Finance Digest for Week of October 25, 2004

LESSONS FROM THE LATEST AND PAST FINANCIAL SCANDALS

At supper on Saturday, I was told by an old college chum, the finance director at a medium-sized firm, that he had found the insurance arrangements at his previous company a bit odd: although the company bought its insurance through a broker called Aon, said broker always seemed to place the business with the same underwriter, AIG. Still, it seemed explicable at the time. Aon is the world’s second-biggest insurance broker, and AIG its biggest insurer. Heavens, in a statement late last week, AIG even said that it upholds “the highest ethical standards”, any breach of which was “unacceptable”.

Its statement might, perhaps, have carried more weight had it not been made on Thursday October 14th, when Eliot Spitzer, New York’s energetic attorney-general, and a man who has made a career out of exposing wrongdoing in the financial-services industry, announced that he was gunning for the insurance industry. AIG and Aon are among those caught up in an investigation of bid-rigging and much else besides.

America’s insurance industry, it is clear, is in hot water. “Trust me, this is day one,” said Mr. Spitzer. Day two brought forth a widening of the investigation, to include life and medical insurers such as MetLife and Aetna, and a dramatic fall in the value of securities issued by insurers and brokers, not least those of Marsh & McLennan, the world’s biggest insurance broker. Spreads on the firm’s bonds have widened dramatically, and its shares fell by 45% in just three days. Though those in other insurance firms have fared less horribly so far, they still look vulnerable. All manner of dodgy practices, and the companies that may have engaged in them, are now under the spotlight.

Unbeknownst to buyers of insurance, it seems, they have been buying their products from a cartel. Insurance brokers are supposed to act as middlemen, buying the cheapest cover for their clients (companies) from the suppliers of it (insurers). During a period of rapid consolidation in the late 1990s, a dozen or so of the biggest insurance brokers were whittled down to three: Marsh, Aon and Willis. This might have suited the companies that used them to buy insurance, since bigger brokers should have more buying power and should thus be able to gouge lower prices from insurers. That, you can be sure, was the argument that the brokers used. As it turns out, however, the brokers received commission not only from those that bought insurance from them but also from the insurers themselves, which skewed the incentives somewhat. It is this apparent conflict of interest that Mr. Spitzer started to investigate in April.

While these commissions might or might not be illegal, other practices that have exercised Mr Spitzer and his shock troops certainly would be. Bid rigging, they claim, is widespread. There is, however, an oddity in all of this. If there were apparently so few insurers doing the business, why did companies feel the need to use a broker? Surely it would not have been much effort for them to make a few phone calls and bypass the middleman. Brokers seem to have made a lot of money out of customer inertia and insurance gobbledygook.

And in that, the insurance industry is not alone. Financial firms the world over make piles of money from customers’ fear of the complexities of finance, a fear that it is not, of course, in financial firms’ interests to calm. Quite the contrary, in fact: making the simple complex, and coming up with apparently easy and cheap solutions to apparently byzantine problems, has long been a staple source of income for financial firms. That is perhaps the biggest lesson of all from the financial scandals of the past few years.

OCTOBER 1929 WAS 75 YEARS AGO -- CAN THE U.S. STOCK MARKET CRASH AGAIN?

Wall Street experienced some of its darkest moments 75 years ago in October 1929. Three “black” days over four trading sessions started a punishing decline in stocks that would not end until 1932. America entered into a decade-long funk known as the Great Depression, and yet many publicly traded companies from that time endured and still exist. But could a crash happen again? Conservative optimism reigns on Wall Street. While most market strategists do not rule out the possibility of a market crash of titanic proportions, the majority say the likelihood is very low, less than 1%.

Robert Prechter, founder of research firm Elliott Wave International and author of Conquer the Crash finds the probability of a 1929-like crash to be high (which will be no surprise to those familiar with his work): “Every one of the preconditions for a crash is in place, to a greater degree than ever.” Alfred Goldman, chief market strategist at A.G. Edwards, finds the probability of a 1929-like crash to be “... zero to none. I don’t even think about it, it’s negligible.”

CENTRAL BANKING IS A SPECULATION

“The Federal Reserve Act does not … contemplate the use of the Federal Reserve System for the creation or extension of speculative credit.” -- Public Announcement by the Fed on February 2, 1929

There is irony all over the place on the above statement. One, of course, is the Fed’s reckless accommodation of Wall Street during the “Roaring Twenties”. This was competently criticized by no other than Alan Greenspan in some essays published in The Objectivist in 1966. Two, as chairman, he then presided over the most reckless credit expansion by the senior central bank since the Bank of England “accommodated” the notorious South Sea Bubble of 1720.

Some time ago, we noted that 300 years of financial history is, itself, a due diligence on central banking and concluded that the concept that the Fed can manage interest rates and the currency is, itself, a highly speculative notion. Orthodox theory insists that the market is a random walk that can be altered by willful manipulation of interest rates and currency valuations. Financial history suggests otherwise as old patterns continue to recur. The key one is that a long expansion ends with an “old” era of inflation that becomes intolerable.

The undeniable collapse of that speculation was followed in every case by an overly celebrated “new” financial era. As usual, this culminated in a bubble and collapse. Also, this historical model allowed for a cyclical recovery in the third year after the mania. As we have been developing, this is now maturing and is eligible for failure. The conviction that the Fed and China can keep the boom going forever is massive. This will be managed by the Fed continuing to “print” dollars and the Chinese continuing to speculate in industrial commodities. The probability of both games continuing is outlined below.

