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

W.I.L. Finance Digest :: April 2009, Part 4

This Week’s Entries :


How to profit from the next round of commodity-price inflation. Too much stimulation?

In the previous weeks we have posted quite a few pieces recommending or otherwise addressing commodities-related investments. Here is another. The overriding question is whether the great credit reflation being attempted by the world’s central banks and national governments will show up as commodity price inflation, and – if so – when.

Jason DeSena Trennert and his company supply institutional research. He sees nominal GDP reviving in a few months and prices of gold, energy and other commodities continuing to recover. He is hardly alone in that view. He has some additional insights worth considering, such as that the era of buy-and-hold investing, which was appropriate during the long post-1982 bull market, is giving way to an era that will favor active money managers once more – similar to the 1970s.

Start girding for reflation, especially in commodities, cautions Jason DeSena Trennert.

The managing partner and chief investment strategist at Strategas Research Partners in New York, Trennert sees economic activity starting to pick up again, most likely in the second half of this year.

And that means higher inflation in the works, he adds – so it makes sense to invest in Treasury inflation-protected securities, or TIPS, and gold, as well as in certain companies with exposure to energy and commodities.

Trennert, 41, and his team provide research to institutional investors. Last week, Barron’s met with Trennert, who founded Strategas in 2006, in his midtown office to hear more about his take on everything from the implications of credit spreads to a few stock picks.

Barron’s: Let’s start with your overall assessment of the market.

Trennert: There are three potential outcomes, given the financial crisis. There is a deflationary scenario, which we saw globally in the 1930s. There is a traditional recovery, in which early cyclical stocks like financials and consumer discretionary should outperform. And then there is reflation, which means that inflation heats up.

Normally, what would be most common is a traditional recovery, in which the early cyclicals do well. My view, though, is that the enormity of the fiscal and monetary stimuli makes the reflation trade the most likely. In a way, that means that the first shall be last and the last shall be first. In other words, the late cyclicals will probably wind up being better investments than the early cyclicals over the next year.

Could you elaborate?

It is very difficult to rely on consumer spending to be a driver of growth from here. Believe it or not, consumer spending as a percentage of GDP reached an all-time high in 2008 of about 71%, whereas the long-term average has been 65%. That may not sound like a lot, but in a $14 trillion economy, that is about $850 billion.

Even if you believe that the American consumer was incorrigibly profligate, access to credit has been inalterably changed. So consumer spending as a percentage of GDP is going to go in one direction for a long time – lower.

What is causing all of the inflationary pressure you expect to see?

The Fed has tripled the size of its balance sheet, and the Obama administration is comfortable with running deficits that are close to 15% of GDP. The magnitude of that type of stimulus, monetary and fiscal, makes it virtually impossible to stick the landing on inflation.

But I expect it to be somewhat different than the inflation rate you saw in the 1970s, when there was broad-based inflation. So it is very possible that out of this policy, which is essentially focused on creating jobs and creating nominal GDP growth – as opposed to real GDP growth – that you get commodity-price inflation. That would be in the energy and basic-materials sectors – and gold. So those types of companies should do well over the longer term.

Is the equity rally that started in early March a head fake?

I actually believe the market saw its lows in March, but I also believe that we are moving into a period where returns are going to be a little bit like a ground war; that is, the easy part of the rally is over. We are using roughly $60 for Standard & Poor’s 500 operating earnings next year. Even if you assume a conservative multiple of 15, that gives you an S&P 500 of 900, versus around 845 last week.

The good news is that a lot of the fears about systemic risk have faded because of the alacrity and the size of the stimulus that has been put in the system. But getting a sustainable rally from here is going to be more difficult. The irony is that it is probably going to be very good for active management versus passive managers.

Why is that?

Because the bogey is going to be a lot easier to beat. So while the 1980s and ‘90s were great periods for our business, it was not a particularly great time for active managers. That is because multiples quintupled.

In 1981, the fed-funds rate was 20%; by 2001, it was 1.75%. That created one of the great opportunities for returns of all time.

It also made it very difficult for the active managers to beat the index. Right now, fed funds are at zero, and so the only silver lining in this cloud of more difficult returns is that the active manager who is a good stockpicker can add an enormous amount of value. But you also have to contend with lower real GDP growth. We are expecting real GDP growth of minus 2.1% this year and plus 1.6% next year. Still, for portfolio managers, the difference between winners and losers is likely to go up dramatically.

In a recent note, you argued that the spreads in credit markets do not support the sustainability of the rally we have seen in equities since early March.

We have actually gotten some push back on that. Some of the people who spend more time on the credit markets see some improvement there.

Our contention is that whatever improvement you see in the credit markets has not been enough to justify a 30% move in the S&P 500 since early March and an 80% move in the S&P Financials. I do not want to dismiss the slight improvement that has occurred in the credit markets, but I also believe that it is still not at levels that are consistent with a sustainable rally in equities from here. In particular, spreads for Baa [-rated] corporates and jumbo mortgages are wider than they should be.

What is the status of the buy-and-hold investing doctrine?

It is going to be a very difficult way to create outperformance. Even long-only investors are going to have to be more active. Buy-and-hold works very well in a period in which multiples are going in one direction, which is what happened in the ‘80s and ‘90s. But it does not work particularly well when it is difficult to get multiple expansion.

So it is going to be more of a trading strategy that makes sense?

Yes, it is going to be more of a trading strategy and old-fashioned stock-picking. Strategists normally call it a stockpickers’ market when they do not know what is going to happen. But I believe that this is going to a be a period in which the truly active manager who is not afraid to trade around positions or to have more turnover will do better than investors who are basically just picking stocks for the long term.

What about the notion of portfolio diversification, which has taken a big hit?

I wrote a piece earlier this year about all the things that I learned in business school that are not true. Modern portfolio theory, efficient markets and diversification is another part of it. Especially when you get into a liquidity trap, the correlations of all assets basically go to one, so that there is really very little benefit in diversification. And we are in a situation, at least for the moment, where liquidity is hard to come by. So that argues pretty strenuously for trying to hit singles, as opposed to trying to swing for the fences.

What particular concerns do your institutional clients bring up?

We are finding it difficult to discuss some of these issues without getting into political discussions about what has happened in Washington. Our job as analysts is to be as objective as possible. So the biggest concern I hear is basically about government spending.

The question really is, how long can the Fed[eral Reserve] and the administration fix the price of Treasuries, which is what they are doing, and how long can the administration essentially keep a lid on inflation and long-term interest rates given the borrowing needs?

Let’s talk about a few specific investment recommendations.

One would be Lazard [ticker: LAZ]. I like a lot of the midtier brokers – because they have none of the legacy issues, and yet they are very likely to gain a lot of market share and a lot of talent from the big banks. The stock has moved up a lot since early March, from around 21 to 30 and change, and it is relatively expensive right now, trading at around 13.3 times forward earnings. But when the markets do come back, which they will, Lazard should be able to take a lot of share. Plus, Lazard has a traditional money-management operation that should be a big boost to earnings in the coming years.

Next pick, please.

Altria Group [MO]. Discretionary spending is going to remain weak in our view. We also think there is a good chance that tobacco will be regulated by the FDA [Food and Drug Administration], which would essentially freeze the company’s dominant market share. At 9.5 times forward earnings, it certainly trades at a reasonable multiple. It is attractive when you consider that the dividend yield is about 7.6%. Another recommendation is Schlumberger [SLB]. We think of the oil-service sector as a good way to play oil if you think its price is going to rise to $50 to $75 a barrel, as we do. It is also a member of the Strategas Bellwether Index of companies with the highest correlations to swings in nominal GDP.

Another of your recommendations is the SPDR Gold Shares [GLD], an exchange-traded fund and a way to get exposure to gold. What is to like there?

It is attractive because, eventually, global investors are going to recognize that there are limits to what the U.S. can fund easily and, as a result, there is going to be a movement away from dollars into hard currencies. Now, the only reason why the dollar is hanging in there versus other major currencies like the euro and the yen is because they are in just as bad shape as we are. But at a certain point, reflation is a global phenomenon. Eventually, investors are going to decide that having some exposure to hard assets like gold is as good a hedge against inflation.

What is your advice to retail investors?

Unfortunately, the best advice I have for them is that they have to lower their expectations about returns.

How does the future look for equities?

I still believe equities are probably the best long-term source of return for investors. But the era in which a rising tide is going to lift all boats is over. Certainly, it will come back at some point, but it will also expose the differences between money managers. I also recommend that investors have some inflation protection, either with TIPS or gold, because the odds of making a smooth landing on inflation are small. In addition, we are moving from an income-statement to a balance-sheet world.

Which means?

The access to and cost of debt capital may be the single important factor determining which companies gain or lose share. When the market bottomed in 2002, it made sense to buy the most-highly-leveraged companies, because the financial system was in very good shape. That is obviously not the case this time. So for investors considering going back into the stock market, I suggest looking much higher up the quality scale for companies that are just strong enough to access the credit markets, but not so prudish that they will not use debt to gain market share. You want companies with a lot of cash, and the ability to take on more debt if they need it.

