Finance Digest for Week of March 1, 2004

TRADITIONAL INVESTMENT STRATEGY

Many of the recent faddish strategies born during the great bull and bubble market of the 1990s emphasize buying. In contrast, traditional investment strategy emphasizes saving, safety, and sound sleeping. The fads hold out the promise of striking it rich -- making it big -- while traditional investment strategy is simply geared toward making your life better. That is why it is sometimes called the traditional investment philosophy, because there is some thought to it and it is geared to promoting your values and beliefs.

The first few steps in this strategy have nothing to do with buying corporate stocks. First and most important is to get out of debt. Getting out of debt is easy. All you have to do is nothing. Just stop spending. Consume less. Stop the financial gimmicks and get those credit cards paid off as soon as possible.

FINDING VALUE IN FOREIGN LANDS

One fund that rode the wave of strong performance from foreign equity markets last year was Vanguard International Value Fund. The $1.7 billion portfolio soared 41.9%, vs. a gain of 38.6% by its benchmark, the MSCI EAFE Index, and a 37.4% return from the average international equity fund. For the five years through January, the fund rose an average annualized 4.7%, vs. 2.3% for its peers.

Ajit Dayal is part of a four-person management team from Hansberger that oversees the portfolio. Palash R. Ghosh of S&P’s Fund Advisor recently spoke with Dayal about the fund's strategy. Edited excerpts from their conversation follow.

A NEW ASIAN SUPERPOWER

India is a legitimate investment opportunity right now. Its GDP will rise 8% in 2004 -- and maintain a 7.5% growth rate well beyond 2005. (By comparison, the United States is only expected to grow 4.3% this year.) Its stocks trade for just 16 times earnings, and money is just staring to flow into the country. Every industry from IT to finance to biotech will grow in the next 12 months. That means corporate profits will swell -- which, in turn, will lead to predictable double- and triple-digit stock gains for investors.

To be a legitimate superpower, you must have a large talent pool of educated people to provide these services. India does. There are more IT directors working in Bangalore (150,000) than in all of Silicon Valley (120,000). Between one-third and three-fourths of all IT development is done overseas -- with India leading the way. Many market watchers liken India to China ten years ago.

DO WE TRUST MARKETS OR MONOPOLIES TO SERVE TELECOMMUNICATIONS CONSUMERS?

The Cato Institute’s director of telecommunications studies Adam Thierer recently questioned the conservative credentials of Grover Norquist, Bruce Fein and Jim Glassman with the assertion that they are somehow “pro-regulation” for supporting Bush Administration policies to open the local phone monopolies to competition, by allowing competitors access to the Bell monopolies’ infrastructure to offer local phone service. This is not about “atonement” for their monopolistic sins, though, it is about requiring the Bells to lease access at compensatory rates, plus profit, to networks built with ratepayer money during nearly a century of government protected monopoly. Mr. Thierer argues unpersuasively that the Bells are no longer monopolies. In fact, since the passage of the Telecommunications Act of 1996, local competition has developed at a glacial pace and the Bell monopolies still control between 85% and 90% of the local markets. That is hardly a competitive environment, but why let a few inconvenient facts get in the way of a good argument.

END OF THE 100-YEAR BEAR MARKET IN COMMODITIES AT HAND

I think commodities will turn out to be a fantastic place to invest for the rest of this decade. Returns in commodities should easily beat stocks and bonds for the next five years. It happened in the 1970s and it will happen again. What I like even more about commodities is that nobody is interested in commodities... yet. Go to MSN’s MoneyCentral, or Yahoo’s Finance page, and try to get a quote on gold or oil, and you will see what I mean. Nobody cares yet. Nobody has commodities as part of their portfolio asset allocation yet... and I love it! As Jim Rogers said in his book Adventure Capitalist, “when Merrill Lynch starts trading commodities again, it’s time to get out.”

After bottoming in late 2001, commodity prices (as measured by the CRB Index) have soared by 40%. But long-term, commodities are the cheapest they have been in 100 years. Right now, you have got two camps of investors out there when it comes to commodities... those that do not want to buy because commodity prices have fallen for 24 years, and those who do not want to buy because commodity prices have risen 40% in the last two. Now where is the camp that is willing to buy? There really isn’t one, yet.

What happens when commodity prices fall this dramatically over such a period of time is predictable. Now demand has arrived, but there is not enough supply. And where has this demand come from? China. For the moment, China is booming, and its appetite for raw materials and commodities appears insatiable. But I will not bite on the direct China plays, many of which will eventually disappear. Instead, I am playing the China story through commodities. They will participate handsomely in China on the way up, and be just fine on the way down -- when China’s bust comes again (and that may not be until the second half of this decade), producing exceptional returns in the process.

SANDISK ONE OF THE MOST ATTRACTIVE NAMES IN SEMICONDUCTOR STOCKS

Tech stock recommendation from Melanie Hollands, president of hedge fund Koala Capital, which focuses on trading/investing in technology stocks: Very few companies in technology are leveraged to an end-market with such strong unit growth and increasing penetration levels of DSC and camera phones. SanDisk will likely grow 60%+ year-over-year and trades at a multiple of less than 20x 2004 earnings.

