Finance Digest for Week of March 21, 2005

BOOMING BROKER FINANCE AND MARKET TOPS

Four of the major Wall Street securities firms just reported blockbuster earnings. Not only are all the securities firms doing exceptionally well, virtually all businesses of each of the brokers are doing exceptionally. This is true by product type as much as it is by region globally. I would argue that there are today no better indicators of broad-based liquidity excess and credit availability than those provided by the operating success of Wall Street. It is worth digging a little deeper.

The degree of recent Wall Street ballooning is demonstrated more clearly by comparing combined first quarter 2005 results back two years to comparable 2003. Combined gross revenues were up 54%, while total combined net revenues were up 44% over two years. How much have positions mushroomed over the past two years to generate such incredible growth? Combining the most recent data available from Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch, I come up with combined total assets of approximately $2.60 trillion. This is up 24% from comparable year-ago total assets, with a two-year gain of 44%.

Listening to the Wall Street earnings conference calls, I clearly sensed a newfound degree of confidence – the type that develops over time after making more money than one could ever have imagined; making it in so many ways in so many diverse markets; and after overcoming myriad setbacks and a few near panics. After all, if things go wrong in one market, there are all these other hot markets. Today’s exuberance is rational but misguided. These diverse markets could not all falter concurrently, could they?

As always, overly abundant liquidity and acute asset inflation create genius and fearlessness, and there is more of all of the above today than ever. Everything is working for Wall Street – absolutely everything! Opportunities seem endless and everyone is energized. We have reached The Pinnacle of Wall Street Finance. Endless credit and liquidity has fueled booms in virtually all asset classes everywhere – 24/7 around the globe. It is too easy today to forget that there are critical market dynamics at play; that market tops sow the seeds of their own demise. We all have learned that a market top is established when “everyone” has finally bought in – literally and figuratively – and there is no one else left to buy.

Not as straightforward or commonly appreciated are the commanding liquidity dynamics that fuel unsustainable asset inflation and resulting distortions. This is true for individual markets tops and can be true as well for entire financial systems. When a credit system as a whole succumbs to speculative market dynamics, liquidity effects and distortions become dangerously systemic. Such dynamics played crucial roles during historic boom and bust periods such as the “Roaring Twenties”, and to a lesser extent late-1980’s Japan. In a definitive demonstration of the power of late-cycle market dynamics, the 1928/29 “blow-off” of margin lending and resulting asset price spikes assured imminent systemic crisis. Highly speculative and inflated asset markets, along with an increasingly maladjusted economy, required uninterrupted and ever increasing amounts of credit and liquidity. There was no way out.

The inevitable (if not easily predictable) market reversal set in motion a liquidation of positions and a self-feeding collapse in speculative leverage. Not only had the boom created its own source of finance, the resulting asset inflation and liquidity effects fostered profound distortions to the nature of spending and investing, hence the underlying structure of the real economy. When the marginal source of liquidity – stock market leveraging – reversed, the financial and economic spheres’ underlying vulnerability quickly manifested. Perceptions and spending patterns changed overnight. To this day, there are many (notably, Dr. Bernanke and the “Friedmanites”) who believe the underlying economic fundamentals of the 1920s were sound. What they fail to grasp about late-1920’s systemic fragility, they fail to appreciate today.

Today, Wall Street “structured finance” is the speculative bubble – the marginal source of liquidity for both the financial and economic spheres. It has evolved to commandeer our entire credit system and others’. And never has the structure of a credit system been more conducive to bubble dynamics. Financial engineering provides the capability to craft any type of security or any instrument to satisfy the demand of would be speculators, investors, or borrowers. It is really a case of the harder Wall Street works the greater the demand for their services and products. The problem today – too similar to 1929 – is that the larger the number and the greater degree that markets domestically and internationally succumb to asset inflation dynamics, the greater the amount of credit and liquidity required for sustaining the bubble.

Ask Wall Street and they would enthusiastically avouch that they are quite up to the task – more than able and willing. And, for now, that may indeed be the case. Importantly, however, we have now reached the point – with spiking crude, California home values, and the current account deficit – that the system has developed a powerful inflationary bias. Sustaining the Wall Street bubble has become immediately destabilizing and problematic. While Wall Street is a huge beneficiary of the inflationary boom, a few of the early losers (to inflation’s wealth transfer) are beginning to surface. The airlines and American auto manufactures come to mind.

I do think we have reached the “pinnacle”. Inflationary forces – most powerfully manifesting in global asset and commodities markets – are reaching the point that risks a significant rise in market yields. The wheels of global credit are spinning much too fast. And this dynamic appears poised to risk havoc upon the highly leveraged and those exposed to interest rate derivatives. Sophisticated models, used in exuberant excess, were not developed to anticipate the historic credit bubble blow-off they have worked to incite. The unfolding environment will surely provide the utmost challenge for our analytical capacities.

Investment banks are too dependent on hedge funds.

Hedge funds have never been short of critics. They have been accused of overcharging, underperforming, destabilizing the financial system and ripping off investors. Still, there is one charge that might have some substance to it: An unhealthy relationship is emerging between hedge funds and investment banks. Indeed, the greatest risk posed by the funds may be to the banking industry.

Earlier this month, New York-based Credit Suisse First Boston examined how much money the world’s hedge funds were paying to their investment bankers. It came up with an estimated total of $25 billion for 2004 – about $19 billion of that came from sales and trading, and the rest from prime brokerage, which consists of providing loans and facilities to hedge funds. That represents more than an eighth of the investment-banking industry’s total revenue pool. Although huge, that is not an unrealistic figure.

It is possible to disagree on exactly how much the banks are making from hedge funds. Still, it is a lot of money. That helps clear up one mystery. We now know why investment-banking profits have been soaring in the past few years, even though mergers and acquisitions have been flat for most of that time, and equity markets have been moribund. All those new fees from hedge funds have been filling their coffers. So is there a dangerous codependency emerging between hedge funds and investment banks? “In any client relationship there is going to be an issue of conflicts of interest,” said Marc Rubinstein, a London-based CSFB analyst, in a telephone interview. “The key lesson the banks have learnt over time is that they have to make sure they are managing those conflicts.”

There are two main points to draw from the relationship between the banks and the funds. First, hedge funds are paying their bankers an extraordinary amount of money. Hedge funds may have created a way of doing business that is too expensive to be viable over time. Next, the banks are becoming dependent on the funds. When hedge funds submit to those kinds of fees, how many bankers will ask tough questions? About 9,000 hedge funds have been launched. The law of averages suggests some of them will go bust and lose a lot of money. It is just a matter of time before one of the main investment banks is caught up in the mess. When it happens, it will not be pretty.

WHAT? THEY NEVER HEARD OF WORLDCOM?

Bernard J. Ebbers, founder of WorldCom, got to add felon to his already colorful curriculum vitae. Maurice R. Greenberg, dictator in chief at American International Group, the global insurance giant, was toppled after almost 40 years at his post. The Federal Reserve told Citigroup it could not make any major acquisitions until it cleaned up its compliance act. And General Motors laid a big, scary earnings egg. Isn’t it nice to know these incidents are anomalies and that most American companies are chugging along, reporting good solid earnings?

Sure would be. But contrary to popular belief, the quality of corporate earnings is on the slide again and, as a result, Richard Bernstein, chief U.S. strategist at Merrill Lynch, is advising investors to tread carefully. “There is an impression that the quality of earnings has improved dramatically,” he said. “That is true relative to the worst levels of post-bubble reporting, but relative to history, the absolute quality of earnings is quite poor.” And getting poorer.

Mr. Bernstein reaches this depressing conclusion by analyzing the difference between the earnings that S&P 500 companies have reported under generally accepted accounting principles and operating earnings, the figures companies typically trumpet because they do not include write-offs and other unusual items. The difference between the two figures, Mr. Bernstein says, is the G.A.A.P. gap. And it is widening. In the most recent period – Q4 2004 – the gap was 13.7%. I.e., operating earnings were on average 13.7% higher than reported earnings. While that figure is well down from the 40% gap reached in 2002, it is much higher than the long-term, pre-bubble average of 6.7%. The result: while stock valuations may not be so high as they were before the bubble burst, the quality of earnings appears to be worse.

Mr. Bernstein said that he thought the recent downturn in earnings quality began, not surprisingly, a couple of quarters ago, when the profit surge started to subside. “If times are good, companies are not under pressure to keep their growth profile up,” he said. “In tough times, when you get a cyclical company that has been coined by the Street as a growth company, it feels pressure to keep up that profile.” That is when the earnings games usually begin. By focusing on operating earnings, rather than on more stringent reported figures, companies try to steer investors away from mistakes such as asset write-downs or restructuring charges. But these factors reflect bad choices by managers – such as overpriced acquisitions – and should definitely not be excluded from investors’ analyses.