Thanks, Jason.


Patrick Welton’s diverse background and knack for sensing market shifts help him deliver good performance while limiting risk.

Patrick Welton made two prescient bets in his younger days: against silver and the Hunt brothers in early 1980 and against the stock market in the fall of 1987. Eventually he decided to forgo a career in medicine in favor of running a hedge fund. The primary goal is to provide good returns without taking big risks, focusing on assets whose performance is not closely correlated with that of stocks and bonds.

Last year Welton’s fund gained 23% thanks to their short positions. Those short positions were of course highly correlated with stocks and bonds returns, but negatively correlated – obviously a good thing last year. According to this synopsis piece from Barron’s, “Commodities generally account for 30% of the portfolio. Currency and interest-rate contracts each make up 25% to 30%, while stock indexes account for about 10%. Welton can go long, short or both.”

When Patrick Welton was working his way through the University of Wisconsin three decades ago, silver futures ran up spectacularly as the Hunt brothers attempted to corner the metal.

The intrepid, and then-19-year-old, Welton decided to risk some of the little money he had by shorting silver. Its price soon collapsed, much to his delight and Bunker Hunt’s dismay. Although that success did not distract him from his original dream of becoming a physician, Welton retained a deep interest in trading.

That interest led him to make another negative bet in the fall of 1987, after stocks had staged a long rally. In October of that year – while Welton was doing post-doctoral work at Stanford – he and his wife, Annette, an intensive-care nurse, shorted an S&P contract in their $10,000 investment account. Again, Welton was right. “We probably made 30% to 40% of my annual salary, which was $30,000,” recalls the investment manager, who now has two children with Annette.

Still they closed the position because they were off to Lake Tahoe. “I remember being on the Tahoe Queen listening to an AM radio, listening to the stock market crashing and crashing and crashing and me calculating. I could not stop calculating how much I could have made. But we couldn’t afford to hold it if we couldn’t be watching it,” he adds.

Today Welton, 48, and Annette run Welton Investment, in Carmel, California. The company, which is registered with the Commodity Futures Trading Commission through the National Futures Association, also has offices in New York and Los Angeles. It specializes in managed futures via its Global Directional Portfolio.

Welton is the CEO; his wife, chief operating officer. Their 19-member team continuously trades in markets around the world, focusing on assets whose performance is not closely correlated with that of stocks and bonds.

At the end of 2008, managed futures assets were $206 billion, while other hedge funds held $1.2 trillion, according to BarclayHedge, a hedge-fund research group.

Unlike hedge funds that often invest in instruments that cannot be sold easily – think credit-default swaps – commodity trading advisors, or CTAs, invest only in highly liquid instruments traded on exchanges. And despite the name, they are not limited to commodities. They also trade options, fixed-income instruments and currency contracts.

Welton’s background is as diversified as his trading strategy. In 1982, he earned a double degree in English and molecular biology from Wisconsin. In 1986, he received a medical degree from UCLA. And in 1990, he got a postdoctoral degree in radiation oncology from Stanford.

While at Stanford, he traded for Commodities Corp., the Princeton, New Jersey, firm where billionaire investors Paul Tudor Jones and Louis Bacon once worked. The Weltons abandoned their medical careers in order to become full-time commodity-trading advisors in 1989.

“One of the big strengths is his diverse background. He can see connections and come up with ideas that are very good,” says Ranjan Bhaduri, managing director and head of research of Chicago-based AlphaMetrix Alternative Investment Advisors, which runs a trading platform for CTAs.

One of AlphaMetrix’s aims is to protect investors from blow-ups caused by concentrated risks. “Our risk-management team is monitoring results in real time. So we know exactly what they are trading per million dollars. If there is any kind of issue, our technology notifies us immediately,” says Bhaduri, adding this has never been an issue with Welton.

While it was down 5.68% through the end of March, the Global Directional Program gained 23% in 2008, a year during which the S&P 500 plunged by 38% and Treasury yields stayed minuscule. Global Directional accounts have an annualized 16% gain since the company’s inception in 2004. Clients pay a 2% management fee, plus 20% of any gains in their accounts.

Welton manages money for institutional investors and for wealthy individuals (who must have investible assets of at least $5 million), plus funds of funds, such as the Grant Park Futures Fund, which is sold by a number of brokers around the country.

In overseeing his investors’ money, Welton diversifies not only across asset classes but also time frames.

In the commodity sector, the program mainly invests in energy assets, including crude oil, gasoline, heating oil and natural gas, as well as the major metals. It also trades agricultural commodities including sugar, wheat, soybeans, hogs, cotton and coffee. Commodities generally account for 30% of the portfolio. Currency and interest-rate contracts each make up 25% to 30%, while stock indexes account for about 10%. Welton can go long, short or both.

About 60% of last year’s gains came from commodities – of that, energy accounted for around 50% and metals and agricultural products each generated 25%. The remaining 40% came from interest-rate positions and some short stock bets. This year, the fund’s currency positions have produced slight gains, while its equity-index trades have slid a bit.

Welton does not take custody of his clients’ assets. Instead, they are held by third parties. In managing the fund, any required margin (roughly a quarter of total assets) is placed on deposit in segregated accounts with prime brokers, such as Goldman Sachs and UBS. The majority of the fund’s remaining assets are held at two institutional money-market funds, each with a triple-A rating, run by units of BlackRock and JPMorgan Asset Management.

This looks like what might become a standard “They/we are not Madoff” piece of boilerplate for hedge funds.

Their results are periodically audited by the National Futures Association, Welton says, and the financial statements are audited annually by Deloitte & Touche.

Right now, the Global Directional Portfolio has positions of up to about 30% in commodities, currencies and interest rates. Stock indexes made up the remaining 10% to 15%.

Investments in accounts run by commodity trading advisors have become more popular with individuals and institutions over the past 10 years, but, of course, they offer risks as well as rewards. “They are most vulnerable at inflection points, where markets change direction.” says Sol Waksman, the president and founder of BarclayHedge.

They also can become the victim of their own liquidity. Barclay’s reports that the industry’s assets under management were flat, year over year, at the end of 2008, despite trading profits of 14.09%. The assets slid from $234 billion in the 2nd quarter to $227 billion in the 3rd and $206 billion in the 4th. Hedge funds sold their holdings simply because they needed the money. However, the fact that CTAs could endure those redemptions without a hiccup speaks well about the liquidity about the investment vehicle, says Waksman.

Global Directional’s assets have grown from $50 million at the end of 2004 to about $510 million today. In 2008, it was added to the investible FTSE Hedge CTA/Managed Futures Index.

Last year, Welton’s 23% gain put him in the top 1/3 among the 993 commodity trading advisors tracked in the Barclay-Hedge database. Of those, 196 returned more than 30%, and 318, more than 20%, according to Futures, a trade magazine.

But finishing at the top is not Welton’s ultimate goal. Providing good performance without taking inordinate risks is. As he puts it: “We are attempting to be essentially in the top quartile of the managers of our class all the time by being distributed in our exposure and distributed in our methods and distributed in our asset classes, at the cost of likely never being at the top of the list.” Then again, given what happened in the stock market last year, 23% does not sound too bad.


Bespoke Investment Group analyzes the stock market. The founders are students of veteran technical analyst and newsletter writer Laszlo Birinyi, whose favorite tool involves dissecting money flows, i.e., large block trades by major funds managers. The Bespoke people pretty well called the market bottom last November, the interim top, and the bottom this past March. Those who paid attention to their calls presumably benefitted.

We are not technical analysis oriented as a primary investment tool, but think it does improve the hand/eye coordination when used as a supplement to fundamental analysis. That said, there is reason to pay particular attention to technical analysis today: The fundamentals are influenced heavily by a historically fragile economic situation which is in turn driven by, essentially, technical factors.

The mortgage finance bubble kept on keeping on until exhaustion and a change in crowd mood – technical factors – brought it to a close. (It’s not the long fall which kills you. It’s the sudden stop when you reach the ground.) There was actually plenty of time to get out near the top as long as you did not insist on trying to catch the exact top. Technical analysis could have helped direct one to, e.g., get out of stocks well before the crash.

Now the the latest and greatest bubble is in government finance. Who knows how long it will continue, but last fall offered a preview of coming attractions for when this bubble pops. The “fundamentals” would have already told you to sell everything, yet this would have left money on the table for those who ignored such factors. With no guidance from fundamentals we have no choice but to look to technical factors, and analysts such as Bespoke.

As the founders of Bespoke Investment Group, which analyzes the stock market, Paul Hickey and Justin Walters pore over tons of data. What they have seen over the past 18 months has been ugly. It is too early for them to call a bottom, the market’s recent rally notwithstanding, because there are so many unknowns, especially around how Washington might try to fix the banking system. Yet they are cautiously optimistic. Hickey, 34 years old, and Walters, 28, launched their Harrison, New York, firm in 2007 after working for veteran market-watcher Laszlo Birinyi. Barron’s caught up with Bespoke’s founders recently to get their latest take on the market – and find out where they see those glimmers of good news.

