Finance Digest for Week of April 19, 2004

WHOLE LOT OF ‘FLATION GOING ON...

In almost every direction we look, we see people going about their business as if nothing were wrong. And yet, they say and do such strange things. One of the things that makes us feel like a very minor character in a very bad movie is the Fed’s “emergency” 1% lending rate. Fed governors admit to no emergency. There is nothing to worry about, they say so often it makes us wonder. Inflation is no threat. Deflation is no problem. And yet, there must be some kind of ‘flation somewhere. Why else would the Fed allow the money supply (M3) to increase at the astounding rate of $1 trillion per year?

And why else would it lend money at less than the quoted rate at which it loses value? The CPI rose 1.7% last year -- even by the government’s own, fishy way of calculating it. Even in the best of circumstances, the Fed could not hope to get its money back... that is, unless things went really bad... and inflation sunk below zero. But this week brought news that inflation was headed in the opposite direction. Last month saw a 0.5% increase in consumer prices. Annualized, inflation is running at about 6 times the fed funds rate.

The Fed’s 1% lending rate is a curiosity. It is extremely rare; a normal, sentient homo sapiens sapiens would consider it a mistake to bet the farm on it. But that is what people do. On the advice of the nation’s leading mortgage advisor, Alan “Bubbles” Greenspan, they refinance their homes at adjustable rates. Maybe rates will go up... maybe they won’t. Our only point is that 1% is extraordinary, and it takes an extraordinarily confident investor to believe that extraordinary circumstances will last forever.

A 1% rate has been reached only two times -- first in the 1930s... and again now. There is something unnatural about it, we conclude; it only happens when there is a crisis on the scale of the Great Depression. Surely, some crisis must be at hand, or afoot. But what?

Still, the wicked thing coming our way could take rates lower... as happened in America in the 1930s... and as happened in Japan in the 1990s... and leave them there for a long time. The inflation people think they see coming could dally a long time before showing up. The people who think they know what direction inflation will take also think they know what direction China’s economy will take. They could be right. Or, they could be wrong. A letter to a colleague suggests that China’s booming growth could come to a halt tomorrow: “On a visit to Shanghai last year the atmosphere felt curiously similar to how Tokyo felt in its bubble. This is a purely subjective opinion I hasten to add, but the air of optimism bordering on invincibility is almost exactly the same. ... To reiterate, this is purely a subjective opinion, but I sold all my Chinese investments shortly after returning, as the parallels to what I had witnessed in Tokyo were to me ominous.”

Now, we have nearly come back to where we began in the 1930s -- with short rates near zero. If we were guessing, we would guess that the downwards trend still has a way to go. Today’s ebullient world could collapse in a heap. China could blow up. The shortage of primary commodities could quickly turn into a glut. The Fed could cut rates, rather than hike them. We don’t know. But at least we know what we don’t know.

CUTTING THE FEDERAL BUDGET TO PREVENT U.S. BANKRUPTCY

Part VIII – Cutting Energy and Commerce

For those who did not read Parts I–VII of this series, total actual cuts in proposed spending (what I call the “Cut-o-meter”) now amount to $370 billion. Those cuts came from Defense, NASA, HUD, the Education Department, the Agriculture Department, Transportation Department, Interior, and other agencies. (Summarized in last week’s Finance Digest starting here.)

Total proposed fiscal year (fy) 2005 outlays for the Energy and Commerce Departments are $22.5 billion and $6.1 billion, respectively. Both have numerous programs which are, to use a polite term, useless, and they can and should be cut back substantially.

The Commerce Department goes back to the 1920’s, a time when Herbert Hoover was Commerce Secretary. Established to promote business, even though it is not needed, this department is today generally a dumping ground for political appointees, usually the type that are fund-raisers for presidential campaigns. But Commerce is primarily a pork barrel department, providing little that is really needed by the taxpayer. Total savings from getting rid of most of the Commerce Department would be about $5.9 billion. Add that to the Cut-o-meter.

Is DOE a Producer of Energy? If you cannot answer that question, then go no further. Of course the Energy Department (DOE) does not produce any energy. But what it does is consume taxpayer dollars. Most of DOE’s programs ($16.9 billion out of a total proposed fy 2005 budget of nearly $22.5 billion) are for nuclear weapons for the Defense Department. That leaves $5.6 billion for civilian energy programs, and of that, $1.4 billion covers civilian nuclear power-related activities. In the near term, it might be impossible to cut the civilian nuclear program. But the remaining $4.2 billion should all be cut. Ronald Reagan reportedly wanted to abolish much of the Energy Department but Congressional opposition prevented him from even attempting to cut it out. Well, let’s give it a try!

Cuts of $5.9 billion from the Commerce budget and $4.2 billion by abolishing the Energy Department bump up the Cut-o-meter to $380 billion. Lest readers think there is nothing else to cut, let me assure them that some really large programs will appear on the chopping block in future installments.

Part IX – Trimming Health and Human Services

The Department of Health and Human Services (HHS), even without the Social Security Administration, is a behemoth that staggers the imagination. With a proposed budget of $579.9 billion for fy 2005, HHS almost approaches the Defense Department budget (after you include all those items that are conveniently parked in other budgets to deceive the public regarding the true costs of defense). The big items in the HHS budget are Medicare and Medicaid which account for about $454 billion and are growing at astronomical rates because of the expansion of programs -- like the recent addition of a prescription drug benefit plan for Medicare. More spending on Medicaid -- which is even being funneled to illegal aliens -- is also making the HHS budget grow even more. The anticipated retirement of baby boomers in the next ten years will bankrupt Medicare. Projections given out by the Bush Administration’s Office of Management and Budget show that by fy 2009, HHS’s total budget will grow to almost $773 billion, nearly $200 billion more than the fy 2005 budget.

HHS is the epitome of welfare state “cradle to grave care”, meaning that someone in Washington thinks they know better than you how to run your life. And this comes at a staggering cost, not only in financial terms but also in terms of gross infringements on your individual freedom. Taking care of one’s own health is an individual responsibility, not the responsibility of the government, whether federal or state. Given the lobbying efforts of representatives of the poor and senior citizens, it might seem impossible to cut this budget. But the fact is that the growth in this spending will eventually bankrupt the nation, even if other government departments are eliminated or cut to the bone.