“The reason you have G.A.A.P. is so investors have consistent clear information,” Mr. Bernstein said. “The U.S. has always prided itself on having the most transparent financial markets. But over the past 5 to 10 years, the U.S. market has become more opaque, and foreign markets have become more transparent. That has huge implications for the economy as a whole and for the cost of capital.”

THE U.S. DOLLAR’S DAYS AS THE WORLD’S RESERVE CURRENCY ARE NUMBERED

In the 20th Century, the U.S. dollar became the world’s reserve currency because it was the coin of the world’s leading economy. In the “Bizzaro” 21st Century economy, this causality has reversed. Today, the primary reason the U.S. remains the world’s leading economy is because the dollar still serves as the reserve currency. However, if market fundamentals can ever manage to reassert themselves, this is a reality that can, and indeed must, change.

In the past, foreign citizens accumulated U.S. dollars so they could purchase American-made goods. Today, foreign central banks accumulate dollars so that Americans can purchase foreign-made goods. In the past, profits from her exports allowed America to become the world’s greatest lender. Today, in order to fund her gargantuan trade deficit, America has become the world’s greatest borrower. The dollar’s reserve currency status allows “rich” Americans to continuously borrow what “poor” foreigners save, and consume what foreigners produce. Without such status, America’s consumption would be limited by its own production, and its borrowing confined by its domestic savings. In such a world, Americans would have a standard of living far lower than the one currently enjoyed.

The main reason that the U.S. dollar is still the world’s reserve currency is that few understand how completely the fabric of the American economy has been rewoven. In fact, the U.S. economy functions in a manner which would be completely impossible were it subject to normal market forces. However, by issuing the world’s reserve currency, it has been immune to these forces, and thus its economy has evolved in a most unnatural way. Recent trial balloons launched by various Asian central banks, concerning diversifying their foreign exchange reserves; indicate that the dollar’s reserve currency status may already be at risk. Once that status is lost, the process of returning to economic viability will be quite painful, and will involve substantial austerity from both the U.S. government and its citizens. Whether America is up to the task still remains to be seen, and though I am skeptical, I nevertheless remain hopeful.

A MORTGAGE IS FOREVER

It seems that De Beers has decided they have neglected a big chunk of the diamond market, that chunk being a woman’s right hand. According to the new campaign, it makes perfect sense for today’s accomplished woman to reward herself by balancing the expensive piece of carbon on her left hand with an equally expensive one on her right. Thanks to De Beers, spending thousands on a rock is not frivolous, or even extraordinary. It is merely a romantic gesture. Buying diamonds seems so normal because De Beers made it so. Prior to their 1939 advertising campaign, rubies, opals, sapphires and even turquoise were the traditional stones for engagement rings. But thanks to a De Beers marketing blitzkrieg, which included persuading movie studios to include some serious diamond fawning in their scripts, diamonds and romance soon became inseparable. What had been a slide in diamond sales, reversed by 1941, and according to diamond experts, jumped 55% over the next three years. In 1947, a copywriter at N.W. Ayer & Son came up with the slogan “A diamond is forever”, a phrase that is not only used to this day, but also was crowned the most recognized phrase of the 20th Century by Advertising Age in 1999.

The other seemingly amazing thing about the De Beers print ads is that they do not mention De Beers by name. Only diamonds in general are hawked. That is because De Beers has dominated diamond mining and trading for most of the last 100 years. As recently as 1998, the company is said to have controlled 75% of the planet’s supply of rough stones. Even today, with the advent of competitors mining outside of De Beers-controlled Africa, the company’s share is put around 55%. We Americans, of course, would never let one company so dominate a market that it set prices and business practices for an entire industry – unless that company could help us remodel our kitchens.

And that is why we love Fannie Mae. The company not only buys more than one out every four residential mortgages originated, its mortgage buying and re-packaging greases the cogs of mortgage finance, making the removal of equity from our homes as easy as turning off a PBS pledge drive featuring the Three Tenors singing polka tunes. With help from Freddie Mac, the dynamic duo bought 45% of all mortgages written last year. And get this: that market share is down from almost 60% in 2003. Traditionally, neither homeowners nor Congressmen have been alarmed by Fannie’s oversized presence in the mortgage business. That may be because Fannie has its own clever marketing slogan. Certainly the phrase, “We’re in the American Dream business” makes them seem warm, and fuzzy and selfless – words seldom associated with the term “oligopoly”.

Fannie and Freddie have lost market shares recently, in part, because the mortgage industry is jumping on sub-prime borrowers like a dog after a mishandled steak. Perhaps taking a cue from De Beers, the mortgage industry has been expanding its market to include any borrower who has a right hand. According to SourceMedia, sub-prime originations jumped 56% to $607 billion last year, thereby tripling the sub-prime share of the overall mortgage market in just two years. The only problem with sub-prime lending, of course, is that the borrowers are, well, sub-prime. Jack Harris, an economist with Texas A&M’s Real Estate Center, figures that the government’s enthusiasm for an ever- expanding homeownership rate may have snared “a lot of people that probably aren’t ready for homeownership.”

Borrowers should go for broke.

As indebtedness in its many insidious forms mounts globally toward an epochal climax, prudence begs the question of why lenders are still frantic to put even more unearned dollars in our sweaty little hands. Zero percent auto loans are everywhere; mortgage money remains easy to come by, even after a 150-basis-point tightening of administered rates; and anyone who is not deceased or in prison can borrow for 3% or less by writing a check on a revolving charge account. Why are lenders making it so painless for us to get in even deeper over our heads? Don’t they know that it can only end badly for borrowers and creditors alike? The simple answer is that their greed has long since exceeded their good sense. Since it costs big banks and retailers almost nothing to raise funds for consumer loans, and because the alchemy of securitized debt has created a practically unlimited supply of lendable dollars, why not just go for it? And so they have, with the laudable goal of gaining market share, but with a relentless zeal that in recent years has savaged the moral and ethical boundaries of lending.

And yet, in a legalistic sense, lenders appear to be acting rationally, if not prudently, owing to certain provisions in a bankruptcy bill that recently was enacted into law after an eight-year struggle in Congress. I followed the bill avidly each step of the way, since it represents the one instance in my adult life where I have been on the same side of the political fence as the likes of Bill Clinton, Ted Kennedy and Charles Schumer, all of whom opposed the measure vehemently. Not surprisingly, the bankruptcy overhaul has the enthusiastic support of credit card companies, banks and retailers. Also not surprisingly, the legislation remained moribund under Clinton, freighted with riders and amendments that kept it bottled up in committee.

In practice, the bill will make it far more difficult for an individual to walk away from debt by declaring personal bankruptcy through a Chapter 7 filing. Under the legislation, those able to pay off some of their debts would have to file under Chapter 13, which allows the court to set up a partial repayment plan. Before, debtors who got in over their heads could wipe the slate clean and start a new life, financially speaking. But under the new laws, some debts could weigh on borrowers for years, perhaps until they die; and then, presumably, the burden would shift to their survivors. Make no mistake; the new law will cause some opportunistic borrowers to think twice before attempting to commit credit card kamikaze. But it will also wreck the lives of many otherwise financially responsible individuals who get deeply in hock for reasons beyond their control.

Ominously, the new bankruptcy law could destroy the lives of tens of million of Americans, whose net worth – and borrowing power – is tied to the value of their homes. What if property values were to decline in the U.S., triggering a severe recession and leaving a substantial fraction of the nation’s homeowners underwater on their mortgages? Could it actually happen? Renowned money manager John Templeton thinks so: “When home prices do start down, they will fall remarkably far,” Templeton said in a magazine interview. “In Japan, home prices are down to less than half what they were at the stock market peak. A property price decline of as little as 20% would put a lot of people in bankruptcy.”

Now that the bankruptcy bill has become law, those who are merely decimated by the coming credit collapse may find themselves in far worse shape than profligate borrowers who literally went for broke. If Templeton is right and millions of mortgagees are reduced to subsistence living, lynch mobs will be demanding the repeal of these new laws five years from now. Until then, the lenders, having legally hedged their bets, will probably think they are sitting pretty if the economy should implode. Any comfort they might take in this belief is delusional, however; for there can be no winners or losers in a deflationary collapse, only survivors.

