Finance Digest for Week of April 25, 2005

THE BURSTING ASSET BUBBLES – INTRODUCTION (PART 1)

The recent implosion of the global equity markets in 1999-2002 – from Hong Kong to New York – engendered yet another round of the semi-eternal debate: should central banks contemplate abrupt adjustments in the prices of assets – such as stocks or real estate – as they do changes in the consumer price indices? Are asset bubbles indeed inflationary and their bursting deflationary? Central bankers counter that it is hard to tell a bubble until it bursts and that market intervention bring about that which it is intended to prevent. There is insufficient historical data, they reprimand errant scholars who insist otherwise. This is disingenuous. Ponzi and pyramid schemes have been a fixture of Western civilization at least since the middle Renaissance.

Assets tend to accumulate in “asset stocks”. Residences built in the 19th century still serve their purpose today. The quantity of new assets created at any given period is, inevitably, negligible compared to the stock of the same class of assets accumulated over decades and, sometimes, centuries. This is why the prices of assets are not anchored – they are only loosely connected to their production costs or even to their replacement value. Asset bubbles are not the exclusive domain of stock exchanges and shares. “Real” assets include land and the property built on it, machinery, and other tangibles. “Financial” assets include anything that stores value and can serve as means of exchange – from cash to securities. Even tulip bulbs will do.

In 1634, in what later came to be known as “tulipmania”, tulip bulbs were traded in a special marketplace in Amsterdam, the scene of a rabid speculative frenzy. Some rare black tulip bulbs changed hands for the price of a big mansion house. For four feverish years it seemed like the craze would last forever. But the bubble burst in 1637. In a matter of a few days, the price of tulip bulbs was slashed by 96%! Uniquely, tulipmania was not an organized scam with an identifiable group of movers and shakers, which controlled and directed it. Nor has anyone made explicit promises to investors regarding guaranteed future profits. The hysteria was evenly distributed and fed on itself. Subsequent investment fiddles were different, though. Modern dodges entangle a large number of victims. Their size and all-pervasiveness sometimes threaten the national economy and the very fabric of society and incur grave political and social costs.

Hot financial markets giving rise to talk of collapsible mega-bubble.

With the benefit of hindsight, reasonable people today agree technology stocks in the late 1990s became a monumental financial bubble. Five years from now, what will the reasonable people of 2010 recall as the great bubble of 2005? Or will they have trouble picking just one? The housing market has become the most discussed candidate for bubblehood this year. But unlike in 2000, when the dot-com mania had no peers, housing has some stiff competition on the financial gasp-o-meter. The commodities market, led by oil, has had many bubble earmarks – not least a near-vertical ascent in prices until recently. The booming Chinese economy has been slapped with the bubble label. The record U.S. trade deficit, partly an effect of China’s boom, also looks bubbly in that economists say it cannot keep growing, yet it does.

Some Wall Street veterans say the global bond and mortgage markets may constitute the scariest bubble of all, as investors and lenders have fallen over themselves to extend credit to companies and individuals at generously low interest rates. The creditors may come to regret it if the economy slows and many borrowers cannot pay their bills. Recently, fear of an economic slowdown left some investors wondering whether the stock market also deserved to be lumped back in the bubble camp after two years of hefty gains.

Given that each of the bubble candidates can be linked to one another with less effort than a game of Six Degrees of Kevin Bacon, it might be reasonable to suppose they represent one mega-bubble – the totality of our economic and financial world. It is not a pretty thought, of course, because the common denominator of all financial bubbles is that they create huge messes when they burst. Recall the hundreds of billions of dollars in retirement savings lost by hardworking people when the technology bubble exploded during 2000-02. Then imagine the potential financial harm if, simultaneously, housing values went the way of tech stocks, China halted its massive buying of U.S. Treasury bonds (which has helped finance our budget deficit and kept interest rates down) and corporate lenders found that too many of their debtors really did not deserve credit, or at least not on such benevolent terms.

The concept of a mega-bubble and its collapse is accommodatingly depressing for people who pine for the end of the world. It also may also be a fiction borne of people’s tendency to relate the present to the recent past and assume that history must repeat. Jeremy Grantham, chairman of money manager Grantham, Mayo, Van Otterloo & Co. in Boston, counts himself as more worried about a financial mega-bubble than many of his peers on Wall Street. Grantham also concedes he has been predicting a financial unraveling for the last two years and has been dead wrong. “We were horribly early,” he said. But his reasoning has not changed. Grantham said the Federal Reserve, by cutting interest rates to generational lows, inflated a new crop of financial-market bubbles by giving investors the wherewithal to aggressively bid up the values of bonds, real estate and (once again) stocks, he said. What we know about bubbles is when you are inside them, it is often hard to recognize that fact. The people of 2010 may have to make that judgment for us.

The Australian Canary

Jeremy Grantham is bubble-tracker. The chairman of investment firm Grantham, Mayo, Van Otterloo (GMO) seems to enjoy tracking and studying asset bubbles, much like a biologist might track and tag endangered California Condors. Asset bubbles, however, are hardly an endangered species. Rare though they may be, several bubbles are currently frolicking in our midst, according to Grantham. In fact, he believes, a massive housing bubble is expanding throughout the English-speaking world at this very moment.

The British bubble is, by far, the most dramatic. But it is the Aussie bubble, he believes, that deserves the most attention. “The Australian residential real estate market could be the canary in the coal mine – that is, a harbinger of bad things to come for a lot of us,” Grantham warns. “Sydney house prices rose earlier and faster than any other. Australia also raised its rates earlier and further than England… And both of these foreign markets have [a large proportion of] floating rate mortgages, so it would reasonably be expected that the effect of higher rates would impact prices faster.” According to Grantham, the Aussie canary is already swooning a bit. “Sydney prices are well off their highs,” he observes, “although as yet far from a real bust.” But the “real bust” is certain to arrive, he warns, because ALL bubbles do “indeed move all the way back to (or below) the trend that existed prior to those bubbles forming.”

Grantham allows no exceptions, simply because he has never discovered a single exception in any financial market. Bubbles form; bubble burst; prices revert to the mean – this is the natural order of the financial universe. Grantham and his research team have identified “28 good examples of previous bubbles” from within the world of global stock markets, currencies and commodities. “I am patiently waiting for the current 28th bubble, the S&P 500, to go all the way back to trend – about 750 versus today’s 1150,” he says. “It fell to within 10% of trend in 2002, but still no cigar. But… ALL the other 27 identified bubbles did indeed move all the way back to [trend].”

Applying the lessons learned from the financial markets to the real estate markets, Grantham reveals that inflated home prices are just as certain to burst as inflated stock prices, and therefore, just as certain to fall back to the trends from which they emerged. The specific trend he finds most useful in assessing real estate values is the ratio of median home prices to average household incomes. On this measure, the real estate markets of Australia and New Zealand are clearly in bubbles, while the U.K. market is, literally, off the charts. The U.S. bubble is less extreme, he allows, but any reversion to trend would still be unpleasant. Furthermore, he suspects that the pricey real estate markets on both coasts of the U.S. could suffer as badly as the Aussie or U.K. markets.

“The ‘best’ reasonably likely outcome in the U.S.,” the bubble-tracker concludes, “is that a moderate stock market decline in the next two years … could be accompanied by up to one more year of average house prices rising, for the U.S. housing market has lagged the other countries and has some good potential for catch-up in certain regional markets. … But by this time next year,” Grantham warns, “time would really seem to be running out for our U.S. housing semi- bubble. It also seems likely that by then the housing markets in England and Australia will have completely run out of steam.” Thus spake the bubble-tracker.

Economists try to explain why bubbles happen.

Jonathan Swift is credited with affixing the label “bubble” to a stock price that far exceeded its economic value in a poem written in December 1720, just after the stock price of the South Sea Company tumbled. The last stanza read: “The Nation too, too late will find / Computing all their Cost and Trouble / Directors Promises but Wind / South Sea at best a mighty Bubble.” Perhaps it is a tad late, but economists are rediscovering bubbles.

Before the prices of Internet stocks crashed in April 2000, most financial economists believed that stock prices closely matched their fundamental economic value. Indeed, a survey of 110 financial economists by Ivo Welch of Yale in 1997 found that fewer than one in 10 disagreed with the statement, “By and large, public securities market prices are efficient.” In an efficient market, all relevant public information is reflected in the price of an asset. Prices cannot be too high or too low; they must be just right. Bubbles were considered a theoretical impossibility. If a stock’s price exceeded its fundamental value, rational investors would sell the shares they own as well as sell the stock short – betting that the price will fall – therefore putting pressure on the price to fall. As long as knowledgeable, rational investors had enough funds to “attack” a bubble by short selling, even the presence of irrational investors would not permit prices to stray from their fundamental values for long.