Two of the greatest events of the past 100 years have been the harsh deflation of the early 1930s and the end of rampant inflation in 1980. The establishment’s opinion on both is self-serving rather than practical. In the later case, there was no change in the basic definitions of money as M1, M2, etc., but after a brief pause in 1981-1982 monetary expansion resumed its relentless pace. Instead of driving commodities and inflation (which was bad), it was driving the stock market, which was good, and naturally the result of brilliant policy. Interventionist economists have yet to explain how, in one decade, vigorous expansion of, say, M2 results in soaring prices for tangible assets, which trashes bonds and then in the next it ramps up stock and bond prices.

Of course, history provides clarity and consistency. Since 1700, every “old” era of inflation has been followed by a “new” era of soaring financial markets -- the 1990s example was the sixth and the transition was always the same but with the distinction that prior to the 20th century policymakers did not take the credit for a natural turn in the financial markets. In 1981 - 1982, institutions had finally accepted that the Fed was the engine of inflation and lousy returns from stocks and bonds would continue. At the time, our summary of the instruction from history was “no matter how much the Fed prints, stocks will outperform commodities”. This was controversial, as is history’s current instruction that as today’s speculative action in both tangible and financial assets burns out, Mr. Market will again deny the Fed’s compulsion to trash the dollar.

PULLING TOGETHER THREE BEARISH THEMES

Three not-so-bullish stock-market themes are at work at the moment: a scary October, the possibility of a major failing rally, accompanied by approaching electoral chaos. Here is a brief update that helps pull the three together.

KEEPING UP WITH THE JONES

“Jim” borrowed money because he wanted to own more things. In the process, he committed a significant portion of his future earnings to the banks. Now he has sold his possessions for a fraction of what he paid for them, and the banks own him. They will continue to own him until he has paid them off. Jim consumed more than he produced... then the bottom dropped out of his productive output, and it pulled the rug out from under his life. If Jim’s foolish behavior were an isolated case, this story would end here. But Jim’s behavior is typical of many individuals in the United States. Right now, there is about $8,000 worth of credit card debt outstanding for every man, woman and child in the United States.

Like Jim, the United States as a whole is consuming much more than it is producing. But instead of transferring its wealth to banks the way Jim did, the U.S. is transferring its wealth overseas, to other countries -- so far to the cumulative tune of about $2.5 trillion. Now, most of this is simply debt money lent to us by investors living in other countries. In July 2004, U.S. government debt stood at over $7 trillion. About 40% of that is owed to investors based outside the U.S. That is almost $10,000 in federal debt for every man, woman and child in America owed to foreign investors. We get their goods. They get our debt, our IOUs.

This would be perfectly fine if there were not such a thing as legal tender laws. Legal tender laws in the United States say that we have to accept U.S. dollars as payment for all debts and transactions, public and private. It follows that there is a real risk that someday -- perhaps soon -- a lot of those dollars are going to come flooding back into the United States. Suddenly, you are going to have a lot more dollars chasing the same amount of goods and services around the U.S. economy. The word for that is inflation.

The rate at which our wealth is being shipped overseas is at a staggering all-time high. The U.S. Department of Commerce’s Bureau of Economic Analysis refers to the annual transfer of wealth we are talking about as the current account deficit. You might know it as the trade deficit. Now, it really does not matter where all this paper money is floating around, whether it is held by the Sultan of Brunei or in a hole in your neighbor’s backyard. The simple fact is that there are a lot of dollars out there -- trillions -- and if they come back into the United States, we are going to experience sudden, severe inflation. That will have a horrible effect on stocks, bonds ... just about any financial asset you can name.

On the other hand, hard assets like gold, silver, copper and other commodities will suddenly require a whole lot more U.S. dollars to purchase. We have all heard the stories about Weimar Germany and the wheelbarrows full of money needed to buy a loaf of bread. We are not predicting anything like that, but the point is we do not need anything like that in order for things to get quite ugly.

Why would all these dollars come flooding back into the United States? The short, simple answer is because they have no place else to go. Since dollars are only “legal tender” within the United States, whether foreigners continue holding them depends on whether they have confidence in the soundness of the dollar. Confidence, of course, can vanish like a pile of feathers during a hurricane. Based on recent market action, it is clear that foreigners are becoming increasingly aware that the dollar is, in fact, an “IOU Nothing” issued by a bankrupt U.S. government.

House that spawned the term ‘keeping up with the Jones’ is collapsing and in disrepair.

The house was built in 1853 by Edith Wharton’s spinster aunt, Elizabeth Schermerhorn Jones, and kicked off a flurry of mansion building up the Hudson River Valley. “Wyndclyffe” sported a four-story tower, 24 rooms, 80 acres of lawn and “sweeping river views”. After the completion of the Jones house, turret towers and extra wings began appearing on nearby homes -- hence the now-famous phrase, “keeping up with the Jones”. Nowadays, the maxim illustrates the modern desire of suburban Americans to keep up appearances ... by taking out home equity loans to buy Humvees and home theater systems.

Hernando de Soto runs a think tank called the Institute for Liberty and Democracy -- not a half-cocked Washington-based fundraising scheme invented by friends and associates of Richard Perle, but rather headquartered in de Soto’s native Peru. The Economist magazine called the Institute for Liberty and Democracy one of the most important think tanks in the world. “Over the past five years,” de Soto explains in The Mystery of Capital, “I and a hundred colleagues from six different nations have closed our books and opened our eyes -- and gone out into the streets and countrysides of four continents to see how much the poorest sectors of society have saved. The quantity is enormous.”

