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

10 THINGS YOU SHOULD AND SHOULD NOT DO IN A BEAR MARKET
August 8, 2008

Bob Prechter's Conquer the Crash came out in 2003, while the post-dot-com bust bear market was still in force. Based on his interpretation of the Elliott Wave principle, Prechter made the case that the U.S. economy was about to enter a deflationary depression comparable to that of the 1930s. The investment approach is wildly different but the prediction is quite similar to George Soros's belief today, summarized last week, that the bill for decades of credit excesses are about to come due.

Prechter appears to have been one market cycle too early with the original timing of Conquer the Crash's publication. (We do not track Soros's results, but he appears to have been more correct in his timing.) But perhaps now, 5 years later, it is time to reread the book. To us the deflation/hyperinflation resolution is not resolved. Alternatively, one might ask if the answer is deflation, then deflation in what? If this depression is accompanied, obviously unlike the 1930s, by the destruction of the fiat dollar currency, then gold could end up being "cash." Stocks, real estate, and commodities might all sink -- or "crash" -- vs. gold while still being a far superior place to be than paper currencies.

With chapter titles like "Should You Invest in ... Bonds, Real Estate, Precious Metals, Collectibles or Cash," Robert Prechter's New York Times best seller, Conquer the Crash, is the ultimate "How To Do," "What To Do" and "Should You Do" guide for investors.

Many of its forecasts are uncanny -- calling for a long-lasting top in real estate prices, and specifically saying that quasi-governmental lending firms Fannie Mae and Freddie Mac will fail in a global credit crisis.

This story, however, focuses on just a few of the golden tidbits Prechter serves up about what to do and not do in a bear market.

(1) Should you invest in real estate?

Uh, if you are even considering this notion, you should immediately begin searching for a highly recommended head shrinker. Here is what Bob wrote back in his best seller:

Short Answer: NO

Long Answer: The worst thing about real estate is its lack of liquidity during a bear market. At least in the stock market, when your stock is down 60% and you realize you have made a horrendous mistake, you can call your broker and get out (unless you are a mutual fund, insurance company or other institution with millions of shares, in which case, you are stuck). With real estate, you cannot pick up the phone and sell. You need to find a buyer for your house in order to sell it. In a depression, buyers just go away. Mom and Pop move in with the kids, or the kids move in with Mom and Pop. People start living in their offices or moving their offices into their living quarters. Businesses close down. In time, there is a massive glut of real estate. [Conquer the Crash, Chapter 16]

(2) Should you prepare for a change in politics?

Short Answer: YES

Long Answer: At some point during a financial crisis, money flows typically become a political issue. You should keep a sharp eye on political trends in your home country. In severe economic times, governments have been known to ban foreign investment, demand capital repatriation, outlaw money transfers abroad, close banks, freeze bank accounts, restrict or seize private pensions, raise taxes, fix prices and impose currency exchange values. They have been known to use force to change the course of who gets hurt and who is spared, which means that the prudent are punished and the thriftless are rewarded, reversing the result from what it would be according to who deserves to be spared or get hurt. In extreme cases, such as when authoritarians assume power, they simply appropriate or take de facto control of your property.

You cannot anticipate every possible law, regulation or political event that will be implemented to thwart your attempt at safety, liquidity and solvency. This is why you must plan ahead and pay attention. As you do, think about these issues so that when political forces troll for victims, you are legally outside the scope of the dragnet. [Conquer the Crash, Chapter 27]

(3) Should you invest in commercial bonds?

Short Answer: NO

Long Answer: If there is one bit of conventional wisdom that we hear repeatedly with respect to investing for a deflationary depression, it is that long-term bonds are the best possible investment. This assertion is wrong. Any bond issued by a borrower who cannot pay goes to zero in a depression. In the Great Depression, bonds of many companies, municipalities and foreign governments were crushed. They became wallpaper as their issuers went bankrupt and defaulted. Bonds of suspect issuers also went way down, at least for a time. Understand that in a crash, no one knows its depth, and almost everyone becomes afraid. That makes investors sell bonds of any issuers that they fear could default. Even when people trust the bonds they own, they are sometimes forced to sell them to raise cash to live on. For this reason, even the safest bonds can go down, at least temporarily, as AAA bonds did in 1931 and 1932. [Conquer the Crash,Chapter 15]

(4) Should you take precautions if you run a business?

Short Answer: YES

Long Answer: Avoid long-term employment contracts with employees. Try to locate in a state with "at-will" employment laws. Red tape and legal impediments to firing could bankrupt your company in a financial crunch, thus putting everyone in your company out of work.

If you run a business that normally carries a large business inventory (such as an auto or boat dealership), try to reduce it. If your business requires certain manufactured specialty items that may be hard to obtain in a depression, stock up.

If you are an employer, start making plans for what you will do if the company's cash flow declines and you have to cut expenditures. Would it be best to fire certain people? Would it be better to adjust all salaries downward an equal percentage so that you can keep everyone employed?

Finally, plan how you will take advantage of the next major bottom in the economy. Positioning your company properly at that time could ensure success for decades to come. [Conquer the Crash, Chapter 30]

(5) Should you invest in collectibles?

Short Answer: NO

Long Answer: Collecting for investment purposes is almost always foolish. Never buy anything marketed as a collectible. The chances of losing money when collectibility is priced into an item are huge. Usually, collecting trends are fads. They might be short-run or long-run fads, but they eventually dissolve. [Conquer the Crash, Chapter 17]

(6) Should you do anything with respect to your employment?

Short Answer: YES

Long Answer: If you have no special reason to believe that the company you work for will prosper so much in a contracting economy that its stock will rise in a bear market, then cash out any stock or stock options that your company has issued to you (or that you bought on your own).

If your remuneration is tied to the same company's fortunes in the form of stock or stock options, try to convert it to a liquid income stream. Make sure you get paid actual money for your labor.

If you have a choice of employment, try to think about which job will best weather the coming financial and economic storm. Then go get it. [Conquer the Crash, Chapter 31]

(7) Should you speculate in stocks?

Short Answer: NO

Long Answer: Perhaps the number one precaution to take at the start of a deflationary crash is to make sure that your investment capital is not invested "long" in stocks, stock mutual funds, stock index futures, stock options or any other equity-based investment or speculation. That advice alone should be worth the time you spent to read this book.

In 2000 and 2001, countless Internet stocks fell from $50 or $100 a share to near zero in a matter of months. In 2001, Enron went from $85 to pennies a share in less than a year. These are the early casualties of debt, leverage and incautious speculation. [Conquer the Crash, Chapter 20]

(8) Should you call in loans and pay off your debt?

Short Answer: YES

Long Answer: Have you lent money to friends, relatives or co-workers? The odds of collecting any of these debts are usually slim to none, but if you can prod your personal debtors into paying you back before they get further strapped for cash, it will not only help you but it will also give you some additional wherewithal to help those very same people if they become destitute later.

If at all possible, remain or become debt-free. Being debt-free means that you are freer, period. You do not have to sweat credit card payments. You do not have to sweat home or auto repossession or loss of your business. You do not have to work 6% more, or 10% more, or 18% more just to stay even. [Conquer the Crash, Chapter 29]

(9) Should you invest in commodities, such as crude oil?

Short Answer: Mostly NO

Long Answer: Pay particular attention to what happened in 1929-1932, the three years of intense deflation in which the stock market crashed. As you can see, commodities crashed, too.

You can get rich being short commodity futures in a deflationary crash. This is a player's game, though, and I am not about to urge a typical investor to follow that course. If you are a seasoned commodity trader, avoid the long side and use rallies to sell short. Make sure that your broker keeps your liquid funds in T-bills or an equally safe medium.

There can be exceptions to the broad trend. A commodity can rise against the trend on a war, a war scare, a shortage or a disruption of transport. Oil is an example of a commodity with that type of risk. This commodity should have nowhere to go but down during a depression. [Conquer the Crash, Chapter 21]

(10) Should you invest in cash?

Short Answer: YES

Long Answer: For those among the public who have recently become concerned that being fully invested in one stock or stock fund is not risk-free, the analysts' battle cry is "diversification." They recommend having your assets spread out in numerous different stocks, numerous different stock funds and/or numerous different (foreign) stock markets. Advocates of junk bonds likewise counsel prospective investors that having lots of different issues will reduce risk.

This "strategy" is bogus. Why invest in anything unless you have a strong opinion about where it is going and a game plan for when to get out? Diversification is gospel today because investment assets of so many kinds have gone up for so long, but the future is another matter. Owning an array of investments is financial suicide during deflation. They all go down, and the logistics of getting out of them can be a nightmare. There can be weird exceptions to this rule, such as gold in the early 1930s when the government fixed the price, or perhaps some commodity that is crucial in a war, but otherwise, all assets go down in price during deflation except one: cash. [Conquer the Crash, Chapter 18]

THE ABSENT-MINDED CREDIT CYCLE
August 11, 2008

Bill Bonner writes a column every business day at The Daily Reckoning. They are short on technical analysis and fancy models and long on well-informed and truly intelligent common sense. Since life changes slowly, this means they often end up sounding pretty similar, day in, day out, year in, year out. They are particularly valuable for taking a measured perspective on the greater trends at work, as divined by Bonner from the headlines of the day.