Experience can be a powerful teacher. The rise and fall of Internet stocks – which created and then destroyed $8 trillion of shareholder wealth – has led a new generation of economists to acknowledge that bubbles can occur. What is wrong with the logic that bubbles should be attacked by knowledgeable investors? Economists now have an abundance of theories to explain why arbitrage behavior, the practice of exploiting the mispricing of assets to make a profit, does not inoculate us from bubbles.

One theory posits that smart investors, like mutual funds and hedge funds, are reluctant to bet against overpriced stocks because they would lose clients if they did not go along with others and the price continued (for a time) to rise. Another says that investors who recognize that a stock is overvalued still pour money into it because they cannot tell when others will sell the stock short, and they would forgo profitable opportunities if they pulled out too soon. If everyone is looking for the exits right away, then the strategy is clear – but no one wants to be the first to leave a good party, even if everyone knows the party is overrated. According to this theory, investors face a “synchronization risk” because many investors must attack a bubble at once for it to burst. Yet others peg the problem on regulation. Two intriguing recent papers look closely at knowledgeable investors’ behavior to sort out these explanations, and both point to synchronization problems.

Peter Temin of M.I.T. and Hans-Joachim Voth of the Universitat Pompeu Fabra in Barcelona, Spain, revisit the South Sea bubble of 1720, examining the daily trading positions taken by Hoare’s Bank, a niche private bank in London. The advantage of looking at this historic event, Mr. Temin said, is that “we can look at the actual records at a time when we don’t have complications of modern life, such as regulation.” Jonathan Swift, Isaac Newton and other lay investors lost substantial sums in the South Sea bubble, but what about sophisticated investors? Hoare’s Bank, which is still in business, opened its archives to the professors. They discovered that Hoare’s was a cautious, sophisticated investor that undoubtedly recognized that South Sea’s price was unsustainable. Yet the bank decided to “ride” the bubble, investing its own funds after it thought the stock was overpriced. In the end, the bank made a tidy profit because it invested early and sold some of its stock as the price fell. The most plausible explanation for this behavior, the economists concluded, is that the bank did not know when other sophisticated investors would stop buying the stock, so the lack of coordination allowed the bubble to grow.

Looking at the Internet bubble 280 years later, Markus K. Brunnermeier of Princeton and Stefan Nagel of Stanford provide the first detailed study of the trading positions of hedge funds. Extracting quarterly information from Form 13F filings, which are required of large institutional investors, they are able to peek at the stock holdings of 53 hedge fund managers, encompassing hundreds of major funds, including Soros, Tiger and Tudor. Like Hoare’s Bank, hedge funds continued to invest in highly priced Internet stocks deep into the bubble. At the peak of the market, in March 2000, hedge funds held 31% of their stock portfolios in companies with the highest price-to-sales ratios. Hedge funds reduced their holdings of Internet stocks when the price fell, but their portfolios were still weighted more heavily toward highly priced stocks than other investors’. Although hedge funds pursued diverse strategies, Professors Brunnermeier and Nagel found “no evidence that hedge funds as a whole exerted a correcting force on prices during the technology bubble.” Riding the bubble and timing sales paid off: hedge funds’ investments in the technology sector outperformed market benchmarks.

Hoare’s Bank and the hedge funds may have been lucky – indeed, there is no evidence that the hedge funds outperformed the market outside the technology sector – but their strategies still indicate that at least some highly skilled investors were riding bubbles instead of attacking them. Bubbles create many problems. Investors gain a false sense of wealth and security, and capital can be misallocated. What should we do about them? Professor Brunnermeier has a modest proposal: Greater disclosure could help to synchronize attacks on bubbles, and thus prevent them from inflating in the first place.

THAT WALL OF WORRY

Maybe I was wrong. Maybe the stock market will not be up a lot in 2005. The year sure has not started robustly. It is always possible to be wrong. What do you do when your plans go awry? First, don’t panic. On Sept. 6, I detailed why having been too bullish does not necessarily mean that you should change course. Those principles apply now. The key is this: You should sell stocks only if you foresee trouble that other people do not foresee; don’t sell in fear of trouble that everyone else is already anticipating. The only reason for a defensive posture, in other words, is perceiving risks that are little noticed. I cannot find many.

So what might be bothering you? Inflation? Rising rates? A weak dollar? Look closely and you will find that such worries are (a) widespread and already priced into the stock market and (b) exaggerated. Inflation is not as bad as you probably think it is. Over the past 12 months prices (excluding food and energy) are up 2.4%. As for rising rates: The rise is pretty much limited to the U.S. and to the short end of the maturity spectrum. Rates are not going up abroad (for the most part) and are not going up very much on long-term bonds. The 30-year U.S. Treasury yields 4.7%, down from 5.2% a year ago. Don’t worry about interest rates unless you have an adjustable-rate mortgage. Rising short-term rates by themselves do not have a predictive history for global stock prices.

Weak dollar? The dollar is actually up against all major currencies so far in 2005. Budget and trade deficits? They are for real, but they do not hurt the economy or the market, as I have pointed out in recent columns. Or, that stocks might fare badly for a decade as is currently fashionable to presume? Relax.There is no rational way to make such statements. Those who do are telling more about what they do not know than what they do.

If you want something to worry about, consider long-shot risks that other people are overlooking. One on my list is if George Bush appoints a disaster to replace Alan Greenspan. Another is if budding intracountry social tensions within the EU cause an economic disintegration there. Others: a large terrorist attack; a new era of repression in China that depresses its economy. None of these is impossible, but I think the odds are sufficiently low that they do not justify an exit from equity investments.

Here are four stocks to consider in the current environment: 1.) MBNA (24, KRB) is the world’s largest credit card company. As investors eventually learn that the consumer is not tapped out (another overblown fear), this outstanding firm should sell at higher valuations than its current 12 times trailing earnings. 2.) Bunge Ltd. (51, BG). A global agribusiness giant, with more than 100 processing plants worldwide and rapid growth, this mid-cap value stock has been public only since 2001, and is going to attract a following and a concomitant higher multiple. 3.) Fiserv (41, FISV) sells software and services to banks, broker-dealers, credit unions, financial planners and investment advisers, and other financial services providers. It achieves consistently high growth rates; yet at 19 times 2005 earnings and 2.2 times revenue, it sells at a significant discount to the average IT firm. 4.) Denmark’s TDC (22, TLD) is dominant in its midsize landline, cell and Internet market yet cheap compared with global peers by almost any standard. Earnings have been poor recently but are coming back. It currently sells at 13 times this year’s earnings – buy it now and you will probably enjoy a dividend yield this year of at least 7%.

MEXICO SHOULD USE THOSE GRINGO DOLLARS

Mexico’s presidential election is not untill July 2006, but Mexico’s investors are already worried to the point of sleeplessness over the electoral outcome. And worry they should. Likely outcome: The winning candidate will keep in place the country’s defective monetary regime. Even though Mexico (no less than the U.S.) has benefited from the 1994 North America Free Trade Agreement and from relative economic stability during President Vicente Fox’s administration, the country still has not fully recovered from the “tequila crisis” of 1995. In the ten years since, annual gross domestic product growth has been an anemic 2.6%. This is not much above Mexico’s annual population growth of 1.5% and far below the 6% you would expect in a country brimming with eager workers and bordering a nation that could easily supply the capital to make them productive.

A key culprit contributing to Mexico’s malaise is its monetary regime. Mexico’s feeble growth stems from the central bank’s manipulation of the peso. It has sterilized dollar inflows. That is, as dollars come into the country and the central bank issues new pesos in exchange, it simultaneously issues debt to soak up the peso liquidity. These operations are not costless. Inflation-adjusted short-term interest rates remain punishingly high at 5.3%, well above Mexico’s growth rate over the last decade.

In the face of Mexico’s malaise the peso is failing to meet the market test. Mexicans prefer greenbacks to a floating peso. In consequence the peso is rapidly losing market share. The Mexican economy continues to spontaneously dollarize. Since 1996 remittances of dollars have totaled $75 billion, while the dollar value of the peso supply has increased by only $17.1 billion. With the peso’s importance shrinking and peso interest rates suffocating the economy, it is time for Mexico to come clean and officially dollarize. But officially adopting a sensible monetary policy – one embraced privately by Mexicans – is probably not in the cards. This means more economic malaise – and more emigration.

THE BARBELL STRATEGY APPROACH TO BOND PORTFOLIO ALLOCATION

Barbells are not just for bodybuilding. This is the name of a smart bond strategy for when interest rates are rising, like now. To create a barbell bond portfolio, you buy obligations with maturities clustered at the two extremes of the yield curve – long and very short, usually a 50-50 split to start. This strategy gives you good interest from the long end (I would go out ten years). From the short end you get the flexibility to produce quick cash for eventually purchasing other longer-term bonds, whose prices will be declining amid the escalating rates.

