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

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

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


The mainstream media did not see this disaster coming and even now seem incapable of imagining how much worse it could get.

Rick Ackerman thinks deflation is going to be here for a while, even thought it is "beyond dispute that the dollar is already absolutely worthless." He does not think that hyperinflation will arrive in time to bail out all the debtors: "It just does not work that way." We have to agree that this reasoning makes as much sense as any when it comes to predicting the timing.

The New York Times led its front page on Saturday with an article about, of all things, deflation: "Fear of Deflation Lurks as Global Demand Drops" read the headline. Better late than never, we suppose. For years, Rick's Picks has been shouting from the rooftops that a catastrophic debt deflation was not merely possible, but inevitable. At times, we even characterized inflationists and those who asserted in print that deflation was unlikely or impossible, as contemptible idiots. Ad hominem attacks aside, we must warn you that these are not the guys you should trust right now, since they still do not get it, not at all.

They will catch on eventually, we are sure -- after unemployment has pushed above 10%, recession has turned into depression, Greenspan's key role in the destruction of the global financial system has been universally acknowledged, and the Dow Industrials have fallen below 4000. But for the time being, the retrograde theorists of inflation remain totally clueless about its opposite and how to deal with it. Doubtless, some have even been buying stocks in recent weeks, convinced that global asset deflation has run its course and that a resurgence of inflation is about to cause share prices to explode. (For the record, we believe deflation has barely begun and that the stock market will not hit bottom before 2015.)

Buffett a Closet Bear?

Still, we would have to concede the numbskulls are in good company, what with Warren Buffett, Bill Gross and Jack Welch ostentatiously professing their bullishness to any reporter who asks. We are pretty sure these guys are closet bears, and would hasten to add that, by taking a symbolic $5 billion stake in Goldman Sachs, Buffett was not exactly "buying America." Let him suck up some GM shares if he is so bullish. As for Gross, he has long been suspected of putting PIMCO's money where his mouth is not. And Jack Welch? Well, as The World's Greatest CEO, he is about as likely to utter a discouraging word as Oprah or Tony Robbins. Still, if such Forbes-list stalwarts can find value at these levels, who are we to quibble?

However, we do have a request to make of those who cling, with every fiber of ignorance that the evidence will allow, to the notion that inflation or hyperinflation lies ahead: Wake us when the price of a modest suburban home reaches a quadrillion dollars. We are not saying this cannot happen eventually, since it is beyond dispute that the dollar is already absolutely worthless. We just do not think hyperinflation will precede deflation -- which is to say, in time to save debtors from death by asphyxiation. It just does not work that way. In point of fact, 99% of the bailout money (electronic credits, actually) so far has gone to shore up the reserves of banks, hedge funds and insurance companies rather than to beleaguered homeowners. And if you think, as the inflationists evidently do, that all that bailout money is going to get turned into loans, we have got a bridge to sell you. Much as the guvvermint wants the banks to start lending, policymakers seem not to understand that there will be precious few takers. Do you know a single person who is not hell-bent on retiring debt right now? We surely don't.

“What Asset Deflation!?”

In any event, we would suggest that readers imbibe articles about the economy in USA Today, the Times, the Wall Street Journal et al, with a grain of salt. The mainstream media did not see this disaster coming and even now seem incapable of imagining how much worse it could get. Conventional news outlets are barely paying lip service to those whose forecasts have been ahead of the curve for years. The truth is, deflationists were regarded as fringe lunatics until relatively recently. Writing for Barron's and the San Francisco Examiner, we had the subject all to ourselves until around 1998, when the collapse of the Thai baht and its spillover effect on Asia brought a few more like-minded lunatics out of the woodwork.

While it is gratifying to see that America's newspaper of record has finally begun to catch up with the deflation story, it is not exactly cutting-edge stuff. Saturday's front-page story was actually pretty tepid, even for the Grey Lady. In demurral of its own thesis, the newspaper noted, for one, that "prices have yet to decline noticeably for more goods and services, with one conspicuous exception -- houses." Perhaps the Times will eventually take notice of the asset deflation that has already caused additional tens of trillions of dollars in wealth -- in the form of stocks, bonds, commodities and commercial real estate -- to vanish forever from the financial system? However, if they do fail to notice, it will be no more egregious an oversight than their having failed to notice the cosmic asset bubble that grew while everyone was obsessing over the piddling inflation measured by a laughably bogus Consumer Price Index.


How much further does this bear market have to go, assuming it has not already ended? Gary North looks at all the excesses, illusions, and, of course, leverage, that built up over the long bull market that preceded it and concludes that a lot more cleaning up remains to be done. At a more visceral level, he does not see true signs of what others label capitulation by investors. He sees too much remaining optimism, which begs to be ground down. He does not rule out sharp rallies such as occurred during the 2002-03 bottoming process before the final bottom was established.

Day by day, the dreams of hundreds of millions of people around the world are being smashed. It is a terrible thing to see from the sidelines. It is far worse to be a participant.

The dreams of easy retirement are disappearing. So are the dreams of automatic wealth. Americans, more than any other people, bought into the dream of automatic wealth. "Just buy a larger home with 5% down and wait. You will get rich." The dream of leveraged money trapped homeowners. It also trapped hedge fund investors.

This dream has yet to play itself out in a wave of bankruptcies. It will. Hedge funds, leveraged 30 to 1, have few reserves apart from stocks in their portfolios. When the stock market falls, they receive margin calls. They must sell more stocks. This depresses the stock market, which triggers more margin calls.

Getting rich looked easy when stocks were rising. Going bankrupt looks easy now. Leverage is a two-way street.

The sellers of dreams are still in business. "Buy stocks and hold."  "Don't sell in a panic."  "This market will rebound."  "The decline in the American stock market since March 2000 is an aberration."  "We are bullish on America."  "The government's bailouts will work."  "The market is approaching a bottom."

Those who were seduced by the dream want to believe these reassurances. There is a market for these reassurances. But, week by week, the audience is shrinking. So is their capital.

Recovery is a dream based on fiat money. Prices will go back up, say the cheerleaders. Yes, they will. When the Federal Reserve System pumps in new money at over 300% per annum, which it did from late August to late October (adjusted monetary base), eventually prices will rise. But few people will be made richer.

Here is the three-step religion of recovery: monetary inflation, increased Federal spending, and regulation. Congress promises to implement this program until the dream revives. Congress promises monetary inflation without price inflation, Federal spending without the crowding out of capital to fund business, and regulation without bureaucracy. This program will not work. It cannot work. We need the opposite program: monetary stability, Federal surpluses, and reduced bureaucracy. We will not get this program ... ever.

The dream was always naïve. The Reagan revolution was based on monetary inflation after the weekend of August 13, 1982, when the FED's tight-money policy, which began in the fall of 1979 under Carter, was self-consciously reversed in the wake of the Mexican bank crisis. The Reagan revolution was also based on massive Federal deficits, beginning in 1983. While bureaucracy's grasping hand did decline under Reagan, as evidenced by the reduction of pages in the Federal Register from 60,000 a year to under 40,000 a year in his first term, it started back up in his second term. It has continued to rise to its present 70,000 a year.

The dream of easy wealth through easy money and debt has accelerated in every American generation since the end of World War II. We have now come to a new phase. Money will be far easier as the Federal Reserve inflates, but profits through debt will become more elusive. Meanwhile, those few Americans who have pension funds dream of the return of the boom of 1982 to 2000.

Last Friday (October 24), the Dow Jones Industrial Average fell over 300 points. This was considered a good day. It had been down over 600 points in the first hour. Volatility is constant. The experts do not know whether this market is ready to soar or not. My guess: It is not.

Alan Abelson, who has been writing a wry weekly column for Barron's for over 30 years, cited the work of John Harris. Harris says that in the years since 1928, whenever a Presidential election is accompanied by a bear stock market, the market continued down to year's end after the election in four out of four cases: 1932, 1948, 1952, and 2000. The average loss on the S&P 500 was 5.9%, but on average the low was 10%.

Past is not necessarily prologue, but it surely is attention-catching.

The experts say that the traditional sign of a bear market climax is a panic sell-off of shares. This is called exhaustion. Exhaustion can produce a bottom. It also creates a sucker's rally.

In October 2002 the S&P 500 bottomed at 777. That was one of the strangest oddities in stock market history. On Friday the 13th, August 1982, the Dow bottomed at 777. (The Dow also fell 777 points one day in September.)

The S&P 500 arrived at 777 in a most intriguing way. It closed below 800 in mid-2002. Then it soared back to about 950. Then it fell back to 777. Then it soared again to about 950. Then it fell back below 800. Only in the first quarter of 2003 did it begin its long trek back up. It peaked in late October 2007. Then the rout began.

The bulls are waiting for the final sell-off. They tell people to stay in this market, yet they also predict a final sell-off.

It seems to me that it is better to sell your shares -- all of them -- and short the market. This way, you profit from the final sell-off. But the analysts never mention this strategy, let alone recommend it.

