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WHEN PICKY ANALYSTS PICK
Maybe you should just give up for the time being on hopes for a broad rally. Instead, try to beat a dead market with a few breakout stocks. We decided to get some ideas from that profession so discredited by Eliot Spitzer and his prosecutorial pack: the Wall Street sell-side analyst. But not any analyst. We got buy recommendations from firms that are very chary of offering compliments, and we considered only the buys coming from analysts with superior records for stock picking.
Apache, for example, is a favorite of both Thomas Covington at A.G. Edwards and Lloyd Byrne at Morgan Stanley. This exploration company has a knack for finding oil and gas in the ground without wasting a lot of money looking in the wrong places. Its stock has had a nice run-up in the past several years, but still it is cheap at 10 times the $5 a share A.G. Edwards’s Covington expects for earnings this year. Dow Chemical is a favorite of high-performing stock watcher Prashant (P.J.) Juvekar at Smith Barney. With feedstock costs rising, efficient chemical producers gain on inefficient competitors. Dow is efficient, says Juvekar. Prudential Financial, the life insurance company, is poised to improve earnings through its rapidly growing international business, says A.G. Edward’s Jeffrey Hopson. Like many a life insurer, it is cheap: only 13 times earnings.
Now let us turn the tables. If you are going to limit your buys to those from firms that do not have many, can you not do the reverse for short sales? We went hunting for sell recommendations from six firms that have a record of being upbeat most of the time. Fifth Third Bancorp gets the thumbs-down from Bradley Vander Ploeg at Raymond James and Gary Townsend at Friedman Billings Ramsey. This fast-growing midwestern bank chain, with a base in Cincinnati, was a terrific investment in the 1980s and 1990s. But it is running out of steam, says Townsend. The top line is growing more slowly than the cost line.Link here.
THE OTHER SIDE OF VANGUARD
When George (Gus) Sauter took Vanguard’s indexing operation in 1987, the firm had just one stock index fund, with $1 billion in assets. Today the Vanguard 500 Index is the world’s largest mutual fund, with $104 billion. Sauter also manages 50 other index funds at Vanguard, ranging from Small-Cap Value to European Stock. All told, Sauter, now Vanguard’s chief investment officer, runs $300 billion in indexed assets. You might assume the country’s most famous manager of index funds would be a diehard believer in the random walk, but you would be wrong. “We’re trying to convey to investors that many of them would be better off with a blend,” says Sauter, 50. “The two styles complement each other quite well.”
Investors usually think of Vanguard as an index shop. Yet the company has more active funds than index funds -- 62 to 56 -- and it actively manages three dollars for every two in its indexed funds. What is more, over the past two and a half decades a portfolio of Vanguard’s actively managed U.S. stock funds has returned an average 0.9 points a year more than the Wilshire 5000 index. After adjustment for risk the active funds’ edge grows to 1.3 points a year. That is no small feat, given the consistent underperformance of actively managed funds in general. Most of Vanguard’s active stock funds are run by outside managers hired for their particular expertise.
Jeffrey Molitor, Vanguard’s overseer of outside managers, says he and his staff spend a lot of time talking to potential managers to understand how they make decisions and whether they have an approach that is likely to let them beat the market. Measures of past performance matter, too, says Molitor, but “they’re not really predictive” because there is so much randomness in past returns. While fund performance is tough to predict, fund expenses are not. The average actively managed stock fund charges 1.68% a year. That is money you can be sure you will lose. At Vanguard the average active stock fund charges 0.47%.
Some investors might see such low expenses as a drawback, figuring Vanguard keeps costs too low to attract the best outside managers. Not so, says Molitor. Vanguard typically pays managers a low rate per dollar managed, but its marketing clout lets it direct a lot of dollars managers’ way, giving them significant revenue. The extra cost to a manager of investing additional dollars is usually small, so Vanguard’s money is hard to turn down. Vanguard also compensates most of its outside managers with performance-based fees.Link here.
RUSSIAN ROULETTE INVESTING
Famous advice from Mark Twain: “Put all your eggs in the one basket and -- watch that basket.” Could you do this, or something close to it, with your stock portfolio? Buy just a few companies, the ones you really, really believe in, and pray? The very idea is poison to most of the financial planning industry. You need at least 50 names in your U.S. portfolio, the experts will tell you, and you need to diversify across different kinds of investing, too -- stocks, bonds, cash, value and growth, domestic and foreign securities. If you cannot get a wide-angle portfolio on your own, they say, you should invest through one or more funds that will accomplish the task.
A good mathematical case can be made for diversification. We are not going to make it here. Instead, this article will explore the reverse course of action. For someone who is young enough and bold enough, a plausible strategy is to diversify only halfway. Put half your money in a cheap index fund. Put the other half in a very concentrated portfolio -- three to six stocks.
To support this radical notion we also can cite superinvestor Warren Buffett. Quoting Broadway impresario Billy Rose, Buffett has said, “If you have a harem of 40 women, you never get to know any of them very well.” Or as he said on another occasion, “If you understand the business, you don’t need to own very many of them.”Link here.
THE GLOBAL TEST
So-so bond yields and a lagging dollar spell out an opportunity for fixed-income investors: foreign bonds.
Two big things motivate bond investors: capital preservation and yield. But with yields on ten-year Treasurys stuck near a skimpy 4.2% and credit spreads tight compared with historic norms, this has not been a happy time for fixed incomes. And things could get worse. Should foreign buyers of Treasurys get fed up with subsidizing American spending habits, domestic bond prices will tank.
Yet to Peter Schiff, president of Euro Pacific Capital, that does not mean you should park your investment capital like a klutz in money market funds earning 1.5%. His solution: foreign bonds. It is not that foreign yields are always better than those of U.S. paper. The overseas bonds’ advantage lies in the weak dollar, which magnifies your return in America. And since Schiff sees the dollar continuing to wilt, foreign debt is more than a wise short-term strategy. “I look at myself as if I’m on a lifeboat and I’m floating around trying to get as many people on board as I can before the ship sinks,” he says.
Morningstar analyst Lynn Russell cautions that betting on currencies is market timing by another name. Currencies “bring a lot of volatility to the table,” she says. The dollar could come back without warning, so do not take your eye off the market. The trouble with getting in and out is that transaction costs are high. You cannot obtain foreign bonds through an online brokerage, for instance. Then there are the government-imposed headaches.Link here.
DODGING THE POTHOLES
The road ahead for stocks seems benign but is chock-full of potholes. On the positive side is the low 15% tax on both dividends and capital gains introduced during George Bush’s first term. Due to expire in 2009, the new rate stands a reasonable chance of being made permanent. Value stocks, which have outdistanced the S&P 500 in each of the past five years, should therefore continue their superiority, since they tend to pay high dividends.
Next year the S&P 500 Index will see a 10% gain in earnings, say the analysts. This is a “bottom-up” estimate -- meaning it was constructed from forecasts for each of the component companies. Chances are these estimates will prove high. If the gain comes in at only 5%, you are going to see stocks climb only 5% next year, absent an expansion in price/earnings multiples. Do not count on any P/E expansion. Multiples are already high by historical standards.
No matter how pro-business the Bush Administration is, persistent and worsening problems with tech overcapacity and inflation will offset his efforts in 2005. The most onerous challenge is rising inflation, heralded by the 50% increase in the price of oil so far this year. This has led to an upward spiral in the cost of many industrial commodities, including copper, aluminum and steel. Costlier commodities will either pressure corporate profit margins or force companies to hike prices. This phenomenon affects everyone from autos to airlines, from dynamos to duct tape. Luckily, inflation hurts stocks only in the beginning. Then stocks adapt to it and recover. Not so with bonds.
Investors are enormously exposed today to the inflation risk in long-term bonds. The yield on the ten-year Treasury, 4.2% as I write, is not much off the 40-year low it set in the summer of 2003. This makes no sense, given that oil and industrial material prices are soaring. If you must have fixed-income securities in your portfolio, stay very short. That means keeping durations to 18 months or less. Given that Treasury bond interest is taxed at up to 35% while stock dividends are taxed (depending on your state) at not much more than half that, you are better off getting your income from high-yielding stocks than from bonds. Here are three dividend stocks to consider.Link here.
