancient history. Before the heavy volatility erupted last summer, the sophisticates said that derivatives, collateralized debt obligations and other new securities had soothed the market permanently. Not quite. These Wall Street darlings went on to be the cause of the trauma.

I am no chronic pessimist, but I do think that we may be seeing a return of the slow, agonizing periods we saw in the 1970s. That is one reason I always seek out high-quality companies whose sturdy finances, steady cash flows and strong brands enable them to hold up well.

I called for a similar defensive stance last year, which turned out to be right, since the highest-quality names have done best. My picks of 2007, which were for the most part the stocks of smaller companies, were up 0.9% (after subtracting a hypothetical 1% trading cost) versus a 0.1% loss for shadow investments made on the same dates in the S&P 500 (with no fees).

His best performing pick was consumer nondurables conglomerate Energizer (112, ENR), of Schick razors and Energizer batteries fame. Now they have bought out Playtex. Rogers estimates that Energizer's intrinsic worth is $125 per share. This is not trading at enough of a discount to this value to provoke one to stop everything and rush out and buy. However, if the company's so-called intrinsic worth is going to keep rising at, say, double-digit rates, then maybe it is worth a second look after all. But in that case the calculation of current value does not seem to take into account that future growth. Is $125 what a strategic buyer would pay for the whole company? Semantics would be useful here.

His worst performer was Journal Register (2, JRC), which lost 76% last year, following a 51% loss for 2006. The newspaper company was undoubtedly hurt by its concentration in economically-troubled Michigan. The greater, or anyway compounding, issue is that newspapers in general are suffering from contracting circulations and a loss of market share of classified ads to the internet. Newspaper companies used to be a classic "Warren Buffett businesses" due to their quasi-monopoly positions in most markets. The internet changed the game entirely. Many value buyers failed to realize or admit this. (Buffet himself, however, has said that newspapers were overpriced as valuations were based on looking through a rear-view mirror rather than a window.) They habitually maintained their old pattern of buying into "undervalued" newspaper companies, whose values continually crumpled under the onslaught of the new medium. This is an example of a "value trap": A discount to value is useless if there is no immediate catalyst to close the gap and that value falls over time.

But Journal Register is picking up eyeballs and ad revenues on the Web. I am encouraged that new Chief Executive James Hall and a bevy of other new, talented people are pumped to turn the business around. The stock is oversold. I believe it is worth $6.65; so there is a 74% discount at its current perch.

Now a 74% discount to alleged value is interesting. Given Rogers's record here you want to make you own independent appraisal of the situation. Also, JRC has fallen to $1.50 since Rogers wrote this article. You should understand well what you are getting before taking a nontrivial position in a stock that risky. Taking a quick look at a recent balance sheet, the high debt level stands out. You really should understand the company's asset values very well before buying in.

Other 2007 winners included medical companies Bio-Rad Laboratories (99, BIO), up 39% since he flagged it in June, and Baxter International (59, BAX), up 25%. The companies are "slow, steady growers with nice recession-proof characteristics." Bio-Rad trades at an 11% discount to his estimate of intrinsic worth, Baxter at a 14% discount. The discounts and company characteristics are similar to those of Energizer. Similar comments apply. In addition, Baxter trades at about 24 times trailing earnings and has about a 1.4% dividend yield. Not exciting on the face of it.

As a contrarian, sometimes I am wrong and other times I am early. I believe it is the latter case with USG (36, USG), the manufacturer of gypsum wallboard and other building materials. It is off 29% since I wrote about it, in response to the housing downturn. I think investors have overreacted. People still need its products to build and renovate homes and offices. USG shares trade at a 37% discount to my estimate of its intrinsic value.

So USG has been hit with other housing-related stocks. "When the paddy wagon comes, the good girls go to," as traders of another era used to put it. The issue at hand is whether its sales deriving from housing maintenance are sufficient to support the intrinsic value calculation. Any homeowner is aware that nature's primary directive is to reduce your house to compost and dust. The maintenance-related business will always be there. So what is USG's baseline exposure to that segment of the building industry?

I tend to be patient with winners as well as losers. Of the 18 recommendations I made last year (including holdovers), I continue to hold 17 of them. I sold Mattel when I became convinced that the toy industry's growth prospects were not as bright as I once believed.

Wall Street is obsessed with growth, yet has shown no particular ability to forecast it (or earnings in general) accurately. Value buyers are comfortable swimming in the lower-growth part of the pool. This is partly because such comparatively dull companies are overlooked and underfollowed by the Street, and therefore more likely to be cheap. And, slower growing companies have a better chance of generating excess cash flow -- cash beyond the growth and maintenance needs of the company (no new plants to build, inventory to finance, etc.). A company's value is at root the discounted value of estimated future cash flows. Growth buyers figure that if sales are growing fast enough now it will all work out in the end. Value buyers appreciate growth as much as the next guy, while also being extra-partial to seeing cash now. But make no mistake: One is always assuming something about future growth rates, explicitly in one's reasoning or not. The reason given for the disposal of Mattel -- a lowered projected growth rate -- is a useful reminder of this.


