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

W.I.L. Finance Digest for Week of February 11, 2008

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

LOOK OUT BELOW

Son of Dr. Doom predicts a long, deep recession.

New York University economics professor Nouriel Roubini follows in the time-honored footsteps of Henry "Dr. Doom" Kaufman. If memory serves, Kaufman was predicting bond market Armageddon back in 1982 as the Latin American countries threatened to take down the American banking system. When Paul Volker did an about-face and started flooding the system with liquidity, and stocks and bonds instead took off, Kaufman, in what retrospectively occurs as an admirable display of flexibility, changed his mind and decided the day of reckoning had been deferred. Now, 25+ years later, Son of Dr. Doom says the postponed is no longer postponable.

It may be time to christen a new Dr. Doom. The candidate: Nouriel Roubini, an economist at New York University's business school. He makes the old Dr. Doom, bond pessimist Henry Kaufman, look like Dr. Phil. No mincer of words, Roubini thinks a full-blown panic will scorch the global economy. He recently laid out his scenario for central bankers in Davos and had them chewing it for hours.

He thinks the immediate spark will be the collapse of bond insurers (MBIA, Ambac, FGIC and others). These insurers have guaranteed $72 billion worth of collateralized debt obligations, now crumbling in value as housing prices fall.

Cheerier sages see an economy lifting off in the second half, fueled by the Fed's rate cuts, and a rebound in the shares of bond insurers. Roubini says lower rates will not help. There are significant risks of insolvency. Here is his prediction of how it will play out:

Bond Insurers Lose the Triple-A. At press time New York State was trying to arrange a capital infusion for the bond insurers. Roubini does not think it will work, and there is no Plan B -- yet. Lacking that, insurers will lose their gilt-edged rating. Then the banks (Merrill, Citi and others) that paid them for protection against default of their collateralized debt obligations will face more writedowns -- well beyond the $100 billion that has been written down already. Financial losses in subprime mortgages could be $400 billion and in the whole financial system more than $1 trillion. A big bank might go under.

Contagion Spreads. Writedowns will begin percolating up from subprime mortgages to near-prime and prime mortgages, commercial real estate, auto loans, credit cards, corporate buyout loans, corporate bonds and derivatives. If leveraged banks, brokers and hedge funds should suffer $200 billion in domestic credit losses, they would have to pull back on $2 trillion in lending, according to a Goldman Sachs analysis. Roubini says the rest of the world will "recouple" rather than decouple, as financial losses spread to other world capital markets, especially Europe. Sovereign wealth funds will not be large enough to play savior. Credit spreads will keep widening. Equities, housing, commodities, emerging market assets and the dollar will get hurt. "Cash is king in 2008," says Roubini.

A Protracted Recession Ensues. Roubini says the U.S. went into recession in December and will stay there for at least a year. We have got excess inventories of unsold goods (consumer durables, autos), a shopped-out consumer and a growing weakness in labor markets with no new jobs (net of losses) and no rise in real wages. Home prices, down 8% currently, could fall by 20% to 30% total before bottoming.

The Shadow Banking System Dies. Banks got hooked on off-balance-sheet entities like structured investment vehicles, which Roubini calls the "shadow banking system." But the shadow system has no access to the "lender of last resort" support of central banks. When the banks tire of bailing out their SIVs [Structure Investment Vehicles], holders of SIV paper will have losses.

ALL THE TROUBLE IN THE WORLD

Doug Casey sees Dr. Doom, Jr. and raises him.

Doug Casey probably thinks Nouriel Roubini (above) is a flaming optimist. Casey has been forecasting a "Greater Depression" for a long time now. Accompanying this, he believes that gold, and especially selected gold mining stocks, are "going to the moon." Not surprisingly, he sees no reason to alter his views on those possibilities now.

If you credit Austrian School economic theory, which I certainly do, you are forced to believe that the business cycle exists. The business cycle is driven largely by government intervention in the economy, in the form of taxes, regulation and, most importantly, currency inflation. These things give false signals to businesses and investors, which cause distortions in the market, and misallocations of capital. When, inevitably, the errors start to be corrected, the result is an economic downturn.

It will be called a "recession" if the government succeeds in preventing widespread bankruptcies and unemployment through one more dose of inflation. Or it will be called a "depression" if today's economic tempest slips out of the government's control. From a financial point of view, a depression is a period when the distortions of an inflationary boom are liquidated -- a mass die-off of the economically misbegotten. From an economic point of view, it is a period when the general standard of living decreases significantly.

The point is that the more highly taxed, regulated, and inflated an economy is, the more likely that it is eventually going to experience a real depression. Perversely, the more control a government has, the longer it can put off the day of reckoning. But the longer the artificial structure is propped up, the bigger the mess will be when it eventually collapses. From my point of view, what will happen next is almost written in stone. The only real question is: When?

In 1980-82 things almost did go over the edge. But the recession was serious enough, and some subsequent extraneous positive events (the collapse of the USSR, the coming of age of China and now India) were significant enough to pull things out.

One could write a book about the 1980-82 recession and subsequent recovery. To us, the salient feature of the recovery was the institution of the regime that has continued to this day and now shows signs of coming unglued: The rest of the world lends money to U.S. consumers and governments (the business sector can still self-fund in aggregate), who then buy lots of stuff. In other words, massive worldwide fiscal stimulus. Keynesian economic theory prescribes a post-recovery pay down of those debts assumed during a downturn, but -- surprise (not) -- the U.S. governments and consumers decided it was a lot more fun to keep spending in excess of their incomes during the recovery too. The Paul Volker monetary medicine, ca. 1979-82, was sufficiently strong, and the overinvestment in capital goods during the 1970s sufficiently large, that people convinced themselves that inflation was not a significant threat for a whole generation.

But now, more than a generation after the last serious crisis -- and four full generations after the Great Depression -- I think there are lots of reasons to be afraid. Very afraid.

Am I predicting the Greater Depression may be upon us? Let me preface my response with a disclaimer. I am not a fortuneteller. But my gut feel is: Yes. I am not going to mount all manner of statistics to buttress the assertion. My point here is to draw your attention to the fact that there is a lot that is likely to go wrong besides the central problem of the business cycle, a problem that is now evidenced in the collapsing housing sector and all the pain associated with that collapse.

The "other" problems now include the Forever War against Islam, Peak Oil, increasing political control over virtually all aspects of life, the potential for social unrest (within the U.S. Mexican community, for instance), the historically high level of foreign holdings of U.S. dollars, a rise in nationalism and protectionism, etc. While not always obvious, all of these things are related, so it is likely that when one of them starts running out of control, so will the others.

What will, in fact, happen? Nobody knows, including me. But I am quite afraid we are in for truly stormy weather in the next few years. Most people are not adequately, or even at all, aware of this prospect.

I suggest you stay with the approach we advise that has a foundation in gold and carefully selected gold stocks. As I am in for the long haul at this point, selling only reluctantly and when absolutely necessary to keep Caesar mollified or for portfolio rebalancing, I still view any weakness positively.

Making mid-stream adjustments to your portfolio based on these buying opportunities is important. Being bold when others are timid can make a big difference. In my opinion, gold is not just going through the roof in the next few years. It is going to the moon. And gold stocks are a leveraged way to capitalize on it.

THE DARK SIDE TO DEBT REDUCTION

This article's content is only obliquely related to the title, but the rumination of sorts nevertheless touches on a lot of ground.

Last Tuesday at approximately 10:35 p.m., 6-8 juveniles approached a man walking westbound on the north side of E. Madison here in Baltimore. One youngster displayed a knife and demanded money. Another pulled the victim's wallet from his rear pocket. The victim, a Johns Hopkins student, grabbed the wallet from the young intruder's hand. He then wisely acquiesced, handing over his cash ($40.00). The suspects, 6-8 males, between 8-15 years of age, wearing dark hoods and dark pants, promptly fled westbound. ...

[W]e read a few snippets from Saturday's New York Times that got us thinking. The Times reports that revolving debt -- the nasty little interest-bearing IOUs for which thank Visa, MasterCard and American Express -- reached a record high $943.5 billion in December. The annual growth rate of revolving debt keeps inching up as well, reaching 9.3% in the fourth quarter of 2007.