De Soto’s search for the reasons why capitalism thrives in the West -- but is the target of scorn elsewhere in the world -- has led him through thousands of pages of archived material, much of it detailing the westward expansion of U.S. pioneers in the late 18th and early 19th century. Going back as far as 1783, for example, George Washington “complained about ‘Banditti...skimming and disposing of the cream of the country at the expense of the many.’” These banditti were squatters and illegal entrepreneurs occupying lands to which they had neither title nor deed. Today’s undeveloped countries are very much like the United States of a century or more ago, when it too was an undeveloped country.

In the U.S., it was not until the application of the doctrine of “pre-emption” that America’s backwater culture began picking up the steam that would empower it to become the foremost economic power on the planet. Pre-emption allowed a squatter who had made improvements on a piece of land, simply by building shack or a mill there, first right of refusal on its purchase. Once the deed became legal, it also became a commodity. The squatters, banditti and flagrant ne’er-do-wells thus became the vaunted “pioneers” of American history.

Unfortunately, nothing fails like success. The process of change, according to de Soto, is unquestionably a political one. “In most nations of the West the major task of widespread property reform was completed only about a century ago... The property revolution was a political victory. In every country, it was the result of a few enlightened men deciding that official law made no sense... if a sizeable part of the population lived outside it.”

The neocons have taken the political lesson to heart and, like the Leninists of the early 20th century, are using Iraq as a test case to see if revolution can be had at the point of a gun. In the meantime, the Fed and the Treasury have lost their way altogether. Gone are the days when self-reliance meant busting your gut to build a house, a factory... or even a fine piece of furniture. Now credit lines grow ever longer and home equity loans more ubiquitous. Boobus Americanus -- to borrow a phrase from H.L. Mencken, by way of Doug Casey -- has regressed along the line from “know-how” to “nowhere”.

How is it that the country from whence naturally arose the property rights that helped unlock de Soto’s “dead capital” -- and serves as a model for emerging nations today -- is also the current site of the most egregious credit-goosed spending binge and bust in economic history? The answer, we fear, lies somewhere in the ruins of Wyndclyffe.

CASH IN THOSE FREQUENT FLIER MILES SOON

For many business travelers, frequent flier miles are part of their nest egg along with their pension plans, their 401(k)s and their stock portfolios. But there is a problem: These globe-trotters may be around a lot longer than the airlines that hold their frequent flier miles. Like technology stock investments from the 1990s, the value of frequent flier miles is declining along with the health of the industry. Airfares have dropped considerably in recent years, decreasing the value of award miles. At the same time, many airlines have added numerous restrictions and fees to redeem miles.

“If you think of miles the same way you hold a stock, holding onto the miles for the long term is like holding onto a stock that has been losing value and looks as though it will continue to lose value as far out as the eye can see,” said Tim Winship, editor and publisher of Frequentflier.com. He advises travelers to use their miles today rather than save them for the future.

If an airline goes out of business, all may not be lost, however. The miles may survive -- on another carrier, possibly at less value than they originally had. The frequent flier database of a failing airline is often attractive to other carriers looking for dedicated travelers. When American Airlines acquired Trans World Airlines in 2001, American took over TWA’s frequent flier program. For determined savers, frequent flier miles can be passed on to one’s descendants -- a practice that experts say is growing. Winship said airlines often want to see a copy of a will, as well as a death certificate.

Ben Kuckens, who retired from Smith Barney last year, uses a computer spread sheet to keep track of his miles. Kuckens, who has most of his miles on American Airlines, said he has trouble booking awards flights because airlines have set so many restrictions. He says he has to book at least nine months in advance to get a flight. Booking a retirement flight is harder than managing his retirement fund, Kuckens said. “The difficulty is getting the seats,” he said. “My retirement fund is already pretty much set up.”

THERE SHE IS... NOT, MISS AMERICA

Hold onto your diamond tiaras, because one of the fixtures of American culture -- the Miss America Pageant -- is coming unplugged: On October 21, “the Atlantic City Pageant was dropped by ABC television, calling into question whether the event could survive, at least in its present form.” (New York Times October 21) The article explained how pageant coordinators tried to reel in ratings with “skimpier swimsuits” and shorter “talent contests”, moving the emphasis from “scholarship to sex appeal”. But despite the makeover, the 2004 show saw viewership drop to an all-time record low.

Sorry but you just cannot turn fruitcake into chocolate fondue. In other words, no matter how you dress her (or undress her, for that matter), Miss America will always be the symbol of the All-American “ideal woman” and “paragon”. And in case you have not noticed, people do not want fruitcake these days. And that fact has everything to do with the current trend in mass psychology, as reflected in the wave count in stocks. A rising social mood “includes a preference for black-and-white morality”, conventional heroes, and classically “masculine” men and “feminine” female role models. A falling social mood invites the opposite: an increase in sex, a blurring of gender roles, focus on alternate sexual styles, and a worship of antiheroes.

A look back at the rise and fall in popularity of the Miss America Pageant makes this as glaringly clear as a beauty contestant’s pearly whites. As recently as 1995 viewership for Miss America rocketed to more than 25 million, right alongside the raging bull market. And now, four years after the all-time stock market high, with the U.S. economy stumbling from “sweet spot” to “soft patch”, ABC is dropping the Miss America Pageant. The Donna Reed Show is out and “Desperate Housewives” is in. ABC’s new smash hit could not convey the shift in social mood more: An hour-long drama centered around the themes of “adultery”, “suicide”, “marital UN-bliss”, “arson”, “sinister, dark secrets,” all with “gratuitous sex scenes”, “racy content”, and the “depiction of motherhood as a worthless chore.” Week three of “Desperate” posted the highest ratings EVER in the 18-49 demographic group.

