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

W.I.L. Finance Digest :: March 2009, Part 3

This Week’s Entries :


Caution from a long-term equities fan: Stocks are cheap – but could get a lot more so.

Major equities fanboy professor Rajnish Mehra thinks stocks are a “great buy” for the long-term while having major downside risk over shorter time-frames. His reasoning? The not very original idea that we have not seen the bear market statistical extremes that would mirror the bull market excesses of not very long ago. In other words, this is a technical calls of sorts. Take a look at the statistics and decide if you agree with Mehra.

It is hard to find a bigger fan of stocks for the long run than Rajnish Mehra. The UC, Santa Barbara economist upended conventional wisdom 24 years ago with a landmark study he coauthored theorizing that stocks more than compensate for their risks with surprisingly fat returns. He calls equities a “great buy” for long-term investors. So when the S&P 500 crashed through 700 earlier this month, you would think he would be pounding the table about how cheap the market has gotten.

Just the opposite. “There is no question stocks are undervalued today,” says Mehra, 59. “But they still could go down another 50%.”

The chart below shows changes in one of Mehra’s favorite measures of market value: The ratio of the value of all publicly traded U.S. stocks to GDP. The average is in the vicinity of 1.0. Moreover, if you adjust for variables like tax rates (because years ago tax rates on capital gains and dividends were higher, so one would expect this ratio to be low), you could argue that the historical average is equivalent to a ratio of 1.5 in today’s economy.

On that scale, we are in the cheap range now. Publicly traded corporate equities are worth $13 trillion, GDP is $14 trillion, so the ratio is only 0.9. Bargain time? Maybe not. The problem is that the pendulum swings to extremes. In previous market drops the country’s market capitalization fell to half of GDP.

A couple of other measures of market value are flashing buy signals right now, too. One is what we can call a 10-year market P/E. This is the ratio of a stock index to its average earnings (adjusted for inflation) over the past decade. In their Depression-era classic Securities Analysis, Benjamin Graham and David Dodd focused on the ten-year ratio as a tool for evaluating individual stocks. The idea here is to smooth over the peaks and valleys of the business cycle. Over the past 128 years this ratio has averaged 16 for the market as a whole. At a recent price of 696, the S&P is at 12 times 10-year average earnings. The level during the tech bubble in 1999 was 44. Note: In this exercise we use bottom-line earnings, after all writeoffs.

Another measure is Q, the ratio of stock prices to book value. Here, book value is adjusted upward to reflect the impact of inflation on the replacement costs of property, plant and equipment. The ratio was popularized by economist James Tobin (1918-2002). Over the past century Q has averaged 0.65, says Andrew Smithers of London consultancy Smithers & Co. Today it is 0.5. In 2007 it was double that.

But if investors are given to irrational exuberance, they are subject to irrational fears, too. How far can the pendulum swing? Yale economist Robert J. Shiller, who has championed the 10-year P/E, notes that the ratio fell to 5.57 in the Great Depression before tuning up. He says there is no “magic number” but nonetheless he is not buying until it falls two points lower to 10. In the last five biggest market drops the 10-year P/E fell a bit lower – to half the long-term average, or 8 times. Q has also bottomed at half its long-term average. If the pendulum swings to the degree suggested by those two measures again, the S&P will go to 460.

Of course, past might not be prologue.

Avi Tiomkin, chief investment officer at Tigris Financial Group, has a reason why stocks should sink further even without any pendulum excesses. “Countries are totally dependent on each other for the first time in history, and the rest of the world is not doing enough to stimulate their economies,” he says. The result is that not only will shares fall more, but also their very role in fueling the economy will shrivel as companies turn to other forms of financing.

Smithers of Smithers & Co. has published studies of 10-year P/Es and Q for years. He says stocks are cheap, yet he has been only “dribbling” money into the market. One reason for hesitancy: The adjusted book value for corporate equities, as calculated by the Federal Reserve (and used in the chart of Q ratios), may be overstated. Companies have not finished coming clean on overvalued real estate holdings, he says.

Another possible worry: Corporate earnings will stay depressed for several years. If so, then the 10-year average earnings on the S&P 500, now $57, will drift downward. One last reason to be gloomy: What kind of taxes will government inflict on investors?

UC, Santa Barbara’s Mehra says investors should put some of their stock money into investment-grade bonds, yielding 5.64 percentage points above Treasurys. Triple-A rated GE Capital’s 6.1% bonds due 2032 yield 11.3% now. Perhaps that rating is destined to be cut. Still, the yield is a point above what Warren Buffett got on his riskier preferred stock investment in GE last year. (He also got warrants to buy shares at $22.25; the shares are trading at $7 now.) At the time, Buffett said stocks were a good deal, but he thought prices might go lower. At least he got the last part right.

The Higher They Climb ...

In past downturns the total value of publicly traded stocks fell to half of GDP. That suggests prices could yet drop a third more.

Looks Are Deceiving

Stocks look cheap whether as a multiple of 10-year earnings or as a multiple of book value. The problem: They often get a lot cheaper. If previous bottoms are any guide, the S&P, recently at 696, could hit 460.


The Depression was not as bad for stocks as many think. That could bode well for the future.

The legendarily bad years for the stock market in the 1930s might be synopsized thusly: “When I was a young man stocks had to walk five miles to get to school every morning, and it was uphill going both ways.” But were they actually that bad? E.g., did it really take 25 years for investors who came in at the 1929 peak just to break even? Mark Hulbert challenges the stories.

First of all, if one included the very substantial dividend yields of the era and the 25%+ drop in the CPI from 1929 to 1933, it turns out that the total real return starting in September 1929 was back to zero cumulatively by early 1937. Obviously lousy, but not catastrophically so – as long as you were not investing on margin and thus forced to sell out at the wrong time.

But the truly bizarre information here is that the Dow Jones selection committee deleted IBM from the Industrial Average in 1939, when it was temporarily doing poorly, and did not add it back until 1979, when the company was past its prime (or would be imminently). Obviously the committee missed its calling as a mutual fund manager or a financial analyst for CNBC. Had IBM remained in the DJIA the whole time it is estimated the average would be twice its current level! (Another analysis claims that this alternative-universe doubling of the Dow Industrials would have happened if IBM and Coca Cola, which was dropped in 1935 and reinstated in 1987, had been retained.) What this means is that the Dow Industrials are utterly unqualified to serve as a measure of the U.S. stock market – which is why everyone uses the S&P 500 as the standard market barometer. It also means that even if you want to ignore dividends and deflation, the 25 years to breakeven number is bogus for all intents and purposes.

Must we look back to the Great Depression to really understand the current stock market?

A year or so ago, when a select few investment newsletter editors began arguing that we need to do so, the overwhelming majority of advisers believed that drawing such an analogy served little purpose other than fear mongering.

It is testament to the severity of this bear market that the consensus opinion has shifted so much that it is now respectable to look to the 1930s for guidance about what is in store for equities.

I am skeptical, however. That is not because I do not think that decade has much to teach us. My skepticism instead traces to the small number of analysts and commentators who have really analyzed what an analogy to the 1930s truly entails. And if we are to genuinely learn the lessons of history, we have no choice but to start with an accurate assessment of what actually happened.

After examining several aspects of the stock market’s behavior during the 1930s, it would appear as though a replay of that decade might very well be less scary than assumed by many of those who superficially draw the analogy.

Here are some myths about the Depression that should be dispelled.

MYTH 1: It took 25 years for the stock market to recover its losses from the high reached just before the stock market crashed in October 1929.

It is easy to see why investors believe this myth to be true: It was not until November 23, 1954, that the Dow Jones Industrial Average closed above the level at which it closed on September 3, 1929, the date of its closing high before that year’s crash. That is a recovery period of more than 25 years.

If the recovery from the bear market over the last year and a half were to take the same length of time, the Dow would not again close above its all-time high from October 9, 2007, of 14,164.53 until – you had better sit down – December 28, 2032.

The truth, however, is that it took stocks far less than 25 years to recover. According to Wharton finance professor Jeremy Siegel, the inflation-adjusted total return index of the U.S. stock market was just as high in late 1936 and early 1937 as it was at its precrash peak in 1929. That was less than 8 years later.

That may not be great news to investors who are hoping to recover their bear market losses in just one or two years. But it is a whole lot better than taking 25 years to recover those losses.

Why the big difference?

One factor is dividends, which were substantial during the 1930s. At the depths of the Great Depression, in fact, the Dow’s dividend yield was in the double digits. Ignoring dividends, which is what investors do when focusing on price alone, therefore, introduces a significant pessimistic bias into any historical analysis.

Another factor is deflation: The consumer price index actually dropped by 27% between its 1929 peak and its low in 1933. A stock that dropped by less than this amount in nominal terms over this 4-year period, therefore, actually turned a profit in inflation-adjusted terms.

Yet another reason why it took the Dow so long to surmount its 1929 peak: The decision in 1939 to delete International Business Machines from the average. It was not added back until years later. According to Norman Fosback, editor of Fosback’s Fund Forecaster, the Dow would today be more than twice its quoted level had IBM not been removed from the average in 1939.

MYTH 2: If we are playing out a 1930s script, now would be a bad time for long-term investors to get into the stock market.

Actually, if the stock market were to exactly adhere to a 1930s-like script, equities would provide a handsome return over the next five years.

Once again, this insight relies on data from Professor Siegel. To locate the date during the 1930s that is most analogous to today, he looked for the point at which the stock market after 1929 had – as is the case today – declined by around half on a dividend-adjusted and an inflation-adjusted basis. That point came at the end of 1930, just 16 months after the August 1929 stock-market top. (Ironically, of course, the current bear market is just 16 months old too.)

