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

W.I.L. Finance Digest for Week of March 3, 2008

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


In trading commodities, or any other volatile asset using high leverage, being right alone is not enough. There are the little matters of timing and money management. The bottom line is that you need a system, and you have to have the emotional dicipline to stick to it. Veteran commodities trader and newsletter writing Kevin Kerr gives his perspective on this, in detail.

As we settle into the young year, I always take a step back and really examine the previous year (actually, the previous five). I look at personal as well as professional issues and see where I am and where I am going.

I closely examine all of my trades for all of my portfolios, as well as a journal of all the trades I wanted to do but for whatever reason did not. Paul Tudor Jones would call those "missed opportunities." Maybe, but sometimes it was better that I "missed" them. Hindsight is always 20/20, so it is important to take this examination with a big grain of salt and some Alka-Seltzer.

My first book has in its title A Not-So-Crazy Road Map to Riches. The reason I use the term "road map" is because I feel it is a must for every trader, big or small, to have a trading plan and to follow it. Let's face it -- there is no GPS for trading. ...

That would be so sweet, but alas, there is no such thing. The closest we can come is to sit down and map out where we have been and where we are going and then -- most importantly -- follow that map. Many people make a plan; they spend countless amounts of time and money studying the resource markets, learning about trading systems, even buying newsletters like Outstanding Investments [Kerr's newsletter], and then they make the cardinal mistake. They stop following the map they invested so much in. It makes no sense, but it is very common.

I had a guy come to me recently and offer me $1,000 per hour to teach him exactly what I do and to let him sit in my office and watch me for a day. I thanked him, but I told him that he could come by my office and sit in for free for a few hours. I would be happy to talk to him as a professional courtesy. He did. I was trading grains that morning, and he showed up at my office. He glanced around and saw all 12 screens and five computers in my office.

As he sat down, his eyes transfixed on the big 60-inch plasma trading screen in the center of the room. Green and red flashing all over the place and me on the headset. It was a busy morning already; soybeans were limit up, and wheat was not far behind.

As I put some orders into the trade desk, he began firing questions at me. "How many are you trading? What month's? Do you have a stop order in? Are you on with the trading floor?" Whoa, boy! Maybe I should have taken your $1,000 per hour, I thought to myself. I said, "Slow down, slow down." I would have offered him coffee, but I think he had had enough.

I said, "I am trading my plan that I made yesterday after the close. See, it is all right here." I showed him the sheet that I write up each day after the close. I showed him that I had made a few changes based on the overnight trading, but more or less, this was my "road map" for the day. He seemed puzzled, but intrigued.

I let him examine the list, and he asked, "So how do you put this together?" I explained that I look at the technicals, the settlements and my notes on activity during the day that I hear about from my trading contacts all over the world. I rank each of the markets I am watching and then cut this down to my top five. Then I really go to work.

I see which markets made higher highs or lower lows, and I look at the moving averages very closely. I also examine trading volumes and open interest very closely. I do many other things too, but those are proprietary, and I told him $1,000 an hour would not be nearly enough.

He said, "Well, this is easy!" I laughed. I took the sheet and crumpled it up and then put it in the shredder. He was horrified. He burst out, "Why did you do that?" I paused and then said, "The problem is not that you need my list, it is that you need your own, and then, more importantly, you need to stick to it." He seemed confused.

I explained that he can use my advice to create his own map, and then when he is confident with it, he needs to follow it. That is where most traders fail -- they may have the intelligence (maybe too much), but they lack the skills of discipline and confidence. What is the old saying? "Give a man a fish and you feed him for a day. Teach him to fish and you feed him for a lifetime." So true. I am giving fishing lessons here at Whiskey & Gunpowder, but once you learn, you are responsible for putting those lessons to work.

If you have read this far, obviously you realize the resource boom is far from over. In fact, the fat lady is not even clearing her throat yet. As trudge through 2008, only one thing is crystal clear to this trader: There will be many wild swings in everything from oil and gold to soybeans and sugar, and certainly all the resource equities too. Having a well thought-out plan and clear-cut approach is essential to weather the tough times, as well as the incredible profit periods. Not only is discipline important when you are taking a loss, it is actually even more important when you have a runaway winner. I have seen many a great trader blow out on a massive winner that turned into a horrific loser, usually because discipline went out the window and greed took over.

Make no mistake, there are many pitfalls on the road map to riches. People like me are committed to helping you avoid them and make the right turns. We will be there for you, but only you can decide if you follow the map or not. I sincerely hope you will.


Six Months of Fun, Fun, Fun from the Fed

The runup virtually across the board in commodities prices, especially since the Fed started cutting interest rates last summer, would seem to indicate a big runup in inflation or expected inflation. On the other hand, reported "inflation" (price increases) usually shows up as a lagged effect of money and credit supply increases. Meanwhile, Treasury Bond yields have been falling. But this could be a flight-to-quality phenomenon rather than the market anticipating a recession and lower inflation. Finally, with the massive amounts of speculative, short-term oriented funds sloshing around the world's markets, trends get magnified. Adrian Ash seems to be leaning towards the idea that there is more inflation to come. Our advice is do not get too wedded any big picture scenarios. Crazy markets might act, but it is by no means easy to take advantage of that fact.

This week marked the six-month anniversary of the Fed's first cut to U.S. interest rates during the current world-banking crisis. And it has been fun, fun, fun ever since for hard asset investors.

Aimed at promoting "orderly conditions" in the world of finance, that 0.5% cut to the Fed's discount rate kick-started the sharpest collapse in dollar interest rates since ... well, since the last time it tried to restore order to the value of U.S. financial assets.

But while short-term money markets remain tight six months later -- and the subprime panic has since spread to "monoline" bond insurers, private equity groups, pan-national banking giants and even U.S. student-loan finance -- the only order so far has come in raw materials, rather than finance. A big fat order of whopper-sized gains, in fact, with a fried egg on top for good measure. [See table.]

The price of gold meanwhile -- whose only real utility, unlike all other natural resources, is as a store of value -- has now risen in 20 of the last 27 weeks. Spot gold prices have gained 44.7% since the morning of August 17, just before the Fed announced its "extra-ordinary" rate change. Whereas the S&P500 stock index has dropped 7.5% of its value. Which surely was not the plan.