Barron’s: What is your view of the market from 30,000 feet?

Walters: Since the October 2007 start of the bear market, we have had four bear-market rallies, the most recent starting early this month [March]. The average rally has seen a gain of about 18%. In this rally, we are up about 19% [through Wednesday]. It is still a bear-market rally, until it isn’t.

Hickey: Looking back at the December rally, we thought we were in the clear, and there was a lot of hope surrounding the nomination of Tim Geithner to be Treasury secretary. Then the market lost confidence in Geithner, temporarily, and the Obama administration has sent some mixed signals. Now, the unknowns are sobering. You can come into the office any day and find it is a whole new ballgame.

What is your sense of the Treasury secretary’s recently unveiled plan for a private-public partnership to buy up toxic assets from the banks?

Hickey: Be careful not to read too much into it, because we have had these announcements before. The market rallied at the end of the year on news of the Citigroup bailout, Geithner’s nomination and anticipation of the TALF [Term Asset-Backed Securities Loan Facility] package. But this is another plan. Is it really going to be what it takes to bring the sellers of the bad assets together with the buyers of the bad assets? There have been many stories about money managers’ [fear the government may] decide a year from now it wants a bigger piece of the pie if too much money is made. We do not want to read too much into one-day events. What was more encouraging was that there was a better-than-expected housing report March 23 for existing-home sales. While we have had a series of economic reports that have not been good, they have been beating expectations. That is the key to the market: How it is performing versus expectations?

What is the market worried about?

Hickey: The big wild card is Washington. Are the policies going to be protectionist? There was a report last week that 17 of the G-20 countries have issued some sort of protectionist policy in the last month. That is a big worry.

So many indicators have gotten to levels that are just off the chart. For a lot of them, you have to go all the way back to the 1930s to find comparable periods.

During this severe downturn, what has made it especially hard to analyze the market?

Hickey: So many [indicators we watch] have gotten to levels that are just off the chart. For a lot of them, you have to go all the way back to the 1930s to find comparable periods. Whenever you say the 1930s, that makes people scared.

The Federal Reserve recently announced it would buy up to $300 billion of Treasuries to push interest rates down. What impact is that having on the market?

Hickey: When the Fed made the March 18 announcement, we saw the intraday move not only in stocks, but in every asset class; there was a repricing. Every asset class went up in value because the dollar went down. For all intents and purposes, it is a devaluation of the dollar, though no one says it in those terms. But it is looking more like the yield curve peaked last fall. On a historical basis, that is a very good omen for stocks.

On what grounds?

Hickey: During the nine times going back to 1962 after the yield curve peaked, the market’s performance is overwhelmingly positive. The market has gone higher every single time, and the financials did great as well. It makes sense when you think about it, because while the banks are borrowing at zero and lending out at a price higher than zero, even a kid could make money in that environment.

Both of you sound cautiously optimistic, and more upbeat than many of the people we have spoken to recently.

Walters: We are definitely cautiously optimistic, but you have to look at things on a much shorter time horizon. Let’s say you are looking at consumer confidence when it broke below historical levels. Every indicator pointed to when consumer confidence got this low, the market was higher six to 12 months later. Obviously, consumer confidence has gotten a lot worse, even after that drop.

“Last November, the market got too oversold, and a lot of indicators pointed to a short-term bounce. We moved a lot of our cash into equities. As the market rallied, we took profits, and moved back into cash. And then in early March, when the market got oversold again, we moved back into equities.”

What in particular are you paying attention to?

Walters: We are looking at a lot of indicators in this bear market. In the current rally, we have seen a few outliers in particular sectors’ performance and in market breadth. Those are some of the signs pointing to the rally’s having more legs, and that the bottom might be in. We do not want to come out and say the bottom is in, because it is such an unprecedented time. We use the cash level in our model to let our subscribers know how bullish or bearish we are at the moment. Last November, the market got too oversold, and a lot of indicators pointed to a short-term bounce. We moved a lot of our cash into equities. As the market rallied, we took profits, and moved back into cash. And then in early March, when the market got oversold again, we moved back into equities. Our cash position got up to 70% before we moved back into equities. The model portfolio is now 22% cash and 78% equities.

What are the various sectors telling you about the market?

Walters: During prior rallies in this bear market, energy, materials and telecom have been some of the sectors that led – the more defensive sectors. But during the current rally, financials have led the way, and technology has been a big performer, along with industrials. Those are the sectors that can get out ahead of the market as it starts to turn around. That they are leading the market is one positive.

Of course, they are coming off a very low base.

Hickey: Look at the prior bear market, in 2002 and ‘03. In the initial stages of that rally in ‘03, tech and telecom, which had done horribly until then, were among the best performers. They were not the best performers in the ensuing bull market, but in that initial rally, like the financials now, they were coming off a low base.

What else is catching your eye?

Walters: Emerging-market countries have really started to turn around. China is up 30% year-to-date, and Brazil is up 13%; India and Russia are both outperforming the U.S. The fact that emerging markets have started to turn around and show gains and signs of strength is another positive.

There has been more volatility lately. What is the significance of that?

Hickey: The market is so unsure of everything out there. Investors do not know what is going to happen on the regulatory front, and they do not know what is going to happen on the global-trade front. It is like driving through the fog and a deer jumps out from nowhere. [After] you swerve one way, you have to swerve the other to get back in line, and it creates volatility in the market. Part of it is that hedge funds play a big role. They can either go long or short, and that increases volatility. Another factor is leveraged ETFs [exchange-traded funds], which offer a very easy way for investors to trade in the market with leverage.

What are you seeing with corporate earnings?

Hickey: Since the start of 2008, negative revisions [to analysts’ earnings estimates] have been [more frequent] than positive revisions for the market and for every sector. Since last fall, we started seeing improvements, although right now there are still more negative revisions than positive revisions. So it is moving in the right direction.

What gives you pause about the market recovering?

Hickey: We still want to see what is going to happen with this toxic-asset plan. We are also looking at credit spreads and default risk. For the financials, default risk is still at extremely high levels, though it is coming down and moving in the right direction. The big problem for any company with debt that is maturing or has to be reissued is that it is going to be hard to raise the money in the capital markets, unless we start to see things really loosen up. The stock market has declined more than 50% from its highs, so we think it has started to look forward. But people are wondering if there is another shoe to drop.

There have only been two other times when we have ever had this 12-year negative-trend return in the market, and both times proved a good buying opportunity, at least long term.

What is your advice to investors?

Hickey: We have had so many people ask if they should be putting money into their 401(k) since October 2007. The time to really pause may have been last summer, last spring or at the peak if you had that foresight, which most people did not. With the market down 50%, that is the time most people want to throw their hands up. But there have only been two other times when we have ever had this 12-year negative-trend return in the market, and both times proved a good buying opportunity, at least long term.

Let’s talk about a few stock picks.

Walters: While we may like a stock's fundamental story, we also don't want to step in the middle of a free fall, so we are looking for stocks that failed to make a new low in the most recent leg down from January to early March. This tells us that even during what can only be classified as a miserable period for equities, these stocks have support.

One of these is MasterCard [ticker: MA]. Even though consumer spending has declined, the percentage of transactions completed with plastic continues to rise. For every one of these transactions, whether it involves MasterCard, Visa or American Express, they collect a toll to complete the transaction. While American Express takes on credit risk, MasterCard and Visa have no credit exposure. So even if banks restrict credit-card issuance, consumers will still use debit cards, where MasterCard and Visa are large players.

We find MasterCard more attractive than Visa because of its valuation, which is about 16 times this year’s profit estimate. The growth of credit- and debit-card transactions versus cash is a secular shift. [For more on Visa, please see “The Pleasure of Plastic.”]

What else looks attractive?

Walters: Archer Daniels Midland [ADM] is a weak-dollar play. If the dollar weakens, agricultural commodities will do well. Since bottoming in October, the stock has been in a steady uptrend without skipping a beat.

Another of our picks is Altria [MO], which yields about 7%. Tobacco is recession-resistant, and while there is always litigation and regulatory risk surrounding tobacco stocks, we believe this only helps keep the leaders entrenched in their positions, and no one is stronger than Altria. Also, while politicians like to portray tobacco companies as public enemy No. 1 behind the banks, federal and state governments generate an average of nearly $2.50 of taxes per pack of cigarettes, so politicians would be foolish to kill the goose that lays the golden egg.

One more pick, please.

Walters: Chip maker Intel [INTC]. While it barely made a bear-market low at the end of February, and therefore does not quite pass our basic test, the stock yields 3.55%. With cash making up 15% of its market cap, that is probably one of the safer dividends in the Standard & Poor’s 500.

Thanks very much, gentlemen.


Suncor’s vast reserves in the Canadian oil sands make the Calgary-based energy’s concern a smart bet on the likelihood that crude prices will rebound to $60 or $70 a barrel in the next year.