In this column Bonner looks at the grim headlines emanating from the consumer sector of the U.S. economy and comes to the same conclusion he has come to hundreds of times before, which is obvious to anyone exercising a modicum of common sense. This apparently excludes most of Wall Street, Washington, and the majority of the U.S. population. To wit: The U.S. needs to start saving more and consuming less. This is going to entail big adjustments -- the pain of which the political establishment will undoubtedly try to thwart, thus delaying the adjustments and creating more economic destruction along the way.

The next big trend, dear reader ... It is coming. Consumers -- especially the baby boomers -- are about to change their way of looking at things. And when Bernanke & Co. realize what is happening, they will greet the new trend like the citizens of Atlanta welcomed Sherman.

"War is hell," said the yankee general, before burning the city down. So is a correction. ...

"Retail sales stall," is the word on the street, coming from Bloomberg. Of course, we already knew it. Restaurants are serving fewer meals. Malls are losing tenants. U.S. automakers are desperate to move their vehicles off the lots.

"Big three face bankruptcy fears," is the headline from CNN/Money.

There are two ways to play a correction ... You can look for bargains as investors sell off their losing positions. Or, you can take a vacation. Read War and Peace ... in Russian. Here at The Daily Reckoning, we will take Option #2. We like doing nothing. It gives us time to think.

Many investors, on the other hand, are sure they are looking at the Opportunities of a Lifetime. They see Fannie and Freddie, for example, and remember when the stocks were trading over $60. "What a bargain they are now!" they say to themselves. Or look at Wall Street. J P Morgan, Lehman Brothers, Bear Stearns ... they are all selling at big discounts.

And do not forget the nail bangers. The housebuilders were the first to get nailed. Their stocks got sold off. Investors lost billions in just a few months. But take a look at the builders now -- hey, maybe they are coming back! "No guts, no glory!" "Go for it!"

[August 6], one of the biggest builders, DR Horton, reported a $400 million loss for the third quarter. While it is possible that we have seen the worst in the housing sector, it is also possible that the sector will never bounce back -- at least, not in our lifetimes. Nor will Wall Street. The bargains, in other words, could turn out to be traps for the unwary.

How could that be? We will explain.

Over most of the last century, housing prices followed GDP growth and inflation. Nothing more. And it makes sense that they would. Housing is the number one consumer item. Consumers buy as much housing as they can afford -- but not more. What happened in the 10 years -- 1997-2007 -- was an aberration, an unnatural freak caused by a rare conjunction of various absurdities. The dollar-based financial system ... the collapse of the dotcoms ... 9/11 ... Asian export-mad economies ... Alan Greenspan -- all conspired to bring about a huge run-up in housing prices and consumer debt.

The two circumstances -- like Butch Cassidy and the Sundance Kid -- worked together. One kept his firearm on the bank manager, while the other cleaned out the vault. Consumers were able to borrow vast amounts, because their major collateral -- their houses -- was rising in value. And with the extra credit, they were able to buy more houses!

But the two desperadoes met their end, it is said, like Che Guevara, gunned down by the federales of Bolivia. And once they were dead, they were dead forever.

So too, our guess is that the bubble in housing and lending is over. If not forever, at least for a long time. Credit or interest rate cycles tend to last a long time -- about as long as an investor's career. High-grade yields reached a peak in 1920 and then retreated until after WWII. Then, they rose again ... for the next 35 years. Since 1981, they have gone down ... at least for 22 years ... maybe longer. One generation is convinced that interest rates always go up. The next is sure they always go down. One thinks credit gets easier and easier. The next knows it will never be able to borrow another dime -- and does not want to. One generation forgets what the generation before it just learned. That is the credit cycle.

But what did U.S. consumers learn during the last great credit cycle? What are they learning now?

One of the surest ways to make money in the last 10 years was to buy a house. The baby-boomers, especially, saw home ownership as equivalent to saving for retirement. Houses always went up in price. Everyone knew that. If you had enough houses you did not need any money in the bank. A popular retirement planning technique was to buy a second house at the beach in your 40's or 50's. And then, when you were ready to retire, you could sell the main house.

But this is where the Next Big Trend comes in. The baby boomers are suddenly realizing that houses are not the same as savings. And they are suddenly facing up to the idea of financing their retirements in a world of declining house prices ... and rising costs.

"Home energy prices are expected to soar," reports the New York Times.

What will they do? First, they will be forced to go back to saving. They will not like it. But they will have no choice. They need money for their retirements. And the only way they can get it is by reducing their spending and saving more.

We know what you are thinking, dear reader: "It's about time!" We are thinking the same thing. Americans desperately need savings ... capital ... resources.

But we are thinking something else too -- that the U.S. economy of the last 20 years was built on excess consumer spending. Savings rates went from around 9% of GDP down to zero. Now, if they go in the opposite direction -- and they must, in our opinion -- the drop in consumer spending will cause the worst recession since the 1930s.

We are not just saying that to be provocative. We can add two and two. Subtract 9% from an economy that is growing at, maybe, 2%. Do that over a period of 10 years (the boomers do not have to save just one year -- they have to save every year). Of course, it is not quite that simple. When money is saved it does not disappear. Some of it is reinvested in the real economy, leading to more jobs ... more output ... and growth. But it takes time to convert a consumer economy into a more balanced economy. And it takes time to pay off debts ... and write-off mistakes. In the meantime, you have an economy walking backwards for a long time. And probably tripping over something along the way.

But wait. Will the Bernanke Fed allow it? Will the Obama administration permit a serious, multi-year recession? How will they try to prevent it? What will happen when they do?

Ah ... we are glad we do not have time to answer those questions today.

Why Is Everyone Surprised?
August 13, 2008

Bill Bonner's followup thoughts from above get extended to the Eurozone. It looks like that as much of a basket case as the U.S. dollar may be, the euro is even more of one. He quotes PIMCO's Bill Gross: "[There is no reason for] the euro's 25% to 30% overvaluation against the U.S. dollar." Taking that at face value, the euro would have to fall below $1.20 before it is fairly valued -- a long way below the current market, even as it has fallen well off its high. Bonner himself quips this week: "As to the dollar/euro exchange rate, we have no prediction to make. It's like a spelling Bee where both contestants are dyslexics. Neither the euro's masters nor Ben Benanke can spell 'sound money.'"

What surprises us about this market is that anyone finds it surprising. Lenders lent to people who could not pay the money back. Naturally, the loans went bad. What is surprising about that?

Consumers spent more than they could afford. Naturally, they ran out of money and have to cut back. Do you see anything unusual about that?

Wall Street partied for years on cheap credit. Now, credit is becoming harder to come by. Is it any wonder that they have had to turn off the music and close down the bar? ...

And now we read in the paper that Freddie Mac has posted a big loss. What a shocker! Gosh, we thought financing houses at 100% to poor credit risks, who lied on their mortgage applications, was a good business. And it was a great business, until housing prices went down. But, who could have seen that coming?

Well ... anyone.

Prices go up. Then, they go down. That is the way it has been going for a long time. Housing prices are "mean reverting," as economists say. In fact, as we pointed out here, they are about the meanest reverters in the whole financial world. Houses, unlike dotcom stocks or paintings by Lucien Freud, are useful. They are bought by wage-earners to live in. So, they have to be priced at levels that the buyers can afford them. In fact, the average house-price has to be within the housing budget of the average house buyer. That is all there is to it.

So don't bother telling us that the housing decline came as a surprise. We have been predicting it ever since it began. (Of course ... we have predicted many other things that have not happened yet ... but that is a different story.)

But here comes the article from Reuters: "Freddie Mac's negative net worth raises questions." Well ... yes. The first question is how a company with a quasi-monopoly granted by the U.S. government could make such a mess of its business. And so fast! Hardly 12 months after the biggest bubble in property in the history of the world and it is already $5.6 billion underwater.

A rumor making its way around Wall Street -- started by us -- is that Freddie is secretly being run by Robert Mugabe. Of course, a string of bad luck can ruin any business. But Freddie Mac could not be explained by bad luck alone; it took an act of Congress! Or maybe a couple of acts of Congress. The one that created the Federal Reserve System, for example.

But let's leave that subject for another day. We opined yesterday [column above], that the financial industry has had its season in the sun. It will not recover its youthful vigor in our lifetimes. Which brings us to the second question: Why would investors buy the shares? Freddie is clearly insolvent.

But most investors do not believe it. Freddie may have a net worth of negative $5.6 billion, but investors buy the stock anyway. These summer forecasters expect the clouds to pass and the sun to come back any day. Ain't gonna happen is our guess.

