Finance Digest for Week of March 28, 2005

HYBRID CAR PLAYS

At first glance, hybrid car economics just do not make sense. A conventional engine costs about $70 per horsepower or, in electrical units, about $50 per kilowatt. Now add the extra cost of going hybrid: The power electronics required to convert horsepower to kilowatts run $6 a kilowatt, battery packs add another $25, and then you need electric motors, at $15 a kilowatt, to turn electricity back into shaft power to drive the wheels. For an SUV these and related electrical parts are going to run something like $5,000. Why pay for all that extra hardware when it ends right back where it began, in the mechanical power of a spinning shaft?

Cut to the chase: You will buy it, and you will like it. By 2015 almost every new car and truck will be built around a hybrid drive. Detroit has not witnessed a comparable revolution in automotive technology since the days of Henry Ford. Companies that catch the wave are going to prosper.

To invest in the hybrid future, do not pick GM or Ford. Look instead to manufacturers of power silicon – Fairchild, International Rectifier, ON Semiconductor, Siliconix (80% owned by Vishay), Diodes and Ixys. “The automotive platform is one of our main engines for growth,” says Ixys Chief Executive Nathan Zommer. But also keep an eye on their foreign competitors – Eupec (an Infineon subsidiary), the omnipresent Toshiba and Mitsubishi (which is also in Powerex, a joint venture with GE). Also worth watching: the main U.S. suppliers of drivetrain assemblies and the entire array of automotive peripherals, like Delphi, Visteon, Lear, Dana, Eaton, ArvinMeritor and TRW Automotive. Auto parts firms have deep troubles these days, to be sure, but those troubles are already reflected in the prices of their shares. By betting on these old-guard companies, you are betting on their ability to reinvent themselves as they reinvent their product lines around power silicon.

FLATTENED BY THE CURVE

The treasury yield curve is flattening. As measured in the nearby chart, the difference between 10- and 2-year obligations has moved from 2.7% in July 2003 to 0.8% now. And it will narrow further, to the benefit of some investors and the detriment of many. The Fed’s campaign has pushed its target short-term Fed funds rate from 1% last June to 2.5%, with more hikes on the way. Subtract inflation, using the Fed’s favorite inflation measure, the consumption deflator excluding food and energy, and you get a real rate of interest of just 0.9%. Use the past 12 months’ change in the CPI for an inflation measure and you have a real rate of negative 0.5%. In other words lenders are paying borrowers to take the filthy lucre away. The Fed does not like that. So short-term rates are headed up.

The consensus view of the experts is that long rates will follow short rates up. I do not share the majority view, so I remain a bull on long-term Treasury bonds. The experts, at any rate, are still waiting for their predicted outcome. The 10-year Treasury yield, which was 4.9% last June, is now 4.5%. Even Fed Chairman Alan Greenspan calls this development a conundrum.

What is going on? We are in a deflating world of excess men and machines in most industries. So, despite the robust U.S. economy, inflation (except for petroleum) is low. Far from generating runaway inflation, as most feared, leaping oil prices are a tax that is knocking a percentage point off GDP growth. Meanwhile growth is pitiful in most other countries. And foreign central banks are happy to recycle their trade surplus dollars into U.S. bonds to keep their exports humming. A flattening yield curve spells the end of the carry trade. This is the borrowing of cheap short-term money to buy fatter-yielding long-term securities. Expect widespread suffering among banks, hedge funds and others addicted to this form of speculation.

Individual investors have their own carry trade in housing as they borrow through adjustable-rate mortgages to leverage up their abodes. Finance company stocks today account for 21% of the S&P 500’s weight, and many of those firms are at heart spread lenders, working the yield curve. Stocks to dump now include those of brokers, who pay short rates for customer money and invest it elsewhere. They will be on the casualty list, along with thrifts and mortgage-finance companies, which use short-run borrowing to profit from underwriting long-maturity home loans. Consumer-finance companies are in the same fix. Although big banks have better protection, since they are in many other businesses besides spread lending, regional and community banks, like the thrifts, are often at risk. Those closed-end bond funds and real estate investment trusts that are leveraged – most of them – will be harmed, too. Sell right away. Most of the yield-curve flattening is over. Still, puzzlement over the compression and disbelief in its continuing have delayed the effects on security prices. Be forewarned.

SOME BANKS PUMP UP EARNINGS BY UNDER-RESERVING FOR BAD LOANS

At a recent $48 a share, banking behemoth Citigroup looks fairly valued compared with its peers. Citi trades at 14 times trailing earnings, a multiple not far from the average for big banks. In another measure, the ratio of price to tangible book value (shareholders’ equity minus intangibles like goodwill), Citi is close to typical at 3.6. Great – but these metrics reflect Citi’s financials on a sunny day.

What if you examined Citi through a darker lens, taking into account what it would need to weather a storm of loans gone bad? Turns out that the reserves Citi stockpiles to cover loan losses is thin compared with reserves at other banks. Adjust the reserve to a more typical level – and thereby move the tangible book down by a like amount – and Citi does not look so cheap. To see which banks were over- or undervalued, we turned to SNL Financial, a research firm focusing on the finance industry. SNL factors in the adequacy of reserves for banks with market values over $2 billion, and the results for some are not pretty. Citi shares are selling at a somewhat steep 5.3 times their adjusted book value.

Why don’t Citi and other banks in similar situations hike their reserve accounts? Because they would have to take a corresponding hit to earnings, and also, with shareholders’ equity depressed, would find their ability to lend somewhat constrained. When you factor in what loan-loss reserves should be, some big banks end up with a higher price/tangible book ratio (a key metric for bank stocks) than they show publicly. So they are overpriced. Others reserve more prudently and are undervalued.

DOLLAR DAZE

No sooner did the Prime Minister of Japan speak than one of his own faithful ministers insisted he misspoke. “I believe it is necessary for Japan to diversify its foreign exchange reserves,” said Junichiro Koizumi on March 10. Minutes later a senior Japanese financial official rushed to insist that he had not meant it. “Given current market conditions, it would be unwise for us to be selling dollars,” corrected the functionary. Unwise for them, maybe. A monetary update is in order. I am bearish – still – on the U.S. dollar. Yet I am also bearish on the most popular alternative to the dollar. But I am bullish on an alternative to the alternative.

Most dollar bears are bullish on the euro. It is liquid and, with its 2% money market interest rates, relatively high yielding (the yen yields 0%, the Swiss franc 0.75%). Most important, there is no central European finance ministry to suppress the rise in its value. It circulates in a dozen countries, the supposed cream of the crop of the 25-state EU. Because the euro can go up, it has gone up – to $1.35 now from 82 cents in October 2000. If the euro knocked the dollar off its reserve-currency pedestal, it would be a first in the history of geopolitics. You need more than a conscientious central bank to establish the world’s top monetary brand. The British had the Royal Navy. The U.S. has the U.S. Navy, Army, Air Force, Marines and Coast Guard. The euro zone is a mere confederation. Like the Pope, it is unarmed.

The contradictions of a trans-European currency has been obvious from the start. They mattered less and less as the euro depreciated. At its lows what counted was purchasing power. The single currency was cheap, warts and all. At $1.35, it is cheap no more. Euro-zone interest rates are lower than dollar rates, and the differences in borrowing costs between the strong and weak euro-zone economies are laughably narrow. Single-A-rated Greece recently issued a 30-year bond yielding only 26 basis points more than do the bonds of triple-A-rated Germany.

For the value-seeking dollar bear the alternative I propose is an investment in Korea Electric Power (14, KEP), a.k.a. Kepco, South Korea’s big electric utility. To its detractors Kepco is a cheap stock that will only stay cheap. And they are right. But Kepco is priced for disappointment. The American Depositary Receipts yield 4%. They trade at 43% of book value and 6.4 times earnings. And though the ADRs are traded in dollars, the won-dollar exchange rate is implicit in the NYSE-quoted price. The won, like most currencies, is in a bull market against the greenback. In the past year it is up by 18% despite the strenuous efforts of the Korean financial authorities to hold it down. One of these days, I expect, the Koreans will let nature take its course, and the won bull market will go into overdrive. Then, too, dirt-cheap Kepco might generate some happy business surprises. Good things happen to cheap stocks.

Bank of England’s King attacks ministers on euro pact.

Bank of England Governor Mervyn King criticized EU leaders for loosening the fiscal rules that underpin the value of the euro, saying restrictions on government spending in the region lack “discipline”. EU leaders agreed to allow finance ministers to permit deficits over 3% of GDP in some cases. The rules permit finance ministers to consider “relevant factors” such as slower growth or Germany’s costs to rebuild its ex-communist East.