According to Siegel, over the 5-year period beginning in January 1931, the stock market produced an inflation-adjusted total return of 7%. That is right in line with stocks’ long-term average performance, in fact.

To be sure, this myth does have a big grain of truth to it. Over the first five months of 1931 – the first five months of this 5-year period – the stock market fell 60%. You read that right: That is a 60% drop on top of a 50% drop over the previous 16 months.

If the stock market today were to suffer a further decline of similar magnitude, the Dow Jones Industrial Average would be trading below the 3,000 level by the end of July.

So, to that extent, it is true to say that, on the assumption we are playing out a 1930s-like script, now would not be a good time to enter the stock market. But this truth pertains more to shorter-term investors than to longer-term investors. According to Siegel, in fact, an investor who entered into the stock market in early 1931 was made whole again by June 1933, despite digging a 60% whole in the first five months.

MYTH 3: The stock market’s recent extraordinary volatility provides a clue to the wild ride that lies ahead if we are playing out a 1930s-like script.

Actually, undeniably large as it has been, recent volatility does not even begin to compare to what it was like during the 1930s.

In fact, there were eight calendar months during the decade of the 1930s in which the Dow rose or fell by more than 20%. The month with the biggest Dow move was April 1933, when the Dow rose by 40.2%. In August 1932, furthermore, the Dow rose by 34.8%.

The biggest monthly losses during that decade were almost as big. The largest came in September 1931, when the Dow lost 30.7%.

These monthly changes dwarf what has been seen in the current bear market. The biggest calendar month loss so far came last October, when the Dow fell by 14.1%. The second biggest came in February, when the Dow fell 11.7%.

To measure the magnitude of the stock market’s volatility during the 1930s, I calculated the standard deviation of the Dow’s monthly returns on a trailing 36-month (or 3-year) basis. In mid-1933, this statistic rose to 15.4%, an extremely high number. During the current bear market, in contrast, this comparable statistic has never risen above 4.1%.

The bottom line? If we are indeed playing out a 1930s-like script, we have an incredibly wild ride ahead of us. But for those who have the intestinal fortitude to hang on, such a story would have a surprisingly happy ending.


Any successful investor or trader will tell you that your emotions are the enemy. They call out for you to buy high and sell low. Succumbing to their emotions is why the herd-like public, and professional money managers as well, consistently underperform the stock market indices.

After stocks have fallen 50% from their peak people are fearful of stocks falling – not entirely invalid, but people should have been a lot more fearful two years ago. As Ken Fisher rationally points out, low prices make stocks less risky, not more, as long as the underlying business has not been concomitantly impaired. Of course he thinks it is time to do some buying.

You cannot be a successful investor unless you can overcome your fears. So what is bothering you? Maybe, after reading one too many stories about investigations of Ponzi schemes, you are fearful that your entire portfolio may have been embezzled. Huge and scary! Yet I have seen nothing addressing this well and simply. There is one foolproof, easy way to be sure this never, ever happens to you.

If you hire anyone to make investment decisions for you, be sure it, he or she is separate from whoever has custody of your money. That is it. Have your assets held at a major-name custodian such as Schwab, Merrill Lynch, Fidelity, UBS or the like. Have someone else nonconnected make decisions about what to buy and sell. End of embezzlement story.

Every story ever about faked accounts, including those involving Bernard Madoff and Allen Stanford (who, by the way, has been the subject only of a civil fraud complaint), combines custody with decision making. Once the portfolio manager has custody he can take the money out the back door. Some set up this way to embezzle. Others start out honest but later fall to the temptation to exaggerate their returns. Separating the two functions is a prophylactic. Without some grand collusion between the two firms, embezzlement is impossible.

Note that even when Lehman failed completely, those who had securities custodied there were fine. Yes, doing this means some types of commingled investments like hedge funds may be harder to do or impossible. But if you set up this way, you will never be Madoffed.

The other fear these days is that of falling stock prices. This is not an irrational fear. Atocks that are off 50% from their highs (and a lot are, at this point) can keep falling. But you can temper your fear by realizing that low prices make stocks less risky, not more risky. Unless there has been a corresponding collapse in its business, a company whose $60 shares are now at $30 is less risky for the investor.

Last month I showed why I think the next bull market will be led by stocks in the energy, materials, industrial supply and consumer discretionary sectors. Here are some.

Alcoa [5.5, AA], the world’s 3rd-largest aluminum maker, is no growth firm but will not disappear, either. Its stock almost did, losing 87% in this bear market. With all the writeoffs and layoffs, no one can see reasons for optimism. I like that. At 17% of its $26 billion in annual sales, even though sales will fall, there is still plenty of room for the stock to rebound. Alcoa has the cash and credit to withstand two years of losses. Its recently announced dividend leaves it with a 12% yield. The dividend will get cut. Still, the shares are a buy.

The French cement firm Lafarge [9.5, LFRGY] is the world’s 2nd largest, with $24 billion in revenue. Tied as it is to real estate development, cement scares the heck out of people. But note that Lafarge had record sales in 2008 and the 4th quarter. Profits declined but modestly. The stock is off 78% in the last year. Yes, earnings will fall, and I do not know how much. But I will bet the stock will recover long before Lafarge’s business does. The company trades at 30% of annual sales and 2 1/2 times trailing earnings.

Britain’s Rexam [16, REXMY] is the world’s largest beverage-can maker, and its shares are down 70% from their September 2007 high. The giant will keep its market share and more after this recession, and we will still use cans. The dividend was just increased and now yields 11%. The price is seven times trailing earnings.

The Dutch firm Akzo Nobel [33, AKZOY] is the world’s leading producer of house paint and is also a leader in industrial and automotive coatings and specialty chemicals like polymers. Akzo is well run and has low costs, a strong balance sheet and great liquidity. It should bounce back hard. At 50% of revenue and 12 times depressed 2009 earnings and with a 6% dividend yield, it is something you can buy and hold.

Wet your whistle on Heineken [12, HINKY]. Also Dutch, it has the leading market share for beers in Europe. It operates at least 100 breweries worldwide and grows moderately. In a downturn beer is not very economically sensitive. But the stock fell with the market – and so should rise with it, too. It sells at 80% of annual sales and 12 times trailing earnings. The dividend yield is a well-covered 3.5%.


Buy shares in companies that predict cancer, alleviate fibromyalgia and treat varicose veins.

We are not a big fan of emerging growth stocks. They tend to look expensive to us, and we are Benjamin Graham investment bargain-seekers to the core. But one cannot deny that the stories behind the emerging stocks are interesting. Here are a few ideas/stories from emerging growth stock pundit Jim Oberweis.

Just now companies with strong earnings growth are harder to find than sunbathers on Chicago’s Oak Street Beach. I have been looking in the health care sector because novel drugs, cutting-edge medical devices and lifesaving diagnostic tests can drive sales growth even if the broader economy is tanking. Be warned: Medical innovation is a risky business. Product development is expensive and regulatory hurdles high. Many companies spend millions on drugs and medical products that never win Food & Drug Administration approval.

When I consider small health care companies, I live by three simple rules. First, cash is king. Promising research is great, but companies need cash in the bank or an established product on the market to fund research and development. Second, new products must have high profit potential relative to the market capitalization of the company. Third, the market should be underestimating the growth that can come from geographic expansion, additional indications for the drug and robust development pipelines. Here are four stocks to buy.

Myriad Genetics [80, MYGN] in Salt Lake City sells 6 diagnostic tests used to measure a patient’s genetic predisposition to cancer. The company’s bestselling product looks at mutations in the BRAC gene to assess a woman’s risk of developing breast or ovarian cancer. Most insurance plans will reimburse the cost (up to $3,000) if the woman has a family history of cancer. Myriad’s ambitious aspiration is to leverage its research in genetic mutations to develop drugs for treating cancer and HIV. That may be a long shot, and it certainly carries a different risk profile. That is why the company is spinning off its drug discovery business into a separate company this spring. The genetic testing business – which makes all the money – is going gangbusters, and its margins will improve once the drug discovery business’s research and development costs are spun off. Myriad has $497 million in cash and marketable securities ($10.62 a share), no debt and a $3.7 billon market capitalization.

Cypress Biosciences [8.1, CYPB] in San Diego has partnered with Forest Laboratories to develop Savella, a drug for treating fibromyalgia. Fibromyalgia is a vaguely defined disorder that causes pain and fatigue in muscle and connective tissue, mostly in women. Six million Americans think they have the disease

s The FDA approved Savella in January, and the tablets are about to hit pharmacy shelves. The medication confronts competition from two other drugs already on the market. Nonetheless, Jefferies & Co. estimates Savella’s market penetration will be 3.1% by 2010 and 7.5% by 2013. With an average treatment cost of $1,000 per year and a royalty rate of 15%, Cypress would make $28 million in royalties next year and $70 million in 2013. Cypress has $150 million in cash ($3.95 a share) and no debt. Its market capitalization is $305 million.

VNUS Medical Technologies [18, VNUS] of San Jose, Calif. markets a minimally invasive system to treat large varicose veins. The procedure involves the application of radio-frequency energy to heat superficial vein walls and close large, diseased veins. VNUS’s technique is an alternative to vein stripping, the more common surgical procedure that requires general anesthesia. VNUS targets critical cases, where the cost is normally reimbursable by insurance. The company has $85 million in cash ($5.30 a share) and no debt. The risk: Widespread adoption is dependent on reimbursement from payers like Medicare. Market value: $294 million.