OIL COMPANIES ORDERED TO CUT OUTPUT

Nigeria and Algeria have ordered international energy companies to reduce their oil production by as much as 10%, the strongest signal yet that OPEC this time will stick to its plan to reduce world oil production despite record prices. OPEC fears a price drop as the spring begins in the northern hemisphere and its biggest consumers need less oil for heating. It argues that the drop in the value of the dollar and speculation by large institutional investors has added as much as $8 to the price.

Ali Naimi, Saudi Arabia’s energy minister, said on Monday: “Number one in our mind is making sure there are no shortages -- that the oil market is stable and well supplied because we recognise its impact on economic growth.” But he warned that Opec would not change its mind about the cuts before the group met again in Vienna at the end of this month.

WHY JOHNNY CAN’T GET A JOB

Modern government cuts the free market off at the knees. Most importantly, it stops the creation of new industries through massive, immoral, Unconstitutional regulation. A modern Orville and Wilbur Wright could never create an airplane in today’s America. Certainly a commercial air travel industry would never be allowed to exist, what with its potential for loss of life. Secondarily -- but not inconsequentially -- modern government eats 50% of every American’s money while giving almost nothing in return. At the same time, it increases consumer prices through inflation and taxation by at least EIGHT HUNDRED PERCENT. Having only half of their money to spend and being forced to pay eight times more than necessary severely limits the amount of money people can use to create industries as well as limiting the time they have in which to do it.

Modern government has replaced the medieval Lord, and the average American the medieval Serf. Modern Serfs are no more in charge of their own destinies than were their medieval counterparts. The difference is that the modern standard of living, established when more people were in charge of their own destinies, makes the modern Serf comfortable and therefore afraid to revolt.

In modern America, it is utterly impossible to create new industries. The last new one created in this country was the home computing industry, and that was over twenty years ago. Ultimately, this industry evolved into a simple commodity like televisions and radios, meaning that there is no longer any real money to be made from manufacturing. Indeed, the profit on the average personal computer to the manufacturer is generally less than a hundred dollars. This has driven manufacturers to decrease production costs. As with every other industry, the highest of such costs are generally in labor, so it is only natural that they have migrated to countries where labor costs are significantly less.

Were there still a free market in the United States, the creative power of 250 million individuals would have long ago driven new industries. Anyone who believes that this is not the case need examine only a pair of the more obvious exciting possibilities: Catalytic fusion promises to revolutionize power generation. Imagine the power for your home run from a generator in your basement the size of your hot-water heater. Imagine enough power to run literally anything you like, for as long as you like, generated for pennies of what the electric, gas, and nuclear industries charge. Imagine that this power is manufactured cleanly, and its only waste byproduct is a small amount of deuterium that you sell to an agent every month. Imagine your car being run similarly, a la the “Mr. Fusion” of the Back To the Future movies. Such power is possible, real, and within our grasp if only government would cease standing in its way.

CAN PEOPLE KEEP THEIR FEET ON THE GROUND WHEN MONEY FLOWS?

There have been lots of little signs that things in the startup/tech world were picking up, but now it seems that even the venture capitalists are convinced we are entering the next boom. The VCs claim things will be different this time, because they know not to take “the bread out of the oven too early,” but are going to let things fully bake before moving on to an exit strategy. Meanwhile, all the entrepreneurs sound like they are standing on the shore bracing for a tidal wave, and do not want to get swept off their feet, talking about the importance of long term vision, ignoring things like share price, but having a strong management team that is in it for the long haul.

These are all things that are good advice and make sense -- but which always seem to get tossed out the window when serious money starts flowing (something about all those zeroes...). As the money flows, so goes the hype, and that means more competition, and companies start making short-term decisions because the feel the need to respond is greater than the need to hold onto their vision.

UK’S LOSS IS THE ISLE OF MAN’S, EASTERN EUROPE’S GAIN AFTER INLAND REVENUE RULING

The Inland Revenue’s decision to shut down a legitimate tax loophole used by the film industry to help finance productions in the UK could work to the Isle of Man’s advantage after the producers of The Libertine decided to switch production to the jurisdiction. The ruling by the Revenue has caused chaos in the film industry, with dozens of productions halted after the government decided, without warning, that as of February 10 it was bringing forward legislation to “address tax avoidance schemes which exploit relief for trading losses through partnerships,” with immediate effect.

“I do have fears for the British industry,” said actor John Malkovich, a co-producer of The Libertine. “It’s already expensive to shoot films in England because of the strength of sterling. But without these tax incentives…? ... Why wouldn’t you in future go to Romania or Bulgaria or Hungary, which are probably a third of the price, and take a few of your key English crew with you?”

The Isle of Man has an investment package that gives filmmakers 25% of their budget on the proviso that over half the film is shot on the island. The incentives have had a small, though growing impact on the island’s film industry. In 2001, the island was location for six films. In 2002 this had grown to eight whilst in 2003 ten producers chose the jurisdiction as a location. Malkovich also marvelled at the unbureacratic approach of the Isle of Man commission. “When I made the deal for Colour Me Kubrick the papers were about a foot high. With the Isle of Man it was a handshake. I just explained the situation during dinner, and 15 minutes later it was agreed.”