Despite the fact that exhaustion has not happened, the analysts also assure us that the stock market is still fundamentally sound -- Herbert Hoover's famous phrase from 1930 to 1932. There is bad economic news on all fronts, but somehow the stock market is sound. Yet the economy is in recession -- something the analysts have denied until recent weeks. The stock market's bottom is supposed to send a message: the economy is going to recover in six months. Or nine months. Yet the experts are now talking about a recession that lasts longer than the traditional 11 months. Then why should the stock market be close to the bottom?

The economy is slowly sagging. This has not been like a fall off a cliff. It has been more like a stroll down a hill. The overleveraged behemoths of finance have taken huge hits, as have the taxpayers, but the economy is not showing signs of anything remotely catastrophic.

There seems to be a disconnect between the stock markets of the world and the world economy. The Hang Seng index of Hong Kong is down by 2/3 over the last year. Yet the Chinese economy, while slowing, still seems to be growing above 7%. These are government-supplied figures. We should not take them too seriously. But the trend is still positive.

Are the Asian stock markets not forecasting really bad news to come in 2009? This is what bullish analysts ought to argue. We are told that the Hang Seng index is selling off because profit projections had been wildly optimistic a year ago. Maybe so, but the question remains: Why?

The answer is the Austrian theory of the trade cycle. The economic boom is created by rising monetary inflation. The bust occurs when the rate of monetary expansion slows. The Chinese central bank is slowing the rate of monetary inflation. It had pumped in money (M1) at a rate of close to 20% per annum for several years. Year to year in September, M1 rose at less than 10%.

In June of 2007, I predicted what I thought was going to happen in China. The bubble in China resembles the 1995–2000 NASDAQ bubble in the United States. The Chinese stock market is trading at a price/earnings ratio above 50. Some stocks are trading at 80. In a speech on June 12, Alan Greenspan commented, "Some of these price-earnings ratios are discounting Nirvana." But let us not forget that the NASDAQ reached a P/E ratio of more than 200 in December, 1999.

In late January, I wrote this: At some point, China's central bank will be successful in slowing price inflation. The economic boom requires ever-larger percentage increases of the money supply. By merely following the policies of the previous year, the central bank will produce a recession. If the central bank is serious about slowing inflation through interest rate increases, it will see its goal achieved. Price inflation will in fact slow. The cause of the slowdown will be a recession in China.

What could trigger this? A recession in the U.S. could. Falling demand for the goods produced by China's export sector will produce bankruptcies in China. They will order no more goods and services. These effects will ripple through the Chinese economy. In the absence of the recessionary efforts of central bank policy, these ripples could be contained by growth in the other sectors. But a reduction of Chinese economic growth is already in the pipeline. The central bank's policy of letting interest rates rise is sufficient to create a domestic recession.

China is now where I thought it would be. China is cutting jobs in the export sector. The government is intervening to save jobs -- the standard approach of governments all over the world. In short, the recession is spreading fast. The crash in Asian stock markets is not a random event.

We have not had a crash in American stocks comparable to the fall in Asian stocks, but the trend is relentless. The stock market does not reverse for long. Optimism is fading. But it still remains. The average pension fund investor has not called the fund to tell it to stop buying stocks. He does not have to tell the fund to sell -- just stop buying.

Because companies match investments in 401(k) programs, investors stay in. They are told endlessly that American stocks will return to their tradition of producing 7% per annum returns, despite the fact that the Dow is down sharply from its peak in 2000 of 11,700, even without the 22% loss to price inflation. The bulk of retirement investors still believe the mantra, despite the evidence.

The falling economy will push down profits. This will push down the denominator of the price/earnings ratio. Prices will fall.

The stock market has obviously reversed its momentum. It heads lower, week by week. The public cannot seem to come to grips with what I have been predicting ever since last November: the end of the boom in stocks and the coming of a long recession.

I think the market will get exhaustion. There will be a sharp move downward. But I also expect to see a repeat of 2002 and 2003: spiked upward moves followed by spikes downward.

When will this happen? I don't know. The market is grinding away investors' optimism. This psychology has not yet moved to real pessimism -- when investors abandon the constant slogan, "Don't sell in a panic."

They should have sold calmly a year ago.


Bulls are missing the implications of this secular shift away from risk.

Mike Shedlock observes the articles expressing bullishness emanating from so much of the mainstream financial press and wonders ... are these guys trying to reassure, or sucker, the public, or do they believe their own press clippings? Shedlock believes we are headed enough lower from here that it makes sense to protect oneself against the decline, however large the declines in the rearview mirror may be. Bottom line: The MSM is early, i.e., wrong.

MarketWatch, the Wall Street Journal, Hussman, MSNBC, and Barron's are all bullish on the stock market. That is pretty amazing optimism in the face of the collapse we have seen. Is such optimism warranted? Let us take a look and see.

The Wall Street Journal is reporting Stocks Look Cheap World-Wide.
World-wide, stock valuations have fallen to a level roughly equivalent to the one that prevailed during the 1970s, according to Citigroup. As of Thursday, global stocks were trading at roughly 10.3 times their earnings for the previous 12 months, even lower than the average of 11.4 through the 1970s.

The selloff has been especially savage in emerging markets. Earlier this week, investors drove down stocks in such markets to valuations that were almost as low as those during the nadir of the Asian crisis in the late 1990s, according to a Merrill Lynch report.

"There are a host of things that have sold off to extraordinarily ridiculous levels," says Uri Landesman, a senior portfolio manager at ING Investment Management in New York. "The baby and all its diapers and onesies were thrown out with the bathwater."

Indian shares, which last September traded at about 25 times the previous 12 months' earnings, now trade at just over 10 times, using Citigroup and MSCI figures. Shares of Chinese companies open to foreign investors are down to about nine times, from 27 times. And Russian shares are trading at about 4.4 times prior earnings, from 13 times.

"Everything looks cheap," says Ronald Frashure, co-chief investment officer of Acadian Asset Management in Boston. That is, "unless the world is going into something like the Great Depression, and we think there is a low probability of that occurring."
MSNBC is reporting Stocks seen as historically cheap amid volatility.
Analysts and money managers agree that unusually sharp volatility and a freeze in credit markets have made it more difficult than ever to forecast a market bottom.

But many of them also say it is clear that stocks are a bargain at current prices, and poised to climb over the long run, even if they zigzag short-term. If third-quarter earnings end up coming in below Wall Street's expectations, some analysts still see room for stocks to gain.

"Any way you slice it, stocks will be either extremely cheap, or cheap, or just average," said Art Hogan, chief market strategist at Jefferies & Co.
MarketWatch warns about The high price of panic.
If you did not see the market's meltdown coming, you have plenty of company. If you are selling now, it is probably too late. For a longer-term, retirement-focused shareholder -- and that is most of us -- selling stocks just because they could fall further not only locks in losses, but also makes it less likely that you will participate in powerful market rallies. Missing those days can be hazardous to your wealth.
It is stunning how ass-backwards MarketWatch has things. Participating in those rallies is what is hazardous for your health because the biggest rallies are in bear markets. There were two 10% rallies in October yet the month finished down 15%. Any long-term investor who caught both of them lost money.

The cover story of Barron's is called A Sunnier Season.
It must really take a lot to scare America's money managers. The Dow Jones Industrial Average is down by 30%. Credit is near-impossible to get. A global recession looms, and the cost to clean up Wall Street's mess is climbing into the trillions. And yet, against these odds, 50% of the investment pros responding to our latest Big Money poll say they are bullish or very bullish about the stock market's prospects through the middle of next year.

Barron's latest Big Money poll reveals unrelenting bullishness among many money managers, despite their pronostications for a "contagious" recession and punk profits through 2009.

Now that stocks have tumbled to five-year lows, 62% of Big Money respondents say they are undervalued, up from 55% last spring. A scant 7% think equities are overvalued at today's levels. Almost 70% say stocks will be the best-performing asset class in 2009, compared with 13% who favor cash, and 11% who prefer bonds.

"A lot of money is on the sidelines," says David C. Hartzell, founder of Cornell Capital Management in Buffalo, N.Y., which handles about $50 million. "But if you are a money manager, you cannot afford to be out of the market, because you might miss the comeback."
There is that sideline cash nonsense again. Sideline cash does not come into the market except at IPO time and secondary offerings. Otherwise there is a seller for every buyer. If someone buys $50 million of Microsoft with "sideline cash" someone else will have $50 million in "sideline cash" to buy stocks with. I remain amazed at the number of people who manage money that do not know how the stock market even works.

In Risk Management and Hooke's Law Hussman makes a case for gradually building an investment exposure.
Though I continue to view stocks as reasonably undervalued, I am a bit concerned that so many investors appear to be looking for a bottom. The S&P 500 currently reflects the best valuations since the 1990 bear market low. We are not trying to catch a rally -- we are gradually building an investment exposure based on valuations.

