Finance Digest for Week of March 14, 2005

NOTHING IS CONFIRMED UNTIL IT IS OFFICIALLY DENIED? SOFTER WORDS FROM GREENSPAN

is Alan Greenspan trying to send a reassuring message on the nation’s record current-account deficit? A close comparison of two speeches – one he made last week to the Council on Foreign Relations and one on November 19 at the European Banking Congress in Frankfurt – suggests that he is. The current-account deficit – the gap in the trade of goods and services that the U.S. has with the rest of the world – is a threat because it has to be financed with money from abroad. If the world became less willing to finance that deficit, the dollar would fall and interest rates in the U.S. would rise.

Mr. Greenspan’s speech in November, which followed comments from other Fed officials about the threat of the growing current-account deficit, seemed to put the central bank’s official stamp of concern on the issue, focusing the market’s attention on it. From then until the end of the year, the dollar fell 4.4% against the euro. Mr. Greenspan’s comments were direct – for someone who customarily speaks in a syntax so complex that it is open to more than one interpretation. He said that sooner or later, foreigners would reduce their appetite for dollars and dollar-denominated securities.

Last week, Mr. Greenspan said again that foreigners “will at some point” reduce their dollar holdings. But he was much more upbeat about resolving the problem, saying, “the resolution of our current account deficit and household debt burdens does not strike me as overly worrisome.” The dollar’s fall the next day may suggest that traders want more than Mr. Greenspan's reassurance.

ANALYSTS PREFER TO SEE NO EVIL, HEAR NO EVIL, SPEAK NO EVIL

Either investors are becoming tolerant of fraud allegations or they are simply shrugging it off as irrelevant. But the barely-batting-an-eyelash response by MBIA investors and analysts to the company’s announcement last week that its financial statements will be restated going back to 1998, after learning that all was not what it appeared, is simply the latest example of this complacency. “People in America have very short memories these days,” says Lynn Turner, former chief accountant of the S.E.C. “Also, the incidence of fraud by management has become so common place, it seems like it is ‘old news’ to a lot of people. It seems as if it takes a major tumble in the markets to get their attention.”

By then, of course, it is too late.

WHY IS DEUTSCHE BANK FIRING, NOT HIRING?

2004 was a very good year for Deutsche Bank. In a handsome payoff for its restructuring efforts, Germany’s largest bank’s net profits soared 87% for the year. So you can imagine everyone’s shock in mid-February when the bank announced plans to cut 6,400 jobs worldwide – that is on top of the 20,000 jobs previously cut over the past three years. The announcement was especially painful because it came right after the government’s report that showed Germany’s unemployment at a record 12.6%. What followed was a public and political uproar. Politicians from German Chancellor to the head of a metal workers’ union criticized the bank.

What is interesting is that they are not the only firm to cut jobs after a profitable year. Allianz tripled its profits in 2004 – and cut staff by 17%; Schering and Siemens saw higher earnings in 2004, but are also planning to eliminate jobs this year. Companies say these unpopular measures help ensure their long-term competitiveness, but can there be another reason?

We think so. In our research, we have observed that hiring, like other economic activities, is driven by social mood. When society’s mood is positive, businesses hire. When it is negative ... hold on to your paychecks. Between 2000 and mid-2004, the German stock market fell dramatically, indicating a falling social mood. And looking at the country’s unemployment problem, for example, it is clear that Germany’s mass psychology is not out of the woods yet. Surprisingly, for the past seven months the German DAX has rallied defiantly. How can stocks be rising amidst the depressed social mood? This is only a seeming contradiction. Just like other economic indicators, employment often lags the stock market.

“Fundamentals” and investor confidence.

Here is a quick tally of Germany’s current economic “fundamentals”: After hitting an all-time high on March 9, Brent crude oil is now 33% higher on the year. The euro is pushing up to its all-time high against the U.S. dollar, too. The number of Germans out of work is the highest since World War II, and “German consumers haven’t increased spending in the past three years” (Bloomberg). Oh, and the German GDP contracted in the last quarter of 2004. That is one bleak picture for an export-oriented, consumer-driven, energy-dependent economy. It is no wonder that German economists were expecting investor confidence to decline in March. But to their surprise, it rose.

Last month, when German business confidence fell, analysts blamed it on the long list of poor “fundamentals”. This month, the “fundamentals” have not improved; in fact, some of them (the euro exchange rate and the oil price) have gotten worse. So how could the same “fundamentals” crush confidence one month and have zero effect the next? Well, say economists, in March investors’ focus has shifted to the “rising exports, industrial production and retail sales at the start of this year.” But those few “positives” have been in plain view for months, so why did investors not choose to focus on them earlier?

It is obvious that this month’s upswing in investor confidence was not caused by the “fundamentals”. Such “explanations”, while convenient and convincing, do not really explain anything. Worse, they do not help forecast economic trends. If only economists saw the stock market for what it really is – i.e., the economy’s leading indicator – they would get far fewer surprises. The real reason for the March confidence rebound was the intrinsic change in investors’ mood, as evidenced by the German DAX. The index has been a persistent rally all year, with a few minor setbacks. Rational “fundamental” arguments rarely work because the stock market is not rational. It fluctuates based on investors’ collective mood.

PEOPLE USE THEIR HOMES TO FINANCE SPENDING SPREES. HOW LONG CAN THIS GO ON?

The personal savings rate in the U.S. has fallen from 6% of GDP 12 years ago to a mere 1% now. Low savings could leave a lot of the middle class ill-equipped to handle retirement. There are a lot of reasons for a low savings rate, but an important one is the ease with which people can unsave, using their home equity. You buy a house for $250,000, putting down $50,000. A decade later you move, selling this house for $500,000 and buying a new one for $500,000. But instead of putting your $300,000-plus of equity from the old house into the new one, you once again put down only 20%, or $100,000. That leaves $200,000 of cash left over. You can spend it on cars and vacations. Or, without moving, you can take out a home equity line or second mortgage on your existing house. So long as this new borrowing is $100,000 or less, the interest on it is deductible (unless you are subject to the alternative minimum tax).

How much home equity extraction is going on? Our calculation indicates $569 billion worth of homeowners who refinance, take out second mortgages or simply extract cash when they move – and then spend some or all of that loot to support their lifestyles. If your thrift consists of putting no money in the bank but just watching your suburban home escalate in value, you may be in for disillusionment. At age 68 you will be living in a lovely $2 million house. But how are you going to pay the light bill?

BOTTOM-FISHING VALUE LINE STOCKS

Two ways to make money on Wall Street: Run with the crowd or bet against it. The Value Line Investment Survey has statistics that can help you implement either strategy. Forty years ago Samuel Eisenstadt created the “timeliness” ranking formula that made Value Line famous. It scores 1,700 stocks for expected performance over the next 6 to 12 months, using a plethora of technical and financial factors. The formula has had a remarkable run. A hypothetical investor reshuffling his portfolio every Jan. 1 to hold only the 100 top-ranked stocks would have earned a 19% compound annual capital gain over the 40 years, says Value Line, against 10% for the S&P 500. (These numbers exclude dividends.) Transaction costs would have dampened the return, but even so the performance has been strong enough to baffle proponents of the Efficient Market Hypothesis.

The formula is secret, but Value Line does publish some of the ingredients that go into it. Stocks tend to get high ranks if they have a run of quarterly earnings gains, beat analyst forecasts and have recent share-price gains in excess of the market’s, i.e., the bias is toward momentum plays. This is a run-with-the-crowd system, and it makes sense for in-and-out traders. Paradoxically, the Value Line ranking system is also useful for the polar opposites of momentum players, namely, contrarian investors. They go for out-of-favor stocks, often with recent earnings disappointments, on the theory that these will eventually make a recovery and reward patient holders. Here it makes sense to start with the stocks ranked lowest for near-term performance.