With its 100 years of reserves and relatively high production costs – cash-costs per barrel of crude are almost $30, versus $10 to $15 a barrel for many conventional producers – Canadian oil-sands leader Suncor (symbol: SU) represents a pretty pure bet on higher oil prices. Its stock soared to $74/share when oil closed in on $150 per barrel and fell to $14 when oil collapsed to $50 before recovering to its current $25. Suncor is also a hedge against the ever-present possibility of turmoil in the Middle East and other oil-producing hot spots the world over. If crude rallies to $60 or $70 a share in the next year, Barron’s sees the stock rising to the mid-30s or beyond.

Alberta’s oil sands represent a set of reserves second in size only to Saudi Arabia’s. The long-livedness of the reserves and virtually zero-risk of drilling a dry hole causes the market to value Suncor at premium PE and cash flow multiples to the major oil producers, who must constantly work against depleting their capital base (comparison table here.) However; this premium disappears in future projections as Suncor’s expansion plans bear fruit. As one analyst phrases it, Suncor is a manufacturing company disguised as on oil company.

In any case, count on the stock rising and falling with the price of oil. It is a poor man’s oil futures – or a more accurate analogy would be long-lived option on the price of oil.

Suncor has been a longtime favorite of energy bulls because the Canadian oil-sands leader has virtually limitless reserves. It has access to oil that could support its current production for an estimated 100 years, versus 10 to 20 years for ExxonMobil and the rest the big integrated energy companies.

Suncor’s status made it a hot stock as oil ascended to a peak of $145 a barrel last summer. With its super-long reserve life and relatively high costs, Suncor was a big beneficiary of $100-plus-per-barrel oil, with its shares rising to a high of $74 last May. The stock consistently commanded one of the highest valuations among large energy producers because it was viewed as the ultimate “call” option, or bullish bet, on the price of crude.

Oil’s plunge to $50 a barrel has hurt Suncor more than its peers, and the stock has slumped to $25 on the New York Stock Exchange after bottoming at $14 in late 2008.

But crude’s decline has hardly destroyed the Suncor story. The company still sits on Alberta’s famed oil sands’ massive reserves, second in size only to Saudi Arabia’s. As a result, Suncor does not have to go far afield or around the world to get its oil, nor does it have to deal with mercurial and authoritarian governments in such places as Venezuela, Russia and Kazakhstan to gain access to the dwindling number of sizable global oil fields.

In fact, Suncor remains a great stock for energy enthusiasts. If crude rallies to $60 or $70 a share in the next year, the stock could easily rise to the mid- to high-30s.

Fetching more than 20 times projected 2009 earnings of $1.10 a share, Suncor does trade at a premium to most big energy companies. First-quarter operating profits ... were weak, falling to about 20 cents a share from 70 cents a year earlier.

In response to the sharp drop in crude prices and its own cash flow, Suncor put on hold a $20 billion Canadian (US$16.3 billion) project to expand its daily oil-sands production to more than 500,000 barrels from the current 300,000 – an effort that was supposed to be finished by 2012 or 2013. Persistently weak oil prices are the chief risk with Suncor because its cash-cost of producing a barrel of crude is nearly $30, versus $10 to $15 a barrel for many conventional producers, because of the energy-intensive process of mining the oil sands.

Suncor faced a key decision in late 2008. It could wait for an upturn in crude prices to restart its expansion project or make an acquisition that could give it the wherewithal to do so. Suncor chose the merger route, and reached a deal in late March to buy Petro-Canada (PCZ), a large conventional energy company whose shares trade around 32, or about $1 below the current value of the deal.

The transaction, if approved by shareholders, will bolster Suncor’s balance sheet and make the combined entity one of Canada’s largest companies by market value, at $39 billion.

While Suncor is not flat-out saying so, investors expect that much of Petro-Canada’s profits will be diverted to Suncor’s oil-sands operations. On a March 23 conference call after the deal was announced, long-time Suncor CEO Rick George, who will retain his position after the merger, said the combined companies will “have a Canadian-oil-sands-centric type of strategy here on a go-forward basis.” About half of the new company’s petroleum output initially will come from the oil sands, but that percentage should grow over time.

“Today, Suncor isn’t a household name, but that will change,” says Charles Maxwell, energy analyst at Weeden & Co. Maxwell, an oil and Suncor bull, believes that the combined company will able to grow its oil output by 5% annually over the next decade. That should stack up well versus the big integrated energy companies, which are struggling to generate any production gains.

Suncor shares do look rich versus rivals’, based on its enterprise value (market value plus net debt) divided by pretax cash flow, a commonly used way of valuing energy companies. Suncor fetches about 7.7 times estimated 2009 cash flow based on the combined Suncor and Petro-Canada operations, according to Credit Suisse analyst Brian Dutton. But that drops to 6.6 times in 2010, assuming oil averages $60 a barrel, and the ratio could fall to five times in 2011, in line with the major integrated oils for 2011.

Dutton calls Suncor more of a “manufacturing” company than a traditional energy producer, given its vast reserves. A fan of Suncor’s management, he sees the stock headed to $35. “The company has ‘visibility and predictability’ of production that many rivals lack,” he says.

While most energy companies run the risks of drilling dry holes or having their oil expropriated by host countries, Suncor does not. It just needs to exploit its existing reserves, in its home country.

Energy prices are not apt to stay depressed indefinitely. And once the market revives, investors should rediscover Suncor’s virtues.


Investment newsletters can lead to riches – but sometimes not for the subscribers. One tangled tale reveals the underside of the stock-promotion game.

Any time you receive a stock tout in the mail or via email you should logically ask why the promoter is sharing the good news with the world. Perhaps he is in a charitable mood. More likely answers are (1) the favored company is paying for the promotion so that the company or its insiders can sell shares, or (2) the touter himself has shares he wants to unload. Even the fine investors and people who appear in the Barron’s Roundtables will not be advertising the stocks they are still trying to buy.

Here Barron’s tracks the machinations of a promotional consortium which specialized in getting the public to take cheaply-bought, close to worthless, stocks off its hands. Their standard M.O. incorporates stock promotions sent by mail. It is probably a good rule of thumb that if you are going to use the services of an investment newsletter, have it be one that you found rather than one that found you.

Calling himself “The other oracle from Omaha,” Mike Schaefer tells his newsletter readers that he learned about stocks hanging around the house of his neighbor, Warren Buffett. On Buffett’s advice, Schaefer says, he became an expert in energy and mining stocks, and, in early 2006, he let thousands of junk-mail recipients in on a “rich man’s secret”: the Calgary-based oil outfit called Gran Tierra Energy. With its team of “oil and gas superstars,” Schaefer said the stock might rise 2,000%.

Schaefer’s “Secrets of Fortune” mailing seemed like just a subscription solicitation for his $495-a-year newsletter. But it also touted Gran Tierra stock (ticker: GTE) in the hire of a stock-promoting crew that has been under investigation by federal prosecutors. Along with ersatz gurus like Schaefer, the promoters were:
Supplying funds for Tompkins and Gottbetter’s deals were Samuel Belzberg, the once-feared corporate raider, and the Houston-based brokerage Sanders Morris Harris.

Gran Tierra Chief Executive Dana Coffield calls his business “one of the most successful start-up companies in recent years.” It reported 16 cents a share in profits last year on the sale of $113 million in oil from wells in the Colombian jungle. Although the stock has fallen to $2.40 from last year’s $8.78 high, Gran Tierra sports a $570 million market cap, because it has pumped out shares as vigorously as oil.

Coffield says he hired Schaefer on the instruction of financier Tompkins. Like all newsletters from Schaefer’s Angel Publishing, Schaefer’s four Gran Tierra mailings carried fine print saying he got no compensation for his recommendation, while mentioning that $750,000 went to an obscure corporation. Wyoming records show the corporation as domiciled on Schaefer’s isolated ranch. Schaefer submitted the corporation’s bills for more than $1 million in “awareness marketing campaigns,” say people who saw the bills.

Gran Tierra’s success to date is unusual among companies promoted by Tompkins, Gottbetter and Schaefer. The other stocks where they collaborated all collapsed after an initial pop. Typical was Alternative Energy Sources (AENSE), an ethanol refiner whose shares peaked at close to three bucks in 2006 – when most trading consisted of blocks going back and forth between accounts controlled by Gottbetter and Tompkins, say people who have seen the trading records.

Not long thereafter, millions of emails spammed out with an Alternative Energy recommendation by Schaefer colleague Jeff Siegel – who has appeared on CNBC as a green-investing guru. Trading volume spiked in the stock, which then unfortunately sold off. It is now nearly worthless; the refinery is shuttered.