My view is that the market is undervalued, that it is priced to deliver attractive long-term returns, and that there is an increasing likelihood of a major bear market advance -- but I do not believe that any of this puts a "floor" below the market in the very short term, and I do not believe markets are apt to bottom while everyone is still looking for a bottom.

As an economist, it is clear that the parallels to 1929 are terribly overblown, not least because unlike the Great Depression, governments in this instance have opened a floodgate of liquidity, capital and base money -- which they failed to do back then. Even if we were to completely zero out two solid years of earnings for the S&P 500, the fact is that more than 90% of the value of U.S. stocks would reside in the cash flows beyond that point. The main issue for good, established companies here is not the risk to the long-term stream of cash flows, but to what extent the uncertainty about the coming year or two of earnings will frighten investors to sell at depressed prices (thereby pricing stocks to deliver even higher long-term returns).
Of the above articles, only Hussman presented a thorough case worth discussing. That said, I disagree with his thesis. Should the S&P drop to 600 (and I think it will) that is approximately a 40% drop from here. Such a drop is worth avoiding no matter how many 10% rallies there are along the way.

I laid my thesis for the S&P falling to 600 or lower in S&P 500 Crash Count Compared To Nikkei Index. Here is the pertinent snip about fundamentals, see the article for the technicals.
S&P 500 Fundamentals It is impossible to predict the future of course, but fundamentally as well as technically there is every reason to believe lower lows are coming, and the rebound off those lows will be anemic compared to past recoveries. Those looking for an L shaped recession are likely looking the right direction.
With so much "Unrelenting Bullishness" in the face of deteriorating economic conditions and a global economy that is clearly in recession, I simply do not see the earnings projections for 2009 holding up. Nor do I see bullish market psychology coming back.

And while there may not be another Great Depression, the similarities between 2008 and 1929 are massive. Inquiring minds may wish to review a Crash Course For Bernanke for a comparison.

A massive secular shift in time preference away from risk is now underway. That pendulum has a long way to go before it hits an opposite extreme in the other direction. In my view, bulls are missing the implications of this secular shift.


Bond yields are always higher than stock divident yields, right? No, actually.

John Mauldin regularly contributes to the "Safe Haven" website, whose primary directive can be encapsulated with the three words "preservation of capital." Mauldin has two weekly newsletters, Outside the Box and Thoughts from the Frontline, both which can be subscribed to from here. This week Mauldin was given permission by well-regarded investment analyst and author Peter Bernstein to freely share the lastest issue of Bernstein's Economics and Portfolio Strategy Letter. Mauldin did not have to receive the offer twice.

This week I have a very special Outside the Box for you. Peter Bernstein is recognized as one of the more brilliant and insightful analysts of our times. At 89, he has been writing prescient material longer than most of us "young guys" (I am 59, and hope I am still writing at 89, or even able to write!) have been even marginally in the markets. His Economics and Portfolio Strategy Letter is read by the true cognoscenti of the investment world.

He has given me permission to reproduce his latest letter in which he offers two insights. Rather than give you some teaser copy, why don't you just jump in a read. And trust me, anything that Peter writes is worth reading more than a few times. For those interested, you can learn more about Peter and subscribe to his letter at here.
This issue analyzes two significant aspects of the current environment, one financial and one from the real economy. Neither of these subjects has received the attention it deserves, yet both have important stories to tell. The financial discussion raises tantalizing questions about investor rationality. The comments about the real sector consider current conditions in the labor market and their implications for equity price/earnings ratios in the years ahead.

Those interested in the details should go directly to the article link above. The bulk of, and more interesting segment of, Bernstein's piece looks at the relationship between bond yields and stock dividend yields. As hard as it might be for today's investors to believe, prior to 1958 dividend yields were consistently higher than or equal to bond yields (see chart). Stocks were riskier than bonds and should have the higher yield, or so the story went then. But since 1958 dividend yields have always exceeded bond yields, as the rationale for growth stock investing and the accompanying rising dividends gained currency and the very real hedge against inflation provided by rising dividends manifested itself in the 1970s and beyond.

So which relationship is the correct one? When 50 year relationships are reversed, and now another 50 years later are at the point of reverting (see chart), it is hard to say. When a fashion lasts that long, calling the supporting theories rationalizations is too ad hoc to be useful.

Perhaps even more confounding is that the correlation between the two yields went from negative during 1954-69, to positive over 1970-99, to negative again 2000-date. All of those correlations were statistically significant by a mile. Now theoretically the correlation between bond and stock yields should have been negative during times of high inflation, like 1970-99, and positive during times of low inflation like the other two periods -- the reverse of what actually occurred. (Under low inflation the two yields are competitors and should move together; when inflation is high, bond yields move up to offset losses from inflation while stock yields should go down to reflect the superior inflation hedge they provide. How superior? Today, dividends are 40 times their 1947 level versus a mere -- cough -- 10-fold increase in the general price level.)

Bernstein notes that correlation between the two yields was closest from 1871 to 1929, back in the quasi-gold standard days when low inflation or deflation was the prevailing order of the day. So investors in the medieval pre-modern portfolio theory and Efficient Market Hypothesis days appear to have behaved more rationally than their nominally more enlightened successors. We would think that ironic, but a deeper intuition tells us that somehow it makes sense.

The second segment of the piece is rather short, and notes that increasing unemployment rates and increased duration of unemployment episodes is going to result in direct political action "to change the egregious imbalance between winners and losers," which has grown increasingly large in the past 15-20 years. Bernstein concludes:

Under these circumstances, and regardless of when the black clouds on the horizon finally begin to brighten, we would put low odds on a renewed bull market with ebullient price/earnings ratios and declining dividend yields. For a long time into the future, equity returns are likely to be muted.

If we are entering an economic environment where dividend growth, never mind avoiding cuts, is hard to come by, then companies which do regularly boost their dividends will legitimately sell at a premium to other stocks and bonds. This Barron's article from a couple of week's ago interviews Rick Helm, manager of the Cohen & Steers Dividend Value mutual fund (DVFAX). The fund specifically seeks out companies which increase their dividends, with lower emphasis on the current yield per se. It is growth stock investing using dividend rather than earnings growth as the prime criterion. The funds top 10 holdings may be found here.

The fund's one- and three-year performance (the fund only opened in 2005) versus the S&P 500 is not sufficiently superior to cause one to summarily declare the concept a no-brainer winner, but Helm's long-term record is good, and the idea is worth retaining. If growth is bought sufficiently cheaply it becomes value investing. Similarly, if you can get the reliable dividend growers at only a modest premium to the work-a-day payors, then why not do so?


Time, of all publications, released a great interview with Jim Rogers. Only buy what you understand, he advises, and everyone can understand commodities ... as opposed to dot-coms, derivatives, and IBM which no one understands. He also claims he is a terrible market timer and only made money by buying cheap and holding a long time, although we suspect that on his short trades he was not quite so indifferent to timing issues. He is still short the investment bankers, and thinks the governments' attempts to avoid economic pain will prolong and deepen it instead.

It all makes good sense to us.

Time: You were one of the first to call the commodities boom. Now that prices have fallen, has your bullishness changed?

Rogers: No, no, not in the least. In the past 150 years or so, we have had eight or nine periods where there was forced liquidation of everything, with no regard to the fundamentals. Well, we are in one of those periods. In fact, what is happening now is improving the fundamentals of commodities. Farmers cannot even get loans for fertilizer. Certainly no one is going to get a loan to open a zinc mine. Supply is going down -- this is very bullish. We have a decline in demand, but the world is in recession. We presume that is a business cycle.

So if I wanted to make money in oil, how long would my time horizon have to be?

I don't know whether you are going to have to wait six days, six months or six years before oil starts skyrocketing again. I covered a lot of my shorts a couple of weeks ago and bought more commodities; I bought more agricultural commodities. I am not a very good market timer, but I have been going back into the market. Ask me in a couple of years.

What other commodities have you been buying?

I only buy my indexes. I bought the agricultural index and I bought the general index. I think I am going to make more money in agriculture than in other things for a while, but I am not a very good market timer. I am the world's worst trader.

You are the world's worst trader? You used to run a hedge fund.

Fine, but that does not mean I was a good trader. Whatever success I have had in investing has been by finding things that are cheap, buying them and owning them for years. I don't sit around trading. Brokers do not particularly like me.

You own the Swiss franc. With the bailout of Swiss investment bank UBS, how does that change your calculus?

The only thing the Swiss have had to sell for 200 years has been the soundness of their currency. I, for the first time in my life, have started asking myself questions about the Swiss franc because of the UBS deal. It never occurred to me that the Swiss would do this [the bailout]. I have not started selling my Swiss francs. I have stopped buying them. I am watching to see how it works out.

How worried are you about the slowdown in China's GDP growth?

I am not worried at all. China could have a recession, it is not going to be the end of the story. In the 19th century, America had 15 depressions with a "d," a horrible civil war, we had very few human rights, we had no rule of law, we had regular massacres in the street. China will certainly have setbacks along the way. A lot of people think China cannot have a recession. That is balderdash. China can have a recession like everybody else. Is it the end of the story? No. If it happens, you buy yourself some more China.

