Finance Digest for Week of July 18, 2005

PEAK CREDIT?

Credit forces always trump great speculative visions and the world is fast running out of speculative credit. No matter whether the speculation has been in tangible assets, as in 1980 or 1988 or, for that matter, in 1920, one key to the contraction has been the spike and reversal in commodity prices. Much the same holds when the mania has been in financial assets, as in the fateful blowouts of 2000, 1929, and 1873 – to mention only 3 of the 6 great financial bubbles. We have been describing this boom as the one that typically arises out of the collapse of a tech mania. With strong commodities, we have also been describing this as an “old fashioned” business cycle. More lately, we have been noting that the crowd has been again showing considerable compulsion to be long the big visions.

However, our mission has been, as best as is possible, to anticipate major trend reversals. Although this phase of speculation has encompassed both financial and tangible assets, the alerts to the reversal will be the old standards of credit spreads widening (since March), commodities topping (ditto), and the yield curve reversing to steepening (not yet, but soon). Too much of the financial world remains convinced that the Chinese expansion is unassailable and the Fed’s compulsion to depreciate the dollar is not to be denied. However, Mr. Market and Mother Nature are about to reverse most, if not all, of the games. Fortunately, this will likely be done in the typical manner that, beyond the stalling out of commodities, will include a profound change in the credit markets.

There has been a wall of worry about massive shortages of base metals, metallurgical coal, and crude oil. One recent example sums it up: “World Reserves of Cheap Oil Have Probably Peaked”. This prompts a line for the way Mr. Market and Ms. Nature will deny the mania in commodities: “World Reserves of Cheap Credit Have Probably Peaked”. The end of great manias involves a mighty struggle of speculative passions. These include the compulsion of the “big story”, those who have been prematurely shorting it and, above all, those who have been providing the credit. The latter always includes the “easy money” compulsion of borrowing short and lending long, which drives the yield curve towards inversion.

Since the advent of the modern senior central bank with the Bank of England in 1694, the ability of market forces to expand and then contract credit have eventually and always overwhelmed the attempts of policymakers to continuously expand credit. All that is needed is to have the mania encompass all of the available credit and then the mystery of the end of a bubble develops. It is essential to fully grasp that it has not been “liquidity” that has been driving prices up – quite the opposite – as soaring prices permit and foster the expansion of credit.

The warnings from change in the credit markets are typical and are mounting, in which case all that is needed is to have prices in the speculative games weaken as credit spreads extend their widening trend and the U.S. treasury curve reverses to steepening. At that stage, Mr. Margin joins forces with Mr. Market and Ms. Nature.

YET TO BE SQUEEZED

Just when you think everybody who knows how to drive already owns a new car, the biggest jump in auto sales in three years helps push June retail sales up a whopping 1.7%. Furniture stores posted their strongest gains of the year, which makes a cause and effect sort of person wonder if everybody went out and bought a pickup just so they could haul their couches home. Business indicators also came in strong with June industrial production coming in higher than expected, just when you think there is no more industry left to produce, unless you count the soothing whir of coffee beans being ground into high margin consumables at Starbucks. And get this – capacity utilization hit 80% for the first time since 2000. Could it be that the Goldilocks Economy is For Real? Or is the economy really more like a thick J.K. Rowling product, perhaps one called Al and the Goblet of Debt, which has nothing to do with golden-haired girls or porridge, but starts out something like this:

Once upon a time, people in a distant village thought it was a good idea to save money and avoid debt as if it were a video clip of a Tom Cruise interview. But then one day, a wizard named Al sneaked into the town with a silver goblet (Al was so over his infatuation with gold) and placed it in the middle of the village, right next door to the local mortgage company. Of course, the owner of the mortgage company was the first one to notice the goblet. So he picked it up, and while most people probably wouldn’t drink out of something they stumbled upon on the way into work, the mortgage banker drank from the cup, and when he did he suddenly realized that all those adjustable rate home equity loans he’d been making would adjust higher one day, and he was sure glad that he’d sold them all off to investors.