IF I ONLY HAD A HEDGE FUND

It seemed like an ordinary evening at Crobar, the trendy Manhattan nightclub. Two weeks ago, as Counting Crows performed on stage, young women dressed in expensive jeans pushed toward the front with their khaki-clad, mostly older boyfriends. Few, however, were regulars. On this night, the very rich and the merely rich intermingled on the club’s two floors – V.I.P.’s upstairs ($1,000 a ticket) and the rest down below ($250). Most of the 1,250 people gathered for the event were part of the city’s unlikely new “it” crowd. Richer than Wall Street rich and more willing to take risks than their traditional money management peers, they are the managers behind the staggering growth in hedge funds, those private, lightly regulated investment vehicles aimed at the ultrawealthy, the run-of-the-mill wealthy and, increasingly, the not-so wealthy.

To critics, the frenzy has a very familiar ring. A flood of capital to the latest investment fad. Spectacular accumulation of wealth in a short time. New ventures created easily and often. Those, too, were the hallmarks of the dot-com boom, and, as everyone knows, the bursting of that bubble was far from pleasant. The stampede to hedge funds, some people fear, will be no different. “It is completely obvious that this will end badly – for the firms, investors, everyone,” said Seth Klarman, founder of the Baupost Group, which manages $5 billion. “No area of financial endeavor is immune from the effects of competition.”

The numbers are mind-boggling: 15 years ago, hedge funds managed less than $40 billion. Today, the figure is approaching $1 trillion. A recent report published by Credit Suisse First Boston said that hedge funds were responsible for up to half of all activity in major markets. Investment banks are tripping over one another to service them. According to the same report, Wall Street made $25 billion catering to hedge funds – one-eighth of the Street’s total revenue pool. Signs that hedge fund managers have become the financial industry’s new elite abound. Young, ambitious talent is fleeing Wall Street in search of hedge funds’ overnight riches. In hedge fund offices, employees have perks like swimming pools and basketball courts. At cocktail parties throughout Greenwich, Connecticut – the informal capital of the hedge fund world – investors sip apple martinis and discuss which funds are in vogue. Then there is the wealth effect. Billionaire hedge fund managers are pushing up the price of everything from luxury apartments to artwork.

Predictably, most people in the hedge fund world scoff at the notion of a bubble. “Hedge funds are not an asset class, so there is no asset class to burst,” said Jane Buchan, chief executive of Pacific Alternative Asset Management, a fund made up of hedge funds with $7.2 billion under management. “It’s not like real estate. Even if you think about people doing silly things for silly reasons, it’s not a bubble. If you look at people traveling on the fringes, it might be a bubble.” Indeed, the so-called smart money – rich investors like Thomas H. Lee, the famed leverage buyout maven – could not seem less worried. “Every investment board I am in touch with is interested in hedge funds,” said Mr. Lee, ticking off the names of such giants as Calpers and Harvard's endowment fund. Mr. Lee himself has invested a substantial portion of his estimated $1.2 billion net worth in a portfolio of dozens of hedge funds. Yet, as Mr. Klarman said: “How many venture capital investors in 1999 said, ‘We are doomed because of all the money flowing in?’”

Whether the hedge fund boom is a bubble may still be open to debate. But it is certainly not alarmist to wonder about the consequences of such torrid growth, built as it is on the leverage that banks provide managers to double or triple their bets. The Federal Reserve seemed concerned enough last fall, when it set up a group to examine what systemic risks had been created by the explosion of entrants into the market and the aggressiveness with which Wall Street was welcoming them. The Fed also encouraged the revival of a high-profile watchdog group formed in the wake of the market-shaking 1998 collapse of the Long-Term Capital Management hedge fund. It will examine everything from narrow credit spreads – a result of low perceived risk – to the cavalier ways that Wall Street lends to hedge funds.

In the same way that there is no quelling the bulls, there will be no quieting of the critics. The Horvitz family of Cleveland, which made its fortune in road construction, media and real estate, started investing in hedge funds in the 1990’s. A decade or so later, it has virtually no money in such funds, said Jeffrey Horvitz, who oversees his family’s investments. Too often, he said, the funds produced disappointing returns. “Hedge funds are no longer attractive,” Mr. Horvitz said, noting the influx of start-ups. “I see no relief in sight, especially for taxable investors like us.”

AMERICAN DOMESTIC ECONOMY IS SIMPLY UNSUSTAINABLE

As this goes to press the American domestic economy and global balances are spiraling further and further away from safe and sustainable orbit. Our stubborn refusal to even acknowledge our declining global economic position and delusional upbeat domestic self perception are fast approaching the strangeness level of the Michael Jackson trial.

Welcome to the MCI WorldCom national economy. The entire US economy is hoping to successfully copy the moves that just got good ole Bernie 11 felony convictions. We have too much money heading out, not enough heading in and our stock – the dollar – is likely to fall. Like MCI WorldCom we have been riding waves of dubiously wise good will. The U.S. is now consuming over 75% of the world’s available savings. As of January The Treasury reports that just under $2 trillion (44%) of our approximately $4.5 trillion national debt is foreign held. Of this 24% of our total debt is held by Japan, Mainland China, South Korea, Taiwan and Hong Kong. CBO forecasts of budget shortfalls in excess of 3% of GDP are gross understatements by design.

The government deficit is only half of the big imbalance story that calls into question the present health of the U.S. economy, the value of the dollar and the reality basis for our self-perception. We are in deficit with 14 of our 15 leading trading partners. The U.S.’s NIIP – Net International Investment Position – measures the net ownership of foreign assets by American citizens less the ownership of domestic assets by non-citizens. For much of modern U.S. history the NIIP was large and positive. Across the 1980s a long term decline commenced that has led to America’s present position as proud owner of the globe leading largest negative number ever recorded – negative $2.5 trillion at the open of 2004, and over 25% of GDP today. We now celebrate this slide as we sell our assets to the rest of the world at the recent rate of over $90 billion per month.

Levey and Brown suggest that there is nothing to worry about on this front in he latest Foreign Affairs. They well express the absent concern about these numbers and those mentioned above. Their thesis, and the conventional wisdom, can be summed as follows: Its Ok, we are OK, we are the globe’s leading economy, innovator and military … blah, blah … let them eat cake.

2005 award winner and standout in the unsustainability arena is the American consumer economy. American households saw no 2004 increase in their incomes despite declining tax burdens. We increasingly desire and consume imports as leading firms sprint for the doors. A red hot housing bonanza feeds the consumer economy. Houses have been ridiculously bid up by low interest rates, reckless mortgage and securitization practices and foreign buying of agency securities. The sinking American middle classes have pre-sold their lackluster future earnings. Mortgage debt stands approximately $7.5 trillion and credit debt is at about $2.2 trillion.

We seem poised to enter a period of rising interest rates, reduced credit access and growing fear of long neglected credit risk. Thus, the above are the prelude to serious structural adjustment in the US global position and macroeconomy. Here again the WorldCom specter haunts. All of the above borrowing and confident boast on position were tolerated only as long as optimism and acceptance defined the day. And, like the tech boom, there is question of what all this borrowed money has been spent on.

The American Society of Civil Engineers 2005 Infrastructure Report Card gives the U.S. a grade of D and talks of a looming crisis absent $1.5 trillions in emergency repair. The CBO presently estimates that Government debt service will cost $350 billion this year and $400 billion in 2006. The consumer has been similarly imprudent as skyrocketing debt has been spent on bigger houses, newer cars, luxury goods, medical costs, and debt service. All the while home equity has shrunk as people pull value out of their houses faster than the asset bubble can inflate their paper wealth. As interest rates rise, credit rationing returns and credit risks are reassessed, the state and consumer are terribly positioned. All that strength and growth that seems justifying becomes condemning on the way down. Don’t take my word for it. Ask Bernie if the unsustainable lasts forever.

Deficit Disorders

The U.S. trade deficit hit a new record in January, at $58.3 billion, an amount that “exceeded everyone’s worst expectations,” said the New York Times. The deficit reached more than $650 billion last year, requiring 80% of the entire world’s savings to finance it. The world has never seen such a huge red number in international trade and does not know what to make of it. It is a sign of the “decline of the American empire”, say some of the commentators. Others take as an emblem of America’s strength. Whence cometh this trade deficit?

It ariseth when Americans buy more from non-Americans than they sell to them. Each day that passes, Americans buy (net) about $2 billion more in foreign imports than they make in overseas sales. That U.S. businesses are more profitable than their Asian counterparts makes no difference. That the American economy is the most dynamic, flexible and delicious confection ever put up on God’s green earth is as irrelevant as tree rings. Nor does it especially matter why Americans overspend. They have their reasons. But even if they did not, the result would be the same. Each day, including weekends, more goes out than comes in.

If the nation were a corporation, the difference between what came in and what went out would be the measure of its “loss from current operations”. If it were a family, it would be the rate at which it impoverished itself. If it were a business it would have gone bankrupt long ago. Even a lesser nation would have run into trouble a long time ago. Only a nation with the world’s reserve currency could have gotten away with it.