My last biotech buy is Alexion Pharmaceuticals [34, ALXN]. This Cheshire, Connecticut firm has an antibody to treat a rare blood disorder known as paroxysmal nocturnal hemoglobinuria, or PNH, which affects 10,000 patients in the U.S. and Europe. Roughly 35% of patients die within five years of diagnosis. Alexion’s drug, Soliris, is the only treatment specifically approved for this condition. Though Soliris costs $400,000 annually, its adoption has been strong.

The negatives: Alexion is a one-hit wonder, and insurance companies may push back on the price. Alexion has $139 million in cash offset by a $44 million mortgage and $97 million in convertible notes due February 2012. Its market value is $2.8 billion.

Health care stocks have held up relatively well in this tough economy. But instead of buying big, stodgy pharma stocks, you should take a flier on some small but relatively well-situated medical innovators with high growth potential. They could produce small wonders among the patients they serve and just might do the same for your portfolio.


If the worst doomsday scenarios come to pass, then one should really be worried about surviving more than growing your capital. Even physical gold coins and canned food are trumped by someone with a gun, unless you also have one.

If things get really bad but one still has the luxury of looking ahead a bit, then where are good places to look in order to preserve your capital? Courtesy of Forbes, we have here a brief overview of some of the options, ranging from defensive stocks to mini-bottles of spirits.

Last September Laura Martin got spooked. The Dow was spinning down, and her boss, Gerald Celente, who heads the Trends Research Institute in Kingston, New York, convinced her the stock market would soon be the least of her worries. Within a few years the U.S. would look like the set of a Mad Max movie: tax rebellions, food riots, chaos.

Martin packed up her Manhattan apartment and moved to a cottage in Woodstock, New York, 100 miles to the north. There she would be far from any postapocalyptic urban unrest. (She also shortened her commute.) Following the Celente story line, Martin cashed out her 401(k) and shifted 60% of her assets into gold coins.

“I realized my money was not safe,” says Martin, 42, whose gold is now worth 20% more than she paid for it. “Everyone thought I was overreacting.”

Let it be noted that we also think she is overreacting. Gold might go to $2,000, but it could just as easily sink to $500, leaving Martin much less able to pay her grocer. Investing, though, is about more than maximizing expected returns. It is also about sleeping soundly. If you are a worrier, put some money in Extreme Defensive Plays. How much? 10% is plenty.

Herewith, a few EDP options.

Vice Stocks

True bears are not too big on stocks these days. In a great crash of the sort we had in 1929-32, just about every sector gets killed. But if you must be in stocks, goes the thinking, you should at least select companies whose sales hold up well in economic downturns. Sin stocks are in this category: makers of booze, like Constellation Brands, and tobacco, like Altria Group (its overseas operations were recently spun off as Philip Morris International). “Smokers are paying us a nice, fat dividend,” says Charles Allmon, a permabear who in December retired after 44 years of writing the Growth Stock Outlook newsletter.

Next, consider firms that deal with the wages of sin: health care providers. If you look at composite performance over the previous two recessions (1990-91 and 2001) and through December 2008 of the current one, 3 of the 5 best stocks to have owned, with market values exceeding $250 million, were in health care, according to FT Interactive Data. They include Hanger Orthopedic Group, Merit Medical Systems and Valeant Pharmaceuticals International.

Unbreakable Bonds

If you worry about corporate bond defaults and rising tax rates, pre-refunded munis are the bonds for you. These are issued by states and cities and collateralized by U.S. Treasurys held in escrow. The Treasurys offer more protection against a municipal default than do tax receipts from a decrepit city or sewer project.

Marilyn Cohen, a Los Angeles investment adviser who writes a fixed-income column for Forbes, is a big fan of pre-refunded munis. Her reasoning: “If the U.S. government reneges on payments of Treasury bonds, then everything else is worthless, too.” Two bonds she likes: the Metropolitan Transit Authority of New York Dedicated Tax Fund with a 5% coupon prerefunded to 2014, priced at $114 to yield 2.3%; and Puerto Rico Commonwealth Prerefunded Public Improvement, with a 5.05% coupon pre-refunded to 2011, priced at $107 to yield 1.75%.

Swiss Francs

As the U.S. prints trillions of dollars to ward off economic collapse, it will spark inflation. So argue (with differing degrees of vehemence) commentators James Grant of Grant’s Interest Rate Observer, Gerald Celente of Trends Research and economist Walter J. Williams of the Shadow Government Statistics newsletter.

Williams thinks it will not be long before a U.S. dollar is worth no more than a Zimbabwean one. “The federal government has taken on obligations that it cannot possibly handle, and it knows it,” Williams says. “It is effectively bankrupt, and it is just a matter of time as to how it works out.”

One countermeasure: Switch some money into a more respectable currency, like the Swiss franc. Switzerland never adopted the euro, was on the gold standard until a decade ago and carries one of the world’s lowest ratios of government debt to GDP (44%).

You can buy franc-denominated CDs (minimum: $10,000 worth) from EverBank of Jacksonville, Florida. Its deposits are FDIC-insured against bank failures (not, of course, against currency losses). They currently pay no interest for 3-month to 1-year maturities. Citibank discontinued a similar product. CurrencyShares offers exchange-traded funds that buy and hold single currencies, including Swiss francs. Annual expense ratios run 0.4%.


This barbarous relic is the most traditional store of wealth in times of trouble. One way to own it is via an ETF like SPDR Gold Shares.

For those who prefer the security of coins in hand, Allmon recommends the South African Krugerrand, which sells at a 4.5% premium to the value of the gold in it. The problem with gold, apart from the markup when you buy it, is the markdown when you sell it, about 5%.

“Gold is seen as the alternative to currency debasement,” says Edward Meir, senior commodities analyst at MF Global.


In the bombed-out Germany of late 1945, American cigarettes were a form of currency. What might be a tradable store of value in a broken American economy? Williams, the dollar bear, advises you to stock up on bottles of scotch and other popular spirits – especially the minibottles the airlines use.

If scotch does not work out as an investment, you can always drink it.

Preparing for the Worst

Overreacting to trouble risks compounding losses. But putting a sliver of assets into defensive plays can help you sleep nights.


The SPDR Gold Trust is an easy way to play gold, but not the cheapest one.

The advent of gold and silver ETFs a couple of years ago made investing in precious metals as easy as buying a stock. The public has taken advantage of the option – one of the gold ETFs now holds $31 billion worth of gold.

A possible issue with the precious metals ETFs is that they are in the end certificates of ownership backed by a stash that is, in extreme circumstances, vulnerable to governmental confiscation – as happened in the U.S. in 1933.

Another issue, which is inescapable no matter how you hold precious metals, is storage costs, bid/ask speads and commissions, and management fees. Are there cheaper avenues for buying and holding precious metals than via the ETFs? Yes, by taking the do-it-yourself approach using futures. The downside: less favorable tax treatment.

The world’s biggest owners of gold: the governments of the U.S., Germany, France and Italy, and an exchange-traded fund. The SPDR Gold Trust [GLD] owns 82,000 gold bars weighing 400 troy ounces each. That $31 billion worth of bullion is stashed away in an HSBC vault in London. If the metal were in a single cubic lump, it would measure less than 13 feet on a side. But, for convenience’s sake, it is spread out over a space somewhat larger than a basketball court. “I have personally seen and held the gold,” says James Ross, managing director at State Street Global Investors, which markets the trust.

The notion of owning a time-tested physical store of wealth is appealing when stocks are sinking and even government bonds look risky. Alongside stocks’ 24% decline, gold has climbed 5% this year to $920 per ounce. GLD is one of the easier ways to own the stuff. It has taken in $9 billion in new investor money over the past three months.

The Gold Trust was set up in 2004 by the World Gold Council, a trade group for the metal’s miners. GLD has helped keep the miners busy. In the past year it purchased 15% of the world’s mine output of 2,400 metric tons. “We surveyed investors and found that they were not [previously] buying gold because it was too difficult to access,” says Natalie Dempster, the council’s investment chief.

Buying GLD may be easy, but the most extreme goldbugs do not trust it or any other investment they do not hold in their hands. Such fears are not without basis. Franklin Roosevelt ordered Americans to sell privately held gold to the government in 1933. The Federal Reserve paid out $20.67 per ounce for 500 metric tons. Most private gold that escaped the cull was illegally hoarded outside of banks and custodial vaults. A hidden coin turned a fat profit when a year later Roosevelt devalued the dollar by raising the fixed price of gold to $35 an ounce.

Unfortunately for gold investors, there are no low-cost ways to buy and hold the metal, as there are with, say, an S&P 500 index fund. If you want to fill your home safe, you buy coins or bars from dealers, who typically tack 5%-to-10% markups onto the spot price. When it is time to sell, you can easily lose another 5% or more to markdowns. That is because the buyer must either undertake assay work or take some risk that your bars are adulterated with a cheaper metal.

Even so, some fanatics insist on gold they can hold. The Internet is rife with GLD conspiracy theories. One questions whether the trust’s metal stash exists. The chatter is fueled in part by the trust’s prospectus, which states it “does not insure its gold” and that “trustees may have no right to visit the premises of any subcustodian for the purposes of examining the trust’s gold or any records maintained.”

“Someone on the Internet accusing us all of being involved in a Ponzi scheme is irresponsible,” says State Street’s Ross. “We do not insure the gold, but HSBC does.” The World Gold Council’s Dempster adds that every six months a random list of serial numbers for 10% of the trust’s bars is produced and the bullion physically audited. “We cannot lease or lend or write derivatives on any of it,” she says.