Bubble Ground Zero

My wife was looking through the real estate section of the local paper last night. She reckons that our house has appreciated somewhere between 33% and as much as 50%(!) over the past year or so. Steve Sjuggerud told me that our town is in the top ten in the U.S. for new home price appreciation. It is Bubble Town, USA, I guess some would say. Funny, though ... I still cut the grass, and pay the bills and fetch the mail down at the end of the road and my wife still has “big plans” for spending more money on our ever-changing, ever-growing landscaping.

But, well, nothing inside our house has changed to reflect this new “wealth”. I am not richer in any meaningful way as a result of this price appreciation of homes in my area. And if I sold my house now, I would only be able to put all this new wealth into something just about like I am living in now, no worse, but no bigger or better. So ... has the housing gone up, or has the currency gone down? It feels a lot more like the latter here at Bubble Ground Zero.

Experience plus my research into real estate has taught me that a house is not really much of an investment, contrary to what everybody will tell you. It does not pay me a penny in rent or interest or income of any kind. I cannot spend it without going into more debt. With investments, you are supposed to earn interest, not pay it! And if I sell my house, I have a choice to make: either use the proceeds for more real estate, or pay a big capital gains tax. My only return is the benefit of living in it. That is it. I would rather take my money out of this house and put it in a pile of gold coins, a few cheap stocks, maybe some nice arbitrage situations ... and an apartment in the city. But if I tried to do that, my wife would never hear of it. So, for now at least, I am stuck inside the bubble.

Appearance vs. Reality

On March 22, thousands of angry New Yorkers gathered outside the main office of the NY Daily News headquarters, demanding the $100,000 prize money each person thought they had won in the paper’s Saturday “Scratch n’ Match” game. Turns out the Jackpot was a Jack-Not, after the agency running the contest revealed a “printing mistake” caused an untold number of cards to hold the winning combination. Somehow, the agency’s public apology for the “inconvenient error” was not enough to Scratch N’ Patch-up things with the infuriated crowd. And really, who could blame them? In general, people want to believe what they see – especially when seeing means a large cash reward. Which brings us to the March 2005 Elliott Wave Financial Forecast’s Special Section on the U.S. Housing market. It just so happens, a similar case of appearance verses – well – NON-realty occurred over the January 2005 drop in home sales.

Here is the gist: The importance of the reversal is “how the National Association of Realtors delivered the news. When its long-standing methodology for recording total monthly home sales showed a massive January decline, the association dramatically revised its graph back through 1988 to include for-sale-by-owner data.” The revised decline as presented by the Realtors is slight and un-alarming, while the decline as it would have looked in the original data is shockingly steep. Everyone who saw the modified chart was given a false impression of the strength in the housing market. However, the error here was actually quite convenient:

“A similar thing happened with the S&P price/earnings ratio and savings numbers that contradicted bullish sensibilities during the bull market in stocks. Historically, unprecedented extremes that clashed too harshly with the prevailing optimism have been smoothed out or explained away.” The way the mainstream experts see it, the U.S. housing market is the win-winning ticket to striking it rich.

Trading places: real estate instead of dot-coms.

Real estate-crazed Americans have started behaving in ways that eerily recall the stock market obsession of the late 1990’s. In Naples, Florida, some houses have been bought twice in a single day, an early-21st-century version of day trading. Buying stocks on margin has morphed into buying homes with no money down. The over-the-top parties of Internet start-ups have been replaced by flashy gatherings where developers pitch condos to eager buyers. Five years ago, CNBC sometimes seemed like a backdrop to daily American life. Its cheery analysis of the stock market played in offices, in barbershops, even in some bars. Today, Dude Room, Toolbelt Diva and other home-improvement shows are the addictive fare that CNBC’s exuberant stock shows once were.

“It just seems like everyone is doing it,” Laurie Romano, a 26-year-old self-described real estate investor, said with a giggle as she explained why she was attending an open house this month for the Nexus, a 56-unit building going up in Brooklyn’s chic Dumbo neighborhood. She and her fiancé, a dentist, had already put down a deposit on a Manhattan condo earlier in the week and had come to look at another at the Nexus.

Nobody can know whether the housing boom of the last decade will end as the dot-com frenzy did. But the parallels are raising alarms among many economists, even those who acknowledge that there are important differences between homes and stocks that significantly reduce the chances of another meltdown. For one thing, houses are not just paper wealth: you can live in them. Still, perhaps the most troubling similarity, some analysts say, is the claim that the rules have somehow changed. In an echo of the blasé attitude that “new economy” investors took toward unprofitable companies, the growing ranks of real estate investors are buying houses they never expect to be able to rent at a profit. Instead, they think the prices of houses will just keep rising.

Adding to the parallels between stocks and housing, some of the doomsayers from the 1990’s have returned with new warnings. “We’re going through something very similar in real estate that we did with stocks,” said Robert J. Shiller – a professor of economics at Yale, whose Irrational Exuberance appeared just a few months before technology stocks began their slide. “It’s driven by the same forces: that investments can’t go bad; that it has the potential to make you rich; that you’ll regret it if you don’t do it; that it looks expensive but is really not.” A new edition of Mr. Shiller’s book will be published next month. The cover promises an “analysis of the worldwide real estate bubble and its aftermath.”

Premonitions of a bubble on the verge of popping do not ruffle those who are bullish on real estate. In Miami, Ron Shuffield, president of Esslinger-Wooten-Maxwell Realtors, predicted that a limited supply of land coupled with demand from baby boomers and foreigners would prolong the boom indefinitely. “South Florida,” he said, “is working off of a totally new economic model than any of us have ever experienced in the past.” The can’t-miss aura of real estate has also helped nudge many families to invest more of their personal wealth in real estate by buying more expensive homes and taking on riskier mortgages – much as ordinary workers used their 401(k) plans to bet on company stocks.

Even at Harvard Business School, where students have traditionally gravitated to careers in investment banking and corporate marketing, real estate is suddenly hot. About 25 graduates have taken real estate jobs in each of the last two years, up from only six in 2001. It is not quite the gold rush of 2000, when about 200 Harvard M.B.A. graduates flocked to technology companies. But even if they are not working in real estate, some of those graduates are now investing in it.

In addition to the flood of investors, the parallels between real estate and stocks extend into mainstream culture. Real estate bulletin boards and blogs like Curbed.com and Real Estate Pimp have taken the place of financial chat rooms like Tokyo Joe’s. ABC has a breakout hit in Extreme Makeover: Home Edition, and Home and Garden Television, a once-obscure cable channel, now draws an average of 827,000 viewers in prime time. The seemingly inevitable how-to guide inspired by Donald Trump – Trump Strategies for Real Estate by George Ross, one of Mr. Trump’s assistants on his hit show The Apprentice – is a strong seller. At the Nexus party in Brooklyn, Steve Nguyen, Ms. Romano’s fiancé, said he was heeding Mr. Trump’s advice. “He says buy, buy, buy,” Dr. Nguyen said.

Another lingering echo of the stock market boom is the role of the Federal Reserve, the nation’s central bank. Alan Greenspan, the Fed chairman, famously asked aloud in 1996 whether “irrational exuberance” was driving the stock market, but then backed off from second-guessing investors. This month, Mr. Greenspan made some comments about housing that offered a faint echo of his 1996 musings. Mr. Greenspan said in a speech in New York that real estate speculation had shown a “marked increase”. Nevertheless, he said he did not expect a “destabilizing” drop in prices, in part because home prices across the country have never fallen significantly.

But by one measure, houses in at least a few metropolitan areas are as expensive as telecommunications stocks were in 1999, relative to their underlying value. The average house in San Jose, California, costs 35 times what it would cost to rent for a year, according to Economy.com. In New York and West Palm Beach, this ratio – a rough equivalent of the price-earnings ratio for stocks – is almost 25. In March 2000, the PE ratio of the S&P 500 – the combined price of the stocks, divided by their profits per share – peaked around 32, and it was briefly even higher for telecommunications stocks. The S&P’s P.E. ratio has since fallen to around 20.

Still, no matter how expensive real estate might be, it continues to provide many owners a return worth boasting about. Holly Peterson, who is writing a novel about the idiosyncrasies of New York’s rich, said that at dinner parties in Manhattan, she frequently hears complaints about high home prices, followed by claims of quick profits. Five years ago, she said, friends at parties were crowing about “making millions of dollars on paper with $25,000 and $50,000 investments.” But “most of those people,” she added, “got wiped out.”

Fannie Mae shrinks loan portfolio.

