W.I.L. Finance Digest for Week of May 5, 2008

WILL THE RECESSION BE MORE LIKE THE 1990-91 DOWNTURN OR THE GREAT DEPRESSION?

This is a pretty stardard mainstream analysis of the headline question by the Washington Post online outlet Slate. As such, issues like whether we are currently seeing the end of in effect a whole world financial system way of life does not enter even in the fringes. They do, however, hint that the recession could be long and deep.

The question of whether the U.S. economy is in a recession is, at this point, a matter of decimal points. Since the population grows faster than 1%, anyway, [the] announcement of a 0.6% rise in GDP for the first quarter is functionally a drop.ss The real question now is: How bad could it get? Are we facing another version of the brief recession of 1990-91, which, as James Fallows once memorably wrote, "was over by the time it was identified"? Or are we going to be wearing barrels for clothes and burning Ikea furniture to heat our homes, in a rerun of the Great Depression?

No one knows. But we may be able to arrive at a rough answer if we break the question down. How, exactly, do Americans distinguish a bad recession from a mild one -- and using those yardsticks, can we at least make reasonable predictions about this one? Here are three ways of measuring recessions.

Duration. This is a biggie, especially in terms of how history will remember the current downturn. What we think of as the Great Depression (which was actually two deep recessions separated by a few years of technical growth) is seared into the national memory in part because it lasted so long. The first phase -- between August 1929 and March 1933 -- was nearly four solid years of declining GDP. Many countries would find it hard to sustain such doldrums without revolution or war, and the United States has experienced only one worse downturn since reliable records have been kept -- a 5 1/2 hell between 1873 and 1879. (A list of historic business cycle expansions and contractions can be found here.)

Could our current downturn last that long? The National Bureau of Economic Research is the body that "officially" declares a recession, and it has not yet done so because growth numbers have not been negative (at least, not until they are revised). But Martin Feldstein, the economist who heads the NBER, said in early April that he personally believes that we are already in a recession and that it could last about twice the 8-month duration of the last two recessions (1990-91 and March-November 2001).

It is not hard to find economists with darker scenarios. Still, Feldstein's 16-month estimate is hardly Pollyanna-ish: It would make this recession a tie for the longest since the Depression. But that is another way of saying that recessions have been getting shorter. The average economic contraction since World War II has been 10 months and the average expansion 57 months. Both figures are much friendlier than historic norms and suggest that policymakers and other economic actors have gotten significantly better at managing the business cycle.

Spare us, please. All the recessions since the 1960s have been stopped by a liberal dose of money growth -- at who knows what cost, but the chickens may be coming home to roost to stay today.

And remember: If Feldstein is right, then we have already been through six months of shrinkage, so only another 10 or so to go. Not a reason to cheer -- but also not a reason to panic.

Joblessness. The age-old joke says that it is a recession when your neighbor loses her job and a depression when you lose yours. The joke contains a kernel of economic truth: The Great Depression involved massive job losses that affected nearly every American family. At one point during that 43-month ordeal between 1929 and 1933, one in every four working Americans was unemployed. Every significant industry cut jobs, and entire towns and regions -- at least in economic terms -- were wiped off the map.

It has never been that bad since. In the 1981-82 downturn, the unemployment rate hit nearly 11%, but the postwar norm has been single digits. (The April rate is 5%, down from 5.1% in March.) True, unemployment is generally considered a "lagging indicator," meaning that if we are in a recession now, we may not yet have seen the worst of job losses. Moreover, critics say that the official definition of unemployed would be larger if it included people who work part-time but cannot find full-time work, the substantial U.S. prison population, and so on.

But no one would dispute that the American economy is more dynamic and resilient than it was in the 1930s. The overwhelming majority of workers in those days toiled in either manufacturing or agriculture, sectors that are especially vulnerable to bust cycles. The employment market has diversified, workers have better skills, and global trade is much more important. So, if this recession leads to increases in unemployment -- as it almost certainly will -- not all job sectors will be uniformly hit. (Even in the severe '81-82 recession, only 72% of U.S. industries experienced declining employment, compared with 100% during the Depression.) Wages may well flatten or shrink -- as they have been doing for years -- but it is difficult to find a credible scenario in which U.S. unemployment is going to hit 10% in the next 18 months.

Depth. The recession between 1973 and 1975 was punishing. Then as now, rising fuel costs led to inflation (more than 12% in 1974). An unprecedented wage and price freeze imposed by the Nixon administration did not stem the problem. Gasoline was rationed, and unemployment rose as high as 9%.

Yet for all that, the actual drop in GNP, according to research by late economic historian Geoffrey Moore, was just under 5%. By that measure, '73-75 was the worst recession since the Depression. The inflation-adjusted GDP (as it is now called) has shrunk only in two brief periods since -- in the early '80s and the early '90s, in both cases by less than 3%.

So, let us say this recession gets as bad as the one in '73-75. The 2007 GDP in current dollars is more than $13.8 trillion. A 5% hit this year would take the economy to $13.1 trillion, or a little less than what it was in 2005. Based on growth patterns that have been quite steady since 1939, we would be back at $13.8 trillion by 2009. Undesirable, but not catastrophic.

Is this an argument for complacency? No. There are lots of important unpredictables, including what happens in the rest of the world and the ability of the financial sector to steady itself. The mortgage crisis and the decline in housing prices are not over. There is also no obvious path for getting out of the current rut. Recent recessions have not resolved themselves without a catalyst, like the tech boom of the 1990s or the housing boom of the '00s (both of which eventually brought on their own crashes). Moreover, if the modern recession is relatively modest, so, unfortunately, is the modern recovery. Expansions may last long, but if the snapback from the 2001 recession is any guide, we are unlikely to see bursts of domestic hiring or big pay hikes once things pick up.

It is telling that an analsis which acknowledges the downside of the two most recent recession recovery catalysts -- to wit, the biggest manias in modern (anyway) history: the dot-com and housing bubbles -- would not also mention that "maybe there is a little problem here." Until some hint of recognition of this fires in the synapses of our egghead policy makers, we are destined to either repeat history or killing ourselves trying to.

WHAT GRAND THEFT AUTO IV GETS RIGHT ABOUT GANGLAND AND ILLEGAL ECONOMIES

Unjustifiable carnage, uneasy alliances, and lots of self-doubt.

Sociology professor Sudhir Venkatesh takes a tour through the latest release of Grand Theft Auto and notes with appreciation the game creators' astute translation of actual urban life, gangland, and illegal economies onto the screen. In fact, he notes, "I found that Grand Theft Auto actually offered a less sensational portrait of gangland and ghetto streets than the one put out by most cops, politicians, policymakers, and even academics. There is nuance in the game that exceeds most of the conventional portraits of American cities. ... I was surprised a video game had such a well-developed, fine-grained understanding of human nature."

If you are a fan of the new Grand Theft Auto video game, I have just the neighborhood for you. The setting of GTA IV, Liberty City, is an amped-up version of the New York metro area. If you want a slice of the real thing, however, I would recommend Chicago's South Side. The last time I visited Chicago, I stopped by 59th Street, near Washington Park (and only a few short blocks from the picturesque University of Chicago). Two of the local gangs were fighting each other in full view for control of a prime sales spot, a hotel. For a monthly fee, the proprietor had promised to allow one gang to turn the place into a bordello -- drugs, prostitution, stolen merchandise. For the gangs, winning meant more than simply getting rid of their enemy. Neither controlled the area surrounding the hotel. Anyone bringing drugs (or women, or guns, etc.) to the hotel would have to run the gantlet formed by other enemy gangs, who would be at the ready to shoot down the transporter.

There is nothing funny about this situation. The residents of this neighborhood are living a nightmare. Their elected political officials have offered little help, and the police do not answer their calls to stop the gang wars. So you guessed it: Their only hope is to pay yet another crack-dealing gang to intervene and keep the peace between the warring outfits. To put it bluntly, they can rely on street justice by turning an enemy into an ally, or they can sit, suffer, and hope for the best.

I thought of these Chicagoans and their moral conundrum when I played GTA IV for the first time a few days ago. Nearly every review has championed the unparalleled technical accomplishments of the creative team -- and there are many. But I also found GTA IV to be a compelling commentary on urban life, gangland, and illegal economies.