The Times also notes that the Federal Reserve found that roughly 4.34% of 100 largest bank's credit card portfolios were delinquent. For those counting, that is roughly $41 billion debt. But what is another $41 billion compared to the more than $135 billion in credit losses and write-downs banks worldwide have announced since the turmoil in the U.S. housing market started last year? According to David Jolly of the New York Times, some analysts estimate that total write-downs could reach $800 billion.

Meanwhile, bubble chasers continue itching for the next big thing. "Put this banking mess aside already," they clamor. "What's next?" The "next big thing" our friends at the Daily Reckoning opine, "will be downsizing, cutting back, making do. Barely on the radar screen now, thrift is coming into focus more clearly day by day. So far, people are a bit embarrassed about it ... a bit ashamed that they have had to cut back. But soon, it will be popular ... fashionable ... and finally, almost obligatory." ...

"Prices are rising in Europe as in America. Bread is up 12% in Germany over the last 12 months. Butter has gone up 45%. Milk 25%." Higher prices often stem from printing more dollars. "Force-feeding the rest of the world $2 billion a day (more consumption)," Warren Buffett reminded us last week, "is inconsistent with a stable dollar (more inflation)."

We share Mr. Buffet's concern. Bernanke keeps printing. Politicians keep promising. Bridges keep crumbling. Wars keep spending. We read this week that the projected total cost of Medical care for U.S. veterans of the Iraq and Afghanistan wars will top $500 billion, a figure on par with the total military spending to wage these wars to date.

And speaking of military might, Defense Secretary Robert Gates estimated in testimony before the Senate Armed Services Committee, the Pentagon will spend upwards of $685 billion next year alone ... $170 billion more than the $515 billion the president proposed in his first-ever $3 trillion budget. ... "I have no confidence in that figure," he admitted. You can expect the estimate to rise in the near future.

A hundred billion here ... a hundred billion there. Who's counting? Apparently, no one.

But that is not to say the S&P cannot weather the storm. The companies representing the S&Ps 500 Index now derive 49% of revenue from foreign markets, up from 30% in 2001. Meaning, those with money to burn (southeast Asian consumers) should keep earnings reports strong. Stronger repatriated currencies should only bolster this trend.

Large American companies' percentage of foreign revenues and earnings has been trending up for years. The weaker dollar makes foreign currency denominated profits that much higher absolutely and proportionally when translated back to dollars, no matter what the story is with unit sales. That makes those companies a hedge against continuing dollar weakness. Of course if the dollar fell to zero, 100% of sales would be foreign, but no one would be very happy.

Unfortunately, we tend to think many Americans believe strong a S&P equals a strong American economy. We tend to see another American economy. We see an economy riddled with debt, more debt and even more debt. We tend to see the American consumer eerily close to tapping out. 34% of Americans now believe they were among the "have-nots".

It serves to reason. More than 405,000 homeowners lost their homes to foreclosure last year. With no homes or credit cards, where will the SUV nation get its cash? Well, we are not so sure. China perhaps. But the Chinese seem reluctant. Maybe they are saving their Yuan to buy more oil. They too may have noted the Pentagon's preparation plans for $225 oil. In short, it seems to us that cutbacks are the only option.

With a stroke of the pen, as Roosevelt did in 1933 and Nixon did in 1971, the government can confiscate the currency and tear it to shreads. In either case, the thief, the politician and the banker are seemingly playing the same game. ... Whether they steal by the sword or steal by the pen, their craft effectively erodes the tangible wealth of the grad student walking home after a hard day's work.

Consequently, our hero is not left with many options. He can always study to become a legislator or a central banker. If that does not work, may we suggest dark hoods and dark pants?

MORE THAN 20 YEARS IN THE MAKING

Doug Noland's Credit Bubble Bulletin, hosted on PrudentBear.com, seldom fails to reward a reading. It provides an almost real-time tracking of the credit market, with an emphasis on those statistics and news items that highlight the the excesses, imbalances, and consequences of the "credit bubble". The weekly commentary is an education in itself.

In the January 25 Credit Bubble Bulletin, Nolan gives a history lesson on the slippery slope of Fed interventism which led to today's crisis. The critique is characteristically devastating, as it exposes not just the consequences of the interventionist policy -- which many people have been long aware and critical of -- but the tragically flawed nature of the mindset itself. It should also be added that this is no 20-20 hindsight appraisal. Nolan has been forecasting the current denouement, or something like it, for years.

It all began innocently enough: "The Federal Reserve, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the economic and financial system."

The newly appointed Federal Reserve chairman, Alan Greenspan, released this statement prior to the opening of market trading on Tuesday, October 20, 1987. The previous day, "Black Monday," the Dow Jones Industrial Average crashed 508 points, or 22.6%. All the major indices were down in the neighborhood of 20%, with S&P 500 futures ending the historic trading session down 29%.

The 1987 stock market crash was contemporary Wall Street finance's first serious market dislocation. Stock market speculation had been running rampant, at least partially fostered by newfangled hedging and "portfolio insurance" trading strategies. When a highly speculative market began to buckle, the forced selling of S&P futures contracts to hedge the rapidly escalating exposure to market insurance written ("dynamic trading") played an instrumental role in instigating illiquidity and a market panic.

Following "Black Monday," there was of course considerable media attention directed at the event's causes and consequences. Some believed at the time the stock market was discounting a severe economic downturn. Others recognized the reality that the situation had little to do with underlying economic forces. The economy was in the midst of a robust economic expansion, while credit was flowing (too) freely. Immediately post-crash, however, the financial system was extremely vulnerable and the Greenspan Fed acted decisively to ensure the marketplace understood clearly that the Federal Reserve was a willing and able liquidity provider.

Credit then really (emphasis added) began to flow. Greenspan's assurances came at a critical juncture for the fledging Wall Street securitization marketplace -- for Michael Milken, Drexel Burnham and the junk bond market; for private equity, hostile takeovers and the leveraged buyout boom; for the fraudulent S&L industry and for many banks' commercial lending operations. While it sounds a little silly after what we have witnessed since, there was a time when the '80s were known as the "decade of greed."

When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated a historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system credit growth, and fight economic headwinds, the Greenspan Fed was more than content to [render] outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back -- not for a second.

In the guise of "free markets," the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy's speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling ... alluring ... seductive story.

Greenspan and allies used free market rhetoric extremely disingenuously to justify not interfering with the growing bubble of credit and speculation. The Fed itself is, of course, the antithesis of a free market organization in that attempts to central plan the whole credit market. It does so about as effectively as the Soviet Union's politburo ran that country/empire's economy, but no matter. Free markets will get the blame for the collapse. The proposed cure will be more central planning of one sort or other.

But, as they say, "there's always a catch". In order for New Age Finance to work, the Fed had to make a seemingly simple -- yet outrageously dangerous -- promise of "liquid and continuous" markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative "insurance" -- accommodating the markets' expanding appetite for hedging -- required liquid markets whereby they could short securities to hedge their risk, as necessary.

There were numerous debacles that should have alerted policymakers to some of New Age Finance's inherent flaws (1994's bond rout, Orange County, Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron, to name a few). Yet the bottom line was that the combination of the Fed's flexibility to aggressively cut rates on demand; ballooning GSE [Fannie, Freddie et al] balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world's reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble -- through thick and thin.

Despite his (inflationist) academic leanings and some regrettable ("Helicopter Ben") speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more "rules based" policy approach of setting rates through some flexible "inflation targeting" regime, while ending Greenspan's penchant for kowtowing to the markets.

Today, it all seems hopelessly naive. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never -- I repeat, never -- have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.

The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their "risk management" approach. Repeatedly, monetary policymaking was dictated by the Fed's focus on what it considered the possibility of adverse consequences from relatively low probability ("tail") developments in the credit system and real economy. In other words, if the markets ... were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through "activist" monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative -- "coin in the fuse box" -- policy approach is disastrous in bubble environments.

The Fed's complete misconception of the true nature of contemporary "inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary -- and greatly unappreciated -- risks were part and parcel to the perpetuation of dangerous credit bubble dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater bubble-related distortions and fragilities -- deeper structural impairment to both the financial system and real economy. In the end, the Fed's focus on mitigating "tail" risk guaranteed a much more certain and problematic "tail" ... a rather fat one at that.

