Finance Digest for Week of January 17, 2005

CURRENCY HEDGES NOT JUST FOR THE WEALTHY

Looking for a way to keep April in Paris from sending your budget south for the rest of the year? That is becoming more of a concern among U.S. travelers. The dollar fell more than 7% against the euro and pound last year and has stayed weak against major currencies. For years, only the well-heeled could deposit money into bank accounts denominated in foreign currencies, whether to protect the value of money set aside for travel or simply for investment. More recently, however, people without 6-figure bank balances have been able to get in on the act via the Internet. St. Louis-based Everbank is one of the U.S. firms offering online banking services that include foreign currency accounts for relatively small deposits. “We have a lot of travelers who are interested in a hedge against a falling dollar, but we also get a lot of customers who do this simply to diversify their investment portfolios,” said Frank Trotter, president.

Everbank, which has about $3 billion in assets, has seen its foreign-denominated deposits grow by about 200% since 2001, Trotter said. Through its Web site, the bank offers savings accounts and CDs in 25 foreign currencies, Trotter said. The deposit accounts require a minimum balance of $2,500 and a balance of at least $10,000 to begin earning interest, while the CDs must be $10,000 or more. Offshore bank accounts also are available through HSBC Financial Corp. of Prospect Heights, Illinois. According to its Web site, investors can open a savings account in pounds or euros with a minimum opening balance of $5,000.

Everbank’s Trotter cautioned that customers need to remember that currencies move in both directions, so just as deposits denominated in euros gained value last year against the dollar, they could suffer this year if the dollar regains strength. That might mean that people looking to make quick use of their euro deposit should just resign themselves to a more expensive vacation than they first bargained for, unless they are willing to gamble on the short-term movements of the currency markets. Bob Potter, an adviser at JNBA Financial Advisors in Bloomington, Minnesota makes an even sharper point on the issue. Potter said last year’s decline in the dollar vs. the euro would have reduced the spending power of $5,000 set aside for travel by about $370. If that small of a setback has anyone worried, they probably should start thinking of alternative destinations, he said.

FORBES 2005 MUTUAL FUND GUIDE IS OUT

This installment of the semiannual mutual fund survey grades the performance of more than 2,500 U.S. and non-U.S. stock and bond funds through both up and down market cycles. The latest “Honor Roll” members are posted here. If you could love just one fund, which would it be? Check here. A lot of mutual fund expenses are understated because they do not include stock trading costs. Making the adjustment, the picture is not pretty. Why do expense ratios disclosed to fund customers omit commissions? Ask the S.E.C. and you get a variety of answers. Unlike the results of stock picking, which are volatile and only weakly predictable from one period to the next, the expense burden is an ongoing drag and highly predictable. Discussion article here. The new fund annual report card on 1,000 stock and bond funds incorporates trading costs for the first time.

THE TRUTH ABOUT HEDGE FUNDS

The S&P Hedge Fund Index just may offer the first clean look at how a diverse sampling of these once-exclusive pools of private capital has performed. Since its launch in late 2002, this basket of 40 funds specializing in nine strategies has returned 7.6% annually, after a 1.4% fee and 20% cut of profits for the managers. The S&P 500 has returned 21.4% annually. To invest in the hedge index, you have to turn to a fund tracking it such as Rydex Sphinx, whose expenses would have cut the return further, to 5.7%. Hedge indexers can take solace in the smooth line in the graph: The fund is an island of calm in a volatile world, with less than 1% lost in its worst month so far versus a 6% fall for the S&P 500 (in December 2002).

STRATEGY FOR A WEAK MARKET

The bulls-bears slugfest for 2004’s first 10 months resembled a tough defensive football game. It was a toss-up whether the market would be up or down for the year. Then came the election and whammo -- the market took off, with the S&P 500 finishing the year with an 11% total return. My 2003 year-end forecast -- that market gains would be more limited last year than in the previous year -- proved correct, with the S&P 500 hitting the lower end of the 10%-to-15% range I foresaw. In 2004 this column recommended 23 stocks, with the average pick returning 12.8% after a 1% transaction fee on new recommendations. Had you bought the lot, you would have ended the year 5.3% ahead of someone putting identical amounts into the S&P 500 on the same dates. Figure in dividends, which are higher on the value stocks I favor than on growth, and the spread widens. Value has outperformed growth over both the past year and the past five, according to the S&P/Barra indexes. The recommendations in this column, before dividends, have handily outperformed the S&P for four of the past five years.

What should the market bring this year? I think it will prove to be another hard-fought contest between the bulls and bears, with the score tipping to the bulls. My guess is a 5% gain for the S&P 500. High oil and raw-material prices are beginning to squeeze profit margins in food, transportation, autos and a host of other industries. A recent survey indicated that profit margins were being eroded in 70% of the companies interviewed. Materials costs are likely to be passed along in higher prices.

My forecast, which runs contrary to most Wall Street thinking, is that the days of minimal inflation are over. The big losers amid rising rates are long-term bonds. A percentage-point rise in the 30-year bond rate will cost investors 15% of their capital. Long-term bonds are the last place to be heavily positioned today. But, ironically, the yields on long Treasurys are close to historic lows on the belief inflation will cool if the economy’s growth rate slows. This is extremely wishful thinking.

While upticks in inflation hurt stocks at first, post-World War II history shows that stocks have adjusted well in a relatively short period (see my June 7, 2004 column). Tech and other growth stocks have traditionally been the worst performers with higher inflation. I would continue to keep most of my chips in value stocks, which, because of their modest pricing relative to the rest of the market, are likely to outperform again in 2005, inflation shock or no.

GO FOR THE BIG ONES

Two years ago in this column I talked about fog of pessimism looming over Wall Street. The stock market was reeling from a recession and corporate scandals. Despite the gloom, I saw a silver lining in smart corporate cost-cutting, low interest rates, lower taxes and the subsequent overly conservative Wall Street estimates. A strong recovery in the stock market followed. Now, however, after two back-to-back years of gains, I am much less enthusiastic. I see pervasive euphoria. Investors are downright giddy after a rally that gave so many stocks substantial gains. Recently published Investors’ Intelligence data show financial professionals have not been this optimistic since January 1987. Recall what happened later that year [Ed: But the market had a huge runup from 1/87 until just before the crash].

I am always skeptical of consensus. Two years ago earnings expectations were too low, while today’s are too rosy. A litany of problems will make it hard for companies to meet aggressive forecasts for 2005. And, yes, there is the terrorism threat. This is not to say we necessarily are headed for a total wipeout. My point is simply that 2005’s stock market gains will likely be muted and you will have to pick your spots.

While my optimism was on target for this 2-year rally, I did miss the mark by forecasting a comeback among large-company stocks. As it turns out, in 2003 and 2004 small-company value stocks were on fire while large caps remained on ice. The Russell 2000 Value Index jumped 22% last year, and the large-cap S&P 500 rose 9%. In light of this impressive run, I believe small-cap performance has gotten long in the tooth, thus returning me to my earlier prediction -- medium- and large-size company stocks will be the best bets for this year, whatever happens. Within that category I am particularly enthusiastic about the downtrodden pharmaceutical sector. Notwithstanding their well-publicized problems, the large drug companies are highly profitable, have little or no debt, pay nice dividends, and the demographics are working in their favor.