THE EXPERTS ARE WRONG
The seemingly endless presidential campaign is over, and there is a strong temptation to forget about it. On hold before Nov. 2, the market has gotten back to business. But the hard-fought election teaches lessons that are as applicable to Wall Street as to Washington. First lesson: Don’t trust experts. To paraphrase the economist John Kenneth Galbraith, experts usually turn out to be those who are asked, not those who know. On Election Day, exit polls showed John Kerry doing well. The wise folks making that call were proved dead wrong hours later.
Second lesson: People do not always do what they say they will do. Opinion surveys this fall said the election was going to be a cliff-hanger. So everyone braced for recounts, legal challenges and weeks of uncertainty following Nov. 2 over who won. It was not a cliff-hanger. Some of the people favoring Kerry in the surveys ended up not favoring Kerry. Like preelection voters interviewed by pollsters, money managers also have a disconnect between saying and doing. Managers will tell you they are cautious and defensive, yet their portfolios are overweighted with the likes of Ebay and Google.
Third lesson: Rules of behavior are baloney. People change all the time. In politics the rule is that large turnouts favor the Democrats. This year we had a record number of voters, meaning Kerry should have won. By the same token, the investing public’s mood is no more easily divined. The rule is that the beginning of the year is when new money comes into stocks. In reality, new money comes in whenever prospects for gain appear good. That is what happened in November, postelection.
While I continue to be bullish long term, my outlook is tempered by several factors. And these lie outside the realm of dumb experts, two-faced opinions and absurd “rules”. My foremost concern is high current stock valuations, an issue I discussed in my last column. Another difficulty is that the market still lacks leadership. I think it is too early for financial stocks to compose, by market value, one-fifth of the S&P 500. In the face of higher rates the sector is vulnerable. I expect returns will be muted over the coming months. What to buy in light of that? Good dividend payers with upside potential, such as utility Consolidated Edison (NYSE-ED) at a 5% yield, and chewing tobacco company UST (NYSE-UST) at 4.8%.Link here.
FIXED-INCOME WATCH: HOW TO DIVERSIFY
For 2005 I again expect good news for the bond market. Rates will stay moderate, or even decline some. Inflationary pressures are minimized in a world where all nations compete. The low-cost producer brings everyone down to his level, making deflation as much a concern as inflation. There are risks, of course, that this rosy scenario will not play out. The wisest plans for all seasons, even if the outlook appears certain, is to diversify your holdings. I am not going to tell you what percentage of stocks versus bonds you should have, or exactly how your fixed-income holdings should be allocated. That varies by personal circumstances like age, financial situation and investment goals.
But I can tell you the different kinds of fixed-income securities to include in your diversification efforts. My commonsense take is that investment-grade securities should form the core. Beyond those, though, look for good returns in such places as convertible preferreds and bonds, Canadian royalty trusts, and junk bonds. The advent of discount brokerage commissions, along with a variety of debt securities sold in $25 preferred instruments, has given fixed-income investors tremendous flexibility in diversifying their portfolios and risks. Take advantage.Link here.
THANKS FOR THE OIL BOOM
As America has entered an age of extreme dependence on oil, the appetite in the rest of the world is growing each and every year. China is burning oil at a record rate, much of it from the Middle East. This year, China will import as much as 120 million tonnes of crude. That is up from 2003, when China imported 91 million tonnes. Chinese crude buyers have been scouring the world for new sources of oil to fuel the country’s runaway economy, buying from nontraditional suppliers such as Canada and Australia. Operating from offices in major oil trading centers like London, New York, Hong Kong, Singapore, and Beijing, Chinese oil companies are using a wide range of mechanisms to secure supplies from the international markets. These include spot purchases, term contracts, and even barter deals. At the same time, Chinese companies have been eager to invest in existing and new oil fields to ensure future supplies.
A major driving force for higher oil demand has been a sharp increase in the number of private cars used in China. Chinese oil demand has been soaring since 2000. But it is still only a fraction of the size that it will eventually reach. Currently, all of Asia consumes just less than 20 million barrels of oil per day. Not much when you consider that Asia has a population of 3 billion people. Meanwhile, the United States, with a population of less than 300 million people, consumes 22 million barrels of oil per day -- per capita consumption of oil is 10 times greater than Asia’s.
Meanwhile, Chinese petroleum reserves currently provide only a 7-day supply, compared with 60 days for the United States. There is a growing gap between Chinese crude production and supply. More and more, Beijing will rely on Middle East imports to make up this difference. According to Dr. Marc Faber, “Asia will revolutionize the geopolitics surrounding the oil-producing regions of the world.” Again, the focus comes back to the Middle East. And a picture of that region is downright ugly. Saudi Arabia and its 8,000 princes have been playing both sides against the middle, maintaining one of the largest foreign lobbies in Washington while paying hundreds of billions of dollars in protection money to al Qaeda.
But let us put all the politics aside and look just at the economics. Does the kingdom have the oil necessary to supply the world’s burgeoning demand for crude? Probably not. The once unthinkable is happening -- even the rich oceans of oil in Saudi Arabia are being severely taxed by surging global demand. So the truth of the matter, oil rose to $55 per barrel because of one fundamental fact -- it is becoming a scarce resource. This fundamental may be ignored for a while. But as oil supplies are taxed more and more each year, and new demand rises out of Asia, you have to wonder not if oil will reach $100 a barrel, but when.Link here (scroll down to piece by John Myers).
Oil drops another 5 percent, nears $43.
Oil prices crumbled to an 11-week low near $43 a barrel on Thursday, suffering the biggest 2-day slide since the Gulf War after an increase in U.S. heating oil stocks triggered heavy selling from big-money speculative funds. U.S. crude oil futures fell $2.34 a barrel, or 5.1% to $43.15, the lowest level since mid-September, while London Brent was down $2.31 at $40.00. U.S. prices plunged $3.64, or 7.4% on Wednesday, and the combined fall over the two sessions is the steepest since 1990 according to Reuters figures. Prices are now more than $13 below their October all-time high, although still 30% up from the start of the year.
Lean U.S. stocks of heating fuel are rising as U.S. refineries ramp up runs after maintenance and unusually mild early-winter weather in the U.S. Northeast limits demand. A U.S. government agency report on Wednesday showed distillate stocks, including heating oil and diesel, rose 2.3 million barrels in the week to Nov 26 to 117.9 million barrels. “The rout was essentially a massive fund bailout across the energy sector,” said brokers Refco in a report.Link here.
THE CHINA FACTOR AND THE U.S. DOLLAR
The possibility that the Chinese authorities may lower their holdings of U.S. assets and substitute them for European assets is seen as a major threat to the U.S. dollar and seems to support the view of most experts. For instance, in his speech on Nov. 19, Alan Greenspan suggested that foreigners might get tired of financing the ever-growing U.S. current account deficit, which stood at a record $166.2 billion in Q2. At some stage, Greenspan maintains, foreigners will start shifting their money away from U.S. assets, thereby depressing the U.S. dollars and lifting the interest rate structure. This in turn will undermine the pace of U.S. economic activity, so it is argued. According to this way of thinking, as long as the U.S. continues to run a massive current account deficit the pressure on the dollar and on the U.S. economy will stay intact. Hence, the only solution to this predicament is to devise policies that can tackle the problem of the growing deficit.
But is it true that the state of the balance of payments determines the currency rate of exchange? Every participant in a market economy is a seller and a buyer of goods and services. In his capacity as a seller of goods he exports those goods to other individuals. While in his capacity as a buyer of goods he imports these goods from others. Every individual in a market economy is both an exporter and an importer. For instance, a baker that produced ten loaves of bread and consumes two loaves can now sell, i.e., “export”, eight saved loaves of bread to a shoemaker for a pair of shoes. The pair of shoes that the baker secures for the eight loaves of bread is his import. Note that he paid for the import with his “export”, i.e., eight loaves of bread is payment for the pair shoes. The essence of this exchange is not altered if, let us say, the shoemaker resides in Europe while the baker is located in the U.S.