Fundamentally, the Greenspan/Bernanke "doctrine" totally misconstrued the various risks inherent in their strategy of disregarding bubbles as they expanded -- choosing instead the aggressive implementation of post-bubble "mopping up" measures as necessary. ... "Mopping up" the technology bubble created a greatly more precarious mortgage finance bubble. Aggressively "mopping up" after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed's previously most potent reflationary mechanism -- Wall Street-backed finance -- is today largely inoperable.

I am not going to jump on the criticism bandwagon and excoriate Dr. Bernanke for his panicked 75 basis point inter-meeting rate cut. From my vantage point, the "wheels were coming off" and I would expect nothing less from our increasingly impotent central bank. Yet it is silly to blame today's mess on recent indecisiveness. The Fed has not been "behind the curve," unless one is referring to the "learning curve". The unfolding financial and economic crisis has been more than 20 years in the making. It is a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For 20 years now the Fed has basically done everything that Wall Street requested and more.

It is also as ironic as it was predictable that Alan Greenspan -- Ayn Rand "disciple" and free-market ideologue -- championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our nation's financial and economic affairs since the New Deal. Articles berating contemporary capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying credit system.

Promoting sustainable free-market capitalism requires a hands-off approach to things. If there is anything the political class loves it is putting their hands on everything. Of course, they love having the goodies the free market produces so they can redistribute them, hence there is some push-pull on interventionism. Whether that abstract knowledge provides much of a counterbalance to the systemic imperative to do something when things heat up is another matter.

And, speaking of the credit system, some brief market comments are in order. ... [S]ome important credit spreads have diverged markedly, most notably many corporate, junk and commercial MBS spreads have widened as dollar swap spreads have narrowed. The spectacular Treasury melt-up must also be causing havoc for various strategies, ditto the recently strong yen and Swiss franc.

I will stick with the view that an unfolding breakdown in various trading models and hedging strategies is at risk of precipitating a crisis of confidence for the leveraged speculating community. ... There is, unfortunately, little prospect for markets to calm down anytime soon. There is no quick or easy fix to any of the myriad current problems -- seized up securitization markets, sinking housing prices, faltering bond insurers, counterparty issues, a crisis in confidence for "Wall Street finance", or acute economic vulnerability -- to name only the most obvious. Again, they have been more than 20 years in the making.

In the classic film Chinatown, Jack Nicholson's tough-guy detective character is warned that when it comes to interfering in the affairs of Los Angeles's Chinatown, he should do "as little as possible." At the end of the movie (spoiler alert), having watched his attempts to do his version of the right thing result in total catastrophe, you see him being led away in a glazed stupor, muttering "as little as possible" under his breath. The movie should be required viewing for all Federal Reserve board member candidates. If he or she does not get the point, then on the next candidate.


1998 REDUX, SAYS KEN FISHER

The worrywarts are overdoing it.

Whenever Nouriel Roubini, Doug Casey (above), or their fellow doom-casters dissertate on how things are headed down the tubes, Kenneth Fisher is reliable for delivering a prescription-level dose of chill pills. One could argue that the Federal Reserve's ability to keep the great credit inflation going has been the wind at Fisher's back for time virtually immemorial now. And if and until the Fed falters in this respect, he will probably keep being right. Until he isn't. The current credit crunch, weak dollar, etc.? Basically a tempest in a teapot, says Fisher. As with other post-1982 scares, he sees the fat being pulled out of the fire again.

The worrywarts seek a parallel to today's market and think they see it in 1930: credit crunch, rising unemployment, financial institutions in trouble. So we must be in for a ferocious bear market. I seek a parallel and find it only 10 years ago. And that makes me bullish.

Early 1998 saw financial crises eerily similar to today's and a lot of hand-wringing about institutions collapsing and setting off a domino chain of other collapses. But guess what? The S&P 500 was up 28% that year. Early January 1998 saw stocks implode on news of the late-stage aftermath of the so-called Asian Contagion. Currencies and then debt markets started disintegrating in Asia, and that should supposedly have brought the world economy down. The parallel today is the American subprime contagion.

Back then the dollar was strong, U.S. stocks led foreign, and technology led on the upside and the downside. Now it is a weak dollar, foreign stocks lead and emerging markets dominate instead of tech. This year January started rough. So what? Despite folklore, history shows January market movements foretell nothing about the rest of the year.

In early 1997 this column started saying that all you needed to beat the S&P 500 was to own any half of its very largest stocks. That worked for 30 months. My definition of large was a stock whose market capitalization was greater than the weighted average of the index. ... Then, the weighted average market cap of the 500 stocks was $55 billion, and 30 stocks topped that, ranging from General Electric down to Bell South. In 1998 these 30 stocks climbed an average 39%.

Nowadays my hunting ground is the whole world, where there are 24,000 stocks to choose from. The weighted average market cap of the MSCI World Index is $81 billion. In one of the stranger coincidences in finance there happen to be 81 companies whose market caps exceed that $81 billion figure. This is where you should concentrate your money. After all, we just started the final leg of a 7- or 8-year bull market (beginning in late 2002), and final legs of bull markets are dominated by big stocks.

If he is wrong about the bull market leg, at least big stocks are a relatively safer place to be.

In 1997 credit spreads had started widening as everyone feared Asia's finances and its low-quality debt. The result was that the biggest, safest firms were disproportionately allocated credit and lower-quality borrowers were cut off. We are seeing a replay now. Last summer junk borrowers were squeezed out of the market, especially the commercial paper market. General Electric and ExxonMobil can borrow all they want.

With big stocks continuing strong and weak ones getting squeezed we could see a bifurcated market in 2008. Do not be surprised if the biggest stocks do well while indexes of small stocks like the Russell 2000 do badly. This contrast will drive technical analysts nuts because they are trained to hate markets where there are more decliners than gainers. Ignore the technical analysts. Here are five huge, good stocks.

Among is recommendations are France's Sanofi-Aventis (40, SNY) at 12 times 2008 earnings, Japan's NTT Docomo (16, DCM) at 1.6 times annual revenue and 14 times likely earnings for the fiscal year ending March 2008, Chevron (84, CVX) at 9 times trailing earnings and a 2.7% dividend yield, PepsiCo (68, PEP) with "stable growth at marketlike valuations", and IBM (107, IBM) at 12 times expected 2008 earnings and 1.6 times sales.


JAMES GRANT’S VALEDICTORY

The good, the bad and the funny.

James Grant, editor of Grant's Interest Rate Observer, is apparently "graduating" from the "school" of Forbes financial columnists. Those who appreciate his wit and wisdom will have to now seek it in other forums.

Columns, like plays, open only to close, and this one now steals into the night. Reviewing its 7-year run, I see the good, the bad and the funny. I also see an authorial face that is slightly less presentable today than it was when the first columnar mug shot was snapped. For much of this weathering of appearance, I blame Mr. Market.

"Yes, But," the motto over these essays, describes the author's skeptical mental equipment. A skeptic is who I am, though my readers and I would be a little richer if, on occasion, I doubted less and trusted more. Skepticism was not the most profitable state of mind to exhibit, for example, when the stock market averages hit bottom five years ago. In the "Yes, But" installment dated December 23, 2002 I unhelpfully argued that the market was more expensive than it looked, that the excesses of the late 1990s had not been fully wrung out and that caution was needed.

Something like reckless abandon would have stood an investor in better stead. Dividends included, the S&P 500 climbed by 105% from the 2002 low to the 2007 high. However, I believe I am beginning to catch on to the facts of financial life. If, as the American essayist John Jay Chapman wrote, "Youth is properly dedicated to error," middle age is the time for wisdom.

Anyway, I understand now, as I did not in my youthful days of certitude, that the financial future is a closed book, that prophecy is usually profitless and that the best an investor can generally hope to do is to identify extremes of sentiment and valuation as they periodically present themselves.

Just how few members of the 2007 class of The Forbes 400 made their money by guessing about tomorrow is a fact to ponder. What we should all seek out is the rare opportunity, not the common forecast, as fetchingly precise as such predictions often are made to appear.