The big budget busters are Medicaid and Medicare. Medicaid is especially pernicious in that it requires states to pony up matching funds for a business that they too have no business being in. If you wondered why your state wants to raise taxes, look at what it spends on Medicaid. For fy 2005, Medicaid proposes to spend almost $183.5 billion. This needs to be abolished over the next three years. That still leaves Medicare proposed spending of $270 billion. The previous cuts will give Congress time to fashion a program to let those not already in Medicare opt out and/or abolish it totally. Those wanting to stay in it should accept benefit cuts. And the latest fiasco, the prescription drug benefit plan, needs to be ended in the next few years. All together, proposed cuts amount to a whopping $255 billion.

And the Cut-o-meter Total is .... $600 billion. Yes folks, we have now reduced spending by about $635 billion over proposed fy 2005 levels and probably more than $600 billion over actual current levels. Being conservative by nature, I only put the $600 billion total into the Cut-o-meter. If the cuts are actually larger, so much the better. Are we finished yet? Of course not!

Part X – Homeland Security, Justice, and State Not Exempt from Cuts

The proposed fy 2005 budgets for the Department of Homeland Security, the Justice Department, and the State Department are $31.1 billion, $23.7 billion and $11.1 billion, respectively. While some would question cutting these departments while the U.S. government is engaged in a war on terrorism, there are many programs laden with pork that are ripe for reduction, if not outright elimination.

In the aftermath of the September 11 destruction of the World Trade Center and the damage to the Pentagon, politicians and lobbyists united to push for the creation of a homeland security department. The Bush Administration, opposed to that path for about 7–8 months, finally did an about face and embraced the idea. Some cynics would claim that Bush’s minions had figured out a way to line the pockets of their cronies in the defense and government-contracting sector, and I would be hard pressed to challenge that assertion. Out of the $31 billion budget, the real pork-laden areas add up to $14.6 billion. At least $2 billion could be squeezed out of these areas, and certainly more in the long run, as a U.S. foreign policy of neutrality reduced the need to protect the country from attacks by terrorists.

The Justice Department includes the U.S. Marshals Service, the Federal Bureau of Investigation, the Drug Enforcement Administration, and the Bureau of Alcohol, Tobacco, Firearms, and Explosives. This whole alphabet soup of agencies should be downsized and molded into one group, with drastically reduced legal authorities. This downsized federal law enforcement group should focus its efforts on getting evidence on terrorists and arresting those who committed acts of terrorism to bring them to justice. Crimes that could be handled by states should be left to the states. Start by cutting $1 billion out of the $9 billion that Justice proposes to spend on all these and cut back their efforts in other non-critical areas. Aditional initial cuts from Justice bring the total to $3 billion. And much more in the future.

Last, but certainly not least, cuts should be made to the State Department budget. While the U.S. -- as long as it has diplomatic relations with other countries -- would need to have embassies staffed by American citizens, the level of staffing and size of embassies could eventually be downsized. Implementing a neutral foreign policy eliminates the need for lots of diplomatic schmoozing, arm-twisting, and bribing of foreign governments to do the bidding of the U.S. government. Add up all the cuts for State and you get a cool $4.9 billion of savings for taxpayers.

The nearly $10 billion in proposed cuts pushes the Cut-o-meter up to $610 billion. And we are not finished!

Part XI – The Treasury Budget Can Also Be Cut

The Treasury Department has one of the largest budgets in the government, with a total for proposed fy 2005 net outlays of $395.2 billion, of which an estimated $349.8 billion is for interest on federal debt. The estimated gross outlay total exceeds $395.2 billion because Treasury anticipates getting payments for loans and other services performed for other departments and agencies. However, there is still plenty of room for cuts.

Several minor programs should be abolished outright, including the super-snooper Financial Crimes Enforcement Network (aka FINCEN). If the FINCEN were abolished, the federal government would still be able to gather data where it was needed for legitimate national security purposes and for prosecuting organized criminals. The FINCEN operation is nothing more than a big brother agency designed to monitor the public’s financial transactions, a gross infringement of the right to life, liberty and property. This Orwellian outfit needs to be deep-sixed.

The bulk of the cuts proposed for Treasury occur in the various welfare state programs administered by the IRS through the personal income tax, namely the various tax credits given to low income people, for children, and for health care expenditures. For fy 2005, the IRS proposes to spend a net of nearly $45.4 billion in these programs. And these are actual cash outlays by the Treasury, not reductions in taxes paid by individuals. Eliminate all of this and give those on welfare an incentive to get a job.

Adding in the minor programs to the above welfare cuts amounts to approximately $46 billion. This pushes the Cut-o-meter up to $656 billion from current spending levels or more than $100 billion over the anticipated budget deficit for this year of $521 billion. And if the cuts I proposed to the HHS budget occurred, the total savings might even be $35 billion higher, as I indicated when using a more conservative estimate of savings. There is one more budget proposal necessary for keeping the U.S. from bankruptcy. Stay tuned!

Part XII – Freezing the Rest of the Budget for Three Years

The final budget proposal I shall make is to freeze the rest of the federal budget -- that is, allow no increases, but only decreases if possible, in the remaining $1.663 trillion being spent this year, fiscal year 2004. To fund increases in any of the so-called entitlement programs, such as social security and its related programs, government civilian and military pensions, matching spending cuts in other programs would have to be made. Those collecting on these retirement programs should not, repeat not, be given cost of living adjustments for the three years of the budget freeze. Thus, there should be no increase in this subtotal -- the $1.663 trillion -- for three years.

By fiscal year 2008, with the proposed cuts implemented, federal spending would be about $1.663 trillion, admittedly still a monstrously large amount. It would represent an actual nominal cut of nearly 28.3% from estimated actual spending in this fiscal year, 2004. This sharply reduced level would give the Congress time to finish off the welfare-warfare state without bankrupting the nation or throwing it into a serious depression.

While my budget proposal might seem draconian to some, it, or a similar amount of cuts in other parts of the budget, is probably the only way the U.S. government and economy can escape bankruptcy and an eventual sharp decline in everyone’s living standards, including those who currently benefit from the welfare-warfare state.