“Stocks that are ranked 5 [lowest] often have high three-to-five-year appreciation, for the simple reason that they are highly depressed,” says Eisenstadt, who at 82 remains chairman of the New York company’s research department. With that in mind, we screened for stocks ranked lowest for timeliness but with expected earnings growth over the next three to five years of at least 10% a year.

SET ASIDE YOUR GLOOM

Those who are financially glommy usually fix on deficits: the budget deficit, the trade deficit and the current account deficit. First, the trade and current account deficits are by definition basically the same, since they are coming from the same basic sources and accounting. Surprise: These two deficits have nothing to do with currency values. Ours came to 5.2% of gross domestic product last year. Britain’s was 5% of its gross domestic product. Over the last three years the U.S. trade deficit came to a cumulative 13% of GDP. Britain’s three-year total is identical at 13%. So why is sterling so much stronger than the dollar?

How about budget deficits? As I noted in my December 27 column, they are in no way associated with poor returns in the stock market. Nor do they dictate currency weakness. If you want to explain currency moves, you would do better to look at interest rates than at deficits. As 2004 started, Euroland’s rates were nicely above America’s, on both short- and long-term money. Arbitragers borrowed in America and lent in Euroland, pocketing the spread. Doing it all at once, they drove the dollar down and the euro up. Over the course of 2004 those rates flip-flopped, and now the game is taking place in reverse. Put aside your gloom and buy stocks like Jakks Pacific (21, JAKK), Sweden’s SKF (50, SKFRY), France’s Thomson (27, TMS), and Britain’s Tomkins (22, TKS).

BORED WITH PLAIN OLD T-BONDS? TRY WAGERING ON THE T-BOND VS. T-BILL SPREAD

Are there any morsels left for yield-starved investors? Investment-grade corporate bonds are yielding the narrowest spreads in five years: 55 basis points between an AAA corporate and a 10-year Treasury, a 5-year low. Junk spreads are also at historically low levels. So here I offer a cautious endorsement of another yield-enhancement strategy: “structured” bonds, which are complex debt securities whose interest coupons vary according to some formula that might or might not work to your advantage. Nominally, these bonds yield 7% or more, but there is a gotcha that makes these things something other than a free lunch. In short, they are appropriate for the right sort of speculator, but go in with your eyes open.

NOW IS THE TIME TO SELL SOME PAST FIXED INCOME RECOMMENDATIONS

Like most financial advisers, I focus predominantly on what to buy. However, I do not forget what I recommended in the past or forget to tell you if you should sell it. Today is a time to sell some of my past picks. We can blame this need to sell on the flattening yield curve and what it is doing to leveraged returns. At issue here is the borrowing undertaken by managers of some closed-end funds that own preferred stocks and bonds. Those funds are going to be squeezed as short rates rise: Dividends that investors reap from these leveraged portfolios will be pared because of costlier fund borrowing. It is wise to get out before the situation worsens.

OUR BECALMED MARKETS ARE DUE FOR SOME WILD PRICE SWINGS

Steady, low interest rates have persisted for so long (at least in the middle range of maturities) and profits have been made in so many sectors that a general mood of calm and optimism has become pervasive. Nowhere do prices reflect the possibility that a storm may be upon us. The market’s calm is precisely definable in the form of a tradable mathematical construct called implied volatility. Based on the prices of out-of-the-money options on a stock index, this statistic measures how much excitement option traders expect from the market over the next month or two. You can buy or sell futures based on the volatility statistic. “Vol traders” can speculate on S&P 500 volatility through the VIX contract and also on implied volatility in the prices of government bonds, mortgages, gold and other investments.

The important thing for the average investor without a Ph.D. in mathematics to know is that all of these gauges are trading at decadelong lows. That is, prices of options are low these days. Not since the 1995-96 period have markets been this comfortable, this quiet and this calm. The VIX stands at 12, having touched 43 just after Sept. 11, 2001, and at 41 when stocks bottomed in 2002. As surely as the stillness before a Florida hurricane, the present low reading means that massive turbulence will soon appear. But how can the ordinary guy take advantage of this phenomenon? I usually hesitate to recommend options, recognizing that the vast majority of investors lose money on them. ...

WORLDCOM TEACHES A PRICEY LESSON

Engineering the earth’s largest accounting fraud and filing the planet’s biggest bankruptcy evidently was not enough for WorldCom. Last week, the company earned its third Dubious Achievement Award. With 13 of its former banks coughing up $4 billion to settle with investors who lost money when the company failed, WorldCom is now responsible for the largest payout in history for a securities class-action suit. And that number may grow because three banks remain as defendants in the civil case. Most notable among them is J. P. Morgan Chase, one of WorldCom’s lead bankers and co-manager with Citigroup of WorldCom’s $12 billion bond offering of May 2001. That deal preceded WorldCom’s bankruptcy filing by just over a year.

The case against WorldCom’s enablers – its investment banks, auditor, directors and officers – has been mounted by lawyers for Alan G. Hevesi, comptroller of New York and trustee of the state’s common retirement fund. Though the trial has not yet begun, what has transpired in the case so far has major implications for Wall Street and investors. Citigroup settled with investors last May, agreeing to pay $2.65 billion. That left J. P. Morgan Chase as the lead WorldCom bank in the suit. In that position, its lawyers have been calling the legal shots for all the banks that participated in the offering, as is industry custom. Results for these banks have been, well, woeful. Some institutions that waited to settle with Mr. Hevesi until the eve of trial have paid significantly more, proportionately, than Citigroup.

The banks that participated in the WorldCom bond deals have endured a double whammy here. First, they were hurt by relying on the lead underwriters – as is the industry practice – to conduct adequate investigation into WorldCom’s financial state before a sale of its securities. Judge Denise Cote of Federal District Court in Manhattan has ruled that the prospectus in the 2001 bond deal was false and misleading. And the banks suffered a second time by following the lead of J. P. Morgan’s counsel for sound advice on settling or stonewalling the class action.

This is now a $4 billion lesson, and it is lost on neither Wall Street nor the law world. Unless J. P. Morgan wins before a jury, the WorldCom case will almost certainly change the way offerings are done and due diligence is conducted. Relying on a lead bank now looks like quite a dangerous tack. There is a good chance that the accounting fraud at WorldCom could have been uncovered much sooner had banks kicked over every rock at the company to see what crawled out. Underwriters have not been asked to be forensic accountants in the past, but the free pass that underwriters gave WorldCom is nobody’s idea of how to raise capital.

OIL DEMAND MAY RISE UNTIL PRICE HITS $80

Crude-oil prices may have to rise to $80 a barrel or higher before U.S. demand for gasoline, diesel and other fuels begins to slow, said Arjun Murti, an analyst with Goldman Sachs. U.S. motorists show few signs of curtailing their driving habits even with retail gasoline above $2 a gallon across much of the country, Murti said in an address at the National Petrochemical and Refiners Association annual meeting. “Our view is that oil prices have to keep rising until the economy is impacted,” said Murti, 35, a New York-based managing director at Goldman Sachs and co-leader of the company’s energy group. “At $80 oil, we might expect some negative reaction on the demand side.”

Oil at $80 probably would send U.S. pump prices for gasoline to about $2.75 a gallon on average, almost 70 cents higher than current prices, based on calculations from the Energy Information Administration, the statistical arm of the Energy Department. The cost of crude makes up about half of the retail price of gasoline and diesel in the U.S., according to department data. Every $1 move in oil prices typically results in a 2.5-cent move in retail gasoline.