Such a maneuver is best accomplished with municipal bonds, which, for high-bracket taxpayers, yield more after taxes than U.S. Treasurys. One reason to use munis is that myriad good ones that pay well are available these days. This is particularly true for short-term munis, whose yields fluctuate to jibe with prevailing rates. What I have in mind are the floating-rate munis with rates that reset daily, weekly or monthly. Their principals stay at par value. Minimum purchase: $100,000. They are blessedly without bid/ask spreads; you buy them and put them back at par to the issuer whenever you want.

RIDING THE REAL-ESTATE TSUNAMI

A new Mike Davis piece at Tomdispatch is, to my mind, always cause for rejoicing. If you live in the San Francisco Bay Area or New York City, or at various other familiar urban locations (or their suburbs), you already know that buying an apartment, or a house, has become a kind of living nightmare beyond the means of most people. Take Washington, where, according to the estimates of real-estate agents and builders, prices have risen by about 15% since the beginning of this year – add that to the 21% rise last year and the 89% rise over the last five years, and you may have the American equivalent of Tulipmania. As Washington Post reporter Daniela Deane puts it of the present housing mania in the Washington area, “It’s another insane spring in the local real estate market. As the prime season for buying and selling unfolds, very few homes are for sale, prices are climbing rapidly and desperate would-be buyers are bidding feverishly against each other… But now the question comes up more and more: How long can this last?”

Needless to say, at least some mainline economists are starting to get nervous about whether the housing boom is not a housing bubble. Mike Davis, on the other hand, asks whether it is not a housing bomb set to explode right under the Bush administration. As he does on just about any subject he touches, Davis takes our real-estate boom and makes a new kind of news out of it, suggesting that the Bush administration is riding this particular economic tsunami to an uncertain – but possibly unenviable – end. Read Mike Davis’s piece and think about the economic realities of imperial America.

Lenders have fueled the housing market with no-money-down, low-monthly payment loans. At what cost?

Economists have all kinds of reasonable explanations for the historic housing boom: Low interest rates, demographic trends and supply constraints are the usual buzzwords. There is another reason, and it is increasingly cause for concern. “Pretty much anyone can get a loan within reason,” said Robert Moulton, president of mortgage brokerage Americana Mortgage Group in New York. To be sure, many home buyers would not be trading up, buying a first home or investing in a vacation house if it were not for lower down payment requirements, loans with ultra-low monthly payments and flexible lending standards.

According to Keith Gumbinger, vice president for HSH Associates, the shift in lending standards started after the dot-com stock bust in 2000. As big investors shifted out of stocks and into bonds – such as mortgage-backed securities – banks had more money to lend out. “What is new today is that lenders are allowing for the layering of risks on top of one another,” Gumbinger added. “What we don’t know is what if we put all these risks together and put them in a rising interest rate environment, a declining housing market, or a weakening economy.” If music stops playing who is left standing? Lenders might feel some pain, said McBride, but ultimately it is the borrower who is stuck with the loan – or the lasting consequences of foreclosing.

Housing experts wary of bubble fatigue.

Bubble or not, the U.S. housing market has stayed afloat at a high altitude for the past two years. So what do experts look for as the first signs of fatigue in a frothy housing market? Mark Zandi, chief economist for Economy.com, said it will not be buyers who will disappear. Instead, he believes disgruntled sellers will bring the market to a halt. “People will start pulling their homes off the market if they think they can’t sell it at a ‘fair price’, which is now perceived to be a very high price,” he said.

Douglas Duncan, chief economist at the Mortgage Bankers Association, believes the biggest factor that will drive a decline in housing demand will be interest-rate changes, particularly a sharp shift higher. Zandi and Duncan are in the camp of those who believe that there is a housing bubble in certain markets that are “infected” by speculative buyers. These are markets in which buyers have no intention of living in the house. Instead, they plan to quickly sell the property and reap the benefits of rapidly rising housing prices.

An increase in aggressive borrowing, practiced by those who look for interest-only or variable-rate loans, also would signal a housing bubble about ready to burst, those in the bubble camp said. The housing bubbles exist in California, the Pacific Northwest, parts of the Mountain West, all of Florida and along the East Coast from Boston to Washington, D.C. “Bubbles don’t pop overnight,” Zandi said. “They continue to build for long periods of time. Look at our experience with the stock market. We were worried about a stock market bubble for over three years before it actually burst.” Others look at not so conventional signs.

High stakes will not allow us to admit housing bubble.

It is hard to overstate the stakes riding on the housing market. The powers that be insist there is no housing bubble. They have to – mass delinquencies and foreclosures are simply not an option, not with the risks built into the mortgage-finance system. My math suggests that the size of the entire mortgage market is more than $8 trillion, about double that of tradable Treasuries. The general concern about these instruments is that they have yet to be “tested” by an inevitable market downturn. Is there risk in today’s lax lending standards? When you see the magnitude of the risk, you know why admitting a bubble is simply not an option.

Consumer confidence fell in April, but the housing market seems hotter than ever.

Confounding most forecasters, who had expected home sales to decline last month, the government reported that sales of new homes rose sharply by 12.2% in March and hit a record annual pace of 1.43 million. The unexpected surge came despite slightly higher mortgage rates last month, worries about slowing growth and an escalating debate about a “housing bubble” in at least some regions that many specialists argue might be on the verge of bursting. But despite scattered signs pointing to slower growth, the strong pace of home-buying is expected to reinforce the Federal Reserve’s intention to keep raising interest rates until they have reached a level that no longer serves as a stimulus for growth. The central bank is expected to raise short-term rates by another quarter point next Tuesday, to 3%, which would be the eighth rate increase since last June.

Analysts said part of last month’s rush to buy homes probably reflected a race by people to complete deals before mortgage rates start to climb higher. But a growing number of Wall Street economists are convinced that a housing bubble is under way, at least in many parts of the country. Housing starts declined precipitously last month, which may have reflected an expectation among builders that higher interest rates would stifle demand later in the year. But sales of existing homes climbed 1% in March and have climbed 4.9% over the last year, according to the National Association of Realtors. “We think there is a bubble, and we think the risks are higher that it will burst,” said Sheryl King, a senior economist at Merrill Lynch. “Even if you adjust for population growth, you’re seeing numbers that are bigger than any we have seen at this point in any previous economic cycle.”

The housing market: what was not said.

On April 26, the mainstream financial media delivered a housing story the likes of which fairy tales are made of, after the Commerce Department reported a 12.2% rise in new home sales for March – the largest monthly gain in more than a decade. The housing “bubble” had been canceled, claimed the experts, as the unexpected surge was clearly “evidence of continued strength” in the sector. And, the celebration from the investment community was immediate. Yet, there remained some who said that while the bubble had been beaten back, they still felt a weak pulse. In their opinion, if and when a real estate bubble bursts, it will pop in one of three ways: gradually and gently, locally – not globally, or later. In any case, the sales news cinched the consensus about the future of housing: It is “red-hot, and only getting hotter.” (ABC News) And really, it is hard not to get a little happily-ever-after-heady when you just consider the record-high surge in new home sales.

But the fact is, this “evidence of continued strength in housing” is only half the story. Turns out, we had to check with the less “conventional” economic publications to find the rest: The median price of new homes in March plunged 9.3%, a drop that tied the largest monthly decline in the history of the data (going back to 1963). Also, construction activity on new homes and apartments in March fell 17.6%, the sharpest decline in 14 years. Not to mention the ever widening gap between home prices and wage growth: In California, for example, only 19% of families can afford to purchase a median-priced property versus 37% in 1999. Obviously, these facts do not fit into the storybook version the mainstream media was hoping to have you believe, which begs the question: how much do you really know about the health of the U.S. housing market?

U.S. investors turn to real estate, pushing home sales higher.

Benedek Investment Group, a 2-year-old investment firm in New York, has provided seed money to startup entertainment companies including Broadcast Interactive Media and Channel M. Now, it is betting on U.S. real estate. The firm, founded by 32-year-old Stephen Benedek with profits from the sale of his family’s broadcasting company, is financing the construction of four houses in the Hamptons, the summer resort on the eastern tip of New York’s Long Island that attracts movie stars and Wall Street executives. The first of his Southampton homes is on sale for $6.9 million.

Investors are treating U.S. homes like stocks and bonds – a chance to make a trading profit. Real estate investors accounted for about 9% of home purchases in 2004, up from 6% in 2003, according to Fannie Mae. In some markets, the share was as high as 30%. “People have been putting more money into housing than they normally would because they’re so disillusioned with the stock market,” said Roger Kubarych, 60, a former Federal Reserve economist who is now a senior adviser at HVB America Inc., a New York-based unit of German bank HVB Group. The Standard & Poo’qs 500 Index is down 22% since the end of 1999.