The grim and unyielding fact is that each day, Americans are about $2 billion dollars “richer” in SUVs, flat screen TVs, and other consumer gee-gaws that come mostly from Asia (where the trade deficit is concentrated), while the Asians are $2 billion richer in U.S. financial assets, notably Treasury bonds. Since 1990, foreigners have acquired $3.6 trillion worth of U.S. assets as a direct consequence of the trade deficits. Individually this makes no great difference. A man decides for himself if he would rather have a big TV or a Treasury bond. But Americans are not merely trading a financial asset for a consumer asset. Savings rates have dropped. People do not dip into capital in order to spend it at Wal-Mart. They dip into debt.

This is just another consumer preference, of course. It is no concern of ours if a man decides he wants a big-screen TV so badly he is willing to go into debt to get it. This preference has become so wildly popular that it takes our breath away. Again, we have no problem with that. But every public spectacle begins with a lie. Later it develops into mass illusion, self-congratulation, hallucination, farce and ... finally ... disaster. Until the disaster comes, you never know quite where you are. So, almost everyday we see a piece in the Wall Street Journal explaining that trade deficits are no trouble. And at a certain macro-economic level, they are no trouble at all ... as long as someone keeps lending money. But even while the money flows, Americans get poorer every day.

Some kibitzers point out that the U.S. ran trade deficits for much of its early history, and that fast-growing countries always have current account deficits. After all, they are building something for the future – factories, plants, machines – all of which take capital. Oh, the flattering reverie of it. But when did you last see a factory, or refinery, or mine under construction in America, dear reader?

The distinguished economic journal, Bank Credit Analyst, looks ahead and sees nothing but good news. BCA believes the information revolution has many more good things to give us. We are prepared to believe there might eventually be some. But information is notoriously light on its feet. E.g., we read that more and more U.S. tax forms are being processed in India. And now comes word from Business Week that American companies are actually outsourcing more and more of the “information” component of modern products. More and more, U.S. companies do not even participate at a product’s design stage. “Many just take our products,” said one Taiwanese manufacturer.

What we are seeing, says Paul Craig Roberts, is the “rapid transformation of America into a Third World economy.” American firms are increasing left with only brands to market. But even those will not last forever, after customers realize that the real innovation, design and manufacture genius is overseas. Some claim that the outflow of dollars is no cause for concern, because the dollars just come back to us. But they come back as renters. Instead of helping the average man earn a living, they make it harder for him. For now, they must be supported too – interest must be paid on debt, or compounded into more debt. Either way, day by day, the burden just grows heavier.

THE FED AND CHINA

Because of its currency peg, China does not have an independent central bank. Having elected to fix the renminbi to the dollar, the People’s Bank of China has all but abdicated control over its emerging financial system to America’s Federal Reserve. As the Fed now moves into the serious stage of its tightening cycle, that could pose a serious problem for an unbalanced Chinese economy. China may be preparing for precisely this possibility. Despite nine months of measured tightening, America’s central bank remains well behind the curve, in my view. The U.S. central bank can no longer afford to play it cute and seek a neutral policy stance – the federal funds rate now needs to be pushed into the restrictive zone.

Insofar as the U.S. economy is concerned, I believe the burden of the coming monetary tightening will be felt most acutely by the asset-dependent American consumer. Even Fed Chairman Alan Greenspan has finally admitted the same when he recently conceded the importance of an increasingly tight linkage between asset markets, consumer behavior, and the current account deficit. The reversal of nearly a decade of excess consumption growth should then follow. That is where a co-dependent Chinese economy enters the equation. Personal consumption in the U.S. currently stands at a record 71% of U.S. GDP, whereas in China the share of household consumption stands at a rock-bottom 42%. China’s biggest export market is the U.S., destination for exactly one-third of overseas Chinese shipments in 2004. By implication, that puts an externally-dependent Chinese economy very much in the cross-hairs of a Fed tightening that is now taking dead aim at the American consumer.

Little wonder that China appears reluctant to impose new tightening measures on a still seemingly vigorous Chinese economy. A new round of domestic tightening by Chinese authorities would raise the risk of significant overkill. Focused on the always delicate balance between reforms and stability, this is not a risk that China wants to take. An important strategic challenge that China thus must address in the not-so-distant future is a more balanced economy and a more flexible policy regime to go along with it. While its special requirements of infrastructure, urbanization, and industrialization are all supportive of a high-investment growth dynamic, China is in danger of pushing this unbalanced growth model to excess. Unfortunately, the currency peg constrains Chinese policymakers from using traditional macro stabilization tools to rein in these excesses by controlling the price of credit. Instead, the authorities revert to their central planning heritage and deploy administrative measures that control the quantity of credit.

However, courtesy of the peg and its linkage to a still-accommodative Fed, speculative capital inflows are powering a persistent upsurge in the Chinese liquidity cycle that may overwhelm the impacts of administrative measures. Despite these concerns, I remain fundamentally optimistic on China. The nation’s steadfast commitment to reforms over the past 27 years is at the heart of the macro tradeoffs it now faces. The delicate balancing act between investment-led growth and stability arises out of the need for Chinese policy to compensate for the extraordinary employment pressures that arise from these reforms. This is an extraordinary challenge for all of us in dealing with the inevitable stresses and strains of globalization. The rich, developed world needs to do a better job in learning to cope with China. But China needs to adapt better to changing global circumstances. The strategy that has worked so well in the early stages of development may now be in need of an overhaul as China comes of age. In that important respect, by going after the asset-dependent American consumer, the Fed may be doing China a real favor.

All this points to a delicate balance in world financial markets. I still believe the Fed could flinch on its policy gambit – thereby pushing the U.S. current-account adjustment back onto dollar-weakening, with concomitant upside pressures on the Japanese yen and Chinese RMB. In a U.S.-centric world, I suspect that America will continue to drive global bond markets. The initial Fed-induced sell-off could well beget the next rally.

China says property boom threatens stability, orders clampdown.

China’s rising property prices pose a threat to the stability of China’s economy and local officials who fail to take measures to rein in growth will be held to account, the country’s highest ruling body said. The State Council, China’s cabinet, ordered the clampdown in a 6-page document that was circulated to city governments and state media. “Excessive growth in housing prices has directly undermined the ability of city residents to improve their living standards, affected financial and social stability, and even influenced the health of the national economy,” the document said.

The circular reflects the central government’s determination to deflate urban home prices that jumped almost a fifth in the past year in Shanghai alone. The central bank on March 16 raised the minimum interest rate lenders must charge on home loans and encouraged them to demand higher down payments in areas of “excessive” growth. “The State Council’s tone is very harsh,” said Fan Weiwei, a Beijing-based economist at China International Capital Corp., the nation’s biggest investment bank. “People’s expectations of future property prices will definitely be changed. The likelihood of further price surges is becoming minimal.”

China’s government is trying to slow economic growth to 8% this year, from an 8-year high of 9.5% in 2004, by restricting investment in property and other industries. Investment in real estate in the first two months jumped 27% to 120 billion yuan ($14.5 billion), the government said this month.

China glosses over a Gross Domestic Problem.

Three months into 2005, China has little to show for efforts in 2004 to avoid a hard landing by its economy. That is not the party line in Beijing. On March 14, Premier Wen Jiabao said investment and lending curbs had “worked to solve prominent problems threatening steady and rapid economic development.” While Wen hedged – saying China “mustn’t slacken” inflation-cooling policies – it is a far cry from a year ago, when he warned of “overheating”.

While China has not said it explicitly, one wonders if the government is close to declaring victory in the battle again inflation and irrational exuberance among foreign investors rushing there. Doing so would be a mistake. Signs of rapid growth abound. Exports jumped 37% in the first two months of the year, while industrial production increased 17% and retail sales gained 14%. In the first two months of 2005, investment in China’s factories, roads and other fixed assets in urban areas rose 24.5%. A slowdown? Perhaps. Victory against overheating? Hardly.

China’s money supply is still growing apace. In February, M2, which includes cash and all deposits, expanded 13.9% from a year earlier after growing 14.1% in January. While down from the 19% pace seen at times last year, China needs much slower money growth to avoid overheating.

GREENSPAN’S SECOND BUBBLE

I knew Alan Greenspan had his first bubble in late 1999 when cab drivers were too busy talking to their brokers on cell phones to talk with customers. The “cab driver test” flashed its second bubble warning light to me just recently when I arrived in Key West for the annual winter vacation with my family. Without any prompting, our cab driver told us of a Key West real estate market on fire. Condos that were selling a year ago for $600,000 could not be touched for $1 million today, while the units under construction were sold four times over before anyone even thought of occupying them. The old hotels were being torn down to be replaced by condos that were selling like hotcakes before construction had begun. Meanwhile, room rates and rental rates in Key West have hardly budged. The implied return on investment in real estate is tied to an expectation of ever-rising prices, not to income from property.

Although Greenspan and his Federal Open Market Committee colleagues may not have the opportunity to come to Key West and talk to the cab drivers about real estate, they could have heard similar stories over the past several years in the red-hot real estate market around Jackson Hole, Wyoming, where they gather annually for central bankers’ summer camp.

