Finance Digest for Week of May 23, 2005

THE FORBES 2005 INVESTMENT GUIDE IS OUT

Articles on planning for retirement, investing in stocks and bonds, mutual funds that mimic hedge fund strategies or track commodities price indexes, insuring art, avoiding pratfalls in real estate, and preserving your assets in the face of the new bankruptcy law are all featured in this year’s investment guide.

INVESTING BY THE (CAREFULLY DISSECTED) NUMBERS

These days investors are fixated on earnings quality, and rightly so. Fannie Mae, AIG, GE – even the best companies are not too sure about their account books these days. But the proper response to concerns about earnings quality and the risk of restatements is not to flee. Rather, it is to be discriminating. Favor companies that are least likely to present unpleasant surprises. Avoid ones that give off signals that they are straining to prop up the bottom line. For an assortment of stock recommendations we turned to footnote digger Donn Vickrey, cofounder of accounting research outfit Gradient Analytics of Scottsdale, Arizona. A former tenured accounting professor, Vickrey supervises a staff of 15 analysts, with backgrounds in public accounting and equity research. Gradient sells its research to 100 mutual and hedge funds. Here, in four industries, are Vickrey’s favorites and unfavorites.

WIRELESS APPLICATION FEVER

After a two-year rise, wireless stocks are gasping for air. Many investors wonder if the sector’s best days are past. However, just as the PC market evolved, with once-strong hardware companies like Wang Computers and IBM giving way to software kings like Microsoft, Oracle and SAP, so will go wireless. The smart money is betting on companies that provide applications – productivity software, games-and-entertainment and collaboration software – to those billion-plus cell phone owners. The best way for investors to take part in the coming boom in wireless applications is to own a mix of small and large wireless multimedia companies. The accompanying table lists wireless applications makers with strong growth prospects and reasonable multiples. There is still value to be found among wireless equipment companies – but the group as a whole is more expensive than the application companies. One stock to consider a core holding in any wireless portfolio is Qualcomm. Its PE ratio is 1.6 times its growth rate – a bit high – but given its stake in wireless chipsets, 3G growth and applications, it may be the best-positioned company in the sector.

DISCOVERING ASIA

For investors seeking portfolio diversification, it is tough to ignore Asia. But figuring out where to invest in the region can be daunting. China is hot, Japan is cold, and the rest of Asia looks just plain volatile: Political unrest, nuclear threats and sometimes-violent protests do not make for stable markets. Not to mention that countries in the region range in size from miniature Singapore to vast and unwieldy China and in economic development from rich Japan to poor Laos, making it tough to get a handle on the economic picture.

But if you know where to look, and can stomach the ups and downs, there are plenty of opportunities to make money in the region. So says Khiem Do, who has spent the past 21 years digging through information on thousands of Asia’s publicly listed companies to find overlooked growth stocks. Do, 51, runs portfolios out of the Hong Kong office of Baring Asset Management, now part of MassMutual. One of them is the $173 million Asia Pacific Fund (ex-Japan), an SEC-registered closed-end whose annualized 11% return for the past five years outpaces its benchmark MSCI AC Far East ex-Japan Index by 9 percentage points. Do’s fund trades on the NYSE at a 12% discount to its net asset value. The bargain element in the discount is largely offset by the somewhat steep 1.9% annual expense ratio of the fund. Go-it-alone investors can cherry-pick many of his individual holdings, as they have ADRs (see accompanying table).

DO YOUR OWN M&A

Why the feverish volume in mergers, going-private transactions and share buybacks? The fact that stocks are cheap and money is even cheaper. Stocks may look expensive to you, but they look cheap to a certain class of investor now avidly buying up entire companies. This year through April, 225 public companies in the U.S. have agreed to be bought out, at a combined cost of $246 billion. I am happy to report that several of these deals were for companies I have recommended recently, like Archipelago Holdings (recommended 4/18 at $18, now at $30) and Premcor (12/27/2004 at $41, now $65). Premcor is being bought by Valero, making it North America’s largest oil refinery.

Most of the acquisitions are being done by other public companies, but some companies are going private. The buyers are in what used to be called the leveraged buyout business and now goes by the name “private equity”. Besides the takeovers, we have 339 companies in the first third of the year that have started programs to buy back some of their own shares. Last year total buy-ins, among both newcomers to the game and old players, totaled $333 billion. Note that these equity retirements dwarf the market for IPOs - with60 companies raising $18 billion so far this year.

What explains this massive reabsorption of equity? Cheap money. The average corporation can borrow ten-year money at under 6%. If your share price is only 12 times earnings, you pick up 8.3 cents of earnings for every dollar invested in a share buyback. That borrowed dollar costs you only 4 cents or so in aftertax earnings. The spread between the 8.3 cents and the 4 cents boosts the earnings per share on the surviving shares. Indeed, you could buy your stock, cancel it and create EPS gains even at stock prices as high as 24 times earnings. A firm more interested in expanding than contracting can buy another firm with borrowed money and get the same effect. All this explains the feverish level of takeovers. Half the global stock market is cheap enough for this. The phenomenon will not go away soon.

Focus your investing now on stocks that are likely to be bought, either in takeovers or in buybacks. The surest bets are companies with desirable strategic attributes for an acquirer, like high market share, low-cost production, regional dominance or brand name strength. Here are some candidates.

THE FED IS ALL WRONG ABOUT INFLATION

For the last year, I have been convinced that inflation is back and getting worse. I can feel it in my everyday life. My favorite pizza guy raised his price for a slice by 20% last month. My kids’ tuitions climbed 8% this year. Heating oil and electricity are more expensive. Breakfast cereal. Books. You name it, it costs more. Yet for the last year, Alan Greenspan and the other members of the Fed’s interest-setting body have been telling me not just that there is not any inflation, but that there really is not any danger of inflation.

Well, I have finally figured out why they are wrong. It is not because government statisticians have cooked the books to keep inflation numbers low (although they have), or that the Fed governors are part of a conspiracy to cut the inflation-indexed payments going to retirees (although they may be), or that these folks are so out of touch with the real economy that they cannot see what the rest of us feel in our everyday lives (although that is quite probably true). No, the real problem is that the Fed is worried about the wrong kind of inflation.

You see, the kind of inflation that the Fed cares about – and tries to fight – is the short-term, cyclical kind. Prices jumped by 13% in 1979, for example, after a 9% increase in 1978, as members of the Organization of the OPEC ratcheted up the price of oil. So the Fed, under then-chairman Paul Volcker, drove U.S. interest rates up to 14.7% on three-month Treasury bills in 1981, throwing the country into a recession that did indeed put an end to double-digit inflation. By 1982, inflation was down to 3.87%. But the kind of inflation that you and I feel right now is not cyclical but what is called secular. My belief is that prices tend to move up in long, long waves that last anywhere from 80 to 180 years and contain many short-term cycles – like the one that peaked in 1979. It is the duration of these waves of rising prices, rather than the magnitude of year-to-year increases in inflation, that is important.