“The timing is perfect,” Benedek said in an interview, referring to his Long Island project. About 1.15 million homes will be sold this year, second only to the record 1.2 million sold in 2004, according to an April 5 forecast by the National Association of Home Builders. Some policy makers and homebuilders are concerned that the influx of investors is helping to overheat the residential real estate market. “A couple of years ago, I was fairly confident that the rise in real estate prices primarily reflected low interest rates, good growth in disposable income and favorable demographics,” Federal Reserve Governor Donald Kohn, 62, said in an April 22 speech at the Levy Economics Institute of Bard College in Annandale-on-Hudson, New York. “Prices have gone up far enough since then relative to interest rates, rents and incomes to raise questions” about whether the market is headed for a decline, he said.

U.S. house market boom set for bust?

In financial crazes, there is usually a general frenzied belief that the old rules of economic gravity have been superseded – but are we about to (re)learn the hard way that prices that go up can come down with a bump? Certainly, the anecdotes indicating there is a boom with at least an element of speculation are starting to echo those of the red-hot Nineties. Official figures just out show that the housing market is as hot as ever: the sales of new homes rose by twelve per cent last month despite widespread gloom about oil prices and debt. Stories abound of property in Florida being bought and sold within the same day to make a killing on the rising price, and the “how to” guides to trading real estate are selling as fast in the book shops as, well, as fast as a new condominium in Florida.

Just like in the Nineties, cheerleaders are urging buyers to believe that staying out of the market means foregoing easy money. David Lereah, the chief economist of the National Association of Realtors, says in his new book, Are You Missing the Real Estate Boom? that investors should “experience substantial and satisfying wealth gains.” He calls the current boom a “once-in-every-other generation opportunity”.

Certainly, one of the best observers of markets believes that the rise in property prices has been driven by speculation. Yale economist Robert Shiller wrote at the end of the 90’s about the bust that was waiting to happen. His book Irrational Exuberance was published in March 2000 as the market started to turn. He has now up-dated it with a focus on the property market. “There is no hope of explaining home prices solely in terms of population, building costs or interest rates. None of these can explain the ‘rocket taking off’ effect starting around 1998. So what did cause this real estate boom in so many parts of the world? My conclusion: home-price speculation is more entrenched on a national or international scale now than ever before,” Mr. Shiller observes.

None of which means that the market is about to turn or even crash tomorrow. Nobody – nobody – can predict market behavior. And a change in sentiment in the housing market may just mean stagnant prices as incomes rise. But caution does seem to be in order. Big debts when asset prices are falling is bad arithmetic.

More trouble may be found at Fannie Mae.

The accounting problems that have rocked Fannie Mae may run even deeper, the federal regulator overseeing the mortgage giant has suggested. Uncertainty created by the accounting scandal at the biggest U.S. buyer of home mortgages has the potential of spilling into the housing industry and making mortgages less available for homebuyers, Armando Falcon said in an Associated Press interview. Government-sponsored Fannie Mae was accused last fall by Falcon’s agency, the Office of Federal Housing Enterprise Oversight, of serious accounting problems and earnings manipulation to meet Wall Street targets. Congress created Fannie Mae and Freddie Mac in order to inject money into the home-loan market. They buy mortgages from banks and other lenders and bundle the loans into securities for sale to investors worldwide.

It helps to have the right picture.

Mortgage rates obviously have not climbed by 80%, but that sure is how far refinancings have fallen. In truth, rates remain at historically low levels, and lenders galore stand ready to convert home equity into debt. Yet the “Running Dry” phrase on the chart has it right (Courtesy of Barron’s ). Home equity is a measurably limited resource; each homeowner can use only so much before it is exhausted. Put in other words, if every house in the neighborhood has all the family jewels already in hock, it tends to cut down on the foot traffic into the local pawnshop. If you do not like the analogy to pawnshops, perhaps a sports metaphor will do: The steroids have run out, and the prescription cannot be refilled./p> Link here.

The most expensive ZIP codes of 2005.

From Beverly Hills to TriBeCa, from notorious enclaves of mansions and lush lawns to little-known niches of wealth, we looked at ZIP codes around the country to find the ones where home prices were the highest last year. Many of these neighborhoods are rarified places, of course. They are close to beaches and golf courses and prime yacht moorings – or at least within spitting distance of the power centers that are the sources of great wealth. Thanks to their high tax bases, these areas also usually offer better schools, health care and public services – not to mention such amenities as better exotic car mechanics, caterers and gardeners. The homes are often proof of the good life, if not always good design.

But there were some surprises. The list is testament to the costs of living in California, with half of our top ten ZIPs in that state, and nearly two-thirds of our top 25. It is not such a shock when you consider that California home prices increased nearly 100% between 1999 and 2004. But the real estate market in some locations has made a U-turn since the dot-com bust – several of the most expensive places are in or very close to San Francisco and Silicon Valley. Meanwhile, the best known ZIP code in California, 90210, also known as Beverly Hills, ranked only No. 15. Then there were the places that indirectly fed off of West Coast money. Two of our top 25 ZIPs were in tax-free Nevada, but not in Las Vegas, where home prices shot up more than 40% between 2003 and 2004. Instead, they were old-money resort bastions around Lake Tahoe.

And while more diverse than postal areas such as the Upper East Side of Manhattan or Lake Shore Drive in Chicago, have more than their fair share of high-priced properties, urban areas usually ended up lower on our list. That is because those ZIP codes are more diverse than those that encompass exclusive and relatively homogenous suburbs where home prices do not dip below $1 million.

Spiraling housing costs hurting more Americans, according to studies.

The American dream of having a job and owning a tidy home is becoming a fantasy for more people. Housing prices are outstripping wage increases in many areas, meaning more people are either spending above their means or living in dilapidated conditions, according to a pair of studies being released by the Center for Housing Policy, a coalition pushing for more affordable housing.

It is generally accepted that a family should not spend more than 30% of its income on housing to ensure there is enough money for other necessities. But in a recent 6-year period, the number of low- and middle-income working families paying more than half their income for housing has increased 76%. In 2003, 4.2 million working families spent more than half their income on housing, up from 2.4 million in 1997. The problem is even more acute for immigrant working families. They are 75% more likely than native-born working families to pay more than half their income for housing.

Barbara Lipman, the research director for the center, said a full-time job does not guarantee families a decent, affordable place to live. “The problem seems to be impervious to economic conditions because the number of working families in this situation has grown during the boom-boom ‘90s and early 2000s,” she said. “More families are competing for a limited supply of affordable housing. The price is going up faster than the wages of working families.” One out of every eight families in the U.S. – 14 million – had critical housing needs in 2003, defined as either paying more than half of income for housing or living in run-down quarters. The center found homeowners now are more likely than renters to have critical housing needs – 55% of the 14 million are people who own their homes.

And even though some people buy houses farther out that are more affordable, their commuting costs increase and consume a chunk of their savings.The group found that for every $1,000 families saved on housing by moving some place cheaper farther out, they are only $225 ahead because their transportation costs go up so much. For renters, the center found a worker needed to earn $15.21 an hour in 2003 to have a two-bedroom apartment that did not consume more than 30% of income. But the national median wages of retail sales workers and janitors, for example, were under $9 an hour.

We are only as safe as housing.

I get a lot of reader mail asking about my strong views on the housing market. One letter this week from a Dallas custom home builder echoed what many other readers have asked: What is the connection between Fannie Mae and Freddie Mac and a housing bubble, if one does indeed exist? Assuming it does, when might this bubble pop? And finally, why are you so caught up in this issue?

So here is my thinking: Let us say for a moment that all of the credit that is being extended to purchase homes at inflated prices is not of the highest quality. The proof here locally is that foreclosures have gone through the roof. That is what happens when bad credit meets up with stagnating home prices. Now extend that scenario to the really hot markets that have yet to suffer flat – not falling, just flat – home prices and you get to what keeps me up at night. Maybe even Alan Greenspan, too.

Because this housing run-up is unlike any other in our history, no one knows what the financial system will be able to bear when the cracks start to break through. Ironically, Fannie and Freddie “shock” their portfolio regularly, testing how their portfolio would hold up in the event of a major housing downturn such as the Texas savings-and-loan crisis in the 1980s. The problem with that is, the test is not stringent enough. National home prices have already gone up by double what they rose leading up to the S&L scandal. When will this happen? If I knew, if anyone knew, we could all sleep better at night. The Fed keeps trying to get interest rates up but has failed because long-term rates reflect how weak our economy is and will be. Until long-term rates rise, though, people will continue to refinance at every opportunity to make up for what is lacking in their paychecks.