The introduction of money does not alter the essence of what we have said, i.e., that individuals pay for their imports by means of exports. A producer exchanges the goods he produces for money and then employs money to secure, i.e., import, goods from other producers. As with the price of goods, the supply and demand for money determines the price of money, or its purchasing power. For a given supply of money an increase in the production of goods implies that producers will demand more money since more goods must now be exchanged for money. As a result of this, the purchasing power of money will increase. Every dollar will now command more goods. Conversely, if the supply of money increases for a given stock of real goods, the purchasing power of money falls since now there are fewer goods per dollar. The prices of goods and services are set in motion by relative increases in money against rises in goods and services. The exchange rates, as set by the relative purchasing power of monies, have nothing to do with the state of the balance of payments. On this score between 1994 to 2004, the Eurozone money printer has been working much faster than its American counterpart. In other words, money growth in the Euro-zone relative to the growth of real goods and services has been much larger than in the U.S.
It is not the U.S. that imports Japanese electrical appliances, but an individual American or a particular group of Americans. They import these appliances because they believe that a profit can be made. Now, whenever an individual plans to import more than he exports, the shortfall will be balanced either by running down existing savings or by borrowing. The creditor who supplies the required funds does so because he expects to profit from that. Subsequently, if the debtor, for whatever reasons, cannot honor his debt, this financial crisis is only of concern to the parties involved and of little importance to other individuals in the community. The idea of calculating the so-called national balance of payments in a free market economy will be absurd.
However, this is not so when government and the central bank are actively tampering with markets. In this context the reading of the balance of payments can provide some useful information regarding the damage that government and central bank policies have inflicted. In the U.S. context, the ever-widening current account deficit is the manifestation of the fact that despite the loose monetary policies of the Fed foreigners are still happy to be paid with U.S. dollars. As a percentage of total foreign reserves, U.S. dollars comprise 69% with Euros about 20%, while the rest is held in Yen, Pound Sterling, and Swiss Francs. The popularity of the US$ is an important vehicle for diverting real savings from foreigners to Americans. If this popularity were to weaken obviously it would be much harder for Americans to divert real savings from the rest of the world.
By printing the most popular international medium of exchange, the U.S. central bank enables the first receivers of dollars that happened to be Americans to divert real wealth from the rest of the world. Loose Fed monetary policies have enabled Americans to engage in consumption without the backup of the production of real wealth. That is, Americans have been engaged in nonproductive consumption. Obviously nonproductive consumption implies importing without exporting that results in a current account deficit.
So the alarm raised by Greenspan, while valid, should actually be addressed toward his own monetary policies. Curiously, in all his speeches the Fed Chairman has chosen to ignore the Fed’s contribution to the current currency turmoil. Luckily for the Fed other central bank’s policies are just as bad, thereby providing a support for the underlying U.S. dollar rate of exchange. China and other countries possibly shifting away from U.S. assets toward European assets may temporarily weaken the U.S. dollar against the Euro. It cannot, however, alter the underlying Euro/U.S. dollar rate of exchange. What set a rate of exchange in motion is relative increases in money supply against increases in goods and services. We suggest this raises the likelihood that the U.S. dollar is not overvalued (not too expensive) against the Euro. Consequently, the Chinese factor can only have a short-lived effect on the dollar, all other things being equal.Link here.
Dollar weakness and threats to U.S. markets.
On 9/16, the Federal Reserve released its latest “Z.1” (“Flow of Funds Accounts of the United States”), with data current through the June 2004 quarter. Although the numbers are subject to revision, the data are more than adequate for big-picture purposes. The Fed is due to release its next “Z.1” on 12/9, which will contain data through the September quarter.
More up-to-date numbers are available for most of the series discussed here. But for my purpose now, presenting the data and accompanying text as they were originally published in September is fine. I simply want readers to reflect on how extraordinarily large the numbers are, as well as on the magnitude and speed of their growth. As it relates to foreign holdings of Treasury and agency obligations, there are some current data later in the missive.
Many investors and analysts remain concerned about the United States’ large and growing trade and current-account deficits, and whether foreign investors will continue to fund them in an orderly fashion. This is certainly a concern I have voiced on many occasions, with an accompanying warning that serious weakness in the dollar could significantly exacerbate the situation.Link here.
YES VIRGINIA, AN EMERGING MARKETS’ FINANCIAL CRISIS IS POSSIBLE IN AMERICA TOO
Like the little girl who plaintively questioned the existence of Santa Claus, many regard the notion of an emerging markets’ style financial crisis on American shores in similarly sceptical terms. It is often said that “since America is a net international borrower, in its own currency, there is little to fear from a lower dollar.” This line of reasoning tends to obscure the fact that balance of payments crises are often precipitated by flaws in the underlying credit structure which are only later accentuated by the misalignment between foreign and domestic denominated debt. It is probably more accurate to say that a balance of payments crisis is symptomatic of a credit system run amok. Although the U.S. may not have foreign exchange risk per se, its fragile financial system is still rife with “Ponzi” style financing.
Analyses of current account deficits almost invariably move on to discussions about currencies, because devaluations are often seen as the adjustment mechanism to sort out the former. Seldom do analysts discuss the underlying credit structure which often precipitates a substantial current account deficit in the first place. In this context, it is worthwhile examining America’s lingering debt disease to ponder whether an emerging markets style balance of payments crisis is indeed possible. It is said that the dollar’s unique status as the world’s major reserve currency has eliminated any potential vulnerabilities posed through the mismatch of domestic assets against foreign liabilities, which was clearly a problem for countries such as Thailand, Korea, or Mexico. But a fresh look suggests that the efforts of US policy makers to avoid a full unwinding of the 1990’s stock market bubble through the encouragement of a credit bubble and a housing bubble has, despite something of a recovery, made America’s underlying credit structure even more vulnerable to a precipitous withdrawal of foreign capital.
The engine of American “growth” has in fact been a fringe of Ponzi finance units that has enabled Americans to “overconsume” -- that is to say, live well beyond their means. That this debt is US dollar denominated does not alter the fact that the U.S. is becoming dangerously indebted to rival nations that are holding its debt paper, collecting the interest on Treasury bonds and private bank loans, or repatriating the profits from companies that used to be American-owned. Central banks have played a role here, but ultimately the U.S., like Mexico, Thailand, or Korea in the 1990s, the endgame will be determined by the private trade in global capital, whether that capital be in dollars or not. The fall in the dollar’s external value per se may not cause additional financing difficulties, but if this fall is symptomatic of a generalized withdrawal of foreign credit, then the whole underlying credit structure could fall apart, as it has done many times before in other financial crises. Given the size of the U.S., the global fall-out will obviously be substantially greater.Link here.
SO MUCH COMPLACENCY, SO MANY EXTREMES
No particular news item is dominating the headlines right now, financial or otherwise. In politics, we just went through an election that was so much bread and circus, though with very little bread. Most of the “drama” was manufactured; the candidates made small differences sound large; and, we ended up with the same fellow we had to start with. Yawn. The economy is, um, doing... something. Early indications on holiday shopping are either “surprisingly strong” or “disappointing”, depending on what you read, or how closely you read the same article. Bigger yawn.
The Dow Industrials are barely above break-even for 2004; the S&P 500 and NASDAQ are slightly better off, though they were in the red only a month ago. Nod. Sports and entertainment? Forget it. How exciting can the rest of the sports year be, after an October that saw the Red Sox win the World Series in a 4-0 sweep? Zzzzz.....
The dearth of news duly noted, the serious point to make is this: The public’s news focus (or lack of the same) typically tells you plenty about the public’s psychology. The current lull, boredom, call it what you will -- indicates a large degree of complacency. So what does this absence of interest and lack of focus suggest? In a word, danger. The perception is that all is well and will get better. Yet reality has a perverse way of defying perception and of showing the conventional wisdom to be foolish. I realize that this sounds speculative, but it is not blind speculation. The “extremes” in the headline are actually very visible.Link here.