Just like all those kids who lined up for their thick Harry Potter books over the weekend, America may not know how it all will end for a long time. “It” of course being the repercussions, if any, from the enthusiasm for adjustable rate mortgage financing. Americans are so gaga over this mortgage flexibility that 63% of mortgage loans originated in the second half of 2004 were adjustable in some way or other. And 11% of all mortgage loans were interest-only loans. But that was last year. After tallying the results of a more recent survey, the National Mortgage News concluded that interest-only loans now account for 21% of loan production.

As any mortgage banker will tell you, if pressed, the problem with adjustable rate mortgages is that they tend to adjust. And adjustable loans offered at a teaser rate will adjust higher even if prevailing interest rates do not change. And they will adjust if interest rates do change. A person visiting Freddie Mac’s website could learn that the going rate for a 1-Year adjustable rate mortgage is now about 4.56%. That means ARM rates today are higher than comparable ARM rates going all the way to mid-2002. And that means that people who bought houses with ARMs over the last year or so ought to be feeling a little squeeze from the adjusting process, teaser or no teaser.

But how much of a squeeze can there be, given the zeal for furniture, including the unassembled kind sold in those IKEA stores the size of Delaware that keep popping up all over the place? Maybe not much. A 2% bump in a mortgage rate can be real money. At 5.35%, monthly principal and interest on a $300,000 loan comes to about $$1,675. But a 1% higher rate would bump the payment to $1,866. In addition, when interest only loans become ARMs requiring both principal and interest, the loan is amortized over the remaining term, not over 30 years. In other words, with interest only loans, higher payments are inevitable. There is one indication, however, that some borrowers are close to getting squeezed. According to research by UBS, 70% of borrowers with pay option ARMS are making the minimum payment. The New York Times quotes UBS analyst David Liu admission that, “That’s definitely a sign that people are stretching.”

Of course who would not stretch to own an asset that always goes up?

When the bills come due, then what?

Thanks to rock-bottom interest rates and easy ways to borrow, consumers have been on an all-out spending spree for several years. Now, though, there are signs that the bills may be piling up too high. The portion of Americans’ disposable income devoted to paying off debt hit a record high recently, even though interest rates have stayed at record lows. That could put a financial squeeze on many households if and when long-term interest rates finally start to go up. U.S. consumers are more vulnerable than ever to rate increases because they have taken on more adjustable-rate debt in recent years – meaning monthly payments fluctuate when interest rates change.

Nearly half of all consumer debt and 26% of all mortgage debt is now adjustable, estimates Joe Abate, senior economist at Lehman Brothers. That is a stark change from the early 1980s when nearly all debt had fixed rates. Other estimates peg adjustable-rate debt at closer to 20% of all consumer debt. And recent data suggest the debt burden on households is growing heavier, despite low interest rates. The “debt service ratio”, the Federal Reserve’s estimate of the ratio of debt payments to after-tax income, hit 13.4% in the first quarter of this year, an all-time high since the Fed began tracking it in 1980. The financial obligations ratio, which adds automobile lease and rent payments, homeowners insurance and property-tax payments to the debt service ratio, was 18.45% last quarter, near the record high of 18.84% in late 2002.

Overall, U.S. consumers now owe roughly $11 trillion, nearly double what they owed a decade ago. The vast majority of that debt growth came from people taking out big mortgages and tapping their escalating home equity. Total household debt grew 11.2% in 2004, the largest year-to-year increase since 1986. “We’re still in the midst of this consumer debt binge,” says Kathy Bostjancic, U.S. senior economist at Merrill Lynch. As long as the housing boom continues, “it’s going to give consumers a false sense of security.”

Here is the impact rising rates can have on household finances: A family with a 30-year adjustable-rate mortgage with a 5% interest rate would see its monthly payment jump from $1,074 to $1,468 – a 37% leap – if mortgage rates rose to 8%. Couple this with rises in other debt payments such as credit cards, home-equity loans and such, and households may struggle to pay all the bills each month. The rise in payments due could be exacerbated if job growth and incomes do not keep pace. For consumers, this means it is high time to make a serious dent in their debts, especially those with adjustable-rate debts such as many mortgages, home-equity loans and credit cards. While it may not be realistic to pay off some debts entirely (easier said than done), borrowers can at least make more than the minimum payments each month – and cut back or stop buying on credit.