Lest I be accused of being unscientific, there is more objective evidence of a housing bubble in the U.S. than that linked to the opinions of cab drivers. Between 2000 and 2004, house prices, nationwide, rose by more than 40% – the fastest rate of increase on record since World War II. Moreover, the pace is accelerating. During 2004, the value of real estate on household balance sheets rose by 12.5%. That is far short of the 30% to 40% increase in prices evident in some markets over the past twelve to eighteen months, but it denotes a substantial and widespread acceleration in the price of owner-occupied real estate. Meanwhile, the ratio of average yearly rents to house prices has been dropping steadily, from about 5% nationwide in the 1990s, to 3.5% in 2004, reminiscent of the way earnings plunged relative to soaring equity prices before the tech bubble burst in March 2000. Rental yields in the hotter markets are even lower.

Bubbles in any market feature expectations for price increases that catch fire, so that more and more people begin to chase the market based only on the expectation of ever-rising prices. This bubble has some clear and proximate causes, none of which by itself would have been sufficient to cause a bubble, but which together create a compelling set of preconditions for a housing bubble. The key underlying elements contributing to the new-millennium housing bubble are the Fed’s responses to a series of unique events over the past seven years, all of which combined to create a conviction among market participants that the Fed would not allow a serious drop in broad asset prices. The Fed, however, is not supposed to target asset markets for the very reason that too much risk taking would be the result of doing so. Yet who doubts that a sharp drop in the market for housing or in the stock market would cause Fed tightening to stop or even to be reversed?

The reason to end the housing bubble proactively is straightforward. If it is a real bubble, it will grow bigger and burst of its own accord with even more disruption to financial markets than would be caused by a preemptive strike from the Federal Reserve. It is a simple matter of pay me now or pay me later, but it is less expensive to pay the price now. Greenspan’s decision is whether to bite the bullet now or leave the hard work to his successor.

Bubbles Then ... Bubble Now?

“Irrational exuberance” is the most-widely quoted phrase ever uttered by a central banker. It is usually repeated in a way that makes Mr. Greenspan sound like the Oracle Who Knew Better, who warned investors that the stock bubble would burst. This is rubbish. He never gave such a warning. As for what Mr. Greenspan DID say about the 1990s stock market, here is a far more definitive remark – especially for him – which has long since vanished down the memory hole:

“It has become increasingly difficult to deny that something profoundly different from the typical postwar business cycle has emerged in recent years. Not only has the expansion reached record length, but it has done so with far stronger-than-expected economic growth. ... The process of capital reallocation across the economy has been assisted by a significant unbundling of risks in capital markets made possible by the development of innovative financial products. ... There are few, if any, indications in the marketplace that the reallocation process, pushed forward by financial markets, is slowing.”

The time was April 5, 2000; the occasion was “The White House Conference on the New Economy”. Yes, Alan Greenspan had purchased a first-class ticket on the “New Economy” train, right as it was about to go off the tracks. Because “the expansion” had “reached record length”, he assumed that it would not derail. He was mistaken. Why bring this up now? Because, once again, Mr. Greenspan has issued a decree on one of the economic issues of the day, this past March 10 to the Council on Foreign Relations:

“A number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode. ... But a destabilizing contraction in nationwide house prices does not seem the most probable outcome. ... And even should more-than-average price weakness occur, the increase in home equity as a consequence of the recent sharp rise in prices should buffer the vast majority of homeowners.”

Now, in that last sentence, substitute “stock values” for “home equity”, and “investors” for “homeowners”. It will have a distant ring – sort of like what investors were telling themselves as their NASDAQ-based “growth funds” were losing 80% of their value over three years. Not that anything of the kind could ever happen again in any other overheated market, of course.

“Be scared – I sell real estate in Manhattan”

A remarkable email showed up in my box this morning. I was going to quote a couple of things it said, but after I did little digging I realized it is worth including from start to finish. The author does indeed appear to be a real estate professional with listings in Manhattan. Beyond that the text speaks for itself. (I did replace a few words with asterisks so that my page can keep its “PG” rating).

“... The real estate situation is so bad that I thought to assist fellow Kossacks, I would tell you what’s happening at the epicenter of the bubble. ... 1) Be afraid, be very afraid. 2) It’s actually quite simple: normal people are absolutely, totally priced out. They are priced 100% out of Manhattan and virtually all the surrounding bedroom communities. Those who can or choose to buy in this very dangerous environment are taking interest only loans because this is the only way they can buy at these alarming prices. 3) Real estate brokers don’t even need to lie any more to close a sale since the internal mania – and it is mania of the buyers, is propelling all sales. Apartments that say, sold for $500,000 12-18 months ago are now selling for $1.3! 4) A revolting piece of sh*t one bedroom walk up – 500 square feet, sells at $500,000 or more. Does this sound normal??

“5) Interest only loans are the scams of the century. They allow the borrower to increase his purchasing power by lowering the INITIAL monthly payment. These are adjustable rate loans so they will increase dramatically over a relatively short period of time. Then as housing prices plummet – and they will plummet – these hapless home/apartment owners will have what is called NEGATIVE EQUITY. egative equity is when the value of the asset (real estate) is worth less then the outstanding mortgage. Then when the recession hits, they will lose their jobs, the banks will foreclose and once that starts it will affect housing prices for everyone.

If your neighbors are selling at 50 cents on the dollar, you sure as hell cannot sell for 80 cents on the dollar. I lived through the housing crash on 91-93. You could not give away apartments in Manhattan! I will say however, the people who made money in those days were the ones running in when everyone else was running out and really offering 45-50 cents on the dollar and guess what, the offers were accepted. On a personal level, it is scary and sad and it is the end of the bubble because people are hysterical and insane to buy and buy at any price. New York City (Manhattan) has become a city devoid of character. It is a city of, by and for the very rich. There is simply no room for anyone else. Period. This state of affairs cannot last indefinitely. There is not an infinite number of hedge fund managers able to sustain the high end of the market.

“I am sure this is true in other areas of the country where the bubble is about to explode, but in Manhattan people who bought a couple of years ago and have watched the alarming rise in prices recognize that in a million years they could not afford to buy THEIR OWN APARTMENT today. Most of the speculative hysteria is being driven by college educated people who were wiped out in the Nasdaq bubble and seem not to have learned. Greenspan has done his job so very well, he’s snookered them again! My advice, stay calm. Don’t f***ing buy. Sit back and wait.”

As stocks go ... so do house prices (with a lag)?

In the 25 years from 1973 to 1998, the UK’s inflation-adjusted house prices showed no change. And in the 6-year period between 1998 and 2004, those prices more than doubled. In the words of one Manhattan-based realtor (see item above), “is that normal?” Back to the UK’s house prices. The BBC reported today that in March, they “experienced their biggest fall in almost 10 years” – 0.6% in one month. The British press is not shy to print stories about a possible “real estate crash”. Opposite views – about a “softer landing” – are just as common. It may be too early to talk about a full-blown crash, but this latest price drop does bring the rate of the UK’s real estate growth to under 10% a year. That is a big change from the 15-17% appreciation the market once enjoyed. Mortgage approvals are down, too. Crash or not, it looks pretty darn ominous.

A couple of years ago, we published a long-term study comparing U.S. stock prices to U.S. real estate values between 1837 and 2000. The finished chart told quite a story: Historically, real estate prices always lagged the stock market. It makes sense that they would. While both the stock and the real estate markets are governed by the same collective psychology, the stock market is a much more sensitive barometer of social mood than real estate. That “slow boat” has too much inertia – partly because houses are less liquid than stocks, partly because information about the condition of the real estate market is not plastered all over the place the way stock quotes are these days.

Since stocks have always been first to react to a shift in mass psychology, when stocks head south, eventually so do house prices. For that reason, British homeowners would be well served to keep an eye on the FTSE. After losing a better portion of its value in 2000-2003, the index has recovered significantly, but is still way below its all time high. Maybe British real estate is only now getting the bearish “message”? The answer lies in the future course of the British stock market.

Smoldering Mortgage Market

You might have heard today’s news that Freddie Mac reported a 42% drop in 2004 profits. Freddie managed to lose $4.5 billion on its derivatives portfolio alone, you know, the one designed to protect the value of Freddie’s mortgage assets when interest rates are volatile. Overall, net income fell from $6.68 per share in 2003 to $3.78 per share last year. Analysts were expecting $6.87 per share. Why the lofty expectations? Who knows? Freddie has not been current in any of its financial reporting since 2003, when it had to restate earnings by $5 billion after confessing it managed earnings, although whether that was to smooth earnings out to please Wall Street or to meet executive bonus targets no court has yet said.