AIG’S GREENBERG LEAVES LARGE SHOES TO FILL AFTER BEING FELLED BY PROBE BARRAGE

Criticisms and investigations over the years have not prevented American International Group from posting stellar returns. In February, even after pretax catastrophic losses of more than $1 billion stemming partly from hurricanes Charley, Frances, Ivan and Jeanne, AIG reported 2004 net income had risen 19% to a record $11.1 billion in 2004 from $9.27 billion a year earlier. That is greater than the combined total of the next four largest insurers in the S&P Insurance Index by market capitalization. Excluding capital losses and accounting changes, net income was up 12% to $11.5 billion from $10.2 billion.

The number and scale of investigations into AIG business practices suggest that employees may have been pushed too far, Edward Jones & Co. insurance analyst Kevin Lampo, says. “Has the culture developed to where people will do anything to meet their targets?” Lampo asks. Greenberg demanded what he calls a 24/7 commitment. He led by example, often starting work at 6 a.m. and making calls long into the night. Greenberg’s desk at AIG is spotless and clear of paper – because any issue is dealt with instantly. “If you sent him a report, you got a note back overnight,” says Doug Henck, 52, a former AIG senior vice president, who is now president of Sun Life Financial Asia. “I don’t know how he did it.”

The AIG claims and underwriting divisions for many lines are in the same building in Manhattan. Claims examiners constantly provide feedback to underwriters – keeping them alert to changing trends in litigation or claims filing, suggesting new language and riders and exclusions that can limit future losses. The communication can save money. AIG claims examiners alerted underwriters to the rising number of claims stemming from adverse reactions to the Fen-Phen diet supplement, which the Food and Drug Administration had asked to be withdrawn in 1997. “Other companies want to be a reliable source of underwriting for their customers,” says Jim Huguet, co-CEO of money management firm Great Companies LLC, which owned 280,282 AIG shares in early March. “AIG says, ‘We want to be a reliable earner.’” Because AIG writes so many kinds of policies, it can walk away from any that it thinks may lose money, something a less- diversified firm cannot or will not do.

Scale brings resources: Vice President Steve Collesano, 52, runs a 100-person research and development department that includes six people with Ph.D’s. No other insurance company could reasonably staff such a department. In 1994 Kevin Kelley, the CEO of a subsidiary, called excitedly, Collesano says. “I need everything you have on ostriches and emus,” he recalls Kelly saying. An importer in the U.S. Southwest, where the flightless birds are raised for food, was seeking to buy special risk insurance on them, and Kelly needed to know how to underwrite the policy. Researchers hit the Internet and phones, searching for life expectancy and pharmacology and toxicology data. They found a South African farmer with much of the necessary data about the birds and confirmed it with government sources. “At the end of the day, you can’t kill them,” Collesano says. “Once you get past the first six months, you have to hit them with a car.” Kelley wrote a “kick out” clause, which excluded claims for six months, and clinched the deal. Now, a new chief executive will have to maintain that brand of enthusiasm and creativity – and, say some investors, that will not be an easy task.

All the way until the fateful board meeting, colleagues and competitors continued to envy Greenberg’s vim and stamina. “You have a man who is 79 and looks like he’s 59 and isn’t showing any signs that he’s flagging,” says Lloyd’s of London Chairman Peter Keith Levene. Whatever becomes of AIG, Greenberg’s departure represents a personal tragedy for a man credited with helping to build the modern insurance industry. Without the barrage of regulatory probes that eventually brought him down, he might have remained in charge at the company he nurtured – and so obviously loved – for years to come.

Ouster at A.I.G. Shows rising assertiveness of boards.

Wth the ouster of the American International Group’s chief executive, Maurice R. Greenberg, the turnover at the top of American companies is starting to look like a 10-car pileup. The upheaval is the strongest sign yet that boards are reacting forcefully to changes in governance put in place to clean up the scandal-ridden landscape of the last few years. The announcement that Mr. Greenberg would be stepping down as chief executive amid several regulatory inquiries brings to seven the number of high-profile executives who have been replaced, mostly against their will, in the last three months.

Amid a new culture of corporate openness, boards have acted to punish poor performance and ethical lapses to stem potential fallout from regulators, major customers and large investors. Their newfound vigilance stems in part from new federal rules and stock-exchange requirements that boards have more independent directors and act in a more transparent manner. The changing culture of boards themselves, after a series of ugly corporate scandals this decade, has also heightened their sensitivity to public-relations embarrassments. That so many chief executives have been ousted amid signs of an improving economy and market shows the strength of the trend toward greater scrutiny, said Evan Scott, president of an executive search firm in Philadelphia.

Changes in listing requirements at the NYSE and Nasdaq, more institutional investor activism and court decisions that have increased directors’ financial liability for their decisions have all pushed boards to be more involved. The changes have spurred a shift in corporate culture. “The fraternal culture that characterized America’s boards is undergoing a dramatic change to a culture of skepticism,” said Arthur Levitt Jr., the former head of the S.E.C. who is now a senior adviser at the Carlyle Group, a private equity firm in Washington. “The humility and embarrassment of the past few years, combined with regulation, have changed the culture of boardrooms.” Sometimes boards are pushing chief executives to the exits in anticipation of similar moves by unhappy regulators. Fear of scandal is also driving heightened scrutiny of executive performance.

Beyond the high-profile cases, top executives have been moving on in record numbers recently. Last month, public and private American companies announced 103 chief executive changes, the most for any month in four years, according to Challenger, Gray & Christmas. It was the first time that companies announced more than 100 chief executive changes since February 2001. As the economy continues to recover, expect more leadership changes at the top, Mr. Challenger said.

THE CHINA DISCONNECT

The world remains in the grips of a China mania. Although it still accounts for only about 4% of world GDP, China continues to be viewed as something close to a savior for an otherwise growth-starved world. It is all about China’s “delta” – visions of an open-ended 8-9% growth trajectory that enthralls western industrialists, investors, and policy makers alike. Meanwhile, the Chinese leadership is treading far more cautiously as it takes its slowdown campaign into a second year. This underscores an important disconnect: Just when the world seems to be counting on China the most, there is a growing risk the Chinese economy goes the other way.

This disconnect shows up most clearly in the contrast between recent trends in global commodity markets and incoming data on the Chinese economy. Commodity prices rose sharply in February and early March, hitting 24-year highs for the broad composite gauges and 7-year highs for the industrials subsets. No economy has had a more significant impact in driving commodity demand in recent years than China. Our estimates suggest that China accounted for about 20% of total world consumption of aluminum in 2004, 30-35% of global demand for steel, iron, and coal, and close to 45% of worldwide purchases of cement. It is not just the rapid growth rate of the economy at work. It is also the unique strain of a Chinese growth dynamic that is driven by industrialization, infrastructure, and urbanization – all activities with intrinsically high commodity content. For that reason, alone, there has been an increasingly tight connection in recent years between the ups and downs of industrial commodity prices and fluctuations in Chinese industrial output.

Largely for that reason, it is tempting to conclude that the latest surge in commodity prices is pointing to a sharp reacceleration in the Chinese economy. Such an outcome could spell heightened risk on the global inflation front – a possibility that has already unnerved global bond markets. However, China’s incoming data flow cautions against that conclusion. Apart from the data flow, there is an even more critical reason to doubt the accelerating China growth story: The government is leaning the other way, and in this command-and-control economy, often times that is all you need to know. The Beijing leadership is telling us that there is more to come on the growth deceleration front.

If the Chinese economy is already slowing and the government wants it slow further, then what is going on in commodity markets? Two possibilities come to mind – the first being a resurgence of non-Chinese global growth. Unexpected weakness in Japan and Germany – the second and third largest economies in the world – argue against that possibility. Nor does America hold the answer. Which takes us to the second possibility – a speculative commodity play by financial investors. Morgan Stanley research suggests that the hedge fund community has not unwound the major long position it established in commodity markets in 2003. Consequently, to the extent there has been a decoupling between commodity prices and Chinese industrial production growth – and that there is no new candidate that fills the global growth void – the role of financial speculation emerges as a prime suspect. If that conclusion is correct, a further slowing in Chinese industrial production growth could catch commodity speculators leaning the wrong way.