This older article was previously covered in Finance Digest, but since we are on a value investing discussion roll, and the author has an interesting and distinct perspective, we repeat it. Forbes columnist and newsletter publisher James Grant has been publishing Grant's Interest Rate Observer for over 20 years. He has cast a skeptical-bordering-on-jaundiced eye on the bubble-prone credit market from the beginning. But the very fact that he is a Forbes columnist tells you that he travels comfortably in mainstream financial circles -- which is useful as long as one does not get co-opted, and he has not. This particular article well evokes the challenges facing the value investor today.

The stock market is falling, or is it the sky? At this writing [apx. a week before Christmas] the answer is debatable. Treasury yields are collapsing, the price of gold is soaring and oil keeps closing in on $100 a barrel. The U.S. dollar is under siege, Fannie Mae and Freddie Mac are on the skids and the economy-stopping word "no" is on the lips of our formerly fearless lenders

Is anyone happy? Well, value investors ought to be. To their way of thinking bear markets are heaven-sent. Of all people, the disciples of Benjamin Graham and David L. Dodd understand the investment appeal of everyday low prices. They like it when stocks and bonds go on sale. They are the Wal-Mart shoppers of Wall Street.

Then, again, it is human beings we are talking about. Not even the purest seeker after investment value is likely to enter a bear market with nothing but cash in his jeans. Falling prices do, ordinarily, spell improving valuations. But they also mean mark-to-market loss on securities purchased at previous, bull-market prices. Besides, not every value investor is immune to the panic that washes over the market in a proper liquidation. The faint of heart are likely to conceive an ardent devotion to Treasury bills just when the bargain hunting gets good.

Which brings me to Graham's own experiences in the greatest bear market of modern times. The principal author of the value-seeker's bible, Security Analysis, first published in 1934, is properly celebrated for his brains. ... But it is his heart as much as his head that ought to inspire the bargain hunter.

On the eve of the 1929 Crash, Graham was managing what we, in the 21st century, would recognize as a hedge fund. He was long $2.5 million of stocks and bonds against which he was short the same amount. In addition, however, he had $4.5 million in outright long positions, and he had incurred substantial margin debt to own it. In his posthumously published reminiscences, Benjamin Graham: The Memoirs of the Dean of Wall Street (1996), the father of value investing described his state of mind this way: "We were convinced that all of our long positions were intrinsically worth their market price."

Discerning modern-day analysts such as Doug Noland, writer of the Credit Bubble Bulletin at PrudentBear.com would recognize the trap awaiting Graham in 1929. "Fundamental" value becomes a slippery concept when the financial economy tail gets big enough that it starts vigorously wagging the real economy dog to and fro. After a while the brain of the poor "dog" starts to hurt. The bottom line is that when sales and asset values are driven by and dependent upon expanding credit, what look like solid numbers turn out in retrospect to be built on castles of sand.

Recent example: During the dot-com boom, IPO companies with money in their pockets to burn bought network servers, telecommunications services, and other infrastructure type investments. Some, seeing at least some danger, chose to participate in the dot-com "revolution" by buying stocks of such apparently solid suppliers to dot-com companies, rather than those overvalued flakey dot-coms. Then the owners of these "solid" stocks saw sales fall off a cliff when all their dot-com customers ran out of money -- due to no profits and no more bubble-money infusions. Not surprisingly, the "fundamental value" of the suppliers fell as fast as their sales, and then some more as projected growth rates were reigned in.

So Graham, by heavily mortgaging himself, unwittingly transformed a conservative investment strategy into a risky one. Top to bottom, 1929-32, his fund was down by 70%, a better showing than the 87% drop in the Dow but a calamity still. The once and future investment genius sorely needed income. Where could he find it?

Why, at the offices of Forbes. Graham was a superb writer who had slummed in financial journalism in the 1920s. In his memoir he describes the "feeling of defeat and near-despair that almost overmastered me towards the end" -- the end, that is, of the washout. But he did not surrender to his own great depression. Near the very end of the decline he collected himself to lay out the case for common stocks. "Is American Business Worth More Dead Than Alive?" was the theme that ran through Graham's three-part Forbes series in late June and early July 1932. A third of all listed industrial stocks changed hands at less than the pro rata share of their companies' net current assets [current assets, i.e., cash, receivables, inventory, minus all liabilities], he pointed out. In other words the business value of those companies was being given away [for nothing] on the floor of the stock exchange.