Either way, something is smoldering in the mortgage-lending market, and the heart of fire is on the balance sheets of Freddie Mac and Fannie Mae. Fannie is not without troubles of its own. The stock itself is violating a 10-year upward trend and moving toward a serious breakdown. Will Fannie’s breakdown and Freddie’s earnings crack-up lead to a wider fall in mortgage lending and homebuilding stocks? It would not be at all surprising. There are other mortgage lenders, but the big ones are Fannie and Freddie – although they are secondary mortgage lenders, buying up the mortgages issued by the likes of CFC, a primary mortgage lender. These three stocks are all excellent put buying opportunities as the story plays itself out. But do not forget the homebuilders.

The HGX is made up of twenty-one of the largest homebuilding stocks on the market. It includes the top five: Pulte Homes (PHM), DR Horton (DHI), Lennar (LEN), Centex (CTX), and KB Homes (KB). As an options trader, I would look at [put options on] all six stocks, HGX plus the big five, as opportunities for leveraged profit as the bubble bursts. But if you are not into leveraged profits, sit back and enjoy the spectacle. Don’t get too comfortable, though. Many institutions – banks, pension funds, even foreign central banks – own GSE-backed bonds. The fire is smoldering.

Playing with housing stats in Silicon Valley.

The pillars of the current Silicon Valley economy are housing and jobs (mostly in that order). The Santa Clara County Association of Realtors (SCCAoR) claims the Feb 2005 county median sales price was $705K vs. January’s $610K. Wow! A $95K median increase in one month? A clue about these numbers is the 824 closed sales. Tracking weekly results from the local paper the median never exceeded $635K. Keep in mind Jan 2005’s 1,330 sales were already off 46% from a June 2004 peak of 2,450. SCCAoR’s Feb 2005 numbers put transactions volume down 66%. Records back to Sept 2002 show the previous volume low was 1,172 leaving SCCAoR’s Feb 2005 numbers 30% below a previous low.

One caveat is SCCAoR may be partitioning Townhomes away from single- family and lumping them in with condo stats. Since townhomes tend sell at a discount to standalone houses but a premium to condos, this would would raise both medians. With Nobody else doing it this way, claims of dramatic price increases would be harder to prove/disprove. More likely, is SCCAoR is not capturing all the county sales. It is merely a happy coincidence if the resulting numbers happen to be inflated and just happen to scare more buyers into rushing out to snap up a house. After all, real estate prices only go up, right? (Ignore that 38% decline in the San Jose median during the early-‘90’s hiding behind the green curtain.) The piece de resistance is a blurb in today’s local paper pointing out y-t-d 2005 Silicon Valley buyers used adjustable rate mortgages at the rate of 82%! Conclusion: Real estate prices are up, on declining volume, increasingly financed with short-term paper.

Buying or selling a home is a very personal decision. Carefully evaluate the current state of the underlying Silicon Valley economy before plunging in with your life savings. One the other hand, if you can gamble with other people’s money (0% down, 100% financing, non-recourse loan, rent it out to cover part of the interest-only payments), maybe it is not totally insane. Oh wait, that is exactly what a lot of buyers are already doing...

“MATERIAL GIRL” BECOMES “MARY’S GIRL”

On March 29, 2004 the Material Girl herself, Madonna, turned heads in a tight black t-shirt with the words “Mary is my Home Girl” emblazoned on the front – as in the Virgin Mary. Exactly one year later, a March 29 New York Times article reveals how Madonna’s fashion statement has truly become en vogue. Religious icons, imagery, and ideology are everywhere. Tank tops, baseball hats, belt buckles all embellished with messages such as “Moses is my Homeboy”, “Buddha Rocks”, and “Jesus Saves”. For those with deeper pockets, there are also designer evening dresses by the likes of Yves Saint-Laurent and Derek Lam, “seeded with ecclesiastical references”.

As the president of one trend-forecasting company observes: “There is no question, religion is becoming the new brand. There was a time when such symbols were worn discreetly and were purchased mostly at gift shops or Bible stores. Now, emboldened perhaps by celebrities, aspiring hipsters and fashion groupies as well as the devout are flaunting similar items, which are widely available at mass-market chains and online.” But that does not explain how the once hot potato issue of religion has suddenly become so cool for the stars of Hollywood (both on and off screen) AND for the fans who watch them.

That is where we come in. See, there is nothing phenomenal about emergence of The Passion of the Christ or the Fashion of the Christ, for that matter. As was written in the October 3, 2004 Elliott Wave Theorist: “The simplest forecast to make [for the coming years ahead] is that social mood and its expressions will escalate substantially toward the style of behavior on the ‘negative mood pole,’ characterized by, to name one: ‘Religion will become increasingly popular. Its advocates will become increasingly passionate.’” So, the question now is, what impact will the trend in social mood have on the stock market and the economy in the months and years to come?

Why is all the corporate dirty laundry coming out now?

A new expose seems to make headlines nearly every week, waiving the dirty laundry of some high-profile insurance, investment, internet, etc. firm. Name the company – Fannie Mae, Bally Fitness, Wal-Mart, AIG, Krispy Kreme – and the top government-sponsored regulatory groups have tracked down the stench of scandal there. And if they have not found it yet, they are sure it is only a matter of time. Even the “Oracle of Omaha” Warren E. Buffet, known as a pillar of ethics, is under attack for allegations of fraud in association with an insurance company controlled by Berkshire Hathaway – which shows us just how indiscriminate the inquest into the corner office has come. The question is, why now?

Well, the answer to that was sniffed out as long ago by the May 2000 issue of the Elliott Wave Theorist: “One result of the metamorphosis in social character is the governmental attacks against highly successful enterprises. [A decline is social mood] will bring the end of the line for bull market accounting standards and the beginning of a climate of scandal and recrimination.” A two-year long uninterrupted decimation of many of our nation’s top CEO’s followed, namely from Enron, Microsoft, and WorldCom. Then, as the stock market initiated a rally from March 2003, the accounts of corporate chicanery seemed to fade, Martha Stewart yielded to serving jail time, and in December 2004 the New York Times insinuated that NY State Attorney General Eliot Spitzer was about to “relinquish his offensive against various financial giants.”

We, on the other hand, got a whiff of something all together different. In the November 2004 Elliott Wave Financial Forecast, we offered the following analysis: “It’s time for the clamps of government control and oversight to be reapplied. The negative social psychology is now powerful enough to wipe out billions in profits – in the blink of an eye. [Be prepared for] another spate of scandals and the desire for corporate executives blood.” Which is exactly what has happened. In January 2005, 92 CEO’s got the boot or retired, the highest figure since 2001 AND the biggest corporate scandal in American history reappeared in the news in March 2005, with the conviction of WorldCom co-founder Bernard Ebbers.

Now with Martha Stewart as their example, CEO’s are ready to clean up their act, and, as a March 29 New York Times articles reveals, “there is a new kind of Puritanism” in the corporate world as companies adopt “zero-tolerance policies” with their employees and their executives alike. Well, as we know, the only thing that will determine whether our bull market heroes of business and finance will reclaim their reputations and recover their stock values is – whether a bull market in social mood and thereby stocks is set to reassert itself.

“Spice” is out, “Glum” is in.

Remember Britain’s Spice Girls, the “international pop sensation” of the late 1990’s? With at least eight #1 singles to their name, they were not exactly The Beatles – who hold a record 17 #1 singles – but they did very, very well. What made them so popular? “Sexy charisma, moderate musical talent, and ‘girl power’ philosophy,” according to one website. Here is how the band members described their philosophy: “You can do what you want in this group, it’s great! You can be as mad as you want, as normal as you want, or as loud, or as proud as you want!” “And be whoever you wanna be!” “Just be happy, have a laugh, so if you want, you can run up and down with no clothes on, but if you do feel the need to all of a sudden do that... feel free.” It was all about “girl power” and pillow fights.

My oh my, how things have changed. For a few years now, pop music charts have been showing that “spice” is out, and the “glum” is in. “Glum rock”, that is – a “glut of melancholic young pop stars whose music is providing the soundtrack to a downhearted generation,” as the UK’s Independent describes it. It all started with British Coldplay, who won two Grammys in 2003 for their 4-time platinum hit album A Rush Of Blood To The Head. Shortly after, a new wave of bands emerged that “sounded uncannily similar to Coldplay” and “accentuated the negative and eliminated the positive from pop music.” At least four of them currently top the charts in the UK and the U.S.

Music industry analysts say that, “imitation is the inevitable result of Coldplay’s runaway commercial success.” Music producers are eager to sign up new artists with the hot new sound, but it takes two to tango. The audiences cannot get enough of it, and the demand “is bigger than ever for guitar-based music,” says one analyst. “It was in the wilderness for so long while dance was exploding in the Nineties that it’s only natural to see a return.” In other words: dance is out, gloom is in.

We observed years ago that trends in music are an excellent reflection of the society’s prevailing mood: “An ‘I feel good and love you’ sentiment in music paralleled a bull market in stocks, while an amorphous euphoric ‘Oh wow, I feel great and I love everybody’ sentiment (such as in the late ‘60’s) was a major sell signal for mood, and therefore for stocks. Conversely, an ‘I’m depressed and I hate you’ sentiment in music reflected a bear market, while an amorphous tortured Argh! ‘I’m in agony and I hate everybody’ sentiment (such as in the late ‘70’s) was a major buy signal.” The popularity of “glum rock” speaks volumes about the current state of European and American societies’ collective mindsets.