This may sound strange, but I found that Grand Theft Auto actually offered a less sensational portrait of gangland and ghetto streets than the one put out by most cops, politicians, policymakers, and even academics. There is nuance in the game that exceeds most of the conventional portraits of American cities. The game goes beyond a black-and-white tale of innocent law abiders fending off the obnoxious criminals. Not that I am suggesting that we turn to GTA IV to solve the gang problem or that we should we make it required viewing in our high schools. The game is a carnival of violence, deceit, and cruelty that makes you slightly nauseated after playing for only a few hours -- I had to periodically rest and play a Neil Diamond song just to calm down. But I have to admit that I was surprised a video game had such a well-developed, fine-grained understanding of human nature.

The game's success can be traced to a simple principle: Niko Bellic, the protagonist who roams around Liberty City, making his way in the world by building relationships. Even in a city dominated by warring gangs and unjustifiable carnage, people have to find ways to work together not only to commit crimes but to resolve disputes, respond to injustice, and otherwise fulfill their assigned missions. As you move the dashing Niko through beautifully rendered streets, you build up his network of friends and comrades. Of course, in the exploitative terrain of the black market, you cannot trust anyone for long. This is one of the key challenges that animate GTA IV. But the point is that a lone wolf cannot survive. Niko has to take a risk and trust somebody.

Even the criminals must follow this rule. In the real Big Apple, the local gangs are made up of self-interested mercenaries who move about as money and circumstances dictate. A Jamaican "posse" may control one project one day, but they will move over a few blocks if the money is right. A gang member might also become a turncoat and join another outfit, even one run by a former adversary. In other words, free agents abound on Wall Street and ghetto streets. GTA IV's Liberty City gets this fluidity of enmity and alliance exactly right. A friend can become a foe; a gang member can turn on you; an ally is never to be trusted for too long. You cannot do it alone, and the game forces you to make your bets.

The story lines of GTA IV's missions also resonate with life on New York's streets. Should our protagonist help his cousin even if it is not in his own interest? Should Niko remain with his girlfriend, even if it might jeopardize his personal safety? Could an enemy gang be befriended and turned into an ally? I was always left with a residue of self-doubt after making these decisions. Right and wrong are never so clear -- at least in terms of the consequences of one's actions -- and Niko's mission can fail because you either did or did not do the right thing.

While GTA IV is both a dizzying and dazzling experience, I definitely will not be playing the game up until the final mission. I could never master the joystick in time to stop running over pedestrians while I am steering Niko's car. But I am curious to see what comes next. GTA IV was, by all reports, a huge improvement over Grand Theft Auto: San Andreas, and I can imagine GTA V taking us to even greater heights (or depths, depending on your perspective).

If the creative team needs some fuel, they might want to visit Chicago's South Side. There, they will find that gang killings and mercenary actions have some interesting consequences -- beyond the tragedy of injury and fatality. When a real-life mission fails and gangs are indicted, the remaining players must first form a gang before they can move on. No one can move forward until they come together and develop shared interests. The result can be a powerful feeling of solidarity -- albeit in the South Side, it is one often wasted on disreputable pursuits.

Another logical step for the creative crew at Rockstar Games would be to extend the logic of the current game: Why not let us form gangs ourselves in virtual space? Imagine the possibilities: My friend and I could form a gang of nasty South Asian suburban nerds. A bunch of middle-class frat boys might realize their common interests. Let women join in the fun, too. They could create a group of disgruntled ex-corporate lawyers who, after failing to make partner, go after their pig-headed male superiors. In this way, the enemies would depend on the gangs we formed, and, over time, the landscape would reflect our decisions.

And, hey, maybe different gangs can advertise online and play each other? I, for one, would love to form a group of writers who could take on the editors at publishing houses who zap my creative juices with their unintelligible feedback. I would like to run them over in the streets, get out of my car and bash their heads in, steal their keys and money, break into their homes and destroy their furniture, and then I would ... You get the point.

GAME GOOGLE, HELP THE WORLD

Why search engine optimization makes the Web a better place.

This Slate article is an interesting introduction to the world of "search engine optimization". The SEO battleground -- similar to that between spam and spam filter creators, or lions and antelopes -- is a never-ending contest between those trying to game the search algorithms and earn a perhaps unjustifiably high ranking in the results, and the search engines themselves who want their output to be useful to users.

The dating service Together bills itself as one of those high-end matchmakers that still connect people the old-fashioned way, face to face. Though they have been around since 1974, the company has long since expanded onto the Web. Google "together dating," and their site is the first result.

Unfortunately for Together, the next two results that Google delivers are from a site called Ripoff Report, which allows people to air grievances anonymously. One of the results links to a complaint from a man named Gary in Crystal, Minnesota, who bought a contract with Together off a friend for $2,300. ... The other result links to all 51 complaints about Together that people have filed with Ripoff Report.

That almost certainly hurts Together's business. Favorable or at least neutral search results are essential for any firm with a presence online. While the most compelling stories from the 650,000 search queries that AOL released in August 2006 were the bizarre things people type into search engines, the data also had a lot to say about the importance of ranking at the very top of the results. As the Guardian reported, the first result got 42% of all click-throughs, while the second got 11% and down from there.

Companies will do whatever it takes to stay at the top -- and ahead of their critics. To that end, a variety of firms promise to drown out the bad publicity with press releases and other friendly content. One even specifically promises to drown out Ripoff Report with "satisfactory rankings from the opinions of Bloggers throughout the Internet."

At first, this practice might offend our sense that the Web should empower the little guy who is up against the big bad corporation. I have argued before that democracy in social media is largely a myth. In this case, I am not convinced that the practice of optimizing press releases for prime search position is such a terrible thing. In fact, the competition it fuels should make the Web a better place.

Gaming search engines has gotten a lot more sophisticated since the days of flooding your site with the word "sex" in invisible text. "Search-engine optimization" is now an enormous industry teeming with both legitimate business -- those who simply want to help Google help you -- and shadier consultants who promise that, by hell or high water, they will get you to the top of the results -- at least for a few days. In the Web idiom, they are referred to as white hats and black hats, and the former crowd usually does not appreciate getting lumped in the same industry as the latter. (Here is a decent rundown of white-hat vs. black-hat techniques.) As usual, there are lots of gray fedoras in between.

Bear in mind that the Internet is a hugely disorganized, dysfunctional mess, rife with sloppy HTML, broken code, and millions of software-generated pages of links that no human would ever want to read. Pity the program that has to make sense of it. Most sites are miserably un-optimized for attention from search engines because many Web masters simply lack know-how to take the basic steps toward making their sites search-friendly. Those who do, or who have the money to hire people who do, are at an enormous advantage.

It is tempting to approach this subject with the consumer-protection assumption that a customer's criticism is fundamentally more honest and relevant than a company's press release. This gets a bit sticky with sites like Ripoff Report or its brethren, like Complaints.com or the Squeaky Wheel. Most allow anonymous posting and do nothing to verify the veracity of their claims. Gary from Crystal, Minnesota, could just as easily be an employee of, say, Match.com.

Because these sites aggregate thousands of complaints under one domain, they pack a lot more clout in terms of relevance, at least on some search engines. (Notice that a Yahoo search for together dating churns up a lot less criticism, as does one on Live Search.) It is very unlikely that Gary from Minnesota -- assuming he is real -- would have made it to #3 on Google's results if he posted his laments on a personal blog without much readership.

A big site like this [Slate.com] can be tough to shake from the top of a ranking. "It's very easy to change up the mix-up in the second page or the bottom of the first page" of the results, says Andy Ball, the president of USWeb, an Search Engine Optimization firm. Drowning out unflattering material in the two or three spot, on the other hand, "is going to take a long time and a lot of effort."

This is the fundamental arms race of the Web right now, and it bears a strong resemblance to natural selection. Companies with robust sites that play nicely with Google's spiders -- that is, its army of bots who read and index pages -- are rewarded with more eyeballs and better odds of survival.

There is one important caveat: The search engines write the rules, and they can rewrite them to discourage people who find a loophole in the system. They can remove and redeem individual players on demand, counsel the lower organisms in ways to succeed, and ruffle the playing field at will. (The New York Times reported last June that Google makes about a half-dozen changes to its algorithm a week. A Google spokesperson told Slate that the company averaged more than one change a day in 2007.)

If -- and this is an important if here -- search engines write and maintain the rules to reward good behavior, like entering relevant keywords and metadata that help connect search terms with content -- then searching will become a better experience for everyone. So long as sites are rewarded with higher ranking for making their sites more search-friendly, competition will spur better, more relevant results.

As it stands, many companies are still very poorly optimized for search, making it harder for them to get noticed and harder for people who are genuinely interested in their sites to find them.