WHAT HAS GOVERNMENT DONE TO OUR MONEY?

Monetary policy is, aside from war, the primary tool of state aggrandizement. It ensures the growth of government, finances deficits, rewards special interests, and fixes elections. Without it the federal leviathan would collapse. Our monetary system is not only politically abusive, it also causes inflation and the business cycle. What is to be done? In answer to that question, the Mises Institute is pleased to present this fourth and slightly expanded edition of Murray N. Rothbard’s classic What Has Government Done to Our Money?.

First published in 1964, this is one of Professor Rothbard’s most influential works, despite its length. I cannot count the number of times academics and nonacademics alike have told me that it forever changed the way they looked at monetary policy. No one, having read this book, hears the pronouncements of Fed officials with awe, or reads monetary texts with credulity. What Has Government Done to Our Money? is the best introduction to money, bar none. The prose is straightforward, the logic relentless, the facts compelling.

Professor Rothbard shows that government has always and everywhere been the enemy of sound money. Through banking cartels and inflation, government and its favored interests loot the people’s earnings, water down the value of the market’s money, and cause recessions and depressions. In mainstream economics, most of this is denied or ignored. The emphasis is always on the “best” way to use monetary policy, which presupposes central planning -- the root of monetary evil. May this book be distributed far and wide, so that when the next monetary crisis arrives, Americans will, finally, refuse to put up with what the government is doing to our money.

The Three Stooges of Inflation

The U.S. Department of Labor’s Bureau of Labor Statistics (BLS) recently announced that the Consumer Price Index (CPI) rose 0.5% in January, its biggest increase in nearly a year. The CPI core rate, which excludes energy and food prices -- like any of us can go without gasoline or food -- rose 0.2%. Both increases surprised analysts, but normal people -- people who actually pay money for goods and services -- were not surprised.

Prices rise constantly, yet Fed representatives say that inflation is low. In fact, half of the time Federal Reserve Governor Ben Bernanke worries aloud about deflation. As if prices have even the remotest chance of falling, while the Fed creates money by the bale. Yet, the CPI seems to support what the three stooges of inflation -- William Poole, president of the Federal Reserve Bank of St. Louis, Bernanke and Alan Greenspan -- are saying; inflation, as measured by CPI, is relatively quiescent.

From January of 1984 to this January the CPI index rose from 101.9 to 185.2, an increase of 81.7%. Nothing to brag about, that is a near doubling in prices over those twenty years. But, does that really reflect what prices have done for the past twenty years? Not hardly. The money supply, as measured by M3 has more than tripled from $2.7 trillion in January 1984 to $8.9 trillion last month. According to the BLS the inflation rate for the past year was 1.9%. During the same period, M3 increased 4.3%. So, why has CPI -- “the most widely used measure of inflation” -- not risen as fast as the mountain of money the Fed has created? Because the government doesn’t want it to. The government clearly has a vested interest in suppressing the CPI, as program benefit and income tax bracket changes are indexed to changes in the CPI. And they have a large bag of statistical tricks to suppress it too, primarily “hedonic quality adjustments” and ignoring housing price changes in favor of an “Owners equivalent rent” measure. An additional point here and there and pretty soon you have real inflation.

A MILLION AIN’T WHAT IT USED TO BE IN THE U.K., THANKS TO THE PROPERTY BOOM

The UK was home to 230,000 millionaires in 2001, but it is predicted that this will rise to 760,000 in 2010 and 1.9 million in 2020. Many of the new paper millionaires are not tycoons or investment bankers, but ordinary people who have seen wild increases in the value of a home bought for a song years earlier. “I’m just comfortable middle class,” says one accountant-turned-landlord, who now has a £2 million property empire. “The international jet-setter image of millionaires is where you have huge amounts of disposable income.”

In some parts of the country million-pound property deals are becoming so common that even estate agents say they no longer mean a great deal. One of the problems for the new property millionaires is that their incomes do not support the lifestyles the hoi polloi would have expected them to have in the past.

Getting hold of the money you are now worth means one of two things says Douglas McWilliams, chief executive of the Centre for Economics and Business Research. He says you can access the money “by trading down in the housing market or releasing equity borrowed against the house”.

A NEW ECONOMIC ERA! (AGAIN)

“Apparently there has been a fundamental change in criteria for judging security values. Widespread education of the public in the worth of equity securities has created a new demand.”

~ The Outlook & Independent Magazine (May 15, 1929)

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One of the most consistent phenomena in the world of investing is the presence of faith in the transformation of economic law after a stock market boom has been in progress for several years. Experts proclaim an advent of a new era, an era in which the old numbers and old patterns of investing have been superseded, usually by a combination of technological improvements and central bank wisdom. Investors are assured that “this time, it’s different.” This time, stocks will go up despite low dividends, interest rates will stay low despite rising government deficits, and consumers will continue to buy despite poor job prospects.

People believe what they want to believe. They resist the intrusion of evidence that points to a different, less pleasant scenario. This is always true. It will always be true. There are always a few pessimists who look at the numbers and conclude: “This dream isn’t going to end painlessly, but it is going to end.” They are like John the Baptist, crying in the wilderness. The worst economic crisis in American history began in October 1929. It did not end for a decade. This is why it is worth looking at what the experts were telling the public in 1929.