Mortgage giant Fannie Mae continues to shrink its loan portfolio at a robust clip and trimmed it by nearly 1.8% last month, a report released Monday by the company shows. Fannie Mae, the largest U.S. buyer of home mortgages, recently was ordered by the SEC to restate its earnings back to 2001, a correction that could reach an estimated $11 billion. Another federal agency has given the government-sponsored company until Sept. 30 to boost its capital cushion against risk by 30%, or some $5 billion. To make up the shortfall, Fannie Mae has recently reduced its portfolio of mortgage loans, raised fresh capital by issuing some $5 billion in preferred stock and slashed its first-quarter dividend payout by half, to 26 cents a share. The company was a darling of Wall Street, marked by spectacular growth in recent years. Its accounting crisis became known last September, as regulators accused it of serious bookkeeping problems and manipulation of earnings to meet Wall Street targets.

Mortgage rates rise for 6th straight week.

Interest rates on 30-year fixed mortgages topped 6% this week for the first time since July. Rates have been rising for six straight weeks and, at an average of 6.01%, are up nearly a half a percentage point since early February. There are some signs that heftier rates are starting to have an impact, but there is little evidence they have taken a big bite out of the housing market. The Commerce Department said new home sales jumped 9.4% in February, the biggest monthly gain in more than four years. The median sales price for a new home was $230,700, up from $210,400 in January. New home sales this year are running slightly below the average of 2004, a record-setting year. Still, builders and lenders are upbeat.

WRONG-WAY GREENSPAN STRIKES AGAIN

Say what you want about Alan Greenspan (and I will in a second), but the guy is really good at one thing: apologizing. Or rather, he is good at appearing to apologize without ever really saying he is sorry. Or, that he made a mistake. Or, goofed. Or, for that matter, any variation of the human feeling of remorse that goes with so often being wrong. I am wondering, if Greenspan accidentally knocked a cup of coffee out of someone’s hand in the hallway of the Federal Reserve would he say “sorry”, or just blame the mishap on events beyond his control. “The slant of this building, together with the spin of the earth, made me miscalculate the clearance I needed,” might be the way he would put it.

I mention this because Greenspan is about to screw up again. Today, for the 7th time since last June, he will convince his rubber stamp colleagues at the Federal Reserve to raise interest rates. It will probably be just a quarter-point – the measured response Greenspan has been sticking with – but if the guy really wants borrowing costs to rise he will spring for a half-point. Don’t count on that, Greenspan likes his mistakes in manageable portions. These rate hikes are really a joke anyway. Even as he is pretending to tighten credit through these rate increases, the Fed has actually been allowing the nation’s money supply to grow rapidly at more than 5% over the last year. If all that money is available, it is going to be put to use – creating the next bubble.

Recent documents from the Fed show that Greenspan and his colleagues were discussing the bubble incessantly in private. But Greenspan never did anything – like raising interest rates or margin requirements – to stop the rampant speculation. He did, however, remember to protect his reputation by publicly uttering some vague rhetoric about irrational exuberance. Again, no apology necessary. My theory is that the Fed chairman is so good at avoiding apologies because he has had so much practice. What will Greenspan be non-apologizing for next? It might have been his backing of private Social Security accounts, except nobody is really sure of his position. Or it could be his thumbs up on the idea of a consumption tax, although here too his position seems too vague to be harmful. The winner, I think, will be the housing bubble. If all these rate hikes finally take hold over a short period of time they will deflate home prices just in time for Greenspan’s Farewell Apology.

CHINA GOES FOR GROWTH

Forget about the China slowdown. That was the distinct message I took away from my annual trek to the China Development Forum in Beijing. The basic message from China’s senior economic and financial decision makers is that the medicine has worked – that last year’s combination of so-called administrative measures and macro adjustments was successful in tempering the excesses of an overheated Chinese economy. In the words of Premier Wen Jiabao in his national “work report” delivered in early March, these measures “… worked to solve prominent problems threatening steady and rapid economic development.” Contrast that with his comments a year ago when he stressed that “overheating is my biggest concern.” As is always the case in Chinese economic policy, the Premier has the first and final word – the rest of the economic team very much marches to the same beat. That was certainly the case at this year’s China Development Forum.

This does not mean that Chinese economic policy is going from restraint back to stimulus. Both Premier Wen and Minister Ma were quick to stress that the efforts of macro control are still in a preliminary stage. Bottlenecks are still viewed as a problem, as are, in Ma Kai’s words, other “irrational elements of economic structure”. But the basic message I take away from all of this is that the biggest part of the push toward restraint in China is now over. The government is much more satisfied with the state of the economy today than it was a year ago.

I think there is a very important lesson in all of this. China is a huge growth machine, but it is growth with a big asterisk. Rapid GDP growth of at least 7% per annum is necessary to compensate for the headcount reductions that arise from ongoing reforms of state-owned enterprises – an elimination of some 8–10 million jobs each year. As such, sustained rapid growth is vital for stability of the Chinese system – stability in economic, social, and even political terms.

For world financial markets, the China call is obviously very important. Those banking on a prompt policy response from Beijing to the surprisingly strong Chinese data for early 2005 are likely to be disappointed. At a minimum, the authorities seem willing to let the economy run for a while before they see how the data shake out in the months ahead. Barring a growth accident elsewhere around the world, that suggests little relief on the demand side of energy or other commodity markets – further fueling inflationary expectations, central bank tightening, and a general back-up in the bond market.

As always, the highlight of this conference is a private session with the Premier in the Great Hall of the People. Not surprisingly, this year’s discussions were framed around the hot topic du jour – Chinese currency policy. Our group of outside experts laid out both sides of the debate to Wen Jiabao. He said nothing to tip his hand and simply reiterated that China continues to actively study the issue and is “now trying to select both the proper plan and timing for RMB reform.” Here, as well, I suspect it will all boil down to stability. At the end of the meeting, the Premier shook his head and exclaimed, “I cannot sleep well at night with this issue of the RMB.” He then glanced at his watch and politely excused himself.

Boom felt across globe.

Each month, China needs to build the equivalent of a Houston or a Philadelphia just to keep up with population growth. Each year, Shanghai – about the geographic size of the city of San Diego but with 10 times the population – constructs or renovates 200 million square feet of building space, about the same amount as all the office space in New Jersey. To fuel that boom, and to feed its hungry factories, China uses more than 40% of the world’s annual output of cement, one-third of its iron ore, one-quarter of its lead and steel, and more than one-fifth of its copper, aluminum and zinc. The country’s unprecedented demand for raw materials has had far-reaching effects, helping drive up the price of raw materials last year and creating short-term shortages throughout the world.

To most consumers, perhaps the most visible effect of China’s growing demand is the recent rise in worldwide oil prices, as an increasing number of Chinese switch from bicycles to automobiles. More than 2 million new drivers hit the roads in China last year – helping make China the world’s No. 2 consumer of oil, after the U.S. – and the number of new drivers is increasing at double-digit rates each year. Although China represents only 8% of the world’s oil demand – compared with 25% for the U.S. – its thirst is increasing exponentially and represents 50% of the growth in the market.

China is not the only reason for last year’s shortages and price increases. War, terrorism and political disruptions helped push up the price of oil. Hurricanes and plant consolidations also put a crimp on building materials. Renewed production by North American factories chewed into metal supplies. In California, the demand for construction materials was also driven by a spate of public works projects. Unlike one-time events that roil the marketplace, China’s demand for raw materials represents a growing source of pressure that could affect commodities for decades to come. Thanks largely to demand from Asia, the U.S. steel mills should be humming for at least the next two years, according to a recent report from the International Iron and Steel Institute. At the peak of the market last year, all 118 cement plants in the U.S. were operating at close to 100% capacity, and even then they could not keep up with demand.

Investment bubble builds new China.

Highway spending has transformed China’s landscape, adding roads, bridges, subways and ports – as well as factories, mines, steel mills and power plants – that could provide the foundation for double-digit growth far into the future. But to an extent that is alarming some Chinese and Western economists, such investment itself is a main driver of China’s economy, which grew at a 9.5% pace last year. The investment binge, like any bubble, could produce unneeded factories and underused highways and power plants, weakening the country’s already shaky financial system. “If China keeps relying on cheap capital to generate growth, sooner or later it will face a major crisis,” said Xu Xiaonian, an economist at the China Europe International Business School in Shanghai. “Right now, the economy is afflicted by the curse of diminishing returns.”