"Even the casual observer can have no doubt that FOMC decisions move asset prices, including equity prices," said Ben Bernanke in a speech of October 2003. "Estimating the size and duration of these effects, however, is not so straightforward." Then a mere Fed governor, rather than the big cheese himself, Bernanke related a pile of highly detailed and utterly pointless research he had done with Kenneth Kuttner of the New York Fed. In short:

The statistical evidence is strong for a stock price multiplier of monetary policy of something between three and six, the higher values corresponding to policy changes that investors perceive to be relatively more permanent. That is, according to our findings, a surprise easing by the Fed of 25 basis points will typically lead broad stock indexes to rise from between 3/4 percentage point and one-and-a-half percentage points.

Bernanke was talking about the kind of gains he would expect to see inside one day! But slashing the Fed funds target by 225 basis points since the global banking crisis provoked him to act back in August, Bernanke has not even got 6.75% across six months ... let alone a 13.5% rise on Wall Street. He has got a surge in the cost of living instead, driven by basic raw material prices. And that is bad news -- as in gruesome -- for Treasury bond owners. [See chart.]

Yes, the Fed's overnight lending rate -- as well as short-term Treasury bond yields -- tipped sharply negative after accounting for inflation during the Greenspan "emergency" of 2002 to 2005. But longer-dated U.S. Treasuries -- those bonds used to fund the vast bulk of Washington's on-going finance needs -- only briefly failed to keep pace with the cost of living. Unlike now. Today they are lagging inflation, and threatening to lag it badly. [See chart.]

The last time U.S. Treasuries paid a whole lot less than inflation, the crisis got so bad that government bonds became known as "certificates of confiscation." Money failed to flee into equities, however, even as the United States faced the very real prospect of being unable to find the cash to fund its government spending. To fix this mess in the world's #1 economy, it took a collapse in nominal bond prices -- driven by record-high interest rates from the Fed -- and the longest recession since the Great Depression to restore America's credit.

Just how miserable might the real returns paid to bond-buyers become if inflation keeps rising today? The runaway producer price index, backed up with $100 crude, stood right behind it wearing knuckle-dusters, growling that things are about to get ugly. And just how far might hard asset prices go as investors flee stocks, bonds, cash and property all at once ...? [See this gold price chart.]

Yes, the current surge in gold prices looks a lot like that infamous "cathedral top" of 1980, right? Gold spiked above $850 per ounce in the spot market in 1980 ... and then fell almost every year for the next two decades. But the move above $800 per ounce came and went inside three days. And the run-up saw gold prices more than triple on their monthly average in little more than a year. Here in February 2008 -- and with U.S. Treasury yields turning negative once again -- gold has taken more than half-a-decade to repeat that feat.

Too much, too fast? With Bernanke at the Fed -- and $100 oil heading for the pumps, as well as for real bond yields -- just maybe we ain't seen nothing yet.


Indicators that you should never ignore when analyzing a balance sheet.

Chris Mayer discusses a sensible and practical tool for analyzing common stocks: the credit quality of the debt of the company, or lacking that, the general credit quality of the company's industry. A practical problem is that by the time Moody's and Standard & Poor's acknowledge credit quality deterioration, it is often quite late in the day. However, changes in ratings from the far less well-known Egan-Jones, it turns out, often precede those of big boys by as much as 8 months.

Pete Arnold of the Egan-Jones credit-rating agency, and the rest of Wall Street have a saying: "Credit precedes common." In other words, changes in a company's credit quality can predict what will happen to a company's share price.

Mr. Arnold's phrase is not an entirely new idea, but it is a particularly timely idea. In the current investment climate, no prudent investor can afford to ignore what is happening to a company's balance sheet. A company's financial position will often weaken first. Then, the market will crush the stock. Therefore, if you keep a close eye on the financial health of your investments, you have an early warning system about danger for the stock price.

Credit has become a more important investment influence than at any time since 1998, when the Asian crisis hit. In the summer of 2007, the subprime crisis finally unsheathed its sword. A number of subprime investors suffered mortal wounds, leading to massive losses. Since then, the crisis has only widened and deepened, spilling over into other areas of the economy. It looks certain to toss the U.S. economy into recession, if we are not there already.

With these thoughts in mind, I put in a call to Egan-Jones last weekend. ... Arnold emphasized the imperative of analyzing company-specific credit trends, not only to avoid risk, but also to recognize opportunities that the equity market may be missing. So credit analysis can sometimes provide a treasure map, instead of warning buoy, you might say. What are the credit markets telling us today? Where are the risks and where are the opportunities? ...

The credit markets are still in lockdown mode. Before August 2007, money was easy. If you wanted to finance a leveraged buyout, people would throw money at you. Not any longer. Now, finding that easy money is like getting a drink during Prohibition. It will cost you.

As such, the list of improving industries is really short. It is basically energy and energy service companies. But especially, Egan-Jones reports, the domestic producers. They are unaffected by geopolitical troubles and have more natural gas exposure. Egan-Jones views the latter as a positive given the wide swings and uncertainty in oil prices.

In the energy service sector, credit quality is strong across the board, Egan-Jones notes. The risk here is that companies might squander their credit on expensive acquisitions. Overall, though, the financial strength in the energy sector is improving. If credit precedes common, then you would expect the stock prices of the group to stay strong, or at least to weather the turbulence better than the rest.

Outside of the oil patch, however, most industries rate neutral, such as the pharmaceutical, retail, chemical, and auto part industries. These neutrally-ranked industries have a swirl of good and bad things going on. Investors will have to pick carefully to be among the "good" names. One example of the dispersion of results from the auto supplier sector: BorgWarner had great results recently, pushing its stock to all-time highs. ArvinMeritor, on the other hand, swung from a profit to a loss. Its stock hovers near 10-year lows.

Let us look at the declining industries ... Many of these you would expect. Insurance is a bad one right now. The mortgage crisis has hit most insurers with losses in their investment portfolios. Many of them now face a wave of mortgage-related claims and writedowns. Egan-Jones is very bearish on insurers.

The banks are not any better off. As the recent wave of mega-billion dollar writedowns illustrates, most of the large U.S. banks possess a very thin shield of capital to protect them against insolvency. Leverage is the biggest part of the problem. Many financial intuitions use titanic amounts of leverage. Consider that Fannie Mae has only $40 billion of equity supporting $840 billion in assets and another $640 billion off balance sheet, hidden in the folds of the footnotes. This whole sector is a disaster.