WORLD WEALTH REPORT LOOKS AT ACTIONS WEALTHY INVESTORS ARE TAKING

Merrill Lynch and Cap Gemini Ernst & Young’s 2004 World Wealth Report, an annual study on wealth trends in the U.S., found that high-net-worth individuals -- people who dispose of more than $ 1 million in investable assets -- are increasingly consolidating their accounts in order to have a single view of their investments. In turn, these individuals are demanding their advisers take a holistic, aggregated view of both proprietary and third-party investments.

Wealthy U.S. investors are turning to professional advice more often and diversifying across asset types and regions, the study showed. Strategies include managed accounts, where assets topped $500 billion, real-estate and so-called investments of passion, such as buying fine art or antiques.

High-net-worth individuals are also using hedge funds and other instruments not directly correlated with equities markets, more often to protect themselves from losses. As these individuals demand more sophisticated advice in volatile markets, advisers in turn will have to be proactive to attract clients, the study predicts.

HOW BENEFICIAL HAVE AMERICA’S EFFORTS TO PROSECUTE WHITE-COLLAR CRIME BEEN?

Since the creation of a special Department of Justice (DOJ) taskforce to tackle corporate fraud in 2002, federal prosecutors and investigators have charged 642 defendants in 290 separate cases with white-collar crimes, and secured convictions or guilty pleas from 250 of them. (A more usual figure for the feds is about 50 such convictions a year.) At the prodding of the DOJ, the United States Sentencing Commission has raised penalties for corporate fraud twice, in January and April 2003, nearly doubling the base penalty for some crimes.

Two worries persist. The first is that, with the media, the public and politicians demanding that heads roll, the government has pursued its prosecution too zealously. Martha Stewart, for instance, is defending herself against the accusation that she committed securities fraud by declaring to her shareholders that she was innocent of insider trading. The government has not actually charged Ms. Stewart with insider trading at all, but of obstructing justice. Thus, prosecutors allege a cover-up of a crime that may never have been committed.

Also troubling are the somewhat vague and sweeping charges brought against Jeffrey Skilling, who ran Enron until his resignation four months before it collapsed in December 2001. The government’s core allegation is that Mr Skilling used accounting trickery, false public statements and other devices to inflate Enron’s share price, thereupon cashing in his share options. Despite the recently-secured co-operation of Andrew Fastow, Enron’s former finance chief, however, the charges against Mr. Skilling seem remarkably free of details establishing exactly how he directed this massive alleged fraud.

The danger is that, by throwing a few bosses to the lions, the government will satisfy the public’s thirst for blood and thus ease pressure for deeper, system-wide reform. Indeed, some critics argue that this was the government’s intention all along, or -- if that seems a bit too conspiratorial -- at least explains its instinct to come down so hard on corporate crooks.

POWER TO THE SHAREHOLDER?

Michael Eisner of Disney and Sir Philip Watts of Shell have both been forced to relinquish their roles as chairman. Both resignations come at a time when a host of other mighty bosses are being humbled by shareholder action. These changes have been chalked up as victories for shareholders. But have investors really got the better of the imperial boss?

Scratch beneath the surface, and these events are not quite the shareholder triumphs that they appear to be. If shareholders had really been on the ball, they would arguably have acted far sooner than they did. Hollywood insiders have been griping about Mr. Eisner and his autocratic style for years; and Disney’s shares were languishing at 1997 levels before Comcast, America’s biggest cable company, launched a hostile bid last month. Nor is it shareholder votes alone that are driving boardroom behaviour. Disney is being influenced as much by the Comcast bid as by what its shareholders are yelling at it. Investigations by the SEC into both Shell and the Hollinger International affair have concentrated minds at both companies -- though so too have the shareholder lawsuits filed against Shell since the reserves downgrade was announced.

There are regulatory moves afoot on both sides of the Atlantic to temper management power. In America, the SEC is considering a rule that would make it a little easier for shareholders to recommend their own candidates for director. But the proposed threshold for shareholder action is high (more than a third of votes against the current incumbent) and the conditions stringent (the candidate must be truly independent), so it is hard to see the proposals being anything other than symbolic. Save your tears for the imperial boss -- reports of his demise have been exaggerated.

PLAYING CHINA VIA JAPAN

If so many markets are so expensive and expensiveness is relative, then something, it has been well pointed out by readers, must be cheap. But what? Japan has been a favourite for many months (though it is a worry that this seems to be becoming something of a consensus view). And although emerging-market debt may be ridiculously expensive, emerging-market equities in general are not. The problem, as always, is that although many emerging economies are growing fast, investors may not benefit from this, since in most of these markets property rights are hideously slippery.

This would seem to be especially true for buyers of the dream that is the People’s Republic of China. Its economy is undoubtedly galloping along. The question is whether investors will see much of this by buying Chinese shares. Possibly, it would be better to buy into China indirectly, via companies that make lots of money in the Middle Kingdom. And Buttonwood can think of no better place from which to do so than the Middle Kingdom on sea, aka Japan.