PLAYING THE ASIAN CARD

While 2003 was characterized by what I call a flight to garbage, 2004 was a tale of two markets, foreign and domestic. American stocks meandered in the doldrums until the week of Oct. 25, when they began to rally with a vengeance, anticipating an election outcome without litigation. (Who would have thought that the U.S. and Ukraine had so much in common?) No coincidence, as well, that crude made its high for the year that same week. For the last two and a half months of 2004 the U.S. was the place to be. Even so, readers know that I think Asia and a few other emerging markets are where the growth stories are.

Three of my columns in 2004 focused on Korea, Taiwan and Japan, the most developed of the Far East markets. Japan has hit a generational low in equity prices and is steadily recovering from a decade-long inertia. Corporate governance is improving, deflation has been defeated, banks continue to clean up their balance sheets and shareholder activism is real. Korea also has had to overcome a strong currency, which has appreciated 20% over the course of the year, mostly since October. Given the strength of the won, I continue to prefer investments that prosper from a rise in domestic consumption. Turkey is another likely winner. What the new government has accomplished since taking over two years ago is nothing short of awesome. The stellar returns of emerging markets in 2003 and 2004 will be tough to repeat. So avoid overconfidence. But a bet now on Asia will be amply rewarded over the next decade.

GIVE IT TIME

This is the time of year for introspection by Forbes stock market columnists. In 2004 I made 51 recommendations. Had you put $10,000 into each, your $510,000 would have grown to a bit more than $574,000 by year-end, a 12.6% appreciation. This calculation assumes, moreover, a 1% haircut for transaction costs. Had you put the same money on the same dates into the S&P 500 (and with no haircut), your ending value would have been only $548,000. In other words, I was a good five points ahead of the market.

My worst pick was Equant (NYSE: 5, ENT), the Dutch telecom firm. I saw Equant as cheap in an improving world. Its world did not improve, and it got cheaper. Equant is dirt cheap at 50% of annual revenue and one times book value. I think it just needs more time. If it does not pan out on its own, it will get bought out eventually.

I confess to having been too bullish. I forecasted a strong year for the market, with most of the gain coming toward the end. The 4th quarter was indeed strong, but I expected more and earlier and did not get it. Now I expect to be blessed in 2005 with what I did not get in 2004. I will stick my neck out and predict a better than 25% gain in 2005 for both the S&P 500 and the Morgan Stanley World Index, and also predict that the excitement will start right around the corner. Next month I will explain why. So do not wait before buying stocks like Germany’s Fresenius Medical Care (NYSE: 26, FMS) and Flowserve (NYSE: 26, FLS).

HOT COMMODITIES

Talk to any financial advisor or read a book about saving for retirement and the word diversification comes up time and time again. Diversify, diversify, and diversify. As your mom told you, do not put all of your eggs in one basket. For too many people, diversification means putting a certain percentage of your money in stocks and the rest in bonds. But, what is a person to do when stocks are overvalued on a historical basis and bond yields are near all time lows? Clearly neither asset class is a bargain and retirement is just around the corner. World traveler and legendary investor Jim Rogers says the next bull market will be in commodities and provides a primer for those who really want to diversify with his new book, Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market.

Rogers was the big idea man behind the Quantum Fund. While the other co-founder George Soros did the trading, Rogers provided the history and economic knowledge for Quantum and the fund generated a 4,000% return in the 1970’s, allowing Rogers to retire. Despite his prescient market calls and success, Rogers is generally viewed as a maverick at best and just plain crazy at worst. On the Saturday morning FOX investment shows he is typically ridiculed for both his investment and political views. While the other guests are providing the same warmed-over stock recommendations, Rogers tells viewers to stay away from stocks and start investing in things.

“Nearly every time I strayed from the herd, I’ve made a lot of money,” writes Rogers in the book’s introduction. “But, when you make some money going against the grain, you’re no longer crazy; you’re just ‘lucky.’” Why commodities now? Well, actually commodities have been doing better than stocks, bonds and even real estate for the past few years. But, commodity bull markets take a couple of decades to play out, so Rogers thinks there is still plenty of time to get in.

China is the primary force on the demand side of the commodities equation according to Rogers. It will be a bumpy ride for China, but the upside is enormous. Only 4% of the Chinese people own cars, the population’s sugar consumption is less than one sixth that of the U.S., and the annual per capita coffee consumption in China is less than half a pound while Americans drink 20 gallons a year. Goldbugs will be disappointed with Rogers who feels that “following an obsession is not the best investment philosophy. ..[T]he search for gold reportedly accounted for 75 percent of the total ongoing exploration for the world’s largest mining companies,” Rogers writes. “It is as if mining professionals were as gaga over gold as the general public.”

According to a Yale study, not only do commodities have less risk than stocks and bonds, they provide better returns, are negatively correlated to stocks and bonds and positively correlated to inflation. The study also found that commodities futures returned triple the gains that investing in the stocks of commodities companies did. Rogers cautions the reader that one cannot invest in commodities blindly. Research is required to get “lucky”. Hot Commodities is the best place to start your research into how to truly diversify your assets and ride this decades bull market.

The next new thing.

A new bull market is under way, and it is in commodities-the “raw materials”, “natural resources”, “hard assets”, and “real things” that are the essentials of not just your life, but the lives of everyone in the world. Every time you walk into the supermarket or the mall, you are surrounded by commodities that are traded around the world. When you get into your car or truck, you are surrounded by other widely traded commodities. Without the commodities, “futures markets” to set and regulate prices, the things we all need in life would be scarce and often too expensive. These essentials include oil, natural gas, wheat, corn, cotton, soybeans, aluminum, copper, silver, gold, cattle, hogs, pork bellies, sugar, coffee, cocoa, rice, wool, rubber, lumber, and the 80 or so other things listed in the traders’ bible, the Commodity Research Bureau (CRB) Yearbook.

Commodities are so pervasive that, in my view, you really cannot be a successful investor in stocks, bonds, or currencies without understanding them. You must understand commodities even if you only invest in stocks and bonds. Commodities belong in every truly diversified portfolio. Investing in commodities can be a hedge against a bear market in stocks, rampant inflation, even a major downturn in the economy. Commodities are not the “risky business” they have been made out to be. In fact, I believe that investing in commodities will represent an enormous opportunity for the next decade or so. Like Americans who never travel to foreign countries for fear of being humiliated or cheated because they do not know the local language and customs, investors who shy away from commodities are missing out on an incredible opportunity.