The number of unsold houses is at its highest in 26 years. Half of them have to be sold before sellers have any pricing power. That will take a long time. Then too, our bet is that the inventory is understated. We know at least a couple people who have taken houses off the market. Not because they want to own them, but simply because they do not think they can sell them. When the inventory gets worked off, these houses will be put up for sale again -- holding prices down even longer.

But the big change in the economy is not in the housing market itself, but in the change of opinion that it causes. Markets make opinions, say the old-timers. And a drop in housing is about to cause an epochal shift away from debt and towards savings. We report it here, even though it has not happened yet. As we explained yesterday, baby boomers now look to retirement as a condemned man looks to the scaffold. They know they should not have done what they did, and should have done what they did not. They regret not saving money -- deeply. And now, the poor baby boomer has only one chance for redemption ... trying to make up for the last 15 years by saving as if the rest of his life depended on it.

In fact, it does. ...

The summer season seems to have left Britain's economy ... A report in the newspaper tells us that food prices are rising at almost 10% per year. Meanwhile, housing prices are falling -- at the fastest pace in 24 years.

So you see, the typical Brit, like the typical American, is caught in no-man's-land ... with inflation destroying his purchasing power on the one hand, and deflation undermining his assets on the other. At the end of the day, he has less money, and it goes less far.

Here is the latest from our colleagues at MoneyMorning, here in London:

"There seems to have been more or less a straight fight between the States and us as to who actually plunges into a recession first. [But] within the last few weeks another strong contender for this dubious prize has emerged. The eurozone now looks like it could get a dose of recession before either the US or the UK.

"Anyone who has been keeping an eye on Spain's troubled economy will not be too surprised to see that the eurozone is really struggling. The Hispanic housing market is collapsing -- sales are down 34% from the peak, say the latest official figures -- and the banking system is on the brink, according to Morgan Stanley.

"A momentous economic slowdown in Spain is now under way ... though just in the beginning stages, with the bulk of the pain to be suffered in 2009", says the investment bank, going on to warn that "the probability of a crisis scenario similar to the early 1990s is increasing."

Meanwhile unemployment has already reached 10.4% and the country's finance minister recently admitted that: "the economic situation is worse than we all predicted ... we thought it would happen slowly but it has hit fast".

It is not just Spain. In Ireland too, house prices are tumbling, with Dublin seeing double-digit falls. New housebuilding has hit a 5-year low. And over in Italy, things are not so hot on the economic front either. Last weekend Prime Minister Berlusconi said he would now be slashing government spending as tax revenues have slumped.

But let us be fair here. Trouble in these countries is not exactly a surprise -- Ireland was heading for trouble from the moment it joined the eurozone, as low interest rates poured petrol on an already blazing economy. Spain was the same. And as for Italy, it is rarely far from economic strife.

Surely the countries at the real core of the eurozone -- France and Germany, in other words - are looking a bit more stable? Well, it seems not. After holding out pretty well during the first half, by mid-July, business confidence was declining abruptly, as the German ZEW economic sentiment indicator suddenly plunged, unexpectedly, to a record low. French business confidence has also dropped away.

Then last week, the overall eurozone activity survey plummeted much more sharply than the "experts" had expected, to its lowest point since March 2003.

What is more, European companies are starting to default on their debts, says Dresdner Kleinwort, which believes that as many as 6-7% of corporate borrowers may fail to pay their debts on time within the next year. That is a 10-fold increase in the estimate since June and, says Moody's Investors Service, the highest default rate since July 2003. ... Because things have got worse so fast that the eurozone now looks like a racing certainty to beat us Brits into recession.

It all points to a sell-off in the euro. Sure, the alternatives may not be great, with both the U.S. and the UK apparently competing to see which can prove the bigger basket case, but to quote one of the oldest market truisms around, currencies are a "zero sum" game. If one falls, another has to rise. And while it is very hard to make a convincing case for the dollar, or indeed the pound, all the signs from the continent are that the euro faces even more problems.

PIMCO bond fund manager Bill Gross recently said he sees no reason for "the euro's 25% to 30% overvaluation against the U.S. dollar", while BNP Paribas also declared: "we are turning incredibly bearish on the euro." It is starting to feel like the dollar, currently trading at around $1.55 to the euro, might just be bottoming out against its continental European cousin. And maybe sterling, which over the last five years has tended to move more or less in line with the buck, could get a ride on its coat tails.

LOOKING LIKE THE MILLIONAIRE NEXT DOOR
August 14, 2008

Rob Peebles writes a periodic column for PrudentBear.com called "Random Walk" (or used to write -- this most recent one came out over two months ago). Here he details the startling plummet, from all-time highs to all-time lows, in one measure of "luxury consumption," all in the course of two years. This has led to uncharacteristic price competition by the likes of Nordstrom, Saks Fifth Avenue, and Neiman Marcus. The obvious explanation is that a lot of the "luxury spending" was financed with credit -- home equity loans and credit cards -- and when credit is reigned in, the spending it allowed must follow.

A lot can happen in nine quarters. A housing boom can turn into a housing bust. A law and order governor can get caught with his scruples missing. [This was written when l'affaire Spitzer was still in the air.] And buyers of luxury items can decide it is time to do time at Costco.

In nine quarters the "Luxury Consumption Index" fell from an all-time high to an all-time low.

As of Q4 2005 the index stood at 104.8, but by Q1 of this year, it came in at a measly 54.4. The index does not measure actual luxury purchases like $2,000 handbags that are almost guaranteed to be the real thing. No, the index measures how much luxury buyers have on their wish lists. And the lists are shorter than they used to be.

A whopping 41% of those surveyed planned to spend less over the next 12 months on "luxury." A mere 13% -- primarily lobbyists looking toward the congressional elections -- planned to spend more. For the record, these buyers of luxury goods had an average income of $173,000 and an average age of 45.9, according to Unity Marketing.

Put in more tangible terms, April same store sales for luxury retailer Nordstrom dropped 3.8% despite an additional shopping day. May same store sales jumped 11% but June is expected to plunge 22%. So despite its high-end image, Nordstrom is taking a page from Stein Mart's playbook. In fact, LA Times reporter Sandra Jones notes that Nordstrom, Saks and Neiman's all are cutting prices and engaging in embarrassingly promotional behavior.

How can this be? Are the rich not recession proof?

While there may be more millionaires next door, lots of the millionaires' neighbors have been buying on credit. In fact, the creator of the Luxury Consumption Index, "luxury expert" Pamela Danziger, claims that there are "more households in the luxury markets today than there used to be."

But as Nordstrom now knows, more luxury buying households is not the same as more rich people.

Not by coincidence, the dollar amount of home equity loans granted of late has plunged like prices of women's apparel at Neiman's (a $200 gift card toward one regular-priced item of $500).

Retail experts are a notoriously polite bunch. Rather than say that millions of Americans have been buying fancy stuff on credit and are now in a tight spot, they declare that today's consumers are more educated. So now, because they want to, Americans are just as prone to buy a designer label at Target as Saks. Savvy is the new chic.

As broken down by Sandra Jones, the luxury market for years grew around 10%. But luxury spending rose just 2.8% in April, well below the 3.2% gain registered by total retail sales which includes the rest of us. Not only that, Neiman's is not the only store struggling with prices. Prices at luxury retailers were flat in Q1 compared to a 7% increase as recently as 2006. Jones quotes an official of a New York consulting firm who studies consumer behavior. For the first time in the study's 15 years, price is the primary driver of purchase decisions.

How unfashionably practical.

HOMAGE TO JACQUES RUEFF
August 13, 2008

The monetary horses have run from bubble to bubble ... delivering more liquidity wherever it would do the most damage.

Jacques Rueff, a French economist who was an advisor to Charles de Gaulle, wrote a series of articles in La Monde in 1976 explaining the dangers of a dollar-based financial system. Notwithstanding the array of obstacles against him (an economist, who was French, working in the government, writing in popular rag ...) his insights were on the mark. Some interesting history is included among his explications.

Today, we take a summer rest and let a dead man do the talking. Jacques Rueff died 30 years ago. But in a couple of articles written for Le Monde in February 1976, this economic advisor to Charles de Gaulle, explained today's monetary system and what was likely to become of it. His articles were unusual, in several respects. It is rare for an economist to have any idea what is going on -- especially a French one. And on the subject of economics, Le Monde has things worth reading about as often as leap years.

To fully appreciate Rueff's insight -- and how it applies to the macroeconomic circus circa 2008 -- you have to begin by understanding the problem of unemployment. In the world of the 1930s, the triumph of capitalism was no sure thing. Communism, for all its faults, at least put people to work. Capitalism often left them "sittin' on the dock of the bay." And here we have our first measure of how far we have come since the 1970s. The average post-Mitterand Frenchman now believes that there are worse things than not working. Such as working, for example. Today, he is eager to pass laws to prevent it.