Federal prosecutors in Manhattan are investigating whether Tompkins and Gottbetter manipulated Alternative Energy and other stocks. Gottbetter declined to talk to Barron’s, while Schaefer and Tompkins did not respond to voice-mails. When subpoenaed by a court-appointed receiver of the seized profits of a Tompkins associate, Tompkins asserted his Fifth Amendment right against self-incrimination and said that he maintained no business records. He warned associates never to send him emails. He did not even have a personal checkbook, Tompkins testified in marriage-dissolution proceedings initiated three years ago by his wife, a former Miss Florida USA.

“I have a pretty simple business,” said Tompkins in his divorce-case deposition. “It’s stocks.”

But Tompkins’ business appears anything but simple. The Securities and Exchange Commission and the U.S. Attorney for the Southern District of New York began looking into his dealings after the February 2007 arrest of Louis W. Zehil, a Jacksonville, Florida, lawyer whom Tompkins had tapped to counsel the public companies he minted.

In parallel civil and criminal cases, the government charged Zehil with surreptitiously selling at least $17 million worth of unregistered shares in seven companies Zehil was advising, including Gran Tierra. Zehil pleaded not guilty, and his case has not yet gone to trial. A court-appointed receiver took control of Zehil’s bank accounts. The receiver, New York lawyer Susan E. Brune, soon heard from eight Tompkins-financed companies, all demanding compensation for Zehil’s alleged betrayal.

Then something strange happened. The lawyer for one of the companies made disturbing allegations, Brune told U.S. District Court Judge Loretta A. Preska, suggesting that the other companies were not innocent victims. Although the lawyer later said Brune had misunderstood him, Brune launched into a remarkable investigation of Tompkins’ activities, issuing more than 100 subpoenas and reviewing 187,000 pages of e-mails, bank and broker statements and other documents.

Brune passed her findings along to the government, and in June 2008, prosecutors got Judge Preska to halt the companies’ attempts to get at Zehil’s money. The government told the judge it was investigating a criminal scheme to manipulate the stocks of the eight companies, among others, and the companies did not appear to be true victims of Zehil’s fraud. Zehil did not talk to Barron’s.

Government attorneys and SEC-appointed receiver Brune likewise refused comment. People contacted in the case say prosecutors are looking at Gottbetter and Tompkins. Gran Tierra chief Coffield says he knows of no wrongdoing beyond that alleged of Zehil. “I don’t understand why he’s still walking around,” grumbles Coffield. “I am very unsatisfied with the legal system in the U.S.”

Whether or not the investigation yields charges against anyone other than Zehil, public records indicate that Zehil, Tompkins and their associates had developed a lucrative system for promoting stocks.

Tompkins called his Tompkins Capital Group “the leading investor in, and executor of, reverse-merger transactions.” Reverse mergers let a private business quickly come public by merging into a shell company that has a publicly-traded stock. Tompkins worked out of the Madison Avenue office of his lawyer, Adam Gottbetter, who did a dozen deals with Tompkins, secured the construction permit for Tompkins’ $6 million Palm Beach condo and even bore witness to the $11 million settlement agreement in Tompkins’ marital breakup. Tompkins’ associates were not surprised by the divorce, saying Tompkins spent weekends in Las Vegas and many evenings entertaining his retinue at the Los Angeles sushi bar KOI.

In the family-court proceedings, Tompkins said that his gross income in 2005 was about $8.7 million, and he was bringing in more than $1 million monthly in 2006. He had spent a million bucks renovating his New York penthouse, and had a $17 million Venetian-style villa in Fort Lauderdale. He had other homes in Palm Beach and the Cayman Islands, a Bentley and a 38-foot yacht. Including nine offshore bank accounts and 20 brokerage accounts, he acknowledged total assets of $18 million.

His wife believed he had more assets hidden. Tompkins “maintains dozens of financial accounts and conducts business through corporate entities in ‘nondisclosure’ countries like the Cayman Islands and Switzerland,” she said in a court petition.

Gottbetter also did well from his work with Tompkins, buying a $12 million co-op at the Stanhope, a Fifth Avenue landmark. He hired rock icon Southside Johnny to play at his 40th birthday party. YouTube videos show Gottbetter singing with Glenn Tilbrook of the group Squeeze, and leading a dad’s band at fundraisers for the exclusive Spence School for girls in Manhattan.

Some of his securities clients were less impressive. They included Scores Holding (SCRH) the operator of a strip club touted by radio host Stern before it lost its liquor license when undercover officers were propositioned by the strippers. In 2003, Gottbetter cut a deal with the strip club to help finance a South Florida club. Scores would pay his banker’s fee to a corporation he called Jackson Steinem – in apparent tribute to the firm run by the evil Gordon Gekko in the movie Wall Street.

So proud was Gottbetter of his reverse mergers that he applied for a trademark on what he called the “Gottbetter Public Offering.” His Tompkins deals indeed had certain trademarks. The companies caught up in the Zehil case, for instance, had private placements arranged by Sanders Morris Harris and Tompkins’ pal Rob Anderson, a top-producing broker at Canaccord. Sanders Morris’s chief executive Ben Morris did not respond to Barron’s questions. Canaccord said that Anderson no longer worked there, and that it had received no regulatory inquiries on the Tompkins deals.

People were attracted to Tompkins’ deals because his stocks achieved large trading volume, say associates. Regular patrons of these placements included several Swiss banks, the top officers of Sanders Morris, Sam Belzberg and Caymans-based entities associated with Belzberg’s son Marc (Samuel Belzberg declined to speak). The younger Belzberg left New York for Israel in 1992, after the SEC successfully sued him for skirting takeover laws in the Belzbergs’ unsuccessful run at Ashland Oil. Tompkins bragged to colleagues that the Belzbergs were “his guys.”

Most remarkable about Tompkins and Gottbetter’s reverse mergers, however, was how shareholders of the shell companies kept the most valuable piece of the merged company. In the 2006 deal that produced Alternative Energy, for example, private-placement investors like Belzberg got 30% of the shares, company managers, 32% – all locked up for at least a year. But the shell shareholders retained about 37%, and those shares were free-trading. These shareholders traded amongst and between themselves as the stock price rose to the initial peak shown on the nearby stock chart. People who have seen the trading records say that most of these shares were held by accounts that traced back to Gottbetter and Tompkins. Former colleagues say they were aghast that Tompkins’ controlling stock positions were never disclosed in SEC filings.

But as Tompkins said, his business was just about stock. “People lie,” he would tell colleagues, “stocks don’t.”


The imbalances produced by panicky fiscal policy and in some countries monetary policy are considerably larger than the original imbalances that led to recession, so the recovery will be short lived.

Martin Hutchinson sees a measurable economic upturn coming in the second half of this year thanks to vigorous fiscal and monetary policies. But then what? Well it will depend on the country and its particular policies: “As in 1929-41, government bungling has in most countries made the recessionary experience much more unpleasant and prolonged than it needed to be. Governments never learn!”

The alphabet soup of possible shapes for this recession is now clarifying somewhat. The recent strength in several U.S. and global indicators, before fiscal stimulus has had time to kick in, indicates that the panic among governments after September’s financial crisis was overblown. Indeed, the strength in economic indicators, combined with the global stock market rise and the impending kick-in of “stimulus,” suggests that the initial trough may be short-lived, with apparent recovery swift and robust. Unfortunately, the imbalances produced by panicky fiscal policy and in some countries monetary policy are considerably larger than the original imbalances that led to recession, so the recovery will be short lived. A year from now, we will probably be diving into a second global “dip” of recession that may well be deeper than the first, and is certainly likely to be much more prolonged.

There are some countries for which this is not true; those which, for one reason or another, did not adopt the prevalent global pattern of monetary laxity and fiscal hysteria. Poland, for example, was always likely to get in trouble from this recession, because it ran a balance of payments deficit, and over 5% of its Gross Domestic Product (GDP) came in through foreign direct investment, which has dropped sharply. However, instead of engaging in massive “stimulus,” Poland allowed the zloty to depreciate by about 30% against the euro since July 2008, while its M3 money supply, up 17% in zloty terms, declined in euro terms by over 10%. Poland also benefited from two other favorable factors: Its economic structure is relatively free-market and its government relatively small, spending only 25% of GDP. Consequently, Poland’s exports have held up well in zloty terms, while its balance of payments is improving rapidly and it appears likely to avoid outright recession. Once global economic recovery arrives, Poland will have no “imbalances” to correct and so should return quite quickly to its trajectory of around 4% to 5% annual growth.

Because of its large international debts, Brazil has since 2002 run a fairly tight fiscal policy and an extremely tight monetary policy, with short-term interest rates of 13.5% going into this recession, against domestic inflation around 6%. Brazil shares with Poland the benefit of a relatively small government, but its economic structure is bedeviled by inefficiencies put in place by past governments, particularly the dead weight of the public sector, irremovable by the 1988 Constitution. Like Poland, it did not have the option of vigorous fiscal and monetary stimulus, which would have caused the Brazilian real to collapse and produced a debt default. Instead, the real has declined by about 27% against the dollar, while domestic interest rates have remained in double digits, allowing only modest domestic reflation. Consequently, Brazil is projected by the Economist panel to suffer only a 1.5% decline in GDP in 2009, with 2.7% growth in 2010 – a forecast that may well be too pessimistic.