What were the things that made you start shorting financials a couple of years ago?

I could see that they were shams. There was no way Fannie Mae was producing 15% growth every quarter. They had giant derivatives positions, and they could not know what they were. I remember being on the telly, telling people that Fannie Mae was going to zero, and they would say, What the hell are you talking about, that is Fannie Mae. Likewise with the investment banks. I used to sit there and say they are all going to eight [dollars per share]. It was clear that there were 29-year-olds on Wall Street sitting around making $10 million and thinking this was normal. I am experienced enough to know that this is not reality. I am still short the investment banks.

Can you quantify how much money you made from those positions?

That is a wonderful question, but you know I am not going to answer it. I grew up in Demopolis, Alabama, where my parents and grandparents taught me you do not ever talk about how much money you have or how much things cost or how much you make. My grandparents would roll over in their poor graves if they heard me talking like that.

What do you make of the global financial crisis more broadly? Do you think there is still another shoe to drop?

Well, it is not over. It is going to be the worst economic time since the second World War, and that is because we had the worst excesses since the second World War. Certainly in the financial community what the governments are doing -- they are making mistakes. In 1929 we had the stock market bubble pop, which was leading to a recession, but then the politicians all over the world made a lot of mistakes and turned what should have been a normal recession into a depression. I see the politicians making mistakes now, which may turn this into much much worse than it should be. The Federal Reserve and Treasury have more than doubled the American debt in the past three months. You and I are going to have to pay this off someday, and it is staggering.

You are not concerned about systemic risk? That if they had not taken the steps they did, things might be much worse?

When Lehman Brothers calls up [Treasury Secretary Hank] Paulson, what do you expect them to say? "Gosh, I got to worry about my Maserati or my plane payments?" No. They call up and shriek about systemic risk. Come on. Investment banks have been going bankrupt for hundreds of years and the world has still somehow survived. This approach has never worked. This is what the Japanese did in the 1990s. They refused to let anyone fail. And they had zombie banks and zombie companies. The way the system is supposed to work is when we have bad times, the assets moves from the incompetent to the competent, and then the competent start with renewed strength and the system rebuilds itself.

A lot of very sophisticated investors have lost a lot of money in this market. What is the ordinary investor supposed to do?

They should only be investing in things they themselves know a lot about. They should not be listening to me or anybody else. If you know a lot about cars or fashion or something you should find great investments in that field. You know a lot more about it than any Wall Streeter or hedge fund manager, because that is your passion.

So people should follow your advice about commodities only if they are farmers?

We all know about cotton. None of us had a clue what a dot-com was, but we all know what orange juice is. Before you go to work every morning, you use cotton and wool and silk and rubber and rice and wheat and corn and orange juice and coffee and sugar. Nobody can understand IBM. The chairman of the board of IBM can never understand IBM completely. It has got hundreds of thousands of employees. All you have got to do with cotton is figure out if there is too much or too little. That is not easy to do, but it is a lot simpler than understanding IBM or Toyota.

Are you riding a motorcycle much these days?

No, you break my heart. I have not ridden a motorcycle in 10 years. If I had a bike now, I would take my little girls riding. But I have just been doing other things.


The Dow/Gold Ratio and cheap stocks.

Gold investors expecting to have been rewarded for forseeing the money printing orgy of the last few months have been sorely disappointed. Perhaps this is focusing too narrowly, however. Yes, gold has declined versus cash U.S. dollars, assuming you kept them in a safe place, but it has held its own against most everything else. For example the Dow/Gold Ratio recently sank to a 14-year low, if you need any more proof that gold has outperformed stocks.

In the article that follows this one we also are told that gold set new record highs for Australian, British, Canadian, Danish, Estonian, Eurozone, Hong Kong, Hungarian, Icelandic (what a surprise), Indian, New Zealand, Norwegian, South African, South Korean, Swedish, Turkish and Russian investors. Of course gold has tanked against the Japanese yen, as has everything else including the U.S. dollar.

You cannot spend relative performance, the old saying goes, but you can sure buy a lot more other things with your ounce of gold today compared to a short time ago.

You might like to know, if you put store by such things, that the U.S. stock market just sank to a 14-year low against gold. With the Dow Jones index dipping below 9,000 last week (two weeks ago as this is posted), the price of gold held near $850 an ounce ... (It has since lost $100; more in a moment.)

So the Dow/Gold Ratio -- which simply divides the one by the other, thus pricing the Dow Jones Industrial Average in ounces of gold -- fell to a little above 10, making the 30 stocks of the DJIA cheaper in Gold Bullion terms than at any time since January 1995. Y’know, like the Tech Stock Bubble and Reflation Rally were merely a dream Alan Greenspan had after eating wild mushrooms and blue cheese right before bedtime.

The Dow has sunk back below 9,000 again today (Wednesday, Oct. 22nd), while gold has lost 11% of its value in U.S. dollars since hitting that new 14-year high in terms of investment assets last week.

So in the big scheme of things, where the big money is made, does this price -- which took 22 years to recover last time it slipped beneath its 80-year average (marked in red on our chart; the Dow priced in gold stayed sub-par for 25 years after the 1929 crash) -- now mean U.S. stocks offer a bargain? ...

Plenty of other smart, successful and battle-hardened investors think so, as well. But these wise old men all believe U.S. stocks are a bargain for other reasons entirely outside of the Dow/Gold Ratio.

Jeremy Grantham, for instance -- chairman of the $120 billion GMO funds -- points to the mantra "stocks for the long run" used by all financial advisors, good and bad. "The early purchases will be painful," Grantham is quoted by Reuters. "But if you could slice in and do some buying before and after the low, seven years from now you will not regret it."

The granddaddy of home-spun investment wisdom -- Warren Buffett himself -- thinks that, because the vast majority of investors are trying to quit stocks, you should "Buy American. I Am" as he titled his New York Times piece last Friday. "A simple rule dictates my buying," said the Sage of Omaha, like he was fishing for a "Boo-Ya!" from the Berkshire Hathaway crowd: "Be fearful when others are greedy and be greedy when others are fearful. Most certainly, fear is now widespread."

It would be churlish to argue with these giants of stock-market success. So step forward the churls here at BullionVault, ready to mix you a snowball of Devil's Advocaat with a maraschino cherry on top ...

#1. Fear & Greed

The Dow/Gold Ratio's most fearsome decline came between April 1971 and December 1974. Inside those 44 months, the Dow lost 7/8 of its gold value. During that period, of course, the gold price was cut free from the U.S. Treasury's official price of $35 an ounce. U.S. stocks, in contrast, lost 1/3 of their dollar price as earnings collapsed in the face of the first global oil crisis.

Fear replaced greed almost entirely on Wall Street, giving brave investors a fantastic chance to buy cheap at the bottom. But for longer-term wealth protection, it proved something of a false start. The Dow might have sunk from almost 25 ounces of gold to just 3.5 ounces. It might then have doubled its gold-bullion value inside 22 months. But the U.S. stock market then sank again -- and sank sharply -- down to barely one ounce of gold by the start of 1980.

That marked the bottom ... just as Ronald Reagan picked out new drapes at the White House. (Actually the drapes expedition happened a year later, unless Reagan was looking ahead with great prescience.)

#2. “But the Dow Doesn’t Represent U.S. Business Today ...”

Very true, and nor does the NASDAQ -- despite what you may have heard (or believed) at the top of the tech-stock bull market in March 2000.

Turning then to the S&P 500 -- that broad-based index of U.S. stocks -- America Inc. rose 32-fold against gold between its record low of Feb. 1980 and the big top hit in summer 2000. The S&P index has since dropped 3/4 of that peak value in gold.

Quite where that ratio is headed is unclear today. Both gold and Wall Street keep selling lower as the deflation in credit destroys leverage and debt in all financial markets. But the outlook for corporate earnings -- let alone investment flows -- is ugly. Very.

"It is always darkest before it's pitch black," said Eric Upin, a partner at Sequoia Capital -- the venture capitalist group which launched Apple, Oracle and YouTube -- at a recent "all-hands meeting" attended by some 100 corporate bosses. "Survival of this storm means drastic measures must be taken now ... so you will have the opportunity to capitalize on this downturn in the future."

Upin used to run Stanford University's $26-billion endowment fund, so you have got to wonder where he would put that money today -- if anywhere -- outside of Treasury bonds. Sequoia's presentation (available here) is worth reviewing if you had any doubts that capital expenditure and corporate growth are being slashed.

It points to a "remendous amount of capacity build up" worldwide (slide 17), with fixed investment rising above 22% of global GDP since late 2005. Last year's earning forecasts for the S&P constituents, Sequoia notes, have come in some 18% over-optimistic. And at the worst of the early 1990s and 2001 recession, that 12-month disappointment reached above 25%.