The real cause of joblessness is obvious, even to an economist. People do not have jobs when it costs more to employ them than employers can get out of them. And in an economic downturn, the unemployment rate goes up. Because, in a slump, prices for "things" fall quickly. But labor rates tend to be sticky. Workers have contracts. And rights! Employers' profit margins are soon squeezed between slippery revenue, and stubborn costs for labor. Result: output falls and fewer workers can earn their keep.

In a free market, wages eventually ease their way down to levels that allow capitalists to exploit workers again. Always have. But for some reason, in Britain in the 1920s, this did not happen. Rueff identified the culprit even before Milton Friedman did:

"Since 1911, there existed in England a system of unemployment insurance that gave an indemnity to jobless workers, known as the 'dole.' The consequence of this regime was to establish a minimum salary level, at which workers would prefer to ask for the dole rather than work for less. It appears that in the beginning of 1923 salaries, which had been declining with other prices in England, suddenly hit this new minimum. There, they stopped falling, and since then, they practically ceased to move."

That is why France runs such high unemployment rates today. Its dole is bountiful. When you add up the costs of "charges sociales," paperwork, and the minimum wage, more than one in 10 potential workers is not worth the money. But no right thinking politician is about to suggest the obvious solution: get rid of the dole. So, Keynes came up with a subterfuge. The central bank should cause price inflation during a slump, he proposed. Rising prices for "things" meant that salaries -- in real terms -- would go down. That was the greasy scam behind Keynes's General Theory of Employment, Interest and Money: inflation robbed the working class of their wages without them realizing it. The poor schmucks even thank the politicians for picking their pockets: "salary cuts without tears," Rueff called them

"Full employment" was soon no longer a wish, but an obligation.

In France, the Constitution of 1946 obliged the government to present year an annual economic plan that achieves the goal of full employment. In the same year, Harry Truman pushed an Employment Act through the U.S. Congress. And today the central bank of the USA has a "dual mission" -- to preserve the value of the dollar while assuring full employment.

"No religion spread as fast as the belief in full employment," wrote Rueff. "... and in this roundabout way, allowed governments that had exhausted their tax and borrowing resources to ressort to the phony delights of monetary inflation."

This is where the post-1971, dollar-based monetary system comes in. It allowed the U.S. to issue dollars -- and never have to redeem them in gold. At first, the inflation caused by the build up of dollars was moderate and agreeable, said Rueff. It reduced the cost of labor. Then, when the tether with gold was hacked off in the early '70s, inflation began "galloping away." Readers may remember that inflation got the bit between its teeth in the '70s, racing along at a record speed of 14.8% in the U.S. in March, 1980, and even faster in Britain. The U.S. government was forced to borrow at 15% yields. Britain could barely borrow at all.

Rueff died in 1978. Had he lived, he probably would have been as surprised as we have been by the stamina of the monetary horses. Except for a brief rest while Paul Volcker was managing the stables, they have run from bubble to bubble ... delivering more liquidity wherever it would do the most damage. All the while, inflation continued to cut the price of labor. Between 1974 and 1984, real wages fell as much as 30%. Then, more moderate levels of inflation held them down for the next 24 years.

But Rueff's insight comes with a warning. The faith-based, dollar-dependent monetary system is like a loaded pistol in front of a depressed man. It is too easy for the U.S. to end its financial troubles, Rueff pointed out, just by printing more dollars. Eventually, this "exorbitant privilege" will be "suicidal" for the western economies, he predicted.

Paul Volcker put the pistol in the drawer. Ben Bernanke has found it. And Jacques Rueff must look on in amusement to see what happens next.

BURST BUBBLE: ENERGY OR SPECULATOR?

The bursting bubble is the leveraged speculating community, rather than energy/commodities.

The "Is energy in a bubble?" question has been on many's minds for a couple of months, especially as it ran up to record highs at the end of June. Now oil is down around $30 a barrel from its highs. Did we just witness a pricked bubble, or a breather after an intermediate price spike? We are inclined towards the later interpretation, although we are not so invested in that view that we have to see a new high in the oil price any time soon.

Doug Noland is also of the view that oil was not in a bubble, but further sees the oil price collapse as one symptom of the pricking of another bubble: the "leveraged speculting community" bubble. The hedge funds and other leverage speculators have been running amuck for the last decade, and now many of the trades that worked well when the overall credit bubble was inflating are falling apart all at once. Even those "hedges" such as going long energy and short financial stocks are subject to reversals and squeezes which can kill a leveraged player.

The upshot: "The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis." The leveraged speculators getting their loans called in while the same is happening for just about everyone else "makes the current market dislocations in the face of rapidly deteriorating fundamentals such a dangerous development."

Here is how I see it. Many are rejoicing the bursting of the energy/commodities Bubble. Rapidly declining oil and resource prices are now expected to alleviate inflationary pressures, while bolstering household purchasing power. There will be no pressure on the Fed to raise rates, while their global central bank compatriots can soon begin cutting. The consensus view is that this is bullish for the U.S. economy and stock market and, if nothing else, market action did take attention away from troubling financial and economic news.

I am not one to easily dismiss notions of bursting bubbles, and perhaps there is something to the energy bust thesis. I am just skeptical of the idea that a slumping global economy is behind recent stunning price declines. Examining the global market backdrop, I sense different dynamics at play -- important dynamics. And I tend to believe rapidly retreating commodities markets should be viewed in the context of a bursting leveraged speculating community bubble.

The leveraged speculators have struggled since this year's initial trading sessions. "Quant" and "market neutral" strategies in particular have foundered, although wild market volatility, illiquidity, and weak global securities markets have been an impediment for virtually all strategies. The hedge fund industry has been trying to adapt to tighter credit conditions from the Wall Street firms and generally less liquid markets. Overall, leveraged strategies have been problematic, whether the underlying positions were in residential mortgages, commercial mortgages or corporate loans. The easy days of leveraged "spread trades" ("borrow cheap and lend dear") quickly became quite difficult. And the easy returns in emerging markets turned abruptly into painful losses. Overall, global equities have performed quite poorly and global bonds somewhat poorly. Not many things have performed well and, worse yet, various trades that were supposed to offer diversification all became too tightly correlated.

Crude ended the first half at $140. Major commodities indices concluded June at record highs -- sporting spectacular year-to-date gains. There is no doubt that the speculator community had all crowded into the energy/ commodities trade, one of a rapidly narrowing menu of speculations offering juicy (and desperately needed) returns. At the same time, the long energy/short financials "pairs trade" was also put on in great excess. The speculator community as well likely crowded further into dollar short positions, for years now an almost surefire winner. The more the crowded industry struggled for performance, the more they were forced to crowd into the same crowded trades. I would argue that the bubble in the leveraged speculating community played a significant role in fueling energy/commodities prices inflation beyond what was justified by exceptionally bullish fundamentals. I would not, however, write off energy and commodities as burst bubbles.

A lot of things had to go right for the vulnerable leveraged speculator community not to be pushed over the edge. Of course, markets tend to not accommodate the impaired -- and the current market is particularly ruthless in this regard. The energy trade has unraveled badly. Commodities markets have been in near freefall. The dollar has mustered its most ferocious rally in quite some time. At the same time, agency debt and MBS spreads have widened, while global bond prices have offered little performance help. Corporate debt prices have performed poorly, while "private-label" MBS and various mortgage-related derivatives have traded dismally. Meanwhile, the financial stocks and other heavily shorted equities have rallied significantly. In short, a whole host of popular trades have gone wrong at the same time -- a huge problem for the fragile industry.

We are now in the midst of another one of these precarious periods. I believe global markets -- equities, debt, currencies, and commodities -- are all in some stage of dislocation (perhaps not emerging debt, at least yet). Trading conditions across the spectrum of markets are as chaotic as I have ever witnessed, a dislocation chiefly related to the now forced unwinds of speculative positions. Recent extreme global market volatility is part and parcel to the heightened monetary disorder I have been addressing for months now. The massive global pool of speculative finance has run amuck. The bulls will celebrate the rally, yet markets this unstable are prone to "melt-ups" that lead to breakdowns.

Earnings reports this week from Freddie Mac, Fannie Mae and AIG -- three of our largest financial institutions -- were horrendous. Financial sector hemorrhaging has actually accelerated, and definitely do not underestimate the impact of tightened credit in the pipeline from Fannie, Freddie and others. With limited "capital" quickly evaporating, Freddie stated that its aggressive retained portfolio growth has come a conclusion. Fannie intimated about the same. Fannie will curtail purchases of alt-A loans, and it is clear that both companies have lost the capacity to provide the speculators a "backstop bid" in the MBS marketplace. This major additional tightening of mortgage credit availability and marketplace liquidity will further depress housing markets and bolster the headwinds buffeting our vulnerable economy.

Yet it is not the nature of dislocated markets to let fundamentals get in the way of price movement. Markets, after all, live on fear and greed. Sinking energy prices and a short squeeze ignited U.S. stocks this week. And surging stock prices always entice the optimistic viewpoint, with many viewing runs in stocks and the dollar as confirmation that the worst of the financial and economic crisis is behind us. The bursting of the so-called energy/commodities bubble is also viewed in positive light.