Stock market bubbles impact those who can afford to buy stocks. When that bubble burst in 2000, that included about 45% of Americans. But a record 70% of Americans now own a home. So housing bubbles have the ability to inflict much more pain on communities and our broader economy.

Some U.S. real estate investors see potential in Asia, Europe.

With U.S. home sales still surging to record highs, some investors are beginning to ask if the easy money has already been made in the U.S. real estate market. And some of them are looking overseas for growth opportunities. A case in point is CalPERS, the massive California Public Employees’ Retirement System. It is investing in a housing development in Mexico, but most experts putting their money into foreign markets are looking to the Far East. “Fundamentally, there’s greater growth in Southeast Asia,” said Sam Lieber, who manages the Alpine International Real Estate Investment Fund, which has tripled in size over the last nine months as investors have poured in. Places like Hong Kong, Singapore and Japan are starting to turn the corner in terms of growth Lieber said. And the UK and Germany are good prospects to he added.

Canada represents a good growth opportunity, ING Global Real Estate Fund manager Ritson Ferguson said, noting that Canadian REITs – essentially, securities that sell like a stock and invest in real estate directly, either through properties or mortgages – are now returning 7.8 or 7.9% versus the 4.8 or 4.9% return for U.S. REITs. Most agree, however, that the best turnaround story is in Japan. With the Japanese economy beaten down for so long, prices are quite depressed and now at levels not seen since 1990.

And then there is China. Richard Kiwata, an analyst at the Penguin Consulting Group, says investors should be careful and asses the potential financial risks of such an investment. “A lot of people have rushed into China and wanted to get on a train that’s running at 110 miles an hour,” Kiwata said

BETTING ON INEVITABILITY

American financial companies are promoting the inevitability that long term stock market returns will treat us as kindly as orchid lovers treat their ungrateful little subjects. As noted last week, Ed Easterling has taken issue with the idea of good times springing perpetually from U.S. stocks, but apparently not everyone has read his book yet. For example, a New York Times article indicates that buying stocks now is a can’t lose situation since stocks have never produced negative returns over any ten year period, except for some glitches in the wake of the 1920s stock market bubble, and that was a long, long time ago.

The thing about Ed’s book is that he does not remind you that the 1990s stock mania was in many ways bigger than the 1920s mania, or how credit excesses are worse today than in the flapper era, or that the unwinding of massive credit bubbles is never kind to asset prices, or that today’s Great Derivatives Era might be more prone to tilt than the 1920s financial environment where the most dangerous financial innovation was the installment loan. No, Ed’s book, just presents the numbers, which evidently, still need to be passed around a bit more. So once again, the accompanying table from Ed’s book shows that, yes, stock market returns for even 20-year periods can be downright unimpressive, particularly if purchased during periods of high market valuation.

But what about today’s bargains? The Times notes that, by golly, stock market PEs are below their 15-year moving average. An appropriate response, as a teenager in the 1970s might have said, is, “Big Whoop”. The last several years have been years of darn high and record high PE ratios. To say that stocks are cheap today because PEs are lower than they have been recently, is like saying that Jimmy Choo shoes are a better value for your dollar than Reeboks whenever they dip below a grand.

The other theme in Ed’s book that apparently bears repeating is that even if earnings grow at historic rates from here, PEs must retain their lofty status to deliver merely decent returns, and they must increase from here if stocks are to produce anything close to average and above-average returns. But for that to happen, as Ed keeps telling us, inflation must stay in the blissful 1.5% range for years, an event as likely as the Weekly World News banning the term “alien” from its headlines.

PENNY STOCK SPIES

Shares in a high-flying penny stock called Ionatron Inc. had been climbing for months on a steady flow of press releases about the company’s opportunities at the sword’s point of high technology in the post-9/11 world of homeland defense. Then suddenly, on March 18, with Ionatron’s shares having climbed to a high of $10.41, the company’s stock was hit with an avalanche of insider selling, as more than 50 Wall Streeters privy to Ionatron’s innermost secrets bailed out of nearly every share of stock they held, knocking more than 30% off the price in the days that followed.

Another cautionary tale from the pump-and-dump annals of the penny stock market? In fact, it is a lot more than that, for behind last month’s bailout at Arizona-based Ionatron lies an astonishing tale of taxpayer-financed intrigue on capitalism’s street of dreams. In reality, nearly every one of the more than four dozen insiders who dumped their Ionatron shares on March 18 have now been identified by The Post as employees of a secretive, Arlington, Virginia, investment group that is owned, operated and financed out of the black box budget of the C.I.A. The group, which calls itself a “venture capital fund”, and goes by the name of In-Q-Tel Inc., was set up in 1999 by the C.I.A’s then-director, George Tenet. His idea: that by investing in promising young companies in digital technology, the fund would be able to keep the agency abreast of developments in this fast-changing world while they were still on the drawing boards.

Whether Tenet was troubled by the many worrisome consequences of allowing the C.I.A. to become a force on Wall Street, he clearly saw at least one problem with the approach, and sought to address it by setting up the fund as a not-for-profit corporation – in this way presumably sanitizing it from any suspicion that employees of the spy agency might be using it to speculate with taxpayer money for their own personal benefit. Nonetheless, a review of various financial documents filed at the S.E.C. reveals at least three public companies in which the C.I.A.-backed fund has taken major equity positions. And in each of the three cases, the fund’s employees were able to stage an end-run around In-Q-Tel’s not-for-profit legal status and benefit personally from the fund’s investments.

ORIGINAL SIN

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the U.S. central bank has led the charge in attempting to rewrite conventional macroeconomics and in making an effort to convince market participants of the wisdom of its revisionist theories. The problem is that this recasting of macro is very self-serving. It is a concentrated effort on the part of the Fed to exonerate itself from the Original Sin of failing to address asset bubbles. The result is an ever-deepening moral hazard dilemma that poses grave threats to financial markets.

I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind. It all began with Alan Greenspan’s worries over “irrational exuberance” on December 5, 1996, when a surging DJIA closed at 6437. The subsequent Fed tightening in March 1997 was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy – consumers and businesses alike. It was a classic example of the Fed playing the role of the tough guy – the central bank that, to paraphrase the words of former Chairman William McChesney Martin, “takes away the punchbowl just when the party is getting good.” Unfortunately, the tough guys were not so tough after all. Predictably, there was a huge outcry on Capitol Hill as the Fed took aim on the U.S. stock market. But rather than stay the course as an independent central bank should, the Fed ran for cover in the face of political criticism. Not only were its initial bubble-containment efforts put aside, but Alan Greenspan went on to champion the notion of a sea-change in the macro climate – a once-in-a-century productivity miracle that would justify the stock market’s exuberance as rational. That was the Original Sin that has since been compounded in the years that have followed.

Out of that pivotal moment in the late 1990s, a New Economy actually did come into being. But it was not the new economy of ever-accelerating productivity growth that infatuated the New Paradigm Crowd and legions of equity-market speculators. Instead, it was the Asset Economy that enabled consumers and businesses to draw on the pixie dust of a new source of purchasing power – asset appreciation – as a means to augment what has since turned into a stunning shortfall of organic domestic income generation. Unfortunately, the asset-based spending model has given rise to many of the distortions and imbalances evident in the U.S. today. That is especially true of low saving rates, the housing bubble, high debt loads, and a runaway current account deficit.

The Fed is not only hard at work in the engine room in keeping the magic alive with a super-accommodative monetary policy but is has also become the intellectual architect of the New Macro. Time and again, since Alan Greenspan rolled out his New Paradigm theory in the late 1990s, senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy. Is this is an appropriate role for a central bank? In my view, absolutely not. The problem with an activist central bank is that decision makers in the real economy – consumers and businesspeople alike – mistake the Fed’s point of view for strategic advice. And so do financial market participants.

The rhetorical flourishes of America’s central bankers have dug the U.S. economy – and by definition, a US-centric global economy – into a deep hole. To this very day, the Fed has never confessed to the Original Sin of condoning the equity bubble. On the contrary, Greenspan & Company have been on the defensive ever since by dismissing the increasingly dangerous repercussions of the original post-bubble shakeout. Far from playing the role of the tough guy that is required of independent central bankers, the Fed has become an advocate of the easy money of a powerful liquidity cycle. One bubble has since begotten another – from equities to bonds to fixed income spread products (i.e., emerging market and high-yield debt) to property. And financial markets have gone along for the ride – not just in the US but also around the world as global investors and foreign central banks have rushed with reckless abandon to finance America’s record current-account deficit.

The day is close at hand when U.S. monetary policy must get real. At a minimum, that will require a normalization of real interest rates. Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone – possibly as high as 5.5%. Yes, this would cause an outcry – perhaps similar to that which occurred in the spring of 1997 on the occasion of the Original Sin. But in the end, there may be no other choice. Fedspeak has taken us into the greatest moral hazard dilemma of all – how to wean an asset-dependent system from unsustainably low real interest rates without bringing the entire House of Cards down. The longer the Fed waits, the more perilous the exit strategy.