The smart investor looks for opportunities to acquire value on the cheap, with one eye out for a dynamic change in the offing that might make that investment even more valuable. Today, commodities fill both bills. The commodity bear market ended in 1998, when prices were approaching 20-year lows (equal to Depression levels, when adjusted for inflation). That year Merrill Lynch, the largest brokerage firm in the U.S., decided to leave the commodities business, and I began a commodities index fund to capitalize on the end of the bear market.

I am convinced that value and strength in the commodities markets will continue for years to come-that we are, in fact, in the midst of a long-term secular commodities bull market. The twentieth century saw three long commodities bulls (1906-1923, 1933-1953, 1968-1982), each lasting an average of a little more than 17 years. The new millennium has begun with another boom in real things. In my opinion, it began in early 1999.

THE DOLLAR CANNOT DO IT ALONE

It was not supposed to be this way. Global rebalancing appears to be stymied. Nearly three years into the dollar’s correction and the U.S. trade gap keeps hitting new records. The external deficit on goods and services widened to a staggering $60 billion in November 2004. I am old enough to remember when this would be a bad number for a year! This seemingly anomalous outcome reflects an important new shift in the macro fabric of the U.S. economy -- a diminished sensitivity to currency fluctuations. That means it will probably take more than just a weaker dollar to spark global rebalancing.

The diminished sensitivity of the U.S. economy to currency fluctuations has been increasingly evident over the past 15 years. Normally, a weakening currency results in a narrowing of a nation’s current account deficit and a pick-up in inflation. That is pretty much what happened in the 1970s and especially in the late 1980s in the aftermath of the dollar’s sharp downward adjustment during most of that latter period. But then it all seemed to change in the 1990s. The dollar’s decline in the first half of that decade was accompanied by a shift in the current account from surplus back to deficit. And inflation barely budged. A similar outcome has been evident in the past three years -- a 16% decline in the broad dollar index (in real terms) accompanied by an ever-widening current-account deficit and persistently low inflation.

It is not altogether clear why this relationship has broken down. My suspicion is that globalization is the main culprit. The globalization of supply chains biases import content to the upside for the high-cost developed world; it also forces the advanced economies to abdicate price setting at the margin to low-cost producers in the developing world. The result is a sharply diminished industrial base in countries like the U.S. The sharply diminished size of America’s industrial base makes it exceedingly difficult for the U.S. to turn dollar depreciation into an advantage and trade its way out of a severe current-account problem through enhanced export growth and import substitution.

In my view, a lopsided world economy needs a shift in relative prices in order to establish a new and more balanced equilibrium. If a weaker dollar cannot do the trick, what can? The answer, in my view, is real interest rates -- the price adjustment that could well qualify as the sufficient condition for America’s role in global rebalancing. The only way America can ever get a handle on its trade and current account conundrum is on the import side of the equation -- it almost mathematically impossible for the U.S. to export its way out of its trade deficit.

Given the asset-dependent character of U.S. domestic demand growth, the interest rate connection becomes all the more critical as an instrument of rebalancing. Higher real interest rates will not only curtail the pace of asset appreciation butwill also raise the cost of debt service -- thereby exerting twin pressures on the asset-driven portion of domestic demand. Needless to say, the saving-short, overly-indebted, and asset-dependent American consumer should feel the impacts of such an adjustment most acutely. But homebuilding will also be hit, as will business capital spending to a more limited extent. So far, interest rates have not budged nearly enough to spark a meaningful rebalancing of a lopsided world. I suspect that the Federal Reserve is about to lead the way in changing that. In looking at real U.S. interest rates over the broad sweep of history, there is nothing but upside from current levels. It will take higher real interest rates to crimp the excesses of the asset-based component of consumer demand. The odds, in my view, are tipping in that direction.

The real interest rate conundrum.

Real, or inflation-adjusted, interest rates remain near rock-bottom levels. That is true in most major segments of the world. It is also true for short- and long-term maturities, alike. This condition is not sustainable. The days of abnormally low real interest rates could be coming to an end. As the world economy returns to trend, a normalization of real interest rates is both appropriate and likely. This poses major risk to financial markets, as well to asset-dependent real economies that have become hooked on low real interest rates. The conundrum is largely made in America, with the Federal Reserve the leading actor in this saga. Fearful of a Japanese-like post-bubble carnage, the Fed slashed its policy rate by 475 basis points in 2001 in the aftermath of the bursting of the U.S. equity bubble. Another 75 bps of rate cuts were implemented in 2002 and 2003 as the U.S. veered toward deflation. To varying degrees, other major central banks went along for the ride. In response, real interest rates have tumbled from the short to the long end of the maturity spectrum.

Nowhere is this more evident than in the U.S. When “deflated” by the headline CPI, the federal funds rate is still in negative territory by about 125 bps. Using the “core” CPI, which excludes food and energy, the real funds rate is basically zero. Based on either inflation metric, U.S. monetary policy remains in its most accommodative position since the late 1970s; the real federal funds rate has been below its post-1985 2% norm for nearly four years and has been at the zero threshold or in negative territory for more than two years. A similar downside breakout is evident for long-term U.S. real interest rates. Real interest rate trends elsewhere in the world essentially mirror those in the U.S. Short rates in both Europe and Japan remain below the inflation rate -- underscoring the extraordinary degree of monetary policy stimulus that is still in place in both regions. Long rates remain equally depressed. Even in the developing world, spreads relative to Treasuries are at lows last seen in the pre-crisis period of 1997-98. The world’s real interest rate cycle is, indeed, in rarefied territory.

We debate endlessly the hows and whys of fluctuations in real interest rates. But there can be no mistaking the implications of a protracted period of low real rates -- unusual support to financial asset valuations and to those economies that convert asset appreciation into aggregate demand. Again, America leads the way in this regard. In a climate of subpar income generation U.S. consumers have been quick to extract “extra” purchasing power from their asset holdings in order to keep on spending. In their most basic sense, asset-based economies are nothing more than a levered play on low real interest rates. And with America at the forefront of this trend, the rest of a U.S.-centric global economy has been eager to go along for the ride.

Consequently, the role of subnormal real interests cannot be minimized as a driving force behind today’s U.S.-centric global growth dynamic. But, at the same time, low real rates are equally culpable in producing the extreme state of imbalance that currently exists in the world economy. Persistence of outsize trade deficits is a recipe for trade frictions and protectionist risks. Moreover, asset-based consumption also entails a bias toward ever-increasing household sector debt loads -- leverage that is manageable for only as long as real rates stay low. While low real rates may keep the party going, the celebration is hardly without consequences. Which brings us to the endgame -- how world financial markets and the global economy are weaned from abnormally low real interest rates. This is likely to be a delicate surgical operation, to say the least. The task is clear -- to restore the policy rate to a level that is compatible with the Fed’s multiple goals of price stability, full employment, and sustained economic growth. I believe that Greenspan & Co. now have their sights set on a policy rate that is in the restrictive zone. Gone are the days when the Fed can afford simply to shoot for “neutrality”.