POLL SHOWS MANAGERS HOT ON STOCKS
U.S. money managers took the re-election of President Bush as a cue to make a significant shift to stocks from bonds after months of hesitation, a new Reuters asset allocation poll shows. The latest monthly survey shows a 65.6% weighting in stocks in November, up from 54.3% in October. The bond allocation fell to 27.1% from 41.0% a month earlier. The latest survey results also show cash rising to 5.2% from 2.3%. The new poll showed the North American equities allocation virtually unchanged from a month earlier at 52.2%. Europe outside of the euro zone received a larger allocation, as did Japan. The other major regions saw declines.Link here.
MONEY FLOWS FROM STOCKS TO HOUSING SET TO REVERSE IN EUROPE?
“For the five years ended Sept. 30, median [U.S.] home prices rose 39%, versus a loss of 13% for the S&P’s 500-stock index,” says today’s Wall Street Journal. With performance numbers like these, is it any wonder that 8% of all U.S. mortgages are now taken out by real estate investors, “up from 7.5% in 2003 and 5.7% in 2000”? The money flow from stocks into homes is one of the main reasons for the current house price bubbles in the U.S., U.K. and Australia. Back in 2000, those investors smart or lucky enough to have sold their stocks near the top began looking for other ventures -- and the global real estate bubble was born.
However, in Britain, this “stocks-to-housing” money flow is slowing, and fast. With only 83,000 mortgages approved in October, the housing market activity is now the slowest in five years. A large U.K. lender Nationwide now expects house prices to grow by just 2% in 2005, compared to 16% last year. And that is optimistic: Barclays says prices will shed 20% in the next three years, and Goldman Sachs sees a 10-15% drop even sooner.
The good news is that so far, “the slowdown has been orderly”, reducing the risk of a real estate crash like the one Britain saw a decade ago. It was different back then, says Nationwide: In the early 1990’s, the “sharp correction in the housing market” was caused by a “severe economic downturn”. In other words, it is the current strength of the U.K. economy that ensures a “soft landing” for house prices.
That is an interesting viewpoint because just today, the Governor of the Bank of England said that the British economy has “lost momentum” in the 3rd quarter and that the GDP growth has been “substantially below” the forecasts. What is more, an international economic think tank put out a forecast for the U.K. economy to perform even worse in the next two years because the “housing market instability remains a risk”. In other words, it is the falling house prices that threaten the current strength of the UK economy. Hmmmm. Well, let central bankers worry about figuring this one out. For European investors, however, there is another important question. Now that house prices are falling, will the money start flowing out of real estate and back into stocks?Link here.
CREDIT RATERS’ POWER LEADS TO ABUSES, SOME BORROWERS SAY
The letter was entirely polite and businesslike, but something about it chilled Wilhelm Zeller, chairman of one of the world’s largest insurance companies. Moody’s Investors Service wanted to inform Zeller’s firm -- the giant German insurer Hannover Re -- that it had decided to rate its financial health at no charge. But the letter went on to suggest that Moody’s looked forward to the day Hannover would be willing to pay. In the margin of the letter, Zeller scribbled an urgent note to his finance chief: “Hier besteht Handlungsbedarf.” We need to act.
Hannover, which was already writing six-figure checks annually to two other rating companies, told Moody’s it did not see the value in paying for another rating. Moody’s began evaluating Hannover anyway, giving it weaker marks over successive years and publishing the results while seeking Hannover’s business. Still, the insurer refused to pay. Then last year, even as other credit raters continued to give Hannover a clean bill of health, Moody’s cut Hannover’s debt to junk status. Shareholders worldwide, alarmed by the downgrade, dumped the insurer’s stock, lowering its market value by about $175 million within hours.
What happened to Hannover begins to explain why many corporations, municipalities and foreign governments have grown wary of the big three credit-rating companies -- Moody’s, Standard & Poor’s and Fitch Ratings -- as they have expanded into global powers without formal oversight. The rating companies are free to set their own rules and practices, which sometimes leads to abuse, according to many people inside and outside the industry. At times, credit raters have gone to great lengths to convince a corporation that it needs their ratings -- even rating it against its wishes, as in the Hannover case. In other cases, the credit raters have strong-armed clients by threatening to withdraw their ratings -- a move that can raise a borrower’s interest payments.
And one of the firms, Moody’s, sometimes has used its leverage to ratchet up its fees without negotiating with clients. That is what Compuware Corp., a Detroit-based business software maker, said happened at the end of 1999. Compuware, borrowing about $500 million, had followed custom by seeking two ratings. Standard & Poor’s charged an initial $90,000, plus an annual $25,000 fee, said Laura Fournier, Compuware’s chief financial officer. Moody’s billed $225,000 for an initial assessment, but did not tack on an annual fee. Less than a year later, Moody’s notified Compuware of a new annual fee -- $5,000, which would triple if the company did not issue another security during the year to create another Moody’s payment. Fournier said Moody’s did not do anything extra to earn the fee. But the company paid it anyway -- $5,000 in 2001; $15,000 a year later.Link here.
JIM ROGERS SAYS THE HEDGE FUND INDUSTRY HAS PEAKED
Jim Rogers, who co-founded the Quantum hedge fund with investor George Soros in 1970, said the industry has peaked because stock and bond returns are dwindling and there is a shortage of good money managers. “I’m not too optimistic about hedge funds because you won’t be making a lot of money from stocks in the next 15 to 20 years and bonds will be doing horribly,” Rogers said at a hedge fund conference. “I’m told there are almost 10,000 hedge funds. With overcrowding, there will be some charlatans and incompetence. You can’t have that many smart 29-year-olds around.” Rogers said most of today’s managers made their reputations during the stock market rally of the 1990s. It will be difficult to replicate that success in the future, he said.
Hedge funds are loosely regulated investment pools designed to profit from falling as well as rising market prices. It is the most lucrative and fastest-growing part of the money-management business. Globally, hedge funds attracted more than $100 billion in the first nine months of 2004, boosting the industry’s assets to about $890 billion, according to estimates from Tremont Capital Management. Rogers, who retired at the age of 37 with what he said was “enough money to satisfy a lifelong yearning for adventure,” said commodities represented the best asset class for investments and China was the best place to make money.
“The current bull market in commodities started in 1999, and if you go back in history, the shortest bull-market period was 15 years and the longest was 23 years,” he said. “Most commodities like sugar and coffee remain at low prices. Even oil, adjusted for inflation, remains 50 percent below its all-time high.” An industrywide drop of investments to find oil in Mexico, Alaska and the North Sea will probably drive oil prices higher, Rogers said.
The Chinese government will ease its currency peg to the U.S. dollar in the next two to four years ahead of obligations made to the World Trade Organization and its hosting of the 2008 Olympics in Beijing, Rogers said. The dollar remains “a terribly flawed” currency and Rogers reiterated comments made this year that its value will fall further as the largest debtor nation continues to borrow. “I assure you it will get worse,” he said. To illustrate his convictions in his investment strategies, Rogers said his 18-month old daughter has a Swiss bank account and a full-time Mandarin tutor.Link here.
Do hedge funds calm markets or inflate bubbles?
Have hedge funds made markets work better or worse? With the explosion of hedge funds -- there are now more than 7,000, controlling almost $900 billion in assets -- there is no hotter issue in global finance. To some, hedge funds are reckless gamblers, using weird financial instruments to blow apart currencies and stocks, pushing up prices and creating speculative bubbles. To others, they are benign new pools of capital that help investors by spreading their risk, and they stabilize the market by taking up contrary positions. Who is right? A study in the October issue of the academic publication Journal of Finance suggests the funds are inflating bubbles, not damping them. If it is right, one of the main defenses of hedge funds has been weakened. And much of the marketing hoopla in which the funds like to cloak themselves will have been punctured.