Japan is not exactly a byword for good corporate governance either, but the legal system there is decidedly more robust. Japan is, moreover, a recognizably capitalist country with a wealth of world-class companies. In the mid-1990s, China was seen as Japan’s nemesis. Now China is seen as an opportunity, largely because the things that China needs -- steel, capital equipment, construction machinery and so on -- are, as it happens, just the sort of stuff that Japanese companies are good at making. And it makes no sense for China to build much of this stuff since its competitive advantage is cheap labor, not cheap-to-run, depreciated blast furnaces like those in Japan. Now Japanese exports to China are soaring.

America’s ultra-loose monetary policy is partly responsible for reflating the world economy, but demand from China is also playing a part, since it has pushed the prices of everything from copper to shipping skywards. As Peter Tasker, fund manager and author, puts it, “Japan is highly leveraged to reflation.” China’s rulers may try to slow their country’s heady growth. Its current-account surplus is dwindling rapidly. But for the moment, China’s leaders seem content to let the economy roar, to the benefit of Japan.

Certainly, financial assets in general are over-priced, especially those, such as shares in technology companies, that are seen as a source of future growth and profits. But investors are increasingly turning to old-fashioned things that you can drop on your foot. And, for good reasons or bad, Japan makes mountains of these.

“THE THIRD RAIL” OF ENTITLEMENT SPENDING

According to Laurence J. Kotlikoff of Boston University, the present value of the gap between promised outlays and projected revenues for Social Security and Medicare is $51 trillion -- more than four times the nation’s annual GDP. Today the household wealth of Americans -- the value of their houses, 401(k)s, cars, refrigerators, toasters, socks, everything -- is about $42 trillion. In impeccable Greenspan-speak, the government’s truth-teller said “significant structural adjustments” will be necessary.

It is axiomatic -- meaning, true outside of Washington -- that everyone is entitled to his own opinion but not his own facts. Here are some facts, many of them gleaned from a new book from the MIT press, The Coming Generational Storm by Kotlikoff and Scott Burns of The Dallas Morning News. A starter: In 1940 there were 42 workers for every retiree. Today there are 3.2 to one. In 2030 there will be 2.2 to 1.

Kerry and Edwards simply recoil from contemplating the consequences of these facts, hoping, like Dickens’ Mr. Micawber, that something will turn up. The Bush administration has a plan (individual accounts investing a portion of Social Security taxes) for coping with the facts, but no discernible plan -- certainly none it will discuss -- for economies that will make possible paying the transition costs. All of which suggests that entitlement reform remains one of those contentious issues that cannot be debated in an election year or the year before one. Meaning: ever.

FANTASIES, FACTS, AND INSIDER SELLING

When it comes to “why” a corporate executive would sell shares of his company’s stock, well -- who knows? The need may arise for tax purposes, a second home, a private island, you name it. A CEO of a medical device company just sold his shares for $13.7 million. Go for it, dude. One executive’s choice to sell may conjure up fantasies, but the same choice by LOTS of corporate executives should focus your mind on solid facts. U.S. executives unloaded $4.9 billion worth of their companies’ stock in February, the highest level since May 2001 and more than quadruple the $1.1 billion in insider sales logged in February 2003. This past October, insiders sold 59 times more company shares than they purchased, the most extreme ratio in more than a decade.

Still, is it possible that this building series of extremes really means nothing to the market? Perhaps not. Maybe history means nothing. Valuations mean nothing. Record mutual fund inflow? Big deal. There never was a bubble. This time it’s different. A “New Economy”.

VALUATIONS STILL AT NOSEBLEED LEVELS. WHY DO INVESTORS THINK IT WILL BE SUSTAINED?

It is my contention that we are in a long-term secular bear market cycle, speaking for the broad market averages that are basically comprised of large companies. In this cycle, I believe, we will see the price to-earnings ratio of these index averages slowly come down. The P/E ratio of the S&P 500 on March 31, 2000, was 29.41. Today the level is at 29.46. That means the P/E for core earnings (which is accountant speak for cash-in-your-pocket earnings) is somewhere north of 35.

The market is still irrationally high, based upon historic trends. It does not mean it cannot go higher. But it does mean it will go lower eventually. History shows us that valuations will revert to the mean over time and even move significantly below trend. There has never been a time in history when P/E ratios hit a range around 30, as they did in 1999 and again at the end of 2003, that the broad stock market outperformed a money-market fund over the next 10 years. Never.

Yet investors keep running stocks up to nosebleed valuations and somehow expect that this time it will all be different. It never is. Let’s look at some of the reasons for such behavior. They are rooted not in mathematics and economic foresight, but in psychology.

The same theory might explain why bear market cycles last so long. Thus my contention that we are just in the beginning stages of the current secular bear market. These cycles take lots of time, anywhere from eight to 17 years. We are only in year four, and still at nosebleed valuation levels. The next surprise or disappointment will surely come from out of nowhere. That is why it is called a surprise. When it is followed by the next recession, stocks will drop one more leg on their path to the low valuations that are the hallmark of the bottom of secular bear markets.

Given the level of investor overconfidence in the marketplace, and given the length of the last secular bull, it might take more than one recession and a few more years to find a true bottom to this cycle. It will come, of course.