With GLD shares you suffer the same bid/ask spreads and brokerage commissions you would on any ETF. GLD also charges 0.4% in annual fees. For the World Gold Council and State Street, that represented $25 million each in fee revenue last year, plus another $13 million for custodian HSBC. With demand for shares soaring, those figures are likely to more than double in 2009. The trust pays these expenses by selling gold from its own store. That reduces the amount of metal underlying each share – from 0.1 ounce at the time the shares were initially offered to 0.098 ounces today. Meanwhile, the GLD share price ranges between 1% above and 1% below the net asset value of that gold.

This opens up an arbitrage opportunity for Goldman Sachs, Merrill Lynch, UBS and the handful of other broker-dealers authorized to create new GLD shares. They do so by delivering roughly five tons of gold to the trust’s HSBC account and receiving in return 100,000 shares. They then wait for a relatively fat premium to NAV to open up, sell the shares into the market and pocket the difference.

Such vigorish is still a far sight less than you will pay to own Central Fund of Canada [AMEX: CEF], a 47-year-old closed-end fund. Traded on the American Stock Exchange and backed by $1 billion in gold and $700 million in silver bullion, it sells at an 11.7% premium to net asset value. Taking advantage of the premium, it regularly sells new shares. It has pledged to sell metal and buy in the shares if their discount to NAV ever reaches 20%.

Cheaper than either: Gold futures on the Comex division of the New York Mercantile Exchange. If you feel confident, as little as $5,100 in a margin account will get you a contract for 100 troy ounces, says David Megar, head of metals brokerage at Alaron Trading. If you reach out six months at a time, you will have two round-trip transactions a year, each costing just 0.01% in commissions and spreads. For long-term players, tax treatment of futures is worse than that of a fund. Futures are taxed as if they were sold every December 31, with gains (or losses) assumed to be 60% long-term (with a favorable tax rate) and 40% short-term.


Avon’s attractiveness is enhanced by its growing worldwide sales force and cost-cutting efforts.

The Avon lady is practically an anachronism in the U.S. Unless they see a UPS or FedEx truck parked outside, most people will ignore a doorbell for fear of finding a mugger, Census Bureau busybody, IRS agent or Jehovah’s Witness tag-team waiting for them. ... Which explains why 86% of Avon’s operating profits come from outside the U.S.

Once a member of the set of Nifty 50 “one-decision” growth stocks in the 1960s and early ‘70s, Avon got crushed during the 1973-74 bear market but subsequently matured fairly gracefully into a steady cash generator. Having been hammered along with everyone else over the past year, the stock now sells at just over 10 times this year’s estimated earnings versus a 5-year average earnings multiple of 20. A 20 P/E is rich for our taste, but 10 is certainly attractive. The stock also sports a nice dividend yield of almost 5%. The dividend was recently increased, so one might safely posit that the dividend is safe. Avon’s foreign currency exposure is a negative right now. It is virtually certain, given the fickle nature of markets and sentiment, that at some point the same exposure will be viewed as a positive.

Imagine an army of desperate (and far from house-bound) housewives selling cosmetics door-to-door and office-to-office, despite the global economic meltdown. That is the battle plan of Avon Products [AVP], which boosted earnings during the 2001-02 recession.

“Women are not going to stop wearing make-up,” regardless of the economic environment, says Joshua Strauss, portfolio manager of the Appleseed Fund, a small 2-year-old socially responsible operation that includes Avon in its $11 million portfolio.

Investors, however, are skeptical. Avon stock is changing hands at about 17, near its 52-week low [down over 60% from] its 52-week high of 45.34. The shares trade at a price-earnings ratio of less than 10, based on Wall Street’s consensus $1.69 estimate for 2009 earnings, which would be 17% below 2008’s $2.04. That P/E is less than half Avon’s 5-year average multiple of 20. In contrast, rivals such as Estée Lauder [EL] and Alberto-Culver [ACV] sport P/Es in the low double-digits.

Fans of the stock say it is undervalued, particularly considering that – unlike much of cash-constrained Corporate America – it has a ton of cash for a company its size ($1.1 billion as of December 31). And Avon still has access to the credit markets. Last month, it sold $850 million of bonds. In addition, the company has $1.8 billion remaining on a stock-buyback authorization after repurchasing $1.9 billion in stock from 2005 through 2008. Moreover, the company boosted its annual dividend to 84 cents a share in the 4th quarter, and now yields more than 5%. “In the past 10 years, Avon has raised its dividend 9% to 10% a year, compounded annually,” says Doug Lane, an equity analyst at Jefferies & Co., which has a Buy rating on the stock and a 1-year price target of 29.

Why, then, is Avon’s stock hurting more than those of most of its competitors?

A major culprit is the dollar’s rise, which reduces the value of Avon’s foreign revenues when they are translated into greenbacks. (Some 77% of its revenue and 86% of its operating profit are generated outside North America.) Andrea Jung, Avon’s shrewd but press-shy chief executive, who declined to be interviewed for this story, has said the company can handle the currency-exchange issues.

During a conference call with analysts last month, she noted, “I myself had to lead through the 71% drop in the [Russian] ruble in ‘98, 56% drop in [Brazil’s] real in ‘99, and the meltdown of the Argentine peso in 2001,” adding that her company has a “leadership team on the ground that is steeped in” dealing with such problems. As for the recession, she pointed out that Avon “thrived on aggressively reaching new customers and representatives” even during the Great Depression.

Another concern is Avon’s $2.5 billion in debt, which has prompted Moody’s, S&P and Fitch to issue a negative outlook on Avon’s credit rating, now single-A. Fitch director Grace Barnett points to the economic slowdown in the emerging markets as a cause for worry. Eastern and Central Europe and Latin America provided 70% of Avon’s consolidated profit last year. The problem was apparent in the 4th quarter, when sales slid 9%, even though, excluding the foreign-exchange hit, they were up 2% from sales in the corresponding 2007 quarter.

Avon’s balance sheet looks solid, and its 2008 operating margin rose by almost four percentage points, to 12.5% of its $10.7 billion in total sales. Maintaining that will pose a challenge for 2009, but the company will be helped by a restructuring plan launched three years ago. The plan is expected to reduce outlays by $300 million this year and $430 million by 2012, when the cost-cutting will be fully implemented.

“If history is any indication, the restructuring will take hold and lead to strong growth,” particularly outside the U.S., where Avon products have more cachet than they do here, says Larry Coats, CEO and portfolio manager at Oak Value, with $60 million in assets under management. Coats, who first bought the stock back in 1995, thinks the cosmetics peddler has “the right mix of overhead and infrastructure, distribution and product price points” to suit this economy.

Avon’s strength is its workforce – the thousands of “Avon ladies” of door-to-door fame. Avon representatives, almost all of them women, typically make $2,000 a year selling cosmetics, fragrances, skin care and toiletries as a part-time job, according to Jefferies’ Lane. In fact, these days, while much is still peddled door-to-door, especially abroad, lots of the selling in the U.S. takes place in the workplace, at lunchtime or during breaks. Customers often know the saleslady because they are her friends, family and neighbors.

Because the workforce is paid solely on commission, adding to it is essentially costless to Avon, and that is what the company is doing. In her conference call, Jung said active reps were up 4% overall, to about 5 million in the 4th quarter, and up 1% in the U.S., where the company plans this year to focus on recruiting, “given the high unemployment levels.”

Avon also is focusing on promoting products more effectively. It spent $400 million on advertising last year, three times its 2005 level, and even bought a pre-Super Bowl commercial. It has signed Legally Blonde film star and Avon Ambassador Reese Witherspoon to hawk its Pro-To-Go lipstick and Courtney Cox of TV’s Friends to endorse Spotlight, a fragrance it will unveil next month.

Avon, founded in 1886 as the California Perfume Co. (though it was based in New York), adopted its current name in 1939.

To boost the motivation of its sales force in the current downturn, Avon has raised the reps’ commissions. And in her conference call, Jung said that a key to success this year will be to strike the right balance between low- and premium-priced offerings to consumers around the globe.

“Given the breadth of our product assortment,” she said, the company is moving quickly “to ensure the appropriate flow of operating in the under-US$5 or equivalent range.” The goal, she added, is to stress value, not discounting, and “to remind consumers of [Avon’s] everyday low prices,” plus the ease of shopping at home or the workplace with no delivery fees. Avon last year increased its prices by an average 6% per item.

One potential growth area is China, which last year made up just 3% – about $350 million – of Avon’s sales. But those sales have been growing 25% a year, and Avon is making a big push to recruit more Chinese representatives for its 5 million global sales force.

“Avon Products is probably the best at direct selling in the consumer stable,” says Steven Ralston, a senior analyst at Zacks Equity Research, which last month put a Buy rating and 6-month price target of 30 on the shares. He says buy low and decide your target price. He would sell only when the stock hit 36, which he believes could happen within a year.

Ralston, who has followed Avon for two decades, adds that eventually the dollar will weaken again, as investors focus on the massive deficits being run up by Washington to battle the recession and credit crunch. “I have seen panic in Avon’s stock before,” he observes. “It is always a buying opportunity.”


A return of approximately 0% is nothing to get excited about, except in the midst of a stock market crash.

Where to safely stash large amounts of cash, amounts well over the FDIC per bank account insurance limit, which is scheduled to fall back to $100,000 in less than a year? T-bills or a T-bill money fund is one possibility. Then there is the “Certificate of Deposit Account Registry Service.” What is that? Read on.