And last, but not least, the U.S. economy would boom! Freeing all that capital from government control and wasteful spending would lead to a big leap in U.S. real economic growth, give existing citizens an incentive to work instead of feed at the state’s trough -- thus limiting illegal immigration, and taking away one of the big incentives for illegal immigrants -- getting a free ride via Medicaid, federal housing benefits, and probably food stamps, too.

Some candidate willing to speak such truths to the public and adopt a program similar to the one I have suggested might stand a good chance of attracting enough voters with such an honest, and necessary, program for U.S. survival. A strong showing by such a candidate, even without a victory, would shake the bloated beltway crowd to its knees. The warfare-welfare state is finished. Now is the time to say so to voters.

WHY THE SUPER-RICH CLUSTER IN LONDON

London property prices have always been jaw-dropping, even for the people who live there. Now they are breaking out into an orbit all their own. The world’s most expensive house is now a white stucco-fronted mansion next to Kensington Palace near central London. Lakshmi Mittal, an Indian-born steel billionaire, paid a record-breaking €70 million for the property, which used to belong to Formula One boss Bernie Ecclestone. Mittal is a self-made businessman and the owner of LNM Group, the world’s second-biggest steelmaker. The fact that he can afford the priciest piece of residential real estate on the market is a solid indicator of how his native country is starting to emerge as an economic powerhouse.

Just as interesting, however, is where he chose to spend his money -- in London, the city that has now emerged as the world’s main playground for the super-rich. Mittal’s new house easily outstrips the previous record of €62 million paid in 1997 for Genesis, a house in Hong Kong, which was repossessed in 2001. Just below that, Bill Gates of Microsoft Corp and Larry Ellison of Oracle Corp have both built houses costing more than the equivalent of €50 million in the United States. A few weeks earlier, the real estate company Candy & Candy said it sold an apartment in Chelsea for €27 million. It was the most expensive apartment of its kind ever. A report by Cushman & Wakefield Healey & Baker said in March that London’s West End had the most expensive office rents in the world.

With the most expensive house, apartment and office, London has achieved a costly triple (and do not even think about finding somewhere to park your car -- you can’t afford it). The words “property” and “bubble” tend to be joined together, and with good reason. Is the London property market for the super-rich a replay of the Tokyo market in the 1980s? Or is it built on more solid foundations? There are three reasons London is attracting so much money.

Britain’s super-rich get richer as their fortunes grow 30%.

The Duke of Westminster has been deposed as Britain’s richest man, amid signs that the aristocracy is slipping down the list of the country’s wealthiest people. Roman Abramovich, the 37-year-old Russian tycoon who bought Chelsea football club last summer, was named yesterday as the man with the UK’s deepest pockets in the annual Sunday Times rich list. His £7.5 billion fortune, which includes a home in Belgravia and a 440-acre Sussex estate as well as the football club, easily eclipses the Duke’s £5 billion property empire.

It was a good year for self-made millionaires as the nouveau riche edged out old money at the top of the league. Philip Green, the high street retail entrepreneur, rose to fourth place as his fortune almost doubled to £3.61 billion over the period. Lakshmi Mittal, the Indian-born steel magnate and the richest Asian in Britain, climbed to fifth as his wealth nearly trebled to £3.5 billion, according to the list.

The rich list portrayed a good year for the super-rich, with their wealth swelling by an average 30% last year, 15 times the rate of inflation. The combined wealth of Britain’s richest 1,000 people rose from £155.9 billion in 2003 to £202.4 billion this year. There were 30 billionaires compared with 21 last year. Philip Beresford, who compiled the Rich List, said: “Britain’s super-rich are getting much richer. [The 30% increase] in anybody’s parlance is phenomenal. They appear to be getting richer faster than the rest of us.” He said the economic recovery, booming property market and a large number of overseas millionaires moving to the UK were factors underlying the rising wealth.

ERNST & YOUNG BARRED FROM TAKING NEW PUBLIC AUDIT CLIENTS

The chief administrative law judge for the SEC barred accounting giant Ernst & Young LLP from accepting new public audit clients for six months because of the firm’s “blatant” disregard and “utter disdain” for rules that require accountants to be independent from the companies whose books they review. Brenda P. Murray also ordered Ernst to return $1.7 million in audit fees it collected from PeopleSoft Inc. from 1994 to 1999 and to hire an outside consultant to overhaul independence policies that the judge called a “sham”.

While a ban on an audit firm accepting new public clients is not unprecedented, it is one of the most serious sanctions the government has attempted to impose on the accounting industry -- “almost as close to the death penalty as one could get,” said Allan D. Koltin, a management consultant to the accounting sector. Experts said that Ernst’s rivals would probably use the ban in an effort to wrest current clients away from the firm. The ruling is a substantial victory for the SEC staff, which recommended the sanction and argued that Ernst’s close business ties with PeopleSoft jeopardized investors’ ability to rely on the company’s financial statements.

WYOMING COUNTY EDGES OUT FAIRFIELD, CONNECTICUT FOR WEALTHIEST IN AMERICA

For the fourth time in six years, Teton County -- home of scenic Jackson Hole and gateway to Yellowstone and Grand Teton national parks -- is the wealthiest in America. Teton’s average adjusted household gross income in 2002, the latest year for which data is available, was $107,694, or 2% higher than runner-up Fairfield County, according to the IRS. Other high-income counties were Marin, California, Somerset, N.J., and Morris, N.J.

Many wealthy people move to Jackson for its myriad outdoor activities and culture, real estate broker Bob Graham said, “It’s second only to the enormous tax advantage the state of Wyoming offers.” Wyoming has no personal or corporate income tax and relatively low property taxes thanks to revenue from a robust minerals industry. Others may delight in the amenities of New York, the hot tubs of Marin County, the pleasant estates of Fairfield County or the Hollywood glitterati of Aspen, Graham said, “but it’s going to cost you dearly.” Jackson Hole offers other aspects such as isolation.