What have the funds been up to? Piling into every passing dot-com they could find, it turns out. It seems that at least until late 1999, their trading mostly supported rather than undermined the technology bubble. Or look at the levels of speculation by hedge funds in commodities this year. Or look at the way many within the oil industry have accused hedge funds of helping ramp up energy prices. It looks as if they are helping inflate a bubble -- just as they did before.Link here.
ALL THOSE FOR ARMAGEDDON RAISE THEIR HANDS
The shorter Oxford Dictionary defines “Armageddon” as “the site of the last decisive battle on the Day of Judgement; hence, a final contest on a grand scale.” Of importance is the simple phrase “final contest” and, for those who are aware of risk, this seems to be focused on just how destructive the collapse of the dollar will be. Instead, history suggests that the most severe financial problem will be when the party of inflating anything that will fly against deliberate dollar depreciation ends. The final contest, then, is the desperation of Western central planners to make their imposed, and still socialistic, theories work against implacable market forces. Regard for socialistic central planning in Eastern Europe began a lengthy loss of regard in the late 1980s. Quite likely, the real Armageddon will be the equivalent loss of esteem and power to policymakers in the senior economies.
The point that we have been making over the past few months is that the street thinks that an absolute collapse of the dollar in foreign exchange markets will be the Armageddon. Not so -- no matter how rapid the depreciation has been, there has always been a binge in soaring asset prices. Disaster starts when prices stop going up. The hangover is inevitable and the one following this party could rank about 8 on the open-ended Armageddon Scale.
Speculative booms and busts are nothing new, but what is rare is the dedication of today’s policymakers in promoting speculation against the deliberately depreciated dollar. There has not been anything to this degree since England’s South Sea Bubble or France’s Mississippi Bubble in 1720. Yes, the tech bubble in 2000 was wild, but the street and policymakers had little doubt that the boom could be sustained. No worries then. Now, there is palpable desperation in this attempt to keep the depreciation and the boom in whatever-is-hot going. This becoming very intense, so intense that it is worth reviewing a recent example of “Armageddon” related to the financial markets.
As late as 1989, best-selling economics textbooks were still touting the wonders of the Soviet economy. The thinking was tautological as interventionist economists assumed that because the Communists were so dedicated to central planning, the results had to be good. Then in the late 1980s, the public in Eastern Europe began to see through the promises of the control freaks and began a long process of diminishing, if not dismantling, all of the state-run monopolies. For the central planning clique that could not move over to the market economy, this must have been the equivalent of “Armageddon”. Despite such a loss of esteem in Eastern Europe, no such censure was suffered by Western central planners.
History has never long abided the policy theory that prevailed during a financial mania and this brings us to just what kind of an Armageddon is possible in a post-bubble world. First, it is important to note that one of the most violent financial Armageddons was the Weimar inflation that was imposed upon Germany by their policymakers in the early 1920s. At the same time, Lenin intentionally employed the same method to destroy the middle class in Russia. Both were printing press inflations that can be argued as impossible to do in a credit-based economy such as the U.S. The paper examples resulted in Communism and National Socialism, which were labels for a horrendous political Armageddon inflicted upon society. Using the history of England and America, it seems that the most violent abuses of the credit markets resulted in an equally violent loss of esteem by the prevailing theory during the financial mania.
Booms, busts, and lengthy contractions have been regular events and there has been no sound reason to propose that some policymakers or central bankers can materially alter financial history. This has been one of the blunders of those who thought that the prevailing agency could keep a financial mania going beyond its standard duration of 9 years.
Beyond the sudden loss of prosperity has been the “Armageddon” of the sudden loss of prestige that goes with a post-bubble contraction. Celebrated as a financial genius during the Mississippi Bubble of 1720, John Law was fortunate to escape France with his life during the intense recrimination during consequent contraction. During the 1920s’ financial mania, Andrew Mellon was celebrated as “the greatest Treasury Secretary since Alexander Hamilton”. He has been condemned ever since as one who allowed the 1930s’ contraction to happen. Of course, during the late 1990s’ mania, Treasury Secretary Robert Rubin was celebrated as the greatest since Alexander Hamilton. He wisely retired from the position before the top with his posterity intact.
However, whatever the reputation, Armageddon that could be visited upon the usual policymaker who overstays his role could be just a personal part of the much bigger picture -- whether taxpayers like it or not, the full faith and credit of the U.S. (so to speak) has been employed to inflate any asset price that could be boosted. Other than personal loss of prestige or a more widespread loss of prosperity, the worst Armageddon that can be considered is the typical collapse in esteem for the “genius” of the theories attendant to the speculative mania. In the late 1980s, it was the collapse of socialist central planning in Eastern Europe. On the next contraction, Western central planners will likely suffer a massive loss of regard and, hopefully, arbitrary power. Armageddon for them; eventually, financial blessings for the general public.Link here.
THE AGE OF INFLATION
With stock prices down considerably since 2001, and apparently heading lower, many Americans have taken a liking to real estate. They have bought homes in record numbers as easy credit and low interest rates have enabled many to buy rather than rent a home. And just like stock prices during the 1990s, the value of homes keeps rising, as does the debt incurred to buy them. According to Federal Reserve data, American homes now are worth some $13.6 trillion, which is 92% more than a decade ago, while mortgage debt more than doubled to $6 trillion. With all that money rushing into real estate, does it blow bubbles, as it did in the stock market, does it reflect chronic inflation and dollar depreciation, or does it manifest rising incomes and growing ownership aspiration?
The governors of the Federal Reserve System modify all interest rates and manipulate the capital markets. In recent years, they chose to keep interest rates far below market rates, and thus guide economic activity along lines that differed greatly from those an unhampered market would have directed. They caused massive increases in money and credit and brought about what economists call “maladjustments” which are the very mainspring of economic recessions and depressions.
Maladjustments in real estate differ visibly from the afflictions of stock and bond markets, which are national or even international in range and scope. Landed property is an inherently local asset that is affected by a great number of local demand and supply factors. Some places may suffer stagnation or price declines while others experience feverish booms. There may be bubbles in some parts of the country while stagnation and recession hold others in their grip. Yet all prices undoubtedly are much higher than they would be in absence of chronic inflation and dollar depreciation.
The Office of Federal Housing Enterprise Oversight informs us that average housing prices rose 38.3% from 1997 to 2002. This knowledge may be of interest to economic historians, but of little use to real estate investors. They are intrigued and lured by local conditions and the possibility of earning high returns through debt financing when prices soar. While the mortgage loan continually depreciates in purchasing power, the owner’s house’s price rises in step with the rising price of his house. In fact, in less than ten years, a ten percent annual bubble rate will shift one-half of the value of his house to him, without having made a single loan payment.
This leverage of debt financing also works in reverse. When the bubble bursts and housing prices readjust, many new owners would soon lose their entire investment. A 10% fall in prices wipes out a 10% owner equity; a 30% or 40% decline, which is rather common in a bubble crash, not only stamps out his investment, but also may inflict additional losses -- unless he walks away from his house, and thereby shifts the losses to the financial institution that granted the loan. When the decline is severe and many owners choose to unload their losses on creditors, the crash may jeopardize the solvency of financial institutions that financed the bubble. Despite such occasional reversals, our age of inflation has made ownership of a home the most effective way to increase personal wealth.
Before the age of inflation, a homebuyer needed a down payment of 30% to 50% of the purchase price; the age of inflation gradually reduced this rate to 20% or 10%, but sometimes 3% or less. The lender’s price risk is minimal; the buyer may just sit back and let the bubble increase his equity. Politicians and government officials look with favor on home ownership, as they themselves do benefit from such favors. Homebuyers enjoy big tax breaks.
The prices of manors and mansions have soared above all other housing prices. When the stock market began to retreat and disappoint in 2001, many underperforming funds sought refuge in real estate, and thus caused housing prices to take off. Most homeowners rejoice about their rising equity, which they calculate in nominal prices. If they would compute prices in inflation-adjusted dollars, their profits would be much lower or even turn to losses.Link here (scroll down to piece by Hans Sennholz).