As this realignment of U.S. monetary policy filters through the term structure of interest rates, collateral reverberations can be expected at the long end of the yield curve. In my view, that poses especially large risks to high-yield, emerging-market, and even investment-grade debt. It also poses great risk to the overvalued U.S. housing market and the concomitant “refi bet” of the income-short American consumer. There is always the risk that the asset-dependent U.S. economy -- and by inference, the U.S.-centric global economy -- is far more sensitive to real interest rates than might be the case for a more normal, income-based economy. Therein lies the most worrisome aspect of the real interest rate conundrum -- an asset economy that will not allow for an easy exit strategy. That should not keep central banks from acting responsibly and attempting to return real rates to more normal levels. The longer the world resists such a normalization, the more treacherous the endgame.

IS A HOME-PRICE DROP CROSSING ATLANTIC?

A recent decline in U.K. home prices may be a harbinger for still-hot markets in the U.S. What is more important than the possible spreading of this trend is how it is developing, a pattern worth watching closely if you are investing in any torrid residential market. The U.K. slowdown is marked by a drop in mortgage approvals, which dipped to a 4-year low last November. Mortgage applications declined because interest rates rose and home values eroded. The synergy of both events likely has quelled housing purchase demand. “There is little to suggest that mortgage applications will change in the near term, given the noticeable slowdown in the housing market,” stated David Dooks, director of statistics at the British Bankers’ Association.

While U.S. Federal Reserve Chairman Alan Greenspan and most U.S. real estate industry groups deny the existence of a housing bubble, there is evidence that some markets are overheated. A Jan. 12 report by Michael Youngblood, managing director of asset-backed securities research for the investment banker and broker Friedman, Billings and Ramsey, identified bubbles in 27 U.S. cities covering almost 20% of the U.S. population using third-quarter figures from last year. The bubble-prone metropolitan areas included Boston, New York, Los Angeles, San Francisco, and San Diego. In Youngblood’s study, 20 of the likely bubbles were in California. Youngblood defines bubbles by measuring the ratio of median home prices to per capita income in each city, then taking the top 5% of those ratios.

“We do not expect the house-price bubble to burst in any city until economic activity has contracted for a minimum of four quarters,” Youngblood stated. “The economic expansion under way generally and individually in the 27 cities that are experiencing bubbles postpones the deflation of home prices.” Overheated markets often recede when investors en masse sense that returns will not be effortless or automatic. Higher financing costs typically damp demand and cool housing values. While it is too soon to say if a bubble is bursting -- bringing about 20% price declines or more -- it is worth watching.

Silicon Valley housing snapshot.

A great deal of money, energy and anxiety is being invested to predict the future direction of Silicon Valley housing prices. We have a strong opinion but the new year is a great time to examine our opinion versus actual facts on the ground. For households worth $5 million+, or less than $50,000, maybe home price trends are not a vital issue. For everyone in between, however, it is critical to “keep up”. One of the better tools for keeping up is the local paper’s Saturday real estate section. You study it if you are in the market, or think you may be soon.

Many statistics can be used to support your agenda, regardless if are a buyer, a seller or just plan on antagonizing innocent bystanders. Even pleading guilty to membership in this last category, a few points caught my eye. “Total new homes” volume is +54.7% year-over-year showing housing prices have clearly been rising long enough to attract new supply into the market. Classically, this suggests prices should have topped out. However, the Silicon Valley housing market has defied classic economics for a long time. After all, local housing continued to rise in 2004 even though Santa Clara County created zero(!) net new jobs and the total workforce declined by -22,000 people (-2.6%).

The back page of the Saturday real estate section was filled with color ads for apartment rentals. Among the 17 ads published this week, eight advertise free rent and two more show "reduced" rent or “manager’s specials”. Of the remaining seven, three are senior citizen apartments and/or “Income limits apply” (i.e., rents are subsidized by the state). Only four of these 17 apartment complexes have not (yet) resorted to free rent or government subsidies to fill vacancies. Maybe the laws of economics are about to apply to housing in Silicon Valley after all?

Signs of trouble building.

I have referred to cash-out refinancings as a lot of things; an illegal narcotic, though, was not one of them. That distinction goes to Douglas Kass, general partner of Seabreeze Partners in Palm Beach, Florida. We were speaking about how ambivalent investors had become about the risks facing the economy when he said: “Investors have ignored that the opium of the consumer -- the cash-out refinancing -- has come to a crawl.” And it is not just refinancings, which have tumbled an impossible-to-ignore 83% since their peak in May 2003. The blasé attitude extends to housing, too. “Investors dismissed the huge fall-off in housing starts in favor of a higher existing-home sales report,” Mr. Kass said, referring to late December trading.

Existing-home sales reflect past activity; it is a lagging indicator. Housing starts, on the other hand, are a leading indicator. They fell about 13% in November, the sharpest decline in more than a decade. Meanwhile, home equity loans seem to be running into a bit of trouble. According to the American Bankers Association, delinquencies on home equity loans pushed the 3 percent level in the third quarter. The number has doubled in less than two years and now stands at a record high. I just cannot imagine how lenders are going to squeeze people into overpriced homes without home equity loans. Maybe they will go the route of the carmakers and increase the time you can take to pay for the house to, say, 40 years. Oops -- I am already late to that party. Seems lenders up north are taking the 40-year mortgage on test drives so buyers can get payments down to doable levels.

Fannie Mae to halve first-quarter dividend.

Mortgage giant Fannie Mae will slash its first-quarter dividend payout by half, to 26 cents per share, as it grapples with an accounting crisis. The announcement by the biggest U.S. financier of home mortgages came after its chief executive and chief financial officer were forced out last month. Government-sponsored Fannie Mae faces a likely earnings restatement of some $9 billion, or about one-third of its profits, back to 2001. To make up the anticipated shortfall, Fannie Mae needs to sell part of its portfolio of mortgages, raise fresh capital by issuing stock or cut dividends -- and its spectacular growth of recent years could be curtailed. Regulators in the Office of Federal Housing Enterprise Oversight ordered the company in September to boost its capital cushion against risk by some $5 billion by the middle of this year.

Should you invest in real estate?

Real estate prices have been going up for so long that many people have forgotten that real estate does not always appreciate. Here is some interesting information from a front-page story in The Wall Street Journal’s Monday edition headlined, “The Housing Market’s Dangers”:

Housing prices, adjusted for inflation, are up 36% since 1995, the steepest boom in at least 50 years, according to Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “This is a particularly bad time to be promoting homeownership among young people,” Mr. Baker told a media briefing last week. “A lot will see substantial losses in home value as a result of that bubble, which will be ending soon.” (The Wall Street Journal, 1/18/2005)

After what happened to stock prices in 2000-01, people are saying, “Maybe stocks can come down for a few months from time to time, but real estate will not; real estate never has.” They are saying it, because real estate is the last thing still soaring at the top of the Great Asset Mania, but it, too, will fall in conjunction with a deflationary depression. Property values collapsed along with the depression of the 1930s. Few know that many values associated with property -- such as rents -- continued to fall through most of the 1940s, even after stocks had recovered substantially.