Yet if the key dynamic is instead a bursting leveraged speculating community bubble, entirely different dynamics are now in play. Enormous short positions have built up, the vast majority as part of "market neutral", "quant", and myriad risk hedging strategies. If today's dislocation develops into a significant unwind of these positions, the market immediately then becomes vulnerable to a disorderly "melt-up" followed almost inevitably by a sharp reversal and disorderly decline. The unwind of bearish speculations and hedges would be a most problematic market development, unleashing a final bout of speculative excess and disorder that would set the stage for a major market crisis.

It is not difficult to envision the backdrop for problematic market liquidation and deepening financial crisis. The hedge fund community is now susceptible to huge year-end redemptions, generally poor performance, shrinking assets and tighter credit -- all taking place in a climate of inhospitable market conditions which dictate ongoing credit system deleveraging. The pool of players willing and able to acquire U.S. risk assets is being depleted by the week. To be sure, the unfolding change of fortunes for the leveraged speculating community is one more key facet of tighter system credit and faltering marketplace liquidity -- extremely problematic financial conditions for the finance-driven U.S. bubble economy. And this makes the current market dislocations in the face of rapidly deteriorating fundamentals such a dangerous development.

THE STRONG DOLLAR ILLUSION
August 16, 2008

Peter Schiff is not buying into the recent strong rally by the U.S. dollar against almost every other currency. Enough said.

Economists who now see American troubles spreading around the world are predicting that foreign central banks will ignore the gathering inflation threat and follow the Fed down the rate cutting path. Similarly, they argue that since the downturn began here, the U.S. recovery will likely be underway while the rest of world is still decelerating. These assumptions have prompted a rally in the dollar, a sell-off in gold, commodities and foreign stocks, and have cast doubts on the ability of foreign economies to "decouple" from the United States. Investors should not take the bait.

America does indeed pose a global threat, but not for the reasons these economists suppose. Foreign economies are suffering not because Americans have slowed their voracious spending, but because they are defaulting on hundreds of billions of dollars of existing loans underwritten by lenders around the world.

The conventional wisdom is that foreign economies depend on Americans to buy their exports. This is false. The global expansion of the past decade has created new demand everywhere, and people and businesses in all corners of the world are spending. However, in America, spending has largely been achieved through a massive vendor financing scheme. Foreign supplied credit has allowed Americans to continue buying, even while American income and savings have dropped. As this credit goes bad, the losses are landing on the bottom lines of foreign financial firms. In other words, the global pain is not resulting from American contraction but from having financed our preceding expansion. This is a critical distinction few have been able to make, and it is vital to appreciating the decoupling that has already occurred beneath the surface.

Schiff makes this argument in depth in Crash Proof: How to Profit from the Coming Economic Collapse. It seems obvious enough, which would explain why the conventional wisdome purveyors do not seem to understand if.

The current losses that banks in Europe and Asia are now suffering are real, but future losses can be avoided by suspending future lending to Americans. Shutting off this credit will of course torpedo the dollar, but that is precisely what must occur. By allowing the dollar to drop to its natural, unsupported level, not only will the American caboose be decoupled from the global gravy train, but the rest of the cars will move along the tracks much faster. Absent the U.S., there will still be plenty of consumers to buy what is produced, and plenty of investment opportunities for those with savings. Rather than dragging the global economy down, such a development would actually untether it.

On the other hand, left to its own devices, the American economy will implode. There will be fewer products for American consumers to buy and very little savings for anyone to borrow.

Some foolishly believe that many of the world's problems result from dollar weakness, and that pushing the dollar back up would be good for all. For example, since the weak dollar is contributing to the rise in oil prices, a stronger dollar should help bring prices down. However, if foreign governments weaken their own currencies to push the dollar up, they will simply succeed in bringing oil prices down for Americans. Oil prices will go up for their own citizens. This cannot be an attractive bargain for any European or Asian political leader.

The weak dollar is merely a manifestation of substantial structural problems underlying the American economy. Unfortunately for us, the solution to those problems, as well as the global economic imbalances, can only be found in a weaker dollar. Efforts to artificially prop the dollar up will only exacerbate those imbalances, and make its ultimate fall that much more severe.

NAKED CAME THE SPECULATORS
August 14, 2008

Credit default swaps are getting marked to market, and it isn’t pretty.

As a buyer of insurance you are betting that some event will happen -- e.g., your house will burn down or get robbed, you will cause some property damage with your car, you will be successfully sued, or that you will die before your time. The insurance seller is betting that that event will not happen. Neither party necessarily hopes the event comes to pass, but nevertheless that is the nature of the bet. The insurance buyer is glad he or she made the bet if the event happens, assuming the insurer has the capacity to make the promised payment.

Focusing on the bet element of insurance, rather than the underlying events, one can see a connection to playing the roulette wheel at a casino, or trading futures contracts or options. The difference with these later examples from typical insurance is that additional risk is created rather than transferred to another party. (Except for commercial hedgers, who are a minority of market participants.)

As the credit derivatives market ballooned in the last decade a favorite gamble was for hedge funds, e.g., to exchange bets on whether a company's credit rating would deteriorate. With credit quality in a raging bear market the ones who bet on credit deterioration have been right, but are not necessarily benefiting much because many counter-parties are unable to pay up. For instance, a Merrill Lynch transaction valued its portolio of purchased insurance at 13% of face value. Some financially strong writers of the insurance, however, are getting hammered: American International Group A.I.G. has written down its mortgage-related C.D.S. portfolio by $25.9 billion so far.

It turns out that most buyers of credit insurance have not been hedging against potential losses but making pure ("naked") bets. This increases the amount of risk in the system. Regulators are deciding they do not like this, long after they could have done anything to reign in the risk taking. Typical enough.

Reining in the runaway freight train otherwise known as the credit default swap market is a rising priority for regulators who oversee banks and insurers. It is a good thing, too, given the secretive nature of the swaps, the losses they are generating at some companies and the size of the market: $62 trillion in default insurance is outstanding, with a fair value of $2 trillion at the end of 2007.

One of the positives that heightened regulatory interest will bring to this huge market is a push to make participants more scrupulous about assigning proper values to their credit insurance stakes. This may be a rude awakening for many players in financial markets.

Credit default swaps, known as C.D.S.'s, allow investors to bet on a company's prospects or hedge against possible default by an issuer whose debt they hold. If a default occurs, the party providing the credit protection -- the seller -- must make the buyer whole on the amount of insurance bought.

Initially, this market was intended to make hedging a corporate bond position easier. But speculators who do not hold bonds now dominate the market, using the swaps instead to wager on a company's health or the prospects of a securities portfolio. In Wall Street parlance, these investors would be characterized as trading the contracts "uncovered" or "naked."

With defaults rising, companies that sold default insurance are getting hammered. When it announced its second quarter results last week, the American International Group, the giant insurance company, took a $5.6 billion markdown on the C.D.S.'s it wrote on mortgage-related instruments. A.I.G. has not closed the positions, and the write-down could turn into a gain if defaults are fewer than anticipated. Since the credit crisis began, A.I.G. has written down its mortgage-related C.D.S. portfolio by $25.9 billion.

Those who bought credit insurance as a speculation (hedge funds especially) have been joyously marking up their stakes to reflect the rising defaults. But the recent unwinding of a big credit insurance stake -- bought by Merrill Lynch to cover potential defaults on risky mortgage-related collateralized debt obligations it held -- suggests that such optimism may be overdone. Write-downs at these institutions may be imminent.

At the urging of Eric R. Dinallo, New York's insurance superintendent, Merrill Lynch agreed two weeks ago to unwind $3.7 billion of insurance it had bought on the mortgage-related obligations. Merrill received $500 million from XL Capital to close out the insurance contract that one of its former subsidiaries, Security Capital Assurance, had written.

There are several remarkable elements to the agreement. First was its valuation: only about 13 cents on the dollar. Because the value of the mortgage obligations covered by the insurance had crashed, it was shocking that the insurance was not worth far more than that.

But these deals are only as good as the party on the other side [emphasis added], and when Security Capital's crucial credit rating was cut to junk earlier this year, the potential that the company would pay out on the arrangement dimmed.

The Merrill deal with XL therefore gives market participants an honest valuation of credit insurance written on junky mortgage-related securities, something that has been missing in the default swap market. The Merrill deal also represents a template for future arrangements intended to unwind C.D.S.'s, Mr. Dinallo said.

Of course, not every swap should be valued at 13 cents. Because each contract covers a different security or pool of bonds with different default probabilities and maturities, they vary significantly. Indeed, on August 1, the Ambac Financial Group, another bond insurer, unwound $1.4 billion in credit insurance it had written on mortgage-related securities at 61 cents on the dollar.