OH, TO BE A FAILED CEO AND REAP THE BIG BUCKS

In recent weeks, I have realized that I have an unfulfilled dream. I want to be a CEO. I do not have any qualifications, of course. That is why I am betting I could be successful. Let me clarify. I do not aspire to be a good CEO. That is not where the easy money is. No, I want to be a chief executive failure.

To prospective employers, let me say that I would be willing to fail for a fraction of the cost of other corporate washouts. I would allow myself to be fired for a quarter of the $42 million it cost Hewlett-Packard to boot Carly Fiorina. I would walk for half of the $46,000-a-month consulting fee that Krispy Kreme is paying ousted CEO Scott Livengood, the guy who put the “dough” in “doughnut” and the hole in the company’s balance sheet. Employees get fired. CEOs get consulted. Advice from the fallen in corporate America still commands a premium.

STRUCTURAL DRAGS

From the macro perspective, U.S. business profits received their main boost from two flows in recent years. One was the phenomenal decline of personal saving, and the other was the soaring budget deficit accruing from tax cuts and higher spending. Saving is the unspent part of personal income. To this extent, wage earners reduce total business receipts in relation to total expenses incurred. The net result is a corresponding fall in profits. Conversely, when households run down their saving, business revenues rise in relation to expenses incurred. The net result is higher profits. In this way, the phenomenal collapse of personal saving in the past few years has been Corporate America’s main profit bonanza. This was far more important than the direct and indirect revenue flows from the soaring budget deficit.

But the trouble is that the soaring U.S. trade deficit in recent years has been diverting a rapidly growing share of such spending and its inherent profit creation to foreign producers. In essence, the trade deficit directly transfers spending and profits from domestic to foreign producers, leaving American producers with the wage expenses, which their employees spend on foreign goods. As we have stressed many times, the trade deficit is the greatest profit killer in the U.S. economy.

We come to the most important macroeconomic profit source in a healthy economy. Apparently unknown to most American economists, this is net capital investment. John M. Keynes expressed it with great simplicity and precision: There are two streams of money flowing to the entrepreneurs, namely, the part of their incomes that the public spends on consumption and the expenditures of businesses on net capital investment. Economists, in general, are completely unaware of the crucial importance of business investment for business revenues and profits. From the perspective of the business sector as a whole, investment spending creates business revenue without generating business expense – until the first depreciation charge is recorded. For the sellers of the capital goods, on the other hand, it produces immediate revenue.

Due to this accounting treatment, net fixed investment is typically the business sector’s most important profit source. But in the U.S., this profit source has dramatically collapsed in the past few years, as rising depreciations have overtaken gross new investment. In 2003, net fixed investment amounted to $154.5 billion, after $404.8 billion in 2000. This implies, first of all, a rapidly shrinking capital stock; and second, a disastrous drag on business profits, because depreciations are expensive.

Answering the question of aggregate profit prospects for the U.S. economy in 2005 requires a macro perspective focusing on changes in four aggregates: personal saving, budget deficit, trade deficit and net business investment. Our crucial assumption is that negative profit influences will grossly outweigh positive influences, suggesting in their wake lower business investment. If the consumer starts to save out of current income, the U.S. economy will slump. We have characterized the U.S. economy as a bubble economy in the sense that asset appreciation has become its main engine of growth. Courtesy of the prolonged sharp rise in house prices, the American consumer has been willing and able to maintain his spending despite a protracted recession in employment and wage incomes. But we see a variety of influences tempering the bubble climate.

Much economic data warn of impending strong disappointment that will prick the bubbles. Not to ignore, moreover, the Fed’s commitment to further rate hikes. Yet the refusal of long-term rates to rise in response to the Fed’s serial exertions to raise short-term rates further is perplexing. The financial community is fully aware of this immense policy risk, strictly limiting the Fed’s scope for further rate hikes. As no one is taking the Fed seriously, it may have to do more than it wants. It ought to be realized that a rise in long-term rates by only 1-2 percentage points would rapidly play havoc with all existing asset bubbles – bonds, stocks, housing – and in consequence, with economic growth. Within a matter of months, there would be deep recession.

Most people inside and outside of America have yet to realize two things: First, that among industrial countries, the U.S. economy has by far the worst structural fundamentals; and second, that it is far more vulnerable today than in the first two years of the decade. Of course, American policymakers and economists have been trumpeting the opposite for years. Having realized their complete disregard of macroeconomics, we are sure that they earnestly believe this fairy tale. It used to be an elementary truism among economists that a healthy economy is rich in savings, rich in productive investment and rich in profits. The U.S. economy is extremely poor in all three. But it is extremely rich in financial speculation and corporate malfeasance. The U.S. economy’s famous resilience had more to do with clever statistics and unprecedented monetary looseness than with true economic strength.

RESOURCE STOCKS ARE PRICED AS IF CURRENT COMMODITY PRICES ARE UNSUSTAINABLY HIGH

Wall Street analysts cannot seem to acclimatize themselves to the idea that commodity prices sometimes go up, instead of down. They still see $35 oil as the “right” price, rather than an anachronism. They have been clinging to the fantasy of perpetually cheap oil. You could say the same thing about almost ANY resource stock. The entire commodity world seems to be in backwardation – both the futures prices and the earning’s estimates. Most of the commodity futures markets, for example, anticipate FALLING prices. At the same time, Wall Street expects earnings to fall year after year for almost EVERY resource company.

In the futures markets, the prices for crude oil and natural gas and gasoline are all in backwardation to some extant – that is, the near-term contracts are higher than the distant contracts. So crude oil for delivery in May costs $54.55 a barrel, whereas oil for delivery three years from now costs only $49.60. This bearish pricing configuration would not seem so unusual, if not for the fact that oil has been in a powerful bull market for more than three years. What seems a bit more unusual is that Wall Street’s estimates for most resource companies reflect even MORE pessimism toward future commodity prices than do the futures markets themselves. Wall Street analysts, e.g., expect refiner Tesoro Petroleum to book about $3.40 per share in profits both this year and next. But then the consensus estimates plunge to $2.80 on 2007 and $1.80 in 2008.

We do not know why Wall Street has been so slow to acknowledge the commodity bull market, dear investor. But whatever the reason, we suspect that the conspicuous absence of optimism toward commodity prices presents an attractive investment opportunity. A couple of savvy sell-side analysts from Goldman Sachs recently attempted to put a price tag on Wall Street’s skepticism toward the oil stock sector: “The futures market suggests oil will average more than $50/barrel in 2006, well above the $35 assumption used in consensus EPS estimates,” observe Goldman Sachs analysts David J. Kostin and Maria Grant. “Current estimates suggest energy earnings will decline by 4% in 2006 compared with a 10% rise for the S&P 500. [But] if the futures market is correct, energy analysts will have to boost EPS estimates by an average of 76%.”

Even if the current commodity bull market perishes in its prime, it should last for another two or three years at least. That should be more than enough time to make some money betting against Wall Street’s skepticism.

THE GERMAN “WALL OF WORRY”

Germans generally are not considered to be a “worrying kind”. Stability, conservatism and diligence are the words that leap to mind as better descriptions of the “German character”. Yet for quite a while now, German businesses have only been seeing storm clouds on the horizon. The latest figures from the Ifo Institute in Munich show that March business confidence in Europe’s biggest economy has fallen to its lowest level since September 2003 (“unexpectedly”). The slump in spirits among some 7,000 surveyed German business owners is blamed on the surge in oil prices and the euro’s recent gains against the U.S. dollar. But let’s not forget that both oil and the euro spent much of last year at record highs, too. That did not keep the German DAX from posting a nice gain in 2004 or German exporters from having a record-breaking year.

German businesses would be well served to keep an eye on the stock market. German stocks are showing healthy gains this year, despite all the bad economic reports. Maybe the shaky business and consumer confidence numbers are just the proverbial “wall of worry” that bull markets are said to climb? Maybe. But every market rally ends sooner or later – and European stocks have been rallying since August 2004. Some analysts say that the slump that began in stocks on March 7 could mean that they are finally hitting a more solid wall. To our frustration, European stocks crept lower and lower during the past few days. But it all made sense yesterday, when the wave pattern we have been tracking was finally complete. And in last night’s update, we said that, “The DAX Index displays the basic Elliott pattern of five [waves] up and three [waves] down.” Despite being “basic”, this pattern is very potent. We see a low-risk, high-potential opportunity here.