If the history of prices is an accurate guide, we are now about 100 years into a wave that has not yet peaked. Pulitzer Prize-winning history professor David Hackett Fischer lays out the case for long periods of steadily increasing prices interrupted by briefer periods of price equilibrium in his 1996 book, The Great Wave. What is fascinating to me about Fischer’s price waves, which are very different from and much more convincing in my opinion than some long-cycle theories, is how much they explain about our current economy. Fischer’s book ends with a discussion of the price wave that began in 1896 and continues today. But the book was published in 1996, so it does not discuss the rise of China and India, the U.S. debt bubble or Washington’s fiscal crisis. Let me try to add those events to Fischer’s framework.

GREENSPAN IS CONCERNED ABOUT “FROTH” IN HOUSING

Alan Greenspan suggested last Friday that the red-hot housing market is becoming a little too exuberant for its own good. “Without calling the overall national issue a bubble, it’s pretty clear that it’s an unsustainable underlying pattern,” Mr. Greenspan told the Economic Club of New York. Mr. Greenspan emphasized that he sees no sign of a nationwide housing bubble, but he acknowledged concerns over “froth” in the market and pointed to a big increase in speculation in homes – particularly in second homes. As a result, he said, there are “a lot of local bubbles” around the country. The comments of the Fed chairman were the closest he has come to acknowledging the possibility that housing prices may be poised for a fall in some parts of the country.

The issue is sensitive for the Federal Reserve, because its policy of keeping interest rates low has helped propel housing prices upward even when the rest of the economy was dragging. But the housing issue highlights an unusual quandary for the central bank: even though it has raised short-term interest rates eight times since last June, long-term interest rates and mortgage rates are actually lower than they were one year ago. The unexpected persistence of low mortgage rates has kept alive the housing boom – in new-home construction as well as in prices of existing homes – much longer than most analysts had expected.

Many analysts have argued for months that evidence of speculative activity has increased over the last year. Much of the evidence is anecdotal, including people buying and reselling houses at developments before construction is even completed. But there has been solid data as well pointing to rapid price increases in second-home markets, reports of many more individuals buying houses and condominiums as investments rather than as places to live, and to the heavy use of interest-only loans and adjustable-rate mortgages that allow purchasers to buy considerably more expensive properties than would otherwise be possible.

Mr. Greenspan acknowledged on Friday that many people were “reaching” to finance their purchases. But he predicted that housing prices were unlikely to decline much, if at all. “Even if there are declines in prices,” he said, “the significant run-up to date has so increased equity in homes that only those who have purchased very recently, purchased before prices actually literally go down, are going to have problems.”

Steep rise in prices for homes adds to worry about a bubble.

Home prices rose more quickly over the last year than at any point since 1980, a national group of Realtors reported, raising new questions about whether some local housing markets may be turning into bubbles destined to burst. With mortgage rates still low and job growth accelerating, the real estate market is defying yet another round of predictions that it was on the verge of cooling. The number of homes sold also jumped in April, after having been flat for almost a year.

Nationwide, the median price for sales of existing homes, which does not factor in newly built ones, rose to $206,000 last month, up 15.1% over the last year and breaking the $200,000 level for the first time, the National Association of Realtors said. Adjusted for inflation, the median price – the point at which half cost more and half cost less – has increased more than a third since 2000. “We’ve had robust markets before,” said Maurice J. Veissi, the president of a real estate agency in Miami, who has been a broker for 30 years. “But this one is so much broader and deeper.” Even before this surge, housing prices had risen more steeply over the last 10 years than during any such period since World War II. A growing number of economists worry that real estate is to this decade what technology stocks were to the 1990’s, with many people assuming that home values will rise forever.

Prices continue to rise most rapidly in the places where they are already highest, including Florida, the Boston-Washington corridor and along the West Coast. In the late 1980’s, a typical house in San Diego cost about as much as two typical houses in Syracuse, New York, according to the Realtors’ association; today, someone could buy six Syracuse houses for the price of one in San Diego. Prices have jumped most sharply over the last year in the West – up 21% in April from a year earlier, compared with an increase of 14% in the calendar year 2004. Price increases also accelerated in the Midwest, to almost 13%, while they remained roughly similar in the Northeast at 16%, and the South, where they are up about 8% compared with a year earlier.

In a separate report, the Census Bureau said Tuesday that the percentage of homes worth at least a million dollars had almost doubled from 2000 to 2003. California had the highest share of million-dollar homes in 2003, with more than 4% valued above that amount. It was followed by Connecticut; Washington, D.C.; Massachusetts; and New York, where an estimated 2.1% of the homes were valued at more than $1 million. Nationally, 1% are worth more than that. “There’s clearly speculative excess going on,” said Joshua Shapiro, the chief U.S. economist at MFR Inc., an economic research group in New York. “A lot of people view real estate as a can’t lose.”

Left with granite countertops.

Talk of housing bubbles and real estate speculator excess has reached such a fever pitch, that, whether it happens this year or next, it is clear that the excitement, new-found wealth, and pure delusional joy that today’s real estate market has engendered will soon be gone. The best case scenario – that prices stabilize or that increases revert to the mean – will cause the mania to subside, many speculators will head for the exits, and the real estate market will return to a more normal condition. People will then take stock of where this has left them and ask “Where to from here?” When the real estate boom finally ends, will we be left with anything other than a pile of debt and a bunch of granite countertops?

Bread, O.J. … and mortgages?

What would you think if the government decided that that the price of bread was way too high and decided to open up a chain of bakeries to sell bread at the “correct” price? What if the government decided that Florida orange juice was priced too high and started selling orange juice by the barrel? If either of these things happened, would you be standing on top of a mountain and screaming with all your might about the insanity of it all? So would I.

So how come there is no screaming about this? The Washington Post reports that Housing and Urban Development Secretary Alphonso Jackson has a message to subprime lenders: “‘We need to reach out to African-American, Hispanic, and other first-time buyers with better loan concepts, more flexible guidelines, and quicker service,’ said Jackson in an interview. ‘I am absolutely emphatic about winning back our share of the market that has slipped away to subprime lenders.’” Excuse me! Since when is it the business of the federal government to “win back” market share on housing loans? How is this any different that the federal government opening up bakeries to compete against the outlandish price of bread baked by private bakeries? If ever there were a case for needed reform, it would be in usury laws that might restrain the insane growth in credit. Instead, we see the FHA deciding to compete against private industry in a bloated housing market.