DOES THE LAW OF SUPPLY AND DEMAND “APPLY” TO STOCKS

Let’s go over the economics explanation of the law: Consumers of goods and services (cars, bread, clothes, shoes, etc.) buy more as prices go down, and less as prices go up. We do not have a problem with that. That is basic economic behavior. What it is not, however, is basic financial behavior.

Don’t buy it? Well, consider what you probably know about the stock market. When the price of a stock falls, trading volume usually does too. And when prices rise, trading volume usually does too. This is the opposite of how the law of supply & demand works! Can you imagine a world where the economic market behaves like the financial market? Have you ever walked into a shoe store and heard the manager shouting, “Double up because prices are through the roof!”

OK. The next question is -- Why is most people’s economic market behavior different than their financial market behavior? Believe it or not, we use a different part of our brain when buying a pair of shoes vs. when we invest in stocks.

UNCOMFORTABLE PARALLELS

The first “new era” of the twentieth century took place during the 1920s. World War I had ravaged the developed world, central banks had been established across the globe, and the U.S. had become an economic and military power. The Progressive Era had reinvented America, giving women the right to vote, establishing a federal income tax, and prohibiting alcohol across the nation. With the world at peace and a series of tax cuts, the U.S. had a prosperous economy during the 1920s.

The decade also experienced a technological revolution as important as the world has ever experienced. This was the decade when the airplane and automobile went into mass production. In communication, it was the onset of mass availability of the telephone and radio. Motion pictures were invented, along with household appliances such as the dishwasher, electric toaster, and refrigerator. The use of petroleum products and electricity increased dramatically while the use of manual power decreased. Assembly-line production became ubiquitous and was seen as the key to industrial progress.

The period of economic boom and stock market bubble during the 1920s is often referred to as the Roaring Twenties. It was far from a utopian time given all the crime, corruption, and violence created by alcohol prohibition, and there were clearly imbalances and instability in the economy. None of this, however, could discourage or dissuade the optimists of this “new era.” Politicians, industrialists, and the financial press were all intoxicated. Irving Fisher was one of the most prominent economists of the period and is still consider by mainstream economists to be one of the greatest American economist of all time. He was an enthusiastic supporter of Herbert Hoover and believed that the great economic prosperity of the 1920s was attributable to alcohol prohibition and, most importantly, the “scientific” stabilization of the dollar that had been undertaken by the Federal Reserve. Naturally with both policies firmly in place, Fisher was completely blindsided by the Great Depression.

The key development of the 1920s was that monetary inflation did not show up in price inflation as measured by price indexes. As Fisher later noted: “One warning, however, failed to put in an appearance -- the commodity price level did not rise.” He suggested that price inflation would have normally kept economic excesses in check, but that price indexes have “theoretical imperfections.” Fisher had stumbled near a correct understanding of the problem of new-era thinking. Technology can drive down costs and increase profits, creating periods of economic euphoria, where economic signals would otherwise inject greater caution and clearer thinking.

In Austria, economist Ludwig von Mises apparently saw the problem developing in its early stages and forecast to colleagues the crash of the large Austrian bank, Credit Anstalt, as early as 1924. More importantly, he wrote a full analysis of Irving Fisher’s monetary reforms, published in 1928, where he targeted Fisher’s reliance on the price index as a key vulnerability that would bring about Great Depression, concluding: “because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions.” He then demonstrated how Fisher-type monetary reforms cause booms and that these booms inevitably result in crisis and stagnation, and he attributed the popularity of the reforms and the resulting cycle to political influence and bad ideology. In addition to demonstrating the inevitability of the crisis, he clearly identified its cause, where most others could not.

He showed that the central bank’s attempt to keep interest rates low and to maintain the boom only makes the crisis worse. Despite the tremendous odds against the adoption of his solution, he ends his analysis with a prescription for preventing future cycles. The only way to do away with, or even to alleviate, the periodic return of the trade cycle -- with its denouement, the crisis -- is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap. In addition to von Mises, his student F. A. Hayek and several others published articles in late 1920s which he predicted the collapse of the American boom. They were all largely ignored.

DISCOUNT PUNCH AT THE NEVER-ENDING PARTY

Four decades ago, the Chairman of the Federal Reserve System who held onto his job longer than any other Chairman, William McChesney Martin, described the FED’s job: to take away the punchbowl just when the party gets rolling. It is clear that his successor, Alan Greenspan, does not see the FED’s job in the same way. He sees it as supplying the punch at discount prices. This report is on the price of punch, the supply of punch, and hangovers.

To understand this report, you need to be a good economist. To be a good economist, you need two imaginary parrots. One sits on your left shoulder and says, “supply and demand”. The other sits on your right shoulder and shouts, “high bid wins”. If you listen to both parrots and apply these truths to the problem you are dealing with, you are unlikely to make a major mistake.

A REMEDY FOR FINANCIAL TURBULENCE?

The severity and frequency of financial crises, especially the combined currency and banking collapses of the past decade, have made financial instability a scourge of our times, one that bears comparison with damage inflicted by famine and war. In a new paper for the Copenhagen Consensus, Barry Eichengreen, from the University of California, Berkeley, has reviewed the literature, attempted to count these costs, and to weigh them against the costs of a particular proposal for remedial action.

The costs can be reckoned in stalled growth and stunted lives. The typical financial crisis claims 9% of GDP, and the worst crises, such as those recently afflicting Argentina and Indonesia, wiped out over 20% of GDP, a loss greater even than those endured as a result of the Great Depression. According to one authoritative study, the Asian financial crisis of 1997 pushed 22 million people in the region into poverty.

What might be done to make financial crises less common? The answer depends on the causes of financial meltdown. Governments bring some crises on themselves by pursuing fiscal and monetary policies that are inconsistent and unsustainable. Such self-defeating policies may be the symptom of deeper flaws in the body politic. If so, there is little outsiders can do. But some countries’ financial fragility results simply from their need for foreign investment. In the most susceptible countries, firms and banks borrow heavily in dollars, while lending in local currencies. If the value of the local currency wobbles, this mismatch between domestic assets and foreign liabilities is cruelly exposed.