Not that timely moneymaking opportunities are so easy to spot. Was an investment in Chinese currency such a brilliant gambit when I presented it in this space on October 13, 2003? Lashed to the dollar in those days, Chinese scrip has only lately begun to deliver a decent, if unspectacular, return to the dollar-holding speculator, up 7% in 2007. A fine idea, that one, except for the little matter of timing.

Then again, only a few truly superb moneymaking ideas are required to deliver the man or woman of moderate habits from the toils of a 9-to-5 job. If the readers of "Yes, But" still have to work for a living, they must not have been attending to columns on -- to pick an example -- my old friend gold bullion.

"All That Glitters" was the headline over the December 25, 2000 essay featuring a frustrated John Hathaway, portfolio manager of Tocqueville Gold Fund, whose share price languished near $11 as the world persisted in putting its monetary faith in the person of Alan Greenspan. The developing bear market in high-tech stocks, the contested American presidential election and the growth in the U.S. current account deficit had failed to excite the barbarous relic. "It grates on Hathaway," it said here seven years ago, "that he anticipated many of these problems, each a candidate to promote a rise in the demand for a monetary asset not created by a political act of the U.S. government. But his forecasts have availed him nothing so far except to be a gold fund too small to be listed in the mutual fund tables of the Wall Street Journal." Since then, gold's price has vaulted to $920 an ounce from $274 and the price of a share of the Tocqueville Fund to $51.60 from $11.25. In the October 15, 2007 issue I suggested anew that you buy it.

Of my six suggestions in 2007, it was the very same Tocqueville Gold Fund (52, TGLDX) that brought up the rear, but the reverse was only temporary. Its total return last year was 12.4%. My best pick was UltraShort Real Estate (106, SRS), prospering off the real estate rout. Overall, after slicing off a phantom 1% commission, my sextet was up 0.7% for the year. Identical amounts invested in the S&P 500 lost 1.6%.

How am I investing my own untold wealth? In a confection of long-short equity hedge funds (no bonds), in gold and in Japanese stocks, chronically cheap but cheaper than ever in 2008. In fact, Japan has produced a previously unknown class of investment bargain, the globally competitive cigar butt. Hi-Lex (trading at the equivalent of $12, ticker number 7279), a geographically diversified and technologically accomplished maker of automotive cables, is one such specimen. Revenues in the past five years are up 8.7% per annum. Yet it trades at not much more than the sum of its net current assets. Available on the Osaka exchange, Hi-Lex stock is off 37% from its 52-week high. Are there warts? Yes, but ...

THE MOTHER OF ALL BUBBLES

Why do suckers continue to line up to buy certificates of guaranteed confiscation?

Peter Schiff believes the U.S. Treasury market, with its 4.5% yields on 30-year bonds, to be "the mother of all bubbles."

In contrast to the dismal forecasting record of mainstream economists over the last few years, the forecasts that I have made regarding the dollar, oil, commodities, precious metals, global stock markets, inflation, and the U.S. economy have all come to pass. In addition, unlike the top economic oracles on Wall Street and in Washington, I can also point to similar accuracy in predicting the bursting of growing bubbles, first with technology in the late 1990s, and more recently with real estate. However, my long-standing prediction about the fate of the bond market has fared much worse. I still do believe this prediction was not wrong, but simply premature.

For years I have predicted that the falling dollar, persistent trade deficit, and the lack of domestic savings would combine to send long-term interest rates sharply higher. The effects of these fundamental drivers would undermine the Fed's efforts to lower short-term rates and compound the problems for the housing market and the U.S. economy. Yet as of today, the yield on the 30-year T-bond still stands below 4.5%, within 40 basis points of a generational low. Either this is the one piece of the puzzle that I somehow got wrong, or other factors are working to temporarily confound fundamental economics and prop up the bond market. As you might imagine, I am confident that it is the latter and consider the U.S. Treasury market to be the mother of all bubbles.

I have often said that the only thing worse than holding U.S. dollars is holding promises to be paid U.S. dollars at some distant point in the future. However, this is precisely what U.S. Treasuries represent. Given all of the inflation that already exists, and all of the additional inflation likely to be created over that time period, why would anyone pay par value for the right to receive $1,000 in 30 years in exchange for a mere 4.5% coupon? Although it looks like the sucker bet of the century, the fools have been lining up to buy. Alan Greeenspan called this a "conundrum". I simply call it mass delusion of the same variety that brought us pets.com, and $800,000 tract homes in the middle of the California desert.

Just like dot coms or real estate, today's bond prices reflect a fantasy world. In this "Bizarro" reality, the dollar will remain strong, inflation will stay low, economic strength will persist uninterrupted, and Fed policy will be predominantly hawkish for the foreseeable future. But when the fog finally lifts, and investors come to grips with a sagging dollar, recession, gaping budget and current account deficits, and the most accommodative Fed imaginable, bond prices will collapse, sending long-term interest rates skyrocketing higher. Unfortunately, for investors who hitched their wagons to benign government CPI statistics and ignored real world evidence of inflation [rapid money supply growth, surging gold, oil and other commodity prices (wheat and soy beans prices catapulted to record highs this week), the sinking dollar, and actual increases in consumer prices,] the losses will be excruciatingly real.

It is important to remember that for every borrower there has to be a lender. For example, if a homeowner wants to refinance his mortgage, there must be someone willing to loan him the money. Practically everyone on Wall Street is hailing the Fedís recent rate cuts because they believe it will allow strapped ARM holders to refinance into more affordable mortgages. However, while low rates are great for borrowers, they are lousy for lenders. Why would anyone want to offer a 30-year mortgage at an artificially depressed interest rate? As soon as the Fed raises rates again, as it clearly intends to do once the crisis ends, all that low yielding mortgage paper will collapse in value. Lenders can surely figure this out and will therefore refuse to volunteer to be the patsy in this plan.

Eventually, the world's lenders will reach similar conclusions with respect to U.S. Treasuries. No matter how low the Fed funds or discount rates get, private savers around the world will simply refuse to lend given the inherent risks and paltry returns. At some point the sheer absurdity of holding long-term, low-yielding receipts for future payments of depreciating U.S. dollars will be apparent to all. After all, it was not too long ago that investors thought holding subprime mortgages from financially strapped borrowers who could not possibly repay them was also a great idea -- so great in fact that many leveraged themselves to the hilt to buy them. Judging from the extremely poor demand at this week's $9 billion auction of 30-year Treasury bonds, the day of reckoning may not be too far off.

For now there are a host of factors temporarily propping up the Treasury bond market, such as unrealistically sanguine inflation expectations, foreign central bank and hedge fund buying, short covering, credit spreads, problems in the mortgage market, recession fears, and flight to what is falsely perceived to represent the ultimately in safety and quality. When these props give way, look out below! As we have learned from previous bubbles they can inflate for a long time before they burst. As this one has been inflating longer then most it has amassed quite a bit of air. When it ultimately finds its pin the popping sound will be deafening.

There may well be other reasons that people are buying T-bonds, at least for now, such as a "rush to quality" with so many other bond-like instruments having lost their credibility. Or "the market" may be forecasting that, contra Schiff, the the credit boom and collapse will resolve in dollar deflation, in which case T-bonds will turn out to be a good choice of investments. This may seem unlikely, but it never pays to get too confident about how you in your infinite wisdom are right and the market is wrong. Even if you are ultimately vindicated, the market can stay irrational longer than you can stay solvent (John Maynard Keynes).


DEBT FIRE SALE IS IMMINENT

Holders of debt instruments whose value has fallen precipitously, or where there never was a legitimate market in the first place and valuations were notional, have been pursuing various reality evading or bailout measures of late. The time-honored approach is still to hold on to the asset and hope its price recovers. The "rescue" packages proposed to keep the insurers of many of the questionable debt instruments solvent is a back door attempt to bail out the insured debt. Now holders of the questionable debt are starting to come to terms with their losses and throwing in the towel. They are selling it to vulture investors who are willing to speculate on the residual value of the assets.

We see this is a largely favorable development. Once markets are clear what the situation is, they are good at adapting. The cleanup can begin. When things are in a state of suspended animation the adjustment mechanisms are thwarted. With reported bids of 5 to 20 cents on the dollar, however, there will obviously be a lot of cleaning up to do.