In the end, nothing is more important to the Chinese leadership than stability. Yet for the West, all that seems to matter with respect to China is the extraordinary pace of its economic growth. There is an inherent contradiction between these two perspectives – especially when the excesses of Chinese economic growth begin to bump up against its stability constraints. Yale sinologist Jonathan Spence has carefully documented this disconnect between the world’s view of China and China’s view of itself (in The Chan’s Great Continent: China in Western Minds, 1998). He argues that it is nothing new – in fact, he traces this bias back to Marco Polo’s 13th century accounts of his travels through China. His bottom line is that the West never seems to get China right – that it almost always views China largely in the way it sees itself. More than 700 years later, and the same China disconnect is alive and well. The real risk today is that China and the West are operating at cross-purposes – each contributing to the other’s tensions. The resolution of these tensions could well have important implications for world financial markets in 2005.

ADVANTAGE: LITTLE GUY

“Liquidity is overpriced,” says money manager Jeremy Grantham, of Grantham, Mayo, Van Otterloo & Co. (Now GMO.) “A long- term investor should always try to exploit the other guy’s short-term horizon and be paid for taking illiquidity.” What the heck is he talking about? Grantham’s idea is really pretty straightforward: Since most big investors can only buy big “liquid” stocks, the best values available in the stock market usually reside among the small, “illiquid” stocks. Jeremy Grantham knows a thing or two about the importance of liquidity; his money management firm oversees no less than $70 billion worth of global equities. He is a well- respected value investor, the type of guy who adores cheap foreign equities, as opposed to glitzy tech stocks. But like many value-focused money managers, Grantham believes today’s equity markets offer very few compelling values ... especially within the universe of large, liquid stocks where most managers of his size explore for opportunity. (Anyone who wants a taste of Grantham’s analysis can head over to www.gmo.com and click on “Research & Commentary”. Occasionally, Grantham will post his observations and insights about the financial markets. The headline of one of his most recent pieces, “Apocalypse Not Now: Inevitable Pain Postponed” [see immediately below], gives you a flavor of what is in his report).

Grantham’s plight is hardly unique. Many of today’s very best value managers gripe about the dearth of value in the U.S. stock market, while complaining about the difficulty of putting money to work in worthwhile opportunities. Even Warren Buffett, in his most recent annual letter to Berkshire Hathaway shareholders, confesses his inability to find many investment opportunities in 2004. Hence, Berkshire Hathaway is now sitting on $43 billion in cash! $43 billion is a nice problem to have, but it is problem nonetheless, to the sorts of investors like Grantham who must attempt to make money by investing in big, liquid companies. Fortunately, individual investors need not limit their focus to big names.

Professional managers value liquidity, not only because they must move around large amounts of money, but also because their careers rely on short-term performance measurements. They cannot AFFORD to focus on the long-term. So they avoid the sort of illiquidity that impedes their short-term trading activities. They want the ability to buy and sell meaningful chunks of stocks quickly, without upsetting the market. And, increasingly, big investors are buying and selling as frenetically as rug-dealers. The average holding period for a stock on the NYSE has tumbled from 8 years in 1960 to less than one year today. In other words, long-term investing is a lost art among most professional investors. Therein lies the opportunity for the intrepid individual investor in small-cap stocks. “[The] ability to handle illiquidity is a major advantage for long-term investors,” says Grantham.

Individual investors are much better equipped to “handle illiquidity” than their professional counterparts. For one thing, individual investors move around smaller amounts of money. For another, they need not worry about short-term performance measurements. They may sit on stocks, like old Horton trying to hatch an egg in the Dr. Seuss classic, Horton Hatches the Egg. As a result of these two differences, small-cap investors hold a distinct advantage – for once – over the likes of the world’s greatest money managers ... even over Warren Buffett.

APOCALYPSE NOT NOW: INEVITABLE PAIN POSTPONED

Great bear markets take their time. Yes, it already seems like we have been waiting a long time allowing – indeed setting up – a sustained bear market for the market low, but actually this wait is far remarkable on a historical basis. In fact, a low in these next 24 months would be the most typical timing we seen in prior new bull markets. But this market cycle has been interestingly different from earlier bubbles and we should not expect a typical experience. The first difference is that the market in 2000 went higher than ever before: 34 times trailing earnings versus 21 times at the market tops of 1965 and 1929. Even Japan, adjusted for cross holdings, was not materially higher. Second, the sustained phase of declining interest rates and easy money has no historic U.S. parallel, either in extent or duration.

Perhaps more interestingly, the favorable credit cycle and moral hazard of the upswing continued through the first leg of the bear market, allowing – indeed setting up – a sustained bear market rally that has been one of the longest in history, and one characterized by extreme speculation of a breadth not seen in prior new bull markets. But is it really a surprise that the market’s “animal spirits” were not thoroughly broken time as they were following the bubbles in 1929, 1965, and Japan? Do not bigger actions need bigger reactions? Doesn’t the removal of such excessive bullishness and faith in a new era need either more than typical bad news or more time?

But now, finally, the credit cycle is turning down and interest rates are being raised carefully, although they still remain far lower than normal and are therefore still stimulative. Does this not all feel like the normal beginning of a stock market downturn? We should prefer a rapid market decline to a slow one. You simply end up with more money if you hit the market low more quickly and then have more time compounding higher returns at the lower prices. So a low in 2002 would have been best. A low this year would be more painful both psychologically and to the pocketbook than in 2002, but much less painful than dragging this thing out to 2009, 2010, or later. Unfortunately, this last alternative seems increasingly likely to me and I wish for us and everyone else that it not be the case and that the market low comes soon. Both articfically strong animal spirits and global growth just seem too strong for the market to get to trend line and below (725 on the S&P 500 vs. a currently fluctuating in the vicinity of 1200) in the next two years, unless there is a crisis.

Replacement Cost: The Bedrock of Value [“Special Topic” afterword to above piece.] The total market must sell at about the total cost of replacement. It may be hard to calculate, but if we could know the true replacement value it would be the fair value of the market. If assets in the market sell away from replacement or fair value, an arbitrage takes place that is central to the effective working of capitalism.

If fair value in the stock market equals replacement cost, then it surely follows that: a.) Changes in short or long interest rates cannot change replacement cost and are therefore irrelevant to fair market value. b.) Tax changes such as capital gains tax rates are also clearly irrelevant to replacement cost and fair market value. c.) Inflation cannot affect the real replacement value. d.) Even imbalances in supply and demand, which will of course change short-term stock prices, cannot affect replacement value. e.) If the market on average sells at replacement cost, then the market must also on average sell at the average profit level of the corporate system times the average PE. This is how we approach fair value: normal margins times normal PE. f.) Since profit margins are very different during booms and busts, while replacement cost stays stable, if follows that replacement cost = high profit margins x low PEs or = low profit margins x high PEs. When you read today that the PE of the market is reasonable, it completely misses the point that profit margins are unsustainably high.

For fair price to equal replacement cost, then it must follow that PE should be perfectly negatively correlated with profit margins. In practice the actual measured correlation between the two is far from a perfect -1. In fact, it cannot even get the sign right! The measured correlation is 0.26. The market is therefore on average extrapolating, not normalizing. This extrapolation is pure behavioralism. For the record, extrapolation of today’s conditions gives analysts a sure way of clustering together and avoiding terminal career risk of being wrong on your own. The double counting that extrapolation causes is the reason that the market is far more volatile than it should be – several times the necessary modest volatility that must be caused by an uncertain future.