If that were not enough, President Bush is now urging tax credits for homebuilders! “To boost housing sales even more, Congress needs to pass my single-family homeownership tax credit,” Bush told a meeting of the National Association of Realtors. President Bush said surging real estate could be enhanced even further if Congress passes a tax credit to encourage homebuilders to target the middle class. Let’s see. New home sales are at an all time high, 69% of American families own a home, prices have gone parabolic, but … the FHA wants to compete against subprime lenders, and the president wants to give tax breaks to an industry that has been setting record profits for the last four years. Is this blatantly stupid or what?

Rest assured that housing would be more affordable if it were not for our “ownership society” policies that encourage Fannie Mae and Freddie Mac to grant 125% mortgages to anyone who can breathe. Combine that with loose lending practices based on the pure faith that Fannie and Freddie are too big to fail, and it is no wonder that home prices are going through the roof. Credit lending standards are in the gutter, but society says no matter how little economic sense it makes, we will try to give you the credit to make your purchase. Subprime lenders seem a bit worried (not worried enough, in my opinion), so they have raised their fees. Now the government comes along and wants to compete with private industry. Do we really have a Republican president with a Republican Congress doing these things?

For what it is worth, I think the government has zero clue about how to get corporations to hire U.S. workers, so it is attempting to goose the one and only thing (housing) that is holding this whole ball of wax together. In the meantime, it is getting more and more costly to “own” anything. Since there is no conceivable way this can possibly end well, I have a fail-safe prediction: It won’t.

The cost of all those McMansions.

It is like living in a parallel universe. Surprising most economists, mortgage rates have gone down in recent weeks rather than up. The housing market, instead of cooling, has stayed hot, with record sales of existing homes in April. And prices are up 15% over a year ago. Even Alan Greenspan, who has regularly dismissed the possibility of a housing bubble, is worrying that current trends are “unsustainable”. But whether prices level out, crash, or even keep going up, the housing boom is already having pernicious economic effects. The real problem: the incredible amount of resources – workers, materials, and money – being sucked into home construction and renovation.

Residential investment has become a black hole, absorbing a staggering 5.8% of GDP. That is the highest level since the late 1940s and early ‘50s, when an entire generation of returning soldiers was setting up families and expanding into newly built suburbs. This time, Americans are building second homes and enlarging current ones at a record pace. By comparison, the tech boom of the ‘90s was at worst a baby bubble. Starting in 1991, business investment in information technology and communications gear began a steady climb, going from 3.1% of GDP to a peak of 4.8% in 2000 before collapsing.

Without much fanfare, residential construction basically followed the same path in the 1990s. Starting at 3.4% of GDP in 1991, it rose to 4.6% in 2000. But rather than turn down, as tech did, spending on housing just kept climbing, fueled by low interest rates. Measured by the increase in its share of GDP, the housing boom so far is about 40% larger than the tech boom. Is the housing boom a bubble? As Greenspan has said, it is hard to tell. But what is certain is that housing-driven growth, while creating jobs and lifting wealth, is also distorting the economy, benefiting low-tech commodity sectors rather than the high-tech industries at the heart of America’s competitive strength.

What happens when the housing boom finally slows? The share of GDP going into housing construction will fall sharply, hurting construction workers, architects, and homebuilders. Homeowners will no longer be able to draw on rising home equity. And what about Americans who borrowed heavily to buy properties for investment, expecting prices to keep climbing? Much like the companies who built miles of now-unused fiber-optic cable during the 1990s, they will be in deep trouble. Yet even if there are temporary disruptions, the end of the housing boom may be good news for the overall economy. The U.S. does not need to drive growth with ornate new homes and elaborate kitchens with expensive marble counters. Instead, a shift away from housing could free up hundreds of billions of dollars for other, more productive investments.

How much is that house next door?

It is not enough to keep up with the Joneses. Now, homeowners want to know how much their neighbors paid for their house and how much their own is worth – even if they have no intention of selling. The home-buying boom has created legions of real estate voyeurs cruising free Web sites such as Domania, ForSaleByOwner.com and HomeRadar.com to find sales prices for homes in their neighborhoods. Many who peruse these sites are people looking for an edge as they buy and sell homes. Others surf these sites to obsessively track what is increasingly their No. 1 investment – their house – much as they would check a stock’s price. And then there are those who just enjoy anonymously spying on their neighbors.

GUNSLINGERS NO MORE: HEDGE FUND MANAGERS BECOME MODELS OF CAUTIOUSNESS

Hedge fund managers once had nerves of steel. In the 1980’s and 1990’s, men like George Soros, Julian H. Robertson Jr. and Michael H. Steinhardt made huge, daring bets on foreign currencies and on interest rate spreads. Secretive, and unsupervised by the Securities and Exchange Commission, hedge fund managers were figures of awe. In the words of a 1994 Business Week article, they were a “widely feared Wall Street subculture”. For years, this feared subculture made millions for its investors. For example, between its inception in 1967 and its dissolution in 1995, Mr. Steinhardt’s hedge fund grew at a compound rate of 24% a year, after fees – more than twice the compound annual growth rate of the S&P 500 stock index (with dividends reinvested). $10,000 invested with Mr. Steinhardt over that span would have swelled to almost $5 million.

Hedge funds did not always grow in a straight line, of course. In 1992, Mr. Soros made $1 billion by betting against the British pound. Two years later, trading in Japan, he lost $600 million – in a single day. Then there was Long-Term Capital Management: in August 1998, using $30 of leverage for every $1 of capital, it lost $1.9 billion and nearly brought down the world’s financial markets. Back then, hedge fund territory was the Wild West of international finance. “In a certain sense, it was the last bastion of nearly pure capitalism,” Mr. Steinhardt said when we spoke last week. “It was a gunslingers’ world and we were the gunslingers.”

These days, though, you will not find many gunslingers in the industry. Instead, hedge fund managers are now content to beat the S.& P. 500 by a mere percentage point or two. Last month, the Hennessee Hedge Fund Index, which tracks about 900 hedge funds, was down 1.8% after fees; the figure is more or less in line with the 1.9% drop in the S.& P. 500. In 2004, the average hedge fund actually underperformed the market, with the S.& P. 500 up 10.9%, the Hennessee Hedge Fund Index gained only 8.3%.