Holders of funky, hard-to-value mortgage paper are starting to wave the white flag and unload bundles of debt once worth billions of dollars into the secondary market at a fraction of their original values. Banks such as Citigroup, Merrill Lynch and UBS have taken hundreds of billions of dollars in writedowns after being the most active originators of so-called collateralized debt obligations (CDOs) and asset-backed securities (ABS) that have plunged in value and caused a general seizing-up in the market.

But widening worries about the credit market, a series of downgrades by ratings agencies and a growing sense that it might be time to give up the ghost of a return in value in these securities are helping to drive some auctions by financial institutions, say debt traders. Traders say a few smaller, one-off sales have hit the market since the markets froze in July. But more liquidations are expected soon, as other sellers finally unwind their troubled CDO and ABS portfolios. CDOs are comprised of debt, including home mortgages and student loans, originated by investment bank affiliates, repackaged into securities and structured into bonds tiered by their credit ratings.

Over the next few days, traders of CDO securities expect to see debt once worth approximately $1.8 billion hit the markets. Bids on the individual debt components likely will be sold for values equivalent to 5 cents to 20 cents on the dollar or less. "Sellers are saying, 'I don't care if we make money on this, I just want to finally reduce my exposures,'" one hedge fund trader told TheStreet.com. ...

Two ... lists of securities, including one known as Diogenes III managed by an arm of State Street, are expected to take offers next week, one trader notes. The State Street Global Advisors-managed deal is a $750-million triple-B-rated list, which was originally underwritten by Deutsche Bank and consists of long positions in cash or synthetic, primarily subprime residential mortgage-backed securities and synthetic short positions. Those securities reference primarily housing-sector related single-name corporate entities. Deutsche underwrote a series of similar Diogenes debt over the past year and a half.

Ratings agencies, including Moody's Investors Service and Standard & Poor's, have been aggressively downgrading asset-backed paper and CDOs due to a belief that the deterioration in the housing market may be more severe than the agencies had predicted. Those downgrades coupled with the downgrades of some monoline bond insurers are causing increased uncertainty about how long pain in the credit markets may lasts. ...

Buyers of CDO paper are willing to take a chance at investing in the troubled paper because deals even at zero are valuable, assuming they do not default, because they pay a coupon. One trader speculated that at a price in the ballpark of about 15 cents on the dollar, a buyer could fetch an attractive 20% yield on some of the paper being trading and another 20% if the debt reaches maturity.

BULL MARKET INSTRUMENTS NOW MULTIPLY STRENGTH OF DECLINE

Here is a followup to last week's journal entry, The Rise of the Mortgage "Walkers".

When bubbles burst, they invariably unleash a negative social response against the most aggressive and successful exploiters of the preceding advance. ~~ The Elliott Wave Financial Forecast, September 2006

One of the things we have been touched on in various passages of The Elliott Wave Financial Forecast is the unexpected ways in which things get turned on their head in a bear market. In the latest issue, for instance, EWFF covers credit-default swaps. On the way up, they performed wonderfully for bond holders and companies alike because they allowed bondholders to protect against downside risk without actually selling a given companies bonds. This kept the corporate bond market percolating as even borderline businesses plans were able to attract capital. This was great for the economy as it kept even the most marginal enterprise humming along -- at least until the trend changed. Now that everything is headed the other way, trillions and trillions in swaps have been issued. In fact, the swaps are worth way more than the bonds that they are derived from. So much more that faltering companies will be worth more to financial participants dead than alive. This means workout plans and loans in which companies survives by restructuring debts will be a thing of the past for many firms.

The walk-away response to falling home prices is another shocker, nobody thought twice about it when home prices were rising. Jim Bianco of Bianco Research says financial participants have yet to fully grasp this dynamic:

"Refusing to pay a mortgage when one has the ability to do it, because home prices are falling, is a real trend. We believe it is being fueled by the large body of borrower-friendly foreclosure laws set up over several decades. In other words, homeowners used to 'beg borrow and steal' because they thought home prices only went up. So, greed drove them to do whatever was necessary to pay their mortgage in order to hold onto their home. Now that they have little-to-no equity and do not believe home prices are going to rise anytime soon, they are walking."

Here is an excert from a 60 Minutes interview that illustrates the homeowners emerging belief that they do not have to pay their mortgages because house prices are supposed go up:

Stephanie Valdez: Why pay a $3,200 payment on a 1200-square-foot home? It makes no sense.

Steve Kroft: That's what you agreed to do when you bought the house.

Stephanie Valdez: Fine. If the value is going up. But we're not going anywhere. The price or the value is going down. It makes no sense because we will never be able to refinance and get a lower payment. There's no way. ...

The pure economic calculus of the walkaway is accompanied by a sense of entitlement.


WHAT IS GOLD WORTH?

As the author indicates, the answer is anyone's guess.

Gold critics often say that the shiny yellow metal has few industrial uses, compared with, say, silver or copper. That happens to be what we call a half truth. It is also beside the point. It is usually lamented by bears refusing to accept the market's valuation of gold.

The whole truth is that gold has very few industrial uses at current prices. Gold is worth about 55 times silver and more than 3,000 times copper per unit of comparable weight. If it were as cheap as copper, we would have wired our houses with it, as well as the Internet. If it were even cheaper, you would probably be sitting on it in the bathroom, as that Commie Lenin advocated.

We do not use gold in more common applications because of its finer qualities: relative scarcity, our vanity, to name just a few. And the bulk of gold's value is still monetary, a fact that its enemies are loath to admit. Consequently, changes in the price of gold tend to reflect mainly changing monetary factors.

Gold bugs cannot ignore the market's judgment, either. They must acknowledge that the monetary demand for gold had in fact ebbed during the 1980s and 1990s in favor of the dollar standard -- a standard launched by default in the early 1970s. The waning view of gold as money helps explain why gold did not keep up with the Consumer Price Index (CPI) through the '80s and '90s, despite the 3-fold increase in narrow money (M1) and the 5-fold increase in broad money (MZM). The bears claim this poor record shows just how bad an inflation hedge it is. But their time horizon is both short and selective.

I will give the bears credit for identifying the drop in the monetary demand for gold as the reason it lagged the CPI in the '80s and '90s. But they are hopelessly naive if they believe that the 35-year-old dollar standard is an evolution in the monetary system, as if it were progress. Gold served as the market's solution for money for thousands of years.

The government forced the dollar onto the U.S. producer by legal tender and other laws. It forced the dollar onto trading partners by extortion. These partners were already drowning in dollars no longer backed by gold. They had to choose between letting the whole system fall apart and using the new "dollar standard" to their advantage. America had the largest and most developed consumer market in the world at that time, and they all wanted in.

Fast-forward to today: After a couple of decades of experimenting with this system, it is no longer working to anyone's satisfaction. In order to maintain their trade advantage, America's trading partners have to inflate at an ever faster pace (than the Fed) and soak up increasing quantities of dollars. This scheme always was untenable, but now it is falling apart. There is even talk of the need for a new global reserve currency.

So far, the media spotlight has been on the euro as contender, but the media will see that is untenable too. Gold is really the only alternative to the dollar. But that is a lesson the gold bull market has yet to teach. Let me know when you can use the euro on the streets of Bombay or in a Wal-Mart in California as easily as you can use the U.S. dollar, or at least when the price of gold stops outperforming the euro. Then I might consider taking it seriously. Meanwhile, we are likely heading back to where this story left off in 1980.

Before I delve into a rudimentary analysis and probably futile attempt to value gold, let me admit that I do not know how high it is going to go. No one really does. We are all just guessing. A bull market in gold basically means that gold's monetary allure is on the rise. That is, market participants are beginning to prefer it again -- either as a hedge against inflation (investment), a measure of monetary value, a means of international settlement, a monetary reference point, or even as a genuine medium. These reasons all constitute what I mean by "monetary demand."

Of course, no such thing as a bull or bear market in gold would exist if gold were already money, because the total demand for money does not fluctuate very much. On the other hand, the total demand for a particular kind of money may. The bull market in gold is a byproduct of the decline of the dollar standard. Not surprisingly, it is outperforming the CPI again.