Finally, if you have time, read Valuing Wall Street: Protecting Wealth in Turbulent Markets by Andrew Smithers and Stephen Wright for the final long word the importance of replacement cost.

DEFICITS MAKE YOU POORER

Most Americans are vaguely aware that Congress has run up huge deficits in recent years, but the numbers involved are so large that it is hard to grasp what our government’s indebtedness really means to us as individuals. The total federal debt is quickly approaching $8 trillion, courtesy of an administration that borrows roughly one billion dollars every day to pay its bills. Ultimately, the U.S. government will either repay its debts or default on them. We need only look at the Argentine debt crisis of 2001 for an example of what happens when a government fails to make even minimum payments to creditors. The Argentine economy virtually collapsed, and the value of her money tumbled. This is something most Americans cannot fathom, especially a political class that mistakenly thinks it cannot happen here.

When the federal government spends more each year than it collects in tax revenues, it has three choices: It can raise taxes, print money, or borrow money. While these actions may benefit politicians, all three options are bad for average Americans. Deficits mean future tax increases, pure and simple. Deficit spending should be viewed as a tax on future generations, and politicians who create deficits should be exposed as tax hikers. The federal government still consumes more of the private economy than it ever has except during World War II, despite the administration’s anti-tax rhetoric.

The economic situation today is reminiscent of the 1970s. The economic malaise of that era resulted from the profligacy of the 1960s, when Congress wildly expanded the welfare state and fought an expensive war in southeast Asia. Large federal deficits led to stagflation – a combination of high price inflation, high interest rates, high unemployment, and stagnant economic growth. I fear that today’s economic fundamentals are worse than the 1970s: federal deficits are higher, the supply of fiat dollars is much greater, and personal savings rates are much lower. If the federal government will not stop spending, borrowing, printing, and taxing, we may find ourselves in far worse shape than 30 years ago.

DIAMONDS ADDING LUSTER TO THE CANADIAN ECONOMY

They have been captivating people for centuries. In 1953, movie star Marilyn Monroe celebrated them in song. In 1971, Agent 007 James Bond pursued criminals attempting to smuggle them. Now they are setting the economy of the Northwest Territories on fire. The excitement began in 1991 when diamonds were discovered at Point Lake near Lac de Gras in the Northwest Territories. Since then, two diamond mines have begun production: EKATI1 and Diavik2 , both in the Northwest Territories. A third mine, the Jericho3 project, just north of EKATI in Nunavut, is expected to be in production in 2005. The Snap Lake4 project, also in the Northwest Territories, is expected to begin production in 2006.

A relative latecomer, Canada is now a major player in the international diamond scene. Not only is Canada rich in diamonds, it is rich in high quality diamonds. From 1998 to 2002 roughly 13.8 million carats have been mined, collectively worth $2.8 billion. This is roughly a 1.5-kilogram bag of ice each day for five years, with each bag worth $1.5 million. Recent production data suggest that by the end of 2003 Canada will have produced almost 15% of the world’s supply of diamonds, the third largest producer of diamonds, behind Botswana and Russia. Diamond mining is adding a new luster to the Canadian economy and dazzle to that of the Northwest Territories. Current projects are contributing substantially, both economically and socially, to Canada and particularly the North.

THE WOLFOWITZ AT RUSSIA’S DOOR PRESENTS AN OPPORTUNITY

And the Academy award for best fascist dictator goes to – Adolph Hitler! Woody Allen cracked that joke once at the expense of the American habit of making awards out of self-congratulation of the least worthy type. Were anyone to dare in the same spirit, they might award the new American nominee to head the World Bank, Paul Wolfowitz, the title of the worst American ever to hold such an international post. For Russia, against whom Wolfowitz has been waging war since he got out of short pants, the nomination of Wolfowitz as president of the World Bank presents something of a dilemma, and something of an opportunity.

During the first post-Soviet decade, the World Bank under outgoing president James Wolfensohn was one of the many instruments the U.S., as the World Bank’s dominant shareholder, used to destroy the economic foundations of its rival superpower; pay stipends to Russian quislings; and oblige the Russian government to incur sizeable debts for the privilege of being advised to dismantle its systems of command and control, and transfer the nation’s most valuable resources into the hands of a dozen individuals eager to betray their country for personal profit. Not without reason was Wolfensohn’s favorite Russian counterparty, Victor Chernomyrdin, the prime minister who enriched himself through creating Russia’s largest company, Gazprom. Wolfensohn was waging war by other means; Chernomyrdin was his collaborator; and the Russian treasury paid in full, principal and interest, for its defeat.

The dilemma posed by the Wolfowitz nomination turns out to be an opportunity for President Vladimir Putin to conclude that, from Russian experience, the World Bank does more damage than good, and that in consequence it should be isolated and ignored by those countries and economies most in need of development financing.

FUELING ECONOMIC GROWTH

There are two new energy technologies that may change the world, but probably not until the 2020s and after. Both are being developed in Asia, one by the Chinese and one by the Japanese. Asia needs them because it is relatively poor in petroleum supplies and relatively heavily polluted. It has been clear to the governments of the East Asian countries that the future of economic growth depends on the resolution of the problems of energy supply and pollution.

The new technology in which Japan is taking the lead is the use of hydrogen as a fuel for cars. All the major automobile companies have been spending very large sums on research into fuel cell engines. This type of engine has great advantages. Its waste product is water. It does not in itself add to the carbon dioxide influence on global warming. Although fuel cell engines still cost 10 times ordinary gasoline engines, the technology is relatively advanced. But there are difficulties, particularly in the distribution of hydrogen as a fuel. DaimlerChrysler promised to have fuel cell cars commercially available by 2004; it has not happened. Toyota is also spending very large sums on fuel cell research, but it has made a success of a less revolutionary technology, the “hybrid” car, which combines gasoline engines with batteries. The 5-seater Toyota Prius, the world’s first hybrid car, was launched in 2000, and production is being expanded to 200,000 a year.

The other new technology, also reported in the Financial Times, is the “pebble bed” reactor, which is being built in China. The new reactor is a high-temperature, gas-cooled reactor; it should be producing power in about five years. It relies on hundreds of thousands of nuclear pellets the size of billiard balls, which provide safety against the possibility of meltdown. It is the first major new design of a nuclear power station for several decades. This is a Chinese “first”, just as the Prius is a Japanese first.

If there is a revolutionary change in the world automobile industry toward fuel cell technology sometime in the second quarter of this century, Toyota is well placed to lead it. In the same way, safety from meltdown is a necessary condition if a new generation of nuclear reactors is to be built. The pebble bed technology apparently also makes conversion to weapons grade more difficult. If one supposes that $40-60 a barrel is now the normal range of the oil price, all sorts of things become necessary or possible. Hydrogen fuel for cars, a new generation of nuclear power stations, and conversion of shale oil and tar sands all begin to look economic. Indeed, they all are economic at anything over $40 a barrel. Yet they all take time. I have an uneasy feeling that there will be serious energy shortages in the period before these new technologies all come on stream.

PRICEY LIQUIDS

“That’ll be $64,” grunted the barman at Smith & Wollensky’s, after placing a Budweiser and two glasses of wine on the bar. “Really?” your editor replied, as he reached very slowly for his wallet. “Only $64?” Fortunately, a generous companion promptly tossed four 20’s toward the barman, thereby obviating the need for your editor to satisfy the bill. UN-fortunately, because we all continued drinking our pricey libations, your editor found himself tossing SIX 20’s on the bar to close out the tab. One Budweiser and two ordinary glasses of wine should not cost $64 ... not even in Manhattan. But they did. And to hear most “experts” tell the tale, crude oil should not cost $56 a barrel. But it does.