INSTANT REPLAY FOR THE MARKET, FROM FIVE YEARS AGO?

Last Friday’s closing low for the year in the Dow Industrials was duly reported in the media, yet over the weekend many observers also said things like “The NASDAQ has held its own against recent Blue-Chip declines.” Indeed, tech and other speculative stocks did not follow the mostly downward trend in the Dow during September and October. The disparity between these two groups of stocks got our attention too, and we believe the question of what it means deserves more than a flippant comment.

Consider the following quote: “When the herd pursues the more speculative stocks to the virtual exclusion of the Dow, it represents a breakdown in the established order and is at the very least a strike against the market’s intermediate-term prospects.” This may seem to speak to what is happening in the markets now, except that it was written nearly five years ago -- in December 1999. The markets around that time were behaving very much as they have been recently. Investors were buying the more speculative NASDAQ, which was clearly outperforming the Dow, which is why we forecast the approaching major trend reversal that began in 2000.

History can repeat itself, if not exactly, then in startlingly similar ways. How similar?

NO NEED TO “IMAGINE” HOW BAD THE GREENBACK LOOKS

In January of this year, the Dollar Index had fallen below 85 for the first time since 1996. The euro stood at record highs against the greenback. Sentiment had grown so lopsided that an international economics magazine declared, “It is hellish hard these days to find anyone who is bullish on the dollar” (including the magazine itself). A well-known weekly financial publication actually compared the dollar’s plight with the calamity that befell the Argentine peso.

We do not see ourselves as “hellish hard to find”, yet at that time it probably IS true that not many publications were showing subscribers a price chart with the headline, “The Dollar is Close to a Reversal”. But that is exactly what the February issue of The Elliott Wave Financial Forecast did, when it published on January 26. Then on February 20 -- two days after the Dollar Index hit a low of 84.56 -- this was the comment in Short Term Update: “A strong bullish key reversal week was had in the U.S. Dollar Index ... providing the first sign that the dollar has indeed bottomed.” An upward move followed, as the Dollar Index began a rally that carried to a five-month high in April.

Now imagine a situation where headlines say the greenback is on the “Edge of a Cliff”, where the Dollar Index has fallen for nine consecutive sessions and in seven of the past eight weeks, and where competing currencies have climbed to multi-month and even multi-year highs. But there is no need to “imagine”, since all the above describes the currency markets as of Monday. What now for the U.S. dollar? Interestingly enough, sentiment has reached an extreme not seen for months. Given what we see in the wave pattern, this sentiment data is interesting indeed.

BOOMING ASIA

In assessing the world economy’s prospects, it is necessary to pay increasing attention to the development in China. Together with the United States, it has become the locomotive of the world economy. But that is only true for the Asian economies, including Japan. During 2003, no less than 58% of China’s imports of goods and services came from Asia, as against 8% from the US and 13% from the EU. In short, China is running a big trade deficit within the region. The booming trade surplus with China was the spark that powered Asia’s nascent cyclical recovery last year.

But this trade deficit with the Asian countries has been more than matched by trade surpluses earned with the US ($88 billion in 2003) and with the EU ($29 billion). During the first half of 2004, China’s U.S. surplus was up to $137 billion at annual rate. Overall, China had a trade surplus of about $29.6 billion in 2003. While the overall trade balance did not change significantly during 2001-03, there have been significant shifts in regional trade balances. China’s trade balance with the US and the EU is rapidly rising, but are being more than offset by rising deficits in Asia. We wonder, however, how much of the export to China from America, Europe and Japan, reflects direct investments of firms of these countries expanding their operations to China, in order to take advantage of rock-bottom labor costs and strong future demand growth.

Now comes an interesting point. Given capital controls and a modest overall trade surplus, one would think that large inflows of foreign exchange are possible. But the point is that the large direct investments from the industrial countries grossly distort the trade picture. In China’s trade statistics, these foreign direct investments show as imports of goods. But these imports involve no payments on the part of China. The result is that China, regardless of capital controls, enjoys a huge net inflow of foreign exchange. In 2003, the central bank’s foreign exchange reserves increased by $116.8 billion, to $403.2 billion, against a trade surplus of only $29.6 billion. As of April 2004, these reserves had further risen to $449 billion.

China’s economic performance is admired around the world. Its real GDP growth has recently been around 9% per year, even after 12% in prior years. More remarkably, no less than 47% of China’s GDP has been devoted to capital investment. Fearful of overheating inflation rates and structural distortions, the Chinese authorities have taken action to slow economic growth. With exports and imports both soaring at annual rates of around 40%, the Chinese economy has suddenly gained outstanding importance in the global economy. Clearly, it has become the locomotive for all of East Asia. But China’s locomotive, in turn, is the U.S. economy. The pull is taking place through two channels: trade and soaring dollar flows to China. During the past two years, U.S. imports from China have sharply accelerated, rising at an annual rate of 18%, in nominal terms. Our particular focus, though, is on the escalating monetary linkage between China and the United States. That is the linkage where, as a rule, the problems loom. Up to 2000, the dollar reserves of the Bank of China had been increasing modestly, from $105 billion in 1996 to $165.6 billion in 2000. But during the following 3 1/2 years until April 2004, they soared to $449 billion.