Historically, the whole point of a hedge fund was to outsmart the market. Because their clients were rich and sophisticated, hedge funds were allowed to gamble with investors’ money. Unlike mutual funds, which are strictly regulated under the Investment Company Act of 1940, hedge funds could take risks: they could buy stock options, use leverage and bet against stocks by selling short. As conceived in 1949 by Alfred Winslow Jones, then an editor at Fortune magazine, a hedge fund hedged its bets by taking “long” positions on undervalued stock and “short” positions on overvalued stocks. The idea was to be smart and nimble and bold, and to make oversized returns. As Mr. Steinhardt said, “I only had one objective: to have the best performance in America.”

In the last decade, however, hedge fund companies have started to resemble mutual fund companies: big, plodding institutions for pensioners. Fewer and fewer hedge funds are now making impressive returns for their investors. In the 10 years through April 2005, according to the HFRI Fund Weighted Composite Index, the typical hedge fund has only just managed to beat the S.& P. 500 Index, with an average annual return of 11.97% compared with 10.26% for the S.& P. 500. In other words, the Wild West has become a suburban community, where managers ride golf carts instead of bucking broncos.

What happened? For one thing, the amount of money invested in hedge funds has doubled in the last five years, to $1 trillion. It is hard to find creative places to park that much money. Besides, no special skills are needed to create a hedge fund – that is why everyone and his uncle know somebody who is starting one. Investors are partly to blame. They love the glamour of investing in hedge funds, but, at the same time, they can not tolerate risk. Most investors cannot tolerate even a month of losses.

The real problem with hedge funds may be the managers themselves: they are earning too much money. It is almost vulgar. In the past, hedge funds were paid 1$ of assets under management, plus 20% of that year’s return. Recently, even as their performance has sagged, more and more hedge funds have increased their fees to 2% of assets under management – plus 20% of returns. To make big money for themselves, hedge fund managers do not have to make big returns; they just need to hold on to their pool of clients.

INVESTMENT CHESS

“First of all, you have to protect yourself from yourself.” – Bernhard Mast

I first met Bernhard in Hong Kong when I was testing my “Investor Personality Profile”, which pinpoints your weaknesses – and strengths – as an investor. From his answers to the questionnaire I could clearly see that he was following all the Winning Investment Habits – except one. Which puzzled me. He did not appear to be following Habit #11 – which is to act instantly once you have made up your mind to buy or sell something. So I queried him about this, wondering if there was some flaw in the format of my questions. He told me that he reviews his portfolio and makes his investment decisions in the morning … but he places all his orders through a bank in Switzerland. Due to the time difference, Bernhard cannot phone his orders in until afternoon in Hong Kong, when Zurich opens for business. As I got to know him and understand his strategy, it became clear that he was, indeed, following all 23 Habits.

Bernhard is living proof that you do not need to be a high-profile investor with hundreds of millions of dollars, or even an investment professional, to successfully apply the Winning Habits. What is more, he has no ambition to have his name up in lights like Buffett or Soros. He does not want to manage other people’s money, and prefers to remain anonymous. His goal is very simple: “When I’m 75, I don’t want to be stacking shelves at a supermarket to earn money to put food on my table. I’ve seen it happen to others, and it’s not going to happen to me.”

What he sees as the greatest threat to his future financial security is the loss, over time, in the purchasing power of paper currencies. As he points out, a dollar today buys less than 5% of what a dollar bought 100 years ago. In contrast, the purchasing power of an ounce of gold has remained relatively constant. He is fascinated by the history and theory of money. And today, his knowledge in this field forms the basis of his investment philosophy. His first investment was in silver in 1985. In 1992 he and a friend went heavily into silver call options, buying $60,000 worth. Soon after they had gone into the market, the price of silver soared. They made 10 times their money! “We felt like geniuses,” Bernhard recalled.

They tried to repeat their success by shorting the S&P index. But American stocks did not fall; they began to creep up. Being “geniuses”, Bernhard and his friend added to their short position, only to see the market go through the roof. “I was wiped out,” Bernhard told me. “I gave back all my profits on the silver options, plus my original investment – and then some.”

It was then Bernhard realized that, to invest successfully, the first thing he had to do was “protect myself from myself.” Bernhard sat down and did something very few people ever do. He spent several months building a detailed investment strategy, and spent some more time testing it, so he could achieve his primary aim: ensuring he would have financial security and independence for the rest of his life.

His overall approach is exceptionally conservative. Unlike the average homebuyer, who will increase his mortgage for spending money when the price of his house goes up, Bernard does not even count unrealized gains when he values his holdings. The only profits he counts as part of his net worth are the ones he has actually cashed in. And while he does not include paper profits, he does subtract paper losses. In other words, values his portfolio at his cost, or the market price – whichever is lower.

Bernhard’s underlying premise is that commodities are undervalued. Eventually they will be fully valued. So he recognizes his current system will stop working someday. “Investing is like playing chess. You have to contemplate the present, but you also have to look ahead to the 4th, 5th, 6th or 7th move.” Bernhard has devised a system which has all 12 necessary elements. And like their approach to investing, his is highly personalized and specialized, clearly drawing on his own unique background, his studies, his experience and interests.

While his method is certainly unusual, it works for him. And he follows it religiously. To ensure he does not deviate from it, he keeps a written set of guidelines – which he calls his “rules” – and continually refers to them. He told me he reviews his list in detail every six months; evaluates his actions to ensure he has been following his rules; and to see if he has learnt or discovered something that could improve them. Such rigor and dedication is unusual in any field. But it is what has made Bernhard – like Buffett, Soros, Icahn and Templeton – a highly successful investor.

GENERAL MOTORS DEBT RATING LOWERED TO JUNK BY FITCH

GM, the world’s biggest automaker, was cut to junk by Fitch Ratings, the second time in three weeks the company lost an investment-grade credit rating on concern about a drop in market share. Fitch followed Standard & Poor’s, which on May 5 roiled bond markets by reducing $196 billion of Detroit-based GM debt to high-risk, high-yield status. GM is the biggest company ever to be cut to junk. Fitch lowered the rating to BB+, the highest of 11 speculative grade ratings, from BBB-, the lowest investment grade. The move follows S&P’s decision on May 5 to cut GM to junk. GM has about $196 billion of unsecured debt, according to S&P. Fitch’s decision forces the bonds out of Lehman Brothers Holdings’s benchmark investment-grade bond index and into its high-yield index, which may cause investors to dump their holdings. Before Fitch cut, the bonds were to leave the index June 1 and re-enter the index on July 1.