Swimming in the ocean of debt.
In recent years, many communities also have been affected by soaring U.S. trade deficits driven by Federal Reserve easy-money policies and mounting U.S. Treasury budget deficits. As trade deficits rose to more than $500 billion annually, that is to more than 5% of GDP, American manufacturers of many consumer goods faced growing pressures of foreign competition and were forced to contract. Many communities soon experienced economic declines and rising unemployment, especially in parts and sections of town occupied by the laboring population. While the construction of mansions continued at full speed, and middle class refinancing generated new life in old neighborhoods, heavily-populated urban areas occupied by welfare recipients and unemployed laborers ceased to grow.
National forces may at times overshadow the local demand-and-supply factors that often drive the real estate market. They surely were overwhelmed during the Great Depression of the 1930s and the six recessions that descended on the country since then. Another recession could do it again. If foreign central banks should tire of financing U.S. trade deficits the U.S. dollar would plummet in foreign exchange markets, American goods prices would rise, and interest rates would readjust. An international flight from the dollar undoubtedly would delimit the Fed's power to manage interest rates. Rising rates would impact on the housing market and reveal the maladjustments that resulted from many years of rate manipulation. Rising rates would expose ill-designed housing built in wrong quantities, wrong qualities, and wrong neighborhoods. Of course, the monetary authorities would do everything in their power to flush the troubles away. Unaware of any inexorable principles of economics and infatuated by the coercive powers of government, they are likely to compound the difficulties and make matters worse.
Even if foreign creditors should never tire of financing American trade deficits and U.S. Treasury debt, the maladjustments are calling for correction. The ocean of debt in which many Americans are swimming cannot brook a major rise in interest rates; it may soon force a readjustment. In short, powerful forces consisting of the value judgments and choices of the people, are working tirelessly to correct the maladjustments in real estate.
It is well nigh impossible to estimate the magnitude of income and wealth, which false interest rates and misleading credit markets redistribute every day. It is unearned lucre that is taken from millions of savers and creditors and bestowed on all kinds of debtors, including millions of mortgagers. Surely, most Americans are both creditors and debtors but rarely equal in both accounts. Most Americans sense the growing importance of government and especially its primary role in the allocation of inflation lucre. They all would redistribute the lucre, few would abolish it. They may even favor and support inflationary policies that blow bubbles in real estate and create incomparable opportunities. Unfortunately, they pay little heed to the great economic and social harm done by such policies.Link here.
ART THE NEW ASSET CLASS?
According to a December 1 New York Times article, the hottest financial investment these days is NOT being held in the stock markets. Instead, it is hanging over your living room sofa. The piece reads: “Art prices are setting records again. In early November, “No.6” by Mark Rothko was auctioned for a record $17.4 million, almost 50% above the top end of estimates… Not only are modern and contemporary artists being treated like pop starts, but earlier American masters are also soaring like late-1990’s Internet stocks…These rates of return are now attracting the interest of financial investors…”
Introducing: the New York-based Fernwood Art Investment company, who next year plans to establish several funds to buy and manage art portfolios. Bear in mind, this Big Apple firm is not THE bandwagon; it is jumping on a bandwagon of art investment companies that started moving through Europe over nine months ago.
In the words of one economic scholar, “art prices have a low correlation with stocks, so art can enhance the performance of a portfolio of equities.” Nothing abstract about that idea. Too bad it is wrong. Back in June when the “red hot art market” started to catch fire, the Elliott Wave Financial Forecast offered this unique insight into the trend: “The obsession with painting is an extension of the panic for stuff… Art prices are not strictly commodities. Their prices are also influenced by social mood as reflected by stock prices and regulated by the Wave Principle.”
This speculative fervor is propelled by the same bullish optimism that has today’s investor leaping into hedge funds, small caps, internet stocks and the like. But the one thing we noticed about art prices in the June issue of EWFF that the mainstream press seemed to miss was this: They “appear to save their boldest moves for the aftermath of the big advances in stocks,” e.g., in 1990-1991. Now, six months after Picasso’s “Boy With A Pipe” shattered the previous record amount paid for a painting, we have U.S. investment firms offering art portfolios to clients who want to cash in on the sizzling art market. All this despite the fact that the big three blue chip stock indexes remain BELOW their 2004 highs.
Don’t get painted into a corner. The writing (or rather the big picture) on the wall is clear, even if most other people do not see it. When ideas about “value” become this abstract, it is time to stop thinking about art and start paying attention to what happens when financial markets go into a fit of extreme psychology.Link here.
“WEAK INFLATION” A WEAK INSIGHT?
Little more than a year ago, the specter of deflation in the U.S. loomed large over the prospect of economic recovery. One day the Wall Street Journal reported that “Greenspan Says Deflation Risk is Small but Requires Scrutiny”, while the next day it questioned the effectiveness of that scrutiny, headlining another article “The Fed May Lack Weapons it Needs to Stave Off Deflation” (May 22 and 23, 2003). As markets surged through the second half of 2003 and into 2004, mention of deflation and its dangers grew increasingly rare. No sooner had that fear been put aside than a more “optimistic” fear of inflation took hold.
It is hard to find evidence to explain the about-face. Nearly every measure of inflation tracked by the Federal Reserve has registered significant lows more than once during the past year. One look at the “core” numbers that subtract volatile food and energy prices, and the perception of pending inflation vs. the reality of potential deflation is unmistakable. This week’s Commerce Department estimates of 3rd quarter 2004 GDP echo earlier reports: 1.) The Personal Consumption Expenditure Price Index (PCEPI) favored by the Fed measured core inflation at a 42-year low of 0.7% in Q3. That is down from a beefy 1.6% core level in May 2004, which still bested the Q3 non-core 1.1% rate; 2.) The Q3 GDP deflator registered less half the size of its Q2 level; 3.) Core CPI was at a 40-year low of 1.1% from November 2003 to January 2004.
Are these signs of the “weak inflation” sought by the Fed, disinflation gone out of control, or the whispers of the deflationary specter creeping up on an unsuspecting crowd of bulls? In Monday’s Interim Report to Elliott Wave Theorist subscribers, Bob Prechter warns that a “deflationary spectacle will be something to see and experience.” That “something” does not have to be unpleasant for you.Link here.
“THE WORLD IS STILL OUT OF WHACK”
If you are ever in Times Square, look for the great big ticker in the sky. There, in the corner 11th-floor office, sits Stephen Roach, Morgan Stanley’s chief economist. His perch is appropriate. Mr. Roach thinks the global economy is on the precipice. Whenever I write about his extreme views, readers ask me if I think the world is truly going to end. Surprisingly, he has taken a step back from the edge in the last month, for three simple reasons: 1.) Oil has fallen from its highs, 2.) China is flirting with the modernization of its monetary policy, and 3.) The dollar has resumed its decline.
I asked if that meant he was “constructive” on the economy. He stopped me right there. He places the probability of a recession in 2005 at 30% now, down from the 40% he was predicting. Even though it may be out of intensive care, the global economy is still not stable, he said. It remains heavily reliant on supply from China and demand from the American consumer. “The world is still out of whack,” he said. We learned Wednesday that the savings rate fell to a record low of 0.2% in October, as spending grew faster than incomes. That is alarming to me. But not to the media cheerleaders who focused on the “good” news that spending had grown more than expected.
“Americans discovered the joys of the wealth effect at the end of the 1990s,” Mr. Roach said. “Then it was equities. Now it’s property, which has had a much bigger impact. ... The wake-up call for the American consumer will come from two places -- higher interest rates and age.”Link here.
HOW “THE MATCH KING” BEGAT AIG
As a child growing up in Sweden, Ivar Kreuger was known as “The Sneak”. Kreuger’s classmates recall the ingenious methods he devised to cheat on tests. Once he climbed in the headmaster's office and stole exam questions. He then sold the questions to other students. It should have been no surprise to anyone who knew his childhood nickname, when “The Sneak” was found dead on March 12, 1932. Kreuger’s family was denied an autopsy and the body was cremated immediately after arriving in Sweden. His personal diaries were burned. “The Sneak” was dead, and no one would ever know how it happened.