This had sweeping monetary consequences. Domestic bank credit surged by 83%, compared with an increase by 49% in the prior three years. For us, today’s China is the parallel to Japan in the late 1980s. The runaway bubble in building and business fixed investment threatens to leave behind collapsing property prices, vast amounts of excessive industrial capacity and lots of bad debt. Yet there are some important differences: First, the investment excesses vastly exceed those in Japan, implying even more extensive malinvestment; second, there is a property bubble, but no stock market bubble; and third, the government owns all banks.

It strikes us as rather ominous that these dollar purchases by Asian central banks have multiplied since 2000, due to an escalating U.S. current account deficit, because U.S. domestic demand has slowed, while Asia has sharply accelerated growth. The decisive difference between the two areas, obviously, is that the Asian economies get their growth dynamic from saving and investment, while the U.S. economy gets it from consumption and “wealth creation” through asset price inflation. Importantly, both sides appear manifestly satisfied with the net economic result on their part. We think both sides neglect the horrendous longer-term costs of their policies.

INVEST IN TANGIBLE ASSETS THAT “SWEAT”

What is an investor to do? The investor today is buffeted by news of a weakening dollar, worried about increasing piles of debt and mounting fiscal deficits, faced with historic trade deficits, bombarded with deadening election year rhetoric -- a veritable potpourri of nasty stuff. Is there anything an investor can do? I think there is. Invest in tangible assets that sweat. Tangible assets are simply things we can touch and feel, things we can see and count. These investments include things like buildings, timber, cash, certain machinery, land, vineyards and other unique assets. Industries that are not going away and that are in no danger of the next generation of competitors making them obsolete.

Contrast this with the most exciting and best-loved investments of the boom years. Companies like AOL, Lucent, JDS Uniphase and a host of others that carried billions of dollars in intangible assets on their books -- such as “capitalized software development costs” or “goodwill”, among others. These assets were on the books because accounting conventions required it, not because they represented value that could be sold or accessed in any direct way. Most of these assets were subsequently written down, leading to billions of dollars in losses for those companies and their shareholders as well.

Tangible assets seldom lose value like that. Most of the time an asset like timber or unique real estate only become more valuable as time goes on. Cash flow is the sweat, the streams of actual cash that a company generates. Cash flow is not earnings, although many investors are probably surprised to learn that fact. Earnings can be very deceptive, cash flow analysis follows the money. Cash flow gives companies options to pursue wealth-generating strategies, to reinvest in the business for future growth, to pay dividends or buy back stock, or to make smart acquisitions.

In addition to tangible assets and cash flow, I want to stay with businesses that I can understand. Warren Buffett has many famous sayings, among them, “Invest inside your circle of competence”. Buffet investments such as candies, furniture and newspapers are all understandable these businesses as opposed to, say, the next biotech drug research or semiconductor test instruments. Peter Lynch is another famous investor who advised investors to buy what they know.

This idea also extends to the disclosures the company makes about its business. If you read the 10-K for Enron during its bubble days you could not help but come away thinking that this was one complex business. There are plenty of fish in the sea, so goes the old saying. We do not need to waste a lot of analytical effort fighting with a company to get at the truth. The final leg of the stool is the idea of buying these businesses on the cheap. Many businesses own tangible assets, generate cash flow and are in simple and transparent business, but fail to meet this fourth crucial hurdle.

Peter Bernstein, famed economist and author, noted that, “the double-digit returns stocks were able to generate over the last century were due to equities starting cheap and getting richer over time ... a part of those realized returns was unexpected windfalls from rising equity valuation multiples.” Or, as he likes to say, “Starting price matters”. Special care must be taken to be sure that your “starting price” or your purchase price is at a low enough level to ensure a good profit even if things do not go exactly as you hoped.

Investment returns move in cycles. The great legacy of the 1990s bubble and bust may be the rise of these enduring tangible assets at the expense of fleeting and bloated intangible assets, a reversion to the tradition of wealth that has created lasting fortunes for generations.

NO BUBBLE IN SWISS PROPERTY MARKET

The Swiss housing market offers good value for money both in domestic and international terms, according to a report published this week, “Making the Property Market Transparent”. It says the recent house-price boom in many countries has “passed Switzerland by”, with typical prices in Zurich and Geneva now below those in cities such as Paris and Munich.

“We have had significant growth in the housing market in recent years, but the increase in prices in the past five to seven years has been only about five to seven per cent. I think what makes our market different is that Swiss residential estate owners still have in mind the experience of the end of the 1980s, when they made big losses,” Charles Stettler, head of the Zurich Cantonal Bank -- Switzerland’s third-largest bank -- private customers branch.

The bank said that compared with increases in real wages over the same period, property in many developed countries was now clearly overvalued, and the risk of a sudden slump -- with potentially devastating economic consequences -- was real. However, it added that the same risk did not apply to Switzerland, as two key value indicators -- the price-earnings (P/E) ratio and the risk premium -- showed that Swiss property prices were below their historical average in domestic terms and “moderate to cheap” in international terms. In property-market terms, the P/E ratio is the relationship between the purchase price of a house and the cost of renting it for 12 months. The current national average is 21.8, compared with a high of 28 during the boom years of the 1980s.

A FURTHER STEEP DECLINE IN THE DOLLAR SEEMS INEVITABLE

Most economists, and this newspaper, have been fretting about America’s huge current-account deficit and predicting the dollar’s sharp decline for years. The trouble with crying wolf too often is that people stop believing you. After slipping 14% in broad trade-weighted terms since 2002, the dollar had stabilized this year, even as the current-account deficit continued to grow. This has encouraged some economists to offer theories explaining why America’s current-account deficit does not matter and why the dollar need not fall further. But the dollar has now started to slide again: this week it hit $1.28 against the euro, within a whisker of its all-time low of $1.29. Trust us, the wolf is real.