But what if recession slips into depression -- the very thing Ben Bernanke was hired at the Fed to prevent?

#3. The Value of Stocks vs. the Value of Money

Amid such a historic collapse in the dollar-price of all assets, studying history to inform your thinking seems at least wise. So let us check what happened to stocks priced-in-gold the last time America sank into deflation.

As credit evaporated (check) and the stock-market sank (check), millions of savers were wiped out (check) while commercial banks failed (a half-check for Lehmans). The only thing to go up was the value of money (check once again, as commodities slump alongside non-U.S. currencies, and retailers run out of exclamation marks to add to their "Sale!" signs).

Back in the early 1930s, however, gold was in fact money, rather than another class of investment entirely. So the Dow's 89% loss was matched exactly by the drop in Dow/Gold. So were its gains when the market picked up, doubled the Dow, in spring 1933.

But then President Roosevelt stepped in, banning private gold ownership and slashing the dollar's gold value. For those U.S. investors who clung onto their gold (say, by owning it offshore, safe from the Treasury's $10,000 fine or threat of imprisonment), Roosevelt's move instantly knocked the Dow/Gold Ratio lower, undoing 12 months of stock market gains and making the Dow 40% cheaper for gold owners wanting to switch into shares at rock-bottom prices.

Might the next U.S. president now do the same for stock prices-in-gold when he takes office on January 20? Will Ben Bernanke not be standing ready to help the Dow find its floor ... by destroying the Dollar (again) to stop it from rising?

Gold Price in Other Currencies

So the spot gold price sank in October, dropping right back to 13-month lows at $683 an ounce. After failing to breach $930, this collapse marked the third step lower from March's all-time high of $1,032. And from a technical perspective, the Gold Chart looks horrible -- recording lower lows and lower highs for the last six months and more.

Right? Well, fact is, the action has actually been greatly muted if we allow for the shocking volatility in gold's #1 competitor for "safe haven" funds, the almighty U.S. dollar. You see, like so much else, the market action just described only sets gold in terms of the greenback (against which it has still tripled since July 1999).

Versus pretty much every other world currency, in contrast, gold in fact enjoyed a banner month this October -- delivering gut-wrenching volatility plus new record highs -- starting right here in London, home to the world's $60 billion-a-day trade in wholesale gold bullion bars (a.k.a. the "spot market"). Mid-month, gold also leapt to new record highs for Australian, Canadian, Danish, Estonian, Hong Kong, Hungarian, Icelandic, New Zealand, Norwegian, South African, South Korean, Swedish, Turkish and Russian investors. Oh, and the 350 million souls in the Eurozone. Plus the 1.1 billion people of India.

Gold Prices have of course slipped back -- and sharply -- against all major currencies since reaching €685 an ounce for European investors and savers on October 10th. (That marked a near-tripling from the low of January 2000.) In the spot market, gold is now trading almost 13% lower as the month-end draws near.

And notable by its absence from the rogues’ gallery of fast-sinking currency zones listed above is the Chinese yuan (which is tied closely to the U.S. dollar), as well. More spectacularly, the world-destroying Japanese yen has squashed the price of gold since turning sharply higher against everything -- real estate, global equities, emerging-market debt, even the Tokyo Nikkei -- in mid-July.

But if we really are witnessing a global currency crisis led by the destructive reversal of the Yen Carry Trade (and it certainly looks like it from inside a wallet of Sterling or New Zealand Dollars, let alone Forints or Krona), then just what kind of fight is gold putting up as the apparent "ultimate" safe-guard against currency shocks?

Regular visitors to BullionVault may recall a chart we offered in August this year, a chart showing the gold price in terms of the world's top 10 currencies by economic output. It is not perfect ... But as a measure of truly globalized gold prices, it both softens the U.S. dollar's long slide of 2002-2008 on the currency markets, as well as tempering this month's intemperate highs in gold bullion vs. the Aussie, Loonie, HK Dollar, Forint, Kiwi, Krone, Rand, Won, Lira, Ruble, Euro, Pound Sterling, Rupee and various Kronas.

You cannot help but spot the volatility ... The way "quant jocks" figure the violence in asset prices, in fact, the daily volatility in this global gold price has more than doubled since August to a three-decade record.

You might also note, however, that gold really has risen sharply against all major world currencies so far this decade, not just the U.S. dollar. And no one should imagine it will be an easy ride -- whether up or down -- from here.

There is too much at stake when you try to measure that $60 billion daily turnover in physical gold against the $3.2 trillion daily turnover in official government currencies.


The subprime mortgage crisis is waning; the prime wave is just beginning to crest.

The most recent delinquency data from the Mortgage Bankers Association found that the "increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans. Thus the foreclosure start numbers will likely be increasingly dominated by prime ARM loans." And this was before the stock market implosion, and before the general economic contraction now clearly in evidence has registered at the street level.

Andrew Jeffery leaves the broader implications of this unexamined for now, but given the large size of the prime mortgage market, versus the significant but relatively small size of the subprime, this sounds potentially ominous.

Subprime-driven bloodletting has been concentrated in regions where land is abundant and the big homebuilders could do their development thing without much resistance. The prime mortgage/housing market is basically everywhere you find the middle and and upper-middle classes residing. Many of these areas have registered comparatively modest housing price declines so far, e.g., 10 to 15%. This relative outperformance will be tested as the mortgage crisis moves upmarket.

The private sector is actively engaging the mortgage crisis with the first broad-based, systemic attempt to prevent foreclosure. Both Bank of America and JPMorgan are attempting to help hundreds of thousands of troubled homeowners with massive loan modification efforts.

Regulators and bank executives are operating under the assumption that reducing foreclosures will slow record drops in home prices. In turn, this will help stabilize the financial system -- and, by extension, the economy as a whole. This logic is not necessarily flawed -- but it is reactive, rather than proactive, which is what is most needed now.

Most foreclosures are concentrated in regions where homebuilders like Centex, KB Homes and Lennar built huge developments, using cheap financing to help fuel speculation and massive over-valuation. These areas, especially those where homes were purchased by lower income buyers, are being decimated by delinquencies and repossessions.

This, however, is widely known. What is less well-understood is the storm that is brewing on the horizon: Trouble in the prime mortgage market -- where borrowers with good credit are starting to miss payments with alarming frequency -- is looming on the horizon.

Recent delinquency data indicates that while defaults on subprime loans are occurring at a less frenetic pace than in recent months, prime borrowers are starting to feel the pinch. In early September -- before the financial crisis accelerated in October -- the Mortgage Bankers Association released its quarterly delinquency data, concluding, "The increase in prime ARMs foreclosure starts was greater than the combined increase in fixed-rate and ARM subprime loans. Thus the foreclosure start numbers will likely be increasingly dominated by prime ARM loans."

There is still a vast misconception that only "subprime" people maxed out credit cards, took out loans they could not afford, and were generally reckless with their personal finances. This could not be further from the truth.

As the economic slowdown swirls outward into the broader economy, cracks are starting to form in established neighborhoods that have thus far experienced minimal home price depreciation. Many of these areas experienced stratospheric appreciation -- just as their subprime neighbors did -- but the strong job and stock markets insulated middle- and upper-middle income homeowners from rising interest payments and the slowing economy.

As mortgage underwriting requirements have tightened in recent months, home buying has slowed in these more well-to-do areas. This trend is being masked by spikes in the distressed sales driving broad housing market indicators.

As layoffs continue, homeowners in these areas will be forced to sell for the first time in years. The illiquidity in these markets means it will take just a few such sales to readjust prices dramatically downward. Homeowners that do not sell by choice, particularly if they have accumulated equity in their homes, are apt to be less picky about their price.

Furthermore, it is likely the recent onslaught of modification programs, tomorrow's election, and pundits' continued obsession to call a bottom in housing will encourage buyers to step back into the market. Increased sales transactions -- even if they continue to be concentrated in distressed areas -- will fuel the perception that the housing market is stabilizing.

This is likely to encourage a fresh round of selling, as anxious homeowners leap to take advantage of "improving" market conditions. This new supply will not necessarily offset inventory that has kept off the market by preventing foreclosures on a unit-to-unit basis; instead, the supply will simply crop up in different neighborhoods.

The subprime mortgage crisis may indeed be waning; its final battles are now being aggressively fought in Washington and bank boardrooms across the country. The prime wave, however, is just beginning to crest.


A wave of commercial real estate debt trouble is coming. Here are two safe harbors.

Commercial real estate may not have been as overbuilt to the degree that residential real estate was, but it is definitely going to take its hits as the economy contracts -- especially the office space-using and bloated financial sector. However, its a market of stocks, not a stock market, the old investing bromide goes. And within the universe of commercial REITs there are opportunities, writes Peter Slatin. Short of total Armageddon, his ideas do look intriguing.

Plunging housing prices and overleveraged homeowners have been the most visible weights pulling down the American economy and causing distress overseas. But commercial real estate is not exactly buoyant, either. While we wait for housing prices to hit bottom and the Treasury Department to decide just whose sorry debt to bail out, a wave of commercial real estate debt trouble is gathering power. It remains invisible to many, but it is on the way.