If the CPI were an accurate measure of changes in the value of money, and the monetary demand for gold were constant, the CPI-adjusted gold price might represent some notion of fair value for gold prices. But the CPI is anything but a reliable measure of change in money values. Chances are it understates this problem.

Is a Gold Correction Coming? I have been forecasting "Gold: $2,000-2,650" for many years now. My early forecasts, back in 1999 and 2000, called for a straight-up move to $2,000 per ounce. That forecast overestimated the willingness of investors to grasp the gold story and underestimated their addiction to the prevailing monetary policy, and I scrapped it in 2001 in favor of a more drawn-out affair.

I adopted the view that this bull market would last 10-15 years and include 2-3 sequences. We are now on year 7 of the current advance -- the first primary sequence. There is little doubt in my mind that the dollar standard is on its way out and that the monetary demand for gold will return to the levels of the late '70s. But the exact prognosis is anyone's guess.

As a trader, I can tell you that nothing goes straight up. The market tends to change the rules just when most people have become accustomed to a particular set. Hence, every bull market contains surprisingly violent corrections. These corrections convince many latecomers that the bull market has ended.

None of the corrections we have seen in gold during the past 7 years qualify as this type of correction. The rise in gold prices to this point has been steady and sustainable. For much of its rise, gold has been in a stealth bull market. But the gold price advance is no longer stealth. It is not as spectacular as oil's advance or some of the base metals' advance in 2006, yet. But the chart says it wants to go parabolic.

That is the good news. The bad news is that such moves bring in weak hands, which set the stage for a big correction. Remember this whether you want to trade the trends or buy and hold.

Lowered Interest Rates Bring Higher Gold

The $64k question is at what point do the central bankers decide that the risk of hyperinflation outweighs to risk of depression. Do they even consider hyperinflation a risk? It would seem that hyperinflation would put the bankers out of their cushy jobs, but who knows what or how they think.

In December, the gold price raced off to record highs for the first time in almost three decades. Now it looks to be closing in on 1,000 U.S. bucks. ... It will also be four times the 1999 low.

The market has added dollars to the gold price for seven consecutive years now, making it the longest-lasting such stretch in history without more than a 25% correction. [The 2006 correction was over 20%.] Even in terms of magnitude, it is the best move since 1979-80. This suggests two things right off the bat. First, it is a bull market; second, the market needs to blow off more upside if it is to give the bears anything more than 25%. (Although, this latter idea does rest on a few other premises.)

John Kaiser of the Kaiser Bottom-Fishing Report believes the market is nearing a flashpoint where the skeptical public finally turns into believers and comes rushing in. It is pure mathematics from his point of view. He reasons forecasts for gold $2,000 are more plausible now that it is but "a mere double"!

It may be a little early to say that gold bugs have been proven right. Undoubtedly, it is getting tougher for the bears to argue that they have been wrong. But what exactly might they be right about?

The market has once again started looking at gold as money, rather than as a mere commodity. The following excerpt from the January 8 Financial Times article, "Gold Is the New Global Currency," highlights this increasingly frequent theme in the leading financial papers:
Gold's rise shows investors are nervous. That is an important message for central banks contemplating interest rate cuts. The Fed must show it is not prepared to allow inflation to take off. Keynes called gold a barbarous relic. It has life left in it. But it is in the interests of business and consumers that its most bullish fans are proved wrong.
I like this quote because it highlights two important and typical contrasting insights. The [third] sentence reveals the most important rule that the Fed and its peer central bankers are breaking, which is one of the main factors driving gold prices higher today. The [last] underlined sentence reminds gold bugs that their clairvoyance is unwelcome and unhelpful, just in case they feel any vindication in others' misery. This will continue. As legendary broadcaster Ed Murrow once said, "Most truths are so naked that people feel sorry for them and cover them up." This is one of those. But that will not make it go away.

The fact that getting rid of a dishonest monetary regime might cause depression is a bad reason to stick with a system that promotes that injustice in the long term. But if central bankers want to preserve such a system, above all, they must avoid prompting too many headlines like these: One of the mainstream criticisms of the Bernanke Fed is that it should have lowered interest rates sooner and more aggressively. One reason it did not was because Bernanke had tried to fight the spreading of the idea that the Fed was going to continue inflating. But that resolve is now buckling under peer pressure. We are probably not yet at the inflection point where the public has become convinced the Fed will inflate endlessly, but recent actions are not helping to discourage this expectation.

So prices will continue to rise, eventually resulting in unemployment and some sort of depression. The pundits will call it stagflation. If the Federal Reserve fails to heed the aforementioned rule by then, it will lead to hyperinflation, or worse. So far, there is no reason to believe that it plans to abandon the inflationary policy.

What with squadrons of central bank choppers swarming like locusts over the major cities on both sides of the Atlantic, hurling bank notes into the thinning air as gold, oil and wheat prices charge to record highs, it would seem rather that central bankers believe money should be able to grow on trees.

Central bankers continue refusing to accept the idea that the cause of these crises is their very own inflation. In a recent interview I read, an old partner of Milton Friedman's, Anna Schwartz [see link], was the first of her kind to point out that Greenspan was responsible for the current crisis by keeping rates down too long. But she said that mistake is behind us now and the current Fed should step up to the plate and inflate like mad in order to prevent making the mistakes of the 1930s Fed.

This brings to mind Talleyrand's oft-cited quote about the thick-skulled French Bourbon kings: "They forget nothing. They learn nothing." It certainly fits central bankers to a T.

What were those mistakes? Apparently, Washington and the moral ethics of Fed officials prevented the Fed from inflating after the 1929 stock market crash. This thinking is a prerequisite for central bankers. They ignore the fact that the ultimate cause of these crises is the intervention required to manipulate interest rates. That is, inflation.

Until they change their thinking (they probably will not), and while the pool of skeptics about this evil remains large, gold has nowhere to go but up. We will continue to have booms and busts and crises, and price and interest rate spikes, and wars, and so on as long as paper money backed by nothing remains the motive power of the world economy. Thus is the general message of gold bugs. Don't shoot the messenger ...

THE POTENTIAL FOR COTTON FUTURES

Commodities boomed during the 1970s great inflation, and then went into a 20 year or so slumber. Some commodities fell to all-time inflation-adjusted low prices by the time the bear market ended. Now, fueled by increased worldwide demand and the inflationary credit expansion policies by the world's central banks -- we suspect the later's effect has been greater -- commodities have boomed again this decade. Metals, energy, and agricultural products have been getting most of the press. Here, Whiskey & Gunpowder's commodity expert Kevin Kerr discusses the prospects of one of the less publicized soft commodities, cotton.

Already a month into the new year, traders begin trying to figure out what trades will be the big winners in the as 2008 rolls on. Now, it is not exactly breaking news that agriculture markets have basically been on fire for the last couple of years. Corn has skyrocketed on the back of huge ethanol demand, and soybeans, for that matter, have too. Wheat exploded this year on poor global crops and much higher demand. So is the big bull run for grains over? No, it is actually just getting started. While I think wheat, soybeans and corn will continue to do very well, another crop may do even better in 2008 -- cotton.

The longer-term effect of all the extra corn and wheat planting in the South could be a cotton shortage and much higher prices. The general consensus is that many farmers are switching out of less profitable crops like cotton and rice and moving into the lucrative corn and wheat market, which has benefited from the ethanol boom.

According to the National Cotton Council's early season planting intentions survey in 2007, U.S. growers intended to plant 13.2 million acres of cotton in 2007. This was a significant decrease of almost 14% from 2006, and 2008 is expected to be even more dramatic. Meanwhile, demand for cotton is showing no signs of slowing around the globe, especially in China.

China is wasting no time securing the natural resources it needs to keep its economy going -- and that includes cotton. In fact, China is so serious it has created its own futures market. Many analysts had noted an imbalance between China's growing economy and the relatively small size of its domestic futures markets. This imbalance was seen as a negative and something that could hinder China's development in the long run.

Chinese merchants and manufacturers are very serious about the cotton business; all you have to do is look at cotton futures trading on the Zhengzhou Commodity Exchange. The exchange is no joke and is the center of cotton trading in Asia. Daily volume in Zhengzhou cotton futures, which will complete their first year of trading on June 1, is now running about 50,000 contracts. Open interest at the ZCE has been running between 60-80,000 contracts per day since last November -- that is just an incredible number. .. [T]he New York Cotton Exchange reached this level only after a century of trading. ... The power of China is amazing.