The dollar’s latest slide seems to have been triggered by uncertainty about the presidential election and a flurry of comments from Fed officials. Robert McTeer, the president of the Dallas Federal Reserve, mused (only “theoretically” of course) that when capital inflows into America dry up, “there will be a crisis that will result in rapidly rising interest rates and a rapidly depreciating dollar that will be very disruptive.”

Policymakers’ usual reply when asked about exchange rates is to say that they are set by the market. But if the dollar was truly being set by the market it would now be much weaker. The dollar has fallen by over 30% against the euro since 2001, but its trade-weighted index has fallen by much less because of heavy intervention by Asian central banks, aimed at holding down their currencies against the dollar. This policy seems likely to continue, despite China’s decision this week to raise interest rates for the first time in nine years. That decision was aimed at curbing its overheating domestic economy, rather than bolstering its currency.

Because Asian currencies have been held down against the dollar, America’s current-account deficit has continued to swell, reaching almost 6% of GDP in the second quarter. The dollar is already below most estimates of its fair value against the euro, but it will need to undershoot if the deficit is to be reduced. Economists at UBS estimate that the dollar’s trade-weighted value might need to fall by another 20-30% to trim the deficit by enough to stabilize the ratio of America’s external liabilities to GDP. Though it might seem unthinkable, that could imply a rate of around $1.70 against the euro.

In the three years from 1985, the dollar fell by 50% against the other main currencies. Inflation and bond yields rose and, in October 1987, the stockmarket crashed. America’s current-account deficit is now almost twice as big as it was then, so the total fall in the dollar -- and the fall-out in other financial markets -- could well be larger. The wolf is licking his lips.

THE “SANITY HAS RETURNED” STAGE IN THIS MARKET?

No investment market ever sees a “new” kind of sentiment, only different degrees of the emotions which are common to us all. The sentiment in a given market cannot be measured with the same precision as the price levels can, yet we do know that when historic price extremes appear, a predictable series of emotions will follow. The “predictable” part shows up in the emotional phrase-of-the-moment that you are bound to read and hear.

For instance, at the peak of the tech stock bubble in 2000, it was the notion that “The only risk is being out of the market”. After the initial sharp declines in the NASDAQ, it was “Okay, some sanity has returned to the market”. In 2001, well, “Nobody knew prices would fall this far”. At the 2002 lows, “Everybody knew it was a bubble!”

That was just about the time that an all-too recognizable sentiment began to build in a “safer” investment, which a CNN/Money headline on October 25, 2002 characterized as “Riding the Real Estate Wave”. The article observed that “with most stock portfolios on a slow road to recovery, investors have begun turning their attention to the relative safety of home sweet home.” The real estate industry began to report unprecedented enrollment in classes to get a realtor’s license, likewise the mortgage industry regarding a mortgage broker’s license.

But that was two years ago. A different trend is unfolding now, and the trail of evidence runs from New England to Detroit to Las Vegas to Southern California. Home prices are either flat or falling fast, accelerated by the growing inventory of unsold properties. As for sentiment -- is the real estate market at or nearing the “sanity has returned” stage?

OIL DEMAND -- WHY SO STRONG?

In October 2004 the call of finance and economic policy makers in Europe, Japan and other OECD countries is for “oil saving and energy conservation”. Oil prices, around $55/barrel, are set to stay above $50/bbl and may “test” price levels beyond $60/bbl. This context proves, even to the most ardent defenders of the New Economy, that the “supply side” is unlikely to fly to the rescue. Calls for OPEC or Russia to increase supply are unlikely to bring down prices, either in the short-term or long-term. The most powerful reason is world oil demand growth.

It is the older, aging societies of the North and not the fast industrializing countries, nor the poorest, vastly less oil-intensive economies and societies of low and lower income countries that will be first and hardest hit by rising oil prices. Deflationary structures and trends, which are intensified by higher oil prices inside the North, will likely result not in an inflation crisis, but deflationary recession inside the OECD countries.

When or if the “interest rate weapon” is applied inside OECD countries, because of belief by policy makers in the myth that “high oil prices cause inflation” this will most certainly result in inflation. Higher interest rates will quickly increase inflation and transmit inflationary trends among the OECD countries. Under any scenario, therefore, economic growth rates will likely fall in the OECD while they continue to increase or remain very high in nonOECD emerging economies. The net result for world oil demand will be little or no significant fall in demand pressure, due to world economic growth remaining high outside the OECD. This again leads, perhaps with a few year “grace period” to structural undersupply and continuously rising prices, or higher oil price spikes in a continuing context of rising oil, energy and real resource prices.

Snazzier houses bring energy crisis home to middle class.

In Ossining, N.Y., a “For Sale” sign hangs on a seven-bedroom home with six fireplaces, an indoor pool with a waterfall, and a steam room. In Wayland, Massachusetts, a 6,500-square-foot home on the market features a master suite with two baths. And in Washington Township, N.J., a five-bedroom, seven-bath home includes a 150-gallon fish tank and a game room with its own hot tub. These examples may be extreme, but they are indicative of the “SUVing”, as some people call it, of the American home. And they show one reason why utility bills, even before the first inflated one this winter, are going up.