What screams “bubble” -- giant, historic bubble -- in real estate today is the system-wide extension of massive amounts of credit to finance property purchases. As a result, a record percentage of Americans today are nominal “homeowners” via mortgage debt. People can buy a house with little or no down payment in many cases. Another remarkable trend of recent years adds to the precarious nature of mortgage debt. Many people have been rushing to borrow the last pennies possible on their homes. They have been taking out home equity loans so they can buy stocks and TVs and cars. Taking out a home equity loan is nothing but turning ownership of your home over to your bank in exchange for whatever other items you would like to own or consume.

Any recommendations to prepare for the bear market? If at all possible, join the one-third of title-holding Americans who own their homes outright.

De-Boomed?

Housing is still rising. The LA Times reports that abodes in LA County rose 21% last year. Down in La Jolla, says Richard Russell, they are up 27%. And the median price for a house in Orange County rose to $551,000 last year. A mystery ... and an existential question: Why would a house be worth more one year than it was the last? Does its roof shed water better? Is its rec room less of a wreck than it was 12 months ago? Is it warmer? Cuter? On the contrary, does it not render exactly the same service it did last year? Capital growth is a fraud, we keep repeating ourselves.

Here in London properties have already begun to fall. Our colleague Merryn Somerset Webb reports that she put her flat up for sale two months ago. So far, only one person has looked at it, even though it is located in a desirable part of town and priced below similar apartments in the same building. London led the global property boom up. It seems to be leading it down too.

REMEMBER WHEN KEN LAY WAS A GENIUS?

Are you new to a high-level job and fearful of failure? Then you may want to consult You’re in Charge -- Now What?, a new management guide by Thomas J. Neff and James M. Citrin, executives at Spencer Stuart, the headhunting firm. But if you are an investor who plans to follow the criminal trials of disgraced former chief executives like Kenneth L. Lay of Enron, L. Dennis Kozlowski of Tyco and Bernard J. Ebbers of WorldCom, an earlier book by the same authors is much more entertaining. Lessons From the Top: The Search for America’s Best Business Leaders, features secrets-of-my-success tips from, yes, Mr. Lay, Mr. Kozlowski, and Mr. Ebbers. Lessons, published in 1999, is a perfect pre-crash, celebrity-C.E.O. period piece that includes fawning interviews with 50 business bigs. Mr. Neff and Mr. Citrin wrote that they used a “rigorous methodology aimed at identifying the very best business leaders in America”, which included results of a Gallup poll of 575 chief executives and an analysis of companies’ stock performance and cash-flow growth.

Since its publication, nine of those leaders -- almost one in five -- have watched their companies become the subject of criminal prosecution, regulatory rebukes, shareholder revolts or all three. Of course, any list of top executives from the bubble era is bound to include some flameouts. As the authors said in an interview last week, many executives on their 1999 list remain successful and in their jobs. Still, given that this will be the year of executives-on-trial, the book provides some much-needed comic relief. And because Mr. Ebbers, Mr. Kozlowski and Mr. Lay may decline to take the stand in their defense, it is good to have a record of their achievements told in their own words.

In his defense, Mr. Ebbers, who was fired from WorldCom in 2002 just a few months before it made the world’s largest bankruptcy filing, is expected to contend that he knew nothing about the $11 billion accounting fraud at the company. He left the arithmetic at WorldCom to Scott D. Sullivan, his chief financial officer, his lawyer says. Back in 1999, however, explaining how he made it to the top, Mr. Ebbers evidenced a more than passing involvement in financial matters at WorldCom, a company he founded. At first he was a passive investor, he explained, but when the company hit some turbulence, he parachuted in.

Mr. Kozlowski, whose trial on charges that he looted the company is set to begin later this month, also takes a star turn in Lessons. Much of the interview centers on the unusually generous reward system he instituted at Tyco. “There’s no upward limit on our incentive programs,” Mr. Kozlowski said. Mr. Lay, facing criminal prosecution in Enron’s failure, has also shrugged off responsibility for the debacle by claiming ignorance of the manipulations that brought it down. Yet, six years ago when the sun was shining on the company, Mr. Lay took responsibility for it all.

Perhaps the most loquacious executive in Lessons is Charles Wang, the former chief executive of Computer Associates, which last year agreed to pay $225 million in restitution to shareholders who lost money as a result of the company’s accounting improprieties. What was the signal value that Mr. Wang said he brought to the Computer Associates’ boardroom? “I think to be a successful person, and C.E.O.’s are often very successful, you have to have integrity,” he said in his interview. “Your word has to be worth everything you’ve got. You must have a moral compass.” Mr. Wang also told his interviewers that it was crucial to give something back. According to Computer Associates, Mr. Wang has not yet offered to give back any of the $14.4 million in bonuses that he earned during years in which the company’s results were inflated by improper accounting.

What even a cursory reading of Lessons From the Top proves, of course, is that the prosecutors and regulators assaulting these corporate commanders are going after the wrong guys. Do they not know that chief executives are gods among men and worthy of worship? That is why their compensation goes up every year whether or not their workers lose their jobs or their stockholders’ returns rise. Companies are not really the property of their shareholders after all. They belong to the giants who run them. And the sooner everyone understands that, the faster we can put this unfortunate and undeserved attack on corporate leaders behind us.

WILL “IT” EVER MATTER?

In the concluding (PrudentBear.com) “Credit Bubble Bulletin” for the year, Doug Noland characterized 2004 as the “Year It Didn’t Matter” and hypothesized that 2005 may be the year it does -- “It” being a catchall for all the negatives and vicissitudes of the past year which seemed to have no visible effect on a U.S. economy which grew at around 4%, long rates and spreads which actually contracted, ebullient equity markets spurted and residential real estate continued to climb. Some of these ignored difficulties include 125 bps of rate increases by the Fed, continuing internal deficit and expanding external deficit, sliding dollar and all time record credit expansion.

Perusing the first WSJ of the year, the issue that corrals all visible economists for forecast, the year looks to be more of the same. The consensus sees 3.6% growth, a long bond inching up to 4.7%, inflation decreasing to 2.5% and the dollar pretty much unchanged from yearend. Separately, the savants of markets see high single-digit to low double-digit equity returns, corporate profits up 10%, and slightly less rapid sales and appreciation in housing.

I will not belabor the ridiculous price escalation in my home area of South Florida, and one can see the Certain Bubble in Orange County, California in the weekly Credit Bubble Bulletin. What fascinated me on these trips was the extent that the U.S/Magoo/Credit Markets had globalized the creation of residential real estate excess. Traveling outside Santiago, Chile last fall, I was struck by the amount of residential construction underway on the far outskirts of the city (comparable to the McMansions going up virtually in the Everglades here in South Florida). Our Chileno guide averred that a few years ago mortgages were hard to come by for people like him, but that Citibank had shown the local banks how to do them for virtually anyone, and all the banks now knew that lending to builders and buyers was the certain way to prosperity. Sadly, the inhabitants of Pitcairn Island of Mutiny on the Bounty fame have no bank to help.