THE ECHOES OF BEIJING

Over the years, I have made probably ten visits to the Temple of Heaven in Beijing. But this time it literally took my breath away. Built in the 15th century, it is one of Ming China’s greatest monuments – an extraordinary complex of sacrificial buildings that is three times the size of the Forbidden City. The centerpiece – the magnificent three-level white marble Altar of Prayer for Good Harvest – was the scene for the major social extravaganza of the just-completed Fortune Global Forum. Staged by the Beijing municipal government, the Temple of Heaven was magically transformed by lights, music, opera, and traditional costumes and dancing into what had to be a preview of the opening ceremony of the 2008 Olympics. It was a truly spectacular event. On the surface, the China boom never looked more glorious.

Beneath the surface, however, there is a growing sense of unease in China. The backward looking data flow still looks terrific, and GDP growth continues to soar – gains in 2003 were just revised upward to 9.5% (from 9.3%) and the Chinese economy was estimated to be holding at that pace in the first period of 2005. The latest update of the more reliable industrial output figures paints an equally impressive figure. But growth is not the issue in China – there has been plenty of it in recent years and there is an ample reservoir of considerably more growth to come in the pipeline. The issue is the consequences of that growth.

Like most things in China, there is more to the Temple of Heaven than meets the eye. The Imperial Vault of Heaven is surrounded by the so-called Echo Wall. If you stand at one part of this circular wall and whisper, your voice can be heard with perfect clarity by someone situated at the opposite portion of the wall. That pretty much sums it up today. The echoes of Beijing are growing louder by the moment. The cacophony of U.S. and Chinese politicians speaks of a debate that is working at cross-purposes – charges and counter-charges that offer little possibility to resolve the mounting build-up of macro tensions between the two nations. For an unbalanced global economy and ever-complacent world financial markets, the echoes of Beijing left me with a deep sense of trepidation.

What if China slows?

The herd always runs tightly in momentum-driven financial markets. That seems to be even more the case today. In a growth-starved world, most are now convinced that the China boom is here to stay. That could be wishful thinking. China is now putting policies in place aimed at taming the internal excesses of its unbalanced economy. At the same time, the rest of the world is ganging up on Chinese exports. What if the unthinkable happens – and the Chinese economy actually slows?

Depending on how China plays it, there is the distinct possibility of a “double-whammy” to Chinese GDP growth – externally-imposed constraints on exports and internally-imposed restraints on property investment. I suspect that Chinese policymakers will tread very cautiously in such a potentially problematic climate. That may well mean delay on the currency reform front – a response that could further inflame the rising tide of Chinese protectionism in the West. China’s latest efforts to take export restraints into its own hands – underscored by Beijing’s just-announced export taxes on 74 categories of Chinese textile products effective 1 June – hints that the nation’s policy makers may have a preference for tax policy over currency revaluation in order to restrain exports. But there is more to Washington’s China-bashing agenda than the textile problem. Despite China’s intentions to manage its own export problems, its biggest customer – the U.S., which accounts for about 33% of total Chinese exports – seems increasingly determined to take matters into its own hands.

This underscores one of the key deficiencies of China’s growth model – excess reliance on exports and fixed investment. Lacking in support from private consumption, the Chinese economy is exceedingly vulnerable to shortfalls in either of these sectors – let alone a squeeze that might hit both sectors at once. All in all, barring a spontaneous emergence of a new source of growth, it is quite conceivable that there could be a meaningful slowing of the Chinese economy. Should that occur, China’s Asian supply chain should be especially hard hit -- underscoring broader downside risks to global GDP growth. A China slowdown would also probably result in further downward pressures on commodity prices – oil and non-oil industrial materials alike. That could also temper inflationary expectations embedded in global bond markets. Moreover, to the extent China delays any shift in its currency policy, downward pressures on the U.S. dollar could be tempered somewhat.

For the past eight years, it has been wrong to bet on the downside of the Chinese growth trajectory. Time and again, China’s resilience has confounded the naysayers. Yet China faces new and more difficult challenges today. The property bubble is an increasingly worrisome source of internal instability. And the currency-export nexus has become an increasingly intractable source of external instability. China faces growing pressures to relieve tensions on both fronts. This time, it will be much tougher for China to avoid a meaningful slowdown. It is time for the rest of the world to prepare for just such a possibility.

MARC FABER SAYS ASIAN CURRENCIES, AGRICULTURAL COMMODITIES AMONG WORLD’S BEST BUYS

Malaysia’s ringgit and the Singapore dollar may give investors the biggest returns among Asian currencies because a U.S. slowdown may prompt the Federal Reserve to slow or stop its interest rate increases, Marc Faber said. Faber, who oversees about $300 million as managing director of Hong Kong-based Marc Faber Ltd., recommends selling the euro to buy the ringgit or the Singapore dollar because they have not appreciated and are therefore more undervalued. Once the U.S. economy deteriorates, the Fed “will go back to the old medicine, which is essentially to print money and the dollar will weaken again,” Faber said in an interview with Bloomberg News. “Compared with the euro, the Asian currencies are very, very inexpensive.”

The ringgit, pegged at 3.8 to the dollar seven years ago to stem a capital flight, has tracked the dollar’s 30% drop against the euro since the start of 2002. The Singapore dollar, which is linked to a basket of currencies, has weakened 12% versus the U.S. dollar in the same time. He also favors the ringgit because speculation that China will loosen its currency peg may pressure Malaysia to follow suit and let its own currency to trade more freely. Faber, 59, is the author of The Gloom, Boom & Doom Report, and has invested in Asia since 1973. He gained notoriety for being bearish on Asian assets before the Asian financial crisis in 1997 caused markets in the region, including those in Malaysia and South Korea, to collapse.

Now, Faber is bullish on Asian currencies because of his view a surge in U.S. property prices, which has underpinned growth in consumer spending there, will stall and precipitate a slowdown in the world’s largest economy. That will result in the Fed lowering borrowing costs and result in a weaker dollar. “The foreign exchange market will anticipate this easing beforehand” resulting in a drop in the dollar, said Faber, adding that he was a “reluctant” holder of dollars. Some investors and traders disagree. 59% of the 54 strategists, investors and traders surveyed globally on May 20 said the dollar is poised for its longest winning streak against the euro since 2000 on expectations the U.S. currency’s 3-year bear market has ended.

Faber is also betting on gold because it has become cheaper compared with commodities such as crude oil. Today, one ounce of gold, trading at $417.60, is worth about eight barrels of oil, according to Faber. In 1998, when oil fell to less than $11 per barrel, gold was trading at about $285 an ounce – equal to about 26 barrels of oil per ounce of gold. “You should be long gold and short oil,” Faber said. Commodity markets “aren’t particularly attractive.” The exceptions are agricultural commodities including wheat, corn and soybeans, which may “easily double” in price as demand from China increases as urbanization and global warming reduces annual harvests, Faber said. Drought is harming 12 million hectares (30 million acres) of China’s farmland, affecting spring sowing of the country’s rice crop and the final growth stage for winter wheat, the China Daily reported in April, citing government data. The price of wheat today is $3.17 per bushel, 20% higher than in December 1998, when oil fell below $11 per barrel. Oil prices have increased more than fourfold in the same time.