Most people knew Kreuger as “The Match King”. After cornering the market for matches in Sweden, Kreuger had gone around the world, offering huge low-interest loans to bail out ailing countries, in exchange for a monopoly on their match business. Several countries, including France, Germany, Greece and Poland, had been bailed out by Kreuger loans. That is how he gained control of 65% of global match production. The tendrils of his empire went around the world. Kreuger’s companies continued to pay dividends of between 16% and 24% even during 1929-32, three years of devastating market losses, while all of Wall Street was struggling to stay alive.
Then, after he died, “The Sneak” was found out. Italian bank notes worth $150 million were found in Kreuger’s private vault. The Swedish finance minister took the notes to a private meeting with Benito Mussolini immediately after Kreuger’s death and asked if Kreuger had made a cash-for-monopoly deal with Italy. He had not. Kreuger tried, but failed, to use the notes to get a loan from a Swedish bank. The bank notes contained the signatures of Italian Finance Minister Antonio Mosconi and another official, Giovanni Boselli. Mussolini took one look at the notes and shouted, “These signatures are forged!” He summoned Mosconi and Boselli to verify the treachery. It was not necessary. The superman of finance had spelled their names wrong.
Headlines soon thereafter revealed, “Kreuger Books are ‘Grossly Wrong’, Some Assets False.” Stock in Kreuger’s companies became worthless. The Irving Trust Company of New York was named as trustee in the Kreuger bankruptcy. Irving Trust liquidated almost all of Kreuger’s assets. But there were four little companies they did not want to liquidate in the U.S. Their assets were debentures with a face value of $95 million, now trading for only five cents on the dollar. But the liquidators at Irving Trust were smart. They thought the debentures would go up over time. If that happened, a large capital gains tax would be applied upon sale. The Irving Trust determined to find a way to eliminate the tax burden on what was left of the infamous Ivar Kreuger’s assets.
A prestigious Wall Street firm offered a solution. They had a company called International Match Realization Company, Ltd., set up and incorporated in ... Bermuda. International Match Realization then went into the New York market and bought the debentures for five cents on the dollar. The assets were liquidated a few years later, having risen nine-fold to 45 cents on the dollar, a profit of $38 million, with no capital gains tax on the transaction. The financial transaction was the founding act of the “Switzerland of the Atlantic”, as Bermuda would come to be known. Word of the Kreuger transactions -- and of Bermuda -- got around.
American businessman, Cornelius Vander Starr, had built a sizeable global insurance empire. In 1947, Starr wanted to move his non-U.S. headquarters from Cuba, which he viewed as an unstable environment. It did not take Starr long to find the ultimate resting place of Ivar Kreuger’s legacy, Bermuda. It was English-speaking and close to the U.S. Bermuda imposed no corporate, income, dividend or capital gains taxes, and operated under the British legal system. Perhaps you have heard of Starr’s appointed successor: Maurice “Hank” Greenberg. Greenberg is the chairman and CEO of the company Starr created, which today has a market value of $159 billion. It is one of the 30 Dow Industrials. The company is American International Group, Inc., better known as AIG.Link here (scroll down to piece by Dan Ferris).
CURRENCY DEPRECIATION DOES NOT BRING PROSPERITY
Key members of the Federal Reserve Board and a cadre of Wall Street economists have become fixated on the current account deficit as a worrying symptom of economic distress and a sign of impending crisis. This has led a host of Reserve Bank presidents and Fed governors to imply that the dollar should fall in order to rectify imbalances before a crisis becomes inevitable. Since the theory of imbalances holds that a crisis eventually will ensue, destructive policy actions that surely would trigger a crisis are being advanced as “solutions” to a non-problem. Steep tax increases to augment “savings”, a depreciated dollar to boost exports, and higher tariffs or a sharp domestic-growth slowdown to discourage imports have all been floated as “solutions” to our current account deficit.
In other words, precipitating a crisis to solve a non-crisis only can reduce the severity of a crisis that would have happened anyway. Lord Keynes captured this kind of logic in the general theory when he said that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
Those advocating a weak dollar to redirect trade flows do not have history on their side. While a depreciating currency is assumed to boost exports and shut off the demand for imports, this is only the first effect. Eventually a weak currency invites inflation, which neutralizes the effect of the lower exchange rate. Weak-dollar advocates assert that the dollar can fall without aggravating inflation as long as capacity utilization rates are depressed. This is a dangerous assumption. It is rooted in illusory tradeoffs between growth and inflation that have been discredited empirically and refuted by history. Persistent currency depreciation has never brought lasting prosperity to any government in the history of the world. If the dollar continues to depreciate it will bring higher inflation, higher interest rates, lower real growth rates, and a reduced standard of living for most wage earners.Link here.
GAMBLING, WHETHER YOU WANT TO OR NOT
I suppose we are all gamblers in some sense. Life is a gamble, as the saying goes. I don’t care much for gambling in a casino -- I don’t have anything against it, I just don’t like to do it. I used to play pool for a beer, but I guess that is betting on my own skill, which is not quite the same as playing a slot machine. I never intended to gamble on real estate, but I wound up doing it anyway. I won, too, but that was plain dumb luck. I happened to be in the right place at the right time. Buy low, sell high. A lot of folks lucked out the same way in those days.
I never intended to gamble in the stock market either, but I wound up doing that too. The company I worked for asked me to manage the profit-sharing trust for about ten years, and I somehow managed to pick the winning no-load mutual funds of that decade. I would not touch them today, of course, but the experience then was good. I thought a lot about the stock market in those days, and I decided that it was essentially a casino, though lacking the honesty of a casino. A casino is a straightforward business with a carnival atmosphere designed to cheerfully separate people from their money. There is no subterfuge about it. The stock market is similar in atmosphere and purpose, but there are more and trickier bells and whistles to distract the customer from what is actually happening.
When a slot machine pays off, its lights flash and it makes noise, alerting every person nearby, who is busy getting nothing for something, that it could happen to them too. That is the idea. Likewise the broker reminds the investor of IBM and Microsoft and sends them a handsome prospectus on this or that up and coming company. Any prospectus is fun to read, especially if you like to write fiction, but in the end the investor has to decide whether to buy, or not. Inevitably, at that point, one looks at the price changes over time and gambles that the price will go up. Is the company making money? Ho hum. Is the company making anything? Ho hum. Is the stock price going up? Oh Yes! Buy! That is gambling. The house, in this case the broker, always wins.Link here.
WHEN OUR DOLLARS COME MARCHING HOME
The financial and popular press has lately focused on the now obvious problems for the dollar created from our massive budget and trade deficits. Indeed, everyone now realizes that for the deficits to be brought into balance, the dollar must go down. It seems that virtually every financial pundit, though, still assumes that not only will the Asian and other foreign central banks continue to accumulate dollar assets forever, but that “those foreigners will never spend their dollars”. However, very little is written about what will happen when all the dollars, built up as foreign central bank and private holdings, get spent. Indeed, we believe that not only will the dollars get spent, but this spending will have massive inflationary implications for America.
Up to now, foreign central banks -- particularly the Asian central banks that currently hold over $1 trillion in dollar assets -- have had every reason to accumulate as many dollar credits, in the form of U.S. treasury securities, as possible. Accumulating these dollar assets has cost foreign central banks nothing as long as they have a trade surplus and can print up more of their own currency for free and swap their free money for U.S. treasuries. Rather than spending their dollars today, America’s trade partners are saving them so they can be spent tomorrow. Moreover, as long as our dollars are happily accepted by countries that produce oil, raw materials, and goods and services they need, America’s trade partners can profit in the future in exchange for paying nothing today, simply by running mercantilist policies!
Another perspective on what is happening is if trade flows were currently matched, foreign countries would not be building up dollar credits; they would be spending dollars “taken in trade today”! This dollar spending would increase the demand for goods and services in America and raise prices, creating inflation. The very fact that foreign countries have not been spending their dollars now but are, instead, storing up massive dollar credits, means there is going to be a whole lot of dollar spending in the future. One can compare this to a huge dam filling up with dollar credits, but look out when this “dollar dam” breaks and the pent up dollar reserves flow out and flood America.