Most recently, we spent a little time in Namibia. The Namibian currency is tied to the South African rand which has tripled in the last couple of years against the dollar. There are beach houses going up along a beach, (known a little further north as the “skeleton coast”) outside Swakopmund in great number! The beach is nice but is washed by the Benguela current which gets up to 50 degrees in the summer. Proves the point that, with financing, and the banks have come back to Namibia, waterfront anywhere in a liquidity flood, will sprout construction. During a visit to Capetown, we saw condo construction along the New Waterfront to rival anything ever seen on Brickell Avenue in Miami. House prices have doubled and, guess which bank is back in a newly constructed downtown core called Sandton? That ultimate real estate financier, Citi.

On the asset side of financial institution balance sheets in the United States, we are fascinated by the 2005 “forecasts” now in vogue. Most forecasts, as with earnings, cluster around the 10% up mark. With 38% of S&P earnings being generated by the financial sector, up from single digits not too long ago, the usual question of how far arises. The world has seen the credit quality numbers of virtually every form of financial institution asset class improve relentlessly since October 2002. Charge-offs are at multi-years lows, provisions are declining or have actually gone negative as recoveries and non-performers performed exceptionally. With oceans of global liquidity, emerging market and junk have refi-ed their way to solvency and rates with spreads so low that even mainstream analysts are willing to think they can go no lower. What few forecasts we see on credit quality, other than the multitude pointing towards continued improvement, do not see any significant deterioration until second half 2005 or, better yet, not in this year’s forecast -- 2006.

There will be a significant number of financial institutions enhancing year-end earnings through provision/reserve reduction based on continued improving trend forecasts and a more than usual regulatory/accountant pressure on any conceivable excess reserve position. Looking at a 10Q of a quite revered bank recently, we saw an 100% expansion in that footnote to credit quality entitled “Over 90 days past due but not non-performing”. The dollar amount would be significant to most analyses. There was no further explanation. We will be paying particular attention to this area going forward as it was an early warning sign in previous cyclical changes. At least it is visible. We are seeing numerous other early warning indicators and, while still not making a forecast, are willing to say that “It” in this case, being credit quality, will begin to matter in 2005.

With the banking system now constituting at roughly $8 trillion, less than 20% of total debt of more than $40 trillion, any comments on credit quality within the system miss most of the risk. Extracting the Government and Government Guaranteed and Sponsored still leaves a truly massive amount of credit disseminated outside scrutiny. We paraphrase the past Treasury Secretary, “In the LTCM debacle, we could call up 20 financial institution heads and solve the crisis, in the next one we won’t even know where the crisis is lodged!” Notional totals of derivatives are now approaching $200 trillion (and we admit the bulk is in interest rate and foreign exchange, much of which is netted, if that gives you any comfort) and, at least, $3 trillion and growing in credit default swaps where notional and real are the same. Some large portion of this derivative base has been used and reused in the world of “dynamic hedging” which the financial engineers have “modeled” as to risk. These models may well be tested in the coming year. The problem with models is that they can only contain the scenarios the engineers input and the world of risk has a way of creating those not “inputted”. It does appear to this observer that there are increasing risk elements and we will not absolve 2005 from being the year when “It,” whatever it turns out to be, may matter.

FORECASTS FOR 2005

When I looked back last January on my 2003 predictions, I decided that, “All in all, not bad. But in general, given the vagaries of prediction, I would be glad to do as well this year.” I can echo that again this year. All in all, not bad, with just one major miss. I called for above trend economic growth, a flat stock market, a falling dollar, rising gold and oil prices and a Bush victory by a small margin. I even thought longer term interest rates would not rise, although I was right for the wrong reason, so that one does not count. Before we move on, let’s make our more or less annual (since 2002) prediction about the dollar. It will go down in 2005. I think the dollar is likely to get stronger for some time, just like it did in the first part of last year -- there are just too many dollar bears, and they need to be flushed out of the trade -- and then once again begin its long climb down. This year we could scare $1.50.

I do not see any real problems for China this year. Just the usual emerging market, fast growth type of issues that we have seen for the past few years. The world economy will slow down from the very robust pace of 2004, but it is not headed for recession and should do quite well, mainly due to Asia. Europe will struggle to post a positive GDP. The Fed is trying to be as clear as they can about current policy -- they will continue to raise rates, but I am pretty sure they do not know when they will stop the tightening cycle. It is quite likely the Asian central banks will continue to buy massive amounts of U.S. government debt. It is also quite likely that short-term rates go to 3.25% by this summer. Can 10-year rates stay flat with a spread of only 1% between the short-term rate and ten year bonds?

Let me jump ahead. I expect the economy to once again grow above my Muddle Through Decade trend of 2-2.5%. We should do about 3%. The trade deficit will grow. The savings rate will stay abysmal. Inflation will rise. The dollar will drop. Government deficits will still top $300 billion. Gold will rise. I think longer term rates rise gradually, but not as fast as the Fed funds rate does. The Fed is going to continue to raise rates until the economy shows signs of trouble. While the Fed in the past has been willing to cause a recession, I do not think this Fed will do so.

Stocks have “issues”, as my kids would say, in the coming year. Right now, they are priced for perfection. We have low interest rates, low inflation, we are coming off a 25% annual rate of increase in earnings and corporate balance sheets are the best we have seen in years. But ... consensus forecast for earnings are 10% or more, yet corporate earnings as a percentage of GDP are at an all-time high. There is very little room for above long-term average growth. While I think earnings do grow this year, they do not grow as much as the consensus forecast. Small disappointments will be the norm. And in a market with high valuations, small disappointments are not good. It puts a lid on overall stock market growth.

The economy is going to be good, so I do not think we see the start (yet) of the next major bear leg, although this year will mark the high for what I think will be many years. This will be a frustrating year for stock market investors. You can always do well if you are a good individual stock picker, but broad indexes and mutual funds are not the place to be. The market is a sideways to down market, with the risk to the downside as we get toward the end of the year and a possible recession on the horizon in 2006. And not to put too fine a point on it, I still think we are in a long term secular bear market. In a few years, we will look back and realize this was a bear trap -- another sucker rally.

As the dollar rallies from its oversold condition over the next few months (or maybe longer), gold will languish. Maybe we even get a chance to buy some more at $400 or less, but at the end of the day, we will see new highs. The risk to oil is on the upside. A falling dollar will not be enough to cure the trade deficit. It will also take a rising savings rate from the consumer. What will bring that about? When the next recession comes in 2006 or 2007, the stock market will drop. Baby Boomerers will realize that the stock market is not going to bail out their retirement hopes. They will stop spending and start saving with a vengeance. Problem solved, only it creates more problems. The world will not like it when the American consumer retrenches.