Why are the assets and liabilities of emerging markets so ill matched? Perhaps because poorly supervised and largely unaccountable managers have scant reason to be careful with other people’s money. But Mr. Eichengreen offers another reason. International investors are very choosy about currencies. Most consider only bonds denominated in dollars, yen, euros, pounds or Swiss francs. This select club of international currencies is locked in for deep historical and structural reasons. Thus, poor countries that want to borrow abroad must bear currency mismatches through no fault of their own.

If this is the problem, possible solutions follow naturally: either create a common world currency, used by rich and poor alike, or invent a liquid, international market for bonds denominated in the pesos, bahts and rupiahs that emerging markets are obliged to use. The first solution, even if it were desirable, is politically impossible; the second is merely very difficult. Mr. Eichengreen spells out in his study an ingenious plan to make it a little easier.

DISSONANCE & EUPHORIA

Bullishness is back, in force and vogue. Soaring earnings and economic rebound are the pillars of a glittering recovery McMansion. There is no disputing that the Fortune 500 had a great run in 2003 -- especially compared to the terrible years of 2001 and 2002. Their 540% increase in profits on 7% revenue gain is both exhilarating and bracing. The causes of macro glee are far harder to understand and follow. While the March BLS employment report was positive, it was far more a PR and short term trading event than an economic sea change. After all, the ranks and rate of unemployment failed to move as 1 month’s good data do not undo three lean years. The present bout of euphoria rests on a very selective focus and more than a little bit of dissonance driven acquisitiveness in the markets.

One has to walk a macro and global economy high wire, refusing to look down, left or right. If you carefully follow this self imposed myopia you too can feel happily assured. If -- by chance or training -- you look around, timber!

Markets have stubbornly refused to price in or trade any of the recent news out of Iraq. The alarming situation in Saudi Arabia bears only passing mention. The personal debt explosion is ignored. The trade deficit is ignored. Budget deficits are ignored. The importance of housing and its exposure to upward rate pressure are off the talking points list. Election year risks do not exist -- even as polls predict a close, bitter race. Energy prices are no big deal. Persistent economic weakness, growing rage over outsourcing and weak job prospects are not worthy of mention. However we all know the above really do matter. Common sense would suggest that the radiant blush may be projected onto the recovery rose by dissonant euphoria.

BOSTON RED SOX OWNER’S SUCCESS DRIVEN BY NUMBERS

Twenty-six years old, and left by his father’s death to run the family farm in the rich soil of the Arkansas Delta, John Henry penciled out his problem this way: 1,000 acres planted with soybeans, each producing 40 bushels, equaled 40,000 bushels of soybeans. What to do with all those soybeans? Henry’s pursuit of a solution led him to the commodity markets, where contracts for agricultural products are bought and sold, and sparked a fascination with price movements that ultimately transformed him from farmer to financier. In less than a decade, Henry, a college dropout, not only taught himself the risky business of commodity speculation, but in short order devised his still-working trading model; pioneered a type of investment called “managed futures”; and launched a firm that is among the most successful of its kind in the world.

In Boston, Henry is best known as owner of the Red Sox, an enterprise that he, like the Yawkeys before him, has so far been unable to lead to the pinnacle of the baseball profession. But in the investment industry, Henry, 54, is an established superstar, described by friends and colleagues in the business as a “genius”, “visionary”, and, most of all, “winner”. In a game in which they really play for keeps, Henry has not only risen to the top, but stayed there through innovation, discipline, and an unconventional philosophy that makes money, as Henry wryly puts it, by “buying high and selling low”.

Through booms and busts, and against doubts that a trading system, tested against figures scratched out in the Memphis public library, would stand the test of time, Henry has stuck confidently to his approach, and produced solid returns for investors who have stuck with him. The result: his firm, John W. Henry & Co., ranks among the world’s biggest traders of futures, with about $2.5 billion under management.

Henry, in the parlance of his industry, is a “trend follower”. Unlike so-called fundamental traders, who analyze economic and market data in an attempt to predict where prices will go, Henry tracks actual price changes to try to pinpoint market trends early on, and ride those trends. Henry’s traders buy after prices come off absolute bottoms and sell after they pass peaks, but still end up with enough of a price spread to profit. Henry says this approach focuses on “what is, not what should be,” a lesson he learned in his early 20s after meeting Jiddu Krishnamurti, the late Eastern mystic who influenced millions. The other key underpinning is a belief that humans, by nature, are trend followers, reacting mechanically to events, much as the clapping of one person in Fenway Park will be followed by another and another until it becomes a crescendo of applause.

INDIA THE NEXT CHINA?

Quite simply... India has been on the brink of “emerging” and becoming a world force about 40 times in the last 20 years. OK, I exaggerate, about once every two or three years. But it never quite sticks. It is not trustworthy yet. India has not yet gathered China’s momentum. Or, as they say these days, it has not reached “the tipping point”.

COMMODITIES ARE HAVING THEIR DAY

Famed investor Jim Rogers thinks commodities are in a 10-15 year up-cycle.

While Rogers may be downright wrong in many respects, he may actually be right on this one. Rogers, a successful co-founder with George Soros of the Quantum Fund, made his non-Wall Street reputation a few years ago with a best-seller Investment Biker in which he went around the world on a motorbike, accompanied by an attractive blonde, to determine which developing countries were about to become investible emerging markets. For his latest book Adventure Capitalist he repeated the process in more countries, armed with a yellow Mercedes and a new blonde (who became his wife part way through the trip.)

The disadvantage of Rogers’s approach to investment was graphically illustrated when he waxed enthusiastic over the prospects for China, while dismissing India in four words: India is a scam. Readers of the book will discover that in rural Jabalpur, India, some unfortunate villager, untutored in the norms of politically correct New York society, touched Rogers’ girlfriend’s bottom -- being a well-toned New York girl, she slapped him several times around the face, after which he fled, no doubt feeling as if he would been in a punch-up with Mike Tyson! Thereby, a billion hard-working Indians were immediately condemned to economic failure.

Rogers’s understanding of investment fundamentals is otherwise pretty sound. In particular, his main recommendation during the meeting, that commodity prices are on a 10-15 year up-cycle while stock prices mark time, is highly thought-provoking. Commentators conditioned by the long 1980s-1990s trend of declining commodity prices in real terms, with the decline accelerating during periods of economic weakness, have been surprised by the strength in oil and gold prices, in particular, since their nadirs of 1998 and 2000 respectively. Gold is currently hovering around $400 per ounce, around 50% above its 2000 low, although still 80% below its 1980 high, while oil prices are well over $30 per barrel in terms of Brent Crude, triple their 1998 low, and are as yet showing no signs of weakening.