“Capitulate” is a fancy word for what investors do after big losses make them more intent on preserving capital than increasing it. If this describes you, or you have sold a business or inherited a bundle lately, it is nice to know that there are still some very safe places to park your precious cash. The ones in the table have never caused investors a loss of principal.

Returns on these investments vary fairly widely based on whether they are subject to early withdrawal penalties, offer fixed or variable yields, or are protected by deposit insurance. All except for U.S. Treasurys (and funds holding them) are subject to state income tax.

Those looking for short-term investments can park up to $250,000 in bank CDs covered by the FDIC. However, that limit is set to fall back to $100,000 at the beginning of next year, so think twice before locking up money in a one-year jumbo CD. Many banks will offer rates higher than they post, especially for large deposits.

One way to put really large amounts into CDs that will remain below the FDIC’s limits indefinitely is the Certificate of Deposit Account Registry Service. The 2,850 mostly small banks in the network offer FDIC-insured CDs on up to $50 million.

CDARS caters to corporations and governments but is open to anyone. It spreads deposits among banks to get full FDIC coverage, which can save investors considerable paperwork. Rates tend to be comparable to those offered by banks directly. CDARS will not reveal the total deposits run through its system but says inflows are up 400% in a year. A list of participating banks is available at cdars.com.

Unexpected inflation is a hazard on any fixed-income holding that stretches beyond, say, a year. Our two longer-maturity investments, TIPS and I-series savings bonds, deflect that risk with adjustments based on inflation.


What signs are there which indicate that all is not well with the company whose stock you own? This article catalogs a useful set of indicators of financial fragility and warning signs that fundamentals are seriously deteriorating. Such problems can be avoided if you stick to companies which consistently generate positive cash flow and whose capital structure is light on debt. Actually understanding what you are buying is the ultimate defense.

What if the income statement and balance sheet are hard to analyze, a la the WorldCom and Enron examples cited below? What if you cannot figure out what the company actually does? Just avoid the situation. There are thousands of clean alternative opportunities, so why bother with one where the situation is murky?

There is a classic saying that if 20 minutes after joining a poker game you don’t know who the sucker is, then you are the sucker. Similarly, if after buying a stock it declines 20% and you do not know whether the market is wrong or you are wrong, then you are the sucker.

Few people seem to spot the early signs of a company in distress. Remember WorldCom and Enron? Not long ago, these companies were worth hundreds of billions of dollars. Today, they no longer exist. Their collapses came as a surprise to most of the world, including their investors. Even large shareholders, many of them with an inside track, were caught off guard.

This does not mean it is impossible to see a corporate train wreck before it happens. Sure, it involves some work, but by digging into a company’s activities and financial statements, even the average investor can identify potential problems. Here are some general guidelines for spotting companies that may be headed for trouble. ...

Cash Flows

Keeping a close eye on cash flow, which is a company’s life line, can guard against holding a worthless share certificate. When a company’s cash payments exceed its cash receipts, the company’s cash flow is negative. If this occurs over a sustained period, it is a sign that cash in the bank may become dangerously low. Without fresh injections of capital from shareholders or lenders, a company in this situation can quickly find itself insolvent. (For more insight, see “The Essentials Of Cash Flow”.)

Bear in mind that even profitable companies can have negative cash flows and find themselves in trouble. This can happen, for example, when a rapidly growing business with strong sales makes large investments in stock, staff and manufacturing plants. At best, there will be a delay between when the company forks out cash for these business costs and when it collects cash from resulting sales. But this delay can severely stretch cash flow. At worst, the sales growth cannot be sustained, and large quantities of stock (and staff) end up idly sitting in warehouses, causing a devastating impact on cash flow. Either way, you should steer clear of companies that report both profits and negative operating cash flows period after period.

In addition, you should examine the company’s cash burn rate. If a company burns cash too quickly, it runs the risk of going out of business. Enron’s cash flow fell from negative $90 million in Q1 2000 to a very troubling negative $457 million a year later. Any questions? (For more details on this measure of cash, check out the article “Don’t Get Burned By The Burn Rate”.)

Debt Levels

Interest repayments place pressure on cash flow, and this pressure is likely to be exacerbated for distressed companies. Because they have a higher risk of default, struggling companies must pay a higher interest rate to borrow money. As a result, debt tends to shrink their returns. (For more on corporate debt, see “Evaluating A Company’s Capital Structure”.)

The total debt-to-equity (D/E) ratio is a useful measure of bankruptcy risk. It compares a company’s combined long- and short-term debt to shareholders’ equity or book value. High-debt companies have higher D/E ratios than companies with low debt. According to debt specialists, companies with D/E ratios below 0.5 carry low debt. And that means that conservative investors will give companies with D/E ratios of 0.5 and above a closer look.

Let us consider Enron’s debt-to-equity levels before it declared bankruptcy in December 2001. At year-end December 2000, its D/E ratio stood at 0.9. At June 2001, it grew to 1.1. Finally, its September 2001 quarterly report showed a D/E ratio of 1.4. Enron would have qualified as a risky debt prospect each time.

At the same time, the D/E ratio does not always say much on its own. It should be accompanied by an examination of the debt interest coverage ratio. For example, suppose that a company had a D/E ratio of 0.75, which signals a low bankruptcy risk, but that it also had an interest coverage ratio of 0.5. An interest coverage ratio below 1 means that the company is not able to meet all of its debt obligations with the period’s earnings before interest and tax (operating income), and it is a sign that a company is having difficulty meeting its debt obligations.

Share Price Decline

The savvy investor should also watch out for unusual share price declines. Almost all corporate collapses are preceded by a sustained share price decline. Enron’s share price started falling 16 months before it went bust. The same holds true for WorldCom.

A big share price decline might signal trouble ahead, but it may also signal a valuable opportunity to buy an out-of-favor business with solid fundamentals. Knowing the difference between a company on the verge of collapse and one that is undervalued is not always straightforward. Looking at the other factors we discuss below can help you tell them apart.

Profit Warnings

Investors should take profit warnings very, very seriously. While market reaction to a profit warning may appear swift and brutal, there is growing academic evidence to suggest that the market systematically under-reacts to bad news. As a result, a profit warning is often followed by a gradual share price decline.

Insider Trading

Companies are required to report, by way of company announcement, purchases and sales of shares by substantial shareholders and company directors. Executives and directors have the most up-to-date information on their company’s prospects, so heavy selling by one or both groups can be a sign of trouble ahead. While recommending that investors buy his company’s stock, Enron Chairman Kenneth Lay sold $123 million in shares in 2000. That was nearly three times his gains in 1999, and nearly 10 times what he made in 1998. Admittedly, insiders do not always sell simply because they think their shares are about to sink in value, but insider selling should give investors pause. (To learn more, read “Uncovering Insider Trading“.)


The sudden departure of key executives (or directors) can also signal bad news. While these resignations may be completely innocent, they demand closer inspection. Warning bells should ring the loudest when the individual concerned has a reputation as a successful manager or a strong, independent director.

You should also be wary of the resignation or replacement of auditors. Naturally, auditors tend to jump ship at the first sign of corporate distress or impropriety. Auditor replacement can also mean a deteriorating relationship between the auditor and the client company, and perhaps more fundamental difficulties within the client company’s business.

SEC Investigations

Formal investigations by the Securities and Exchange Commission (SEC) normally precede corporate collapses. That is not surprising; many companies guilty of breaking SEC and accounting rules do so because they are facing financial difficulties. Unfortunately for most Enron and WorldCom investors, the SEC did not spot problems in these companies before it was too late. However, the SEC has a pretty good nose for detecting corporate and financial misdeeds. While many SEC investigations turn out to be unfounded, they still give investors good reason to pay closer attention to the financial situations of companies that are targeted by the SEC. (For more insight, see “SEC Filings: Forms You Need To Know”.)


Just as a seriously ill person can make a full recovery and go on to lead a fulfilling life while a seemingly healthy person can drop dead without warning, some very sick companies can make miraculous recoveries while apparently thriving ones can collapse overnight. But the probability of this is very low. Typically, when a company is struggling, the warning signs are there. Your best line of defense as an investor is to be informed – ask questions, do your research and be alert to unusual activities. Make it your business to know a company’s business and you will minimize your chances of getting caught in a corporate train wreck.


The Austrian economists like Tom Woods continue to fight the good fight against conventional economists and politicians who like what they hear from the conventional economists. The title of Wood’s new book Meltdown: A Free Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, is pretty self-explanatory with regard to its contents.

The “geniuses,” Tom notes, find it expedient to act as though stealing production from the voluntary exchange sector of the economy and redirecting the resources to projects favored by the politically connected will make us all better off. Of course someone will be made better off by the forcible exchange, but it will not be the average citizen.

Exposing all the flaws in the conventional thinking – not that that term “thinking” actually applies – is an arduous task. Keynesianism is a de facto religion, whose believers’ faith is unperterbed by counter-evidence or reasoning. But Woods and other Austrians are up to the task.

How effective will the recently passed “stimulous” bill be in reviving the economy? It will be an anti-stimulous, says Woods,. “a dagger through the heart of the economy.” But for those who believe in the tooth fairy ...

So the “stimulus” package, a dagger through the heart of the economy, has passed. The geniuses who govern us, who insist that seizing the produce of the voluntary economy and devoting it to arbitrary projects will make us wealthy, have had their victory.

Much of the debate turned, unfortunately, on how much “pork” was in the bill. This or that spending program was silly or an obvious waste of money, critics said. All too true, of course, but unless we are looking to be hired by the Titanic’s Department of Deck Chair Rearrangement, we are missing the point with arguments like this.