Can the Fed downshift smoothly?

It is called a “soft landing” – when the Federal Reserve tames inflation and tempers an overheating economy’s growth by raising interest rates. It is not easy. The problem is that when the Fed boosts interest rates, as it has been doing steadily since June, it usually sends the economy into a crash landing. Virtually all recessions since World War II have been preceded by Fed interest rate hikes. With fresh signs in recent weeks that economic growth is slowing while inflation is heating up, analysts are debating whether the U.S. economy could be gearing up for a repeat performance. Some economists contend that the Fed has less control over the economy this time around, partly because of bulging trade and budget deficits as well as China’s growing economic and financial clout. “I think we’re very, very vulnerable now,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. “The record on engineering soft landings isn’t terribly good.”

Others think that the Fed just might pull off the soft landing, because the central bank is starting from a better location than it has in the past. Interest rates are still far lower than they were in the last three decades. The central bank, having no intention of causing a recession, could stop raising rates before the hikes trigger a severe downturn, the optimists argue.

SHORTING ETF’S: THE LITTLE GUY GETS THE SHAFT – AGAIN

I have been shocked to discover that the rapid proliferation of new Exchange Traded Funds has resulted in retail investors being routinely denied their right to take advantage of shorting opportunities promoted by sponsors, underwriters, exchanges and brokerage firms. Since their creation in 1993, ETF’s have been advertised as available for shorting, many without the burden of uptick rules or the need to utilize riskier strategies such as options, futures, or leverage. However, average retail investors are getting the shaft while institutional investors and brokerage trading desks easily do so.

This is a combustible and potentially scandalous situation. Since the mutual fund trading scandal rocked Wall Street in 2003, ETFs have become the preferred alternative to conventional mutual funds. This has led to an explosion of ETF issuance. At the same time, most market sectors were either rising or in trading ranges making the demand for shorting less apparent. At some point, this may market condition may change. Investors wishing to strategically hedge their portfolios or speculate may find popular ETFs difficult, if not impossible, to short. Most of the explanations offered for ETF shorting difficulties deflect attention from the core retail issue: institutions and brokerage trading desks are receiving preferential treatment at the expense of retail investors. In addition, we see several other related problems.

BANK OF JAPAN SAYS DEFLATION WILL LAST FOR 8TH YEAR

Japan’s deflation will last for an eighth year, the central bank said, making it less likely it will soon end its policy of keeping rates at zero and pumping cash into the world’s second-largest economy. Core consumer prices will fall 0.1% in the fiscal year ending March 31 and rise 0.3% the following year, according to the median forecasts of the bank’s nine policy makers. In their last twice-yearly outlook in October, they forecast prices would rise 0.1% this year. Governor Toshihiko Fukui has pledged to keep the four-year-old policy until core prices stop falling and they are unlikely to resume sliding. Japan’s recovery from a 4th recession since 1991 will not be strong enough to put an end to deflation this year, Shirakawa said. The predictions of central bank policy makers compare with a median decline of 0.2% this fiscal year forecast by 12 economists in a Bloomberg Survey. Prices will rise 0.1% next year, the survey showed.

THE GDP RABBIT IS OUT OF THE HAT

You might remember back a little more than a week ago when the same government that is putting out today’s GDP release said that its CPI jumped a shocking 0.6% in March to a 3.1% annual rate. The markets shuddered. The headline writers smiled: stagflation was back. Even with all its nips and tucks, and all its New Age theories, Washington has not been able to make inflation fears disappear. Today a different arm of the government will accomplish that feat. Look deep inside today’s GDP report (table 4, to be exact) and you will see an inflation number that will be less than the fear-inspiring 3.1% reported in the CPI. In fact, the pros think the inflation calculation that is used in the GDP will actually drop from 2.3% in the last year's fourth quarter to 2.1% in the newest period.

So why should we care about all this? Because the government is not supposed to make magic with its numbers. For instance, if the inflation in the GDP report were only as large as that in the CPI, economic growth would be reduced by 0.8 of a percentage point. And 2.7% growth in the economy would not make anyone happy. We should also care because a lower GDP number would explain a few things. Yesterday the government announced the biggest monthly drop in durable goods orders since 2002. And oil inventories are booming – which means there is less demand for fuel because of the slowing economy. Today’s figure should not be nearly as vibrant under the circumstances. So, the next time Treasury Secretary John Snow or some other administration official comes out to proclaim how great the economy is doing, you can look at the guy on the TV screen straight in the eye and say: “I know your tricks.”

THE MONEY SHUFFLERS’ VIG

In economics it is always difficult to know precisely what stage of a price, business, or speculation cycle one finds oneself to be in. However, we know that consumer price increases have been moderating since 1980 and that interest rates have been declining since 1981. At the same time, asset markets have been rising since 1982, although equities experienced a serious downturn after 2000. Therefore, it is easy to determine that we are not at the beginning of consumer price disinflation and an asset inflation cycle. Rather, we are likely to be in either phase two of the asset inflation cycle or, even more likely, in the third phase where the inflection point from asset inflation to consumer price inflation is reached.

Why do I think so? Unless a business downturn occurs, interest rates in the U.S. cannot decline any further. A business downturn, however, would not be good for asset markets, as affordability of the inflated assets would become a serious issue. If, however, the economy continues to expand, inflation to accelerate, and interest rates to rise, then it would seem to me that even modest interest rate increases brought about by the Fed, or by the market if the Fed does not take any action, would cool, or more likely depress, various highly leveraged investment or asset markets. This, as mentioned above, would occur in the U.S. through either deflation of asset prices in dollar terms or a depreciating dollar. The combination of the two is very probable, as was the case in Latin America in the early 1980s and during the Asian crisis in 1997/1998.

Characteristic of phase three of the asset inflation cycle is the rapid increase in the price of commodities. Now, I am aware that some observers maintain that, in today’s economy, rising commodity prices have little impact on consumer prices. But rather than pay attention to these new theories, I look at a Legg Mason study which shows a very close correlation between commodity and consumer price inflation over the last 200 years. So, until proven differently, I suppose that rising commodity prices do have the tendency to increase consumer prices. I may add once again that it is very likely the CPI in the U.S. is understating the rate of inflation for the average household, which, I estimate, is running at least at 5% per annum.

Also, pointing to the U.S. economy having reached the third phase of the asset inflation cycle is the fact that it is internationally no longer competitive, which is reflected in the large trade and current account deficits – in the case of both high consumer price inflation and high asset inflation, a country loses out on competitiveness and will have rising trade and current account deficits. In both cases, either tight money policies by the central bank (high real interest rates), which curbs domestic demand and leads to disinflation and sometime even deflation, or the market mechanism, will eventually make the adjustments through a collapse in the bond market and the currency.

Then there is another point to consider. During commodity and consumer price inflation phases, speculation focuses on commodities and resource shares, while the financial sector performs miserably. (In the 1970s, a large number of brokerage firms closed down or were taken over.) During the asset inflation cycle, however, the financial sector performs superbly. Last September, Ray Dalio and Amit Srivastava of Bridgewater Associates published a report entitled “The Money Shuffler’s Vig”, in which the author wrote that “the money that’s made from manufacturing stuff is a pittance in comparison to the amount of money made from shuffling money around; 44% of all corporate profits in the U.S. come from the financial sector compared with only 10% from the manufacturing sector.” Until the onset of the asset inflation phase in the early 1980s, the manufacturing sector’s profits always accounted for more than 40% of total profits while the financial sector never accounted for more than 20%. Moreover, the 44% figure is unlikely to include financial earnings from “industrial” companies such as GE Capital and GM’s financial subsidiaries, and the profits earned by large multinationals from their treasury activities, which resemble hedge fund-type financial transactions.

So, even if the economy is not running on “empty”, it certainly runs on plenty of money shufflers!

Did you notice …?

Are households becoming richer because of net capital formation, employment, and wage gains, the traditional drivers of the economy, or is the increased household net worth largely a function of easy money policies which have led to a rapid credit expansion? In this respect, Paul Kasriel, the chief economist of Northern Trust, argues that this is one of those rare cases when the conventional wisdom is correct – that is, households are saving very little to the detriment of their future standard of living. Kasriel starts out by asking the rhetorical question: In recent years, has household borrowing (a flow concept) risen relative to household spending (also a flow concept)? According to Kasriel, the answer is unequivocally yes.

Kasriel’s conclusion is that, starting in 1999, and continuing through 2004, households’ cash outlays on goods, services and tangible assets have exceeded their cash incomes. From 1952, the beginning of these data series, through 1998, this phenomenon of households spending more than they were taking in had never occurred.