With supply limited in the short and medium term, the prospects for oil prices indeed appear bullish, with a return to 1981’s peak of around $70 per barrel in 2004 dollars by no means impossible. Of course, that would have enormous knock-on effects on the world economy in general and the U.S. economy in particular. Rogers, who is not particularly bullish on gold, instanced lead as another commodity whose price was likely to soar, since no new lead mine has been opened in 30 years. Here however he is on shaky ground; world demand for lead has shrunk dramatically over the last half century, as awareness of its toxicity has risen -- roofing, pipes and petroleum additives are all former rather than current uses for the metal. Silver is another commodity whose principal industrial use, photography, has been replaced by new technology.

But whatever happens to output in the West, the entry into the world’s commodity markets of 2.3 billion Indian and Chinese consumers is likely to tighten the supply/demand situation for many commodities for a decade to come -- with huge implications for the world economy, almost all of them bearish and inflationary.

Here is a bubble you can still buy.

Concrete, copper pipe and lots of steel ... If that does not sound sexy to you, you are not paying attention. The crush outside a Morgan Stanley investment conference door reminded some of a similar standing-room-only meeting the investment bank held almost exactly four years earlier. That one was called “Networks, Internet and Software.” We have us a bubble here, folks, but unlike that Internet thing this one is just beginning. Computers and natural resources are both cyclical industries, but they have radically different tempos. You can outsource a router to Singapore almost overnight; it takes years to dig a mine.

“We have not added to productive capacity in most resources for several years,” says Charles Ober, manager of T. Rowe Price New Era (PRNEX), one of the longest-tenured managers in this newly popular sector. “There’s a window of at least three to five years before a lot more capacity comes on to satisfy what we see as growing demand.”

Demand is growing throughout the world, and nowhere more than in China, whose gross domestic product skyrocketed at a 9.7% rate in the first quarter and whose infrastructure building has created the fastest-growing market for energy and materials. Funds like Ober’s and RS Global Natural Resources (RSNRX) are in a position to outperform the market for a good long while. The RS fund is “one of the least-correlated with the S&P 500 in its category, making it an attractive diversifier,” says Morningstar analyst Lynn Russell.

Golden opportunities for investors in commodities.

Right now commodities are hot. You might think tin a dull metal, but if you had bought a ton in April last year for the then market price of $5000, it would now be worth $9000. Thereby hangs a tale of developing economies -- China, India, and neighbors such as Malaysia -- and their red hot economic growth and insatiable appetite for raw materials used in manufacturing. 75% of global tin production comes from Asia, and Asia has become the worl’s factory. Our lost capacity to manufacture is their gain. This is the compelling story behind the rise in all commodity values over the last several years.

There is a fundamental split in the commodity market. Most commodities, including crude oil, tend to go up in value as demand increases due to economic activity. Gold and platinum are not necessarily priced this way. They are used as hedges against risk in periods of volatility. Platinum has just reached its highest price in 24 years, at $930 per ounce. So the current commodity markets put up some conflicting signals.

The mining sector of the FTSE (Financial Times Stock Index) All Share index has grown in value by 40% over the last year, against a rise of 20% for the FTSE 100. As long as the arguments about China’s appetite for raw material are believed, this is likely to continue.

Commodities to the moon

In the 1970s, the United States played fast and loose with its monetary policies. The result was a decade of stagflation and the largest bull market in commodities in over a century. As we can see, Washington is again busy running the printing presses by pushing interest rates to record lows. True, rates must eventually rise... but the “damage” has been done: Bernanke’s printing press and the lowest rates since Eisenhower’s time have already kicked off a roaring bull market in commodities.

But there is a second and perhaps even more powerful fundamental that will drive commodities throughout this decade -- the rampant growth of consumerism. And this time around, it is not coming from the U.S. (for how could consumerism in the U.S. grow even more prevalent?). Instead, the growth of consumerism is charging from a direction you may not have expected: the East.

In his book How Much is Enough?, futurist Alan Durning argues that the world is broken down into three distinct groups arranged by economic wealth. He calls these classes, “consumers”, “the middle income”, and “the poor”. Consumers make up a little more than one billion of Earth’s 6 billion citizens, and are concentrated in North America, Japan and Western Europe. The poor make up about the same number and are largely represented in Africa. It is the middle-income class -- the 3.5 billion people who live in China, India and Latin America -- that will soon place the greatest strain upon the world’s natural resources. Why? Because as they move up the economic ladder, the middle-income class will become a class of consumers. And consumers do exactly as their name suggests -- they consume, particularly copious amounts of real assets.

From 1950 to the mid-1990s, Japan increased its aluminum consumption by more than four times, multiplied its energy needs by five and upped its steel consumption 25 times over. Japan is a nation of less than 130 million people (and counted only 83 million back in 1950). Apply Japan’s economic growth over the latter half of the 20th century to China’s 1.3 billion people, and India’s 1.1 billion... and the numbers quickly become so big, they are hard to comprehend.

Rally in non-oil commodities is sustainable says World Bank.

A rally in non-oil commodity prices should accelerate slightly in 2004 amid tight supplies and firm demand, the World Bank said in a report Monday. It said prices should climb 10.4% this year, a notch higher than the 10% rise in 2003.

AUSTRIAN ECONOMICS MADE REAL

With much trepidation, I opened the Scholar’s Edition of Murray Rothbard’s classic, Man, Economy, & State w/ Power and Market, to begin a deeper study of Austrian economics. With much relief, I found the reading to be pleasurable; the concepts easily understood; the logic flowing seamlessly as Rothbard leads his reader to a clear understanding of the principles developed by Mises in Human Action, and much more. I relaxed and read during the four days spent in the car, traveling to and from Texas.