According to an October 7 report from Wachovia Securities, $86 billion in securitized debt on commercial properties will reach maturity in 2012, almost twice the $44 billion that will do so in 2010. Such a number may seem almost quaint in light of the massive worldwide erosion of investment capital in October, but it represents a very large piece of U.S. commercial property sales volume. In the peak year of 2007, $497 billion in commercial properties were sold in this country, up from $311 billion in 2005, according to Real Capital Analytics. As the credit markets have frozen, investment so far this year has shrunk to $123 billion.

Some 30% of the loans out there are for office properties, but that does not mean billion-dollar trophy offices. The average loan size is $9 million, mostly on suburban office buildings. Debt on retail properties is the second-biggest segment of the chopped-up securitized money pile. The debt on hotels is relatively small, as borrowing for hotels was generally deemed too risky to securitize when that was the thing to do. (Securitization has virtually disappeared this year.)

Wow. There was something out there that was actually considered too risky to securitize?

Office-space expansion is likely to be very limited for some time to come, especially for companies that have focused on buying in secondary or suburban markets. Those were decent enough locations when office buildings in central business districts were filling up with financial service firms such as banks and mortgage companies. Back-office suburban space was essential for them. Now the banks that survive will be saddled with expensive leased downtown space and have to use that for their back-office personnel if they cannot sublet it, which will not be easy in a slow-growth market.

Even where there was not much construction, suburbs will be overstocked with debt-heavy, tenant-light office buildings. Especially vulnerable will be companies such as Parkway Properties, Highwoods Properties and Brandywine. All three have been hit extremely hard and have been forced to offer unsustainably high yields -- Brandywine's was above 20% in late October -- for the cash they need. Their long-term growth prospects could be significantly worsened as job losses continue to roll through suburban as well as urban markets.

Still, not all office markets and office companies are endangered, even in this economy. Some have been so savaged by the flight of investors that they are at or near bargain prices. Office real estate investment trusts are (as of October 22) down 38% this year. It will be some time before SL Green (32, SLG), the dominant Manhattan office REIT, gets back to its alltime high of 153, but at the moment its 9% yield looks pretty attractive. Green owns one of the most well-leased, happily boring and monotonously cash-flowing portfolios in Manhattan. Granted, rents on the island are sure to fall 15% or more over the next couple of years, but the stock is trading at a discount of at least 25% to the value of its holdings. SL Green has Citigroup as a key tenant and has thus been tarnished, like many REITs, by its association with the financial sector, but it offers serious opportunity alongside some Manhattan-based risk. It has $800 million in cash and lines of credit, more than enough to handle debt maturing over the next two years.

At least one blue-chip specialty office company not only has held up fairly well against the downdraft but also leads the market in an area that should grow both short- and long-term. Alexandria Real Estate Equities (69, ARE) owns properties used by life-sciences businesses, including medical office buildings, biotech research labs and related properties. The company is developing -- still -- a 1.1 million-square-foot lab complex on Manhattan's East Side. If it takes off, and there is little reason to believe it will not, the place could be something of a game-changer for Manhattan by setting off a miniboom in science parks, while contributing significantly to Alexandria's profits. With a market capitalization of $2.2 billion and a yield of 4.6%, Alexandria is a conservatively managed firm that is positioned to benefit both from the retreat from investment in financial companies and from increased spending on health care. It has little cash on hand but strong rental growth and can tap a large line of credit.


Waste management companies were once great growth-via-acquisition stories. Now dominated by large publicly held companies, that element of the investment thesis is behind them. But the businesses retain certain desirable characteristics yet, like recession resistance -- while trash generation is not insensitive to aggregate economic activity, it is hardly going to fall off a cliff -- and an ologopolistic market structure. Most local markets are dominated by no more than two waste haulers, often industry giant Waste Management plus someone else. This lack of competition is reflected in the high gross margins characteristic of industry players, as this article points out.

During the 2000-02/03 bear market the stocks in the industry held up well, and then more than matched the S&P 500 during the ensuing market recovery. Great, but are they bargains? Waste Connections, the company with the best balance sheet, is selling about where it was 12 months ago, at a P/E of 23. Waste Management is essentially flat versus a year ago too, with a P/E of 13. Dividend yields are nil or negligible. So the point about resistance of the stocks during market downdrafts is well-made. But the stocks do not look that cheap. On the other hand, our technical analyst dark side reminds us that stocks which outperform in bear markets usually outperform in the bull market that ultimately follows.

As markets have gone from bad to worse, wary investors have flooded into recession-safe stalwarts, ranging from gold to Procter & Gamble. Here is one that has not been picked through yet: trash.

Waste haulers have a history of coming out of recessions smelling sweet. During the last one, which ended in early 2003, the S&P 500 lost 35% of its value. The stocks of garbage haulers held up. Republic Services (20, RSG) was up 18% and Waste Connections (31, WCN) 4% during the downturn. Even the laggard of the business, Waste Management (28, WMI), did better than the market, losing 22% of its value.

The sector did pretty well in the expansion, too. As the market rebounded between 2003 and 2005, the S&P 500 gained 41%. Republic Services tacked on 77%, Waste Connections 60% and giant Waste Management 45%. "The waste names were more protected on the downside and were in line [with], to slightly better than, the market on the rebound," says Brian Butler, an analyst at FBR Capital Markets.

What do these guys have going for them? Fat profits, for one. The sector's average gross margin of 36% in the year through June, compared with 31% for the S&P 500. Not even a nasty downturn seems likely to do much damage.

Moody's says the major players are well positioned to weather a decline in trash volumes. That is because the industry operates largely on contracts with municipalities that lock in revenues for years at a time. It can also pass on higher costs along the way via fuel surcharges and other add-ons.

For the debt-wary, Waste Connections ... is worth a look. It is sitting on a pile of $550 million in cash, which it could plow into new trucks and landfills to expand its market. Or if, as expected, Republic Services and Allied Waste Industries (9, AW) merge, Waste Connections would be well positioned to pick up assets that antitrust regulators force its combined rivals to dump.

If that is not enough to get you sniffing around, consider that by their own standards the trash haulers are cheap. Historically, the industry has traded at a ratio of enterprise value (debt and preferred, plus market value of common, minus cash) to operating earnings (EBITDA) of 10 times. The current figure: 7.5 times.


How do you profit from the Paulson-Bernanke rescue of the financial system? Not easily.

David Dreman looks at the Keystone Cops financial system saviors and finds it hard to come up with a productive investment strategy to hedge against the fallout, never mind actually take advantage of it. It brings to mind the old bumper sticker: "If you are not confused, you just don't understand the situation."

The trouble is the wild inconsistency, across time and in the treatment of tottering financial institions. One day everything is allegedly hunky-dory, the next day we are told that no-questions-asked emergency action is required. Are these guys as dumb as they sound? Some institutions are "too big to fail." Other equally big ones are allowed to fail. Hold on to your blue chips, and keep some dry powder awaiting cheaper stock prices advises the Forbes columnist.

I wince at the $700 billion bailout. It was a necessary evil, but it does not make me feel good as an investor. I think you should be very cautious for the next several months. Hold on to your blue chips, but do not buy speculative stocks. Keep some cash with which to buy stocks as they get cheaper. Keep your bond maturities short for the inevitable inflation to follow.

Congress -- and Ben S. Bernanke and Henry Paulson -- had to do something to contend with the worst financial panic since the 1930s. The panic has threatened the solvency of most of the nation's commercial banks, almost completely blocked credit for businesses, shut down the commercial paper market and curtailed auto loans. It could lead to a severe, prolonged recession.

How could the U.S., the strongest country on earth, put itself into this horrific situation? First, as both presidential candidates have stated, regulators took their eyes off the ball. Safeguards put in after the 1929 crash to rein in bank speculation were abandoned. The Securities & Exchange Commission relaxed the uptick rule on short-selling and failed to enforce the rules against naked shorting. This made room for the bear attacks against banks and brokers that sent Lehman Brothers into the dumpster and pulled down some banks' stocks by 80%.

The 1999 repeal of the 1933 Glass-Steagall Act, which separated the functions of banks and investment houses, left both kinds of institutions taking on enormous risks as they competed to generate higher returns in a mortgage market dangerously unregulated by either the Federal Reserve or the SEC. Fannie Mae and Freddie Mac have been vilified with some justification, but they both had far higher credit standards than did the banks and brokerage firms. Collateralized debt obligations came to pay up to 15% annually, so who wanted to look inside to see how poor the paper really was?

The time for action was not September 2008 but spring 2007, when the deep fissures in the financial system first appeared. Unfortunately, both the Fed and the Treasury were asleep at the switch. Fed Chairman Alan Greenspan said in October 2006: "Most of the negatives in housing are probably behind us." His successor, Ben Bernanke, said in May 2007: "We see no serious broader spillover to banks or thrift institutions from the problems in the subprime market." Said Secretary of the Treasury Henry M. Paulson in April 2007: "I don't see [subprime mortgage market troubles] imposing a serious problem."