The primary fallacy of the tooth-fairy economics at the heart of the stimulus is the very idea that economic health is the product of government spending, which is financed either by borrowing (which leaves private businesses with a smaller share of the pool of savings for them to borrow from), printing money out of thin air, or direct seizure from the population. Whatever government spends the money on is necessarily arbitrary – government lacks the profit-and-loss feedback mechanism that keeps the private sector from squandering resources and employing factors of production in ways that do not cater to consumer wants. It can seize its resources from the people without their consent, and it makes no difference to government whether or not people actually want or wind up using the things it produces. Meanwhile, the economy loses the goods that would have been produced by the voluntary sector had the government not seized these resources for its own use.

The more sophisticated Keynesians, if that is not an oxymoron, will come back with the argument that while they really do agree with you in cases when the economy is experiencing “full employment,” your point does not apply when there are “idle resources.” In that case, we can “stimulate” those idle resources into action without drawing resources out of alternative employments. These resources currently have no alternative employments.

Nice try. But whatever projects our wise planners come up with to put these “idle resources” to work will inevitably draw complementary resources away from alternative employments that are more urgently desired than what the government intends to use them for. Resources will unavoidably be drawn from current employments in the attempt to kick-start “idle resources.” So the “idle resources” argument does not really manage to evade the opportunity-cost problem.

Beyond that, pro-stimulus thinkers show remarkably little curiosity about why the so-called idle resources are idle in the first place. They are idle because of some previous entrepreneurial miscalculation. What might have caused systemic miscalculation of this kind? Could it be the Federal Reserve’s manipulation of interest rates, which leads investors to make incorrect assessments of profitability and provokes false economic booms, as F.A. Hayek won the Nobel Prize for showing in 1974?

Consider a circus that comes to town for a few weeks. A restaurant owner may expand his seating capacity in the false expectation that the circus and the related demand for his food that it brings in its wake will last forever. But when the circus leaves town, he will find he has “idle resources” on his hands. We should not want to put these idle resources to work. Doing so would only draw labor and other resources away from other sectors of the economy, where they are employed in the satisfaction of real consumer demand. The expansion of the restaurant should not have occurred in the first place. We should want this bubble activity to shrink back down to size, in order that other, non-bubble activities in the economy can be correspondingly strengthened.

In the wake of a previous, unsustainable boom brought about by the central bank’s credit expansion, the market economy and its price system, left to their own devices, will adopt another arrangement of resources that employs available factors in the service of producing goods and services that correspond to real consumer demand. During the bust, free individuals interacting within the market nexus sort out which projects and business ventures are healthy and sustainable, and which are bubble activities that cannot survive without a constant artificial increase in the money supply, and cannot (and should not) survive now that reality has reasserted itself.

That is what the market was allowed to do in the long-forgotten depression of 1920-21. Instead of a “fiscal stimulus” package, the government cut its budget. The Fed, for its part, did little. Meanwhile, the economy was allowed to clean out the malinvestments of the false boom of previous years, thereby making a robust recovery possible.

The artificial housing boom made Americans feel wealthier than they really were. As a result, they consumed more than they would have if the Fed-created housing bubble had not distorted their assessments of their net worth. What the economy needs now, therefore, is not “spending” per se. Too much spending and debt caused the initial problem. People bought more house than they could afford, and on the basis of its seemingly incessant appreciation they went out and purchased more consumer goods than they now realize they should have. Americans are in more debt than they can pay back – credit-card defaults will provoke calls for the next round of bailouts. How can “spending” solve this problem?

Meanwhile, part of the reason the American savings rate has been so low is that for many Americans, saving seemed superfluous. After all, they possessed an asset that (they falsely believed) was guaranteed to appreciate over time. That, after all, is what the experts told them. The dramatic rise in housing prices is not an unsustainable bubble that has to burst, Fed economists said. It is a sustainable increase based on real factors.


We should not want to “stimulate” an economy based on debt and overconsumption back into existence. We should want to restructure it along sustainable lines.

For instance, we are now learning that Starbucks, at least in its one-store-every-10-feet business model, was a bubble activity. With the housing bubble having burst, people now have a more accurate estimate of their real level of wealth. They are now less likely to buy a $5 cup of coffee – or, in the case of the ailing Cold Stone Creamery, spend $6 for an ice cream cone. These are resources that need to be freed up so business firms carrying out genuine, non-bubble activities can be strengthened and the recovery accelerated.

In his recent press conference, President Obama cited the case of Japan as if it were evidence for his side of the argument. Exactly the opposite is true. Japan has done everything to itself that our government has done and is threatening to do to us, and with no results. From partial nationalization of its banking system to “stimulus” packages amounting to trillions of yen, from propping up zombie companies and dropping interest rates to zero, they have tried it all.

Naturally, the Keynesian response is that Japan simply did not spend enough. Oh? Thanks to the misnamed “stimulus” packages that the Japanese government imposed on its hapless people, Japan is the most indebted country in the developed world. So becoming the most indebted country in the developed world – and that is saying something – still is not enough spending for Keynesians?

What would be enough, then? A quadrillion dollars? A googol dollars? Infinity minus one dollars? It would be interesting to know what “stimulus” figure might make a Keynesian declare, “Now that is too much!”

If there is one silver lining to the crisis, it is that more and more people are figuring out that so-called respectable opinion has been dead wrong, and for a long time. The economics profession, by and large, has embarrassed itself with a Keynesianism so crude it would not satisfy a bright 6th-grader. People trotted out as experts, who failed to see the crisis coming and have no idea how it occurred – “excessive risk-taking!” they say, in a non-explanation that merely begs the question – have no idea how to solve it.

This, incidentally, is why I wrote my new book Meltdown, which gives a free-market overview of what caused the problem, where we are now, and how we get out. People are ready to listen to reasonable, previously neglected ideas, especially if the people who hold them managed to predict the current crisis – as indeed the economists of the Austrian School did. It is up to us to bring them these ideas.


Going all out to reinflate the credit bubble.

PrudentBear.com’s Doug Noland’s estimate is that behind all the smoke and mirrors lies the simple fact that approximately $2.0 trillion worth of annual credit growth is required these days to avoid a systemic collapse. And the Fed’s Q4 2008 indicates that indeed this growth is still happening. Barely. This is why the Great Depression II has not happened. Yet.

Q4’s credit growth was achieved by the U.S. federal government expanding borrowings at a 37% annualized rate. With the bust in the U.S. consumer and corporate sector credit growth – the former was actually in negative territory in Q4 2008 – there was no one else but the USG to supply that growth. The unfolding government finance bubble has thus been a major stabilizer of the economy. And it will continue to be ... until it isn’t.

The price of this massive government effort? Nolan believes, as do we, that the U.S. government is now trapped in this game of massive inflation of Treasury obligations – with the latest round of historic credit inflation captured clearly in the Federal Reserve’s Q4 2008 “Flow of Funds” report. “The worst case scenario unfolds when our creditors and the marketplace turn against these government obligations.” At which point the effort to inflate credit further fails.

The Federal Reserve’s Z.1 “Flow of Funds” reports are no less fascinating in today’s post-bubble landscape. The basic thrust of my credit bubble analysis these days is that the highly maladjusted U.S. (finance and “services-"driven) bubble economy requires in the neighborhood of $2.0 trillion of annual credit growth to hold implosion at bay. Recent dramatic financial and economic tumult – especially during the 4th quarter – supports this view. But it is, at the same time, important to differentiate today’s economic backdrop from the dynamics that fomented financial and economic collapse throughout the emerging markets during the 1990s and earlier this decade (i.e., Mexico, Southeast Asia, Russia, Brazil, Argentina, etc.). The U.S. economy is in severe crisis, but it is not today collapsing. We are not in another Great Depression. We are not yet witnessing the worst-case scenario.

The “Flow of Funds” illuminates why the collapse of the greatest credit bubble in history has not yet translated into one of the greater economic collapses. Despite financial panic and the freezing up of credit markets, Total non-financial credit expanded at a 6.3% annualized rate during the fourth quarter. While down from Q3’s 8.1% pace, I would argue that 6% plus credit expansion was about the minimum required to forestall systemic implosion. Importantly, this feat was achieved by the federal government expanding borrowings at a 37% annualized rate.

Some would argue that this massive federal credit expansion has had minimal impact. They would point to moribund markets for housing and autos, the steep rise in unemployment, and the sharp economic slowdown. Sure enough, Household Mortgage Debt contracted at a 1.6% rate during the quarter, with Household (non-mortgage) credit sinking at a 3.2% pace. And corporate debt growth, having expanded at a double-digit rate during the first half of 2007, slowed markedly to 1.2%. Yet, despite collapsing markets for private-sector credit, Total (economy-wide) Compensation for the 4th quarter was actually up 1.9% y-o-y to a record (annualized) $8.1 trillion. For the year, National Income was up 1.5% to a record $12.5 trillion, with Total Compensation up 3.1% to $8.1 trillion. How was it possible for such a deeply impaired credit system to sustain such an inflated level of National Income in the face of a housing and asset market collapse?

Remarkably, Domestic Financial Sector Debt Growth accelerated from Q3’s 6.8% pace to a 7.2% rate of expansion. On a seasonally-adjusted and annualized Rate (SAAR) basis, Total Financial Sector borrowings jumped to $1.2 trillion during the quarter. This was in the face of the asset-backed securities (ABS) market contracting SAAR $616 billion. This critical contraction in private sector credit was, however, largely offset by combined GSE debt and MBS growth of SAAR $569 billion. Bank Commercial Loans expanded SAAR $858 billion, while Open Market Paper increased SAAR $341 billion.