Even with all the global interest in cotton, the futures have sold off heavily and there is a lot of bearish sentiment ... One big reason is demand has not been as high as expected in the first quarter, which has limited the upside trade in cotton, at least for now. Cotton futures have had a bit of a boost in the last few months that will likely continue during 2008 because of speculative fund buying in cotton. The price for cotton is still relatively very cheap.

Analysis of the farming regions in the U.S. indicates that all areas will have some reduction of cotton. The South will be affected the most. Another factor to keep in mind is Mother Nature. Weather is always a major factor for any agricultural commodity, and it will be pivotal in determining final crop size, no matter what.

When we apply each state's cotton yield in 2006 to its 2007 projected harvested acres, it generates a crop size of 20.5 million bales. ... [That is] down only 1.2 million bales from the previous year's number. But if we examine the numbers a little closer and look at history, we see crops are often subject to yield deviations -- in other words, coming in less than expected. When we look back over the past decade, a pattern of deviations is obvious. It suggests that under ideal conditions, 22 million bales would not be out of the question, while weather problems could also push the crop to the 18 million-bale range.

While first quarter demand might not be at the anticipated levels, there is no denying that there will always be a demand for cotton. Clothing, home furnishings, and even medical supplying are all industries that rely heavily on cotton. If the weather influences the harvest the way many are predicting, the price of cotton could be the next great bull market in commodities. Gold and oil have had their day, but now the softer side of commodities could blanket some lucky investors with big gains.

One wonders how serious he is about gold and oil having "had their day." Some of his colleagues have different opinions.


International Effect on Cocoa Prices

Another Whiskey & Gunpowder discourse on the prospects of another one of the less publicized soft commodities -- cocoa, this time. The story is similar to that of cotton: More demand from Asia and possible weather-related problems with supply.

Over the past decade, an economic awakening has occurred across Asia. The over 2.4 billion people that make up both China and India have ... recently become consumers, and they are consuming at record-breaking levels.

The effect of China and India's awakening has already been felt in the oil and precious metals markets. But there is something else that all this economic freedom has brought. China and India have finally developed their sweet tooth. Cars? Check. Roads? Check. Now all they need is something sweet for later ... [like] chocolate. Simple, sweet, delicious chocolate has become big business. With all these new mouths to feed, we can certainly expect continued upswings in the cocoa futures market.

Much of the world's cocoa is produced in Africa, notably in the Ivory Coast. In recent years, the demand in China for different commodities produced in Africa has risen exponentially. ... The taste for chocolate had not really existed previously in China. You were much more likely to find someone snacking on more savory dishes like dried fish or meats. The idea of a milk-based dessert was virtually unknown, compared with the popularity of rice-based treats. Of course, that is partly to do with cultural and historical differences. Many people in China were not brought up eating chocolate as we have been in the U.S. But economic factors are a big reason for the absence of what is relatively quite common here.

Importing such a delicacy would have been unheard of only a few decades ago. Across the ocean, in Japan, there has already been the desire and demand for chocolate. The average Japanese person consumes about five pounds of chocolate per year, compared with less than a quarter of a pound for the average Chinese, and even less for the average Indian.

Of course, those figures are soon likely to change. Like many things in China, past numbers for chocolate consumption appeared to be spread equally among economic classes. Affluent members of society were consuming as much chocolate as the citizens hovering around the poverty line. That has changed now. Reflecting just how wealth can change tastes, we find that richer Chinese are eating chocolate now in numbers more relative to their wealth. ... As the growth of chocolate demand is good news for companies in the chocolate business, the Chinese themselves still have a lot to get used to when it comes to the rich delicacy.

Last month, the South China Morning Post published an almost comical article describing the health effects of chocolate. The article discusses some of the benefits that chocolate possesses, while also answering some frequently asked questions that many Chinese have had on the subject ... The answers to these questions may sound simple and obvious to us, but for over a billion people in China, chocolate is a new and unique delicacy that they are not yet used to. However, they certainly are enjoying themselves.

China's National Food Industry Association believes that the chocolate industry should grow by more than six times its current size. It believes the chocolate industry in China will soon be worth as much as $2.8 billion, making it the largest market in the world.

Chocolate companies are making a push for the emerging Indian market, as well. Already, Nestle and Cadbury sell chocolate in the subcontinent and make up 90% of the chocolate market. Despite this big market share, Hershey Foods has decided to make a big Indian push, as well. The candy giant is attempting to alter the tastes and consuming habits of over a billion potential customers and establish itself as the chocolate leader in India, just as it is here in the U.S.

The emergence of these two new huge markets is big news for investors dealing in cocoa futures. Some of the largest supplier regions of cocoa in the world have been hit with weather problems over the past several months that have made it more difficult for the countries to reach their desired outputs. The Ivory Coast, for example, has been without rain for more than a month.

These factors, along with the increased worldwide demand for the products derived from cocoa beans, have prompted many investors to get onboard. Traditionally, the price of cocoa has fluctuated wildly and has made the commodity difficult to predict. However, many hedge funds have begun betting on cocoa's rise and have seen some good returns on their investments.

The emerging markets in India and China are changing the way a lot of commodities are traded and invested. Many American companies are altering their business models to target these growing areas, and that is only pushing the price higher and higher. As long as the economic climate continues moving in this direction, some investors could find some delicious profits on their pillows very soon.

CONAGRA IS A VALUE IN THE PACKAGED FOODS GROUP

No one ever accused the packaged food industry of being glamorous. ConAgra foods (22, CAG) has long been the homeliest sister of a dowdy bunch. Many of ConAgra's brands are far from top of the line: Hunt's, Healthy Choice, Chef Boyardee. To make matters worse, ConAgra last year recalled Peter Pan peanut butter and Banquet pot pies amid suspicions of salmonella contamination.

Package foods stocks generally were assigned low multiples in the 1970s when commodities inflation and recessionary times drove up their costs faster than they were able to raise their prices. When the 1980s brought a reversal of both those trends and a revived appreciation of the business value of brand names took hold, the stocks came into a favor they have enjoyed more or less to this day. A major consolidation and rationalization of the industry also led to higher returns on capital, which helped power further multiple expansion. In truth, the group was glamorous for quite a stretch.

Still, the company is undergoing a turnaround that should help the stock reverse its salmonella swoon, down $6 since last July. Gary Rodkin, the PepsiCo and General Mills veteran who took over two years ago, has sharply pared costs and upgraded longstanding offerings. For instance, he brought out a new flour under the Eagle Mills brand that includes whole grain, plus a low-sodium Orville Redenbacher's popcorn and an Egg Beaters ham-and-cheese omelette mix.

So, despite rising food costs, ConAgra on Rodkin's watch has reversed its declining net income. For fiscal 2008's first half, ended 11-25-2007, earnings rose 11% to $420 million. While commodity increases are a burden for all food producers, ConAgra benefits from its trading and merchandising division (14% of revenues), which buys and sells food commodities, fertilizer and energy. To Kenneth Goldman, analyst at Bear Stearns, this natural hedge and the appeal of consumer staples in a recession spell a buy. At a 13 trailing P/E ratio, ConAgra is cheaper than rivals Heinz (17) and Kraft (19), and the industry average of 20.

Because ConAgra's brands are not top of the line, unlike those of Heinz and Kraft, it tends to get assigned a lower multiple. But 13 vs. 17-20 does sound like an excessive discount. However, the discount could easily be resolved by reduced multiples for the higher P/E food stocks, what with agricultural commodity inflation back in force.


HENRY SINGLETON’S SECRET

Henry Singleton, legendary cofounder and longtime CEO of Teledyne, was an exponent of stock buybacks long before they became commonplace. By the time the bull market in stocks that began in the early 1980s had matured, buybacks were surreptitiously used as a stock price support mechanism and a way to whitewash the dilution from profligate stock option issuance. Most such buybacks were done without much regard for the the repurchase price. It was hard to tell whether there was any semi-rigorous value-added criteria behind the decision at all. Mostly they were done because everyone else was doing it. It was fashionable.