China’s leadership agrees to an extent. Officials in Beijing have been trying to cut what they see as unneeded investment projects and reduce growth to a more sustainable pace. Yet in 2004, independent experts who examined government statistics say, investment in such projects represented 45% of China’s G.D.P., the broadest measure of the economy. Mr. Xu said the economic payoff from these huge investments had fallen sharply. He estimates that 15 years ago, China generated 50 cents of growth for each dollar it invested in fixed assets – roads, subways, and steel mills and the like. That return has fallen to about 20 cents for each dollar invested, he says.

While it is not unusual for a fast-developing country to derive a substantial part of its growth from new investment, no other major country has depended so heavily on fixed investment. The United States, which relies mainly on consumer spending to generate growth, invests about 15% of its G.D.P. in fixed assets. Japan and South Korea never invested as much as 40% in fixed assets. Today, the share is below 30% in both countries. Senior Chinese officials and most private economists agree that investment rates cannot remain at such levels without setting off high inflation, unneeded capacity and fresh piles of bad bank loans. The question is how much investment must come down and whether the reduction will cause a slump in the broad economy.

Morris Goldstein and Nicholas R. Lardy, economists at the Institute for International Economics in Washington, wrote in a recent survey that the Chinese investment surge might take a few years to unwind at considerable cost to growth. They said China would have to limit investment to the high 30’s as a percentage of the G.D.P. to avoid widespread waste. Yet doing so would probably cause the overall growth rate to dive to perhaps half its current level.

Wave of corruption tarnishes China’s extraordinary growth.

China has been shaken by a series of large-scale bank robberies in recent years, but they are not the Bonnie-and-Clyde type. These are inside jobs: top executives, branch managers, loan officers and thousands of everyday employees have been running off with billions in customers’ money. Consider what has happened in just the first two months of 2005. First, a branch manager at the Bank of China disappeared with more than $100 million in cash. A few weeks later, dozens of employees of another commercial bank were arrested for conspiring to steal nearly $1 billion. And then midlevel officials of the China Construction Bank fled with about $8 million.

There is no word yet whether any of the money has been recovered. But the chain of events underlines an ugly byproduct of China’s aggressive embrace of a freewheeling, get-rich-quick form of capitalism: a long-running wave of corporate and government corruption scandals. The scandals are by no means limited to banks. Since the early 1990’s, China’s modern robber barons have focused on all manner of state-run companies. Brokerage houses, government-controlled investment management firms and dozens of state-owned companies have been looted of billions, according to government investigators. The official media are filled with accounts of executives and public employees accused of embezzling money and sometimes gambling away those funds at border casinos.

With China awash in speculative money intended to fuel its economic boom, many corporate executives have turned greedy, and even low-level employees are engaging in self-dealing transactions and learning how to funnel millions of dollars into offshore accounts. “Corruption is pervasive in China,” said Larry Lang, a professor of finance at the Chinese University of Hong Kong.“qA lot of state-owned companies have been simply stripped clean.” In the last four years, at least 25 government officials have been sentenced to death for accepting bribes and kickbacks. Hundreds more are serving lengthy prison terms. But every month, the number of fraud cases seems to mushroom.

In many ways, the corruption scandals offer a telling glimpse into the darker side of China’s remarkable ascent. Though the economy is soaring, incomes are rising (per-capita income grew to $1,100 in 2003, the last year figures are available) and foreign investment continues to flood into the coastal provinces, China’s finances are in a mess.

WAITING FOR THE BIG WAVE

By all logic, this nation should be in deep water right about now. In the 1980’s, wise kahunas foretold a watery day of reckoning within the following two or three decades if nothing were done to counteract the scourge of chronic inflation that has proceeded unhampered since the early 20th Century. We all note that indeed nothing has been done. On the contrary, the waves of increasing prices have not let up for a moment, growing at a rate of at least 2-3% a year since 1900. So, since the dollar is now falling on the international marketplace, should we begin preparing for the crashing Big Wave as predicted? History says there will be retribution in the long run; but there are at least four elements of our modern economy that might explain the stealth with which it is approaching.

One of those is the extent of the recent technology boom. The discovery of electronics is the equivalent of the wheel in its significance to the economy. Computers and high-speed communications have brought productivity not only to an all time high, but frankly to another cosmic level; and through this factor alone, general prices should have decreased several points, just as they did back in the 1800’s during the industrial revolution. Yet this has not happened. Why? Because the expected price decreases have been offset every year by a lowering of the dollar’s value through “out of thin air” credit creation and currency inflating that camouflages improper price increases. Both the wasted cost devaluation and the parallel dollar debasement can remain invisible for years – at least until people wake up, as they are beginning to do.

This is the second reason for our Big Wave’s invisibility: economic statistics are misleading and inaccurate, to the point where one wonders just how naive economists must think we are. Let’s have some fun conjecturing: How much purchasing power might we really be losing on an annual basis, above the 3% the Fed has already admitted to? Maybe 5% a year, or 100% of our wealth confiscated over a 20 year period, at the very minimum. The punch line is that no one can certify that this is incorrect. Do you suppose this is one explanation why our dollar can’t get no respect these days?

A third element that may be contributing to this exquisite prolongation of our Big Wave’s dénouement is that the U.S. is perceived as a bastion of economic strength compared to every other nation in the world. Based on that, billions of our “good-as-gold” dollars, stocks, and U.S. bonds and assets are being held as the safest investments. To top it off, the dollar is also used as a substitute money by foreign citizens of less financially secure countries. But recently these dollars are buying less and less, and the bonds are decreasing in worth, so our fiscal rogues and central bankers are wont to diversify. By way of illustration, a recent Columbian street gang bust turned up a suitcase full of euros. If the drug lords and OPEC are already getting skittish, what will happen when the world’s central bankers decide to act upon the realization that the dollar is not as good as gold, releasing a tidal wave of currency and bonds that will head home for lack of takers?

I prefer to perch under this huge wave’s crest, hoping to catch another good ride when the devil’s plans play out. It is sad: if only all of humanity – not just the bankers, the U.S. government and the smart speculators – could ride at the pinnacle of this technological progress that is holding us afloat today. Instead, the usual losers will remain clustered in herds along its flanks, trying to go about their business of competing sportsmanlike for the small swells, though increasingly unnerved by the moody seas and disrupting gulps of salt water. Like our Asian friends, their short memories will not allow them to conceive of the tsunami that may be about to bowl them ashore – or maybe even tumble us all asunder.

BUBBLES ABOUND IN A WORLD OF READY CASH

There is the housing bubble and the commercial office space bubble. There is the bond-market bubble and its two progeny, the junk-market bubble and the emerging-market-debt bubble. That $2.50-a-gallon price you see at the pump has all the markings of an oil bubble. And the premiums being paid for all those corporate mergers and acquisitions is a pretty good indication of a stock-market bubble. In fact, nearly every asset market you can think of is showing signs of bubblelike behavior. The reason is pretty clear: The global economy is awash in free cash. “There is an excess of liquidity around, and it is proving very hard to get rid of it,” said John Makin of the American Enterprise Institute, using the term preferred by economists. “The possibility of a liquidity bubble around the world concerns me,” Citigroup Chairman Charles Prince told the Financial Times last week.

To some degree, this excess liquidity is what you would expect as a giant baby boom generation reaches its peak earnings years and begins to save more for retirement. And surely a good part of the story is the stimulative monetary policies of central banks around the world for most of the period since the Asian financial crisis in 1998. Fed Maestro Alan Greenspan has argued that nobody can really identify a financial bubble until after it has popped, which was one reason the Fed did little to try to prick the stock market bubble in the late 1990s. That sophistry was exposed last month when transcripts of Fed meetings from 1999 were released showing that Fed officials, including Greenspan, were quite aware that they were dealing with a bubble of immense proportions. And it is now belied, as it was then, by any number of objective indicators of the widening gap between the economic and market value of various assets.

Ray Torto, an old friend and real estate guru, has a report out showing how the gap between the monthly out-of-pocket cost of buying a home vs. renting it has been widening at an accelerating pace. Nationally, the gap is now 8%, while in hot markets like San Diego and San Francisco it is more than 50%. In Washington, it is 41% more expensive to own than to rent. The house market is so hot, there is even the equivalent of day traders. Makin reports that during his drive in from the Key West airport recently, all the driver would talk about was the million-dollar condos that were flipped several times before construction was even completed. Five years ago, the talk was all about Nasdaq. The downtown office-building market is also red hot, despite the fact that, nationally, there has been little increase in net rents. Torto said most of the price escalation can be explained only by an expectation that price appreciation will continue at its current pace. Phil Verleger, the energy expert, brings a similar analysis to the recent run-up in oil prices, which he said is being driven less by fundamentals (supply, demand and the cost of replacing reserves) than it is by the upward pull of futures markets.