Still, Mr. Dinallo said, the valuations of C.D.S.'s remain absurdly optimistic on both the books of the bond insurers who wrote them and the companies who bought them. As regulator in this particular poker game, he gets to see both parties' hands.

The Merrill deal came together, Mr. Dinallo explained, because Security Capital Assurance could have been threatened with a regulatory takeover had it been required to pay Merrill in full on the insurance. One reason Merrill came to the table was that it was afraid it would get no payment at all on the policy.

"There was the looming threat of us sending the whole thing over to rehabilitation where it is still uncertain what happens," Mr. Dinallo said. In a regulatory takeover, for example, the credit default swaps might be deemed as junior to other claims against the insurer. "This uncertainty presented the market clearing price for the credit default swaps," he said.

Mr. Dinallo is pushing for similar arrangements with 13 other banks that bought credit default insurance from Security Capital. It is easy to see why Mr. Dinallo wants these swaps off of insurers' books. As of last September, bond insurers had written some $656 billion in credit insurance on structured finance products. Some $126 billion of that covers the kind of mortgage thingamabobs Merrill was trying to protect. Yet the insurers' resources to pay those claims stood at $54 billion.

"It would be very valuable for the bond insurers if we could resolve all of these," Mr. Dinallo said. "We are headed to a regime where if we let anyone use credit default swaps again, they have to have an insurable interest. If the S.E.C., Federal Reserve and Treasury want to allow naked credit default swaps, that is O.K. But they are not insurance policies."

Other regulators are demanding more transparency in credit default swaps from the institutions they oversee. At the end of July, the Federal Deposit Insurance Corporation proposed a new rule that would require troubled banks under its regulatory wing to produce, on the agency's demand, detailed records of swaps and other financial contracts, their current market values, collateral posted by counterparties, the identities of those parties and copies of the agreements.

The rule should help the F.D.I.C. understand what positions a troubled institution holds before it encounters difficulties. This would allow the F.D.I.C. to conduct an orderly unwind of the positions or to transfer them quickly to another institution. The F.D.I.C. has asked for industry comments by September 26.

As the sheriffs begin to confront the C.D.S. cowboys, more losses are bound to show up in this Wild West. But a silver lining to the credit cloud we have been under for the last year does seem to be taking shape. Regulators are once again regulating. And we can bury for good the fantasy that financial market participants are able and willing to police themselves.

This is the kind of conclusion you expect from the NY Times. Financial market participants would not need to police themselves if normal market mechanisms were in place. They would have the incentive to act prudently in order to avoid going out of business permanently. What has been definitively shown, over and over, is that you cannot expect central banks to police themselves.

GROWTH STOCKS ARE CHEAP, SAY MUTUAL FUND MANAGERS
August 13, 2008

The top-ranked mutual-fund managers in the latest Barron’s/Value Line survey say it is a great time to load up on shares of fast-growing companies selling at hefty markdowns.

We are not a huge fan of mutual funds. Overall they at best match the market, minus transaction costs and management fees. They tend to be locked into an institutional mode of thought which can easily devolve to a preference for being wrong as long as everyone else is wrong too, at the expense of being right but taking a risk. Money managers live and die by relative performance, which feeds the fund rankings, but you can't eat relative performance. Managers also know by experience that most investors are lazy and will stick around for a while even in the face of mediocre performance, leading to a strategy of avoiding noticeably bad short-term results even if that entails little chance of outstanding results. In short, there is an incentive asymmetry between fund investors and fund managers.

But some managers unquestionably display superior talent and results, and it is at least worth listening to what they have to say. Barron's checks in those who demonstrated superior results over the previous year. The diverging opinions expressed over energy stocks and financial stocks are certainly food for thought.

Rattled by the return of the bear, panicked investors are dumping stocks indiscriminately of late, letting go the good companies along with the bad. Yet now might be the time to do just the opposite: Load up on the shares of fast-growing corporations selling at markdowns not seen in years. The best way to profit in ursine times: Stay calm, nimble and true to your long-term investment plans.

These are among the words of wisdom shared by the top mutual-fund managers in our 13th annual Barron's/Value Line survey, which aims to identify investment pros who consistently beat peers with similar investment objectives over a period of at least three years, without undue volatility in returns. "Keep a cool head," says #1-ranked Jan-Wim Derks, captain of the ING Russia Fund. "In emerging markets, we know all about that. This is the best time to make money."

Most of the 100 managers [PDF] on this year's list generated sterling returns in the past three and five years ended June 30, according to Value Line. But they have taken their lumps since the credit crisis exploded last summer and the stock market headed south. Most are in the red on a 12-month and year-to-date basis, although the majority continue to outpace the broad market, which was off about 13% in 2008 through the end of June.

ING Russia is the top gainer, by far, in the 3- and 5-year spans, returning almost 50% over three years and 38% over five. For the second time in three years, a Russia fund has led our pack -- no surprise, perhaps, in view of soaring energy and other commodity prices, which have sent the Russian economy and stock market, at least until recently, into overdrive.

What bear market? So scoffs Kenneth Heebner, manager of #2-ranked CGM Focus Fund, which is well ahead of the pack -- and fundland, generally -- with a 71% one-year return. CGM is also the leader in 2008, returning 17% through June. "The performance was driven by energy, steel, industrial materials and infrastructure," says Heebner, who has run the fund for 11 years.

Roger Hamilton offers another sound recommendation for investors: Invest in companies with good business models, with long-lasting assets. The manager of #3-ranked John Hancock Large Cap Equity is taking his own advice, having recently snapped up shares of Bovespa Holding (ticker: BOVH3.Brazil), parent of the Brazilian Stock Exchange, and discount broker Charles Schwab (SCHW).

Other mutual-fund managers also are tip-toeing into financials. "I am nibbling at financial companies," says Thomas Soviero of #4-ranked Fidelity Leveraged Company Stock Fund, which invests in companies laden with debt. "A lot of companies are trading at less than 12 times earnings. It is hard to ignore these situations."

While some fund managers are taking profits in energy and materials stocks, they remain bullish on oil, long term. Energy fundamentals "are good and valuations are low," says Hamilton, whose $3 billion, 59-year-old fund has 25% of its assets in energy stocks, versus the sector's 14% weighting in the Standard & Poor's 500.

The Barron's/Value Line survey identifies the top managers in nine broad investment categories. We exclude asset-allocation, sector and index funds, and others that rely on passive management. Funds must have at least $200 million in assets to be included in the survey.

Last year, small- and mid-capitalization specialists took the lead in our survey.

This year, the penthouse residents include mostly large-cap funds in the Growth, Aggressive-Growth and Foreign-Equity categories. Two country funds made the Top 20, with Fidelity Canada jumping to #16 from #69 last year, and ING Russia making its debut.

Some fund firms have multiple offerings on this year's list. Fidelity leads with six, followed by BlackRock, with four. Two managers appear twice for their stewardship of different funds, including Jenny Jones for Schroeder U.S. Opportunities (#39) and Wells Fargo Advantage Small Cap Opportunities (#45).

Manu Daftary of Quaker Strategic Growth (#9) is the leader in Aggressive Growth this year, as last, while Jill Evans of Alpine Dynamic Dividend (#49) is tops once more in the Income strategy. Daftary, whose fund returned 6.2% in the year's first half, laments that skillful stock-picking might be insufficient in today's market, where investors seem willing to punish the shares even of companies with strong fundamentals. "There is so much uncertainty about the direction of the economy," he says. "Stocks are being driven by sentiment more than fundamentals. I don't know where the minefields are anymore."

Daftary's fund has ranked among the top 25 in our survey for nine consecutive years, and it has returned 18% annualized for five years. His top pick from 2007, Ford Motor, hit a major pothole this year, but another favorite, IBM has fared much better. Nowadays, Daftary thinks engineering concerns McDermott International (MDR) and ABB (ABB) are attractive.

While Daftary's stock-picking skills have continued to serve him well, that is not the case for some other notable fund managers. Legendary investor Bill Miller, previously a regular on the Value Line survey, failed to make the list this year. Morningstar notes that Miller's Legg Mason Opportunity Trust (ticker: LMNOX) missed the run-up in energy and was punished for bets on home builders and mortgage lenders. The fund's 4% loss for the 3-year period through August 7 trails 98% of its peers.

Another notable absentee is Scott Barbee, last year's winner, whose Aegis Value Fund (ticker: AVALX) celebrated its 10-year anniversary in May. It has returned more than 12% a year in the decade, but is down 12% over the past year, hurt by selloffs in small-caps and Spansion (SPSN), a maker of flash-memory chips whose shares have fallen 76% in the past 12 months.

Despite Miller's absence, the 2008 survey is replete with other high-wattage names. Ron Baron, whose Baron Partners Fund clocked in at #22, and Mario Gabelli, whose Gabelli Small Cap Growth was #67, join Heebner as repeat winners.