U.S. SHOWS SOME PARALLELS WITH ARGENTINA OF 1990’S

The U.S. is not Argentina. Real wages in this country are not 20% lower than they were seven years ago, goods imported from Europe do not cost more than four times as they did then and 40 percent of the population is not living in poverty. Still, there are some disturbing parallels between the U.S. of today and the Argentina of the 1990s when the country was living well beyond its means, borrowing abroad to finance large budget and current account deficits, while government leaders ignored the urgent need for more prudent fiscal policies. And in the final pages of a new book that tells in exquisite and chilling detail the Argentine story of borrowing, boom and bust, Washington Post financial reporter Paul Blustein notes some of those parallels in terms of large foreign borrowing and the possibility of a shock associated with a reduction in such flows. “It could happen here,” Blustein writes in And the Money Kept Rolling In (And Out).

“Americans who give Argentina’s story fair consideration and conclude otherwise are deluding themselves. The risks are much lower for the United States than they were for Argentina, but they are unacceptably high. The words of Miguel Kiguel, Argentina’s former finance undersecretary, are apropos: ‘Once you know the markets are there, and there is financing, you behave as if financing will be there forever.’ The United States has shown every sign of having adopted that same cavalier, incautious attitude in the first few years of the twenty-first century,” Blustein says.

Argentina had its spree and since the end of 2001 has paid a horrendous price for its folly. It had borrowed in dollars and had not nearly enough to repay its exploding debt when foreign investors shut off the flow of new money. There has been no similar day of reckoning yet for the U.S., and the eventual price to be paid is unknown. It should not be on a scale vaguely comparable with that of Argentina’s, though it may be uncomfortably large.

A PRISONER OF PROFIT

Karl Hill turned about $6.5 million into over $19 million in the five years between March 2000 and March 2005. Who is Mr. Hill? He is the owner and chairman of Monroe County Bank in Forsyth, Georgia … and, evidently, he is also a very savvy investor. Two weeks ago, Hill shared some of his insights with those of us attending the Grant’s Spring Investment Conference in New York City. The 75-year-old Hill, despite his folksy Southern style and modest appearance, is well educated and worldly. Frankly, seeing him and listening to his speech was worth the hefty price of admission to the entire conference. So how did this Yankee-educated Southerner triple his wealth? Well, he did it on the basis of a few big ideas.

First, Hill followed the old maxim “Keep it simple”. He talked about the verse by the Greek poet Archilochus: “The fox knows many things, but the hedgehog knows one big thing.” Hill aims to know a few big things and not get lost in the details. He also cited the famous idea of William of Ockham, the 14th-century scholastic philosopher who formulated the “law of parsimony”, commonly known as “Ockham’s razor”. The basic principle could be summed up in the notion that the simplest methods are the best. In addition to favoring simplicity, Hill favors small companies over larger ones. So the two cornerstones of Hill’s approach are: Keep it simple; and, the smaller, the better.

Then, he basically had one big idea: The dollar is a doomed currency … at least for the time being. Therefore, he looked for ways to “short-sell money”, i.e. to bet against the value of paper currency versus the value of real-world things. From this idea, he formulated a plan to invest in tangible assets, things you can “feel and touch”, as he put it. He thought housing would do very well, because he thought that when the average fellow looked around for a “safe” place to park his money, he would put it in housing. So he invested heavily in homebuilders. Second, he bought gold and silver companies, base metal producers, oil and gas companies and some real estate companies. Of course, you do not need to know the specifics of how these sectors performed to know that Hill was right on target.

So what is he doing today? Well, he has sold most of the homebuilders, he says, because he is worried that interest rates will move higher. He has done a complete about-face on this sector. He dismisses the housing market as a bubble. But otherwise, he continues to play the same general tune: The value of our paper dollar will go nowhere but down over the long run and the value of “things” will rise. He has taken on foreign currency exposure, like the euro, and bought some TIPS (inflation-protected government bonds).

MOODY’S, S&P ARE FLAWED GATEKEEPERS TO CAPITAL

The stone in the shoe of the global bond market these days is when and if General Motors and Ford will lose investment-grade ratings at Moody’s Investors Service and Standard & Poor’s. The fate of about $375 billion worth of debt hangs in the balance. Rating companies have the power of life and death over the borrowers whose debt-paying abilities they assess. Their importance is growing as regulators enshrine credit ratings in accounting and investment rules, and as the global capital markets depose banks as the primary source of lending.

In The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness, Timothy J. Sinclair argues that there is a strong subjective element in how rating companies arrive at their conclusions, and that their perceived authority imposes a single set of business-practice standards globally. “You could argue that by institutionalizing rating agencies, Anglo-American capitalism risks losing that wonderful capacity for creative destruction,” Sinclair said in a telephone interview. “Rating agencies are defenders of increasing property rights. That can become an ossification.”

Their power is a kind of confidence trick. Ratings only matter if you and I both agree that they do. Moreover, Moody’s and S&P have pulled off the neat trick of appearing to be independent, impartial arbiters of creditworthiness, when they are nothing of the sort. “People view them as important and act on the basis of that understanding – even if it proves impossible for analysts to actually isolate the specific benefits the agencies generate for these market actors,” writes Sinclair, who teaches international political economy at the University of Warwick in England. “What is central to the status and consequentiality of rating agencies is what people believe about them and act on collectively, even if those beliefs are demonstrably false.” Moody’s and S&P, who dominate the world of credit ratings and “pass judgment” on about $30 trillion of securities, are replacing banks as the “gatekeepers” of who gets to borrow and who does not, Sinclair argues.

Previously, banks stood in the middle by taking deposits and lending that money to borrowers. Both borrower and lender had a contractual relationship with the bank, rather than with each other. The growth of the securities market is dissolving that relationship, in a process called disintermediation. “Judgments about who receives credit and who does not are no longer centralized in banks, as was the case in the past,” Sinclair writes. “Over the past decade, the liberalization of financial markets has made rating increasingly important as a form of private regulation.” This makes ratings a political issue. Rating companies influence decisions such as whether to make a new highway into a toll road. That in turn has a social impact on local residents. “The ‘who gets what, when, how’ questions of distribution are the sort of political questions that cannot be separated from a broader consideration of bond rating,” Sinclair says.

“By not making it clear that their decisions are judgments, they foster the popular myth that rating actions reflect simply the facts revealed by economic and financial analysis,” he says. “Consequently, they make it seem that any clear-thinking person, possessed of the right sort of knowledge, would come to the same view. Split ratings challenge the idea of a knowable rating universe that the agencies are trying to reflect in their work.” Sinclair goes on to argue that assigning a grade is “highly indeterminate, qualitative, and judgment laden. Rating is, first and foremost, about creating an interpretation of the world and about the routine production of practical judgments based on that interpretation.” Sinclair says if investors had a better understanding of how ratings work, it would “perhaps lead to a more skeptical use of rating information.” He has something in common with other critics of the current ratings duopoly, though, including myself: He has not found anything to replace it with.

HIGH-YIELD BOND MARKET’S TROUBLES MAY BE HARBINGER OF ROUGHER DAYS AHEAD FOR ECONOMY

Investors typically demand higher returns on high-yield debt, commonly referred to as junk bonds, to compensate for the risk that the issuers could go broke and not pay them back. That is why bond rating agencies term them “below investment grade” securities. But in recent years default rates have been low and institutions and individual investors in search of higher payouts have snapped up billions of dollars worth of these bonds or mutual funds that specialize in them. Now investors are backing away from junk bonds as the economy shows signs of slowing and the Federal Reserve keeps bumping up interest rates. Almost $1.5 billion in high-yield bond offerings were postponed last week, some leveraged buyout deals could be in trouble, and mutual fund investors are starting to cash out of high-yield bond funds.

AHEAD OF THE HERD

From 1970 to 2003, Ralph Wanger, famed manager of the Acorn Fund, made his fortune investing in no-name, small-cap stocks. Companies like Newell Industries, International Game Technology, Houston Oil & Minerals and Cray Research were the “heavy hitters” that made up his portfolio – the exact kind of companies most fund managers do not have the guts to even look at. Too bad for them. Wanger made over seven times more money than the average fund manager on Wall Street for more than a quarter of a century. And he eloquently describes in his book, A Zebra in Lion Country, he did it by mimicking the behavior of the “Outside Zebra” in the wild. Zebras that reside on the outside of the herd are calculated risk takers. They know there is always a chance a lion could pounce out of the bush, wrap his gigantic paws around their neck and fatally sink his fangs into their jugular. But the allure of lush green grass, fresh water and the cool breeze is worth the risk of an attack.