Much of the debt spree reflects unusual market trends in recent years, particularly the housing boom. Even as the U.S. economy sputtered and jobs fizzled in 2001 and 2002, consumers continued to borrow and spend as they did during the raging 1990s bull market. But as home prices surged and interest rates hit record lows, consumers took out bigger mortgages and started tapping their escalating home equity like a credit card. U.S. regulators kept interest rates low to keep the economy chugging. “It was a good strategy in that we needed something to boost the economy in the economic downturn,” says Dean Baker, founder of the Washington think tank Center for Economic and Policy Research. “But it sets us up for an even worse crash when housing” cools. “In the long term, we’ll probably regret it.”

What is more, consumers’ attitude about debt is changing, says Robert D. Manning, a finance professor at Rochester Institute of Technology. While older generations are more debt-averse and cut spending during economic downturns, younger generations rely on debt for spending money. “What we’re seeing here is really a deferral of the financial responsibility and consequences,” Mr. Manning says. “We may be heading into a very gut-wrenching period.”

AMERICA’S MOST OVERPRICED PLACES

Once an overpriced city, always an overpriced city. That may not be how the old saw goes, but it is one of the things we gleaned from the fourth edition of our “Most Overpriced Places” study. A couple of cities fell off the list, and others shuffled places. For the most part, the roster is still made up of metropolitan areas that will suck dollars from your wallet in a flash.

Plenty of places are expensive. You probably think where you live is far too costly, especially since real estate costs keep heading north around the country. Movie tickets used to cost a quarter, and with a million dollars you could get yourself a mansion. In Los Angeles this year, the median home price rose above a half-million dollars, according to the California Association of Realtors. And do not even get us started about the cost of catching a film. Still, if jobs are plentiful and incomes are rising, the real effect of increasing costs is small. But when prices go up, when employment is stagnant and when incomes are flat, well, that is when things are overpriced.

Seattle, once again, took the highest spot on the “Overpriced List”, because it is still recovering from the dot-com blowout five years ago. New York and San Francisco, which have hard-earned reputations for being super-pricey cities, made the cut, as did a couple of New Jersey locations. Miami, on the other hand, dropped from the list, but came in at a close No. 12. Job growth there is solid, but the cost of housing is still high. Milwaukee came in just outside the top 10, as well, with its expensive housing.

In fact, housing costs were a major factor in determining the rankings. Despite all the talk of a bubble that is sure to burst, real estate continues racing up a steep price hill. If you are unfortunate enough to live in an overpriced city, stop your whining. After all, there must be something keeping you there, whether it is the museums or the easy commute. And if you are lucky enough to live outside of the top 10, count your blessings – and your dollars.

Big houses could be big trouble.

We Americans seem to be in the process of becoming wildly over-housed. Since 1970, the size of the average home has increased 55%, to 2,330 square feet, while the size of the average family has decreased 13%. By and large, the new American home is a residential SUV. It is big, gadget-loaded and slightly gaudy. In 2001, one in eight homes exceeded 3,500 square feet, which was more than triple the average new home in 1950 (983 square feet). We have gone beyond shelter and comfort. A home is now a lifestyle. Buyers want spiral staircases and vaulted ceilings. In one marketing survey by the National Association of Home Builders, 36% of buyers under age 35 rated having a “home theater” as important or very important.

Of course, homeownership (now a record 69%) symbolizes success in America. The impulse to announce more success by having more home seems to span all classes. In his book Luxury Fever, Cornell University economist Robert Frank noted that Microsoft co-founder Paul Allen built a 74,000-square-foot house. According to Frank, that roughly equaled the size of Cornell’s entire business school, with a staff of 100. Frank sees a “cascading effect” of imitation all along the social spectrum. The super-wealthy influence the wealthy, who influence the upper-middle class – and so on. People constantly enlarge their notion of “what kind of a house does a person like me live in.”