It is more of a stretch to argue that stock prices have again entered bubble territory. Certainly as a multiple of earnings, today’s prices are only slightly above historic averages. But there is a strong sense of deja vu in seeing banks and Wall Street investment houses tripping over one another to provide gobs of money on easy terms to companies and private equity funds engaged in bidding wars for telecom and software firms. And I assign some significance to the fact that Warren Buffett, who correctly identified the last bubble, now has $43 billion sitting in the bank, unable to find acquisitions to make at reasonable prices.

The tendency among economists has been to assume that bubbles happen only when there is too much cheap money around and that responsibility for controlling the money supply and containing bubbles rests with the Fed and other central banks. Adam Posen of the Institute of International Economics did a nice job of knocking down such outdated monetarism in a short, pithy article in a German newspaper last week. But Posen – like the Greenspan Fed – also makes a mistake in concluding from that observation that policymakers need not worry about asset bubbles, largely because they have little long-run impact on what economists call “the real economy”. That may once have been true, but in today’s world, the old distinctions between financial markets and the “real economy” quickly blur.

PLANNING FOR TOMORROW IS CALLED A “FORECAST”

Technology writer John Dvorak said he was recently digging around his office and came across the 1995 edition of the Consumer Electronics Industry Year in Review, which featured “new technologies that were going to change the world.” He notes that while it included lots of talk about fax machines and CD-ROMS, the astonishing part is what the review did not say: “The Internet is not mentioned once, and even in the section about communications and computers only a few references to modems are made. There is nothing about the Web.” Yes, Dvorak has the benefit of 10 years of hindsight. But remember that the World Wide Web went online in 1990, while the first popular web browser (the NCSA Mosaic) appeared in March 1993. By 1995, all the elements were in place for what has arguably been the most important communications technology since Gutenberg’s moveable-type printing press. As Dvorak points out, it took less than 10 years for the Internet-inspired boom/bust cycle to unfold.

His technology story helped me recall one of my own. Back around 1994 here at Elliott Wave International, we were looking for ways to deliver our charts and analysis electronically. Two computer-savvy colleagues of mine went to meet with CompuServe, which at the time was one of the major online players. During the discussions someone mentioned a competitor of CompuServe’s – a little start-up firm that was crazy enough to mail disks of its software to computer owners. Folks at CompuServe had a “no big deal” attitude toward little firm, which called itself America Online. Again, hindsight is 20-20, but we all must plan for tomorrow. In the financial markets, planning for tomorrow is called a “forecast”. And the vast majority of market forecasting either projects today’s trend into tomorrow, and/or plays follow the leader.

Just 10 days ago, Bloomberg ran a story with the headline, “Gold May Gain as Dollar’s Allure Erodes”. It said, “traders, investors and analysts surveyed from Sydney to New York on March 10 and March 11 advised buying gold, which rose 2.7 percent last week.” Yet in the two weeks since this survey, gold has fallen more than 4%, while the U.S. dollar has rallied handsomely. Linear projections and follow-the-leader are your forecasting options if you do not have a method. We cannot claim perfection, but we absolutely DO have a method.

WHY COMMODITIES MAKE SENSE NOW

Stocks and bonds ... when most people think of investments, that is where they start. Lately, however, some investment professionals are suggesting that people take a look at commodities and commodity funds. The reason is obvious to anyone who has filled up a gas tank: Prices have been surging – and not just for oil. Increased demand combined with reduced supplies for commodities such as copper, nickel, iron, and natural gas have helped fuel big gains in commodity prices over the past four years. One index of 17 commodities reached a 24-year high last week and is closing in on the peak set in 1980.

Fortunately, there are ways for the individual investor to profit. Just as the price of commodities has soared, so have commodity funds and more broadly invested natural-resources funds. For the 12 months ended March 11, natural-resources funds posted an average return of 40.7%, beating all other domestic-fund categories for the period, according to Morningstar Inc. in Chicago. Meanwhile, the PIMCO Commodity Real Return Strategy Fund, for example, gained nearly 95% from its inception in June 2002, through Jan. 31 of this year.

“We have a bull market in commodities because supply and demand has gotten out of whack,” says Jim Rogers, investor and author of Hot Commodities: How Anyone Can Invest Profitably in the World’s Best Market. “There”s been only one lead mine opened in the world in the last 25 years. There have been no great oil discoveries in over 35 years. Fields deplete. Mines deplete. After 25 years of no investment in production capacity, supplies are running low, demand is continuing to grow.” Even when higher prices begin to support new development, “it takes several years, five to seven years, to bring a new mine into production,” says Louis Stanasolovich, a fee-only financial planner in Pittsburgh. “Prices only recently got high enough to justify starting to develop new mines.”

Is it too late for investors to cash in? “We view commodity funds probably as being in the fourth inning of a nine-inning game,” Mr. Stanasolovich says. “They have had a nice run-up so far. I think you’ll get three out of the next four years being positive, which I don’t think you’ll get from the normal stock market.” Stanasolovich’s baseball analogy is in line with historical patterns, analysts say. Over the past 130 years, commodities and stocks have tended to trade off outperformance in cycles that last an average of 18 years. 2004 was the fourth year of outperformance for commodities, says Curt Morrison, a stock analyst with Morningstar.

WHY BUY A CHEVY?

It is apparent that neither American nor German carmakers can compete with Toyota, even on their own turf. If you want to know the future of GM, just read the reviews of its new Cobalt model. What the heck could the company’s engineers and marketing honchos have been thinking when they set out to update a design more than two decades old? They cannot even copy the innovations of Japanese automakers, let alone come up with good ideas of their own. Bottom line, American cars stink, and the industry can only continue to lose market share to Japan. Japan will have similar worries from China someday, but that day lies well down the road. Eventually the Chinese will export luxury models that will sell for a third of the price of comparable Mercedes Benzes.

In a perfect world, one managed by Adam Smith, the U.S. would be out of the car business by then and into something we can do better. “Like what?” you ask. Unfortunately, there is no obvious answer.

A FLOOD OF BABY BOOMER RETIREMENTS COULD CAUSE STOCKS TO TUMBLE – TRUE OR NOT?

Baby boomers have triggered social change at each stage in their lives – from expanding school rolls to inventing the yuppie. Now, they are reaching a milestone that has some experts worried. The first boomers turn 59-1/2 this year. That is old enough to pull money out of IRAs without tax penalty. And while no one expects a huge drawdown immediately, some financial analysts are concerned about what boomer retirement will do to the stock market. If the nation’s 80 million boomers fund their golden years by pulling their trillions of dollars out of stocks and bonds, markets could tumble, some experts say. Others counter that the threat is overblown because markets are far too complex to judge using generational shifts alone. This debate is heating up as boomer retirements loom. In just three more years, the first boomers will be eligible for early Social Security payments. Three years after that, they will reach the classic retirement age of 65.

The generation is closely watched because of its outsize impact. It is 50% larger than the previous generation and one-seventh bigger than the following one. By 2030, when all boomers will have reached retirement age, the share of Americans over 65 is predicted to jump from 17% in 2000 to 27%. That spells demographic trouble, according to some analysts. In their view, the stock market boomed in the 1990s because that was the period when many boomers moved into their peak years of earning and stashed away money for retirement.

Over the next four years, boomer demographics will continue to help fuel the stock market, pushing the Dow Jones Industrial Average to a record high of about 36,000, forecasts Harry Dent Jr., an author and futurist. Then, he says, the market will collapse backward into a depression until the boomers’ children hit their own peak earning years a decade or more later. Even a much less dramatic scenario could nonetheless have big effects. Since the 1920s, stocks have returned each year an average 6% above bond yields, notes John Geanakoplos, director of the Cowles Foundation at Yale University. But because of boomers retiring, average stock returns for the next 15 years or so will be weak, he predicts, maybe only 2% a year above the yield on bonds. Despite these arguments, many economists remain skeptical that demographics tell the whole story.

Interestingly, surveys show that most boomers already expect – and often desire – to continue working past 65. When financial planner Richard Erwin talked with baby boomers 10 years ago, a lot of them mentioned early retirement. Not any more. “They say, ‘I might have to work until I’m 70,’” says Mr. Erwin. Actually, boomers may be working until age 71 or 72 whether they like it or not, add economists Anne Casscells and Robert Arnott. That is what they say is needed to maintain today’s “dependency ratio” – the number of nonworking people, including retirees and children, per working person.