The inside zebras tend to be thin - gaunt even. The grass they graze on has been trampled on by hundreds of other zebras. What little there is to eat is up for grabs by the entire pack. For the zebra, every move it makes is a calculated risk. And the same is true for investors. The question you have to ask yourself is, can you handle the risk of being an outside zebra investor? Or are you satisfied with the gaunt returns of an inside investor? Wanger decided early on in his career he was an outside investor through and through. He knew if he invested like everyone else and listened to the same investment advice everyone else did, he would consequentially make the same return as everyone else. So he sunk his money into small-cap companies (those with a market capitalization of $1 billion or less) that the mainstream analysts simply did not follow. Sounds like an obvious thing to do – easy in fact. But it was not. Wanger had the same problem small-cap investors have today…

He had to sift through thousands of companies that were not worth the paper their stock was printed on. So he developed a strategy to help him separate the good from the bad. First, Wanger only invested in companies that had a strong niche in its industry. In other words, he was not going to invest in an upstart software company that had no business competing with Microsoft. Secondly, Wanger insisted the company be financially strong – with enough working capital to sustain and grow for years to come. And finally, he had a defined exit strategy.

Of course, there are real risks involved with being an outside zebra investor. You are not always going to win. Eventually, you will take your lumps. That comes with the territory. And Wanger certainly took his over the years. But Wanger never deviated from his strategy - even when the market got ugly...like it is today. This is a very important point. Wanger never abandoned the whole market because it looked expensive from 30,000 feet. He focused on the details, on the merits of individual companies, where most investors do not care to look. You need to do the same right now. Everywhere you look today, folks are bad mouthing the small-cap market. Its six-year reign over the large-caps is over. Run for the hills! SELL!

Even my respected colleague, Dr. Steve Sjuggerud, said that now is the time to bail on the small-cap market. He astutely pointed out that the average stock on the Russell 2000 currently trades for over 20 times earnings and two times book value – the highest level since the 1970s. But I am not saying you should buy the entire Russell 2000 right now. However, you would be an absolute fool to give up on all small-cap stocks now – just because everyone else is. There are still bargains to be found. Always have and always will be. Look at the individual trees, not the forest. Companies, not indices. According to Multexnet.com, there are 5,910 companies trading on the major exchanges. Of those 3,993 have a market cap of $1 billion or less. That means 67% of the market is in the small-cap universe. And it also means 67% of the market is NOT being covered by most Wall Street analysts, hedge funds managers and mutual fund managers. In other words, you still have an advantage as a small-cap investor – if you are willing to separate yourself from the herd.

A GOOD INVESTMENT – OR A GOOD STORY?

Excited about a stock? It pays to remember Warren Buffett’s Investing Rule #1: “Never Lose Money.” What makes investors pile into a stock? The answer to this question was of great concern to a Vancouver stock promoter I met many years ago. After all, that was his business: harnessing investors’ greed to sell out his stake in a new company at a profit to himself. He had noticed that some newly listed companies took off, while others that had pretty much the same balance sheet and profit and loss statement stagnated or even fell. By analyzing pairs of such companies, he discovered that the difference that made the difference was the story. The company with the sexy sizzle was the one that caught the attention of the media, that got brokers and investors hot under their collars and excited enough to open their wallets. When he promoted companies like this – even when they had more story than substance – he could bank a handsome profit.

The boring stodgy company – that made bricks, or industrial parts no one had ever heard of – was the one that went nowhere. Even when it was the company that was the better investment. If you pick up any issue of Forbes, Fortune, or any other business or investment magazine, you will find the same principle of “boosterism” at work. I cannot resist quoting a story from Fortune magazine. It begins: “The company that pioneered the trading of natural gas is applying its old paradigm to a newer type of commodity: Internet bandwidth.” The article concludes by saying that this company has resources most dot-coms would die for, and that where every well-funded tech whippersnapper looks like a genius, it was tempting to root for a graybeard. The entire article exuded great optimism about the future prospects of this company. You could not help but believe they were on to a good thing. And the implication was that this new business would generate profits that would drive up the price of the stock. The article came from the January 24, 2000 issue of Fortune. The title: “Enron Takes Its Pipeline to the Net”.

This is an extreme example. But it is not uncommon. You see, business publications are primarily in the entertainment business. Yes, they contain information – a lot of it good. But their primary aim is to get you to renew your subscription. They achieve that, in part, by serving large dollops of exciting success stories about people and businesses that have made lots of money. I challenge you to find an issue of business publication without such an article. So next time a report gets you excited about a company, ask yourself: “That’s a good story – but would it make a good investment?” Even in investing the old marketing adage applies: “Sell the sizzle, not the steak.” Sometimes there is not even any steak.

DOT-COM BOOM REDUX?

It almost seems like a dream: On March 10, 2000, the Nasdaq Composite Index soared past the unprecedented 5000 level to set an all-time record high. You would think the last thing today’s investor would want to do is to celebrate the anniversary of this extraordinary event, like a champagne toast to the unhappy time when thousands lost their fortunes, even as they still lick their wounds five years later. Something better left forgotten – in other words – especially considering the post-technology-bust world is hardly back on its feet. But as a Wall Street Journal article pointed out, there is no gray area when it comes to the speculative spirit surrounding Bay Area stocks. On the 5th birth (err, death) day of the Nasdaq’s high, bullish enthusiasm for the tech-sector was as persistent as ever. Recent news stories drive the point home.

Three days later, a New York Times column observed a rush by venture capitalists to “stake their claim” in the “hot area” of open-source technology companies: In 2004, 20 of these businesses raised $149 million in venture money, and in March of 2005 alone, three start-ups raised $20 million. Now, there are many explanations for how the investment community could hurry headlong into a market still struggling to recover from a 5-year long bust: Endemic amnesia, for one. That WSJ article cites a different reason, offered by a Nobel Prize winning economics professor. In a controlled lab environment, the professor made this observation: “Even after bubble-era participants hopes are dashed by an initial break, they invariably get back in, thinking they will be able to sell their positions before trouble strikes, only to express surprise when they weren’t able to get out before a second collapse.”

Rest assured, say the experts. Real life is not a lab. Differences, such as these will make all the difference: “Unlike the experiments, where there is only one thing to trade in, the world offers a myriad choices”; “Untested companies built on blue-sky expectations, for the most part, don’t exist anymore”; and “The real mania today is in real estate, not tech-stocks.” So, are they right? Is a dot-com boom redux in store for the U.S. economy?

INFLATION VS. DEFLATION

Here is a question that pops up over and over again: does the future hold inflation or deflation? Inflationists point out that rising energy prices will cause prices in general to rise, and that is inflationary. Deflationists say that slowing economic growth will cause prices to fall. However, these are not the issues. They are the consequences of events and circumstances.

Inflation is not a general increase in prices, and similarly, deflation is not a general decrease in prices, just as fever is not an infection. Fever is the consequence of an infection and if you do not know that, how would you know to look for the infection and cure it? You can mitigate the fever with drugs, but that will not make the infection go away. As long as people think inflation is an increase in prices and deflation is a decrease in prices they will not be able to look beyond the nonsense promoted by the general media.

Monetary inflation is an increase in the supply of money and deflation is a decrease in the supply of money. That is it. But when the money supply increases, money loses value in relation to goods and services and that can lead to a general increase in prices. The increase in prices, however, is a consequence of money losing value. Price increases themselves are not inflation. Deflation, of course, is just the opposite: a decrease in the money supply.

But what is money supply? Ron Paul asked Federal Reserve Chairman, Alan Greenspan, what he considered to be the best tool to measure money supply. Greenspan plainly admitted that he was at a loss for picking out what such a measure might be. When Paul suggested that it must be difficult to manage something you cannot even define, Chairman Greenspan not only agreed with him but also said it was “impossible”. What a startling admission by United States’ leading maker of monetary policy. If we do not know what money supply is, how can we determine whether the money supply is increasing or decreasing?

Those who argue that inflation is more likely contend that the Federal Reserve will most likely reduce interest rates at the first sign of economic trouble and low, or falling interest rates, will be conducive to still more debt creation, which is also an increase in money supply, and therefore inflationary. Deflationists argue that the amount of outstanding debt, and borrowers’ ability to pay the interest and principle due on that debt, are the real risks. Should the economy slow down, or interest rates rise, we could see an increase in the amount of defaults and bankruptcies. If the lenders do the correct thing, which is to write the bad debt off their books, the money supply will be reduced and that is deflationary. I think that the biggest threat is deflation and there is, in my opinion, not a thing the government can do about it.

If you are trying to figure out whether the gold price will rise or fall depending on whether the U.S. experiences inflation or deflation you are wasting your time. In the short term the gold price in U.S. dollars will rise or fall depending on what the U.S. dollar exchange rate does. In the long term the gold price in U.S. dollars will depend on the inflation rate of the dollar. Since the dollar is a fiat currency, it is bound to be inflated until it is worthless, however long that may take.