As companies begin playing SEO hardball, other content providers, like media sites, will have to improve as well, spurring innovation from both parties. It helps Google, too, because it gives them better material to work with when deciding, across a broad spectrum of sites, which ones are more relevant than others -- an admittedly vague qualification. In their 1998 research paper that introduced Google, founders Sergey Brin and Larry Page acknowledged that this quality is in the eye of the beholder. As they wrote, the maps that their algorithm created, using hyperlinks from other sites as the fundamental electors of relevance on the Web, provided "an objective measure of its citation importance that corresponds well with people's subjective idea of importance."

As companies spend more money paying other sites for a few good links, for example, search engines will have to get smarter about detecting paid links, all with the goal of rewarding Web sites for behaving in ways that make them easier to search and target for specific, relevant pages.

The burden falls to the search engines to build and maintain an environment that can turn this inevitable arms race for rankings into precise search results. Thus far, they have proved to be a decent bet in this task.

BERNANKE’S NIGHTMARE CHART

Gary North once more maintains that the Federal Reserve has not been inflating, all claims to the contrary notwithstanding, since the credit crunch hit. As before, the evidence he cites is the lack of increase in the adjusted monetary base since last August. However, he does explain this time why this flat trend is unlikely to be sustained.

In this report, I introduce you to an amazing chart. It is getting zero attention from the mainstream financial media. The information it conveys is at the heart of Bernanke's looming problem. I have decided to post a link to this chart on a permanent basis in the "Free Materials" section of my website.

But, first, here is some background information. The Federal Reserve System on December 17 began a unique experiment: debt swaps with large commercial banks. The Fed is now swapping at face value highly marketable U.S. Treasury securities in exchange for discounted mortgages. Nothing like this has ever been attempted before. It represents an innovation in central bank policy. It is called the Term Auction Facility (TAF). The initial offer was for $20 billion in swaps.

Since that time, the 28-day swaps have risen in volume to $75 billion. As of May 5, according to the Fed, $150 billion in TAF swaps have taken place.

The rate charged is about 2%. This is why the Fed has cut the FedFunds rate to 2% -- not to stimulate the economy directly but to make available TAF loans at low rates.

Here is how the game is played. The borrowing banks can place the borrowed Treasury debt on their books at close to face value. This looks as though the banks are meeting their capital requirements. What is really going on? Deception on a massive scale -- a fully legal deception that the U.S. government's bank auditors understand and go along with.

Let me make a comparison. When a person who wants a mortgage signs the loan application, he is asked if any of his down payment is borrowed. The lender does this because he wants the equity to belong to the home buyer. He does not want any other lender, such as a relative of the home buyer, to be able to claim first dibs on the money if the home buyer walks away. On the other hand, when it comes time for a large bank that loaned money to a defaulting borrower to cover itself by borrowing high-rated assets, the bank's auditors do not ask the same question of the banks: "Is any of this capital borrowed?"

The Fed's decision-makers were able to convince four other central banks to adopt a similar swap policy with the government-issued debt of their nations. The Fed is making it worthwhile for the other central banks to cooperate. It is providing these banks with the money to make the swaps. The Fed's May 2 announcement describes what is going on.

In conjunction with the increase in the size of the TAF, the Federal Open Market Committee has authorized further increases in its existing temporary reciprocal currency arrangements with the European Central Bank (ECB) and the Swiss National Bank (SNB). These arrangements will now provide dollars in amounts of up to $50 billion and $12 billion to the ECB and the SNB, respectively, representing increases of $20 billion and $6 billion. The FOMC extended the term of these reciprocal currency arrangements through January 30, 2009.

The fact that the other central banks are going along with this plan indicates that the subprime mortgage crisis has spread far beyond the borders of the U.S. Commercial bankers in other nations made the same mistake that America's commercial bankers made. They assumed that a package of mortgages with different degrees of risk would create sufficient risk diversification that the market value of these packaged pools of debt would not fall from book value. Beginning in August 2007, this assumption was revealed to be breathtakingly naive.

Bankers loaned money to hedge funds to buy these packaged mortgages. Now the hedge funds that invested heavily in these mortgages are unable to pay interest to the banks. The liquidity for these assets has fallen. The market has discounted these assets to 80% or less of face value. So, the collateral for the bank loans to the hedge funds is trouble. If the banks mark these assets at market value, as new accounting rules in the U.S. require, then the banks will have to cut their estimates of their capital, which will require that they cut their lending. All this is happening as a recession in the U.S. has begun, despite the financial media headlines. This has been argued persuasively by economist Stefan Karlsson.

WOULD YOU FUND A USED CAR PORTFOLIO FOR THIS BANK?

Back in 1960, a Democrat drew a cartoon of Richard Nixon. Under the Nixon's face was this question: "Would you buy a used car from this man?" Because the election was so close, we can blame Nixon's defeat on almost anything, including the ballots cast in Cook County, Illinois, where, in the words at the time of black comedian Dick Gregory, "your vote really counts, and counts, and counts." But I prefer to blame that cartoon, which was reproduced everywhere.

With this as background, let us consider the words of the Federal Reserve System as of May 2.

In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve's Schedule 2 Term Securities Lending Facility (TSLF) auctions. Primary dealers may now pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations, beginning with the Schedule 2 TSLF auction to be announced on May 7, 2008, and to settle on May 9, 2008. The wider pool of collateral should promote improved financing conditions in a broader range of financial markets.

Deciphering the FedSpeak, we learn that the Fed is swapping U.S. Treasury securities for packages of loans on just about anything. I suppose this could include cars, if the FOMC decides the asset meets its wider standards.

I cannot help it. I have this mental image of Ben Bernanke on some late-night television commercial for used cars. He is out on the lot, walking down a row of used cars. "Friends, you've got to get down here tomorrow morning. No matter how long and hard you look around town, you won't find a beauty like this 2005 Hummer." He whacks the hood. The bumper falls off.

All over the banking world, the bumper has fallen off. As for the AAA-rating, let me quote the late Senator Everett Dirkson. "Ho, ho, ho -- and, I might ad, ha, ha ha." If the AAA rating meant anything significant, the paper would not be trading at discounts from face value.

Consider these words: "The wider pool of collateral should promote improved financing conditions in a broader range of financial markets." Let me translate.

The wider pool of eligible capital for swaps will allow banks to convince government auditors -- wink, wink -- that the assets on the banks' books need not be marked to market with a discount. Therefore, the banks will not have to call in loans in order to bring their loan-to-capital ratios back into line with regulations.

HOW LONG CAN THE GAME GO ON?

It can go on for as long as the Federal Reserve System has U.S. Treasury debt to swap. As Hamlet said, "There's the rub."

In November, 2007, two weeks before the first TAF auction was held, the Federal Reserve System held about $800 billion in Treasury debt. As of May 1, it held $539 billion. "May day! May day!" The Federal Reserve's "creative financing" to bail out banks that have invested in creatively financed mortgages has a limit. The limit is its portfolio of Treasury debt.

This brings us to the chart. It is published by Cumberland Associates. It lets us see the decline in the Fed's holdings of Treasury debt. The important section of the chart is labeled "Securities." The color is deep purple.

It took from 1914 until November 2007 for the Federal Reserve to accumulate $800 billion worth of Treasury debt. It has take from December 17 to the end of April for the Fed to divest itself of $260 billion of this portfolio, a decrease of 1/3. In its place, it has placed AAA- rated mortgages. At the current swap rate, the Federal Reserve System will be out of Treasury debt in December of 2008. But by adding car loans to the list of eligible paper, the Fed has guaranteed that this rate will accelerate.

During this period, the financial media have remained characteristically mute. Half a century ago, in Damn Yankees, the musical treated us with this lyric: "Whatever Lola wants, Lola gets, and little man, little Lola wants you." The Fed wants a docile press to match the docile Congress. It gets what it wants. "There's no exception to the rule. It's irresistible, you fool. Give in."

The chart is Bernanke's nightmare. It reveals the reality of the limits of the Fed's program to make the banking system solvent without creating fiat money by purchasing assets. The Fed has not created new money since early last August. In fact, it has deflated. We can see this in the chart. Its ending date in May 1.

Several decades ago, Ben Stein's father Herbert, who had been the head of Nixon's Council of Economic Advisors, uttered one of the profound observations of our era: "When things can't go on, they have a tendency to stop."

The more common cited version of the quote is: "If something cannot go on forever it will stop."

The Fed's swap programs are going to stop. I think they will stop this year. If I am correct, then the Fed will have to come up with a fall-back program.