Maybe these two phenomena are related. Are $64 cocktails not as much a picture of dollar weakness as $56 crude oil? The commodity bull market and the dollar bear market are one and the same. As the nearby chart clearly shows, the recent price histories of the CRB Index and the euro are as entwined as young lovers. They are rising together because the dollar is falling against both of them. Or to express this phenomenon from another perspective: The price of crude oil in dollars may have reached a new record high, but the price of crude in euros remains well below its record high.

The message is clear: the dollar bear market both powers and enhances the commodity bull market. Rising commodity prices are not ONLY a function of physical supply/demand dynamics in each of the individual commodity markets; they are also a function of limitless dollars encountering finite natural resources. Both of these trends are well established and durable. In which case, the commodity bull market is likely to “have legs”. The bull market in commodities, we submit, is not the handiwork of “hedge fund speculators”. It is the love child of a U.S. Treasury that produces too many dollars and a global population that consumes ever-growing quantities of “stuff”.

There are only so many barstools at Smith & Wollensky’s. If you want to occupy one of them, there is a price to pay. There are only so many barrels of oil in Saudi Arabia. If you want to own one of them, there is a price to pay. In either case, be sure to pack your wallet with plenty of Andrew Jacksons.

The view from the summit of Hubbert’s Peak.

Algeria’s minister for energy and mines has conceded what many in the “Peak Oil” camp have been arguing for quite some time: OPEC has reached its production limit, and trying to stretch output by one million barrels per day is not likely to lower oil prices. Chakib Khalil said prices were high because of world economic growth – particularly in the U.S. and China: “OPEC has reached its production limits. It doesn’t have much production capacity. If it came to a crunch, it has capacity for one million barrels (more per day), and I don’t think a production increase would influence the barrel price.” he told reporters last week. Depletion dynamics are, as the geologist M. King Hubbert predicted decades ago, alive and well.

The problem of increasing supply shortages has also been exacerbated by oil companies’ failure to add new refining capacity to keep up with global demand for petroleum products. This is exacerbating already tight oil supply conditions and fuelling the rise in oil prices to nominal record highs. With the increasing preponderance of heavy oil on the markets, the need for increased refining facilities is even more acute, but substantial barriers remain: Stricter environmental laws in the U.S., Europe, China and India are compounding the lack of excess refinery capacity as companies invest in new equipment to reduce sulphur content at the expense of adding new capacity. Last yearwts increase of 2.65 million barrels a day in global oil demand overshadowed the modest rise of 700,000 b/d in global refining capacity in 2004. U.S. refineries are working close to capacity, yet no new refinery has been constructed since 1976. And oil tankers are fully booked, but outdated ships are being decommissioned faster than new ones are being built.

Current market conditions have led to the most remarkable Damascene conversion of all: The rapid rise in global oil demand should lead the industrialised world to promote energy conservation and alternatives to oil, the International Energy Agency (IEA) warned last week. The cri de Coeur from the West’s leading energy-policy advisor marks a sharp turnaround from an organization which has hitherto dismissed notions of an imminent supply shortages and consistently overstated energy supply. The perception long fostered by the IEA has been that supply has continually exceeded demand. It has made the behaviour of prices since March, 1999 hard to understand. By contrast, the work of oil consultants Groppe, Long, & Littell, Matt Simmons and Colin Campbell have consistently constructed their supply/demand data by tracking the physical flow of oil, rather than relying on the politically doctored numbers furnished by the members of OPEC. Using this method has made today’s high oil prices far easier to understand, particularly in light of the persistent evidence suggesting widespread overproduction of OPEC members in regard to their respective quotas. The evidence, however, is becoming irrefutable and the IEA is finally sounding the alarm: “The reality is that oil consumption has caught up with installed crude and refining capacity,” the agency said.

Even Wall Street, long in the camp projecting a return to $25 per barrel oil (on the back of what now appear to be absurdly optimistic predictions regarding Iraq’s future potential production of crude), is reflecting the new analytical paradigm. Thus, Deutsche Bank warned in a recent piece that the hydrocarbon era was “increasingly likely to be coming to an end”, and “politicians, company chiefs and economists should prepare for this in good time, to effect the necessary transitions as smoothly as possible.” The problem, as energy investment banker Matthew Simmons – long a smoke alarm for Peak Oil – has said repeatedly, “is that the world has no Plan B.”

Clearly, it is not an overstatement to say humanity’s way of life is on a collision course with the basic facts of oil geology. The descent from the peak of Hubbert’s summit is likely to be far more painful than the ascent, yet few have offered anything in the way of serious contingency planning to deal with this oncoming problem. Of course, it is likely that over the longer term, the global economies might find the necessary resolve and unity of purpose to develop a new non-fossil fuel economy. But this is unlikely to occur in the absence of crisis first: More industries will likely be forced to the wall as a consequence of rising energy costs. Further environmental degradation is likely, as is mass starvation in some countries. The competition for energy security will, as we noted last week, almost invariably lead to further global conflict. Abundant energy from fossil fuels was a one-time gift, as even the IEA is implicitly conceding today. No one has yet suggested a realistic and pain-free alternative.

A Trillion Barrels of Oil ... and Prices RISE?

The price of crude oil has climbed by some one-third in 2005. I would like to consider what is NOT driving that price trend higher. Let us start with a blanket dismissal of explanations in the financial media: in one way or another, virtually all of the reporting links higher oil prices to “an increase in world demand”. This is nonsense. Demand for all of 2005 will likely increase by about 2-3%, well within the typical annual range over the past few decades. You tell me if this math works to explain a 33% price increase since the first of the year. And as I noted several weeks ago on this page, there is no gasoline shortage -- not now, not in the next 50 to 100 years. Untapped reservoirs in Canada and Venezuela hold more than three trillion barrels of oil. The explanation for rising oil prices lies elsewhere.

Prices in a freely traded market are always a function of what the seller asks and what the buyer bids. Innumerable factors will affect the psychology of the buyer and seller -- yet when their minds meet, you get a price. And make no mistake: that meeting of those minds is, above all, psychological. That psychology unfolds in recognizable patterns. ...

REAL ESTATE: THE NAME OF THE GAME

Have you heard? Now you can pay off your mortgage, buy a duplex to rent, retire, and travel cross-country in a brand-new motor home, all in less than 60& minutes – thanks to CashFlow, the board game that uses play money to teach adults about real-world investing. Talk about putting the fun back in funance. And, as any member of one of the 800 CashFlow Clubs around the world will tell you, the vicarious thrill of winning (fair and square) the American Dream cannot be beat. Unless, of course, the Dream came true. Which brings us to a March 14 CNN Money report on one New York City-based CashFlow Club’s decision to “turn the game about getting rich into a game plan for getting rich.”

The time is right, claim the group’s members, to roll the dice in the real-world real estate market. They have come together to put down the playing cards and “pick up the name of a good contractor, the number of a trusted real estate lawyer, or to offer cash, credit or time as one member of a real estate partnership.” In other words, relative strangers are partnering up to place their combined capital in property based on the experience they gained and lessons they learned from playing a board game. What’s next – People buying hotel chains because they kicked butt in a few rounds of Monopoly?

But as crazy as this may sound, many experts claim that in the game of real estate, there is no losing. Take, for example, the March 12 testimony by a chief economist for the National Association of Realtors: “The U.S. housing boom should continue for at least another decade. Thankfully, American’s are ignoring warnings of a [housing bust] and investing in real estate in droves. Those who say the ‘sky is falling’ are trying to compare real estate to stocks, but it’s apples and oranges. Stocks are, by their very nature, speculative. Real estate is more long term.” Exactly. If the housing bubble bursts, you cannot just pick up the phone and sell your real estate investment, as you could shares of a falling stock. You first have to find a buyer.