SLUMPING U.S. DOLLAR RAISES FLAG

The chances that the decline of the U.S. dollar will turn into a rout that triggers a worldwide financial crisis are “one in four and rising,” a U.S. economist said. “I think there is a reasonable risk that there is some kind of brief global financial crisis,” Mark Zandi, chief economist and co-founder of Economy.com, said in an interview in Toronto, after a presentation on the U.S. and world economic outlook. “How brief and how severe will depend on how global policy makers respond to it.”

The U.S. dollar has fallen about 15% on a broad trade-weighted basis since peaking three years ago, driven by growing concern about the U.S.’s massive and growing current account and trade deficits, and helping to push up the Canadian dollar, the euro and the yen in the process. If the decline remains orderly, Mr. Zandi expects the greenback to fall another 10% or so over the next three years. However, the stresses that could trigger a disorderly plunge are “evident and they’re growing,” he said. The key issue is the “increasingly unhealthy” and “increasingly untenable” relationship between the U.S. and China, the two “engines of growth” in the world economy, Mr. Zandi said. “The Chinese have to change their currency policy and the U.S. has to change its fiscal policy.”

China is under increasing pressure from the U.S. and other countries to unpeg the yuan from the dollar and let it float freely to find its real value, which, critics hope, will be substantially higher, thus lessening its large price advantage in world trade. It has kept the yuan at about 8.28 to the U.S. dollar for more than 10 years. Mr. Zandi argued that China has a narrow window to take this step. Recent rumblings that both South Korea and Japan, for example, want to diversify their foreign currency reserves by selling greenbacks have spooked the markets, despite official denials. But Mr. Zandi thinks the process is already under way. “They are diversifying,” he said. “That’s exactly what’s happening.”

THE DECAY OF PAPER CURRENCY

Inflation, as it is commonly known, has not always been the normal state of affairs. As James Grant, editor of Grant’s Interest Rate Observer, has pointed out, “From George Washington to the A-bomb, prices alternately rose and fell... As Alan Greenspan himself has pointed out, the American price level registered little net change between 1800 and 1929.” The basic nature of our money assures it will lose value over time. It can be created nearly at will and it is left in the hands of government officials, who routinely spend more than they have. In such a state, a nation’s paper money has a shelf life like a fresh egg or a jar of mayonnaise. It does not last forever. Unlike these foodstuffs, paper money has no printed expiration date.

According to economist Felix Somary, who experienced firsthand the devastating monetary inflations that destroyed the German mark in the 1920s, it took Rome four centuries to destroy its currency. Germany and Austria reached that point in just nine years, ending in the famous hyperinflations of the 1920s, and before that, Russia managed it in only five years. Everyone’s experience is different, but our collective experiments in paper money have not created a currency that increases in value over time. The life and value of a monetary unit has less to do with the wealth of a country than with the simple facts of supply and demand. As the great Austrian economist Ludwig von Mises noted, “Even the richest country can have a bad currency and the poorest country a good one.”

For some interesting insights into the flight of the dollar, I want to share some thoughts I recently read from Justin Mamis, author of several investment books and a longtime market adviser. Mamis was born during one of the great turning moments in stock market history – 1929. Mamis talks about the experience of the dollar’s immediate predecessor as cock of the walk, the old British pound. As Mamis puts it, the status of being a “reserve currency is not a permanent appointment.” To pinpoint when the dollar’s status as the world’s currency of choice will end is an impossible task, but that should not deter the investor from making the basic assumption that the dollar of a decade hence will buy less than a dollar of today. “We must warn not to turn the next century’s global changes into something that has to be evident in its entirety all at once – or else denied. Nor will our concerns be proven instantly ‘wrong’ because the dollar finally has its oversold rebound,” says Mamis. Well said.

The euro may strengthen against the dollar, but I think the dollar and the euro share the same fate, like the passenger pigeon and the Carolina parakeet. The road to extinction may be of indeterminable length, but the final destination of that road is not in doubt. The same can be said of all our paper currencies, be they yen or pounds, pesos or ringgit. All of them are on the same slide. But there are other ways to beat the decaying paper currencies that make up so much of our financial wealth. The idea of tangible asset investing, investing in stuff that has survived and prospered in a variety of conditions, should meet the challenge in the years ahead.

A BULL MARKET IN CAUTION?

Most folks know what you mean when you say “combat duty pay”, even if the official military phrase these days is “Imminent Danger Pay”. It is the extra money which service men and women receive for the extra risks they take. Risks in the financial markets are far less literal when it comes to life and limb, but the principle of take more risk/get more money is similar indeed. In the debt market, higher-risk debt typically pays a higher yield to the debt holder, e.g., junk bonds pay more than Treasury bills. The rationale for this should need no explanation. The surprise would be if investors did not demand higher yields for riskier debt.

Of course, 2003 and 2004 were full of surprises – namely the collapse of the credit spread, or the difference in yield between high vs. low risk bonds. The appetite for risk brought the spread to its most narrow point ever. Junk bond yields were only slightly higher than Treasury yields, yet investors bought junk hand over fist anyway. But just earlier this month, an obvious psychological shift showed up on the charts that measure the credit spread. The appetite for risk turned into “a bull market in caution”. Six days later, the chart trendline has thrust up above the green “resistance” bar. This has dramatic implications not only for the debt market, but for the larger psychology that drives the stock market too.

TRACING THE DJIA’S TRAJECTORY TODAY BY LOOKING BACK AT 1937

With the Elliott Wave Principle, you can see patterns repeating themselves. Sometimes you can even see patterns from previous years of previous decades, which provide instructive comparisons for where today’s market is headed. A little more than a year ago in his January 2004 Elliott Wave Theorist, Bob Prechter made the case that the stock market since 2000 is tracing out a path similar to that of 1937 but at a much slower pace: “1937 appears to provide the single best model for the starting form of the current bear market. Cycle wave I ended in March 1937. Cycle wave II, which ultimately bottomed in 1942, began with five waves down for wave (1) of A. The amazing thing is that wave 1 since 2000 took 10 times as long to unfold as wave (1) in 1937! This is a huge top formation, befitting the Grand Supercycle degree of the turn.”

TOO MUCH CAPITAL: WHY IT IS GETTING HARDER TO FIND A GOOD INVESTMENT

There is too much capital in the world. And that means that those who own the capital – investors – are in for some unhappy times. That thesis may sound inherently unlikely, but it explains a lot. Those with capital find they must pay high prices for investments that are likely to produce only a little income. The relative importance of things other than capital, like commodities and cheap labor, has grown. Evidence of the capital glut can be seen in interest rates. Market rates are low, and even when central banks set out to raise short-term rates, longer-term rates are slow to move. Little additional yield is available to those who buy very risky bonds. For the same reason, stock prices are high. Profit disappointments may not cause the stock market to plunge, since the capital will have to go somewhere. But the return on the underlying investments is likely to be below what investors have expected.

We have seen too much capital before, but not on a worldwide basis. It flooded into Japan in the 1980’s when money there was cheap and the success of the Japanese economy obvious. Japanese business still suffers from excess capacity. Excessive investment in telecommunications in the late 1990’s left a lot of unused fiber optic cable. The excess of capital is bad news for wealthy economies, especially as it is happening when aging populations in Japan, Europe and the United States need good investments to finance retirement. But it should be good news for economies that need capital to develop. Capital will not remain in excess forever. Money will be spent on consumption rather than investment, and new technologies and rising demand will eventually create more uses for a supply of capital that will have been depleted as low returns discourage saving. But for those with capital, that could be a slow and painful process.

THE DANGER OF THE DEBT TRAP

In the preface of The Theory of Money and Credit, Ludwig von Mises wrote, “No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempts to remedy a present ill by sowing the seeds of a much greater ill for the future.” A closer examination of the current international monetary scene reveals that the same fundamental issue raised by Mises is being contested again.

The economic crisis, which began in the latter part of summer 2000, has given way to a cyclical upswing in the major western industrialised countries. Monetary policy, however, has kept short-term interest rates at crisis levels. Despite the U.S. Federal Reserve increasing interest rates six times in a row, the bank’s policy is still very expansionary, as evidenced by real short-term interest rates remaining in negative territory (see chart). Therefore, it is no wonder that money and credit expansion in the U.S. has remained rather buoyant. Concurrently, the short-term interest rates of the European Central Bank have remained at their lowest levels, both in nominal and real terms, for more than two decades, and matching the Bank of Japan’s short-term rate level in real terms. The strong increase in money and credit – for which international central banks can be held responsible (see chart) – poses a clear risk to the purchasing power of money: it is perhaps one of the best proven hypotheses that, when too much money is chasing too few goods, inflation will inevitably emerge.