Rothbard’s examples help the reader visualize the principle being explained, so when I came to: As the offering price rises, the disproportion between the amount offered for sale and the amount demanded for purchase at a given price diminishes, but as long as the latter is greater than the former, mutual overbidding of buyers will continue to raise the price. The amount offered for sale at each price is called the supply; the amount demanded for purchase at each price is call the demand... as long as the demand exceeds the supply at any price, buyers will continue to overbid and the price will continue to rise. The converse occurs if the price begins near its highest point. (Pgs 114–115)

I instantly visualized, “Auctions!” Country auctions. City auctions. Butcher shop auctions. Estate auctions. Amish auctions. I have been to more auctions than I could ever count.

SOME LONG-TERM CONCERNS ABOUT MICROSOFT

Despite its overwhelming market share, I still have long-term concerns about Microsoft and its growth outlook. Aside from slowing growth at the company and the competitive threat of Linux, my concerns include the delay of Longhorn and the transition leading up to its introduction. That said, I think the company may eke out a slightly better-than-expected quarter when it reports on April 22.

Long-term the basic problem with Microsoft is that IT budgets are not going to grow very fast over the next several years, and they already own large chunks of the market. So there is limited ability to increase revenues from the MS Office business because the company risks ticking people off and driving more people off license. Microsoft does have some areas where it can grow. Databases and analytical services are two, as well as in the small business end-user segment.

I believe that MSFT at 9x sales is a stock that is priced too high for this scenario. I would consider somewhere around 7x sales to be a more appropriate reflection of its growth outlook.

WORLD’S RICHEST GET BACK TO BASICS

Until recently, according to the Sunday Times, the wealthiest person in the U.K. was the Duke of Westminster, whose fortune is estimated by the paper at $9.8 billion. Now the duke has been bumped down to second place by Roman Abramovich, the 37-year-old oil billionaire, whose fortune is estimated at $13.4 billion. The change reflects the way that wealth is changing in Britain and around the world. The two men could hardly be more different, and the paths they took to acquire their fortunes were also dissimilar.

The duke, as his name suggests, inherited his money. The family owns the land on which most of central London sits. As London has become richer, so has the Westminster family. Abramovich, who bought the Chelsea soccer club last year, is chiseled from much rougher stone. A self-made man, his fortune stems from the chaotic sale of state assets after the breakup of the Soviet Union. Abramovich got control of Sibneft, Russia’s fifth-largest oil producer.

As in Britain, the global crown may change hands sometime soon, as well. Earlier this month, the Swedish business publication Veckans Affarer caused a ripple of controversy by claiming that Bill Gates, the founder of Microsoft, was no longer the world’s richest man. That throne had been taken, it said, by Ingvar Kamprad, the founder of the Swedish furniture chain IKEA. It would be wrong to get too excited by that calculation. There are a couple of caveats to bear in mind. In any case, Forbes estimates his fortune much more conservatively, at just $18.5 billion, which makes him merely the 13th-richest person in the world on its list.

Still, pushing statistical disputes aside, there is an interesting nugget of truth in there. Publications of rich lists are not a precise science. Estimates are just that. It is the direction that is interesting, and that tells us that the traditional holders of wealth are being challenged. The businesses of Abramovich and Kamprad are about digging stuff out of the ground, turning it into things and then selling the final product. Those are basic, simple industries -- and that is where the world is wealth is now being accumulated.

THE 15-MINUTE RETIREMENT PLAN

MONEY Magazine has created a simple system for getting your retirement on track, using principles you can learn in just 15 minutes. Our plan includes no detailed calculations of future living costs, or worksheets for locating every penny of your net worth. But that does not mean this program is not sophisticated. Basically, we have done the heavy lifting and distilled retirement planning into a flexible system that can grow with you.

Best of all: Once you put our plan into action, you need to do very little -- about 15 minutes’ worth of work a year -- to maintain it. And that will liberate lots of time to, say, play with your kids or figure out your next vacation. So let’s get to it.

BANK STOCK WARNINGS TO BE IGNORED (OR NOT)

In recent years, Buttonwood has written many an article on the American banking system. Learned, pithy and opinionated, the only thing about his analysis that could possibly be faulted is that it sometimes turned out to be spectacularly wrong. Bank after bank has announced a sharp increase in profits in the first quarter of this year. And yet bank shares have foundered: the banking bit of the S&P 500 is some 7% off its high. Investors, it seems, doubt whether the good times can continue. Though fully in agreement with these views, his dismal track record at the very least requires Buttonwood to put the case for the defence. For example, bank profits could actually rise when the Fed raises rates.

Banks essentially take two risks. The first, dubbed “maturity transformation” risk, involves borrowing short and lending long. The bigger the difference between short- and long-term rates, the more money banks make. Thanks to the largesse of the Fed and its 1% short-term rates, the yield curve -- the difference between short and long rates -- has been at or near a record high over the past couple of years. The difference between two- and ten-year Treasuries, a good way of measuring the slope of the curve, has been two-and-a-half times its average of the past 20 years, says David Hendler of CreditSights, an independent research firm. As a result, he says, “you could have strapped any monkey to a trading chair and made money.” The fear, of course, is that banks could lose heavily if long-term rates rise sharply, because the (longer maturity) securities that they have bought already would fall in value. And many other investors have also taken full advantage of the steep yield curve, which might mean a decidedly nasty fall as they head for the exits at the same time.

But the second risk that banks take -- credit risk -- is just as big a concern in a rising interest-rate environment. Credit costs have fallen sharply in recent years for consumers and companies alike, thanks to a buoyant economy and low rates. David Fanger, of rating agency Moody’s, argues that those costs are likely to remain low because the Fed will be raising rates at a time when the economy is humming along nicely. But given how high consumer and corporate debts are, and how low the price now charged to lend to riskier borrowers is, such a view seems overly sanguine. You may feel, however, that such warnings can be safely ignored.

TECH STOCKS: WHAT IS LEFT TO BUY?

It is still not easy picking tech stocks, even as the industry recovers from a three-year slump. Some investment professionals advise that the best method might be banking on large, established players. Others say to seek out fast-growing smaller firms, or to bet on expansion in a niche like online advertising or wireless telecommunications. And as you would expect, there are plenty of professional pessimists who recommend wagering on last year’s most successful stocks to take a fall.