Another cause of this relentless upsizing is that the government unwisely promotes it. In 2005, 80% of the estimated $200 billion of federal housing subsidies consists of tax breaks (mainly deductions for mortgage interest payments and preferential treatment for profits on home sales), reports an Urban Institute study. These tax breaks go heavily to upscale Americans, who are thereby encouraged to buy bigger homes. Federal housing benefits average $8,268 for those with incomes between $200,000 and $500,000, estimates the study; by contrast, they are only $365 for those with incomes of $40,000 to $50,000.

What if bigger homes lose value? Say what? Gosh, we are in the midst of the greatest real estate boom in U.S. history. But booms have a habit of imploding. The latest evidence that cheap credit and speculation have artificially inflated home prices comes from a study by the investment bank Credit Suisse First Boston. It finds that home buying is increasingly driven by purchases of investment properties and vacation homes. In 2004, these buyers accounted for 14.5% of all home sales, up from 7.5% from 1998 to 2002.

Even if home prices do not collapse, their long-term performance may disappoint. In a new edition of his book Irrational Exuberance, Yale economist Robert J. Shiller examined home prices since 1890. His startling conclusion: after adjusting for inflation, home prices rose only 0.4% annually through 2004. After periods when they outpaced inflation – say right after World War II – home prices slow down. Their recent surge is, by Shiller’s figures, unprecedented. The implication is that prices may soon enter a period (after inflation) of stagnation or decline. As Shiller notes, home prices cannot rise too much faster than average incomes for too long without excluding many buyers from the market. One way or another, Americans might want to reassess their passion for ever-bigger homes. Do we need to go from SUVs to Hummers? Maybe we should revert to sedans.

In Manhattan, novice investors are unfazed by talk of a real estate bubble.

With the giddy days of the high-tech investment bubble a fading memory and home prices in some of the hottest housing markets up 100% over the past few years, America’s housing boom is providing investors with a tempting new chance to grab a slice of the fortunes now being made on the streets of many towns and cities. New York’s Ultimate Investors Real Estate Club, for example, is one of 178 in the National Real Estate Investors Association, up from slightly more than 40 in late 2002. The association now counts some 35,000 individual investors as members.

One of about a dozen real estate investment clubs in the New York area, Ultimate Investors has seen its membership mushroom to nearly 300 over the past few years, says club founder Wesley Barney. The club offers paid members the opportunity to network with other investors and industry specialists at monthly meetings, go on field trips to scope out housing markets and attend educational workshops. Members, who pay $189 in annual dues, also get a newsletter on real estate investing. Barney, worked for for the New York City Fire Department until becoming a full-time investor about five years ago, says that because New York City real estate prices are so high, the main goal of his group is to help members find affordable properties in up-and-coming markets like Syracuse, N.Y., and Kansas City, Missouri.

Sylvia Scott, a mortgage specialist from Chestnut Ridge, N.Y., who is a relative newcomer to real-estate investing, recently placed bids on three properties in Syracuse – two single-family homes and a 6-apartment building – after her husband, Louis, visited the city on one of Barney’s trips. “For people just starting out in real estate investing a place like Syracuse is a good place because the city is on its way up,” Scott said.

Canadian housing market breaks record.

More homes traded hands in Canada last month than ever before, easily surpassing the record set nearly two years ago. Low interest rates, a strong job market and Canadians’ seemingly insatiable appetite for real estate have sent the industry to new heights once again, just when most thought things would settle down. Average prices were up 1.2% in June from the previous month and 9.5% from the same time last year.

U.K. house prices declined for 11th straight month in June – link.

What does “low financing costs” really mean?

Times change faster than benchmarks do – and to see what I mean all you have to do is read today’s news about the latest housing data. The stories I saw correctly reported that housing starts were flat while building permits increased, and then went on to say things like “low financing costs are driving home buying – the average rate on a 30-year fixed mortgage in June was 5.58%, the lowest monthly level since March 2004’s 5.45%.” The “30-year fixed mortgage” has, of course, long been the benchmark in the housing market. But as for its relevance these days, let us just say that recent trends in mortgage lending have made it downright quaint (if not as ancient a notion as a down payment).