This brings to mind another board game by a different name: RISK. And, over the past few years, the degree of risk relevant to the HOME sweet home sector has soared sweet soared: Once merely a place to live, it is now 1.) A place to earn a living: In 2004, 25% of the 7.7 million homes sold were purchased strictly as investments; and 2.) A way to ensure a livelihood: A March 15 AP article points out “of the 243,000 net private payroll jobs added by California’s economy in the last two year, 122,000 of them were directly related to the real estate sector. The job gains over the past year reflect not an economy in the midst of a true recovery, but an economy still in the midst of a real-estate-fueled spending binge.”

Beat the bubblicious real estate market.

You have heard the conventional wisdom: Don’t think of your house as an investment. Think of it as a place to live. But how can you not think of it as an investment when it has been such a good one lately? Can this continue? It turns out that caution may be in order for 2005. The good news is that purchasing or owning a house remains one of the best investments you can make over the long term. Historically, the real estate market often spurts, then pauses, and sometimes even declines slightly. Prices have never really plummeted on a national basis.

Yet for three years, home-price appreciation has been running far ahead of rates of inflation, wage increases, and national economic growth. The kinds of growth chalked up since 2002 are likely unsustainable, in the view of most analysts who follow the housing market. That does not mean home prices will crash, but they might retreat some in your region, especially if they have risen extraordinarily fast in recent years and if a downturn hits your local economy. Even barring that, as interest rates rise (and long-term rates have spiked in recent weeks), fewer people will be able to afford current home prices. That may lead to flatter real estate prices even if demand stays robust.

A few troubling signs of a real estate market top are emerging: An increasing percentage of home financings are done with adjustable-rate mortgages (ARMs), which indicates people are stretching to afford the homes they want. If rates rise quickly, buyers with short adjustment periods may face higher rates sooner than they expected. Another worrisome trend: NAR reports that 36 percent of home sales in 2004 were second homes. Of those, the number of people reporting that they made the purchase primarily as an investment climbed from 20% in 1999, to 64% in 2004. That is a sign a lot more speculative buyers have come into the market, and that could be fueling a real estate bubble in some areas.

If you are thinking about putting more of your assets into real estate in 2005 – whether you are a first-time buyer, looking for the retirement home of your dreams, or still think you can make good money investing in real estate – here are some guidelines for maneuvering in what is likely to be an overheated market this year.

They call them flippers.

In the 1990s, Flippers were stock jockeys who finagled their way into initial public offerings, only to flip them days or hours later for big profits. These days the go-go market is homes, not stocks. In hot spots like Las Vegas and Florida, real estate flippers have discovered that a modest down payment and a little patience can net them tens (even hundreds) of thousands of dollars in profits, sometimes tax-free. The most aggressive of them figure that some combo of paint, new flooring and kitchen upgrades can turn the dumpy house they bought for $300,000 in February into a $400,000 property they can unload in July. And in the most sizzling markets, they have been absolutely right.

Ask Angel Cooley, 54, who moved to Las Vegas three years ago and has since flipped 8 houses. Even with the Vegas market cooling somewhat in recent months, Cooley expects her real-estate-related net worth to reach seven figures this year. “A year ago you could buy something in Vegas for $200,000, and in less than four months you could gain $150,000,” she marvels. “It was a crazy kind of hysteria here, like people running after a Brink’s truck.” Sound tempting? Absolutely. While quick-hit real estate investing is nothing new, the confluence of new tax breaks, low interest rates and exploding prices has created a perfect storm for flipping opportunities (at least in some markets) and has made legions of instant moguls.

Problem is, the playing field is getting crowded. In Las Vegas, 7% of all homes sold last year had been owned for less than 6 months. Nationally, 14% of all new mortgages these days are for second homes or investment properties, up from 8% in 1999. If you have been considering putting in your application for that real estate mogul position, statistics like these should give you pause. So should the example of veteran flippers like Jeff Bliven, who, after 20-plus years in the game, says he is dropping out. “With some of these mortgage companies, if you can fog in a mirror they’ll make you a loan,” says the 42-year-old resident of Newtown, Connecticut. “When everyone’s doing it, it’s time to liquidate.”

ARE YOU AN INVESTOR OR A SPECULATOR?

An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. ~~ Benjamin Graham and David L. Dodd in Security Analysis

In general, Americans feel pretty darned smart when it comes to handling money. Since the stock market crash of October 19, 1987, the Dow Jones Industrial Average has gone from 1,738.40 to a March 14, 2005 closing price of 10,804.51. Granted, many people lost money when the dot.com and telecom bubbles burst, yet Americans remain unshaken in their collective belief that staying in the stock market will make them wealthy in the “long run”. What a dream world America has become where we can read the business pages, watch CNBC, “invest” in can’t-lose stocks, and then grow wealthy, over time, without much thought or effort. When examining this prevalent mindset, using Graham and Dodd’s distinction between investing and speculation, I must conclude that most Americans are speculators not investors. This position is easy to defend.

In 1983, Warren Buffett conveyed 13 owner-related business principles for Berkshire Hathaway’s shareholders to embrace. He writes: “Charlie and I hope that you do not think of yourself as merely owning a piece of paper whose price wiggles around daily and that is a candidate for sale when some economic or political event makes you nervous. We hope you instead visualize yourself as a part owner of a business that you expect to stay with indefinitely, much as you might if you owned a farm or apartment house in partnership with members of your family.” Indeed, having an ownership mindset is a step toward becoming an investor, yet, on a stand-alone basis, does not quite get you there. For if an individual is truly an investor in a business, he would have a basic understanding of its operations, its assets and liabilities, its profitability, and its cash flow. If someone cannot read a financial statement, then when it comes to purchasing common stock in publicly traded companies, such a financially illiterate person is inherently a speculator, not an investor. After all, such a speculator has no idea how to value a business and merely owns a “piece of paper whose price wiggles around daily.” With financial illiteracy being the overwhelming norm in America, I believe I have successfully defended my position that most American “investors” are simply speculators.

For those who feel that they fit the mold of being a speculator, yet want to make the effort to become an investor, there is hope. Let me give you a crash course. The first step to take is to read Benjamin Graham and David L. Dodd’s classic book Security Analysis. This book will teach you how to read a financial statement. The next step is to read The Intelligent Investor by Benjamin Graham. As Warren Buffett stated, it is “By far the best book on investing ever written.” Enough said. Finally, you must gain an understanding of Austrian economics. Keep in mind that it was the “Austrians” who correctly identified and explained the dot.com and telecom bubbles that left so many stock portfolios in tatters. By combining Graham and Dodd with Austrian economics, you will have the tools necessary to become a successful investor. After all, long-term wealth accumulation requires a great deal of thought and effort – not the opposite as promoted by America’s financial pop culture.

HOW FAST CAN AN ECONOMY GO FROM GOOD TO BAD?

The most recent GDP figures seem to echo what Fed Chairman Greenspan said in February in his semiannual Monetary Policy Report to the Congress. For brevity’s sake I will condense his opinion about the U.S. economy into three words: All is well. I could offer a fact-filled and scathing rebuttal, but why be quarrelsome? Instead I would like to answer this simple question: “How quickly can a very large industrial economy go from good to bad?” My case-in-point, Japan, is recent indeed -- up through the business news as of February 16, 2005. All the headlines and subheads come from BBC News reports. Please note the dates.

Mind you, the reports of growth and optimism just one year ago in Japan looked convincing indeed. The Japanese economy and stock market had been through bouts of deflation and decline since 1990; the Nikkei index saw rallies of 48%, 34%, 56% and 62% before hitting a 20-year low in April 2003. Japan’s central bankers tried (and keep trying) every monetary policy trick in the book. And when those policies appeared to be working, they spoke with just as much confidence as Mr. Greenspan has.