Thomas Marsico, of Marsico Focus (#87), is another fund-industry heavyweight -- and contrarian. He is bearish on oil and bullish on stocks, and he thinks the S&P 500 could reach 1,700 in 18 to 20 months, almost 35% above today's level. Marsico, who has been cutting his stake in energy while buying financials, thinks economic growth will accelerate by the middle of 2009, while "housing will find its bottom in the next 12 months." His advice: Own companies with strong balance sheets, and preserve your capital.

In a recent report, BCA Research recommended that investors reduce their positions in Russian stocks, warning that the Russian inflation boom might soon turn to bust. But cutting back could be a mistake, says Derks, a Dutch native who has managed the $989 million ING Russia Fund since 2001. Director of emerging-markets equity at The Hague-based ING Investment Management Europe, he was lead manager of the fund until early 2008, and now runs it with Gus Robertson and Remco Vergeer. "We don't think the story of emerging markets and Russia is over," says Robertson.

The Russian stock market could advance 10% to 15% by the end of the year if oil stays above $100 a barrel, says Derks. Russia's gross domestic product is growing by a sturdy 8%; the market has little exposure to the U.S., and Russian stocks are cheap at 10 times earnings, compared with China's 15 times. The economy is broadening beyond oil and gas, and the managers are finding increasing investment opportunities in telecommunications, retail and other consumer-driven names. They have been dialing back their energy exposure and overweighting consumer staples, now 4% of fund assets.

While the fund world ponders Bill Miller's fall from grace, some in the media now dub Ken Heebner the nation's best fund manager. CGM Focus Fund's 35% 5-year return trails only ING Russia's in our survey. Heebner, #3 last year, has been a fan of fertilizer companies such as Mosaic (MOS) and Potash (POT), which have sprouted huge gains. Steel-producers United States Steel (X) and Nucor (NUE) recently were the fund's two biggest holdings.

Roger Hamilton, a Wharton graduate and tennis buff, has helped guide John Hancock Large Cap to a 23% gain in the past year, owing to big stakes in energy and materials stocks. The fund is one of only 11 in the survey to have generated positive returns year-to-date, up 7.5%. Although its co-manager departed earlier this year, Hamilton says its investment strategy, which includes finding stocks with identifiable catalysts, remains the same. "When we find a name we like, we want to take a big position," he says.

Hamilton bought Schwab and Bovespa in the second quarter. Schwab, which is up 15% this past year, could increase net new assets steadily, he says, while Bovespa will grow with Brazil's percolating economy.

#4-ranked Fidelity Leveraged Company is up more than 7% year to date. Manager Soviero, who has guided the fund to a 23% five-year record, relies on Fidelity's deep bench of analysts, and his own strong background in high-yield bonds to sift through opportunities among heavily indebted companies. Big investments in Chesapeake Energy (CHK), Forest Oil (FST) and other energy stocks have paid off, and Soviero remains an oil bull. "The supply side will keep oil high over the next three to five years," he says.

Our #5-ranked fund, BlackRock International Opportunities, is down 6% year-to-date and 4% for the past 12 months. Managers Thomas Callan and Michael Carey are not used to that; since 2003, foreign-equity funds have beaten U.S.-focused portfolios. Despite its near-term setback, however, the fund, which reopened to new investors in March, has earned a place among our survey's top 10 for four consecutive years, posting a 26% return for the 5-year period.

Callan and Carey are taking profits in energy and materials and buying shares of New Jersey's Hudson City Bancorp (HCBK) and Sweden's Nordea Bank (NDA.Sweden).

Callan advises allocating assets among a diverse group of funds run by proven managers. At the risk of boasting, the Barron's/Value Line survey is a good place to start.

There is an interesting table included with the article, "Class Acts," listing managers who added the most value in their fund objectives. It included some managers not mentioned above, and one who did not make the top 100 from the Barron's/Value Line survey.

BEATING THE MARKET, WITH CAUTION
August 16, 2008

Douglas C. Lane, who heads an money management firm named after himself, follows a long-term, value-oriented, investment philosophy that anyone could emmulate, but it takes dicipline. Note, e.g., in this interview his choice not to take the emerging markets bait. The value of his 40 years in the business clearly gives him a valuable perspective that shows up in several places in the talk. Well worth chewing over ...

Douglas C. Lane & Associates hews to traditional investment values. That is, the firm invests long-only, aims for low portfolio turnover and takes a long-term view -- typically three to five years -- of securities.

In running money for individual investors, families and some institutional clients, the New York outfit oversees about $2 billion. The portfolio managers do not check off just one or two boxes in the style grid, preferring to invest wherever they see opportunity in the stock market. So they buy both traditional growth and value stocks. And although they do hold some American depositary receipts, or ADRs, they do not invest directly in overseas markets, which they view as too risky.

All of this has led to solid performance. As of July 31, the firm's core equity composite -- a measure of overall performance for all of its portfolios -- had soundly beaten the Standard & Poor's 500 index based on 1-, 3-, 5-, 7- and 10-year periods. Through the first seven months of this year, the composite had a net loss of 7.1%, versus a deficit of 12.7% for the broader market.

Barron's recently spoke with Douglas C. Lane, who launched the firm 14 years ago, to get his take on the market, individual stocks and other topics. One area where he sees opportunity is media, including several cable companies and newspaper publisher Gannett, whose shares have been battered.

Barron's: Your career dates to the late 1960s. How does this market stack up to others you have seen over that time?

Lane: I see a lot of similarities to the market of the early 1980s: rising commodity prices, soaring oil prices and the consumer beginning to slow down in terms of purchasing, getting us into a recession. And the market had been flat for about 10 years, similar to today. The big difference is that interest rates were very high in those years, and they are low today.

What do you see the market doing for the rest of this year and into 2009?

The excesses created by interest rates that were too low are being cleaned up, and that is going to go on for a while. We all think the medicine gets taken and you get well right away, but there is always the aftershock. So I would not be surprised if the market tests its 2008 lows in 2009. Besides that, the biggest risk is to be out of the market when all of this clears up. I was looking at what happened in 1982 and 1983. The market hit its bottom in 1982 and, nine months later, it was up 60%. Nobody believed it at the time, but that was the beginning of a long bull market.

How do you see the U.S. consumer doing over the next year?

There is a mountain of credit card debt, and we have got to climb that mountain and solve the problem. Commercial real estate is another big worry, although it is not affecting the consumer that much. But the consumer is going to struggle for at least a couple of years.

Has the credit crunch, which began in the U.S. about a year ago, created any investment opportunities for you, especially in the financials?

It has created some opportunities, but I am not sure I want to take advantage of any. There is a temptation to step in too early and benefit from a rally. But then you wake up 18 months later, and you have not gotten anywhere. So you have to fight that temptation. We do fight the temptation, but sometimes we end up being a little early anyway.

In a letter to clients early this year, you said you do not invest directly in emerging markets. You do hold some ADRs, but why not try to make money directly in some of these markets -- that is, by investing in their local stock markets?

We get a lot of anecdotal evidence. For the past four years, I have had lots of questions from clients asking me why we do not own emerging-market mutual funds and why we do not invest around the world. After a while, you realize what is really going on.

It is a huge sales pitch to get people into emerging markets from all the retail entities, including brokers and trust officers. Even our institutional clients are asking the question. But when you are shoving a lot of money into a very narrow space, who do you sell it to when it is time to leave, or when you find out it did not work, or when you have to cut back? China is down about 50% this year, so that is somewhat indicative of what you can expect in those worlds, which are too dangerous for us.

Presumably a lot of the U.S. companies you invest in, along with the ADRs, have significant exposure to overseas markets.

That is right. We do not feel we are lacking exposure to the growth of demand from China, Brazil or anyplace. But I have more confidence that domestic companies will deploy their capital more efficiently around the world than mutual fund managers will.

As of June 30, your portfolios were underweight energy -- nearly 14%, versus 16.2% for the S&P 500. What is behind that move?

We did not reach an underweight in energy until a couple of months ago. We were double the index weight three years ago, and rode it up. But we got nervous that the risk factor was too great. And if you look at the ExxonMobils and the Chevrons of the world, they are going to have a difficult time increasing production. These are great companies, but they will probably have a difficult time growing. One of the things that made us nervous about energy was that three of our top five holdings in the firm were in energy. That is a good warning sign. So we cut out a lot of those holdings except for the biggest companies, like Schlumberger.

What else do you see in terms of sectors?

There are times when it is really important to get the sector calls right. If you miss that, it is a painful 3- or 4-year period. Right now, though, I cannot find an entire sector that I am excited about.

When that is the case, you need to walk away and try not to do sector investing. During the 40 years I have been in the business, it is about 50/50 -- 50% of the time, you should just focus on individual companies and not worry about the macro environment, and 50% of the time, if you miss the macro story, you are going to have a painful experience. You do not have to hit the macro right on Day One, but you have to try to anticipate it. But for the past two years, we have been focusing on individual companies. We have taken money out of basic-materials stocks, which came to about 20% of our portfolios, and we have lightened up on energy, as I mentioned.

One sector where you are overweight is health care. What do you see there?