INFLATION IS ONE ANSWER

If the Fed buys more Treasury debt to swap for AAA- rated paper held by banks and financial institutions, then it will have to abandon its anti-inflation policy. Then again, the Fed could keep the game going a while longer. It could sell its other major asset: gold. This of course assumes that the Fed still is sitting on physical gold. If it is, it can sell it. For accounting purposes, it is held at $42.22 per ounce.

If it hikes the price by 20 to one before selling, this will increase the monetary base, just as surely as the purchase of a comparable quanti ty of T-bonds would. The Fed officially holds 262 million troy ounces of gold. That is over $200 billion in gold at $800 per ounce. To sell gold at $42.22 an ounce would transfer enormous windfall profits to the buyers. Congress might take a close look at such an arrangement. Technically, the U.S. government owns the gold. So, I do not think the Fed will sell off its gold.

The Fed is hoping that the market for AAA-rated mortgage packages and car loan packages will recover before the end of the year. If it does not, then the banks will no longer have a cooperating buyer of these packages at face value for 2%.

CONCLUSION

The clock is ticking for Dr. Bernanke and his fellow Board members and Federal Open Market Committee members. They have adopted the most creative "creative financing" program in central bank history. They have invited other central banks to adopt the program, which they have.

The problem is, there is an economic law here: "At a below-market price, there is greater demand than supply." There is a rush by commercial banks and financial institutions to swap AAA-rated paper for Treasury debt. I can understand their enthusiasm.

The game cannot go on indefinitely. Remember Herb Stein's law: "When things cannot go on, they have a tendency to stop."

The Fed is not inflating today. My opinion is that it will not maintain this policy through 2009.

With all due respect to Mr. North -- and a lot is due -- we fail to see how buying assets at greater than market value is not already inflating. North has identified why the current Fed scheme cannot go on indefinitely, but it is not fooling anybody anyway. The adjusted monetary base may not have gone up since last summer, but markets antipate events, and they see full well where the Fed is leading us.

THE NEXT BIG THING: CONSUMER DOWNSIZING

With the U.S. consumer by all odds tapped out, even if certain statistics have not yet utterly confirmed that, one might be suspicious about high P/E stocks that depend on middle class Americans' discretionary spending. Count us in. Herein are a few suggestions about how to take advantage of this incipient trend.

The "next big thing" our friends at The Daily Reckoning recently predicted, "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." This new austerity craze -- if/as/when it arrives -- will impose hardships on many American companies. But a select few might actually benefit.

The cause(s) of downsizing are pretty clear. Home values are falling so sharply that very few homeowners can still pull equity out of their houses. Stock prices are also drifting lower, more or less. Meanwhile, inflation is ramping up. 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 per day (more consumption)," Warren Buffett reminded us last week, "is inconsistent with a stable dollar (more inflation)." We share Mr. Buffett's concern. Bernanke keeps printing. Politicians keep promising. Bridges keep crumbling. Wars keep spending. ...

But that is not to say the S&P cannot weather the storm. The companies representing the Standard & Poor's 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.

Unfortunately, many Americans believe a strong 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 see the American consumer eerily close to tapping out. 34% of Americans now believe they are among the "have-nots."

It serves to reason. More than 405,000 homeowners lost their homes to foreclosure last year. Most middle-income Americans, the ones driving our buy-now, pay-later economy, have spent well beyond their means. Americans currently perpetuate a negative savings rate. That cannot last forever.

Cheap oil and cheap credit have fueled this era of consumption ... this gilded age of instant gratification. But the days of ultra-cheap oil are firmly behind us. The U.S. government began pricing oil at $225 per barrel in the not-too-distant future, says our oilman Byron King. The U.S. Navy, for example, is currently designing future ships using $225 per barrel as a baseline for the price of fossil fuel. The days of ultra-cheap credit look to be waning, as well.

The endgame: Americans will be forced to consume less and less. It seems to us that cutbacks are the only option. So investors should be very cautious on stocks reliant on American consumers. We suggest you take special note to exercise caution regarding companies like Apple Computer, Starbucks or P.F. Chang's China. We have no particular prejudice against any particular one of those companies. In fact, we could have easily picked three different businesses.

Simply put, 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 smokeswell before he made another dinner reservation on his 2008 iMac while sipping a $3 cup of joe. Furthermore, these companies are not cheap.

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 staunching 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?

You get the idea. So for those readers stubbornly loyal to the American economy, we believe the best American equities right now are top-quality blue chip stocks that provide staples to the American and foreign consumer. Stocks like Exxon, Johnson & Johnson and the Altria Group come to mind. We are not recommending these businesses. We are only using their names to make a point: Downsizing is the next big thing.

ETHANOL POLICY

The U.S. ethanol subsidization policy was almost certainly doomed to fail from the start, and it was definitely a boondoggle from the start. Kevin Kerr fills in some details.

It seems that every time you pick up the paper or switch on the TV, someone is talking about a new way to make his car run on biodiesel or ethanol: "I converted my car to run on old McDonald's french fry oil, and the mileage is pretty darn good."

Well, there we have it ... energy crisis solved ... right? Wrong. You see, for every good idea and every well-thought-out plan that may work on a small scale, there are always problems on a widespread level. Ethanol from corn is a perfect example. We will examine why ethanol has failed in a moment. And why even bother with alternative fuels? Do we really need them?

Let us think about some alternative fuels and energy sources. Think of nuclear, solar, hydrogen, geothermal, coal and biodiesel. While we are at it, let us think about ideas like recycling, conservation, smaller cars, efficient homes and even walking. Yes, walking. These ideas are no longer just for polite cocktail party talk. These things will now be necessities if the world -- and, most certainly, the U.S. -- is going to continue to function in the face of dwindling easy-to-get-to sources of oil.

One thing is for sure. The vast petroleum needs of a growing planet are not slowing down. In fact, quite the opposite. We suddenly have a whole new ballgame, as millions and millions of new drivers hit the road in India and China. The economic boom in those places has spurred a new middle class. These are not the regimented masses of just a few decades ago. The new middle-class citizens of the developing world are not content with meager rations, bare-bones quarters and Mao or Nehru jackets. Instead, they are demanding more luxury items and a far superior standard of living. And you know what? They have the money to pay for these things.

So we have a problem. There are a lot of people competing for the world resource pie. But the pie is not growing very fast. In many ways, the size of the pie is static, and in some respects, it is actually shrinking. Thus, we get the golden rule of supply and demand, which is that those who have the gold make the rules.

The idea of ethanol from corn or other feedstock is not new. Byron King and I have talked about this in our Outstanding Investments letter many times before. Farmers have used ethanol from corn for years on a local basis, and it has served them well.

I visit many farms every year. One small town in Minnesota is a perfect example of how corn-based ethanol's evolution went from a simple small-scale solution to a nationwide disaster. In the small southern Minnesota town of Waseca lives a good friend of mine, Geb. Geb is a lifelong farmer and resident. Geb made his career in farming, and his hands tell the tale of many years of hard work and toil. Geb now enjoys retirement and investing, and his son Scott handles the day-to-day operations of the farm.

I visited Geb and Scott's farm about two years ago. As we walked over his farm, Scott was nice enough to show me the incredible advancements in farming technology. Global Positioning Systems (GPS) in the tractors and combines enable the driver to know exactly which parts of the fields he has already sprayed with fertilizer, in order to save money. And this level of technology is just a start. There are many other things that make this not your father's farm. Different seeds, different irrigation methods, different weather forecasting. I was impressed.

Later that day, the discussion of ethanol turned into more of a history lesson and led me to realize that corn-based ethanol on a nationwide scale was going to be a disaster. (Remember, this was about two years ago.)

Would it not be great to grow enough of something in your yard and then have a machine turn it into fuel you could put in your car? What could be better than taking a small portion of your corn crop and converting it into ethanol at either your farm or the locally owned farmers' co-op down the road? You could then use the ethanol to run your farm vehicles. And if you did not need all of it, you could sell a little to the local gas station or your neighbor. It makes an incredible amount of sense on that small-scale level, and it worked like that in the Corn Belt for many years. Fast-forward to 2008 and we find a much different story.

The idea was simple at first. We would use ethanol for fuel, just as they do "back on the farm." But when the time came to scale it up, everything became super complex. Oil prices surged year over year, and the idea emerged that alternative fuels -- like ethanol -- would start to replace oil, just as they had done in Brazil years earlier. It was a nice idea. However, without any real planning or study, it was doomed to fail. And now we know that it has failed.