Not so with Singleton. When the stock was high, he used it as a currency for acquisitions. When it was low, i.e., selling at a discount to its intrinsic value, he bought it back -- for cash and in quantity. In the 1970s and early 1980s such opportunities were more common, to be sure.

"Buy low. Sell high," is not just an ancient Wall Street saying, it is also the formula that made Henry E. Singleton a fabulously wealthy individual. Henry Singleton was the cofounder of Teledyne. It was, like Buffett's Berkshire Hathaway, a conglomerate of many kinds of businesses. Singleton ran the company for many years, from its founding in 1960 through 1986. His story is rich in wisdom on markets and how to beat them.

Warren Buffett says Harry E. Singleton had the best track record of any industrialist in the history of American business. That is very high praise from a guy who may be the greatest investor of all time. In his book, Money Masters of Our Time, John Train writes: "The failure of business schools to study men like Singleton is a crime, [Buffett] says. Instead, they hold up as models executives cut from a McKinsey & Co. cookie cutter."

First, let us take a quick look at that track record, and then we will look at one of the keys to his success -- what I call "Singleton's secret" -- and how we can use that insight in our own investing. Teledyne went from $100,000 in profits in 1960 to $238 million in 1986. Shareholders' equity grew from $2.5 million to over $1.6 billion. Those returns, needless to say, crushed the market over time -- by a multiple of nearly four.

Note that revenues went up 2380-fold while equity "only" went up 640-fold. With all the acquisitions for stock and buybacks for cash, the equity line on Teledyne's balance sheet is a number whose meaning over time is hard to discern. And with acquisitions and divestitures one could say the same about total revenues. Some value per share numbers would be most telling.

But what became Singleton's signature mark was his pioneering use of the stock buyback. A stock buyback is when a company buys back its own shares. The wisdom of buybacks is pretty simple ... assuming the stock is cheap. As Warren Buffett wrote in his 1980 annual letter, "If a fine business is selling in the marketplace for far less than its intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interest of all owners at that bargain price?"

Singleton did this more than anybody. When his stock was high, he used it to buy other businesses. In fact, he bought hundreds of businesses over the years. When his stock was low, he bought stock back.

Today's CEOs do not always get the playbook, though. They think regularly buying back stock is a good thing, like paying a regular dividend. They do not seem to get that it works only if you buy back the stock at cheap prices. Otherwise, you are just throwing money away. Better to just pay your shareholders a dividend. During the binge of buybacks we have seen in the past few years, companies have often made that mistake. First, look at the chart below [image link here] and you will see the surge in buybacks. It is pretty clear that corporate chiefs preferred buybacks to dividends in recent years.

The higher stocks went, the more buybacks. It seems corporate managements are susceptible to the same herd instincts as speculators. As once noted in the Elliott Wave Theorist: "Company officers are part of the market's psychological fabric just like everyone else, and they tend to become bold when things look good, and that is usually near a top."

Leon Cooperman, an exceptional investor and founder of Omega Advisors, delivered a presentation on Singleton and buybacks at the Value Investing Congress in New York. Cooperman is a real enthusiast of Singleton's career -- a "Singleton junkie," in his own words. He has spent a lot of time studying the man and his methods.

Cooperman cited many examples of companies that routinely spend billions buying back their own stock. Unfortunately for those shareholders, the stock prices have subsequently gone down, flushing billions down the proverbial toilet bowl. The offenders make up a roll call of blue-chip companies: Microsoft, Intel, Lexmark, Masco, Pulte Homes, Circuit City, Chico's and many more. Countrywide is one of the most egregious recent examples. It spent nearly $2 billion on stock buybacks in the last two years. Countrywide's stock price has since lost 75% of its value.

James Grant, writing in his newsletter Grant's Interest Rate Observer, recently wrote about boneheaded buybacks in today's marketplace. Grant then paid tribute to Singleton when he wrote: "Henry E. Singleton, visionary builder of Teledyne Corp., set establishment tongues wagging by issuing stock at high prices and repurchasing it at low prices. People wondered what he was thinking about. Our postmillennial captains of industry seem not to understand, either."

But just because most everyone seems to act like they do not know what they are doing, it does not mean that there are not some companies who get it and wisely buy back stock [when the price is sufficiently low].

SHORT TAKES

On the IMF’s Proposed Gold Sales

The G-7 approved the IMF'S gold sales plan this weekend in Tokyo. Quoting a Morgan Stanley analyst endorsing the plan, "This is arguably a good time to consider selling some of these gold holdings and investing the proceeds in financial securities with positive yields." According to the same article, the head of the IMF said, "There was an acceptance among the G-7 that resources should be raised by selling gold."

Gold bulls should not panic. The media does not understand the situation, as usual. ...

The writer notes that the amount of gold the IMF plans to sell is equivalent to about one day's worth of trading volume. Moreover, the IMF's record in gold sales is about as stellar as one would expect from a government beaurocracy. During the 1970s, the IMF sold gold heavily and the market snapped it up with hardly a bout of indigestion. And as each sale failed to dampen sentiment, the bulls gained confidence. Conclusion: "The market should brush this off as another potential bureaucratic blunder."


Inflation Killed by Recession! and Other Lies to Destroy Your Money

Worried about inflation? Oh, stop your carping and set an extra place at dinner for the fast-looming recession instead.

See, your cost of living cannot possibly keep rising now that Europe and the U.S. are plunging into a credit-led slowdown. Inflation is dead, killed by the slump. The value of money is going to stop sliding, even as interest rates fall.

Says who? Says just about everyone.

The bottom line is that inflation falls during recessions, but it never goes to zero. Moreover, the correlation between inflation and money supply growth, whether money is broadly or narrowly defined, is very high. Over a 30-year horizon, they match each other almost exactly, even as there are lags in the system over shorter time horizons. The world's supply of money is surging right now.

[A]s long as gold prices keep screaming that somewhere something is amiss between inflation and bond yields, that dumb lump of metal might just keep finding a bid. Gold has now risen in 18 of the last 24 weeks. [Last] Friday alone, it hit new record highs against both pounds sterling and euros. Still, nothing to worry about. The U.S. recession is sure to send inflation to zero -- just as it didn't in four of the last five recessions.

Investing in Penny Stock Options

[W]hen most people think of penny stocks, they think of one thing: buy tiny companies at extremely low prices and sell high, when these companies are finally discovered by Wall Street. ... On February 1 this year, O'Reilly Automotive (ORLY: NASDAQ) proposed a buyout of CSK Auto Corp. (CAO: NYSE) for $8 a share. Fortunately for CSK shareholders, their shares had just closed the day before at $5.95. ...

If you had bought just $1,000 worth of shares at the end of trading on January 31, you would have walked away with $580 in pure profits by 12:30 p.m. the next day. ... But what would you say if I told you that there was a way you could've used that 58% spike to make 500% instantly? ... [P]eople can also buy options on CSK. Options are simply contracts that permit the owner to purchase or sell an asset at a fixed price until a specific date. Meaning, with the added risk of timing the market, the rewards skyrocket. Take a look at what I mean here ...

The same day that CSK's share price went up 58%, the February $5 calls went from $0.70 per contract to as high as $4.20 per contract. That is a gain of 500% in just a few hours. And if you had gotten in a week earlier, you would have paid just $0.55 a contract and seen a 664% gain!

The same goes for stocks that fall, which we have seen plenty of so far this year ... Take a look at radio frequency-components maker, RF Micro Devices, Inc. (RFMD: NASDAQ). In mid-January this year, the company cut its earnings outlook and Wall Street cried bloody murder. Shares fell 25% the day that came out and nearly 44% for the month of January [see stock price chart here].

If you had $1,000 invested in RF Micro at the beginning of January, you would be left with only $565 by the end of the month. Now, if you had bought a handful of RF Micro February 2008 puts at the beginning of the month, it would have cost you only 15 cents a contract. By the end of January, you would be sitting on contracts worth $1.90 each. That is a 1,167% gain in one single month!

The revelation that you can make a lot of money quickly in options if you get the timing and direction right is not exactly new news. But for those for whom low priced stocks are not speculative enough, we now have options on those same stocks. Sounds like progress.