When the market took flight in 1933, so did Graham, whose partnership that year earned more than 50%. Between 1929 and 1956 Graham, along with his partner, Gerald A. Newman, generated a compound annual return of 17%. Note that this sterling record incorporates the evil days of 1929-32.

Now then, what is on the equity bargain counter at what, today, is certainly not the bottom of a titanic bear market? Hutchison Telecommunications International (22, HTX), for one. The Hong Kong wireless company (it trades as an American Depositary Receipt) does a profitable international business but has been punished in the market for its February decision to auction off its money-spinning Indian subsidiary to Vodafone (VOD). Never mind that Hutchison got a tremendous price, no less than $860 per subscriber. The stigmatized seller, excluding its cash, is now valued at just $380 per subscriber. I estimate that Hutchison changes hands at a 37% discount to the sum of its conservatively valued parts.

I suppose that Graham, with the 1930s in mind, might not regard Hutchison as such an irresistible bargain. But -- at least -- it is an interesting relative value for these tumultuous times.

"Relative value" is a term that can cover up a lot of sins indeed. But on the face of it there is some absolute value here too. Except, if the value-per-subsciber -- a typical quick and dirty, and easily abused, way to value a subscriber-driven business -- is some bubble number, based off of what people with easy access to credit have been paying in the heat of momement, then the calculation might not be very robust. Such is the lot of the value buyer today: trying to be disciplined and rational, while conducting measurements using a yardstick made of rubber that has been stretched by some indeterminate amount.


Another Forbes columnist and money manager, Lisa W. Hess, shares her insights and projections, successes and failures:

Charles Dickens began his masterpiece about the French Revolution: "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness." Such a dichotomy would be a good way to describe last year's markets. Things went wonderfully if you owned stocks or bonds in emerging markets, badly if you owned U.S. financial stocks or anything related to housing.

The Jakarta index was up 52% in 2007 while the KBW Bank Index, a cap-weighted basket of U.S. domestic banks, fell 24%. Indian and Chinese shares continued their upward streaks (47% and 97%). If you bought shares in a domestic brokerage firm you were toast.

Shares of U.S. companies doing business abroad did well. Researchers at the International Strategy & Investment Group found that U.S. stocks with the highest foreign exposure (as measured by sales) advanced an average 16% in 2007; those with the lowest went down 2%. Analyst sentiment has picked up that pattern and now is extremely bullish for foreign-heavy S&P stocks and very bearish for the U.S.-centric ones.

Typical Wall Street behavior, jumping on a trend whole-heartedly well after it has been established. Join in haste, be prepared to repent at leisure (or perhaps haste). Foreign exposure is an indicator of non-U.S. dollar currency exposure, which obviously would have been helpful in 2007.

The big question for 2008 is whether that pattern will reverse. Right now it is hard to see any upsurge for stocks connected to the U.S. economy. Credit is hard to come by, and the ripple effects of the housing downturn have not yet been fully felt. The pessimism is so rampant that a big worry is what Wall Street calls "recoupling." That is shorthand for: "Will the sluggish U.S. economy drag down emerging markets?" I do not think that will happen because the growth momentum in nations like China is too strong.

Seemingly a difference of opinion with Ken Fisher above.

Contrarians argue that this is a great time to buy U.S. financial stocks. Nope. Too early. The financial sector is facing balance sheet weaknesses, illustrated by Morgan Stanley's $9.4 billion writedown, and dwindling income streams. Fees from leveraged lending? Poof. Trading profits from structured products? Gone. Mortgage origination? You must be kidding. There will be a terrific opportunity here sometime in 2008, but much later.

U.S. financial stocks look like potential "value traps" here, as discussed regarding newspaper stocks above. They look cheap, but there are probably more asset writeoffs, dividend cuts, and earnings disappointments to come. After a long bull market from 1990 to 2005-6, with concommitant excesses in industry behavior, it would be surprising if financial stocks were done with their correction after such a short time. That is just a guess, but, as Warren Buffett likes to say, you are standing at the plate with no umpire. You do not have to swing. Financial stocks are not an unambiguous fat pitch here.

As a result I look for investments in companies that can weather a U.S. economic slowdown, have good global exposure in their sales and sport robust balance sheets. Some such stocks have seen their prices fall because speculators, particularly those guided by quantitative research, dubbed them buyout bait. When the credit markets froze, and the debt for leveraged buyouts suddenly became scarce, those stocks suffered.

She likes Enpro Industries (30, NPO), maker of sealants, lubricants, compressor systems, vacuum pumps and diesel engines. Decent balance sheet, 42% of sales non-U.S., selling at 8 times cyclical earning, and the stock has fallen from $46 in mid-July, as LBO prospects evaporated. Worry-factors include a "contained" asbestos liability, management succession issues, and a recession. But half its sales are in spare parts, which are not cyclical.