The old homestead -- and not just the kind with seven baths -- is increasingly filled with multiple refrigerators, plasma TV sets, and lap pools. The result is that this year’s energy woes, more than ever, are hitting the American middle class and upper middle class as well as the poor.

Home heating-oil prices are 60% higher than a year ago. Propane, often used by rural and lower-income families, is 30% higher. Natural gas, currently about 11% higher than last year, is expected to rise in price once winter begins. For the average family, these higher prices may be a wake-up call. In 2000, the American Council for an Energy Efficient Economy estimated the average home budget for energy was about $6,000, split evenly between fueling the family car and heating the hearth. Now, that number is estimated to be between $8,000 and $9,000, Neal Elliott, industrial program director of the ACEEE says.

Moreover, it is not just mega-appliances that have raised energy consumption. The increased use of “plug-ins” is also making an impact. For example, a cellphone charger, if left plugged in, continues to consume a few watts of energy. The same is true for the microwave, VCR, stereo, and home computer. Secretary of Energy Spencer Abraham calls them “energy vampires” because they are constantly sucking a little bit of wattage out of the wall. “After a while they all add up to be as big a load factor as the refrigerator,” says Elliott. Americans are also adding refrigerators so they do not have to travel far for a cold drink. “We’re seeing that second, third, or fourth refrigerator in a home,” says Elliott.

Energy expenses are rising even though many houses have better insulation and efficient “Energy Star” windows. New standards have also made appliances such as refrigerators and air conditioners more efficient. This lowers the cost of heating on a per-square-foot basis. But at the same time, the nation’s abodes, just like the size of the average car, are getting larger and more complicated. According to the National Association of Home Builders, the average new house was 2,230 square feet in 2003, compared with 1,500 square feet in 1970. And it is not unusual to see something much larger.

THE SECOND 9-11 COMMISSION HEARINGS, AS CONVENED BY PRESIDENT HILARY

The Second 9-11 Commission was established in November 2009. It was commonly referred to as the second 9-11 commission because it shared with the first 9-11 hearings a key feature … they were both enquiries to determine why the USA was ill-prepared to prevent a major setback to the nation’s well being. Before reporting on the hearings, a brief review of events leading up to the establishment of the commission would be in order.

U.S. PAYROLLS TELL LESS THAN HALF THE STORY

With a year of employment gains under its belt, many commentators have projected a long and happy recovery for the labor market. However, quite apart from their erratic monthly variations, the payroll data tell less than half the story about U.S. labor market conditions. The percentage of the civilian population of working age in employment reached 64.7% in April 2000, a record that looks as though it may stand for a generation. The current figure, 62.3%, is a marginal improvement on the lows of 62.1%, but it has taken a monumental effort to halt the slide and this is likely to prove temporary. Moreover, despite the net addition of 113,000 jobs in the past three months, the shocking deterioration in the public finances in recent years has limited the potential for government employment to take up the slack.

GREENSPAN PLAYING THE FOOL OR THE SCOUNDREL?

Oil prices soar above $50 a barrel with little prospect of returning to more normal levels anytime soon. Not to worry, says Fed Chairman Alan Greenspan, new sources of energy are just over the horizon. House prices continue rising several times as fast as everything else, driven by record levels of household debt. Not to worry, says Greenspan, the debt is manageable and housing is not susceptible to speculative bubbles. The nation’s current account deficit heads toward 6% of gross domestic product , a level unheard of for a major industrial economy. Not to worry, says Greenspan, financial markets will gradually bring things into balance.

The urgent question before us today is: What has the chairman of the Federal Reserve been smoking? I will leave it to others to speculate on Greenspan’s motive for taking his one-man Dr. Pangloss show on the road in the months leading up to a hotly contested presidential election. But what are we to say about a Fed chairman whose biggest economic concern a few years ago was that the government was projected to run such a big budget surplus that it could eventually force the Treasury to invest some of it in corporate stocks and bonds? There are not too many people worrying about that one any more.

Of course, one reason we are worrying about record deficits rather than record surpluses is that Greenspan gave his seal of approval to a series of tax cuts. Two possibilities present themselves: 1.) Greenspan figured that, once the tax cuts were in place, Congress would cut spending to match, in which case he is more of a fool than anyone imagined. 2.) He knew all too well that the spending cuts would not follow, in which case he is a scoundrel.

RARE TOYS FOR BIG BOYS

European stocks are well above their 2002-2003 lows, yet the deep declines of those years were too much to handle for some investors. Many of those who now see stocks as “devalued” have turned to real estate. Others, with perhaps a keener eye, have turned to collectibles. In Britain, one item in particular has been getting lots of attention lately: Rare toys from the 1960s, reports the Financial Times. Sentimental childhood memories aside, some British toy aficionados fully count on their collections to help them retire in comfort. “It’s going to be a hell of a lot better than the other pensions I’ve got,” says one baby boomer who has been collecting rare toy sets for the past decade.

He is not alone. The number of people who see “toys as a sound investment” has been growing. And why not? Certain toys that forty years ago sold for less than £50 today go for over £1,000. What is interesting is that the biggest customers at some toy auctions are investment bankers. Clearly, this fad is more than just a sudden outbreak of Peter Pan complex among British “gentlemen aged between about 45 and 70.” Collectibles have been hot in the U.S., too. This year, Picasso’s “Boy with a Pipe” brought the highest price for a painting ever: $104.2 million. Works by other artists, such as Jackson Pollack, have also set new records recently. Does it mean that collectibles is a safe place to invest in these days?