POWERING IRRIGATION WITH SOLAR ENERGY

This article presents an interesting speculative play on the energy and water problems plaguing farmers now getting wider-spread recognition. Something to put on the watch list perhaps.

One of the largest problems for farmers is getting sufficient supply of water to their fields. The other problem ... is the cost of fuel. You have heard the stories about truckers striking on highways and national "Don't gas up" days, and now you are starting to hear about farmers unable to fuel their tractors. That is a major concern as the price of diesel -- which is used in over 95% of tractors and other farm equipment -- reaches $4.25 per gallon.

Even if you read Kevin Kerr's blurb, you may not be aware of the impacts that fuel and electricity prices have on water supply. We are talking the powering of irrigation equipment. Today, dear reader, we have the solution ... and one micro-cap with the technology to solve this problem. ...

Worldwater & Solar Technologies, Inc. (WWAT: OTC) is a solar technology development company that focuses on farmers' needs. The company's lead product, AquaMax, is the simplest answer to the highly complex irrigation problem.

Powering the massive irrigation systems of our beloved Great Plains is a huge problem. Sure everyone is focusing on how to bring new energy onto the grids, but no one -- that is until now -- has thought outside the box (or grids in this case).

AquaMax is a very simple, yet innovative, development. It works like this: A series of solar panels are set up on the farm, which tie into the power grid already in place. This gives the farmer his own secondary source of power, which juices up the underground water pumps used in the irrigation system [see diagram].

This does a number of things, which the company's website does a great job of explaining in this chart. As you can see, AquaMax keeps the water flowing even if the grid goes down, saves the farmer thousands of dollars when the sun is shining, and eases the strain on pump motors -- which increases the lifespan and costs of replacement of the motors.

Now, of course this company does not come with a guaranteed profit. In fact, much of the anticipated growth is already factored into the shares of Worldwater. Last year, from the January 1 to mid-summer, shareholders had the chance to pocket over 530% gains! But, as everything else in the market fell apart, so did shares of Worldwater ... giving back nearly 50% since its peak. That may or may not give us a buying opportunity.

But, I will say this ... any company with a technology like this to save farmers right now, might see very similar or better results over the next few years.

INVESTING IN LEAPS

LEAPS are options with long-term expiration dates. Due to the vagaries of effcient option pricing, it often seems like an option that expires in three years is priced at a surprisingly small premium versus one that expires in three weeks. Rest assured that this is an illusion, at least vis a vis the inputs that govern option prices: option strike price, asset price, volatility, risk free interest rate, and time to expiration. However, if you believe you have an insight not priced into the current market value of the asset, longer-term options give the capacity to leverage your bet while also giving you more time to let your thesis proove out. It is a, well, option worth knowing about.

LEAPS stand for Long-Term Equity AnticiPation Securities. Like options, LEAPS are traded publicly and represent the right to buy or sell an underlying stock at a predetermined price. But unlike options, which have expiration dates measured in months, LEAPS expire in a matter of years. That means that LEAPS let investors make long-term plays long after options would have expired.

As with regular options, LEAPS plays are not relegated to individual stocks -- LEAPS are also available for major indices like the S&P 500 and the Dow, and LEAPS are also now available for sector groups.

So what is so great about having options that last for more than one year? Well, for starters, having more time until expiration means that any movements the underlying stock makes can going to be a lot bigger than anything you would see with shorter-term options. ...

Because of this, LEAPS are an excellent way to make long-term leveraged plays on most widely held stocks. Because purchasing $1 of LEAPS gives you several dollars of investment leverage, going long with LEAPS is a popular way of making bets on a stock.

One of the best ways to achieve this over a longer period of time is by using "rolling LEAPS." Even though LEAPS offer longer expiration dates than regular options, it may not be enough time for your investment to come to fruition. That is where rolling LEAPS come in.

With rolling LEAPS, you rollover your LEAPS when they expire by selling your current LEAPS holdings and buy the equivalent one with a later expiration date. Theoretically, you can rollover your LEAPS indefinitely.

Remember, though, that every time you roll your LEAPS over, you will have to pay for the new ones, meaning that if you do it for long stretches, your investment had better be going up enough to cover the cost of the LEAPS options!

Like options, LEAPS are also a great way to hedge the stock holdings in your portfolio -- especially the ones you are planning on holding for the long-term.

Like most things, LEAPS do not come without a caveat. Since they give you more time to realize your gains, it stands to reason that LEAPS cost more than traditional options do.

How much more? Well, a General Electric call option that expires in May 2008 with a strike price of $30 costs $3.05, while the LEAP that expires in January 2010 costs $5.90 today. If you do not plan out your investment predictions well enough, a few bad LEAPS buy could end up cutting into your portfolio performance.

And even though LEAPS are not a foolproof investment tool, they are one that can put you "LEAPS and bounds" ahead of the competition if used well.

COMMODITIES INVESTING

An excerpt from legendary Jim Rogers's book Hot Commodities addresses and dismisses away some of the myths many people associate with commodity markets. A lot of the prejudices we hear against "commodities" -- as Rogers relates in his book as well -- are linked to stories about how one can lose "everything" participating in the futures market using small margins -- except that the last factor often gets lost in the story. High leverage makes any investment risky. It just takes more leverage to make an otherwise dull investment, like 2-year T-notes, exciting. A little less leverage will do the trick for raising your blood pressure when trading pork bellies.

Recently, at a party in New York, I mentioned that I had been talking to various groups in the United States and Europe about investment opportunities in the commodities market. Before I could get out one more word, a woman interrupted me. "Commodities!" she exclaimed, with the kind of incredulity in her voice that Manhattanites reserve for people moving to Los Angeles. "But my brother invested in pork bellies and lost his shirt. And he's an economist!"

Everyone seems to have a relative who took a beating in the commodities market, and this fact (or fiction) is considered sufficient reason that no sane person would ever risk playing around with such dangerous things. That this particular victim was also a professional economist makes the warning seem even more ominous. I, however, could not help laughing.

Billions of dollars are invested in the commodities market every day. Without the commodity futures markets, many of the things that you depend on in life, from that first cup of coffee in the morning to the aluminum in your storm door to the wool in your new suit, would be either scarce or nonexistent, and certainly more expensive.

There are several other bromides out there for why "ordinary people" should not invest in commodities, and I want to lay these myths to rest, once and for all, so that we can get on with the more interesting business of how you can begin to make some money investing in the next-generation asset class.

About That Relative of Yours Who Got Wiped Out -- He was inexperienced. You can learn. Most likely, he was buying on thin margin -- the minimum deposit a broker requires to take a position in a particular commodity -- and when the market went against him he lost big-time.

Here is how it happens: Like stocks, commodities can be bought on margin. Unlike stocks, however, where by law you have to put up at least 50% of the price of the shares, the margins on commodities can be even lower than 5%: You can buy $100 worth of soybeans for $5. If soybeans go up to $105, you have doubled your money. Beautiful. But if soybeans go down $5, you are wiped out. Not so beautiful.

Experienced, smart speculators can make tons of money buying on margin. They also know that they can lose tons, too. But they can usually afford it. Your relative was in over his head. If he had bought $100 worth of soybeans in the same way that he can buy IBM -- for $100 (or maybe even $50) -- he would be happy when it goes up $5 and a lot less sad should it go down $5.

Whenever I mention commodities in public, someone always points out that we now live in a high-tech world where natural resources will never be as valuable as they were when we had a smokestack economy. But if you read your history you will discover that technological advances are as old as history itself: The introduction of the sleek and beautiful Yankee clipper ship dazzled the world in the mid-19th century, loaded with cargo, sailing down the trade winds at 20 knots and more, averaging more than 400 miles in 24 hours and able to make it from U.S. ports around Cape Horn to Hong Kong in 80 days; within a decade, the clippers had been replaced by the steamship, no faster but not dependent on wind power; and before long the next big thing in transport had taken over, the railroad, which, of course, was the original Internet -- and prices in the commodities market still went up.

In the 20th century came electricity, the telephone, and radio (three more Internets) and then television (a fourth Internet). There was also the automobile, the airplane, the semiconductor -- and in the midst of all of these truly revolutionary technological breakthroughs came periodic, multiyear commodity bull markets.

When the supply and demand in raw materials is seriously out of whack, the emergence of new technology will not necessarily restore the balance quickly. To be sure, changes in technology, for example, have made the economy less dependent on oil. But we still use plenty of it, and whenever there is not enough prices will rise. Computers or robots may do amazing things, but they cannot find oil or copper where there is none or make sugar, cotton, coffee, or livestock grow faster than nature allows. We can put in orders all day long on our computers for lead, but all that Internet technology will be in vain if there are no new lead mines. Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear.