“Agricultural commodities have never been as inexpensive as right now. You will have more droughts, more flooding and more natural disasters” causing harvests to fall and prices to rise, he said. In China, farming “acreage is declining due to urbanization. In the long run, China will also be a stronger buyer of all agricultural commodities.”

A LOVE/HATE RELATIONSHIP WITH TECH STOCKS

Hedge fund managers hate tech stocks. Is there any better reason to love them? Last week, we dispatched our colleague, Hilaire Atlee, to a hedge fund manager’s investment conference in Midtown Manhattan. His mission: To gather intelligence – not the quasi-intelligence that issues forth from the podium, but the anecdotal intelligence that one gleans from informal comments and off-the-cuff remarks. “Everyone hates tech stocks,” Hilaire reported during his debriefing. “Really? Who’s everyone?”, we replied. “Everyone,” he repeated. “Everyone I talked to said that they were ‘underweight’ tech and that they had no interest in upping their exposure to the sector. Even though techs are bouncing a little, I think a lot of guys are afraid to step in and buy them. They don’t want to get burned again, like they did when they bought energy stocks earlier this year.”

“So what’s your takeaway?” “Well,” Hilaire answered, “I think you have to take a good, hard look at tech stocks, at least for a trade. These stocks had been flying below the radar for the last several months while everyone was busy piling into oil stocks. So the tech rally began kind of quietly. But now that it’s well underway, maybe the techs will keep rallying for a while.”

Hedge fund managers are not the only group of investors who profess to dislike tech stocks. Bearish sentiment toward the tech-stock-heavy Nasdaq Index remains very high, which, as a contrary indicator, bodes well for the index. Meanwhile, the Nasdaq’s “technical” structure continues to improve, according to the many folks who track the ambiguous squiggles etched by stock price trends. “The Nasdaq Composite Index broke through its 200-day average on Tuesday and has broken its 2005 down trend-line,” observes veteran market technician, John Murphy. “Its relative strength line has turned up relative to the S&P 500. [As the chart below illustrates]. The shares of Dell Computer and Intel appear to be leading the charge, just like in the days of old.

It is possible that the recent Nasdaq rally is much closer to an end than a beginning. So you probably should not buy Dell at 25 times earnings … unless you REALLY want to own Dell at 25 times earnings. It is never easy for us value-based investors to embrace a rally that seems to rely primarily upon touchy-feely factors like “sentiment”, “momentum”, and “technical strength”. We would prefer to base our buying decisions on the terra firma of tangible value. But the stock market does not always accommodate our desires. Sometimes cheap stocks go down while expensive stocks go up. Specifically, sometimes lowly valued resource stocks go down, while pricey tech stocks go up.

And sometimes, pricey tech stocks go up a lot. So we would not be surprised to see the Nasdaq continue rallying for a while … until, eventually, hedge fund managers fall in love with them once again … or at least hate them less.

PARCHED

As the summer draws near, we might find ourselves parched for liquidity – not the type that fills a frosty glass with iced tea, but the type that fills a frothy stock market with buy orders. And when liquidity fails to fill a frothy market, share prices fall … sometimes a lot. “Liquidity”, simply speaking, is the flow of cash and credit through a financial system. When there is too little liquidity, economic activity tends to slow and/or asset prices tend to fall. When there is “too much”, economies tend to boom – for a while – and asset prices tend to climb … for a while.

But when there is way too much liquidity coursing through a financial system, spectacular dislocations usually occur. We call these events, “bubbles”. One interesting thing about bubbles however, is that they do not seem so bad while they are inflating. The resulting damage only becomes obvious after the fact, after the liquidity drains away. Think of excess liquidity as a 100-year flood. It uproots every structure in its path and lifts it to unnatural heights, while simultaneously destroying the structures’ foundations. And when the flood recedes. Nothing is as it was before. Everything is a mess. We may be approaching the flood/recession stage. The flood of money that has been elevated asset prices in the U.S. may be on the verge of receding. For years, the U.S. financial markets have enjoyed an abundance of liquidity. What now concerns us is that we may soon have too little to keep asset prices afloat. In which case, many asset markets would suffer, especially stocks and real estate.

The liquidity created by Greenspan’s late-1990s Y2K monetary policy flooded into the Nasdaq, thereby elevating the index to extraordinary levels. But then the Nasdaq crashed as the liquidity drained from the tech-stock sector of the stock market. The Nasdaq is still down about 60% from its all time closing-high of March 2000. Interestingly, the liquidity that fled the tech sector did not abandon the market entirely. The Russell 2000 Index soared to a new all-time high late last year. The shares of many mortgage lenders and other financial institutions have also soared to new all-time highs during the past two years. At the same time, U.S. bond prices floated to their highest level in more than 40 years – a phenomenon that enabled home prices throughout the country to set new all-time record highs. In other words, the excess liquidity in the U.S. financial system has simply moved from one kind of asset to another.

Alan Greenspan understands that in a liquidity crisis, money stops looking for somewhere else to go. It simply withdraws into the safety of time deposits or the tedious ennui of debt-repayment, neither of which propels share prices higher. So the Fed will be keen to keep the liquidity flowing. Unfortunately, the Fed does not control every aqueduct into the financial markets. Liquidity black holes often develop spontaneously, without regard for the intentions of the Fed chairman. We wonder, therefore, which inflated asset is next in line to suffer the agony of withdrawn liquidity. Will what happened to the Nasdaq eventually happen to the Russell 2000? Or the bond market? Or, heaven forbid, the housing market?

And what, if anything, can investors do to protect themselves? Or to rephrase the question, what will go up when liquidity goes down? The answer: Not stocks. To the extent that all stocks are financial assets, any stock you own – regardless of the quality of the business or the earnings—is at risk of falling during a liquidity crisis. But there is one thing and one thing only that goes up when liquidity vanishes: volatility. In a liquidity black hole, therefore, you either want to be a seller of stocks, or a buyer of volatility. For conservative investors (I count myself in that category) a liquidity black hole is to be avoided like a well-done meatloaf. Very few stocks perform well when liquidity recedes. A safety-first approach works best.