Multiple times on these pages we have advised against hastily jumping back into the the financial company stocks. Part of this is intuition born of many observations of stock groups that have experienced extended time/price stock price runups, along with concomitant capital malinvestments spurred by the accompanying bull market hubris. In practice, a 1-year, 30% decline is simply not enough of a time/price correction to unwind the previous excesses.

An additional factor in our warning is that financial companies are routinely and highly leveraged. Whatever errors in judgement one makes, explicitly or not, about the values of financial companies' assets will be magnified due to this leverage. The credit ratings of these companies reflects the assessment of third parties who have an incentive to be accurate in their judgements, and who also have information unavailable to the average stock investor. Egan-Jones's bearish assessment of the financial sector companies is consistent with our previous advice.

Egan-Jones also warns against broker and finance companies. Companies such as Morgan Stanley and Bear Stearns reported their first quarterly losses in company history. Many of these companies will need capital infusions, probably from Asian Sovereign Wealth Funds or from deep-pocketed Arab funds. Auto manufacturing, homebuilders and cable television/media companies round out the declining industries.

Interesting note on the homebuilders: In 2007, write-downs overwhelmed profits for the industry as land values fell. Egan-Jones points out the specific case of Lennar Corp., which sold a property portfolio for 40% less than the value of the property on Lennar's balance sheet. The company had to book a $475 million loss as a result. Bad stuff still brews in the land of homebuilders.

I should add that there are good reasons to pay attention to Egan-Jones. For one thing, unlike competitors Moody's and Standard & Poor's, Egan-Jones does not receive money from the companies it rates. Egan-Jones is simply a subscription service ... Therefore, it is truly independent.

Not surprisingly, independence is an extremely valuable attribute in the world of credit analysis. A recent study relates: "Credit ratings from Egan-Jones more accurately reflect information in the marketplace and are frequently up to 237 days ahead of actions taken by Moody's and S&P."

In short, if you buy the notion that "credit precedes common," you will want to hang onto your energy stocks and tread carefully in the mortgage-lending, insurance and brokerage sectors. The message from Egan-Jones is quite clear: If you invest in the stock market, you cannot afford to ignore the credit market.


Chris Mayer argues that natural gas is one of the best commodity buys at this time. One of the factors that could lead to a revaluation is the the amount of gas required to heat all the excessive cubic footage constructed during the housing bubble, the initial phase of which was accompanied by cheap energy prices.

The commodity market is no different than an old fish market. When the fishermen have a lot of salmon sitting on ice, they drop the price to get rid of it. During the warm winter of 2008, a lot of natural gas is "sitting on ice," which means its price is depressed. Maybe too depressed.

A warm winter does not help the price of natural gas catch up at all with the price of oil. Warm winters mean that people use less of the stuff to heat their homes. It means higher inventories of natural gas. So even though the price of oil soars, the price of natural gas languishes. Old salts of the energy markets steer by the lights of a roughly 6-to-1 ratio between the prices of oil and natural gas. Today, that rate is closer to 13-to-1. Either oil is expensive or natural gas is cheap.

I think natural gas is cheap. I think it is one of the best buys on the commodity menu right now. There are a few things that make me comfortable with the idea that those rich natural gas inventories will not last much longer.

For one thing, as Grant's Interest Rate Observer recently pointed out, Americans are living in bigger and bigger houses. Natural gas is a popular fuel to warm them. The amount of gas Americans use to heat their homes is rising per unit of cold. Grant's quotes Leigh Goering, who runs a natural resource fund for Chilton. Goering says, "We've reached a point where we need warmer-than-normal winters for the system to operate properly." And if the forecasters are wrong and we get a good old-fashioned cold winter? The imagination reels. Suffice to say, the price of natural gas will rise.

The size of homes was an interesting angle I had not considered before. It is like an echo (or an aftershock) of the housing boom. The great housing bubble financed bigger and bigger homes that are costlier to live in. Even though the boom has turned to bust, its effects will linger on as a drag on America's pocket books for years to come.

The second big issue is the new energy bill, which was kind to ethanol, to put it mildly. The bill requires a 5-fold increase in ethanol production by 2020. The popularity of ethanol is one of the best things that ever happened to the natural gas industry.

Ethanol is a great natural gas guzzler. Most ethanol distilleries burn it to make ethanol. And we have many new ethanol facilities coming online in 2008 -- the vast majority of them will burn natural gas. But there is more. American ethanol producers also need a lot of corn. Corn is also the biggest consumer of fertilizers among the big row crops. Fertilizers can make up 40% of the cost to produce corn. And some 90% of the cost of fertilizers depends on the price of natural gas. It is a double whammy. Making ethanol itself burns gas, and producing the corn burns even more of it.

The U.S. federal government subsidies to encourage ethanol production are utterly insane and transparently stupid. The energy bill should be called the "Drive up grain and energy consumption while wasting money" bill. To paraphrase H.L. Mencken: "Nobody ever went broke underestimating the intelligence of the U.S. government."

Finally, there are a number of new utilities coming online that burn natural gas. In 2000, nearly 95% of the new electric capacity in the U.S. burned natural gas. This has lead to a surge in natural gas usage post-2000. (See nearby chart titled "Natural Gas -- Running a Hot Second.") Since natural gas burns cleaner than coal or oil, it is in an enviable position in a world suddenly highly conscious of its carbon emissions.

Add all that up and you have got a healthy backdrop to the demand for natural gas.


Kevin Kerr makes a fundamental case for buying gold, even at $1000 per ounce. (He has forecast $2000 a number of times.) The validity of the argument really depends on whether the dollar and other paper currencies keep losing their cachet. The increased demand for precious metals is the merely the converse of decreased demand for currencies. If the dollar were a reliable store of value, Chinese and Indian consumers would be happy to include more dollars and fewer ounces of gold in their asset allocation mix.

If you are worried about the U.S. economy, buy gold. If you are not worried about the Chinese economy, buy some more gold. China's economy is in overdrive, growing 11.4% in 2007. ...

The McKinsey Quarterly reports: By 2010, 40 million households will earn more than 48,000 renminbi ($6,000) per year, equivalent to $24,000 in terms of purchasing power parity and enough to qualify a household as middle class by U.S. standards. Meanwhile, the number of Chinese with at least $1 million in assets hit about 350,000 recently, and you can bet that number is increasing daily. (The number of millionaires in the U.S. is reported to be 9.3 million.) China has a lot of catching up to do. As it catches up, gold will tag along. That's because the Chinese cherish gold as the premier symbol of wealth and store of value.