“But My Stock Broker Tells Me That Investing in Commodities Is Risky.”

Tell me again about all those Cisco shares you owned back in 2000. Or JDS Uniphase, or Global Crossing? So many risky stocks made the turning of the new millennium a not so happy time for many, who watched their portfolios evaporate.

If you do your homework and remain rational and responsible, you can invest in commodities with perhaps less risk than playing the stock market. You do not need me to emphasize that investing in anything is a risky business. But let me point out something that you might not have realized: There has been more volatility in the NASDAQ in recent years than in any commodities index. Cisco, Yahoo! and even Microsoft have been much more volatile than soybeans, sugar, or metals. Compared with the risk record of most tech stocks, commodities look safe enough to be part of any organization's "widows and orphans fund."

And let me remind you of one more important difference between commodities and stocks: Commodities cannot go to zero, while shares in Enron can (and did).

COMING PEAK FOOD

It seems everywhere I go, people want to learn more about commodities trading, the resource markets and where I think we have been and where these markets will go next. Whether my travels take me to the Middle East or the Midwest of the U.S., the stories are very similar. Most people are concerned about the rising costs of commodities. Investors and fund managers are always asking me if this is a commodities bubble and when it will burst.

In fact, now you have all of these dollar bulls coming out and saying that inflation and the commodities markets are simply speculator driven and the worst for the dollar is over. I disagree. Do you remember as a child wishing for something, wishing so hard, yet it did not come true? Wishing for something to happen does not mean it will be so. (I never did get that red bike.)

As I shared with my Outstanding Investments readers, and as my Resource Trader Alert readers know, I sold our silver positions for some solid profits a few months ago, and then sold half of our gold, too. And just the day before the gold sold off, it looked brilliant. But I have to claim a little luck on that one. Any good trader knows to give credit to Lady Luck once in a while. Anyway, it was the right thing to do, and now that gold is correcting, my new target is around $850. And here we are: I think now it is more like $820, but I am seriously looking at adding more longer-term options down here in both gold and silver.

I believe this move in the dollar will continue a bit, although short-lived, and the same problems that drove the dollar into the basement will persist, and even worsen. The Fed cannot just snap its fingers and wipe away twin deficits with some stimulus checks. Too many folks are subscribing to the idea that the consumer will somehow come to the rescue and spend our way out of recession. It is pure fantasy.

Do I think commodities are in a bubble? No. Do I think that there is a lot of froth in the market? Absolutely. The fact of the matter is that we are in a new paradigm for commodities and the old-school thinking about how commodities used to be traded has to be changed. And this is true of most commodities -- none more so than the agricultural ones.

Peak Food: You Heard It Here First

As I sit here in the transit lounge for business class, I am watching CNN out of the corner of my eye, and on the air is Jonathan Stevens, a baker from a Massachusetts company called Hungry Ghost Bread. He is starting to grow his own wheat and encouraging his customers to do the same. Not a bad idea. For a 50-pound bag of organic flour, he used to pay $25, but now pays around $60. So in back of the store, the bakers are now growing their own wheat. Funny, but they may have the last laugh.

Now, while farming in your backyard may not seem very practical, it is great marketing, and also a new reality. Costco limiting the number of bags of rice -- and now other things -- that you can buy is clearly physical demand. I am a speculator and a Costco member, but have not been there to buy rice lately, especially 20-pound bags.

Sure, speculation is a part of this puzzle, but to lay the blame on the farmer's doorstep or to say it is all speculators and hedge funds causing the run-up is a sad mistake. Real physical demand and a weak dollar are two of the biggest reasons. I do not see demand going anywhere but higher, and this year is getting off to a bad start for agriculture in the U.S., as the weather has been awful. This year's corn crop could be extremely disappointing. We are betting on much higher prices in soybeans and corn over in Resource Trader Alert and are using option spreads to take advantage of this. I just got back from meeting with farmers in Minnesota and learned some very interesting things and ways to invest for the next big move. ...

I have to say it is very satisfying to have been one of the only people at last year's Agora Financial Investment Symposium to speak on the topic of Peak Food. Some of my colleagues snickered ("There goes Kevin again") and some audience members looked puzzled. After all, nobody in the mainstream press talked about higher food prices or the coming rally for agriculture, and now we seem to hear about them every day.

Times are certainly getting tough out there. Hey, I'm just the messenger.

With Food Prices Soaring, You Need to Protect Yourself

My grandmother, Oget Palm, was just a little girl when my family was scheduled to sail from Europe to New York in 1912. Her parents (my great-grandparents) and her siblings were prepared to make the trip from Gothenburg, Sweden, where they lived. They were scheduled to be in the steerage compartment -- as all immigrants were -- aboard the newest and "safest" ship on the sea, the RMS Titanic.

It is funny how fate can change so many lives. Just before the trip from Sweden, my great-grandmother contracted rheumatic fever, or what they used to call consumption. Nobody is really sure why. She was only 33. Sad to say, she died.

But there is another side to the story. The family was delayed from sailing to America as they mourned their loss. Thus, they missed sailing on the Titanic. And everyone knows what happened to the Titanic.

Later on, my grandmother and her family sailed into New York Harbor on a different ship. She remembered gazing at the Statue of Liberty. I returned with her in 1997, and we walked through Ellis Island together. We even found her name in the book they used to categorize everyone who came through, an experience that is truly chilling. Back then, everyone was processed at Ellis Island and made their way to the places where they had relatives. Typically, the Swedes and Norwegians went to Minnesota, and that is how yours truly ended up being born there.

The light that burns twice as bright burns half as long. And America has burned very brightly for a long time. As the resource battles begin to heat up, we are already seeing where some of the major battle lines will be drawn, and it is not a pretty picture. The simple fact of the matter is the world's resources -- not just oil -- are dwindling faster than Britney Spears' career.

While shortages of key industrial and energy commodities are frightening, no other sector will threaten global stability more than agriculture.

It seems ironic that as global population is reaching an all-time high, we are turning at least half of our crops into ethanol or biofuel. This is a questionable, if not idiotic, alternative that clearly does as much damage as good. While the short-term impact is obvious, the longer-term ramifications for agriculture on a global scale could be devastating.

In 2007, we saw stark glimpses of just how bad this situation will get. The "Tortilla Crisis" in Mexico, the "Pasta Protest" in Milan (I happened to be there for that one), the riots and crushing of one supermarket shopper in China over cooking oil ... we have seen dairy, meat and bread prices skyrocket.

The idea of food inflation is new to many Americans, who are used to prices for food being only about 13-16% of income. Back when my grandmother got off the boat in 1912, they were more like 45%.

In recent years in the U.S., the number of immigrants has swollen. The porous borders continue to attract newcomers as if it were still 1912. Here in the U.S., a lot of people think that America can still absorb a massive influx of immigrants from all over the planet who are poor, tired and hungry. And while that is nice, romantic thinking, the fact of the matter is we cannot. Now, I would hate for us to change the plaque on Lady Liberty to "Bring us your well-fed and rested, employable and intelligent," but the truth is maybe we have to.

As investors, we must look at this situation as an opportunity for our portfolio. First of all, I suggest if you have some extra land (condo developers and house flippers, listen closely), grow a vegetable garden, and if you are ambitious, raise some sheep and cows, because they will come in handy. A little more practical and with less bunker mentality is to add stocks of some of the key agricultural companies that help support the industry, like those dealing with equipment making, fertilizer, irrigation and transport.

My grandmother may have missed the Titanic, and figuratively, I hope we all do too. But keep in mind that our ship (the USS America) is sailing in uncharted waters and we had all better get smart fast. Really, the food supply is stretched and getting stretched thinner and thinner. There are only so many lifeboats, and unfortunately, that is the new reality. Increasing population and rising demand for scarce resources mean that there is a big iceberg ahead. So man your stations.

GROWING YOUR MONEY IN CHINA

Is now the time to get into China, now that the market has undergone a very serious correction? Perhaps. Wayne Mulligan strongly believes in the long-term case for investing in the country. As for the timing of your entry (or reentry), he only suggests that now is the time to be taking a "VERY" serious look.

There was a question on TickerHound a couple of weeks ago that touched on a subject I am personally very passionate about. However, I held myself back from weighing in right away. I really wanted to see what some of the other TickerHound community members had to say.