South Korea, also, has been affected by the Western banking system collapse and by the sharp fall in Asian exports. However, through allowing the Korean won to decline by 23% against the dollar, it has limited the decline in its exports and caused its balance of payments to swing into sharp surplus. Like Poland and Brazil, Korea has implemented only limited stimulus. The Economist forecasts a budget deficit of only 3.5% of GDP in 2009. Unlike Poland and Brazil, the Economist forecast a sharp recession for Korea, with GDP declining more than 5% in 2009. Given Korea’s relatively small public sector and open economy, that looks much too pessimistic. In any case, also like Poland and Brazil, there will be no reason for Korea’s economic recovery to be delayed once its economy has bottomed out.

All three of these countries have survived the downturn through what in the 1930s were called “beggar my neighbor” devaluations, the policy followed by 1930s Britain under Neville Chamberlain to great success. By definition, not all countries can follow such policies, and indeed even these three moderately substantial countries – by following these policies – have made the position of their neighbors more difficult.

IMF aid will go predominantly to the least-productive countries.

For most other poor and middle-income countries, the constraints against uncontrolled monetary and fiscal stimulus are strong because of the danger of financial collapse due to their fragile credit positions. In the context, the expansion of International Monetary Fund lending facilities, if it takes place, will be thoroughly unhelpful. In IMF-favored cases, such as Mexico, unconditional IMF facilities will allow the countries to purse more expansionary fiscal policies than would otherwise be possible (this danger also exists in Poland, but the Polish government is pretty sensible). In other cases, the prospect of IMF conditionality is so unpleasant that countries like Indonesia will seek to avoid it at all costs. Thus, most IMF help will go to such countries as Pakistan, Ukraine, Hungary and Latvia where past profligacy has been so great that no non-IMF solution is possible. In other words, as has been the case for so much of recent “stimulus” programs, the extra IMF aid will go predominantly to the least-productive countries.

In the rich world, the Polish solution has not been tried, as memories of the 1930s make competitive devaluation unacceptable even if, in a closed planet, it were possible. Instead, most governments, with the partial exception of Germany and France, have indulged in expansionary fiscal policies, many of them running budget deficits up to unprecedented (in peacetime) levels of around 10% of GDP. In monetary policy, there is a difference between the U.S. and Britain, which have both been highly expansionary to counteract the effect of their banking collapses, and the Eurozone and Japan, which have cut interest rates but maintained monetary growth at moderate rates – 7% in euro M3 in the 12 months to February 2009, for example.

It now seems likely that the next few quarters will see an economic bounce.

It now seems likely that the next few quarters will see an economic bounce. The rate of decline of economic indicators has slowed sharply in almost all countries. Confidence indicators such as the University of Michigan sentiment indicator have ticked up, albeit from very low levels. The worrying collapse in Asian trade has turned around, showing itself to have been a largely a matter of inventory correction in the supply pipeline to the U.S. consumer. In countries such as Britain and the United States, where monetary policy has been exceptionally expansive, this expansion has doubtless played a part also – and even in the EU and Japan, monetary policy has been far from contractionary.

Now the fiscal stimuli are about to kick in – in the U.S., for example, the modest Obama tax cuts are appearing in April pay packets. While the economy is so far below full capacity, these stimuli will have the expected Keynesian effect in boosting demand further. If you asked me to guess, I would expect that the 3rd and probably 4th quarters of 2009 would show quite robust global growth.

China and India are both special cases.

Then what? In only a few countries, like Poland, Brazil and Korea, one could in isolation expect growth to continue, producing a normal-strength business-cycle upswing. China and India are both special cases. In China, infrastructure investment should also produce an upswing, but with the caveat that the problems in the Chinese banking system have not gone away and may be getting worse – thus the future trajectory is more or less unknowable. In India, the fiscal deficit is so large, and the prospects for reform if a Congress-led government wins the current election so poor, that, absent an unexpected BJP triumph, it seems likely that growth even if it resumes will be sluggish and interrupted over the medium term.

In the rich West, there will be two factors tending to impede growth. In some countries, such as the U.S. and Britain, rapidly rising inflation will pose the authorities with a problem they will urgently need to deal with. In most other countries (but only marginally in France and Germany), large fiscal deficits will produce a “crowding out” effect by which private investment is stunted by the excessive demands on credit from the public sector deficit. Both these imbalances will be larger than previous imbalances that the recession has corrected, notably the U.S. payments and savings deficits, which were 6% and 8% of GDP, respectively, compared to the 2009 budget deficit’s 12% of GDP.

Bernanke’s claim that the Fed will remove liquidity when it needs to is pure hogwash. The U.S. economy will relapse into inflationary stagnation.

Countries with both large budget deficits and inflation will pay a pretty obvious price: Higher interest rates, which will impose costs across the economy. Federal Reserve Chairman Ben Bernanke’s claim that the Fed will remove liquidity when it needs to is pure hogwash. The Fed will be slow in reacting as it almost always has been with inflation, because it will be politically much easier to deny that inflation has become a problem. Hence, inflation will get a major hold on the economy, and the combination of inflation and excessive budget deficits (which were not a problem in 1979-82 – the federal budget deficit peaked at 6.6% of GDP in 1983, after inflation had been broken) will prove exceptionally intractable. The recession will not be W shaped, because there will not for several years be a final upward swing from the W. Instead, after a sharp middle upswing, which is now beginning, the U.S. economy will relapse into inflationary stagnation, the right-hand side of the W becoming an L or even declining further.

In countries without inflation, such as Japan, India and the Eurozone countries with excessive budget deficits, there will be no inflationary signal of trouble. Instead, the recovery will much be weaker than in the U.S. and the U.K., because it will lack the exceptional monetary stimulus and will be retarded by excessive public sector deficits. The pattern will be that of late 1990s Japan, with the bottoming-out process exceptionally prolonged – a very sluggish U-shaped recession. In these countries, particularly in Japan, Ben Bernanke’s favorite demon of deflation, prolonged price declines, is also possible. The correct solution will be a combination of moderate monetary laxity and severe fiscal tightness, similar to Poland’s current policy, which will both remove government’s drag on the economy and allow prices to resume a gentle rise.

Over the next five years, it will be better to be Polish, Brazilian or Korean than Japanese, Indian or Anglo-American.

The reversal of recovery in the inflationary countries and the lack of recovery in the deflationary ones will make economic recovery in even the paragons of Poland, Brazil and Korea sluggish, because of the lack of buoyancy in their export markets. Nevertheless, over the next five years, I would rather be Polish, Brazilian or Korean than Japanese, Indian or Anglo-American.

As in 1929-41, government bungling has in most countries made the recessionary experience much more unpleasant and prolonged than it needed to be. Governments never learn!


If British governments return to their pre-1979 high-tax ways, as seems likely, what will happen to what is left of London’s financial services business?

Martin Hutchinson has written previously of the decline and fall of the City of London’s financial services business. A good deal of the decline was inevitable with Britain’s decline in fortunes, as its empire fell apart in the conflagration of the two world wars. But part of the decline was due to self-inflicted wounds, according to Hutchinson, such as ill-advised deregulation in the 1980s, and high British tax rates which deprived the financial industry of capital and drove high-earners offshore.

With Britain apparently returning to pre-Thatcher confiscatory tax rates, what will happen, ponders Hutchinson, to what little remains of the British financial services business? More shrinkage of market share, and more migration out of the country. And the London office building market may suffer the fate of the equivalent New York market in the 1930s. Particularly grim is the forecast for the trading floors of Canary Wharf, which lack architectural distinction, adaptability and convenient location. They “would become cavernous echo-chambers, home only to bats and rodents feeding off decades-old junk food wrappers.”

Amazing how much destruction governments can create without firing a shot.

Last Wednesday’s British budget did very little to rectify that country’s yawning fiscal deficit, but what little it did was almost entirely at the expense of the country’s high-income earners, those making over 150,000 pounds ($210,000). The fascinating question is: if British governments return to their pre-1979 high-tax ways, as seems likely, what will happen to London’s financial services business?

Not content with raising the top marginal income tax rate from 40% to 45% last November, Chancellor of the Exchequer Alistair Darling raised it again to 50%. Two tax increases in one year will certainly start to convince affluent Brits that this has become a habit, as it was with previous Labor governments. Indeed, yawning future budget deficits, and the accompanying financing difficulties, are likely to lead to further such increases. Now the EU wants to impose a Europe-wide statutory limit on bankers’ bonuses.

In the 1930s, you did not want to own a major Manhattan office building. 40 Wall Street, for example, briefly the world’s tallest office building before being eclipsed by the midtown Chrysler Building and Empire State Building, leased slowly during the 1930s, for rents about half those projected at the time of its construction. The building defaulted on its bonds in 1935 and was still failing to cover even senior debt charges four years later, at which time it was only 81% occupied.