While there is little agreement, the fund managers and financial advisers who recently spoke with Wired News about their stock picks concurred that finding screaming buys has become more difficult. That said, with a little patience and a lot of research, professional stock pickers believe there are still good deals to be had.

Fred Siegel, president of The Siegel Group, a New Orleans financial advisory company, advises investors to evaluate their risk tolerance before plunging into technology, which is historically one of the market’s most volatile segments. Bob Strauss, portfolio manager for the Icon Information Technology (ICTEX) mutual fund, says that “Now it’s become a much more selective process to identify value.” Using a formula his fund employs to gauge a stock’s intrinsic worth, Strauss estimates technology stocks are about 6% undervalued. Certain niches within technology, such as wireless telecommunications, technology distributors and Internet software and services, are even more undervalued, he said.

REAL ESTATE DANGER SIGNS

“Real estate on this here island is only goin’ up,” my dental hygienist told me last week. She is probably 19 years old, but she was certain about getting rich in real estate. You would have thought that the Lord had whispered, “Buy Florida real estate” in her ears... Quite frankly, everybody where I live believes that real estate prices can only rise. There is nobody here that believes that real estate prices can fall... which is exactly my cause for concern...

Long-time readers of mine know that I do not think U.S. real estate is wildly overpriced... yet. But I think it is about to be. Everybody sees real estate as a “sure thing”. I am concerned that people now think real estate is even more of a sure path to wealth than the Internet stocks of the late 1990s. And we all know what happened to that “sure thing”.

Barron’s magazine recently featured an interview with Mike Kirby, whom I consider to be the best in the business in real estate stocks. Kirby started Green Street Advisors 20 years ago. Green Street simply analyzes real estate investment trusts. REITs are a great way for investors like you and me to own a professionally managed, diversified portfolio of real estate, simply by buying a stock (a REIT). Green Street does not do investment-banking deals, and it is not affiliated with a major brokerage firm. I believe that makes this company pretty darn independent.

Cutting right to the chase, Kirby says, “Valuation levels are probably as rich as we’ve ever seen”q As an example, Equity Office Properties (NYSE: EOP), the largest real estate stock, “is trading at more than 20% over our estimate of net asset value.” In plain English, the stock is selling for 20% more than the liquidation value of EOP’s properties.

I stand by the advice I gave to True Wealth subscribers last week: “I expect real estate to continue higher, and we’ll continue to ride it. But I’ll have no problem exiting when the time comes, or when we hit our trailing stops on our real-estate-related stocks (some of which are up over 150%). Enjoy it while it lasts. But be aware. Know that a speculative bubble is being created, on a pile of debt, and the end will likely be ugly.” I am not trying to be Chicken Little here -- I am just calling it as I see it.

So where are the good values to be found today, if not in real estate or stocks? What sounds like a risky, ludicrous investment right now? What investment seems ridiculous to make, that nobody will ever make money on? That is what you should be asking, as that is where you will find the real bargains. In the end, when folks fresh out of high school are certain that real estate is a sure thing, you can be sure that it isn’t...

A RIVER OF LOSSES IS ON THE WAY

“I was leaning toward the view that some assets would continue to increase in value in 2004. I am now increasingly concerned that sometime soon ‘everything’ could begin to unravel. When interest rates rise, it is conceivable that bonds, stocks, commodities and real estate will all decline in value at the same time.” -- Marc Faber, in the Financial Times.

This is the most important advice I have ever given. And, chances are, you do not want to hear it. In fact, after you read this essay, you might never want to hear from me again. But it is a chance I am willing to take. So here it is: Very soon, you could lose a lot of money. Right now, the way I see it, it will be extremely difficult over the next year -- at least -- to make money ANYWHERE in investing.

I think Marc Faber is right. The fact that interest rates have been at multi-generation lows for a very long time has caused investors to chase anything and everything higher. The obvious result is that everything has been bid up. Stocks and bonds were first. But now commodities and real estate have been bid up as well. As I will show, I think many markets are close to their peaks. I now see the stock market (and most investable assets) like a river, working its way from the mountain peak to the sea. I see investments as that river today. The inexorable flow in investment values is down.

Let us consider some of the major asset classes (like stocks, real estate, and commodities), and see what may happen in the coming months and years. And then we will talk about the eddies -- which investments, if you are ambitious enough to consider them, might flow against the current.

I do not work on commission. I do not have an interest in whether you buy, sell, or hold. And so, unlike your broker, I am free to tell you -- this next year could be devastating to many “traditional” investments. If you do nothing else, I recommend you get out of the markets right now. Cash may turn out to be the best-performing asset of the next year.

FOREIGN CENTRAL BANKS STILL BUYING U.S. DEBT

Foreign central bank holdings of U.S. debt have hit another record high, the Federal Reserve reported on Thursday, which should ease concerns in the market about a slump in foreign demand for Treasuries. The Fed said its total holdings of Treasury and agency debt kept for offshore central banks rose $4.715 billion to $1.186 trillion in the week ended April 21. The increase came despite speculation that the Bank of Japan had sharply reined in its currency intervention recently, leaving it with fewer dollars to invest in U.S. debt.

NOTHING IN LIFE IS FREE

Inflation -- an expression of the universal desire to have something for nothing. Politicians meet that desire by creating “free” money at a faster rate than the economy is growing. It happens every time the American economy is not running at full efficiency. Unemployment begins to creep higher, wages begin to stagnate and the god that is retail sales begins to falter. And the federal government responds like a fire station would to a five-alarm alert. Rather than using thousands of gallons of water to douse flames, the government throws in trillions of dollars to stop the worst calamity that any politician can imagine -- DEFLATION.

They lower interest rates... they damn the deficit budget and open the government’s spending spigots. Both float the economy, and over the short term nobody thinks twice about the real cost. But there is an old saying, “Nothing in life is free”. Why does the government think otherwise? As the government attempts to combat inflation with short-term solutions, we begin to feel the long-term effects.

Inflation is called the silent tax. Only when it becomes extreme do you realize that your purchasing power has gone to hell... and that even if you are making more money than you were before, you are actually able to afford fewer things. So be careful the next time you hear someone tell you something is free. Especially a salesman or a politician.