But for traders, there may be a profitable solution to the liquidity black hole problem. If you could quickly and easily “buy” volatility in the options market, you could buy the one thing that WILL go up in a liquidity crisis. You would want to buy the “fear gauge”, better known as the volatility index (VIX). The Chicago Board Options Exchange (CBOE) was scheduled to begin trading options on two separate VIX-related indexes in late April, but the launch date has been missed with no indication on when VIX options will start trading. Keep your eyes peeled. I suspect a lot of traders, institutions, and hedge funds will like the idea of hedging their stock market exposure with VIX options, which means, ironically, that VIX options should enjoy being a deep and liquid market in a time of market illiquidity.

BOND BUBBLE, AMERICAN-STYLE

The past seldom obliges by revealing to us when wildness will break out in the future. Wars, depressions, stock-market booms and crashes, and ethnic massacres come and go, but they always seem to arrive as surprises. After the fact, however, when we study the history of what happened, the source of the wildness appears to be so obvious to us that we have a hard time understanding how people on the scene were oblivious to what lay wait for them. ~ Peter Bernstein, Against the Gods

We believe a nasty popping of the bond-market bubble lies in wait for investors. Why? In short, yields are too low, bond prices too high, and quality spreads too tight. The gargantuan rally, which actually peaked in June 2003, as evidenced in the monthly chart of 30-year bond futures below, should soon be history.

The primary source of the “wildness” seems easy to pinpoint ahead of time – this time. It is the U.S. Federal Reserve. It was the engineering of the emergency Fed Funds rate, to save the world from the clutches of deflation (denying this as the proper cleansing agent for economic sins past) that proved most impressive as bubble fuel. It is now the long march toward the elusive “normalization” of benchmark interest rates that will draw Zeppelin-like comparisons from observers as long-bond prices head toward earth.

We would not be surprised to see a surprise in the form of inflation scare, major hedge-fund collapse, or foreign bank reserve reallocation to hasten the descent of fixed income prices across the entire spectrum: from Treasury to junk. Those holding junk bonds, now the darling of yield chasers, will soon understand the moniker.

The Fed’s “policy mistake” was to run the printing presses 24/7 in order save the U.S. economy from what it perceived as a Japan-style deflation. It was a conscious decision by the Fed to create asset bubbles rather than face the painfully healing music of recession. Because the yield on cash was at historic lows, both professional and not-so-professional investors quickly realized the advantages of borrowing short and lending long. In other words, the Fed has engineered the largest one-way bet in history. The bet: long rates will stay low as far as the eye can see. Risk and uncertainty do not enter into the equation when there is such “easy” money to be made. What seems to be coming into focus is our “understanding how people on the scene” are “oblivious to what lay wait for them.”

Carry trade sets the limits to rate hikes.

Although the Fed has moved its federal funds rate from 1% to 2.75%, its speakers, and Alan Greenspan himself, keep emphasizing that “easy money” is still in place. The official target is to raise the Fed’s federal funds rate to a “neutral” level. Although Mr. Greenspan has admitted not to know where that rate is until he gets there, there seems to be a general assumption that it implies sustainable economic growth with price-level stability. Where could that rate be in the U.S. case?

We have learned that the inflation-adjusted federal funds rate has averaged around 2% over the postwar period. Given a present inflation rate for consumer prices of around 3%, this would put the “neutral” nominal federal funds rate presently at close to 5%, plainly far above its current reading of 2.75%. To be sure, nobody in the Fed is seriously eying this rate. They are undoubtedly fully aware that a short-term rate at this level would definitely pull the rug out from under the whole U.S. financial system.

The crucial point to keep in mind is that America’s present high level of asset prices has its foundation not – as is normal – in available savings, but in highly leveraged “carry trade”, the extensive practice of financial institutions to ride the yield curve by borrowing short at low rates to buy higher-yielding assets, mainly longer-term bonds. As short-term rates rise, the carry traders get squeezed. Implicitly, there comes a point when they are forced to liquidate their leveraged positions. However hawkish the Fed’s talk about fighting inflation may be, the monstrous carry-trade bubble is setting narrow limits on any further rate hikes, regardless of what may happen to consumer price inflation.

To put it briefly and bluntly, the Fed is no longer in control of its interest rate instrument. Considering the threat of collapsing carry trade, it would surprise us if they dared to move the federal funds rate above 3.5%, though this might barely match the current inflation rate. With 20 times leverage, or just 5% equity, as the virtual norm in bond carry trade, a rise in the yield of 10-year bonds by just one percentage point would more than wipe out the whole underlying equity. Judging from past experience, we presume that the Fed’s hawkish tone about fighting inflation through faster rate hikes has the purpose of precisely preventing the need for such action by assuaging the markets.

AN OMINOUS PARALLEL

It can no longer be doubted that the world economy is heading into a new downturn following a recovery that has been unusually short and weak among the industrial countries. The loss of momentum during the second half of last year was especially pronounced in Japan and several Far Eastern countries. In Europe, the major eurozone economies have been making headlines for some time with very unpleasant growth and employment numbers. There seemed to be two great exceptions to this unfolding general economic slowdown: the U.S. and China. That, at least, has been the overwhelming perception.

As we have explained in detail many times, we radically disagree with the general unconcern about the U.S. economy. Its stellar aggregate growth rates, particularly since 2000, have masked a dramatic deterioration in the four key fundamental determinants of long-term economic growth: national and personal savings, productive capital investment, profits and the current account of the balance of payments. All four are in shambles.

In essence, recessions are the phase in the business cycle in which consumers and businesses unwind the borrowing and spending excesses of the prior boom. In the U.S. case, the ugly reality is that the excesses and imbalances of the boom years in the late 1990s have grown in the past few years to extremes unprecedented in history. The big question now is whether the rosy assessment of the U.S. economy is right or wrong. In our view, it is dead wrong.

While scrutinizing the economic data, we first noted a sharp slowdown in consumer spending. With weak numbers before our eyes, we have been following the public discussion and the Fed’s statements about the strong economy with amazement. It reminds us of a similar experience in 2000. There is an ominous parallel. In the consensus view, the U.S. economy continued to boom. Taking everybody – including the Fed – completely by surprise, the share market and the economy went into a sudden sharp slump, while the Fed kept raising interest rates in order to fight inflation. We see today the very same uncritical complacency about the U.S. economy.

For most economists, economic analysis today is little more than the simple extrapolation of the economy’s most recent growth rates. Economic growth in 2005 must be strong, because it was strong until late 2004. There is literally zero public discussion about the future implications of rock-bottom savings, skyrocketing levels of unproductive debt, a massive budget deficit and a soaring trade and current account gap.