EU INTERNAL MARKET COMMISSIONER SPEAKS ON EU ACCOUNTING STANDARDS

Speaking at the annual dinner for the Institute of Chartered Accountants in England and Wales (ICAEW), the EU’s Internal Market Commissioner, Frits Bolkestein addressed the highly topical issue of accounting and auditing standards within the European Union. He Suggested that the collapse of Parmalat had demonstrated that the EU was right not to be complacent following several earlier corporate governance scandals in the United States.

“At the heart of our strategy is the application, from 1 January 2005, of International Accounting Standards. I remain firmly committed to this strategy,” he said. Mr. Bolkestein also stressed the need for a two way “co-operative approach” between the EU and US in order to avoid duplication of oversight, and to minimize conflicts of law in this area.

THE TWO INCOME TRAP

As technology has progressed and as standards of living have changed, the cost of the basket of goods that one requires in order to participate in this “new economy” has vastly increased, so that, along with soaring healthcare, education, and insurance costs, there is a very heavy burden placed on anyone who is not seriously rich. In this vein, a recently published book, The Two Income Trap, by Harvard Law School professor Elisabeth Warren and Amelia Warren Tyagi, explains “why middle-class mothers and fathers are going broke.”

According to Elisabeth Warren, who conducted extensive research on the subject: “The families in the worst financial trouble are not the usual suspects. They are not the very young, tempted by the freedom of their first credit cards. They are not the elderly, trapped by failing bodies and declining savings accounts. And they are not a random assortment of Americans who lack self-control to keep their spending in check. Rather, the people who consistently rank in the worst financial trouble are united by one surprising characteristic. They are parents with children at home. Having a child is now the single best predictor that a woman will end up in financial collapse.”

According to the authors, it is not over-consumption that is driving many middle-class families into bankruptcy, but the lack of a safety net. Middle-class families do not qualify for all kinds of programs that are available to the poor. Moreover, the family safety net no longer exists for the modern two-earner couple, which makes them “actually more vulnerable than the traditional single-breadwinner family.” A generation or so ago, a stay-at-home mother served as the family’s ultimate insurance against unemployment or disability-insurance: she could find work and add a new income source to help the family stay afloat financially.

The problem with the two-income family is that it does not plan its financial commitments geared to a single income by saving the extra income that is derived by the mother. Instead that second income is used to purchase opportunities for their children -- a home in a safe neighborhood with good schools, a comprehensive health insurance policy, two reliable cars, preschool, and college tuition. So, when one of the members of a two-income family loses his or her job, the safety net (the mother entering the workforce) that was available to the single-breadwinner family is no longer available. And once the combined income of the two-income family collapses as a result of one member losing his or her job, “the modern couple doesn’t have a prayer of making ends meet.”

The high and continuously rising cost of living in the Western industrialized countries has created what might be called modern-day poverty, or poverty in affluence, whereby a large number of middle- and even upper-middle-class families have very little left by the time they have paid for their mortgages, taxes, insurance premiums, food, and children’s education. I simply do not buy the argument -- repeatedly advanced by economists and strategists at investment conferences -- that the U.S. consumer, or for that matter any average consumer in the Western industrialized countries, is in “great shape”. The “two-income trap” is a sobering and saddening fact of our modern society. Moreover, after having recently visited Argentina and seen first-hand the decline of a formerly rich country, I am deeply concerned about the economic future of the West.

THE GREAT TRAIN WRECK OF 2004

After spiking upward in the latter half of the 1990s, household compensation as a percentage of GDP abruptly reversed and headed downhill. Today, it stands at its lowest level in more than 20 years. Household liabilities as a percentage of assets also moved in a healthy direction in the second half of the 1990s, namely downward. Yet just as suddenly, the figure started to rise, likewise to levels not seen in more than 20 years. So to compensate for slow wage growth, consumers are doing what they have done over the course of the entire bull market: borrowing more money.

F.Y.I. -- The current running total of consumer debt is $2 trillion, a record high. And that does not include real estate related loans such as mortgages. Factoring in this figure would hike the amount to $9 trillion, also known as up to your eyeballs in it. But if Fed Chairman Alan Greenspan “sees no alarm” in the situation, are we just being worrywarts? The March issue of The Elliott Wave Financial Forecast presents a visual show of falling wages verses rising liabilities, put together in one chart labeled, “The Great Train Wreck of 2004”. It is not too late to jump off.

NO MORE BUYS AND SELLS?

The New York Times reported something unprecedented: “The British bank HSBC has decided to scrap its analysts’ buy and sell recommendations.” According to a company spokesperson quoted in the story, HSBC’s clients decided that “traditional equity research was not something they were interested in anymore.” As for why “traditional equity research” lost its credibility with this group, well it is the same thing that has troubled investors en masse previously. Namely, because “so few sell calls were made that it seemed as if analysts never met a stock they didn’t like.”

Yet to read the Times’ version of events, you would think this sort of imbalanced or biased stock advice was not “traditional” at all, but merely a phenomenon of the recent past: “The dubious worth of some research was revealed a few years ago when the technology bubble was imploding and some analysts publicly praised companies that they were describing privately in unflattering terms.” But even the recent past is distant enough for most folks to forget: “HSBC’s rivals appear to see no need for repairs,” the story says. The average recommended stock allocation from the largest Wall Street firms hovers steadily at 70%, so yeah -- Why fret over a major imbalance of “buys” vs. “sells” in your market analysis if your investing strategy is unflinchingly buy-and-hold?