We have been observing the public’s obsessions with art and other collectibles for as long as we have been analyzing financial markets -- for over 25 years. Here is a summary of our conclusions:

“What we are witnessing is one mania, an investment mania, with various outlets, art being one of them. Art prices appear to save their boldest moves for the aftermath of big [stock] advances. The [current] obsession with paintings and other collectibles is an extension of the panic for stuff, which is a curtain call for the mania’s post-peak echo. It is a twin to the high of May 1990, which was also accompanied by a spike in commodity prices and a brief burst in consumer prices. As disinflation re-asserted itself, however, a debacle referred to in art circles as the “nightmare of 1991” ensued. When manias end, items considered priceless at one time can become little more than curios. Aside from the greatest works of art and special historical items such as an original copy of the Declaration of Independence, most things that people deem collectibles today will be worth little to nothing in coming years as the urge to speculate that characterized the 1990s fades away.”

Like any investor, art collectors must put many hours into studying their venture in order to succeed. But most art investors, just like most stock investors, do not. Instead, they buy what’s “hot”, which is often a sure recipe to get burned.

AN AUSTRIAN ANALYSIS OF U.S. INFLATION

The inflation-deflation debate continues to intensify. In a deflationary environment, the appropriate strategy involves investing in bonds and cash; this strategy, however, in an inflationary environment will prove suicidal. Therefore, correct prediction of monetary developments becomes crucial for investor survival.

The objective of this article is to present an Austrian analysis of the inflation-deflation debate. We present the Austrian stages of inflation, provide the crucial criteria that allow us to differentiate between those stages, and illustrate them with prominent examples. Then we apply the Austrian inflation theory to the current U.S. monetary environment and infer the current stage of inflation, the likely monetary developments in the future, and the appropriate investment strategies in this environment.

Having properly grounded our analysis in Austrian inflation theory, we can draw our conclusions. First, there is little doubt that U.S. inflation today is “low”, as defined and explained previously. As a result, the government will aggressively pursue inflationary monetary policy because it clearly stands to benefit from it. Given the current fiat monetary system, there is nothing to stop or restrain more inflation in the future, short of tremors in derivatives. Given that “low” inflation can last for many years and that inflationary psychology changes very slowly, I expect that the United States will continue to have “low” inflation for another couple of years, possibly three, four, or even more. It is important to realize that as prices begin to rise faster, at the 4-6% rate, the Fed will step up its inflationary policy in order to keep ahead of prices and to sustain and prolong the government benefits from inflation. Second, it is important to understand that when inflation moves to its second stage, the Fed will continue to inflate for a few more years. “High” inflation can go on for many years -- 3-5 will not be unreasonable, before it is finally abandoned.

Therefore, we must expect more inflation for the next 6-10 years: 3-5 more years for stage one to mature and morph into stage two, and 3-5 more years for stage two to develop and mature. I will readily admit that these are only rough estimates, based on historical knowledge and adjusting for the role of the U.S. dollar, and each stage could admittedly last longer or be truncated by sudden, unforeseen events, such as a dollar crisis or a derivative crisis. However, it is a safe bet that inflation will be with us to stay for many more years.

I would like to emphasize that nowhere did I indicate that there would not be any deflation. I am also not saying that those that predict inflation are right, and those that predict deflation are wrong. On the contrary, I predict that eventually deflationists will get their deflation, but they better be prepared to wait for another decade before their wish is granted. Notwithstanding their constant cries that deflation is just around the corner, a rigorous Austrian analysis demonstrates that this is not really the case. Notwithstanding their constant threats that deflationary forces are too strong to overcome by sheer inflation, in a fiat monetary system this is clearly not the case either. And, if a pundit predicts deflation, make sure you find out whether they have sold their house or not!

Before we turn our attention to the ultimate endgame, we must observe that inflation has been going on for too long in the United States. As a result, the economy has developed too many distortions and accumulated too many malinvestments. Therefore, it is likely that the economy will perform rather poorly over the next 5-10 years, although when the Chinese bubble economy eventually falls into a Great Depression, so will the American economy. However, we must emphasize that Depression or bust do not necessarily mean deflation, as many people erroneously assume. In other words, I predict many years of stagflation, before America ultimately succumbs to another Great Depression.

The ultimate endgame presents the choice between hyperinflation and deflation. This is the third stage of inflation, and at this point it is purely a matter of speculation as to which way the monetary system will tip. From an economic point of view, deflation is clearly the better of two evils. However, it is far from clear that deflation is a choice given the overhang of derivatives on the financial markets. When derivatives begin to cascade in a series of cross-defaults, their monetization is likely to lead to a sudden burst of hyperinflation. Therefore, I believe that the ultimate outcome, hyperinflation or bust, will crucially depend on how the derivatives problem is handled.

In conclusion, the U.S. still has many years of inflation before the endgame arrives. The intelligent investor is advised to position himself accordingly. In an inflationary environment the obvious choices are hard assets (precious metals, industrial commodities, real estate) and strong foreign currencies. Personally, I have my doubts about real estate. As a student of speculative manias, there is no doubt in my mind that real estate is in a bubble of historic proportions that is destined to burst. As such, real estate is grossly overvalued and must be avoided. On the other hand, commodity shortages due to China’s and India’s industrialization are practically across the board. Energy problems are here to stay with us for the next decade or two, and the energy sector presents spectacular investment opportunities. Yet demand for commodities is dependent on a strong worldwide economy. A worldwide depression will hardly prove bullish for commodities. Only precious metals will provide the ultimate safe-haven in such an environment. Even though gold is the ultimate choice, I believe that over the next decade, silver will outperform all investments.