Sooner or later all currencies come home to their native country to be spent, but as long as the dollar is viewed as the international reserve currency, the process of massive credit and dollar inflation showing up is delayed. The fact that the dollar has been the world reserve currency simply means that the dam full of dollars has been allowed to fill up higher than anyone could have ever imagined.
How do our dollars finally get back home to our country? Well, if China does buy Noranda, the Canadians can invade shopping malls south of the border. If China also buys Latin American resources, Latin Americans can then buy the rest of Miami. As dollars get spent and move from country to country like a hot potato, eventually the dollars will come marching home because a dollar will always buy something in America, even if it is not very much.Link here.
INFLATION UNDER CONTROL, SAYS THE MAN BEHIND THE CURTAIN
U.S. inflation is under control and is expected to remain tame, Federal Reserve Board governor Ben Bernanke said. “I think inflation is still quite well-contained. And I think inflation expectations are well-contained,” Bernanke told reporters after a speech to the National Economics Club. “Whatever risks exist are not large ones.”
But as the economy approaches full-employment over the next year or so, and as pricing power returns a bit, he maintained, “we need to be exceptionally vigilant to make sure that inflation pressures don’t re-emerge.” Bernanke said the economy has been “quite resilient” and growth in the fourth quarter “will be similar, perhaps a bit higher” than the 3.9% growth rate in the third quarter. Bernanke said the large US current account deficit is “a world problem” and cannot be solved by Washington alone. He said U.S. consumers must save more, but foreign countries must increase their domestic demand and not rely so much on the U.S. markets to sell their goods.Link here.
MORE HOMEOWNERS BORROWING AGAINST EQUITY IN THEIR HOMES
Americans may be filling the malls for holiday shopping, but when it comes to serious financing needs they are lining up in record numbers to tap their real estate equities. New research by mortgage market giant Freddie Mac found that 60% of all refinanced mortgages the corporation purchased during the third quarter of 2004 involved “cashouts”, where homeowners increased the size of their loans and pocketed the difference tax-free. That 60% figure was up from 42% during the second quarter and represents the highest rate since mid-2002. For the year as a whole, Freddie Mac estimates that homeowners will cash out $118 billion of their home equity.
The key to this trend, of course, is an unusual confluence of high home value appreciation with near-record low borrowing costs. The average house in the United States has gained 44% in value in the last five years alone, according to the Office of Federal Housing Enterprise Oversight. In some high-roller markets on the West and East coasts, appreciation gains of 60 to 80% or more during that period have been commonplace. Meanwhile, 30-year mortgage rates have hovered at or below 6%, making borrowing money from your home piggy bank cheaper than it has been in four decades.
Another booming technique for tapping rapidly accumulating home real estate wealth: equity lines of credit. Home equity credit lines are hot in part because lenders have cut rates, cut settlement fees, and streamlined the closing process dramatically. Equity lenders, primarily big banks, now routinely offer credit lines priced at or below their prime commercial rates for eligible homeowners with high credit scores. After taxes, the effective cost of these lines is in the mid-to-upper 3% range for many consumers.
With most of the traditional application and settlement fee hassles removed, should equity-flush owners join the crowds and hock their homes to the hilt? Hardly. Remember: Equity lines and cashout refis add to your outstanding household debt, and can raise your total monthly debt payments significantly. Since both types of mortgages are secured by your house, they open you to the possible loss of your residence and your equity in the event of a foreclosure, unlike other consumer loans.Link here.
WHY A FREE CREDIT REPORT IS WORTH YOUR TIME
A new federal law, entitled the Fair and Accurate Credit Transactions Act, went into effect this week enabling millions of Americans to get a snapshot of their credit history for free. The FACT Act grants consumers one free credit report a year from each of the big three credit reporting bureaus — Equifax, Experian and TransUnion. Currently, the cost of a credit report is around $9.00.
Your credit report should not remain a mystery to you because it allows an institution or person, such as a potential lender, credit card company, landlord or employer to view your credit history and determine whether you would be a good risk for a loan, credit card, home or job. And, according to the Public Interest Research Group, one in four credit reports has errors that are serious enough to disqualify consumers from opening a bank account, purchasing a home or even getting a job! Furthermore, a negative credit score can impact the mortgage, auto and credit card rates available to you. Additionally, a credit report is an excellent tool to determine if any fraudulent transactions have occurred on your accounts.
The easiest way to access a free credit report is to log on to this web site. All of the background and vital information -- including when the free reports will be available in your state -- is available and easy to retrieve. You can also obtain a copy of your report by calling 877-322-8228. It is important to note that if you log on to one of the big three’s Web sites to order a report, in most cases you will be charged. One of the bureaus, Experian, is already providing a free report to consumers independent of their geographic location.
If you live in the southern or eastern U.S., free reports will not be available until June or September of 2005. However, you should not wait until then to access a copy of your report. In fact, if you believe an error on your report was cause for your denial of a mortgage, employment, insurance or credit, you may be eligible for a free credit report immediately.Link here.
THE FABULOUS DESTINY OF ALAN GREENSPAN
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?” asked the Fed chairman, when he was still mortal. The occasion was a black-tie dinner at the American Enterprise Institute in December 1996. “We as central bankers,” Greenspan continued, “need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. But we should not underestimate or become complacent about the complexity of the interactions of the asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”
Mortals make mistakes. But Greenspan was right on target then. It was later, after he became a demi-god, the “Maestro”, that the Fed chief erred. In 1996, the bear market of 1973-74 and the crash of 1987 were still functioning as caution signs. However, a steep drop in the first half-hour after the market opened, as overnight sell orders were executed the day after the chairman’s remarks, the market began a rebound and never looked back. By the spring of the year 2,000, the Dow had almost doubled from the level that had so concerned the Fed chairman.
But while the maestro was alarmed at Dow 6,437, he was serene at Dow 11,722. Fatal to Greenspan’s judgment was a combination of bad information, bad theory and a human nature that -- though unchanged for many millennia -- seems to have slipped the attention of central bankers. Greenspan’s theory was that by carefully controlling the cost of credit and the money supply he could avoid serious economic downturns. For today’s purpose, we will just point out that Mr. Greenspan has everything he needs to get the economy back on track, except the essentials. He cannot make telecom debt worth what people paid for it. He cannot restock consumers’ savings accounts. He cannot erase excess capacity, nor make investment losses disappear.
In addition to the bad theory, Mr. Greenspan had bad information. The “information age” brought more information to more people - including to central bankers ... but the more information people had, the more opportunity they had to choose the misinformation that suited their purposes. Since the late 1990s, however, many of the figures used to justify the New Economy have been revised, downward. What was true for the nation’s financial performance was also true for that of individual companies. What they were often doing was exactly what Alan Greenspan worried about -- impairing balance sheets in order to produce growth and earnings numbers that delighted Wall Street. But by 1998, Alan Greenspan no longer noticed; he had become irrationally exuberant himself. Markets make opinions, as they say on Wall Street. The Fed chairman’s opinion soon caught up with the bull market in equities.
Shares rise, as Buffett put it, first for the right reasons, and then for the wrong ones. Shares were cheap in 1982 ... the Dow rose 550% over the next 14 years. Then, by the time Greenspan warned of “irrational exuberance”, shares were no longer cheap. But by then, no one cared. Shares rose further; and people became more and more sure that they would continue to rise. “The Fed will always step in to avoid a really bad bear market,” said investors. Over the long term, there was no longer any risk from owning shares, they said. And even Alan Greenspan seemed to believe it.
But risk -- like value -- has a way of mounting up, even while it seems to disappear. The more infallible Alan Greenspan appeared ... the more “unduly escalated” asset values became. Having warned of a modest “irrational exuberance”, the maestro created a greater one.Link here (scroll down to piece by Bill Bonner).
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