For 2007 my 15 stock and 3 bond picks (after a 1% trading cost) lost 3.8%, versus a 1.3% gain for identically timed investments in the S&P 500.

My best suggestion was Itron (96, ITRI), which makes smart electric meters -- the kind that lets utilities give you a discount if you run your washing machine at night, when power is cheaper. ... Green-oriented companies are still in favor. I think you should keep holding this one.

My worst performer for last year was Corporación Geo (3, GEOB.MX), a Mexican home builder, which was a holdover from 2006. It fell 43%. I think you should stay with it, too. There remains a huge demand for housing south of the border. Geo has a sizable bank of vacant land to build upon. The only bad news: The company cut its forecast of revenue growth in 2007 from 17% to 20%, down to 14% to 16%, because of rain delays for construction in coastal areas. That is still double digits. Right now anything related to housing is cursed in the stock market. But the reasons for fleeing U.S. home builders do not apply here.

Clearly speculative, but an interesting offbeat idea.


The Coming Oil Price Decline

Oil prices have finally reached $100 a barrel. I now hear predictions of $200 a barrel. People who make forecasts like round numbers. I do not expect $200 oil any time soon. I expect $85 oil first, and $70 oil first, and $50 oil first.

I do not believe in doomsday scenarios that relate to the earth’s resources. There are phenomena in the universe that can end the earth or human life on it. They do not include running out of energy because we lack resources. ...

[A]lthough recession may trigger lower prices, it is not at all the reason for my forecast. I am stressing the standard free-market industry dynamic. Higher prices call forth greater supplies with a time lag. These supplies drive prices down, often to a surprising degree. Free markets work. ... It has happened before. I expect it to happen again.

I expect oil prices to decline in the coming months, perhaps between now and several years from now. I do not know if $100 is the top price or not. No one can forecast the exact top. It is foolhardy to try. But since I am forecasting price decline, I may as well spell out that implicitly this means that I expect further upside progress in the price of oil, if it occurs, to be labored, limited (say 10%), and short-lived. The next move of substantial magnitude that occupies a substantial amount of time I expect to be down.

A Great Junior Mining Opportunity

How much would you pay for an asset that promised an annual stream of positive cash flow in the $200-300 million range, possibly rising to $500 million in the third year of a 10-15-year time frame? ... It depends on how sure this stream of income is. If it were as sure as a U.S. government T-bond, the income would be worth an investment of over $4-6 billion at today's apparent 4% yield.

Mining assets are a little riskier, so investors demand a fatter return. For a typical mining asset that promises an income stream of this magnitude in a politically stable part of the world, and from a company with a track record in production, the market currently pays as much as 20 times its expected near-term cash flow, especially if it promises some growth. This valuation comes pretty close to the so-called risk-free rate of a T-bond, but it includes optimism for metal prices.

Today, I am going to tell you about a company with a claim to just such a future stream of income, with a market value less than two times its expected annual free cash flow (starting in 2010) and less than one time its long-term average annual cash flow -- thus implying a yield of something like 40%.

I am not going to tell you, however, that it is risk free. The implied yield says it all. However, I believe those risks can be calculated and are known and that the market is overstating them. ... If I am right, it means that this stock has the potential to be a ten-bagger from today's price.

A Canadian mining company in 2003 made one of the largest and richest discoveries of gold and base metals over the past decade. Nevsun Resources Ltd., which trades on the TSX and Amex under the symbol NSU ...

Classic Small-Cap Types

Today, we have a very special Sleuth. We were able to get an excerpt from Satya Dev Pradhuman's Small-Cap Dynamics: Insights, Analysis, and Models. Pradhuman is CEO of Cirrus Research and former director of small-cap research at Merrill Lynch. This book is the "essential handbook" for all small-cap investors -- small or large. In this excerpt, he discusses the three types of small-cap evolution, along with two classic examples ...

Small stock investments typically take one of three shapes. A rising star is a growth stock that evolves from a microcap to a megacap status, seemingly overnight. Another type of small stock is the fallen angel. Like Icarus, who, in Greek mythology, soared too close to the sun and fell because his wings melted, hyperactive growth can lead to disastrous missteps, which can cause a fall from grace. Small stocks that fall from the large-cap arena into the small or even the microcap world could be considered "damaged goods." The third path of a small stock can be like the rise of the phoenix from ashes. It is a resurgent fallen angel or a stock into which market participants have priced too much risk. All investors want to partake in the first and third stages and avoid at all costs, buying into a falling angel. At one time or another, all stocks fall into one, two, or even all three of these categories.