A SEDUCTIVE SCENARIO: STOCKS BOUNCE BEFORE HEADING TO NEW LOWS

Jay Shartsis doesnot write poetry ... but he does craft some very seductive prose. Specifically, he examines a wide range of sentiment indicators to gauge the stock market’s likely future course. In the days preceding the March 30 rally, Shartsis had been warning his clients of an extreme “oversold” conditioned in the U.S. stock market. Based on his observations, the savvy options trader had devised a “working scenario” in which stocks bounce very forcefully for several days, before ultimately exhausting themselves and “rolling over” to new multi-month lows.

Jay based this scenario primarily on the fact that option- buyers had become a bit too bearish, which, as a contrary indicator, suggested that stock prices would advance. In particular, he noted that small investors (those who purchase less than 10 contracts at one time) had become conspicuously aggressive put-buyers. This group of traditionally “dumb money” often bets against the market at exactly the wrong time. Shartsis also observed bullish signals emanating from two other sentiment gauges he monitors.

But “longer-term sentiment indicators tell a very different tale,” he warned, referring to the final phase of his scenario – the looming sell-off after the rally. “After the market has a rally to relieve the current oversold condition,” he wrote to his clients earlier this week, “a first-rate problem for the bulls is the position of the ‘large speculators,’ thought to be mainly hedge funds, that own Dow futures contracts. They are often wrong and are now net long a record 14,196 contracts. The last time they were heavily net long was in February 2001, when they were net long 7,407 contracts, and the Dow cratered 17% in only a month a half into mid-March 2001. Particularly worrisome now is that their position is nearly twice as large as in 2001, and that looks pretty ominous.”

BEWARE OF SINGULARITIES

As the Fed raises interest rates quarter point by quarter point, the financial environment may seem to be changing little, but in reality it is becoming increasingly at risk of singularities, financial tornadoes that appear from a clear sky and produce economic devastation. Conventional economics deals primarily with equations that are linear or exponential. Relationships between the different components of the economy are held to be linear, economic growth is held to be exponential, with the economy increasing in size each year by a constant or even an increasing rate, depending on productivity growth, which is supposed to be constant in the short run albeit possibly increasing in the long run. Linear and exponential equations have the great virtue of being relatively easy for economists to solve; they also tend to behave in smooth ways, so that if an economy behaves in one way in one year it will behave in a similar way in the following year; change is always gradual, and there are no point “singularities” at which sudden changes occur.

It is an attractive if somewhat sterile picture, no doubt useful when teaching economics to the less academically gifted students. The reality is more complex, and the complexities are not simply errors of detail in the standard economic model, but fundamental flaws in its underlying mathematics. Equations were simplified to linear and exponential forms by the early econometricians, who were not particularly good mathematicians and wished to construct computer models of the economy using equations they thought they understood. In reality, a significant number of economic equations appear to be determined not by linear or exponential equations, but by power series equations, mostly of the quadratic, cubic or quartic order. This fits economics in well with physics, chemistry and other “hard” sciences where such relationships are relatively common.

Although simple quadratic equations are easily solvable, complex systems with such equations intermingled are not. The principal difference between such systems and linear/exponential systems is the existence of singularities, where a small change in conditions or a small interval of time produces a large and discontinuous change in the output, a discontinuity in the “phase space”. Modern mathematics, in particular “catastrophe theory” and “chaos theory” have examined these types of systems in much more detail than was possible 30 years ago. Discontinuities in the system do not occur randomly; over large areas of the system there are no discontinuities, while in other areas where the equation set is “critical” there are many discontinuities or even an infinite number of them.

Turning with relief back to the real world, we can see that economic crises follow this pattern quite closely. During some lengthy periods, there are no crises, and obvious areas of unsoundness in the system have very little effect, continuing or even intensifying themselves for years, without causing the damage that is predicted for them. During other periods, crises occur with bewildering rapidity, while institutions that have appeared entirely stable and well managed suddenly spiral into bankruptcy with very little warning. Late 2001 and early 2002 was one such period. The attack on the World Trade Center caused a crisis in confidence that was not reflected in any great movement in financial markets, but was nevertheless pervasive through the U.S. population. While the stock market as a whole had declined only moderately from its peak, the tech sector had imploded much more severely, and the Nasdaq index was fully 70% below its peak level of March 2000.

Cheap money, record volumes of mortgage refinancing, and negative savings rates ended what proved to have been a remarkably mild recession. For an example of how the world does not necessarily end “happily ever after” in this way, examine the three recessions of 1969-1982, which can increasingly be viewed as a malign “triple dip” linked by a period of high inflation, low economic growth and extremely low or even negative productivity growth. The economic malaise that accompanied these collapses was very severe, worse than anything since the Great Depression, far worse than the 2001-2 blip, and caused a stock market decline of 75% in real terms in 1966-82, second in U.S. history only to 1929-32, albeit masked by inflation. The difference between the two periods arose from the level of interest rates and the growth in the money supply. When interest rates are low, and real money supply growth is high, crises are few and far between and generally do not lead to unpleasantness in the economy as a whole.

When capital is cheap, with a bubbly stock market and low interest rates, frauds almost certainly proliferate but they do little damage. When real interest rates are high, on the other hand, the stock market is low, and capital is expensive, frauds are much less likely, but unexpected bankruptcies caused by the high cost of capital happen quite often, and the adverse effect on investor confidence and the economy in general from such events is severe. This is why investors today should beware of singularities. Short term interest rates are increasing steadily, and may have to increase faster because even at 2.75% the Federal Funds rate remains significantly below the rising rate of inflation. Banks, which have covered up an almost infinite quantity of insane consumer and corporate lending by the profits from the “carry trade” of borrowing short term and lending long, are looking at a bleak future.

In the corporate sector, General Motors’ likely debt downgrading will add hugely to its cost of capital, any decline in the stock market will put its pension fund irretrievably under water, and consumer difficulties will affect both auto sales and auto financing. The same is doubtless true at Ford and at DaimlerChrysler. Hedge funds, with $1 trillion of capital, have invested altogether unwisely and covered their losses through profits on the “carry trade”, which have distorted the government debt market beyond recognition. Expect huge losses of capital in this sector. Fannie Mae and Freddie Mac can expect their debt ratings to decline as rates rise and mortgage defaults soar, while their mortgage backed securities portfolios become illiquid. Expect a repeat of the Nasdaq fall of 2000- 2002; the tech sector’s only consolation is that it will not be alone, this time.

As I said, singularities. Mathematically, it will be very interesting indeed!

A SPECTACULAR BOOM IN DUBAI

I am not easily impressed. And it is not really my style to indulge in hyperbole, so I am a bit taken aback by what I am going to tell you. But what is happening in the United Arab Emirates (UAE) simply beggars the imagination. I have written a lot about the boom in China, especially Shanghai; Dubai exceeds it, and takes the meaning of a boom to a whole new level. Words like “unbelievable” and “breathtaking” are warranted. The place is like Las Vegas, but multiplied by 10. I have been to about 170 countries. But, until last month, never to the UAE, outside of the airports in Dubai and Abu Dhabi for refueling. Based on the shabby facilities and the few shops peddling knick-knacks, there seemed no reason to bother getting a visa to take a closer look. Big mistake.

The fact Dubai is not a recurring feature in most magazines is testimony to how provincial the world still is. What is happening in this part of the Persian Gulf, abutting Saudi Arabia, just about 60 miles across the water from Iran, and about 800 miles from Iraq, is far different – and ultimately far more significant – than anything going on in those places. The UAE was formed from British protectorates known as the Trucial States. After the Empire went home in 1971, seven of them joined together in a federation that became the UAE. Abu Dhabi, with gigantic oil revenues, was and is the biggest. Dubai is next in size. Dubai started pumping oil in 1969, but while the reserves were gigantic for a country of 100,000 citizens, they were small by Gulf standards, and it was clear they would decline towards zero over the next 40 years. Better than oil, which is usually a curse to those who have it in any event, Dubai was blessed with a particularly prescient leader. And a long history of making its living as a trading port.

It is funny how provincial and hysteric Americans are. When I mentioned I was going to spend a few weeks in the Mid-East I was confronted by looks of awe, fear, shock, and disgust. Dubai, I can assure you, is far safer and more interesting than 99% of the places in the U.S. And much more prosperous and developed. The place opened its first hotel only in 1959, and its first airport in 1960. The current signature building in Dubai is Burj Al Arab, a fantastic, sail-shaped building and the world’s only 7-star hotel. I tried to get a room but, even at $1100+ per night for the least expensive, they were completely booked. But, then, every one of the city’s roughly 250 hotels seemed to be booked. In addition to the most spectacular hotel in the world, Dubai will shortly have the Burj Dubai, now starting construction, which will be, at over 500 meters, the world’s tallest building and abut the world’s largest shopping center. The entire project is billed as “the most prestigious square kilometer on the planet”. I believe it.