Gold demand in China relative to GDP is about five times higher than in the U.S. And this robust demand is growing. Gold consumption in Mainland China rose 25%, to 78.9 tons, in the three months ending last September. But the real opportunity for gold in China comes with China's central bank. For several years, Yu Yongding, a committee member of the People's Bank of China, has advised that China use its foreign currency reserves -- the largest in the world -- to buy gold. He is not the only one. Other Chinese economists are urging their government to QUADRUPLE the nation's gold reserves.

Is it not interesting that these recommendations arrive at the very same moment that the International Monetary Fund is seeking to dispose of its gold to satisfy budget deficits? China is accumulating tangible wealth while the West is squandering it. Here are two points of interest ... So the U.S. has 70% of its reserves in gold. Let is say China puts just 1/3 of its foreign reserves into gold. That would be $500 billion worth -- or about five times the amount of gold the IMF hopes to sell!

India is the world's largest gold market. Consumer demand in the third quarter amounted to 185.1 tonnes -- or more than twice the Chinese demand over the same time frame. And during the first nine months of 2007, Indian demand totaled a staggering 500 tonnes, according to the Khaleej Times.

Driving that gold buying is a booming Indian economy. India is the world's fastest growing major economy after China, and its GDP grew at a rate of 9.4% in the fiscal year to March 2007, which, according to The Economic Times, was "its strongest pace in 18 years."

Household income in India is growing at a double-digit pace. A lot of disposable income means India's middle class -- which is larger than the entire population of the U.S. -- is buying everything from cutlery to cars to air conditioners ... to gold.

So the yellow metal may be headed to $1,000 very soon. It is sitting about $15 shy of there, as I write this. But don't expect it to stop there.


Jim Nelson, managing editor of Penny Sleuth, a daily small-cap e-letter that we frequently tap, says that small cap precious metals producers are undervalued relative to their large-cap brethren. Now is the time to buy in, he believes.

Unless your local currency is the Zimbabwe Dollar, then you have noticed that the bottom is falling out of the U.S. Dollar. In fact, it is getting so sad that we have seen reports of people flying from London to New York just to go shopping. Those are not the rich, old money Europeans. It is the Average Joe, middle-class going to the Big Apple to buy their TV for their flats in South Kensington. It is that cheap for Europeans.

The dollar is falling so fast, that precious metals are struggling to keep up. Both gold and silver are at all-time highs, and every day it seems they are breaking records. When I got into the office today, silver was sitting above $18, and gold is around $935. [Article was dated February 26.] That is incredible. I know we do not normally talk about precious metals, or macro ideas here in the Penny Sleuth, but this one cannot be ignored. Plus, there is an amazing way to use penny stocks to leverage this boom market.

A while back, I discussed how in markets like this, the best way to profit from the falling dollar is to buy shares in junior miners. ... There are three stages to any precious metals rally. When we first wrote to you (in the summer of 2006), we were right smack in the middle of the second stage of the rally. Let me explain ...

The first stage of the rally begins when the economy takes a large hit (September 11, 2001), and precious metals begin to be viewed as an investment to avoid the crashing dollar. As you can see [see chart], between about 2001 and 2004, the Dollar was valued higher than gold. But at the end of that period, the precious metal started its first move, ever so slightly.

The second stage of the gold rally goes like this ... Investors notice the price of the dollar slip in comparison to the price of precious metals. In the chart above, you can see that happening in 2003-2004. Once this happens, institutional investors replace traditional gold bugs as the major investors. Silver is also brought into the picture at this point.

But ... institutional investors are wary of anything not in the S&P 500. So, they dive into physical gold and major producers. Our junior minors remain the only undervalued avenue for investment at that point. This sets up the third phase, which is just about to start ...

Compared to the last huge precious metals rally, this one is more of a slow and steady increase. This gives us a clearer picture of this all-important third phase, which goes something like this ... People outside of the institutions and Wall Street begin to realize what they have missed during the first two stages of the precious metals rally. They want in. Just as they did during the end of the dot-com boom in 1999 and 2000, everyone throws their money at the hottest thing, which, in this case, is precious metals.

So instead of continuing to invest in the already overbought mega-producers, this new crowd begins to buy up the undervalued junior miners. This is our chance. Take a look at stage three during [the] last rally (see table here). Almost every junior miner out there is undervalued right now.


Chris Hancock makes a case for basic industry stocks over consumer stocks. Back in the early 1980s, analysts were making the precise opposite case. Notwithstanding that it was a consensus view, it turned out to be correct. If the past is mirrored from here, the consumer sector could underperformed for many years ahead.

Federal Reserve Chairman Ben Bernanke gave us a choice this week: A debilitating recession or destructive inflation. You decide. We vote for recession. Bernanke, however, opts for inflation.

We shrug. So does Mr. Market. The Dow tumbles. Oil surges to a record $102.59. Gold jumps $15.50, to $970. Wheat, cotton, rice and corn follow suit. Before long, the dollar menu at McDonald's will require a Jefferson [a rare $2.00 bill], instead of a Washington. Meanwhile, Americans keep lining up for unemployment insurance. The Labor Department reported that new applications for unemployment insurance benefits rose 19,000, to 373,000, last week.

It gets worse. More than 405,000 homeowners lost their homes to foreclosure last year. The Pentagon strategically braces for $225 oil. Drivers are paying 19 cents more per gallon than they did just two weeks ago. Some experts think the price will go to $4 before the summer comes. ... So how will John Q. Public pay for a Happy Meal? We are not sure. But the day of the American consumer keeps fading wistfully into the night.

So what does that mean for you, dear reader? We believe investors should be very cautious of stocks reliant on American consumers. We suggest you take special note to exercise caution regarding companies like Apple, Starbucks or P.F. Chang's China Bistro.

We have no particular prejudice against any particular one. In fact, I work on an Apple, drink Starbucks and eat at P.F. Chang's. Sometimes I do all three simultaneously. However, if John Q. Public lost his house and credit card, we imagine he would use his last $20 to buy toilet paper, Folgers and a pack of smokes. He is not going to make another dinner reservation on his 2008 iMac while sipping a $3 cup of joe. Furthermore, these companies are not cheap. [See table.]