Although, on a global level, consumer price inflation appears rather muted at present, there are indications that the devaluation of money might be taking a new route, namely via “asset price inflation”: excess money is actually flowing into asset markets, driving up prices for real estate and – most importantly – bond and stocks. Even though inflation is typically measured via consumer price changes, asset price inflation erodes the value of money in the same way as consumer price inflation. Such a development is highly costly. As Friedrich August von Hayek put it, “… the chief harm which inflation causes … [is] that it gives the whole structure of the economy a distorted, lopsided character which sooner or later makes a more extensive unemployment inevitable.” And, "In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.” It might therefore not take any wonder that central banks, in a desperate attempt to keep the economies going, try their best to increase money and credit supply further via record low interest rates.

There is indeed cause for concern that a “debt trap” might arise as a direct result of a prolonged period of a low rate monetary policy. Unsurprisingly, cheap money makes credit funding increasingly attractive for borrowers; under a cheap money policy, the level of indebtedness tends to rise for private households, firms and governments. If returns on investment fall short of expectations, e.g., the cost of borrowing, it is clear that a rising portion of the economy’s income will need to be spent servicing the debt. This would clearly be a highly unfavorable development – and there is currently a significant risk of this occurring.

The marked increase in indebtedness in the western industrialized countries, especially as a result of the major central banks’ cheap money policy, should have convinced policy makers to change course already. However, it is worrying that central banks show no sign of returning to a more “normal rate policy”, as evidenced by the still record low long-term (real) capital market yields. This might well be taken as an indication that markets could believe that central banks are already caught in a kind of debt trap. Against this background, one can only hope that the major central banks will be encouraged to reign in excessive money and credit expansion, so that attempts to remedy the present ill will not sow the seeds of a much greater ill for the future.

THE TEST FOR THE FEDERAL RESERVE MAY FINALLY BE HERE

The U.S. Federal Reserve is behind the curve and scrambling to catch up. Inflation risks seem to be mounting at precisely the moment when America’s current-account deficit is out of control. Higher real interest rates are the only answer for these twin macro problems. For an unbalanced world that has become a levered play on low real interest rates, the long-awaited test could finally be at hand.

In an era of fiscal profligacy, real interest rates are the only effective control lever of macro management. It is important to stress the “real” dimension of this construct – the need to strip out the money illusion associated with fluctuations in the price level and focus on inflation-adjusted interest rates. From that simple vantage point, America’s central bank is swimming upstream. Measured tightening is being largely offset by a measured increase in underlying inflation – muting the impacts of the Federal Reserve’s efforts to turn the monetary screws. And it has become a real footrace: The Fed tightened by 25 basis points on March 22, only to find that a day later the annualized core CPI accelerated by 10 bp. In fact, the acceleration of the core CPI from its early 2004 low of 1.1% y-o-y to 2.4% in February 2005 has offset fully 74% of the 175 bp increase in the nominal federal funds rate that has occurred during the current 9-month tightening campaign. At the same time, America’s current account deficit went from 5.1% of GDP in early 2004 to a record 6.3% by the end of the year – a deterioration that begs for both higher U.S. real interest rates and a further weakening of the dollar. The response on both counts has paled in comparison to what might be expected in a normal current-account adjustment. Behind the curve? You bet.

But how far behind? The answer to that question, of course, hinges on one of the slipperiest concepts in economics: the “neutral” policy rate. This is the magic threshold at which monetary policy is judged to be perfect – neither accommodative nor restrictive insofar as its impact on inflation or the real economy is concerned. The problem with neutrality is that it is only a theoretical notion – we honestly do not know the actual number. So let us venture an educated guess: Say, for purposes of argument, that the neutral real federal funds rate is 2% – or approximately equal to the 1.9% long-term average of the inflation-adjusted policy rate since 1960. Having played it cute and waited too long, the Fed must now aim for a “restrictive” target in excess of 2% – for expositional purposes, say 3%. Then add in some upside to the core CPI of about 2.75% and, presto, the Fed needs to be shooting for a nominal funds target of around 5.75% – or more than double the current reading. That amounts to another 300 bp of tightening. Little wonder that talk is now rampant of stepping up the pace of tightening. Remember 1994?

From my perspective, this is where the rubber meets the road for the Asset Economy. Lacking in support from labor income generation, America’s high-consumption economy has turned to asset markets as never before to sustain both spending and saving. And yet asset markets and the wealth creation they foster have long been balanced on the head of the pin of extraordinarily low real interest rates. The Fed is the architect of this New Economy, and most other central banks – especially those in Japan and China – have gone along for the ride.

Asset markets around the world are now quivering at just the hint of an unwinding of this house of cards. And they quiver with the real federal funds rate barely above zero. What happens to these markets and to an asset-dependent U.S. economy should the Fed actually complete its nasty task of taking its policy rate into the restrictive zone? It would not be at all pretty, in my view. The optimists tell me not to worry – that the real side of the US economy barely skipped a beat in the face of wrenching unwinding of carry trades in 1994. But America was much more of a normal economy in 1994, with a personal saving rate of 4.8%. It had yet to experience the joys of consuming and saving out of assets. The equity bubble of the late 1990s and the property bubble of the early 2000s – both outgrowths of extraordinary monetary accommodation, in my view – changed everything.

Largely for that reason, I still do not think America’s central bank is up to the task at hand. In the face of disruptive markets or growth disappointments, this Fed has repeatedly opted to err on the side of accommodation. It did not have to be this way. The big mistake, in my view, came when the Fed condoned the equity bubble in the late 1990s. It has been playing post-bubble defense ever since, fostering an unusually low real interest rate climate that has led to one bubble after another. And that has given rise to the real monster – the asset-dependent American consumer and a co-dependent global economy that cannot live without excess U.S. consumption. The real test was always the exit strategy.

BANKING ON TROUBLE

Commercial bankers typically have a pretty good feel for the pulse of the local business scene. Collectively, lenders have access to the financial statements of hundreds of local business, allowing them to stitch together a rather accurate composite sketch on such items of interest as sales growth, profits and the health of corporate balance sheets. Moreover, they can develop a sense for the mood of business owners, since they are in frequent contact with them: are the owners optimistic and expanding or are they cautious and holding back? Local lenders can answer these questions intelligently; at least the good ones can.

Unfortunately, this financial “sixth sense” does not necessarily improve their ability to forecast the future or even to competently manage their own affairs. Bankers still make mistakes – lots of them – and are subject to episodes of bad judgment. I should know, since I was a member of their tribe for more than a decade. Often, when I get together with my old banker friends and former colleagues, I ask them about what they are seeing. Sometimes, what happens locally is a microcosm of what is happening nationally. We met where bankers often seem to meet, in the elite confines of a local country club. Over toasted club sandwiches and lobster bisque, washed down with the club lager (brewed on the premises), I expected to get the skinny on the local scene.

This time, however, the conversation was less about the business scene than it was about the business of banking itself. And my banker friend’s mood was darkened by what he saw as gathering storms on the horizon. “Fee income is drying up,” he said, “especially the punitive ones”. Ah yes, those delightful overdraft fees and late fees. Consumers may not realize this, but bankers love it when consumers do dumb things with their money. Writing a $28 check only to be whacked with a $34 overdraft fee is the foundation of many a bankers’ fortune.

From a banker’s perspective, fee income is the most desirous sort of income. It is not interest-rate sensitive; the banker gets his fee whether rates are 2% or 6%. Lacking fee income, bankers must rely more on their traditional interest rate spreads ... and that is much harder work. “Now that the yield curve is flattening [i.e. the difference between short-term and long-term interest rates is shrinking],” I observed, “profit margins must be feeling the pinch.” He winced, as if I had just doused an open wound with salt water. Tighter margins and less fee income mean pressure on bank earnings, and more pressure to grow through acquisitions or by building new branches. Acquisitions are tricky by nature, and create new headaches of their own. Branch-building is expensive and the payoff does not usually occur until well into year two or three. Plus, banking is a competitive business. Branch expansion is no cinch for new profits, because your competitors do not stand still.

We had an old saying in banking that the market was only as good as your stupidest competitor. In other words, it only takes one bank to start giving away money and then you have two choices, each of them ultimately painful. You can either match their deals, preserving your market share, but putting off the pain until later (when your profits are depressed) or you can take a hard-line stance, in which case the pain is immediate and you lose a bunch of customers. Pick your poison. In the over-banked Washington area, Commerce Bank appears to be the “stupidest competitor”. And the long bull market in banking stocks is showing signs of wear.