Since the bond market usually anticipates the actual recession, which means that long-term bond rates will fall, we should see an inverted yield curve prior to a recession. Major caveat: with Fed manipulation and foreign central bank buying, we are in new territory. The old rules may no longer apply, or be applied differently. Pay attention, gentle reader. This is one we will watch closely. As far as the end game, the short version is that once the recession starts, the Fed moves aggressively to stimulate the economy, brings back inflation and we get high rates and inflation. Over time, we end up in stagflation. Of course, we will hit the reset button, work our way through that and start the next big bull move. But all that is in our future. For 2005, we can enjoy the seesaw, and hope our partners do not jump off.

THREE MORE REASONS TO DOUBT BOND MARKET’S SANITY

Investors are lending free money to junk-rated companies. Argentina is blackmailing its lenders three years after taking the prize for the biggest default ever. And the Federal Reserve says there is evidence of “excessive risk-taking” in the low yields investors are accepting on corporate bonds. These three examples should chill fixed-income money managers. Fear and greed are omnipresent in financial markets; they also seem to be achieving omnipotence in the current bond market environment, with fear of unemployment prompting investors to make greedy bets they would typically run a million miles from.

In the past four months, bond buyers have made more than $2 billion of “borrow now, pay much later” loans to non-investment grade borrowers including Inmarsat Ventures Plc, a London-based satellite operator, and New York-based Warner Music Group, the fourth-biggest record label. The loans are in the form of so-called discount notes. In November, for example, Inmarsat sold $450 million of bonds that are interest-free for the first four years, after which the issuer starts paying 10.375%. Investors pay just $668.94 for $1,000 of the notes, which boosts the return when they are due for repayment in November 2012. Provided Inmarsat meets its obligations, buyers will make 635 basis points more than if they had bought a U.S. Treasury note of similar maturity. Standard & Poor’s responded by cutting the company’s credit rating to B+, four levels below investment grade, citing Inmarsat’s “more aggressive than expected” financing policy. The bonds themselves are rated CCC+, seven steps away from investment grade.

A desperate search for yield is making investors willing to hand over free money for four years or more to companies such as Kohlberg Kravis Roberts and Clayton Dubilier & Rice, two New York-based buyout firms that have also sold discount notes. High-yield dollar bonds offer an average of about 322 basis points more than government debt, down from about 1,000 basis points in mid-2002, according to indexes compiled by Merrill Lynch. That hunt for yield also means emerging-market countries have enjoyed their cheapest borrowing costs for at least seven years -- even though Argentina, in the messy aftermath of its December 2001 default, is a reminder of just how risky lending to high-yield countries can be.

“Some participants believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets,” policy makers said. They cited corporate bond spreads, an increase in initial share sales by companies, a jump in mergers and acquisitions, and suggestions that speculators are bidding up house prices. The Fed is worried that its efforts to avert deflation with ultra-low interest rates have started a party that will end in tears. Even as it takes away the punchbowl by raising interest rates, the guests may already be too drunk to care.

GM’s bonds fall to record low.

General Motors’ bonds weakened to their worst levels on record on Thursday, as concerns about the credit quality of the U.S. vehicle maker showed no signs of easing after its first-quarter results. Its chief rival, Ford Motor, added to the negative sentiment when its bonds took a hammering following its first-quarter earnings report. But GM remains the biggest concern in the corporate bond market. The company’s benchmark bonds fell sharply this week after Standard & Poor’s said its concerns about credit quality had grown since it downgraded GM in October.

GM’s main problems are its eroding market share and large pension and health care obligations. But it was last week’s earnings guidance and subsequent comment by S&P that triggered the sharpest sell-off. The yield spread, or premium over government issues that investors demand to hold corporate bonds, on GM’s most traded bonds has widened by more than 100 basis points -- one percentage point -- since the start of the year. The spread on the 2013 bonds has weakened by 23% and the long-dated 2033 spread has fallen by 45% in the past three weeks.

GM is currently rated Triple B minus by S&P, the lowest investment grade rating, and a downgrade would take the company into speculative, or junk, territory. GM is on a stable outlook and a change to a negative outlook could trigger another sell-off, as many funds are restricted from owning speculative-grade bonds. But GM’s bonds already trade like junk debt. The spread on its euro-denominated 2013s currently trades 390bp above the comparable Bund. In comparison, the aggregate spread for speculative-grade bonds is 310bp while the Triple B spread applied to GM’s peers is about 80bp, according to data from Lehman Brothers.

“On fundamentals alone, you could argue that the bonds are cheap now,” said Stephan Michel, credit analyst at Barclays Capital. But he added that every time someone had tried to enter the market in recent months, a flurry of sales orders had pushed the spreads wider. “There is no support in the market,” he said.

Does BB equal an “A+” investment?

The January 21 New York Times observes that, “In 2004, almost 16% of new corporate bonds were rated Caa2 or lower, the highest proportion ever in history.” 1998 was the heyday for this class of bonds. Of those, “40% defaulted within 3 years, and by now 74% of them have done so.” But, as the NYT piece reveals, two major disasters ended the “party in 1998”: The Asian financial crisis and the Russian default. And the way the experts see it, “No such crisis appears on the horizon now.”

That kind of optimism explains how the Caa2-rated debt issued by Warner Music Group (the withering branch of Time Warner purchased in March 2004 as it stood $197 million in hoc) could be music to the ears of investors. It also accounts for the “sudden popularity of Charter Communications debt.” As of January 20, Charter stands $19 billion in debt and counting, AND its stock trades at $2 a share. Or take General Motors for example: On January 20, GM corporate debt fell to its worst yield EVER in the auto giant’s history, slashing its ratings to one notch above junk status. But apparently high-yield investors are not biting.

A Dow Jones Newswire article explains: “In order for the bonds to really prove a good long-term deal, you have to have a fairly strong opinion that the bleeding is almost over, at least until a downgrade places it firmly in high-yield territory. Better to enter this at the point of maximum pain, and that’s not today.” Then, as the story goes, you get in at the cheapest price and reap the biggest rewards -- that is IF the economy does in fact take the BULL by the horns, ensuring that bond issuers will be able to fulfill their obligations. Investors believe the odds of this scenario to be, well... consider this: The spread between junk bonds and 10-year Treasuries is narrower today than it was during the “New Economy” of 1999-2000. So, is this irrational exuberance or invincible wisdom?

FEWER COMPANIES ARE BEING COVERED BY ANALYSTS TODAY THAN AT ANY TIME SINCE 1995

If you thought equity analysts were not paying enough attention to your company during the gold-rush days of the late 1990s, we have got bad news. Although the number of equity analysts in the U.S. has climbed 7.5% since 2003 -- up to 3,207 -- that number is still 9.5% lower than it was during 2000, according to data released by StarMine, an analyst-research firm based in San Francisco. This means that there are fewer companies being covered by analysts today (4,508) than at any time since 1995. To add insult to injury, the analysts left standing are also covering more tickers per person, 8.6. Last year was the second consecutive one in which that figure went up, rebounding from a 6-year decline that started in 1996 (when it hit 11 tickers per analyst). This data shows that for small- and midcap public companies that are already grappling for coverage, things will undoubtedly get worse before they get better. And for those receiving coverage, quality will probably not rise as analysts struggle with an increasing coverage universe.