As for what to buy, ask yourself: Can a company raise prices? Think of things you need. Beer and cigarettes come to mind. Well, you may not need these items, but I will use them to illustrate a point.

When is the last time you actually looked at the price of one beer versus another? I am not talking Heineken versus Pabst Blue Ribbon, mind you. I am talking about Heineken versus Corona ... or Bud Light versus Miller Lite. Customers in this sector buy on preference. And they buy a few more cases when the price is cheap. One could make the same case for shampoo and bandages. The point: When times are tight, we will still continue (hopefully) washing our hair and binding our wounds.

You also want to ask yourself: Can a business control its basic costs? When 1.2 billion Chinese start demanding a protein diet, can P.F. Chang's easily pass on its input costs (higher meat prices) to a cash-strapped consumer? Will margins suffer? In the case of a discretionary item like traditional Chinese cuisine, the switching costs are very low. In this business, consumers have many choices. Reprising the menu could easily suppress demand. That is one reason we avoid the restaurant sector. Restaurants do not possess a very good (if any) economic moat [i.e., they have a lot of competition].

On the other hand, companies that own tangible assets, base metals or natural resources should prosper. Companies well positioned to service the world's immedaite need for infrastructure should also do quite well. That is one reason we made the case for a Mexican cement producer in Free Market Investor. We believe it has been unfairly punished as a "housing sector" stock. ...

Our advice: Sell the Apples and buy the basic needs ...


The comforting platitude about the current credit crunch is that we have seen it all before, perhaps in some other guise but similar in the essentials. The Long Term Capital Management implosion of 1998 is frequently cited as a previous example of when the collapse of a highly leveraged institution could have led to a catastrophic cascading wave of defaults -- but didn't. A little well-timed intervention and arm-twisting by the Fed helped prevent LTCM's implosion from infecting the system.

Will the same tactics work this time? Doug Nolan argues against it. There is too much leverage in the system as a whole now, meaning there are too few institutions who can absorb the deleveraging of others by taking on more themselves. There are no sober partygoers left to drive the drunk ones home. Moreover, credit expansion depends on confidence -- and the borrowers' and the lenders' parts -- as Robert Prechter would not hesitate to point out. Once deleveraging and credit contraction go long and far enough, the contraction and the concomitant loss of confidence feed on themselves. Nolan contends we have reached that point.

The Economist: "After hubris comes nemesis. On January 24th more than 1,000 leading figures in the European hedge-fund industry gathered for a dinner at the swanky Grosvenor House hotel on London's Park Lane to witness the EuroHedge awards for 2007. Out of the 20 awards, two -- credit fund of the year and new fund of the year (for non-equity strategies) -- were awarded to Peloton Partners, a credit manager set up by ex-Goldman Sachs employees in 2005."

I will go out on a limb and suggest that this week provided another critical juncture for the unfolding credit and economic crisis. Peloton Partners, commencing the year with about $3 billion under management, is run by smart, seasoned investment managers. One of the fund's founding managers was previously a co-head of macro proprietary trading at Goldman. They recognized and profited handsomely from last year's subprime collapse, with their flagship "ABS" fund ending 2007 up 87%. By recent industry standards, their strategy was not particularly risky. To capitalize on the dislocated credit market and depressed prices, the fund increased leveraged exposure to "AAA" securities. It was reported that a week ago Friday the fund had posted losses for the month of about 8%. A few days later Peloton funds was in full crisis, forced to halt redemptions and seek liquidation. This evening [2/29] the Wall Street Journal reported that some of its Wall Street lenders had moved to seize assets. Investors will suffer huge losses on "AAA"-rated securities bought at a discount.

The co-founders stated in a letter yesterday to investors: "Credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls." They are clearly not the only funds pounded abruptly by sinking asset values, illiquid markets, and increasingly distressed lenders. In the case of Peloton, leverage of 4 to 5 times was used commonly, with sinking prices on $9 billion of assets quickly burning through equity. It is convenient to blame an implosion on the margin clerk, although in this highly unstable environment playing with leverage is playing with fire.

Also yesterday, Thornburg Mortgage -- seasoned leveraged "AAA" MBS players that last year had aggressively retrenched, cut holdings to $37 billion from $53 billion, and had seemingly weathered the subprime storm -- reported that they were once again hit with margin calls and forced liquidations on a portion of their mortgage holdings. The root of the problem was a 10% to 15% drop this month in the values of "Alt-A" mortgages. With an estimated $950 billion of "Alt-A" mortgages in the marketplace, such a dramatic price decline pelted scores of investors/speculators in these mortgages, mortgage-related CDOs, and myriad derivative instruments. Leveraged players, such as Peloton, were crushed. Forced liquidations and a rush to hedge in the derivatives market exacerbated the spiral. The troubled major banks and Wall Street firms have significant direct exposures in this area, as well as huge indirect risk on such collateral used by their leveraged clients. The impaired lender community today has no alternative than to manage risk very diligently, which means an aggressive approach to margin requirements and forced liquidations has become part of the new (post-bubble) marketplace reality. The "smart guys," that had jumped in over the past months to capitalize on market tumult, have been humbled, chastened, and in some cases bludgeoned. Many are coming to recognize that the market backdrop has fundamentally changed.

Compounding systemic stress, this week also saw significant forced liquidations in the municipal bond market. This has been a hot area for sophisticated leveraged trading and derivatives strategies. Today, one can add this huge market to the list of bubbles burst. It is difficult to know the scope of the unfolding liquidation and resulting inventory of muni bonds overhanging the marketplace. It is easy analysis, however, to suggest that liquidity for this key market will be scarce for some time. The ramifications for municipal finances, state and local borrowings, and overall economic activity are disconcerting.

In many respects, systemic stress from deleveraging is more intense today than even during the LTCM fiasco. Many have been eagerly anticipating a LTCM-style Federal Reserve-orchestrated "reliquefication." It is not forthcoming. I will again remind readers to think in terms of this being the first post-credit bubble "reflation" attempt. The Fed's influence on risk asset prices has been dramatically diminished. Unlike LTCM (or 2002 for that matter), it is simply no longer a case of the Fed lowering the cost of funds for the leveraged players and in the process enticing them to increase holdings of mortgages, MBS, junk bonds, stocks and derivatives (all on leverage). There are these days much greater financial and economic forces at work.