Brokerage firms, expected to be the building’s premier tenants because of its location next to the Stock Exchange, both went bankrupt and downsized sharply during the decade, so that even the main office of Merrill Lynch, then as later the country’s largest retail broker, took up only one of its 87 floors. Mind you, if you were a tenant the fringe benefits were great. Remodeling was done at cost, many repairs were free and the building ran a free shopping service and provided embryonic IT services, fixing tenants’ ticker tapes that seized up. Fortune magazine’s superb July 1939 celebration of New York (timed to coincide with the World’s Fair) tried to put a brave face on the building’s fate, and it did much better after World War II, but for a decade or more the struggle for its owners was grim.

This time around, much of the Manhattan financial services sector has already migrated to New Jersey, where its absence will be largely hidden from general view as its offices are adapted to Mafia-run light industry and hazardous waste disposal. In any case, given the size of the U.S. economy, at least the great bulk of U.S. financial services will remain domiciled in the country, very largely in the New York area, so Manhattan real estate should not suffer as it did in the 1930s.

It is London whose office buildings may suffer the fate of 40 Wall Street, or much worse. Should the London financial services business relocate, the trading floors of Canary Wharf, lacking 40 Wall Street’s architectural distinction, adaptability and convenient location, would become cavernous echo-chambers, home only to bats and rodents feeding off decades-old junk food wrappers. In the City of London proper, the smaller and older buildings would readily re-adapt to small-scale mercantile operations, and only the largest and most opulent offices would lie derelict. Needless to say, petty criminals would benefit more from such dereliction than the British Exchequer or the staggering British economy.

It may be objected that the City of London survived tax rates on income far higher than Darling’s current effort, with top rates above 90% for most of the period 1939-79, and remaining higher than today until Nigel Lawson’s budget of 1988 (one of Lawson’s worst mistakes was in waiting so long to reduce the top rate from 60% to 40%, thus ensuring that the City boom of the 1980s occurred in an atmosphere of tax evasion). Indeed, in one spectacularly awful budget designed by the allegedly moderate Roy Jenkins in 1968, the top income tax rate was levied at 135%. (Jenkins, in most respects no fool, recognized the adverse supply-side effect of tax rates above 100%, so imposed the levy retroactively on the previous year’s income, legally and constitutionally disgraceful but economically less self-defeating.)

To optimists pointing out smugly that those four decades of economically suicidal top tax rates did not destroy Britain’s financial services businesses, I would respond that they came damn close. The jobbers, partnerships that made markets in British shares, were taxed at top marginal income tax rates on their profits, while inflation rates of up to 25% eroded their capital base. Consequently by 1980, they were far too undercapitalized to play their proper role in the capital market, and fell victim to the misguided “big bang” reform of stock exchange trading. The merchant banks also had their capital bases halved in real terms by the 1970s inflation and sterling devaluation, and their partners were no longer rich enough to inject additional capital. Consequently, they also were too small to compete with the U.S. and Continental behemoths when the “playing field” was so misguidedly “leveled.”

The 1986 Financial Services Act was a bureaucratic nightmare, which left investors far worse protected than they had been under the previous “gentlemanly capitalism,” and together with “big bang,” delivered the British-owned houses trussed up as victims to foreign predators. However, because of the decimation of British wealth caused by the taxes and economic ineptitude of previous decades, it may well have been inevitable, if Britain was not to fall behind entirely in the race for internationally-sourced business.

The merchant banks, brokers and jobbers of 1939-79 were deeply attached to British-domiciled institutions and deeply rooted in British society. They and their senior staff had very little alternative but to remain passively in place for the Exchequer to loot. Those controlling the limited international corporate and capital markets business of those highly protectionist and unglobalized decades also had very little alternative but to transact their business in London. Even so, much investment management business migrated to Switzerland, not historically a major home for global private wealth and investment management, but free from the capital controls and intrusive regulations and taxes of London.

However, New York, the principal potential competitor to London, was artificially split between commercial and investment banking, and the investment banks were undercapitalized and focused almost entirely on the gigantic U.S. domestic market. Hence, with a considerable amount of wobbling by the late 1970s and early 1980s, London houses were able with difficulty to maintain their position, and even to regain some of the capabilities that had been destroyed by World War II and the decades of exchange controls.

Since the destruction of almost all the historic British financial institutions in 1986-2000, the picture is very different. A high proportion of the participants in the London market are foreigners, and even British participants are much more securely members of the international moneyed elite than of the decayed British aristocracy or impoverished middle class. The significant London financial institutions are almost all headquartered outside Britain, and their London staff have caused the head offices endless cost and risk over the last few years by their careless attitude to the parent institution’s risks and insatiable appetite for their own rewards.

Potential clients are themselves global, with corporations manufacturing worldwide and run by rootless M.B.A. management, while the wealthy are almost entirely from non-U.K. cultures, possibly effectively without any domicile at all if their home country has been taken over by crooks, thugs or Marxists. In any international business, London is no longer without serious competition. For one thing most owners of London financial houses have taken good care to install equivalent capabilities in their home country headquarters.

In such an environment, the government appears to believe that by turning a blind eye to foreigners’ tax evasion, it can preserve London’s capabilities. However, this is probably wrong (although imposing full British taxes on foreigners would kill the City even faster). British bankers will not wish to continue forever as impoverished valets to their wealthy foreign overlords; they will migrate to some non-U.K. jurisdiction where they are not grotesquely discriminated against by the local tax authorities. Their employers, finding London an expensive place in which to do business, no longer with any great advantages in terms of local expertise, will move London’s operations back to their headquarters, or to third-country tax havens. Foreign staff, finding themselves far from home in a declining business environment where their wealth is fiercely resented by the impoverished overtaxed locals, will seek some alternative low-tax domicile.

If the EU caps bankers’ bonuses (at a level that after the next few years of inevitable inflation will seem laughably inadequate), this will merely ensure that the international financial business moves to New York, Shanghai, Dubai, the Caymans or (my guess) Singapore, rather than to Frankfurt, Paris or even Dublin.

Much of the financial glory of the past two decades is one with Nineveh and Tyre in any case. No regulator will ever again believe in bank self-management of risk. And hedge funds, the obvious alternative homes for the financially adventurous, will find it impossible to attract either equity capital from newly suspicious institutions or debt finance from newly cautious banks. However, even within this duller, diminished universe, London’s market share is almost certain to shrink, as successive British governments seek to finance their overspending habits and close the resulting deficits from the resources of the ever-dwindling number of rich.

The British economy may not quite experience the traumas of the United States in the 1930s (though Britain’s GDP has already fallen as much as in the better-managed British 1930s, without much hope of subsequent vigorous recovery as in 1932-37.) However, the London office market, particularly that in the isolated and unreusable Docklands, will almost certainly suffer a downturn that will make the grim New York 1930s market seem the epitome of prosperity.


Repeat after me: There ain’t no such thing as a free lunch.

Doug Noland believes the unfolding government finance bubble could ultimately destroy the creditworthiness of the entire economy. As with the previous bubble, the mortgage finance bubble, the markets too easily and for too long accommodate massive credit expansion ... until they don’t. At some point, as we have recently seen, raging greed turns to panicky fear “and a reversal of speculative flows marks the onset of the bust.”

The massive inflation of inherently non-productive government credit ensures this inevitable crisis of confidence. The debt can only be serviced by the creation of more debt. “And this Ponzi Dynamic is The Greatest Cost to what I fear is a continuation of unsound policymaking.”

Strong stuff. We find the analysis to be compelling.

An astute analyst posed the following question yesterday: “The current debate is centered on whether the Fed can take back the liquidity in time in order to prevent inflation. Suppose it can. Suppose they execute this perfectly. But if the Fed is able to flood the system with the liquidity (thus reducing the severity of the downturn) and take it back before it causes inflation, it seems there is a free lunch. We get something for nothing. So, assuming a perfectly executed game plan by the Fed, is there a cost? Do they keep rates low for a time, only to raise them a lot a year down the road – is that the cost? Or is there another cost?”

I am short on time today, so I will attempt a brief response.

First of all, while it often appears otherwise, finance provides no free lunch. The mispricing of credit and misperceptions of risk in the marketplace have deleterious effects, although their true impact may remain unexposed for years. Indeed, the more immediate (and always seductive) consequences of loosened financial conditions tend to be reduced risk premiums, higher asset prices, and a boost to economic “output.” Conventional analysis of monetary policymaking still focuses on “inflation” and “deflation” risks. I would strongly argue that our contemporary world has already validated the analysis that acute financial and economic fragility are major costs associated with market pricing distortions.

When the Federal Reserve collapsed interest rates following the bursting of the technology bubble, the results seemed constructive. Stock and real estate prices inflated; a robust economic recovery ensued. There was at the time some recognition of the potential for real estate excesses. But this was seen as such a small price to pay in the fight against the scourge of deflation. It was not until 2007 that the nature of the true costs of a massive “reflation” began to come to light. [Ed: Many, e.g., the Austrians, understood the costs from the beginning.]