Health care is 16% of U.S. gross domestic product. If you are looking for individual companies, it is pretty hard not to find some companies in that sector, which has been cheap.

How has your long tenure in the business helped you as an investor?

It gives you perspective, but age and experience do not do you any good if you do not keep working hard. You cannot just go home and think: You have got to keep reading the 10-Ks and the 10-Qs. And you have got to keep traveling and visiting companies.

Let's discuss some of your holdings.

We like Gannett [GCI], among other media holdings.

The stock has been on steady descent, going from north of 60 a year-and-a-half ago to around 18 as we speak. What do you like about the company?

The question is: Is it a newspaper company or is it a news-gathering organization that is going to be able to find a way to monetize the news beyond newspapers and through the Internet and other means? All newspapers are going through that transition. But Gannett is better-financed than most going into the transition, so they are going to have a better way of getting through it. It is a question of whether merchants are going to pay for internet advertising or for newspaper advertising, and how much.

For years, the local newspapers could count on a 4% price increase in advertising rates, but the world has changed. The profitability of local newspapers will decline -- but from a very high level -- so they are not going to go out of business. You would have to convince me a lot more that the internet is going to replace newspapers. I remember when TV was going to replace radio, and cable was going to replace the movies, and none of that happened.

So the business model of providing local information, including news, is viable?

People are going to want to know what is going on in their town, and the only way to get [that news] is for someone to gather it.

At 18, the stock trades at less than six times forward earnings.

We got interested in it when it was in the 20s, so we are not too bad off now. We are not blind to the changes that are occurring in the newspaper industry. I cannot draw the plan that they are going to use, but I know that most of these guys, particularly the guys at Gannett, get it.

Let's move on to another holding.

We also have a stake in General Electric.

What is to like here?

We like the dividend. It is yielding more than 4% right now. We like Jeff Immelt, the CEO, and that he is changing the business mix. Given more time, I think he would have reduced the financial businesses even further, but he is smart enough not to do that today. He might even take his war chest and add to GE's businesses.

Why would he do that?

Do not forget that GE [GE] is able to maintain its triple-A rating only because it has all of these gigantic industrial businesses. If their financials were independent, they would be facing problems. Now Immelt can go out and pick up some businesses dirt cheap. There is no question that there will continue to be loans, finances and credit cards for a long time.

But isn't this a very tough growth environment for GE?

Not for jet engines, gas turbines and other products.

The consensus has next year's earnings growing by about 5%.

If you are only paying 12 times earnings for that growth, that is OK. Plus, you get the dividend. If you can get 4% from the dividend, you only have to get 4% from the stock for an 8% total return. You do not have to grow a lot to get to an 8% return, and there is not much risk. Of course, I would have thought there was not much risk when the stock was at 35, versus around 29 currently. This is in the eye of the beholder. But I like what Immelt has done, and I will be interested to see what he does here. I am happy to continue to accumulate the stock and have it be 2% of our portfolios.

Any tech holdings you can discuss?

Qualcomm [QCOM] is one of the few technology stocks we have held onto. [Mobile phone third-generation technology] is important, and Qualcomm has the technology in 3G. We are not particularly happy with their fight with Nokia [over patent-license royalties]. They settled recently, though I do not understand the settlement as well as I would like to. But so far, it looks OK.

Looking ahead, what is it about Qualcomm's business that you like?

3G involves sending data over the phone. We are convinced that the transmission of data and video over phone lines is going to continue right to your laptop or to your cellphone, etc. It is going to happen, and 4G is just a faster version of transmitting data. Look at Qualcomm's business model. They get a license on every phone, based on the value of the phone. It is an incredible business model. As long as you believe that you are going to have a camera on your phone and you are going to get video on your phone, you want to be in 3G. I think the broadcasting of the Olympics from China is the biggest thing for 3G yet.

One more pick, please.

Kimberly-Clark [KMB] is a new holding. I am impressed with the management. It is trading at the same price as it did nearly 10 years ago. The earnings have expanded a lot, and it is a steady consumer-products company. So it is just brand management. If you manage your brands right and work hard on your costs and get new-product introductions, you will be fine. The management team there now is in their late 40s and early 50s, so they have got a bunch of young people working hard to run the brands right.

Any brands in particular?

Depend is a premier product for the elderly. They have an incredible market share there. They are not doing so well with the Huggies versus Pampers. But they have an incredible brand name and position with Depend. That is important. With people living longer, you are going to run into incontinence more and more. It is a fact of life. And Kimberly-Clark is another dividend-paying stock. The yield is about 3.8%.

Thanks, Doug.

GLASS HALF FULL: JOHN TEMPLETON, R.I.P.
August 16, 2008

John Templeton got in very early on the international investing game, and developed a reputation for being willing to step in and buy when there was pessimism all around. He also expatriated from the U.S. to the Bahamas way before such moves became common, and before the U.S. made such moves substantially less remunerative tax-wise. He used his wealth to set up the John Templeton Foundation, which "serves as a philanthropic catalyst for research and discoveries relating to what scientists and philosophers call the Big Questions." Templeton recently died at age 95.

John Templeton said: "The 21st century offers great hope and glorious promises. It is perhaps a golden age of opportunity." Good to remember in today's troubled financial environment. Chris Mayer has some additional thoughts.

When you have a lot of problems you also have a lot of opportunity. I want to start with some wise words from John Templeton. Templeton actually died a few weeks ago at the age of 95. His is a great story.

Born and raised in rural Tennessee, Sir John was the first person in his town to go to college. He went to Yale during the Great Depression and when things got tight, his father could no longer keep him there. So he helped pay his own way through college with his poker winnings, which sort of adds to his legend. He eventually went on and won a Rhode Scholarship, went to Oxford and set up in Wall Street in 1937.

Now, you can imagine what the world look like in 1937 ... a lot of bad news, the Great Depression, war looming on the horizon. And in this environment of chaos, Sir John got to work.

One of his famous bets came to him in 1935 when he bought 100 shares of every stock trading for less than a dollar in the NYSE. He made four times his money in the next four years. That was sort of a pattern throughout his career. He was always an investor who was able to find the opportunity during times of market upheaval. He famously bought stocks the day after the 1987 crash, for example. He also bought airlines after 9-11 and made a lot of money in a short amount of time. So I think he is a good investor to focus on these days because, as investors, we have so many problems to deal with in the marketplace.

I also want to say he started his famous fund in 1954 and it was incorporated in Canada because there was no capital gains tax there at the time. And during 1954-1992 he racked up an average return of 15% a year. That is a great track record over a long period of time.

He also offered a lot of phrases that we take for granted as common sayings today. "It's different this time,' are the most expensive words in the English language" -- That is Templeton's. Maybe his most famous saying is, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." He later added that the best time to buy is during points of "maximum pessimism."

When I think of Templeton's influence on me, I think of two things. One is that he was one of the first really successful investors to invest overseas. He was an early investor in Japan, for example, and he drove home the idea that a quality investment idea does not have to be large, U.S. blue-chip company. He was equally at home investing in South Africa, Australia, Japan, wherever. The second thing I think of is that he had this focus on finding great opportunities even when markets seemed like a really bad place to be.

He wrote this when he was approaching his 95th birthday: "Throughout history, people have focused too little on the opportunities that problems present, both in investment and in life in general. The 21st century offers great hope and glorious promises. It is perhaps a golden age of opportunity."

Now, you might think he was nutty saying that. And when you look, there is a lot of bad news out there. I think the U.S. economy is probably in recession and Wall Street is a disaster. The dollar is in the tank, debts are high and taxes are going up. My state of Maryland, for instance, just passed the largest tax increase in state history last year. That is pretty amazing considering all the things people get hit with nowadays. And now we are getting hit with higher taxes too. California also had an increase in taxes by some large amount, and Sacramento already has higher taxes than NYC. So to top it all off -- as if that is not bad enough -- it is also an election year! So we have to listen to all the politicians tell us how they are going to solve our problems with a wave of their magic pen.

Today, the big issue is scarcity. When you think about how the prices of everything from food to gasoline are rising, you might think we face scarcity in a lot of things. This may or may not be the case. One thing we do not have scarcity of, however, is paper money. The money and credit growth for the last 12 months is really incredible. The Australian dollar, the Canadian dollar, the Chinese Yuan, the euro ... all these currencies are increasing at 22%, 21% 18%. The only major currencies that are not increasing at a double-digit rate are the Japanese yen and the Swiss franc. So, when we look at market prices, this distorts what we see.

For example, let us look at oil. Every time I hear that oil is in a bubble, I think of ... [the fact] that as money supply increase, the price of oil has increased along with it. In fact, roughly 87% of the increase in crude oil can be explained just by the increase in money supply. So when you see oil make this huge jump, you have to put it in context. This is true for all commodities. It looks like we have skyrocketing prices, but what we are in fact seeing is the collapse of the dollar. It is just another factor that makes investing difficult, another factor we have to consider.

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