This week the California Association of Realtors reported that January home sales were down almost 30% from a year ago, with median prices sinking 21.9% y-o-y. Median prices dropped $46,010 during the month, putting the decline from June's high at an astounding $163,900. These "averages" are being skewed by the lack of mortgage credit -- hence transactions -- at the upper end. Inventory is up to almost 17 months supply and will likely growing rapidly as thousands of foreclosed properties hit the market in the coming months. Keep in mind that the California downturn is relatively recent -- running about a year behind Florida, for example. Increasing recognition of the dimensions of the unfolding real estate collapse in California (and elsewhere) certainly is a major factor for the sinking valuations of "Alt-A," "jumbo" and MBS generally in the markets. And the resulting further tightening of lending standards by the mortgage companies, banks, GSEs, and mortgage insurers will only exacerbate the unfolding real estate bust.

This is No LTCM. The current financial and economic backdrop is altogether different. Speculators that would typically seek to capitalize on depressed securities prices now confront enormous uncertainties. How bad will things get in California, Florida, and elsewhere? How many will walk away from underwater mortgages -- for starter homes and million dollar-plus California bungalows? How badly will the U.S. "services" economy be hit by housing and financial woes? How bad are the unfolding credit problems in state and local finance? Will pinched consumers also turn their backs on credit card, auto and student loans? How long will the seizing up of the securitization markets last? How will corporate credits hold up in the event of prolonged credit restraint and economic tumult? What are the ramifications if the "monolines," GSEs, private-label MBS/ABS, the credit derivatives marketplace, and Wall Street "structured finance" (more generally) do not recover? None of these pertinent questions were even remotely contemplated or relevant in 1998.

The problem today remains a highly leveraged credit system now confronting massive -- and unquantifiable - credit losses. And Moody's and S&P can continue to claim that the major "monolines" are "AAA" -- while the GSEs [Freddie and Fannie] can pretend they are adequately capitalized. But the marketplace is not buying it. Sinking securities valuations are not a "technical" market issue that will be resolved when the margin calls are satisfied. Indeed, the credit crisis and the economic downturn are gaining significant momentum.

Throughout the system, risk models have broken down. They will now be functionally inoperable for some time to come. At the heart of the now unfolding systemic deleveraging are some newfound realities. Leveraging, as Peloton Partners realized this week, has become a perilous endeavor. The markets have become hopelessly illiquid, providing no escape route for even the perceived safest securities. Worse yet, the greatest leverage has accumulated in the perceived safest securities -- creating atypical deleveraging risk and acute systemic fragility. Credit costs are now spiraling higher, and it is today impossible to accurately forecast either the timing or scope of losses for securities from subprime to munis to agency debt and MBS. Meanwhile, Wall Street and the securities lending community are reeling and will over time impose only tighter standards (less leverage and more collateral).

Importantly, the nature of systemic liquidity and credit risks has become a major risk factor working against leveraged speculating. Or, said differently, the bubble in leveraged speculation has burst. Today's reality is one of a credit system severely impaired, with the ABS, junk, and CDO markets basically closed for business. Now the huge muni and investment-grade bond markets are badly faltering. This week also saw the Swiss franc and the Japanese yen as the best performing currencies, gaining 4.7% and 4.2% respectively. For those borrowing in these low-yielding currencies to finance leveraged speculations in higher-yielding U.S. (and other) securities, there is now also recognition of acute currency risk. The stage is set for a panic out of the crowded leveraged trades.

This is No LTCM. And a very strong case can be made that Fed rates cuts have destabilized the credit system. While the argument that Fed rate cuts worsen an already problematic inflation problem certainly has merit, there is a greater risk that goes unrecognized. During the Greenspan tenure, the Fed was keen to use the leveraged speculating community as its key monetary reflationary mechanism. This, over time, became an instrumental facet of the credit bubble, the bubble in Wall Street finance, and the U.S. bubble economy.

Recent desperate Fed efforts to sustain both the bubble in leveraged speculation and the deeply mal-adjusted U.S. economy are futile. As for the leveraged speculating community, it would be better for the long-term health of the system to let the bust run its course. Today's reflationary efforts are clearly fueling further wild and destabilizing global speculation and excess, with major -- and increasingly obvious - negative consequences here at home. As for the U.S. bubble economy, throwing additional credit at the current unsustainable ("services-based") economic structure only ensures greater future credit losses and financial sector upheaval, along with more problematic economic dislocation. Importantly, the Fed (Kohn and Bernanke) made another major mistake this week downplaying inflation and dollar risk -- focusing instead on economic risk. Ironically, the Fed is today impotent with respect to the economy. It had best start paying attention to the stability of the currency markets, where it could have some impact.


Former Citibank CEO Charles Prince notoriously pronouced that as long as the liquidity music was playing, they had no choice but to keep dancing. Now that dance party has turned into a 1930s-style dance marathon, where the contest winner is the last couple standing. Michael S. Rozeff notes that Citibank and several other high profile dancers have already hit the floor with a well-deserved thud. And he hopes the music keeps playing and weeding out the weaklings, although he suspects that the fix is already in.

Certain financial developments of late, commonly treated by the mainstream media as negative, are gladdening my heart. It is sheer delight to read that Carlyle Capital Corp. is unable to meet margin calls. Its stock fell from $12 to $5 in one day. I hope it goes to $0. I am happy because Carlyle is an affiliate of the Carlyle Group, which is a charter member of the corrupt military-political-industrial complex. It is the home, or former home, or palace, or safe deposit box of both Bush presidents and an incredible roster of other once high-placed officials, such as John Major, Frank Carlucci, James Baker III, Richard Darman, Arthur Levitt, and Mack McLarty, to name a few.

Carlyle invested $21.7 billion in mortgage-backed securities issued by two government-sponsored enterprises, namely, the Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Loan and Mortgage Corporation, known as Freddie Mac. Carlyle used excessive leverage (issuing debt of its own) to finance these purchases. It borrowed by issuing very short-term debt known as repurchase agreements using the mortgage-backed securities as collateral. When these mortgage-backed securities fell in price, the lenders demanded more capital (margin) from Carlyle. But it had borrowed so much that it could not meet the margin calls. It received a notice of default. Wonderful!