Policymakers cannot come to your rescue -- no one can take better care of your financial future than you can. Investors who do not give in to false hope can take advantage of real opportunities.

SELL YOUR GOLD NUGGETS WHOLE, RATHER THAN MELTING THEM

Natural gold nuggets are collector’s items. You will get more per ounce selling them whole. Today refined gold trades at about $445 per ounce (near a 15-year high); even the smaller gold nuggets sell for about $560 per ounce. Bigger nuggets are harder to find and can fetch more than $1,000 per ounce. Prospectors find only a small percentage of the world’s gold in the form of nuggets, or bits of placer gold. “Placer” gold deposits are those that accumulate in the sediments of stream beds. The smallest nuggets, called screen gold, weigh less than half a pennyweight, or three-quarters of a gram.

Gold is measured using troy weights (as opposed to the more familiar avoirdupois weights): 24 grains make a pennyweight, and 20 pennyweights make a 31.1-gram troy ounce. Dealers say that a gold nugget of 1 troy ounce is about as rare as a 5-carat diamond. Collectors and jewelers buy nuggets as precious gemstones, favoring specimens with particularly nice shapes or colors. Most nuggets are between 85% and 95% pure gold, but the remainder can be one of several kinds of minerals. Nuggets in laterite can be either reddish or black; nuggets in quartz appear cloaked with white. Any nuggets not deemed to be “jewelry-grade” get melted down and sold as pure gold.

REAGAN’S REAL REVOLUTION

Ronald Reagan may have called himself a conservative. But his real revolution lay in redefining conservatism as an activist, world-improving creed. There were four key elements to Reaganomics. Restrict the money supply in order to slow inflation (admirably carried out by Paul Volcker at the Fed). Cut taxes (a 25% across-the-board tax cut was enacted in 1981). Balance the budget by controlling domestic spending. (A complete failure ... deficits grew larger than ever.) And reduce government regulation. (Ditto.)

As you can see, the first two objectives were, more or less, achieved. They produced, more or less, what Milton Friedman had expected. But neither was an activist measure. Both merely undid some of the worst damage done by previous office-holders. Lyndon Johnson, Richard Nixon, and Jimmy Carter had made a mess of the economy. Ronald Reagan and Paul Volcker helped clean it up. But without action on the other two objections, the clean-up lacked the necessary suds and elbow grease. The dirt and clutter were mostly left alone, while new trash was heaped on.

The big cut in taxes gave people more money to spend. Since government spending was not cut, the result was more net spending in the economy. This was equivalent to an increase in the money supply – or an increase in demand. Consumers began a buying spree, while government borrowed the money to fund the deficit. Looked at from a macro-economic perspective, Americans had no more money to spend after Reagan took office than they had when he was in California. But they thought they had more. They had more money in their pockets. More money to spend.

Few people asked, “Where did it come from?” If they had thought about it, they would have realized that, collectively, they were merely going further into debt in order to increase their current standards of living. If they had reflected on it deeply, they would have realized that they were running up bills that future generations would have to pay – they were spending money that their children and grandchildren had not earned yet. Hardly anyone thought about it then ... or since.

Ronald Reagan’s deficits have been upstaged by those George Bush. And the Reagan boom has evolved into the Bush boom. But interest rates were high in 1981, and coming down. Stocks were low, and going up. It is nearly a quarter of a century later than when Ronald Reagan took office. We do not know what will happen, but surely the sun must be sinking and the questions must be rising...

AMERICA SMELLS THE COFFEE

Tipping points are a great concept, but virtually impossible to identify ahead of time – let alone when they are occurring. It is only with the great luxury of hindsight that we can look back and know that the proverbial bell has rung. In my view, March 16, 2005 could end up in the running as a possible tipping point for America. Suddenly, the U.S. has taken on a very different aura in an increasingly unbalanced world: The confluence of a record current account deficit, a disaster from General Motors, and yet another new high for oil prices all speak of an increasingly precarious role for the global hegemon. World financial markets have barely begun to sniff that out.

The current account deficit probably says it all. As I have noted ad nauseum, it is an outgrowth of America’s biggest problem – an unprecedented shortfall of national saving. America now requires an average of $2.9 billion of capital inflows each and every business day to keep the magic going. And when GM throws in the towel on earnings (again) and its bonds trade at near-junk status, maybe there is more to this story than a quick flicker on the screen. The demise of U.S. manufacturing is now taken as a given and most simply dismiss GM’s latest travails as a non-event.

I think there is a deeper meaning to all this – especially coming on a day when the current-account deficit was reported to have taken yet another ominous leap into uncharted territory. Not surprisingly, the U.S. trade deficit on goods accounted for fully 98% of America’s total current account deficit in 4Q04. That is right, a once proud Smokestack America has borne the brunt of the unprecedented U.S. saving shortfall. And just as GM led the charge in the heyday of America’s manufacturing prowess, it is now on the “bleeding edge” of its darker days. Coincidence? I doubt it. It may well be that the accelerated erosion of America’s manufacturing base in recent years is the most painful outgrowth of a record U.S. saving shortfall. Washington, of course, wants to pin the blame on unfair foreign competition. Instead, it ought to take a look in the mirror: It is the budget deficit, of course, that has been crucial in pushing national saving to record lows in recent years.

March 16 was also a day of record oil prices. No, this is not just America’s problem. But in a falling-dollar climate, other nations enjoy a cushion from this blow as their currencies rise. Not so in the US as the current account deficit keeps the greenback under pressure. The press, of course, is filled with commentary about how oil no longer matters. All I can say is – been there, done that. My experience tells me that this is precisely the rhetoric we always hear in the midst of an oil shock. And shock it is: In real terms, $56 oil represents more than a quadrupling from the lows of late 1998 – putting this price spike very much on a par with those devastating blows of the 1970s. The fact that consumers have not caved yet does not mean the Holy Grail of a new immunity to rising oil prices has been discovered. It could mean that something else has temporarily deferred the endgame.

That “something else”, in my view, goes right back to America’s biggest hole – the current account deficit and the capital inflows from abroad that keep funding it. The Washington spin is that foreigners cannot get enough of dollar-denominated assets and the returns they offer in an otherwise return-starved world. Don’t kid yourself. This rush of foreign capital is not about private investors plunging back into U.S. assets. It is a conscious policy move on the part of foreign central banks. The U.S. Treasury data do not accurately reflect the obvious – an extraordinary build-up of dollar-denominated official foreign exchange reserves held by the world’s monetary authorities. The resulting subsidy to US interest rates – and the asset-driven consumption that engenders – goes a long way in cushioning the blows of stagnant real wages and surging oil prices that might have otherwise clobbered the American consumer.

But the message from overseas is that this game is just about over. One by one, Asian central banks – America’s financiers at the margin – have dropped the not-so-subtle hint that they are saturated with dollar-denominated assets. From Korea and Japan to China and India – not to dismiss Malaysia, Hong Kong, and Singapore – there is a growing protest to massive dollar overweights in official reserve portfolios.

In the end, of course, there is far more to this story than economics. As I noted recently, history is replete with examples of leadership tests that pit a nation’s military prowess against its economic base. Yale historian Paul Kennedy has long argued that great powers typically fail when military reach outstrips a nation’s economic strength. In that vein, there is little doubt that America is extending its reach. Wars in Afghanistan and Iraq were the opening salvos. In Paul Kennedy’s historical framework, America is extending its reach at precisely the moment when its economic power base is weakening -- a classic warning sign of the fall of a Great Power. Was March 16, 2005 America’s tipping point? Only time will tell. The optimist can hope that it was a wake-up call for a saving-short U.S. economy to put its house back in order. It is time for America to smell the coffee.