Government credit growth is outdoing the historic surge in mortgage credit during the mortgage finance bubble years.

For all of 2008, Treasury securities outstanding increased an unprecedented $1.24 trillion, or 24.3%. Meanwhile, Agency securities (GSE debt and MBS) jumped $716 billion, or 9.6%. Combined federal and quasi-federal securities outstanding ballooned an incredible $1.96 trillion in just one year. For comparison, Treasury and the Agencies combined to increase debt securities $1.15 trillion during 2007, $514 billion in 2006 and $390 billion in 2005. This ramp-up of government credit growth is outdoing even the historic surge in mortgage credit during the mortgage finance bubble years.

Federal debt growth offset a contraction in several key sectors of private-sector credit intermediation/creation. Total Mortgage Debt (TMD) expanded only $78 billion during 2008. TMD growth reached about $1.4 trillion annually during 2005 and 2006 and averaged $1.18 trillion annually during the 6 bubble years 2002 through 2007. For comparison, TMD expanded on averaged $270 billion annually during the 1990s. With the mortgage finance bubble now burst, the ABS (including Wall Street’s “private-label” mortgage-backed securities) market is in disarray. Through the first 8 years of the decade, the ABS market ballooned 240% to $4.50 trillion. Annual growth peaked in 2006 at $912 billion. In an historic reversal of fortunes, the ABS market contracted SAAR $616 billion during Q4 2008 and declined $442 billion for all of 2008.

Nowhere was the implosion of “Wall Street finance” more apparent than it was with the securities broker/dealers. Broker/Dealer Assets contracted nominal (non-annualized!) $785 billion during the final three months of the year, although much of this was likely reclassification of Lehman and Merrill assets. It is worth noting that Miscellaneous Broker/Dealer Assets contracted SAAR $1.73 trillion, while Treasury holdings expanded SAAR $774 billion. For the year, Broker/Dealer Assets were down $875 billion, or 28%, to $2.2 trillion.

With the “moneyness” of Wall Street finance having disappeared, the (offsetting) issuance of government “money” has amounted to nothing less than a historic explosion of debt issuance. For the year, Agency debt expanded 9.0% to $3.459 trillion. GSE MBS grew 11.2% to $4.97 trillion. Over the past two years, Agency debt expanded $585 billion, or 20%, and GSE MBS ballooned an unprecedented $1.13 trillion, or 29%. Combined with Treasury’s 2-year debt issuance of $1.48 trillion, one tabulates incredible 2-year federal government (“money”) issuance of $3.20 trillion (28%). And this already incredible debt growth is now poised to really accelerate. At the Federal Reserve, Total Assets expanded an unmatched $729 billion during the quarter to $2.27 trillion, with 1-year growth of 139%. Washington should feel quite fortunate that the markets continue to accommodate such alarming debt expansion at such meager little interest rates. There is no mystery why the Chinese and our other creditors are increasingly disturbed by our government’s borrowing habits.

The unfolding government finance bubble has been somewhat able to mitigate the implosion of Wall Street finance.

The unfolding government finance bubble has been somewhat able to mitigate the implosion of Wall Street finance. But the greater dilemma is 2-fold: On the one hand, the distorted economy requires massive ongoing credit creation. Here, government finance can and has taken up the slack. However, the nature of spending created by the inflation of government obligations will remain quite dissimilar to that spurred by the runaway inflation of Wall Street finance. The flow of finance has been permanently altered. There will be no rejuvenating the previous asset inflation and consumption booms. Indeed, the household (and non-profits) balance sheet rather starkly illustrates the nature of the problem.

During the fourth quarter, Total Household Assets dropped a record $5.4 trillion, or 31% annualized, to $65.7 trillion. Wow ... financial asset values sank a record $4.5 trillion (to $40.8 trillion), and Real Estate dropped a record $871 billion (to $20.5 trillion). Little wonder auto purchases and retail spending went into a tailspin, as Household Net Worth shrank a record $5.1 trillion during the quarter (to $51.5 trillion). For the year, Household Assets collapsed $11.3 trillion (14.7%), while Liabilities were little changed at $14.2 trillion. For the year, $11.2 trillion of Household Net Worth (“perceived financial wealth”) disappeared. This compares to the average annual increase in Household Net Worth of $5.4 trillion during the period 2003 through 2006. The household balance sheet continues to offer invaluable insight on the workings of a bubble economy.

Rest of World data document a quarter of mayhem in global finance.

Rest of World (RoW) data document a quarter of mayhem in global finance. RoW holdings of U.S. financial assets increased SAAR $738 billion (to $16.9 trillion), down from Q3’s $1.0 trillion and Q4 2007’s $804 billion. But there were some abrupt shifts in the composition of holdings. Net Interbank Assets jumped SAAR $1.34 trillion, while Securities Repos dropped SAAR $1.27 trillion. Treasury holdings surged SAAR $1.09 trillion (to $3.2 trillion), while Agency and GSE MBS holdings dropped SAAR $1.0 trillion (to $1.33 trillion). Miscellaneous Assets expanded SAAR $407 billion during the quarter to $5.4 trillion. For the year, ROW holdings of U.S. assets increased $857 billion, down from 2007’s $2.1 trillion increase – to the slowest rate of growth in more than a decade.

Chaos on Wall Street has thrown an additional layer of complexity upon an already challenging Banking sector “flow of funds” analysis. I am forced to keep it simple. Banking system assets were up $1.0 trillion (nominal) during the quarter to $13.4 trillion, with 2008 growth of $2.2 trillion (20%). Bank credit expanded 15.2% for the year to $9.7 trillion, while Miscellaneous Assets jumped 65% to $2.9 trillion. On the Liability side, Total Deposits were up 8.9% for the year to $7.2 trillion. Miscellaneous Liabilities jumped 62% to $2.9 trillion.

The Fed’s and Treasury’s move to bolster the money fund complex was critical to averting financial collapse. Retaining their “moneyness,” Money Fund assets expanded at a 45% rate during the 4th quarter to a record $3.8 trillion. For the year, Money Fund assets jumped $724 billion, or 24%.

Elsewhere, the enigmatic Funding Corps had a huge quarter and year. Funding Corp assets increased $1.06 trillion during the quarter to $3.57 trillion, with total 2008 growth of $1.74 trillion. Credit Union assets expanded 7.3% last year to $814 billion, while Finance Companies were about unchanged at $1.9 trillion. REITs contracted about 10% in 2008 to $523 billion. Savings Institution assets fell 16% to $1.53 trillion. Life Insurance assets declined 6% last year to $4.4 trillion.

The system is perhaps not today as acutely unstable as many fear. For now.

I suppose I will for now reside in the camp that believes the system is perhaps not today as acutely unstable as many fear. The unfolding government finance bubble is – until it isn’t – a major stabilizing force. Government finance by its nature will not exert sufficient stimulus to rejuvenate deflating asset markets, but it is nonetheless playing a major role in underpinning wages and incomes. Moreover, the massive inflation of government finance is thus far bolstering the markets’ perception of “moneyness” for tens of trillions of Treasury, Agency debt, MBS, municipal, corporate and household debt securities, along with another ten trillion or so of bank deposits and money fund liabilities. This “bolstering” of “moneyness” is also likely central to the resilience of the dollar. But such extraordinary stabilization does not come without a heavy price. I am firmly in the camp that believes that Washington is now trapped in a massive inflation of government obligations – the latest round of historic credit inflation captured clearly throughout the Q4 2008 “Flow of Funds” data. The worst case scenario unfolds when our creditors and the marketplace turn against these government obligations.

Mistakes Beget Greater Mistakes

Continuing in the vein of his piece above, Doug Noland this time analyzes specifically how the Washington policy-makers continue to compound error with folly. As he puts it:

Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking.

Whether they are truly “completely oblivious” to the risks they are taking and the flaws in their economic theories is a debate for another day. To us it looks like yet another round of what the U.S. government and Federal Reserve have been doing forever, or at least since 1966: papering over the latest crisis – the symptoms – rather than addressing the underlying disease. Today’s effort is merely the largest and most blatant, not fundamentally different in kind.

The magician’s act has always been to try to hide the tawdry facts of money/credit creation out of thin air behind the “rescue” efforts of the day. Now the trick is available for anyone to see – issue government debt and then sell it to the Fed. The only action not yet resorted to is for a heliocopter to start dumping money over the countryside. As we well know, that option has not been ruled out.

Bloomberg (Kathleen Hays and Dakin Campbell): “Bill Gross, co-chief investment officer of Pacific Investment Management Co., said the Federal Reserve’s purchases of Treasuries and mortgage securities won’t be enough to awaken the economy. ‘We need more than that,’ Gross said ... The Fed’s balance sheet ‘will probably have to grow to about $5 trillion or $6 trillion,’ he said.”

“The problem with discretionary central banking is that it virtually ensures that policy mistakes will be followed by only greater mistakes.” Here, I am paraphrasing insight garnered from my study of central banking history. Naturally, debating the proper role of central bank interventions – in both the financial sector and real economy – becomes a much more passionate exercise following boom and bust cycles. The “Rules vs. Discretion” debate became especially heated during the Great Depression. It was understood at the time that our fledgling central bank had played an activist role in fueling and prolonging the ‘20s boom – that presaged The Great Unwind. Along the way, this critical analysis was killed and buried without a headstone.