The Fed and the Treasury continued to misread the meltdown even after the bailout of Bear Stearns in March. In July Paulson reaffirmed that both Fannie and Freddie were adequately capitalized. Only in September, with the entire system teetering, did he take real action, putting the mortgage giants into conservatorship.

Similarly, in March James Lockhart III, chairman of the Federal Housing Finance Agency, which regulates Fannie and Freddie, said they had cured most of their problems, so he was reducing their required cash cushion from 30% to 20%. Congress authorized this on July 31. On September 6 Lockhart endorsed the conservatorship, because of their mismanagement and lack of capital. Confused? So am I.

The seizures of Fannie and Freddie not only wiped out their shareholders, they also froze capital desperately needed by financial companies. Secretary Paulson reacted to the subsequent debacle with little consistency. AIG, one of the largest insurance companies in the world, collapsed, and the Fed gave it a $123 billion loan, taking 80% ownership until it is repaid. That shook the banking industry to its core. Lehman was left to the liquidators. Merrill Lynch had to merge, and a run on deposits sent Washington Mutual and Wachovia into shotgun weddings at giveaway prices. The market nose-dived in response. Why buy bank shares if a "rescue" will dilute your stake?

Secretary Paulson will have enormous freedom in spending his $700 billion. Will he help banks by buying mortgages at higher-than-liquidation prices? No one knows. Are there safeguards to keep special interests from benefiting while taxpayers pay enormous costs? No one knows. Will some favored financial institutions be saved while others go down? No one knows.

Will the investment community make big money from it all? Definitely. Paulson is allowing a handful of firms to execute the mortgage buybacks for a fee of 1%, which will total billions of dollars. That is more than double the fee that portfolio managers for bond funds charge, yet there is no risk involved, so it is triple or quadruple a reasonable rate. Is it just possible that Goldman Sachs, Paulson's alma mater, will be one of the designated firms?

Investors should be skeptical about the goings-on in Washington. Hope for the best -- but prepare for the worst.


Buy a Dow index for familiarity and safety. It is as inexpensive as it has been in my lifetime.

Fixed income analyst and money manager Lisa Hess came a cropper by trying to pick a bottom in the housing market and Freddie Mac's/Fannie Mae's stock prices. In this she was not alone -- not a consolation. Now with the Dow Industrials yielding more than 10-year Treasury bonds she actually recommends an ETF which tracks the DJIA. She also likes certain municiple bond closed-end funds selling at substantial discounts to net asset value.

You have heard various versions of "the three greatest lies in the world," all beginning with "The check is in the mail." [The middle one varies, while the last one is always "I'm from the government and I'm here to help you."] Here is my updated version: Emerging markets are not tied to the U.S.; commodities are a new asset class; an AAA rating means no risk to your principal.

This has been a year most of us would like to forget. I made the horrific mistake of looking for a bottom in the housing market and in consumer spending way too soon. Fannie Mae and Freddie Mac were nationalized, wiping out not only their common stock but their preferred as well. In the ultimate irony, neither agency has yet borrowed a dollar from the Treasury.

It is tempting to play ostrich and stick one's head in the sand. However, rolling over short-term Treasurys that yield 1% preserves capital in nominal terms but almost certainly not in real terms, against inflation. The best advice I can give you is to choose an allocation whose level of risk and opportunity you can live with, stick to it and rebalance it once a month.

Risk and opportunity look similar now for all kinds of assets, including high-yield bonds, emerging markets stocks and bonds, tangible assets like coins and commodities, venture capital, leveraged buyout funds and long/short hedge funds. They are all correlated, particularly when things go bad. With the world deleveraging, it has become obvious that diversification was a myth. Why? Because everyone borrowed from their bank or their broker, so when prices collapsed, the margin clerks ruled the whole world.

As I reach for my textbooks to reread the history of the Great Depression, I am reminded of something Mark Twain is supposed to have said: History does not repeat itself, but it does rhyme. What is different this time is the global nature of the panic. We did not stand a chance of halting the waves of selling until central banks started working in unison and governments injected capital into their banking systems in a coordinated way.

The financial markets will stabilize, but the recovery of the real economy will be a long, slow process. Meanwhile, here are a few suggestions. First, turn to the grand old daddy of the equity markets, the Dow Jones Industrial Average. It took its present form in October 1928, so we can follow it from just before the Depression to the present day. It is a price-weighted average of 30 stocks that is reconstituted as necessary to ensure that it represents the giants of industry. It may be missing tomorrow's growth stars, but it stays relevant, always following 30 very large-capitalization businesses. (Curious that it started in October. Its birthday months in 1929, 1987, 1999 and 2008 will never be forgotten.)

My suggestion is to make dollar-cost-averaged investments in the ETF Diamonds Trust Series 1 (DIA), a tracking stock for the Dow. The advantage of dollar-cost averaging—investing a fixed number of dollars at regular intervals -- is that you buy the most of a stock when it is cheapest and less when it is expensive. You may be shocked that I would suggest something as banal as tracking the Dow, but right now it stands for familiarity and safety and is as inexpensive as it has been in my lifetime. I can see no good reason to venture further afield.

As I write, the Dow is down 20% over a month, 31% over a year, 2% over three years and up 1% over five years. Nobody can consistently time the market, of course, but a quick glance at the fundamentals shows the Diamonds to be an excellent value. Its expense ratio is 0.16%. The Dow's average price/earnings ratio is 11, its price/sales ratio is 0.75 and its price/book ratio is 2.7. It is well diversified, with 12% in oil and gas, 11% in computers and 11% in retail. Its dividend yield is 3.8%. That is comfortably above what you earn on 10-year Treasurys.

My second suggestion is that you purchase a portfolio of municipal bonds in a closed-end fund (closed-end funds issue a fixed number of shares and trade like stocks). Selloffs by struggling hedge funds and banks have hammered the long-term muni market. The Nuveen Investment Quality Municipal Fund (10, NQM) is selling at a 13% discount to its net asset value and makes monthly distributions currently yielding 7.3%. It is diversified across many states, but both Nuveen and its competitor BlackRock offer single-state funds as well. Negatives: The fund relies on leverage, having sold preferred shares to pay for 32% of its holdings, and its expenses are a pricey 1.2%. Positives: 21% of the portfolio is in bonds that are pre-refunded and therefore are as safe as Treasurys. As above, I would dollar-cost-average my way in.

Sixteen years ago Queen Elizabeth stood before the world and decreed 1992 to have been her annus horribilis. The marriages of her two children had fallen apart, and Windsor Castle had nearly burned to the ground. Bravely she charged on, and today Prince Charles has happily remarried and the monarchy is intact. Let us put this horrible year behind us.


“Our biggest enemy in this business is opinions and emotions.”

Steve Leuthold qualifies as a Wall Street veteran, having plied the trade for almost 50 years and seen both the frothy 1960s markets and the brutal 1973-74 bear market. He heavily emphasizes quantitative analysis, seeking to avoid the counterproductive effect of human emotions on investment returns.

The numbers led Leuthold to turn bearish in 1998, ahead of the final dot-com driven blowoff but, in light of the poor equity returns of the last decade, essentially correctly. His persistent caution since then has given him a "perma-bear" reputation, notwithstanding his generally bullish stance from 1980 to 1998. Apparently Leuthold was "super bullish" in December 1980, which would also have been a premature call. The S&P 500 did not bottom until August 1982, around 20% lower.

Now Leuthold pronounces himself to be in the bull camp. His numbers indicate valuations are the best since 1984, which was still early in the 1980s/90s bull market when valuations and multiples had a long upward climb ahead. The current market P/E multiple, based on earnings averaged over 20 quarters, is 12. Over the last 55 years multiples have been that level or higher 85% of the time, and the average 1-year gain from such earnings multiple levels is 18% since 1926. Of course the market multiple has been lower 15% of the time, which means that in playing the odds Leuthold will be early in those longshot instances when the market overshoots and gets super-cheap or expensive, e.g., in 1998 as cited and in late 1973 when stocks were cheap and Leuthold turned bullish but 1974 still lay ahead. And this year. He went decisively bullish in August -- well off the peak but, as everyone knows, before this fall's exciting times.

Steve Leuthold has seen a thing or two in his nearly five decades in the investment business, from the roaring bull market of the 1960s to the current liquidity crisis. As chairman and chief investment officer of The Leuthold Group, an institutional research outfit, and of Leuthold Weeden Capital Management, Leuthold, along with his staff, pores over reams of financial data. Their joint efforts result in the monthly green book, which is a quantitative investor's dream. "Our biggest enemy in this business is opinions and emotions," he says.

In managing money, Leuthold, who is based in Minneapolis, combines number-crunching with fundamental analysis. Like many fund managers, he has hit a difficult stretch this year. The Leuthold Core Investment Fund [ticker: LCORX] is down about 31% in 2008, but its 5- and 10-year numbers best those of most of its Morningstar peers.