We got some AMAZING responses to the question: "People are saying the China bubble has popped and we will not see profits there for a while now -- thoughts?" Click here to read a few of them.

And now I feel like it is my turn to weigh in on the "China Story." Anybody who has known me for a while, knows I have had an interest in this market for quite some time. I lived in China for a while. I speak Mandarin Chinese, I studied the subject extensively in college and some of the biggest winners I have ever had in my portfolio happened to be investments in Chinese stocks. So needless to say, I am a long-term bull on the overall success and prosperity of China as a country and as an opportunity for profits.

But the member who asked the question definitely has valid concerns here.

The Negatives

The Chinese equity markets have been white hot for several years now. In four years FXI (FTSE/Xinhua 25 Index) -- the ETF that tracks the 25 largest companies in China -- shot up 300% before beginning a decline in November 2007. Since then, the fund has dropped by more than half in a very short period of time.

China's also been hit with a number of well publicized infrastructure shortfalls, such as its inability to deal with a massive cold snap that gripped half the country last year. Not only that but with the product quality issues that have been making headlines (tainted medicine, children's toys containing toxic chemicals, etc.) and the latest spat with Tibet, it is no wonder why many people would question if it is wise to continue sinking money into this country.

But, as always, there is another side to the China Story ...

The Positives

I could sit here all day and list the positive qualities the Chinese economy has going for it.

I can talk about the massive consumption of commodities, the record number of college graduates and the tremendous amount of homegrown industries cropping up all over the place. But the fact of the matter is, somebody could come along and have three arguments against each of these reasons. So I am not going to even discuss those things here. Because there is one thing about China's economy that nobody can argue or disagree with: China's demographics!

This is a country with 1.4 billion people! To put that in perspective, the U.S. only has 280 million people, so that is about five times the size of our country. Back in 1981, almost 53% of China's population lived below the poverty line. Today, that number is under 8% -- that means China has almost 500 million people who were once poor and no longer are!

That is half of a billion people who are now part of the middle class and want to buy goods, services and products commensurate with that newly found social status. Goods like cars, homes, technology products, etc.

The aggregate demand that has been built up in this country is only just beginning to be unleashed. In this writer's opinion, China is by far and away the greatest wealth generating opportunity for the next 20 -- 30 years!

Long-Term Opportunities

Now, is this to say that China's market could not go down further? Of course not ... But I am not talking about investing in China for the short term here -- these are long-term factors we are talking about (demographic shifts, aggregate demand, etc.), and therefore, we need to take a long-term perspective when looking at this country as an investment opportunity.

So, if you have a belief in this sector as I do, then the question should not be, "Should I invest in China?" The only question in your mind should be, "When should I invest in China?"

And remember ... this is not a recommendation to run out and start buying stocks or funds in this market. It is a recommendation to take the opportunity in China VERY seriously and equip yourself with enough information to make the right decisions. Because you have two choices here:

Be the guy on the golf course listening to stories about how much money your golfing buddy made investing in China.

Profit from Wireless Technology in China

Following up on the article above, Wayne Mulligan has a specific recommendation for investing in China: Its #1 wireless carrier. Selling at a P/E of 33 the stock is not cheap, but we have seen growth stocks sell for a lot more in our day.

Well, it looks like my article on China last week [above] raised some new questions for you and some of your fellow investors out there. One of the questions that hit TickerHound as a result was: "Ok, China's a great place to be -- but what stocks can we invest in for the long term?"

Now I tried to stay away from this question when writing my original article. If you do not have the time to really study this sector, then you are better off finding one of the ETFs that tracks China's markets and investing directly into those instead. But I can understand that some people out there do, in fact, have the time to study individual equities in this sector and just need a push in the right direction. So for today's article, I am going to discuss one stock that has served me well for a long time and that I think will continue to outperform the market over the long haul.

But before I get into that, here are a couple of those China ETFs I was talking about. They are definitely worth looking into if you want some exposure to China but do not have the time to dig too deeply into the Middle Kingdom:

• SPDR S&P China ETF -- Symbol: GXC
• iShares FTSE/Xinhua China 25 Index Fund -- Symbol: FXI

Both funds have been down this year, along with the equities markets in China, but as I said, this is for those who have a LONG TERM belief in this market and are looking to position themselves for the long term.

For me, investing in China is a no brainer ... We are coming into a country while it is still very early on in its growth phase. The economic picture is improving each month. And the companies do not have to be terribly innovative in order to profit -- all they really need to do is take a page from the playbooks of their Western counterparts and they have an instant recipe for success.

So when I look for individual stocks to buy, I try to take a top-down approach. First I try to identify the most rapidly growing markets on a global scale -- that is how we got to China in the first place. Then I try to find the hottest sectors in these markets. Right now, I think you would have to agree that the hottest sectors in China are commodities and technology.

From there I try to find the sectors that I know the most about -- in this case, it is going to be technology (in particular, wireless technology). And finally I try to find the strongest companies within that sector. Then all you have to do is make sure you are buying the stock at a reasonable price and from there it is like shooting fish in a barrel!

So now that the stage has been set -- we are looking for the strongest wireless companies in China -- we can discuss the one stock I think could show long-term oriented shareholders some very handsome profits for many years to come. And that stock, my friend, is China Mobile (CHL: NYSE). Here is the quick 'n' dirty:

• China's population is at about 1.6 billion people.
• There are only 555 million mobile subscribers -- that means almost two-thirds of China's population still does not have mobile phone service ... Essentially, there is A LOT of room for growth here.
• China Mobile holds the dominant position in the market with roughly 450 million subscribers!
• The company has made a major push into rural areas to scoop up customers before the competition, thus cementing their position in the market even further.

The bottom line: The wireless penetration rate in China will continue to increase and China Mobile will likely be the company most people will be using. That means BILLIONS of dollars in recurring subscription and services revenue for China Mobile -- and some serious profits for shareholders. While the rest of the market in China has done well over the last 12 months (up roughly 45%) China Mobile did even better than that, rising almost 90% in the same period!

What about the price? Great question! China Mobile's closest competitor, China Unicom (CHU: NYSE), has a P/E of about 40. China Mobile's is approximately 33. ... China Mobile is trading at a serious discount given how much larger and more successful the company is. The stock is 15% off of its October/November high and to me that smells like a buying opportunity.

So for those who are looking for some long-term exposure to one of the strongest companies in the hottest sectors of the fastest growing market in the world, then China Mobile is the place to be!

PROFIT FROM THE GRADUATION TO A MAJOR EXCHANGE

An interesting short piece on stocks that "graduate" from over-the-counter status to a major "exchange" (NASDAQ is evidently considered an exchange these days). Apparently only 2% of companies listed OTC accomplish this jump (keep this in mind the next time you get a tout via email or the regular mail), but for those that do there is an interesting pattern they follow, on average.

I spend a lot of time researching tiny, over-the-counter companies. Many of which are too small to mention here. After crunching the numbers, reading the reports, and listening to the calls, I sometimes check out the message boards. If for no other reason than to have a chuckle. People on those things crack me up.

Anyways, on almost every single one, there is a string of comments about the company jumping to a major exchange. Message boarders love the idea that their tiny stock will be flooded with institutional money the minute it hits a major exchange. That makes perfect sense. But what they do not realize is only 2% of OTC companies ever graduate to a major exchange. So, the odds of your company doing it are slim.

However, if you look past the message boards and evaluate management, balance sheets, and competitors, you do have a better chance of finding that next jumper. ... Sometimes, the message boarders are right. Their stock may graduate to the NASDAQ, and then they might see huge gains. It does happen. However, not all jumpers are like that. In fact, many do something quite a bit different from what most believe ...

In Dan Haltzclaw's The Little Black Book of Microcap Investing, he studies this very subject. His findings are actually pretty shocking. According to Haltzclaw, over 90% of all recent jumpers see their share prices fall by an average of 33% in the first one to four months.

That is not what the message boarders think. They honestly believe that the minute their stock jumps, all their problems will be over. Haltzclaw's findings disprove that notion pretty handedly. Here is a quick chart of one of these average jumpers. But, that is not the end of the story. In fact, it is really the beginning of a much larger story ...

It is not that institutional money does not ever come to these companies. Of course it does. Just not right away, as the message boarders seem to think. Why? Well, there are a lot of people that want to dump their shares too. Chances are, in the time between the graduation announcement and the jump, investors (most likely message boarders) are buying up a lot of new shares. When this happens, it gets other shareholders nervous. They see that they are sitting on nice gains, and want out. So, the stock gets listed, and early investors bail. This usually starts a free fall for a few months until it levels back out. When that happens, we have a buying opportunity.