I believe the Bernanke Fed committed a historic mistake this week – compounding ongoing errors made by the Activist Greenspan/Bernanke Federal Reserve for more than 20 years now. I find it rather incredible that Discretionary Activist Central Banking is not held accountable – and that it is, instead, viewed as critical for a solution. Apparently, the inflation of Federal Reserve credit to $2.0 trillion was judged to have had too short of a half-life. So the Fed is now to balloon its liabilities to $3.0 trillion, as it implements unprecedented market purchases of Treasuries, mortgage-backed securities, and agency and corporate debt securities.

And what if $3.0 trillion does not do the trick? Well, why not the $5 or $6 trillion Bill Gross is advocating? What is the holdup?

Washington fiscal and monetary policies are completely out of control.

Washington fiscal and monetary policies are completely out of control. Apparently, the overarching objective has evolved to one of rejuvenating the securities and asset markets and inciting quick economic recovery. I believe the principal objective should be to avoid bankrupting the country. It is also my view that our policymakers and pundits are operating from flawed analytical frameworks and are, thus, completely oblivious to the risks associated with the current course of policymaking.

Today’s consensus view holds that inflation is the primary risk emanating from aggressive fiscal and monetary stimulation. It is believed that this risk is minimal in our newfound deflationary backdrop. Moreover, if inflation does at some point rear its ugly head the Fed will simply extract “money” from the system and guide the economy back to “the promised land of price stability.” Wording this flawed view somewhat differently, inflation is not an issue – and our astute central bankers are well-placed to deal with inflation if it ever unexpectedly does become a problem.

Our federal government has set a course to issue trillions of Treasury securities and guarantee multi-trillions more of private-sector debt. The Federal Reserve has set its own course to balloon its liabilities as it acquires trillions of securities. After witnessing the disastrous financial and economic distortions wrought from trillions of Wall Street credit inflation (securities issuance), it is difficult for me to accept the shallowness of today’s analysis. In reality, the paramount risk today has very little to do with prospective rates of consumer price inflation. Instead, the critical issue is whether the Treasury and Federal Reserve have set a mutual course that will destroy their creditworthiness – just as Wall Street finance destroyed theirs. Additionally, what are the economic ramifications for ongoing market price distortions?

The counterargument would be that Treasury and Fed stimulus are short-term in nature – necessary to revive the private-sector credit system, asset markets and the real economy. That, once the economy is revived, fiscal deficits and Fed credit will recede. I will try to briefly explain why I believe this is flawed and incredibly dangerous analysis.

First of all, for some time now global financial markets and economies have operated alongside an unrestrained and rudderless global monetary “system” (note: not much talk these days of “Bretton Woods II”). There is no gold standard – no dollar standard – no standards. I have in the past referred to “Global Wildcat Finance,” and such language remains just as appropriate today. Finance has been created in tremendous overabundance – where the capacity for this “system” to expand finance/credit in unlimited supplies has completely distorted the pricing for borrowings. As an example, while total U.S. mortgage credit growth jumped from $314 billion in 1997 to about $1.4 trillion by 2005, the cost of mortgage borrowings actually dropped. It did not seem to matter to anyone that supply and demand dynamics no longer impacted the price of finance. Yet such a dysfunctional marketplace (spurred by unrestrained credit expansion) was fundamental in accommodating Wall Street’s self-destruction.

Government finance bubble replaces mortgage finance bubble.

Today, the markets will lend to the Treasury for three months at 21 basis points, 2 years at 84 bps and 30 years at 371 bps. I would argue that this is a prime example of a dysfunctional market’s latest pricing distortion. As it did with the mortgage finance bubble, the marketplace today readily accommodates the government finance bubble. And while on the topic of mortgage finance, the Fed’s prodding has borrowing costs back below 5%. This cost of finance also grossly under-prices credit and other risks.

I would argue that market pricing for government and mortgage finance remains highly distorted – a pricing system maligned by government intervention on top of layers of previous government interventions. These contortions become only more egregious, and I warn that our system will not actually commence its adjustment and repair phase until some semblance of true market pricing returns to the marketplace. Yet policymaking has placed peddle to the metal in the exact opposite direction.

The real economy must shift away from a finance and “services” structure – the system of “trading financial claims for things” – to a more balanced system where predominantly “things are traded for other things.” Such a transition is fundamental, as our system commences the unavoidable shift to an economy that operates on much less credit of much greater quality. But for now, today’s Washington-induced distorted marketplace fosters government and mortgage credit expansion – an ongoing massive inflation of non-productive credit. I would argue this is tantamount to a continuation of bubble dynamics that have for years misallocated financial and real resources. In short, today’s flagrant market distortions will not spur the type of true economic wealth creation necessary to service and extinguish previous debts – not to mention the trillions and trillions more in the pipeline.

Market confidence in the vast majority of private-sector credit has been lost. This bubble has burst, and the mania in “Wall Street finance” has run its course. The private sector’s capacity to issue trusted (“money-like”) liabilities has been greatly diminished. The hope is that Treasury stimulus and Federal Reserve monetization will resuscitate private credit creation; that confidence in these types of instruments will return. I would counter that once government interventions come to severely distort a marketplace it is a very arduous process to get the government out and private credit back in (just look at the markets for mortgage and student loan finance!). This is a major, major issue.

Today’s financial structure has no chance of spurring the necessary economic overhaul. None.

The marketplace today wants to buy what the government has issued or guaranteed (explicitly and implicitly). Market operators also want to buy what our government is going to buy. In particular, the market absolutely adores Treasuries, agency MBS, and GSE debt. There is no chance that such a system will effectively allocate resources. There is today no prospect that such a financial structure will spur the necessary economic overhaul. None.

There is indeed great hope policymakers will succeed in preserving the current economic structure. On the back of massive stimulus and monetization, the expectation is that the financial system and asset prices will stabilize. The economy will be, it is anticipated, not far behind. And the seductive part of this view is that unprecedented policy measures may actually be able to somewhat rekindle an artificial boom – perhaps enough even to appear to stabilize the system. But seeming “stabilization” will be in response to massive Washington stimulus and market intervention – and will be dependent upon ongoing massive government stimulus and intervention. It is called a debt trap. The Great Hyman Minsky would view it as the ultimate “Ponzi Finance.”

As I have argued on these pages, our highly inflated and distorted system requires $2.0 trillion or so of credit creation to hold implosion at bay. It is my belief that this will ONLY be possible with trillion-plus annual growth in both Treasury debt and Federal Reserves liabilities. Private sector credit creation simply will not bounce back sufficiently to play much of a role. Mortgage, consumer, and business credit – in this post-bubble environment – will not re-emerge as much of a force for getting total system credit near this $2 trillion bogey. In this post-bubble backdrop, only government finance has a sufficient inflationary bias to get trillion-plus issuance. But the day that policymakers try to extract themselves from massive stimulus and monetization will be the day they risk an immediate erosion of confidence and a run on both government and private credit instruments. Also as I have written, once the government “printing press” gets revved up it is very difficult to slow it down. This week currency markets finally took this threat seriously.


Ugly View from Below

Mexico has a history of self-inflicted wounds. It also has had ample experience with having strong fiscal/monetary medicine forcibly adminstered by the kindly fellows from the U.S. government and IMF – regimens which may have ultimately helped but were painful enough in the short run. Now Mexico looks north and notices that what was sauce for the goose is apparently not sauce for the gander.

Pain, for Americans? What are those crazy Mexicans thinking?

Spending our way out of a crisis is something new for the U.S., and the policy is taking many citizens aback. But to no one does the spending craze seem stranger than to the inhabitants of the rest of the hemisphere. After all, the U.S. is now reacting to its financial crisis in the very fashion it always told our neighbors not to.

Consider what must be running through minds in Mexico. Mexicans remember all too well their country’s 1995 financial crisis: Politicians had spent wildly before an election; then the government devalued the peso, scaring investors, who lost confidence in Mexico and pulled out. The U.S. Treasury and the IMF moved in to stabilize the peso, with our Treasury helping to arrange loans and assistance worth more than $50 billion. But many U.S. lawmakers did not like the idea. Representative George Miller (D-California) complained that “the bailout rewards speculators playing with middle-class money. The only thing that can correct the crisis is the marketplace, not a bailout.” Here, Mr. Miller was repeating a standard line from what is known as the Washington Consensus, the doctrine that markets, not government, are the solution to financial crises in wayward Latin American countries.

The haste with which our Treasury moved and the high sums involved all had the same superheroes-to-the-rescue feel that Henry Paulson exuded last fall. But that’s where the similarity ended. For Mexico, there was no forgiving stimulus package that followed. The IMF and the Treasury, along with Mexico’s leadership, demanded the opposite of stimulus. Shareholders in banks lost everything. Monetary authorities tightened. Thousands of autoworkers were laid off. As Mexicans were losing their jobs they saw interest rates on their credit cards explode. Small restaurants closed their doors. ... Mexico did indeed recover--and within a year or two. Its banks strengthened, the peso stabilized, and its economy climbed a path to strong growth. ...

But in the current crisis the U.S. is doing exactly what it advised Mexico against doing. Instead of taking the painful steps necessary to reestablish credit, the U.S. is spending at rates that would make Juan Perón proud. Many of the same American politicians who preached to Mexico in the mid-1990s are now calling for unprecedented outlays. George Miller, the Democrat who had opposed the Mexico bailout, recently spoke on the floor of the House, commenting on the stimulus package: “The only question about this package really is, is it large enough?”

Observers from south of the border are quietly aghast. “What the U.S. is doing is like giving sugar to a child who has diabetes,” Ricardo Medina Macías, a journalist from Mexico’s El Economista, told me recently, when I was traveling in Mexico.