How long the mighty fall before they manipulate the system to bail themselves out is anybody’s guess. In the meantime, it is fun to see even a token victory. Half a loaf of comeuppance is better than none. ...

Investors who over-reached for yield and over-reached for yield spreads are learning the hard way that this was a risky policy. When yields on short-term money market funds fell drastically, the number of ultra-short bond funds doubled. These bring in extra current yield by, among other things, investing in mortgage and other asset-backed securities. Although they seem like money-market funds, they are not. A fund like Fidelity’s Ultra-Short Bond Fund maintained a $10 value for over 4 years, only suddenly to drop to $8.61. (Some others have fared better, depending on their investments.)

Carlyle Capital bought debt securities of FNM and FRE, but their stocks are also falling. The stock price of Fannie Mae, which almost hit $90 in December of 2000 is down to $22. It fell over 10% on March 6 alone. I hope this company goes bankrupt along with Freddie Mac, which is down to $20 after being north of $70 a share. The government has no business butting into the mortgage business, so if Fannie Mae and Freddie Mac fail, good riddance.

Although I would enjoy seeing a complete debacle occur in these two government-created monsters, quite possibly the government will prevent or otherwise forestall their bankruptcies should they ever be imminent. The government provides no explicit guarantees to these companies, and the companies state that there are no guarantees. Nevertheless, investors have acted as if the companies had some implicit guarantees. They have good reason. Congress clearly wants these companies around so that they can buy up mortgages. The political fallout from their failures would be severe.

Investors therefore have lent money to Fannie Mae and Freddie Mac at (low) rates not in accord with their risk. This has allowed these companies to create and dominate a secondary market in mortgages. They bought up mortgages originated by banks, packaged them up, and resold them as the kinds of mortgage-backed securities that Carlyle invested in. How ironic that a company with so many ex-politicos in it might be dented a bit by another government-sponsored enterprise! These securities have been turning sour because the mortgages in them are defaulting. As a result, the yields on these debts are running 3% higher than Treasury bond yields, as compared with a more typical 1%. And even that premium is not as high as other troubled mortgage-related debts.

What is this secondary market that Fannie Mae deals in? It is basically a used-item or resale market. A secondary market is a market in which buyers and sellers can trade an item, like a security, after it has been issued. The used-car market is a secondary market. So is the New York Stock Exchange. ...

There is no natural financial or economic law that says that every loan or security must have a secondary market, liquid or not. A secondary market develops spontaneously if conditions and circumstances warrant it. Otherwise, it does not.

Farmers used to write illiquid forward contracts to sell their corn production. Later, the futures markets, which provided far more liquidity by standardizing the contract and by other risk-control methods, came to displace the older forward contracts. Put and call markets used to operate as an illiquid dealer market and with ads in Barron's until the Chicago Board Options Exchange devised standard contracts. On the other hand, there are thousands of bonds that are unstandardized and that have illiquid secondary markets.

Entrepreneurs devise secondary markets if it pays them to. E-bay created or enhanced many secondary markets. There is no need for government to foster or encourage secondary markets where none naturally exist or where they are illiquid. ...

When the government steps in, as it did in 1938 when it created Fannie Mae, it does so to benefit some special interest groups. The government draws resources into an uneconomic use and it undermines the primary market in various subtle ways. This happened in the secondary mortgage market.

Banks used to hold mortgages and not resell them. Fannie Mae gave the banks a way to sell their mortgages. Since Fannie Mae borrowed at privileged rates, due to the implicit government guarantee, and bought mortgages from the banks, the banks benefited. Bank capital is limited, and the amount of mortgages they can carry is therefore limited. But if a bank can originate a mortgage and then sell it to Fannie Mae, then with the same capital it can increase the number of its mortgage originations. Its profits go up. Its incentive and capacity to push mortgage loans rises. This distorts economic activity.

In the good old days when the banks both originated and held the mortgages, they faced several risks, and good bank management required that they manage these risks. They generally borrowed short and lent long. They borrowed by issuing short-term securities such as CDs. They lent by making long-term mortgage loans. ...

When mortgage loans were illiquid, the bank had to be careful to maintain alternative sources of funds in case interest rates rose. It had to be careful in managing its mortgage and loan portfolio so that they were diversified. It could not concentrate too heavily in one type of loan, one maturity of loan, or one borrower.

The bank also had to maintain the quality of its mortgages, because if interest rate rises were associated with hard times or brought on hard times, then its bad mortgage loans might rise. The bankers managed these risks partly by knowing their customers. The three C's of credit were Character, Credit, and Capital. ... The loan officer's own reputation and prospects of rising within the bank through promotion depended on his being careful in making the loans.

In recent years, the three C's became a joke. Banks made loans on no character, no credit, and no capital. Why not? They sold these loans to Fannie Mae and Freddie Mac, or to some other intermediaries who then repackaged them into pools (called securitization) and resold them to other investors. These included all sorts of institutions including large banks overseas.

The secondary market, combined with the innovations in securitization and the ready pools of money seeking high yields in a low-yield environment, altered the incentive structure in mortgage origination. Mortgage lenders no longer cared as much to whom they lent; and the guidelines for how much they loaned deteriorated.

The stocks of a heap of banks and mortgage companies are now falling in price drastically, the main reason being that they are holding bad loans. Washington Mutual (WM), a bank known for its mortgage loans in overheated markets in California and Florida, is down to $11 from $47. Citibank (C) is down to $21 from $55. They, not I or you or the taxpayer, made these bad loans, and they (and their suppliers of capital) should suffer the consequences. If those who took the loans walk away, and that is their choice, so be it. If the lenders have to deal with the costs of foreclosures, that is how it should be. Why should you or I bail them out? If we do, they will give us a repeat performance (this is called moral hazard).

I am hoping to see the bankruptcies roll along unimpeded, but realistically what I expect is a roll call of political rhetoric, name-calling, blame-placing, and misguided government attempts to halt the truth of the ticker tape, which is that the boom is over and its excesses are now being liquidated. So I have to take what little enjoyment I can get from watching the stocks of these enterprises collapse.

A good, solid, scary bear market that chastens all concerned is just what we need, that is, if it were allowed to provide its salutary effect, which it will not. Many more people need to be taught many lessons.