In his book, Holtzclaw found that six months after graduation, investors bring the share price back up to the graduation price. So, if you have a company that falls 50% after it jumps, and you buy it, chances are it will go up 100% to where it was trading at before. Brilliant! But, it is not as easy as that ...

Some stocks do not follow this trend at all. Some just continue to go down, while others go up much more than just to the graduation price. Finding the right ones is not easy. It takes time and effort.

How to Buy Penny Stocks

One of the questions we get a lot here at Penny Sleuth HQ is, "How exactly do I buy penny stocks?" Buying penny stocks is not much different from buying most any other stock, but there are some things worth knowing if you are going to make a habit of it.

If you are new to the game, you might be wondering what exactly a penny stock is. And that is not a bad question -- especially since the answer might be different depending on whom you ask. While some experts say that penny stocks are anything that costs less than $1, others will tell you that is not the case. We recently put a report together explaining this a little clearer. Check it out here: Investing in Penny Stocks.

But of all investments out there (well, at least other than subprime debt), penny stocks usually get the worst rap. That is because with low prices and lower liquidity than most other stocks, they are easier to manipulate. But don't let that scare you away from penny stocks.

Even though penny stocks are more volatile, they also present investors with the most profit potential. ... Every day there are penny stock success stories, even in a year like this when the S&P has taken a tumble. ...

But let is go back to the question at hand: "How do you buy penny stocks?" The simple answer is, simply, just as you would buy any other stock. Place a trade with your normal broker. But, to be fair, there is a little more to it than that.

First off, if you have never traded penny stocks before, your broker will need to approve you for investing in them, and will send you an information sheet about the risks of penny stocks. But these are mainly formalities.

Two places where you will see a difference with investing in penny stocks are in the commissions you pay and your ability to use margin. Most brokers have a slightly different fee structure for stocks that cost less $1.

Also, some brokers either will not allow you to use margin to trade penny stocks, or will make you maintain higher minimum margin requirements than you otherwise would have to. ... If you do not have a brokerage account yet, check out this free report on picking the right one.

Hopefully, this little primer on buying penny stocks has shown you that the learning curve for these kinds of investments is not quite as steep as some would make it seem.

THE POWER OF MYTH AND YOUR PORTFOLIO

Benefits of diversification my ... foot.

Mutual funds allegedly give the small investor the benefits of a diversified portfolio that would otherwise be too expensive to maintain. In practice the small investor ends up well hedged against capital gains. From 1983 to 2003, the people at Elliott Wave International tell us, the S&P 500 averaged a 13% annual gain while the average stock mutual fund investor earned 3.5% annually.

Part of the problem is the advisory fees charged -- a 1% and change fee a year subtracted from returns adds up over time. More surprising is that the professional solons managing the funds, who are supposed to be dispassionately calculating stock values and patiently waiting for the value to out, are instead chasing performance like the best of the amateurs. The average equity mutual fund averaged a 91% turnover rate over the last 15 years. That is a lot of commissions and market "slippage" (the effect on a stock's price from the fund's trading) to overcome. We are told the cummulative effect of the trading expenses and advisory fees ate up about 45% of the total fund portfolios' gross return during the past two decades.

This brought to mind a Warren Buffett comment from a long-ago Berkshire Hathaway annual report -- some searching revealed it to be the 1983 report -- on the hyperactive trading of the day, which by today's standards was literally nothing. He was specifically defending the decision to not split Berkshire's stock (25 years later, it still has not been):

One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as "marketability" and "liquidity", sing the praises of companies with high share turnover (those who cannot fill your pocket will confidently fill your ear). But investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pickpocket of enterprise.

For example, consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value [those were the days!], the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the "frictional" cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)

All that makes for a rather expensive game of musical chairs. Can you imagine the agonized cry that would arise if a governmental unit were to impose a new 16 2/3% tax on earnings of corporations or investors? By market activity, investors can impose upon themselves the equivalent of such a tax. ...

(We are aware of the pie-expanding argument that says that such activities improve the rationality of the capital allocation process. We think that this argument is specious and that, on balance, hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy.)

Back to the original theme of the article, the point is that the benefits of diversification have proven to be elusive for a variety of reasons. A consistent failure in practice has not overcome the myth given by the theory. (There are other major areas this applies to as well. People continue to believe in the myth of governm--- ... no, let's not go there today.)

The Power of Myth is all well and good in the realms of literature, theater, cinema, and even comic books. Alas, in the more tangled world of markets and finance, a myth can be so deeply cherished that most people mistake it as fact: The "Katrina made oil prices rise" myth became real in the collective mind, and a mountain of evidence to the contrary has not overcome the delusion.

There are other examples. Take the "benefits of diversification" myth, for example, which has given birth to the $4 trillion stock mutual industry -- a big reality by anyone's yardstick. Here are a few points of fact to consider; you tell me if this adds up to "diversification" (quotes and chart from The Wall Street Journal).

"From 1950 to 1965, equity mutual funds turned over their portfolios at an average rate of 17% per year; in 1990-2005, the turnover rate averaged 91% per year.

"As shown in the chart nearby, direct ownership of stocks by American households has declined from 91% in 1950 to just 32% today. The 9% ownership stake held by financial institutions in 1950 crossed the 50% mark in 1983, and now totals 68% of all stocks.

"The excessive advisory fees, expenses, hefty sales loads, and huge commissions on portfolio transactions paid to brokers in return for their sales support consumed something like 45% of the real returns earned on fund portfolios during the past two decades.

"Institutional investing is now largely the business of giants. America's 100 largest money managers alone now hold 58% of all stocks."

Now, do not even think about telling me that I fail to understand "diversification," and how it helps reduce risk. From 1983 to 2003, the S&P 500 averaged a 13% annual gain. The average stock mutual fund investor earned 3.5% annually over the same period. In the real world, the only thing diversification has managed to "reduce" are investor returns.

The truth is this: An ever-larger number of people give their money to an ever-smaller number of managers, who in turn oversee the taking of an ever-bigger slice of the pie.

Facts do not usually persuade the collective mind, but it can be otherwise for individuals who think for themselves. See the evidence we see, and you will have no trouble distinguishing myths from reality.

TECHNICAL ANALYSIS ON PRECIOUS METALS

Here is a quick technical review of market action in the precious metals complex. To us, technical analysis always looks logical as can be when it confirms our prejudices, and like mumbo jumbo otherwise. But for those inclined towards wanting to accumulate larger holdings in gold, now is a better time to be looking than the craziness of a couple of months ago. And the article author thinks the downside is limited from here.

Gold was taken to the woodshed the past few weeks [see chart]. Support at $875 was broken and caused a sharp run to the major multi-decade support area of $850. I do not see Gold going any lower but if it does it still does not signal an end to the bull market. We need to see many other things fall into place for that to happen. Right now the fundamentals for the metals to go higher are better than ever and improve weekly.

All the major technical indicators -- RSI, MACD and slow STO -- are in buy territory as they only get to these lows at major bottoms. Short term Gold must hold $850 or run the risk of running to $825. The 200-day MA should provide good support there along with chart support.

Don't worry, technically this is healthy action and the multi-decade high of $850 should be tested and hold to signal an ongoing bull. While some people see the breakout as never to be tested, in my experience, more times than not the price will come back and test that area before resuming higher with a large degree of force. So you can trade it that way if you are shorter term and technically inclined. I have been buying recently ...

Silver had a down week as well and touched strong support at $16 [see chart]. The indicators are very oversold but not yet extreme and could actually benefit from coming down further. Next support is the moderate area of $15.50 then stronger support at $15.00.

Platinum was down but very constructive as no real support was broken and it closed the week above the $1,900 area where support is building [see chart]. ... The fundamental just got a whole lot better this week and the only way a major decline will happen in Platinum is if production jumps a large degree in short order. And I just do not see that happening.

Palladium broke loose and ran down to the 200-day MA, which held up nicely as well as chart support at $400 [see chart]. This metal has a long way to go on the upside and the fact that it resolved itself so quickly and in a good technical manner bodes well. $425 is resistance then $450 and $475. The indicators are healthy and could even stand to go a bit lower. They could come down further and that would give Palladium a downside target of the January gap region of $375.

Either way we look at it the Metals will be higher this time next year. For more on this story, check out Precious Metal Stock Review. There you will find this story, along with my others on similar subjects.

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