Still, the news articles were at least half right – because there ain’t no doubt about the fact that financing costs ARE low, and ARE driving home buying. It is just that if you look closely enough at the mortgage lending figures, you discover that “low financing costs” mean that 60% of new mortgages these days have adjustable rates, and are often combined with “interest only” or even “negative amortization” payment schemes.

In case you are wondering, negative amortization loans go beyond interest-only payments, and typically mean that you do not even have to pay the full amount of interest you owe the bank each month – for the first year, that is. Then, depending on how foolish the borrower is, the payments will begin to rise slowly. And after five years, the so-called owner will not only have NO equity; the mortgage will be a larger amount than the “owner” faced to start with. Finally – just in case you think mortgages like this are rare – an MSNBC report earlier this week said, “40 percent of mortgages over $360,000 that have closed so far this year are ‘neg-am’ loans.” What eventually happens in an economy where people trend home purchases the way they do the balance on their credit cards?

Greenspan heightens warning on risky mortgages, housing price declines.

Federal Reserve Chairman Alan Greenspan cautioned that certain types of increasingly popular, risky home mortgages could be “disastrous” for some borrowers betting on ever-rising house prices. “There’s potential for individual disaster there,” Greenspan told the House Financial Services Committee. It was his strongest warning yet about the potential pitfalls for consumers and lenders in the nation’s red-hot housing market. Greenspan also warned lenders to “fully appreciate the risk that some households may have trouble meeting monthly payments as interest rates and the macroeconomic climate change.” Greenspan discussed the housing market while delivering an upbeat assessment of the overall economy in his semiannual report to Congress. Employment, retail spending and business investment have all risen in recent months, he noted.

U.S. housing bubble expected to spread.

The bubble in the U.S. housing market is likely to grow – and spread even further – said John Calverley, chief economist at American Express. The boom in U.S. house prices has started later than in other countries such as the UK, Australia, the Netherlands and Spain. However, figures suggest that it is catching up fast. Builders started work on 1.65 million new homes in the year to May – the highest number since record began. And about 900,000 condominiums were sold over the past year – almost twice the rate seen in the late 1990s.

Some economists have sought to assuage concerns about prices, saying that they are the natural result of lower interest rates. But Mr. Calverley warned that the boom had definitely become a bubble. The giveaway signs included excitement in the media and new lending policies from banks. People were borrowing as much as they could because they expected prices would only go up. Meanwhile, new entrepreneurs were springing up offering property advice or “condo flipping”, when flats are bought off-plan and sold as quickly as possible.

A swift end to the phenomenon was unlikely unless interest rates rose significantly. Instead, the U.S. could expect an expansion of the bubble and an even harder landing, predicted Mr. Calverley, who last year published a book called Bubbles and How to Survive Them. He forecast that new metropolitan areas would see strong rises as people turned to more affordable houses.

Assessing the demand for residential real estate.

Demand For residential housing can be classified into two categories. The first covers houses (or condos) purchased for buyer-occupancy as primary residence (PFR). All other purchases can be categorized as Purchases for Investment (PFI). Vacation homes which are not the primary residence of the owner will be included in the PFI bucket. The next two sections examine the demand in these two groups. Only net demand is considered here – someone selling a house to buy another does not create net incremental demand.

The magnitude of the unfulfilled demand for housing combined with financial “new product development” can keep the current housing boom going for a few more years. However these new financial products have yet to stand the test of the vagaries of the environment – an economic downturn or an interest rate spike or other events that may cause lenders to pull in the reins. To understand the magnitude of the impact of a constrained lending environment it is useful to look at the sharp decline in prices of telecommunications stocks in 2001-2002 when investors became more risk-averse. Some companies went bankrupt and those left holding the bag (like the author) did not receive any bailout from the government. Others like Lucent and Nortel are currently trading at less than 5% of their peak values.