A CFA Institute study recently revealed that 40% of equity analysts polled expressed dissatisfaction with the number of hours they work, although 79% expressed satisfaction with the work itself. Things are far worse overseas, however, as investment banks take a hatchet to their research divisions. The number of analysts in developed European countries, for instance, has dropped 13.3% since 2003, says StarMine.

WARREN BUFFETT SEES NO WAY BUT DOWN FOR U.S. DOLLAR

The dollar cannot avoid further declines against other major currencies unless the U.S. trade and current account deficits improve, legendary investor and businessman Warren Buffett said. “I don’t know when it happens. I don’t have any idea whether it will be this month or this year or next year, but we are force-feeding dollars on to the rest of the world at the rate of close to a couple billion dollars a day, and that’s going to weigh on the dollar.”

Buffett, nicknamed the Oracle of Omaha for his investment acumen, has a net worth of some $41 billion, second only to Microsoft chief Bill Gates, according to Forbes magazine. But he said he saw few opportunities in the near term. “I’m having a hard time finding things to buy, if that says anything about the market,” he said. “If I find something ... tomorrow to buy, I don’t give a thought as to whether the market is going up,” he added. “I barrel in.”

IS A SECULAR BEAR MARKET INEVITABLE?

The U.S. faces a high probability of “Economic Armageddon” according to Stephen Roach, chief economist at Morgan Stanley. “Balance the budget? Fugitaboutit” says PIMCO’s Bill Gross. Meanwhile Warren Buffett has described financial derivatives, with contracts totaling $84 trillion in notional value concentrated among a handful of large US commercial banks, as “financial weapons of mass destruction” while moving $20 billion out of the US dollar into foreign currencies. Put mildly, some marquee names in the financial realm are sounding cautious regarding our financial future. At the same time today’s business news carries a ready stream of articles and commentary from experienced financial professionals which generally suggest that the economy can be expected to continue expanding at a moderate rate and financial asset prices, although not at historically low levels, offer reasonable value for the patient investor.

The diligent investor, having taken the time to follow what these professionals have to say, might be excused for feeling concerned, confused and frustrated. What hope do they have of untangling contradictory views from some of the best in the business? And, importantly, if the long lasting financial devastation of a secular bear market (Dr. Roach’s economic Armageddon) is a possibility what chance do they stand of determining the likelihood of such an event? Fortunately our financial future can be considered in a fundamental and readily understandable yet widely overlooked manner, as will be evidenced within this article.

Two secular bear markets have occurred during the past 100 years of US history. 1929 saw the beginning of a 90% decline in equity values which transpired over the subsequent three year period. The Dow industrial index did not regain its 1929 peak until 1954. The second secular bear growled its way through the 1970’s, and it was truly secular in nature. Contrary to a common belief equities did not simply move sideways through the 1970’s before moving to new highs with the great bull market starting in 1982. This illusion is caused by the inflation which plagued the period. Deflating the S&P 500 with the CPI (see chart) reveals that the market peaked in 1969, not 1973, before falling 64% over the subsequent 13 years, ultimately bottoming in 1982. Stock prices failed to exceed the 1969 peak until 1993, and did not move convincingly through the 1969 level until 1995. At this point the weary, and rather aged, investor still faced capital gains taxes on a phantom 300% gain wholly due to inflation.

Secular bear markets must be avoided if an investor hopes to enjoy expectations regarding their financial future; the damage wrought is too deep and long lasting for a buy and hold strategy. For older investors failure to stay clear of the secular bear will result in financial devastation from which they will have no realistic hope of recovery. Unfortunately, the majority of investors are bound to suffer this damage since the mass of long term financial paper will not conveniently go away during a secular downturn. Somebody, meaning most everybody, must carry these financial positions all the way down. To avoid this fate one must understand the force driving the secular bear so they have some sense as to when to seek safe harbor, a necessity they should face only once or twice in a lifetime.

Given that distortion of interest rates constitutes the fundamental force driving business cycles and the fact that interest rates continue to be distorted, by the Fed and through conduct of finance, combined with historical evidence indicating that very long secular cycles, punctuated by interim cycles, have previously developed as a consequence the answer seems clear. Yes, another secular bear market is inevitable. Of course what we most want to know is when is the beast likely to bear upon us?

The Fed will soon face two dreadful options, either course likely initiating the secular decline: a persistent tightening which will cause the system to cascade into deflationary decline or an attempt to fuel the next boom while necessarily fomenting price inflation, driving real short rates deeper into negative territory. The deflationary scenario is not likely due to political realities and institutions which have been put in place since the 1930’s to circumvent deflation (e.g., FDIC). We can count on the Fed to use all means at its disposal in its role as lender of last resort when the time comes, as has been promised by members of the Fed. Hence we should anticipate a secular decline characterized by price inflation. Investors who take a defensive position today (investing in T-bills, TIPS, real assets including some precious metals and not currencies) will have moved out of harm’s way just in time within the secular timeframe whether the worst of the decline begins 6 months or 18 months from now.

My hope is that readers of this article will find the insights offered compelling enough to serve, at least, as a basis for rejection of the notion that we are in a “new era” or that things will somehow “be different this time”, notions which have proven ill conceived time after time/cycle after cycle, and that readers will be encouraged to protect themselves from the inflationary secular bear market which is inevitable ... and now imminent!

7 OUT OF 10 BRITONS CANNOT AFFORD TO SAVE

The British consumer -- the main engine of the UK’s consumer-driven economy -- is tapped out. The money is just spread too thin. And yet, most British consumers are unwilling to change their spending habits. “Two thirds of those claiming that they cannot save admit to spending money on luxury goods.” (BBC) This is what is known as a “financial suicide”. Why are these people doing it to themselves? Because they are optimistic about the future, and have been for years. And it is not just the multitudes of imprudent British consumers -- it is the whole of British society. The upbeat British social mood has already translated into a real estate bubble, into historically low unemployment, and into hourly productivity that has been growing for more than a decade (according to the UK’s Office for National Statistics).

But things are changing. Home prices across the UK are down. The 2004 Christmas season sales came in lowest in 23 years. The UK’s Council of Mortgage Lenders says that mortgage borrowing keeps slowing. In fact, the overall “public sector borrowing” in December 2004 was 30% lower than a year before. And, Morgan Stanley reports that British consumers are planning to reduce their credit card spending by 30% in the next three months. The British Chamber of Commerce remains concerned about the manufacturing sector’s “persistent inability to sustain recovery”. The only remaining bright spot is the UK’s low unemployment rate. While the private sector jobs are shrinking, the public sector -- i.e., the government -- is still hiring. For now.

Add all this up, and what do you get? A shift in psychology. While saving money is still not “a priority in the British psyche”, the recent retail sales, the mortgage borrowing and other figures all hint that the decade-long widespread optimism is running thin. With the downturn in consumer spending, a downturn turn in stocks and economy may come next.