You might think that a country that is 100% desert would not need more land. But you can always use more beachfront. Dubai has already constructed The Palm, a development that has been built out into the Gulf and adds 120 km of shoreline, plus thousands of homes, and about 40 new luxury hotels, etc., etc. It is one of the world’s greatest engineering projects. But the second Palm is under construction, and the third – which will be about the size of Paris – is planned. The scale of all this is mind-boggling. Most spectacular of all is The World, a complex of 300 artificial islands to be built 5 km out in the Gulf, resembling a map of the world. The islands range from about 2 to 10 acres apiece, and they are all pre-sold, the cheapest at $23 million. You buy your island, and you can do whatever you wish on it or with it.

Dubai has set up the Dubai Knowledge Center that, through a combination of e-learning and physical facilities, offers degrees in conjunction with a number of globally recognized academic institutions. There is also a Medical Center, a Media Hub, a technological hub and even an outsourcing zone to compete with India, all of which use the nation’s streamlined regulation and pro-business bias as a very sharp competitive edge. Almost all the labor is from India, Pakistan, Sri Lanka, or Bangladesh. When they go home, they spread tales of how the streets of a free-market economy are paved with gold. The national airline, Emirates, is probably the best in the world as far as I am concerned. I do not know any others that, as a complimentary service, pick you up for your ride to the airport in a 7-series BMW. Emirates has been highly profitable since its second year, and made about $300 million last year, even though it was only started with $10 million in capital in 1985. And they did it with no subsidies.

Naturally, I stopped by the stock exchange. For the last couple of years, all the markets in the Mid-East have been howling; Dubai was up 5% on the day I stopped by. Will I open an account? No. It is simply too hard to watch companies on the other side of the world. And I hate to get into anything that has been so strong for so long. But I now watch it out of the corner of my eye. And the day will come, when this (or any of the world’s 75 or so other stock markets – I do not care which) can be purchased for dividend yield. In the meantime, my capital has been fully deployed in junior mining and oil stocks. As you know, they have been great performers. And they are just warming up.

Will the boom continue?

As a longtime anarchist, I am of the opinion that the best government is no government at all. The fact that Hong Kong has been, until recently, just a “night watchman” state is responsible for its spectacular success; it (was) as close to a political ideal as exist(ed) in today’s world. But, perhaps because of some atavistic genetic coding, humans generally seem to want somebody in charge, a father figure who can give them the illusion of security and somehow guarantee that they live in the best of all possible worlds. It has often been said that a benevolent dictatorship is the best practical form of government, and that may be true, as long as the dictator stays benevolent. Generally, however, only the most flawed type of person actually gets to be a dictator. There are exceptions, of course, like Lee Kwan Yu of Singapore who, despite his somewhat laughable and idiosyncratic attempts at social engineering, not only did an excellent job, but found an able and non-corrupt successor. I do know that “democracy”, a vastly overrated, currently quite fashionable and widely misunderstood system, is not the answer.

Dubai’s Sheikh Rashid, who ruled from 1958-1990, said: “What’s good for business is good for Dubai.” He not only talked the talk, but walked the walk. His son, Sheikh Mohammed, is apparently at least as business-oriented. They intelligently directed revenues from their oil, when it still flowed, to prime the pump, and then let the market do its thing. This country is literally run like a corporation, with the Sheikh acting as the Chairman. The aristocracy is the other directors, and the 100,000 citizens the shareholders. Any serious deviation from a proven corporate culture simply would not be tolerated. A benevolent dictatorship that is run like a profitable business, not a dictatorship, actually can work.

People are, in most ways, very conservative. Sometimes I want to say stupid. One definition of stupidity is doing the same thing – like socialism – over and over again, and expecting different results. Another definition of stupidity is the ability to learn something – like “capitalism works” – only very, very slowly. You would think that after enough people had been to the United States in its halcyon days, all the world would have wanted to model itself after America. But nooo … they stupidly kept buying into every cockamamie socialist scheme that came down the pike from Europe.

It was argued that, somehow, America was anomalous, or that its success was due to something other than its free market practices. So America acted as an example to individuals, but not to other states. Hong Kong – basically a barren rock, devoid of any resources other than poor opportunity seekers and the free market – was not planned as a free market entrepot, but anyone could see how successful it was. Singapore, watching Hong Kong, was probably the first country in the modern world to consciously adopt capitalism (albeit in a rather paternalistic and adulterated form) to achieve success. Then, in the early ‘80s, China started copying Singapore: a socially and politically circumscribed free market. Far from ideal, but an outstanding success nonetheless.

Dubai will be, I predict – this is easy because it already is – the most successful city in world history because it is, in most ways, the freest. But what is more important is that as leaders of other countries – especially small, poor ones – visit the place, they will increasingly see that they have no alternative but to emulate it. Dubai has truly let the cat out of the bag. There is no doubt in my mind that in the next 10 years, other Dubai look-a-likes will spring up around the world, variations on a theme. For most countries, it is either that, or plan on becoming a petting zoo for those who do.

What is happening in the Emirates makes me think that even when things go bad in the U.S. – and if they go bad in China – the world economy will still continue apace. The reason is that any leader of a backwater country who sees what is happening here will understand that if a boom can be created in an absolute desert in the world’s most notoriously unstable region, then it can be created anywhere. But Dubai is important in another way. It is an example to the Arab world that they can do something as spectacular as has ever been done – and do it without the deus-ex-machina device of oil.

The success of Dubai is due, partly as a result of this ongoing change in self-perception by Arabs, to the withdrawal of their money from America. Because of the absurd War on Terror, anyone from the Middle East who keeps substantial capital in the U.S. has to be an imbecile. But where, then, to put their money? Before Dubai, there was no place within the Arab culture that was safe. Now there is. It is safer than America, and much more profitable. I wish I had gone through Dubai pre-9/11, before property prices doubled. I still think property is going a lot higher, despite the immense supply, simply because Dubai is still only for the people from the Mid-East and the sub-continent. It has barely been discovered by Europeans, less by Orientals, and not at all by anyone in the Americas. But it will be.

If you are in any business that has interests abroad, this place is in a class with any other for buying, selling, trading, outsourcing, or you-name-it. If you are looking for a good location for an offshore company, or a secure bank account, look in this part of the world or the Orient. These people are not going to be pushed around by the U.S. and other declining powers. Most important, call your travel agent and take a look.

IS WARREN BUFFETT LAZY? OR FOOLISH?

Why else would he allow more than $40 billion dollars to pile up on the balance sheet of Berkshire Hathaway? Why else would he refuse to buy any of the stocks that Wall Street’s finest minds recommend? It is possible, of course, that the Oracle of Omaha is still as shrewd as ever. So let us examine, one by one, the possible explanations for his investment IN-activity.

Explanation #1: Buffett is lazy. Maybe so. He certainly deserves to lean back in his chair and kick his feet up on the desk for a while. The 74-year old multi-billionaire has amassed more than enough money for one lifetime. In fact, he has amassed more than enough money for about 1,000 lifetimes (even after taking into account the effects of inflation over an 80,000-year span). So why should he bother with the daily grind of buying low and selling high? The answer is that he probably should not bother, but he does. He continues to explore for investment opportunities and continues to chastise himself publicly when he fails to find them. He still shows up at the ballpark every day ready to play.

Explanation #2: Buffett is foolish. This explanation seems less plausible than sloth. Smart people sometimes do stupid things, even very smart people. As Buffett recently confessed, “I made a big mistake not selling several of our large holdings during The Great Bubble.” But despite Buffet’s occasional lapses into mediocrity, he has amassed an unparalleled investment record over the last 40 years. It would have been impossible to hide foolishness for so long. Since 1965, Buffett has delivered an average annual gain of nearly 22%, or more than double the annual returns of the S&P 500 over the same time frame. Hmmm ... this does not seem like the handiwork of a foolish investor.

Explanation #3: Buffett remains a shrewd – if inactive – investor. The man is disciplined to a fault – investing only when superior opportunities present themselves and abstaining when they do not. Unfortunately, Buffett has not been finding anything he considers worth buying. In fact, as this chart illustrates, Warren and Charlie have not been finding a heck of a lot to buy for many years. Back in 1994, cash was a nearly invisible asset class on Berkshire’s balance sheet, while equity investments were equivalent to 128% of book value. But cash has been piling up ever since. This year, for the very first time, Berkshire’s cash exceeds the stated value of its equity holdings. Buffett admits that Berkshire’s growing wad of cash is burning a hole in his trousers, but he ain’t buyin’ just for the sake of buying.

In Berkshire Hathaway’s 1990 annual report, Buffet wrote, “The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It’s optimism that is the enemy of the rational buyer.” Buffett’s aversion to optimism may also explain why he is not dabbling in the real estate market either. Perhaps Buffett has observed sometime during his lifetime that real estate prices, like stock prices, do not always go up. Perhaps too, he has noticed that real estate prices are already falling in some parts of the country. “So here’s the most under-asked question of the year,” Susan Walker, in an insightful article for Fox News, concludes, “If Warren Buffet isn’t putting Berkshire Hathaway’s money in stocks [or in real estate], can this be a good time for anyone else to do it?” Good question, Susan.