Bearish for most of this decade, Leuthold, 71, switched to the bull camp recently. Barron's spoke with him last week to find out about his change of heart, along with some of his other thoughts about the market and various sectors.

Barron’s: What is your assessment of the market's big selloff this fall?

Leuthold: There were two stages, the first being what we thought was a normal cyclical bear market. We thought the economy had peaked in last year's fourth quarter. And then, about six weeks ago, after the market had come down about 25%, it looked to us as though the market had discounted a recession. By that time, the recession was eight or nine months old. So we thought that, as normally happens, the market tends to turn up in the middle of a recession.

Then came the liquidity freeze, which was the second stage, and that took us down over the past six weeks and really hurt us. We were doing pretty well up until that point because we were defensive, but we turned bullish too early.

In a recent research note, you wrote: "I remain bullish and wrong." Is that still your sentiment?

Yes, it is. I was just looking at an interview I did with Barron's in December 1980, and I was called a super bull. And then we got prematurely bearish in 1998, and people started calling me a perma-bear. Right now, though, I am not a super bull, but I am a very convinced and optimistic bull.

What underscores your case?

Certainly, the intrinsic value of stocks. In terms of our valuation model, it is the most positive we have seen since 1984. We look at 28 different factors, including price-to-earnings and price-to-sales, and they are quite decidedly positive. Because we look at normalized earnings, we smooth them out over a business cycle. We have always done it that way, and we are at about 12 times earnings now.

Is that on forward earnings?

No. What we do is we take the last 4 1/2 years of historical earnings, and then we project forward only six months. Then we divide the whole thing by 20, or the number of quarters. We have found over the years that it is almost imperative that you do that -- that is, smoothing out the business cycle to get the underlying level of earnings.

How does that 12 times P/E ratio compare to other periods?

Looking back 55 years, we are in the 15th percentile, well into the bottom quartile, and this is where markets very often have bottomed out. So on a valuation basis, this is a really cheap market. At these levels, we are really down in bull-market territory. From here, on a 1-year basis -- and this goes back to 1926 -- the market has been up about 18%, on average, in the next year.

The so-called green book that your firm puts out every month is famous for crunching and analyzing a lot of data. How do all of those numbers help you?

They give you the conviction that you have not missed very much, if you missed anything. But that does not mean that things cannot change. When you get a special factor like the freezing up of liquidity that we have seen over the last six or seven weeks, it can disrupt some of these quantitative indicators.

Have investors reached the point of capitulation?

We have been in a capitulation phase for two weeks.

And yet the market keeps going down, although there was a big rally last week.

Well, we get new people capitulating. You have the hedge funds and you have the mutual funds, although recently there were net inflows into U.S.-focused mutual funds for the first time in six weeks. It was a net inflow of $1 billion, compared to $14 billion that went out the week before. It is probably back to a net outflow for the most recent week, though. There are new people who are forced to sell securities. It is a series of capitulations, really.

You have worked in a lot of different markets. Does this one remind you of any you have seen previously?

The one market similar to this was the decline from 1972 through 1974, and we were also premature in turning bullish there. We turned bullish in the fall of 1973, when the market was down about 20% to 25% from its peak. The market turned around, but then it rolled over and went way down in 1974 to a brand-new low. That is very similar to what we are seeing now.

In that recent note, you looked at the various financial panics throughout U.S. history. How does this one stack up?

A lot of people have not been in this business for 45 years, and they do not study market history, so I wanted to demonstrate that this -- namely government intervention into the financial system -- was not new. This is not something that has never happened before, because it has. But I do not think, except for the Depression, that we have seen a time where liquidity was as frozen as we have seen here. But there are some really good signs of that easing.

When did you turn bullish?

In August, and we went to an allocation of 65% equities, versus our maximum of 70%. Since that time, the market action has taken us back down to 60% in equities. I would not be surprised to see that increase back up to 65%, momentarily.

Is the rest of your portfolio in bonds?

We cannot find a lot to buy in the bond market, so we were holding quite a bit of cash. First, we put about 10% our total assets in some foreign bonds where we saw really big yields, primarily in Australia and Brazil. In the last week or so, we have added about another 10% in U.S. high-yield corporate bonds, whose spreads looked very attractive to us.

We also see a lot of value in municipal bonds. We normally will have a maximum of about 30% of our portfolios in fixed income. But we have had a terrible time here, because until recently we have not seen much opportunity -- because yields have been so low. So we are underweight fixed income, which would normally be about 30% of our portfolios. Right now, it is at about 20% for fixed income, 20% in cash and 60% in equities.

How does that compare to the beginning of the year?

We were only 30% in equities at that point, and that was our typical bearish mode. We were sitting with a lot more cash because we still did not see much attractive in fixed income. In mid-January, after the market took a big dive, we increased equities just slightly.

In light of what has happened this year in the banking world, do you see the pendulum swinging back to more regulation?

Absolutely. It may be free enterprise, but even free enterprise has to have some rules, or you get a free-for-all. It is like playing a football game with no rules.

Does this particular downturn remind you of any other economic slumps in particular?

This recession is probably similar to the one that occurred around 1981. The average recession since World War II has been about 11 months. The longest was 16 months, and we have had two of those. And I think this one is going to last at least 16 months and probably longer than that, maybe 20 months.

This recession started in the fourth quarter of last year, so you are looking at a recession through the fourth quarter of 2009. But you have got to remember that the stock market is a lead economic indicator, and historically it has turned up about 60% of the way through a recession. Applying that timetable suggests that this market should be bottoming sometime this month, and that is very, very possible.

Let us drill down a bit and talk about some sectors that you like.

Our U.S.-focused equity portfolio is about 50% of the total portfolio. About 32% of the U.S.-focused portion of the portfolio is in health care, normally a pretty defensive area. But we also know that when new bull markets start -- and that is what we have to prepare for -- it is very often the most aggressive stocks that perform the best. So we have about 15% in biotech stocks.

What is to like about biotech?

First, I do not think they are terribly closely aligned with the economy. Biotech firms operate in a world unto themselves. Second, they tend to operate without a great deal of government regulation in terms of products, because they are developing products. And third, many of them are acquisition candidates for the big established drug companies that really need to expand their product lines, especially if they do not have much in the [research-and-development] pipeline. Some of these are bigger biotech companies, and some are smaller. But when this market does turn, biotech could very well be one of the areas that really benefits.

What other sectors look interesting?

Another group whose shares have come down a lot is the oil drillers. Their prices have come down more than the price of oil has. But you are going to see more offshore drilling, regardless of what has happened to the price of oil short-term.

These companies have built-in books of business for the next three years. Their problem is they do not have enough rigs to drill. They are trading at six or seven times earnings, which is really cheap when you consider that the earnings-growth outlook is outstanding over the next three years or so.

What else?

This is a little weird, but the home-improvement companies look attractive. And we have a fairly significant position in that sector. You can pretty much guess the names there.

Probably Home Depot [HD] and Lowe's [LOW].

There are couple of other smaller ones as well. We are not too excited about the consumer's prospects in the coming expansion, when that occurs. But you also have a heck of a lot of foreclosures and a lot of work that is going to be done to those properties to get them back into shape for sale. So these home-improvement stocks are relatively cheap, and they have good growth prospects. They have been beaten down, but it is one area where I feel confident about the consumer, primarily because of fixing up the foreclosed properties.

What about non-U.S. stocks?

We have 10% of our equity holdings in companies outside the U.S. We have a huge database covering 59 countries and every stock with a market cap of more than $200 million. One of the countries that looks really interesting is China. There are still 214 Chinese companies that have more than $1 billion in market value. The mean P/E on those stocks, as of last week, was 13, down from a peak in 2007 of about 56 times.

In China, you are going to see slower GDP growth of maybe 5% or 6%, down from 9%, but there are some extremely attractive values there. And although people say you are trying to catch a falling knife, the Shanghai index is down 75% from the peak in October of last year. So China has become our largest holding in terms of emerging markets.

What is your view on small-cap stocks, which until recently had held up relatively well this year?

Small-caps generally are the best performers when the market turns. Looking at our entire equity profile, we are close to 60% in large-caps, with another 30% in mid-caps and 10% in small-caps. But I have been surprised that the run in superior large-cap performance has not lasted very long, maybe 18 months. This seems to be too early for the small-caps to be coming back, but they are doing it. So, that is one of the biggest questions we have: Is this a turn for real in small-caps -- or not?

But couldn't you argue that, if you are bullish on the market right now, that this would be a good time to increase your small-cap allocation?

That is exactly right. That is why we have the small-caps in biotech, for example. And maybe we ought to have more in small-caps. Our technical analysis suggests they are re-emerging as market leaders, and then I think, 'God, it is too soon for that to be happening, considering the long period they had of leadership over large-caps.'

Thanks very much, Steve.