Many would today argue that it was simply a case of the Fed’s failure to take the punchbowl away in time. Such analysis misses a key facet of bubble dynamics. Once the mortgage finance bubble gained a foothold there was absolutely no way policymakers were going to be willing to risk bursting such a consequential bubble.

An unfolding worldwide government finance bubble, amazingly, dwarfs even the mortgage finance bubble. It is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic bubble.

I see ample support for my view that bubble dynamics have taken root throughout government finance. This unprecedented inflation includes Federal Reserve credit, Treasury borrowings, Agency debt, GSE MBS guarantees, FHA and FDIC insurance, massive pension and healthcare obligations, the myriad new market support programs, etc. This government finance bubble is domestic as well as global. Amazingly, the scope of the unfolding bubble dwarfs even the mortgage finance bubble. And, importantly, it is reasonable to presume that the Federal Reserve will find itself in the familiar position of being trapped by the risk of bursting a historic bubble.

Similar to mortgage finance 2002-2007, the marketplace is significantly mispricing the cost – and failing to recognize the risks – of a massive inflation of government finance.

So I see the probabilities as very low that the Fed will reverse course and impose tightened liquidity conditions upon the marketplace. Actually, reflationary pressures may force the Fed to increase its Treasury holdings in an effort to maintain artificially low interest rates. At the same time, I do not see higher inflation as the greatest cost associated with this predicament. Much greater risk lies with the acute systemic fragility that I believe is inherent to major bubbles. Similar to mortgage finance 2002-2007, the marketplace is significantly mispricing the cost – and failing to recognize the risks – of a massive inflation of government finance. And while every bubble has its own dynamics and nuances, the unfolding government finance bubble has even more precarious Ponzi Finance dynamics than the mortgage bubble.

The markets are on tract to accommodate $2 trillion or so of Treasury issuance this year. This incredible amount of debt creation is in the range I would expect necessary to temporarily stabilize the U.S. (“services”) bubble economy. Importantly, this amount of new finance both plugs financial holes and works to stabilize inflated income levels. From yesterday’s [April’s] income data, one can see that Personal Income was up 0.3% year-over-year to $12.04 trillion. And while 0.3% is very meager growth, without massive government fiscal and monetary expansion (inflation) the economy would have suffered a destabilizing income contraction. Keep in mind that personal income has inflated 65% since 1998 and 33% from 2003.

Panicked policymakers see no alternative than to try to sustain the current (deeply maladjusted) economic structure.

I will try to explain my belief that dangerous Ponzi Finance Dynamics are in play with the current course of policymaking. First, I view panicked policymakers as seeing no alternative than to try to sustain the current (deeply maladjusted) economic structure. A more natural course of economic adjustment – from finance and consumption-driven bubble economy to a more balanced system – was going to be much too painful to endure. So a massive government inflation was commenced in desperation – with the grandiose objective of revitalizing securities markets, housing prices, and the overall U.S. economy. I just do not see how this reflation goes much beyond stoking a susceptible artificial recovery.

With government finance now completely dominating the credit system, one cannot even begin to contemplate how this process might nurture an effective allocation of financial and real resources.

First and foremost, with government finance now completely dominating the credit system, I cannot even begin to contemplate how this process might nurture an effective allocation of financial and real resources. Indeed, I see today’s manifestations of credit bubble dynamics as an extension of similar mispricing, misperceptions, and over-issuance that led to last autumn’s near financial collapse.

This extra layer of debt only delays and sidetracks the necessary adjustment process and, importantly, exacerbates system vulnerability.

Admittedly, the massive extension of government credit and obligations works wonders in stabilizing a devastatingly impaired system. Inflationism is always seductive; $trillions worth is absurdly seductive. Yet this extra layer of debt does little to affect change to the underlying economic structure. Actually, a strong case can be made that it only delays and sidetracks the necessary adjustment process. And, importantly, this enormous additional layer of system debt exacerbates system vulnerability.

There are no benefits – only escalating costs – to throwing massive credit inflation upon an unhealthy economic structure. ... A massive expansion of non-productive credit – obligations that are created without a corresponding increase in real economic wealth producing capacity – which can only be serviced by the creation of more debt obligations.

At the end of the day, a system is made or lost on the soundness of its underlying economic structure. I posit that a sound economic structure is reliant upon only moderate credit growth and risk intermediation. Our system requires massive credit expansion and intensive risk intermediation. I would also posit that there are no benefits – only escalating costs – to throwing massive credit inflation upon an unhealthy economic structure. And, returning to Ponzi Dynamics, one of the major costs to such inflationism is a massive expansion of non-productive credit – obligations that are created without a corresponding increase in real economic wealth producing capacity. The debt can only be serviced by the creation of more debt obligations.

The massive inflation of non-productive credit that ensures the unavoidable crisis of confidence. The government finance bubble is on track to destroy the creditworthiness of the entire economy.

The danger is that markets too easily and for too long accommodate massive credit expansion during the boom. Federal Reserve policies are fundamental to this dynamic. But at some point and out of the Fed’s control, as Wall Street learned, greed inevitably turns to fear and a reversal of speculative flows marks the onset of the bust. And it is the massive inflation of non-productive credit that ensures the unavoidable crisis of confidence. Can the underlying economic structure service the mounting debt load or, instead, is it the massively inflating debt load that is sustaining a vulnerable economy? And it is in this vein that I fear the government finance bubble is on track to destroy the creditworthiness of the entire economy. And this Ponzi Dynamic is The Greatest Cost to what I fear is a continuation of unsound policymaking.


It’s Alive!

From alfalfa to zinc, prices are on the march again.

The commodity bull is showing signs of life. after falling into a comatose state of declining prices and waning investor participation, key indexes have reanimated: The Dow Jones-AIG Commodity Index gained 3.96% for the month of March, while the Standard & Poor’s GSCI recorded a 4.51% gain. These indexes each track a basket of products, ranging from crude oil to gold to soybeans, with each assigned a specific weight reflecting worldwide production and active trading of a physical commodity.

Analysts and index watchers suggest the March gains could hold clues to the overall economy’s health: “Modest increases in commodity prices are a sign that demand is coming back to the market,” says David Krein, senior director of institutional markets for Dow Jones Indexes.

The March increase is also a sign that financial markets may have found some degree of stability, says Andrew Karsh, co-lead portfolio manager of the Credit Suisse Total Commodity Return Strategy [ticker: CRSOX], which was valued at approximately $1.8 billion as of March 31. “Once you have stability, this can lead to a furthering of an upside from a commodities perspective, as the global economy starts to digest the stimulus – which will then lead to further inflation as the monetary system starts to rebound,” Karsh adds.

Analysts and index operators say the components leading the gains are also telling. Industrial metals like copper drove the gains in March, with the S&P Copper Index up 16.79% and the DJ-AIG Copper Index up 19.32%. Preliminary April data show continued gains for the metal, which is heavily used in manufacturing and infrastructure.

“The S&P Copper Index has been one of the best component performers within the index this year, indicating that there is some potential for an economic recovery,” says Michael McGlone, S&P director of commodity indexes. Copper prices have been buoyed of late by signals of increasing Chinese demand.

In addition to industrial metals, agriculture also performed well in March, as prices increase ahead of farmers’ spring-planting decisions.

The energy sector has been one of the weakest performers in commodity indexes since mid-2008, in part owing to crude oil, which got hammered by economic weakness, excess supply and contango in the futures market. (Contango occurs when deferred contracts are priced higher than nearby months, making a roll-out of nearby futures expensive for market participants.)

Still, the energy component did manage a small gain in March: 4.72% for the S&P Energy Index and 4.40% for the DJ-AIG Energy Index. Index-trackers will be keenly watching energy to ascertain whether hints of economic recovery are paying out in the oil market.

Of course, one month of gains does not a decisive uptrend make. Christopher Burton, co-lead portfolio manager for CRSOX, says the commodity downtrend has been broken, but “the question is whether it will result in an uptrend near term or if it will be more flat.” The prognosis: The commodity bull’s vitals are improving, but more time is needed for a full awakening.

Phoenix Leads Nation in Home Price Declines in February

City’s home prices off 51% from their peak.

A new report shows home prices across the country continued to drop in February, and Phoenix has the unfortunate designation of loss leader. Phoenix home prices fell 35% from February 2008 to February 2009, according to the new S&P/Case-Shiller 20-city home price index. That is the largest decline of any of the 20 largest cities in the U.S. In addition, Phoenix home prices are down 51% from their peak.

The weak housing market continued to plague home sellers in February as home prices extended their losing streak to 31 consecutive months ... The entire 20-city index fell 18.6% for February, compared with a 19% year-over-year decline in January. The good news is the pace of year-over-year slowing lessened for the first time since October 2007.

While it is too early to tell, the less intense drop in February could signal a bottoming out of the national housing market. Of the 20 cities in the index, 16 recorded smaller declines in February than in January.

Rounding out the five biggest declines were Las Vegas, San Francisco, Miami and Los Angeles.