HEDGE FUNDS ARE NEWEST SCAPEGOAT

Every large market decline must have scapegoats – people investors can blame for their losses. While the timing of the next market collapse is anything but clear, the scapegoat is already in view. It will be those horrid hedge funds. In recent weeks, every little market gyration, whether in bonds or commodities or stocks, seems to have been chalked up by some commentator or other to a hedge-fund strategy gone awry. Memories of Long-Term Capital Management, whose near-collapse in 1998 so alarmed Wall Street that the Federal Reserve organized a rescue, are fresh again.

The hedge fund industry is a tempting target, one that has been growing rapidly with minimal public disclosure. The industry fought bitterly against a proposal by the U.S. S.E.C. to require funds to simply register with the agency. Even with registration, there will be few rules governing such funds. That will change if and when hedge funds take the blame for whatever financial disaster may await us. Perhaps they will deserve it. Past scapegoats have rarely been blameless, although finding someone to blame could also be convenient for those who would rather not dwell on their own poor investment decisions. After the 1929 crash, blame was attached to the short-sellers and to the use of high leverage to buy stocks. In 1987, it was program traders who bought and sold baskets of stocks with hedges against stock index futures. And in 2000, blame was heaped on analysts who had issued rosy forecasts for overvalued stocks. Later, that blame was extended to corporate bosses who had fudged their profits. In each case, there were new rules to assure that old abuses would not be repeated.

There are limited signs that the growth of the hedge fund industry is leveling off. In the first quarter, according to Tremont Capital Management, just $24.6 billion went into hedge funds, 36% below the year-earlier level. But that was still more than went into such funds in any full year before 2001. Running a hedge fund can be both lucrative and fun. Management fees are high, and access to all that capital can bring power, as was shown this year when the management of Deutsche Börse was forced out after it alienated institutional investors, including some hedge funds. That power angered German politicians, though, and those fund managers are now being investigated.

Whatever happens there, in the long run it is unlikely that the returns of most hedge funds will justify the fees being charged. Hedge funds can do well because the managers are geniuses, but there may not be enough of them to go around. Or they can do well by being average performers and using the magic of leverage to multiply return on equity. But the increase in short-term interest rates, particularly in the United States, has made leverage much more costly. There is a risk that higher interest rates and more difficult markets will only encourage hedge funds to roll the dice. There is a problem with a fee schedule that gives the decision-maker a big cut of the profit but requires others to bear the losses. As in baseball, those swinging for the fences may be more likely to strike out. Around 10% of hedge funds go out of business each year, according to Tremont.

Hedge funds will not be the only potential scapegoat if there is a meltdown. If it appears that some derivative security allowed hedge fund managers to gamble with little or no real equity invested, calls for regulation of the over-the-counter derivatives market could multiply. But with minimal information available about what hedge funds are doing, it is inevitable that there is fear they are up to something bad.

RUNNING OUT OF BUBBLES

Remember the stock market bubble? With everything that has happened since 2000, it feels like ancient history. But a few pessimists, notably Stephen Roach of Morgan Stanley, argue that we have not yet paid the price for our past excesses. I have never fully accepted that view. But looking at the housing market, I am starting to reconsider. In July 2001, Paul McCulley, an economist at Pimco, the giant bond fund, predicted that the Federal Reserve would simply replace one bubble with another. “There is room,” he wrote, “for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism. And I think the Fed has the will to do so, even though political correctness would demand that Mr. Greenspan deny any such thing.” As Mr. McCulley predicted, interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt. All of this created jobs to make up for those lost when the stock bubble burst. Now the question is what can replace the housing bubble.

Nobody thought the economy could rely forever on home buying and refinancing. But the hope was that by the time the housing boom petered out, it would no longer be needed. But although the housing boom has lasted longer than anyone could have imagined, the economy would still be in big trouble if it came to an end. That is, if the hectic pace of home construction were to cool, and consumers were to stop borrowing against their houses, the economy would slow down sharply. If housing prices actually started falling, we would be looking at a very nasty scene, in which both construction and consumer spending would plunge, pushing the economy right back into recession. That is why it is so ominous to see signs that America’s housing market, like the stock market at the end of the last decade, is approaching the final, feverish stages of a speculative bubble.

Some analysts still insist that housing prices are not out of line. But someone will always come up with reasons why seemingly absurd asset prices make sense. Remember Dow 36,000? Robert Shiller, who argued against such rationalizations in Irrational Exuberance has added an ominous analysis of the housing market to the new edition, and says the housing bubble “may be the biggest bubble in U.S. history”. In parts of the country there is a speculative fever among people who should not be speculators that seems all too familiar from past bubbles – the shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints showing CNBC, not ESPN, on their TV sets in the 1990’s.

Even Alan Greenspan now admits that we have “characteristics of bubbles” in the housing market, but only “in certain areas”. And it is true that the craziest scenes are concentrated in a few regions, like coastal Florida and California. But these are not tiny regions; they are big and wealthy, so that the national housing market as a whole looks pretty bubbly. Many home purchases are speculative; the National Association of Realtors estimates that 23% of the homes sold last year were bought for investment, not to live in. According to Business Week, 31% of new mortgages are interest only, a sign that people are stretching to their financial limits.

The important point to remember is that the bursting of the stock market bubble hurt lots of people – not just those who bought stocks near their peak. By the summer of 2003, private-sector employment was three million below its 2001 peak. And the job losses would have been much worse if the stock bubble had not been quickly replaced with a housing bubble. So what happens if the housing bubble bursts? It will be the same thing all over again, unless the Fed can find something to take its place. And it is hard to imagine what that might be. If housing enters a post-bubble slump, what is left?

Mr. Roach believes that the Fed’s apparent success after 2001 was an illusion, that it simply piled up trouble for the future. I hope he is wrong. But the Fed does seem to be running out of bubbles.

“Bubbles”, and the (overlooked) role of government.

Financial bubbles have attracted a lot of attention in recent months, both in the media and in academic research. Naturally the commentary has focused on investor behavior, but to fully understand the beginning and end of a bubble, it is crucial to understand the role of government policy.

Consider the U.S. bankruptcy code, for example. The year 1978 marked a major revision in that code, namely to a highly lenient standard. Much of the impetus for a change in the law flowed from the perception that times were tough, as indeed they had been in the stock market and economy. In truth, of course, the beginning of the great bull market was nearby. The more lenient bankruptcy standard has held for some 27 years, but this coming October a new – and more conservative – change in the law will take effect.

What is more, New York state attorney general Eliot Spitzer is at it again, this time with “sub-prime” lenders in his investigative sights. These lenders have been one of the primary drivers in increased levels of home ownership, but also mortgage products such as “interest only” mortgages, and in other allegedly abusive lending practices. What does this suggest?