Among our influential leaders, I see no evidence of any truth-telling. Was there ever? I seem to remember at least occasional flashes of truth emanating from an occasional Senator or Representative or novelist or artist. But in recent years, there is not even the smallest sign from any of the rich and powerful who command the nation and the airwaves that they are prepared to lay aside their demoniacal control over this country.

There are two Americas: the official America of endless b.s., and the real America glimpsed in the unhampered and uninhibited writings beneath the surface in the blogosphere. I do see hopeful signs of light in the blogosphere.

I will keep my computer running while I continue to make sure that my Mute button works on other media so that I can tune out the waterfall of official baloney that such bankruptcies or a grinding bear market will elicit. The rich and powerful cannot halt a bear market or all its ramifications. But, sad to say, they know how to use it to their advantage in order to propagandize and solidify still further their grip on the lives of Americans.


British writer Ambrose Evans-Pritchard has been as vocal as anyone in the mainstream financial press in sounding the alarm about the current credit crunch. Here he declares that notwithstanding actions to date such as the Fed's "emergency" rate cuts, we are headed towards a "full-blown" debt deflation. Curiously, he seems to think that more of the same will do what it has heretofore failed do, and avert deflation. He seems to think that a long, Japanese-style, soft deflation/stagnation is a possible tradeoff the Fed is able to and should entertain. Realistic or not, the loudness of Evans-Pritchard's alarm is unmistakeable.

The verdict is in. The Fed's emergency rate cuts in January have failed to halt the downward spiral towards a full-blown debt deflation. Much more drastic action will be needed.

Yields on two-year U.S. Treasuries plummeted to 1.63% on [February 29] in a flight to safety, foretelling financial winter. The debt markets are freezing ever deeper, a full eight months into the crunch. Contagion is spreading into the safest pockets of the U.S. credit universe.

It is hard to imagine a more plain-vanilla outfit than the Port Authority of New York and New Jersey, which manages bridges, bus terminals, and airports. The authority is a public body, backed by the two states. Yet it had to pay 20% rates in February after the near closure of the $330 billion "term-auction" market. It had originally expected to pay 4.3%, but that was aeons ago in financial time. I never thought I would see anything like this in my life," said James Steele, an HSBC economist in New York.

No sane mortal needs to know what term-auction means, except that it too became a tool of the U.S. credit alchemists. Banks briefly used the market as laboratory for conjuring long-term loans at Alan Greenspan's giveaway short-term rates. It has come unstuck. Next in line is the $45 trillion derivatives market for credit default swaps (CDS).

Last week, the spreads on high-yield U.S. bonds vaulted to 718 basis points. The iTraxx Crossover index measuring corporate default risk in Europe smashed the 600 barrier. We are now far beyond the August spike. Sub-prime debt is plumbing new depths. A-rated securities issued in early 2007 fell to a record 12.72% of face value on [February 29]. The BBB tier fetched 10.42%. The "toxic" tranches are worthless.

Why won't it end? Because U.S. house prices are in free fall. The Case-Shiller index for the 20 biggest cities dropped 9.1% year-on-year in December. The annualized rate of fall was 18% in the fourth quarter, and gathering speed. As the graph shows below, U.S. households are only halfway through the tsunami of rate resets -- 300 basis points upwards -- on teaser loans.

The UK hedge fund Peloton Partners misjudged this fresh leg of the crunch. After an 87% profit last year betting against sub-prime, it switched sides to play the rebound. Last week it had to liquidate a $2 billion fund. Like many, Peloton thought Fed rate cuts from 5.25% to 3% (with more to come) would end the panic. But this is not a normal downturn, subject to normal recovery. Leverage is too extreme. Bank capital is too eroded. Monetary traction eludes the Fed. An "Austrian" purge is under way.

This is a rare nod to the Austrian economics schoold from a mainstream financial writer.

UBS says the cost of the credit debacle will reach $600 billion. "Leveraged risk is a cancer in this market." Try $1 trillion, says New York professor Nouriel Roubin. Contagion is moving up the ladder to prime mortgages, commercial property, home equity loans, car loans, credit cards and student loans. We have not even begun Wave Two: the British, Club Med, East European, and Antipodean house busts.

As the once unthinkable unfolds, the leaders of global finance dither. The Europeans are frozen in the headlights: trembling before a false inflation; cowed by an atavistic Bundesbank; waiting passively for the Atlantic storm to hit. Half the eurozone is grinding to a halt. Italy is slipping into recession. Property prices are flat or falling in Ireland, Spain, France, southern Italy and now Germany. French consumer moral is the lowest in 20 years.

The euro fetches $1.52 (from $0.82 in 2000), beyond the pain threshold for aircraft, cars, luxury goods and textiles. The manufacturing base of southern Europe is largely below water. As Le Figaro wrote last week, the survival of monetary union is in doubt. Yet still, the ECB waits; still the German-bloc governors breathe fire about inflation. The Fed is now singing from a different hymn book, warning of the "possibility of some very unfavorable outcomes". Inflation is not one of them.

"There probably will be some bank failures," said Ben Bernanke. He knows perfectly well that the U.S. price spike is a bogus scare, the tail-end of a food and fuel shock. "I expect inflation to come down. I don't think we're anywhere near the situation in the 1970s," he told Congress.

Indeed not. Real wages are being squeezed. Oil and "Ags" are acting as a tax. December unemployment jumped at the fastest rate in a quarter century. The greater risk is slump, says Princetown Professor Paul Krugman. "The Fed is studying the Japanese experience with zero rates very closely. The problem is that if they want to cut rates as aggressively as they did in the early 1990s and 2001, they have to go below zero."

This means "quantitative easing" as it was called in Japan. As Ben Bernanke spelled out in November 2002, the Fed can inject money by purchasing great chunks of the bond market. Section 13 of the Federal Reserve Act allows the bank -- in "exigent circumstances" -- to lend money to anybody, and take upon itself the credit risk. It has not done so since the 1930s.

Ultimately the big guns have the means to stop descent into an economic Ice Age. But will they act in time? ... For the first time since this Greek tragedy began, I am now really frightened.

His worry is justified. If he had read into his Austrian economic theory a little deeper, however, he might have come to a different conclusion than that the "big guns" have the power he seems to think they do. The cumulative distortions are there. The economic losses are in the bag. There is no way to undo all the investment decisions that got us here. The big guns can do a lot of damage trying to hide this fact, or allocate the losses away from their friends and sponsors. But that is about all.