Unflinching for now, anyway. “Traditional equity research” still holds that “the biggest risk... is not being in stocks.” Well, the latest (legal) insider trading data tells us that the folks who run the companies disagree [see “Fantasies, facts, and insider selling” story above]. Don’t take Wall Street at their word. Look at all the evidence yourself.

INFLATION LEADS TO PROTECTIONISM

In a debate between CNN’s protectionist News anchor Lou Dobbs and free trader James Glassman from the American Enterprise Institute. Dobbs kept harping about the current account deficit, while Glassman responded by claiming that the American economy was fundamentally sound. Actually, both sides are wrong. The American economy is unsound, not because of free trade but because of the inflationist policies of Alan Greenspan and the deficit spending by President Bush. And the current account deficit is similarly not the result of free trade but of the policies of Greenspan and Bush.

What drives trade/current account balances are not, as protectionists would suggest, trade policy or wage levels but rather the level of national savings as well as a country’s attractiveness for investments. A higher level of savings will, other things being equal, increase surpluses or decrease deficits, while increased attractiveness for investment will increase investments which in turn will lower surpluses or increase deficits.

Hong Kong and Singapore have West European income levels, are geographically close to the much maligned countries of China and India, are 100% committed to free trade and have no trade or capital movement restrictions whatsoever. If any countries should have deficits due to competition from low wage counties then Hong Kong and Singapore should be the ones. Yet, the reality is the opposite of what the protectionist’s theory would predict. Hong Kong and Singapore have huge current account surpluses while the United States has a huge current account deficit, because they have a very high savings rate while the United States has an extraordinarily low savings rate.

Then why is the U.S. savings rate so low? Partly, it may be for cultural reasons. Americans have long been very consumption-oriented while the Chinese and other East Asians value thrift. But perhaps more important are the policies of Greenspan and Bush. Greenspan has pushed interest rates all the way down to 1%. And not only are American households not saving due to Fed policy, the federal government makes matters much worse by dissaving in the form of a deficit of more than $500 billion. The current account deficit is actually roughly equal in size with the Federal budget deficit. We can here see yet another example of Ludwig von Mises’s theory of how interventionist policies produce unintended problems, which are then used as an excuse for yet more interventionism.

INFLATION OR DEFLATION? (...OR INDEFLATION?)

A few economists are marching to a different drummer. They are certain that stocks are greatly overvalued and prices are bound to fall soon, and that we must brace for deflation leading to recession and even depression. They are the deflationists who envision and observe a gradual reduction in the stock of money or substantial declines in spending, which will depress the economy. They fault several economic and political forces that will cause a deflation despite the apparent present expansion and recovery of stock prices. During the 1990s, they contend, the American economy enjoyed an unprecedented boom that generated a huge bubble of excess capacity; it is bound to deflate soon and depress economic production for years to come.

The official guardian of progress and prosperity, the Federal Reserve System, will be unable to bail out failing banks and businesses because the deflation will affect the entire world economy and render failure systemic. Surely, the Fed will load the banks with money, but they will prefer to invest their funds in U.S. Treasuries rather than lend them to failing businesses. The stock market, according to the deflationists, will be the key and gauge of the deflation and depression to come. Deflationists do not tire likening present economic and financial conditions to those of the 1920s that led to the Great Depression of the 1930s. Deflationists also seek to prove their case pointing to the decade-long recession in Japan.

This writer readily concurs with the deflationists’ analysis of economic bubbles. In contrast to mainstream economists, they correctly perceive the gross overvaluation of corporate stock, the economic maladjustments which they call “excess capacity”, and the market pressures of readjustment. They observe the changes in technology and international competition, but draw conclusions that differ radically from those of this writer. They plan the future by the past. This writer braces for more inflation and stringent government controls to come. In his judgment, the future will be different from the past.

As U.S. authorities are determined to continue their easy-money policies, and even accelerate them as they deem fit, U.S. deficits on trade or current account are bound to grow; ever more dollars will flow to the rest of the world and swell the debt. If it were not for Asian central banks, mainly in Japan and China, which are absorbing the rapid outflow of dollars and investing them in U.S. Treasury securities, the U.S. dollar would plunge even deeper. Sooner or later, for any combination of reasons, they may cease to support the dollar, or even dump it. The dollar would fall precipitously, interest rates would soar, and financial markets would crash. It would present the Fed with two possibilities of courses of action.

Both allowing interest to rise to market levels or embarking upon super expansion would daze and stun the American people with the sudden upheaval. Their likely actions would reinforce the very forces of deflation foreseen by the deflationists. But no matter how the American people would react, the inflation forces would reign supreme in international money markets and beseige the dollar. They soon would follow it to American shores and overwhelm the deflationary tendencies in the end. Rising prices of essential foreign energy and many imported consumers goods as well as newly protected domestic products would determine the outcome. If the Federal Government should decide to follow the pattern of the Hoover and Roosevelt New Deals or the Japanese deal of the 1990s, it would constrain and retard economic activity and give rise to an admixture of inflation and stagnation, commonly called “stagflation”.

Most American economists misjudge the very causes of the Great Depression, which may mislead them in their analysis of the present situation. Japanese governments during the 1990s were marching in the footsteps of the American New Deals. Deflationists blithely overlook and ignore many forms of government intervention that impede, thwart, shackle, and curb economic activity and lead to deep depressions. And they pass over the peerless position of the U.S. dollar as the world’s primary reserve currency, which allows the Federal Reserve System to inundate the world with U.S. dollars -- until the principal creditors, China and Japan, call a halt to the delusion. At that time, the U.S. government may contrive a Bush or Kerry Deal. We are bracing for fervent controls and dreary stagflation to come.

AMERICANS LIVE IN A FANTASY WORLD

Americans live in a fantasy world. This fantasy world is going to be destroyed by economic forces that are already well-established. It is easy for readers to think, “He’s talking about the other guy.” Maybe I am, but if you are doing essentially what the other guy is doing, then I am talking about you.

When the economy falls down and goes un-boom, the voters run to the government. “It hurts. Make it better.” What snookums needs is a cotton swab drenched in alcohol. “This is going to hurt.” Response: “No! Don’t!” The child wants the hurt to go away now. He does not want what is necessary to solve his problem -- his real problem. He does not know anything about infection. He knows only that his knee hurts and he wants mommy to make it stop hurting. In politics, however, mommy has to be re-elected at regular intervals. Mommy is not secure in her high office. So, she promises never to use that nasty old alcohol. She will kiss the wound and make it well. In doing so, she will increase the risk of infection.

The West has entered its second childhood. It has become dependent on government to provide fiat money. America has become dependent on Asians to supply us with loans and capital. Except what appears to be Asian investment today is in fact Asian fiat money. The Japanese central bank and the Chinese central bank are in high gear. If the world’s central banks were ever to stop creating money, the malinvestments which their low interest rate policies have created would be exposed by the capital markets as misused capital. The capital markets would fall like a stone. The West’s central banks have undermined thrift, and what little thrift remains is lured into projects that cannot be sustained apart from the illusion provided by even more fiat money.

The nanny state has kissed the nasty scrape, and in doing so, has infected it. The voters cry, “Make it stop hurting!” They never stop crying. The West is now in its second childhood. It refuses to do what is necessary to grow up: reduce taxes, increase thrift, pay off the national debt, and stop creating new money. This can be done, but it won’t be done. To do it would hurt. One drink at a time, the drunk consumes his future and then his present. One consumer debt at a time, an individual does the same thing. So do collectives that pursue the same policy of immediate consumption at the expense of future consumption.

The nanny state today goes looking for injuries to kiss. The voters need to tell the state exactly what it can kiss. But the voters never do. This story is not going to end well for most people. I hope it ends well for you.

A TALE OF PETERS AND PAULS

One may deduce further that a mental fog of illogic prevails in the centers of power in America today. Occasional rays of light break through. Unfortunately, it is never enough, and it seems to me that the full revelation of our current situation and what it calls for would never be supported either by those with power or by much of today’s electorate. Federal Reserve chair Alan Greenspan recently announced the need to address the long-term problems faced by Social Security and Medicare “as soon as possible”. Greenspan, whatever his role in helping bring about the mess we are in, is not stupid. He doubtless knows the truth. We need more than a few cosmetic adjustments. Otherwise we are on our way to an economic/financial train wreck. He doubtless also knows, though, that if he rocks the boat he can be replaced. That’s how our present political order works.

As the saying goes, any program that robs Peter to pay Paul can always count on the support of Paul. The welfare state’s dilemma: the population of Pauls grows steadily, while the population of Peters eventually shrinks. With so many Pauls now dependent in one way or another on the present system and flocking to the polls to ensure the continuation of their freebies, advocates of the deep cuts in spending needed are simply not going to be elected. The Pauls will not vote for them, and are beginning to outnumber the Peters. The Peters, meanwhile, are often too busy working feeding their families (and paying their taxes) to see the big picture. They do not see that they are rapidly becoming outgunned.

It is time to face an unpleasant reality: our so-called democracy -- which was never intended by its founders to be such (remember Mr. Franklin’s “[a] republic, if you can keep it”?) -- is broken. Late 18th century historian and jurist Alexander Fraser Tytler put it best, in the statement he is best remembered for: “A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves largess from the public treasury. From that time on the majority always votes for the candidates promising the most benefits from the public treasury, with the results that a democracy always collapses over loose fiscal policy, always followed by a dictatorship.”

Tytler went on: “The average age of the world’s great civilizations has been 200 years. These nations have progressed through this sequence: from bondage to spiritual faith; from spiritual faith to great courage; from courage to liberty; from liberty to abundance; from abundance to selfishness; from selfishness to complacency; from complacency to apathy; from apathy to dependency; from dependency back again to bondage.”

The illogic and irresponsibility of the past several decades will exact a price. It is not a matter of if but when. The longer it takes, the worse the train wreck will be. Not to mention the possibility of a day, once the emergency sets in or possibly sooner, when dissent may simply be made illegal in the interests of “homeland security”.