The expectation with the housing market now is quite different. Despite the new bankruptcy law that makes filing Chapter 7 more difficult, house buyers are purchasing financial products with greater risk on the downside. Investors are pouring more money into the homebuilders and the lenders. Part of the bet is that with the scale of liabilities of the mortgage industry, especially the GSEs, the Fed and the government will bail out the financial sector from any disasters, shifting the burden to the public. As alluded to by others, “character” is being tested – that of buyers, lenders, builders, investors, and the public at large.

NOW IS A GOOD TIME FOR CD’S

July is a great time to grab a deal on flip-flops, patio umbrellas and, believe it or not this season, bank CDs. Savers cannot afford to take this summer off. If you shop around, you can nab some short-term certificates of deposit that are paying 4% or so. So at last, savers are seeing CDs that are not laughable. Last June, the average yield for a one-year CD had fallen to a crummy 1.51%. Last week, the national average yield was 2.82% on a one-year CD, reports Bankrate.com. And some of the locally promoted deals are among the best out there. The highest one-year CD yields nationwide last week were 4.1% to 4.16%.

CD yields have been slowly inching upward since the Federal Reserve began raising short-term rates last summer. But savers have been reluctant to tie up their money for a year or more, knowing that the Fed was on a rate increasing binge. Why lock up a rate of 2% on a one-year CD when the rate could be higher in three months? And banks have been heavily promoting money market accounts, including deals of 3.25% or higher. Some money-market offers are teaser rates, though, and last only a few months.

If you decide to pick up a CD, find out: 1.) Is the CD insured by the FDIC? Some CDs pitched by brokers and others are not insured. 2.) Does this mouth-watering promotional rate apply to me? Look in the fine print for words like “new money”. At some banks, you cannot just transfer money from another account at that bank to a well-advertised money market or CD at that same bank. 3.) What is the penalty for early withdrawal? What if you need the money before the CD matures?

THE FEDS AND BERNIE EBBERS HAVE A LOT IN COMMON

Last week’s consumer price index was downright Ebbers-like. The Labor Department said – presumably without a single bureaucrat snickering – that consumer prices did not budge in June. And that followed a decline – yep, I said a decline – of 0.1% in May. Hold your noses, because those numbers just do not pass the smell test. Housing prices are soaring, gas stations cannot get the higher prices posted fast enough, and education costs are jumping faster than IQs are falling – and the government actually wants us to believe that inflation does not exist.

I have explained extensively in the past how the government makes inflation disappear through statistical gimmicks. But the torture inflicted upon last week’s CPI was cruel if all too usual. For instance, my friends John Williams of ShadowStats.com and Bill King of Ramsey King Securities point out that the American Auto Association calculates that gasoline prices have risen 21.5% since this same time last year. But the government swears gas prices are only 6.9% higher over the year and actually down 1.2% for the month. That little trick alone saved the CPI from being 0.53% points higher, and it kept the politically sensitive GDP from being lower by an equal amount. And housing? Despite all you have read, the government thinks housing is only 2.2% higher over the past year. Others, including the National Association of Realtors, calculate that housing is up at least 12.5%.

But this is not just about numbers. Bernie Ebbers is not going to jail just because he fiddled with a few decimal points. He is going away because in playing with the digits, he cheated people out of money. If you receive Social Security or an inflation-adjusted cost of living increase, the government is Bernie-ing you.

INFLATION CONVERGENCE

Is inflation global or local? That is a key aspect of the macro debate, which is now moving to center stage in financial markets. Generations of economists, policymakers, and investors are trained to look at inflation as a closed-economy phenomenon, driven by the “cost mark-up” models of yesteryear. However, as an unmistakably powerful convergence of inflation rates around the world suggests, globalization argues for a different approach. Country-specific inflation calls are increasingly becoming global inflation calls.

he evidence on geographic inflation convergence is compelling. As recently as 1990, CPI-based inflation in the so-called advanced economies was running at a 5% rate, whereas the median inflation rate for developing countries was slightly above 15%. According to the IMFs latest estimates, inflation in the developed world is likely to average around 2% in 2005 and 4.8% in the developing world. That means over this 15-year time period, annualized inflation differentials between these two categories have narrowed from slightly over ten percentage points to just under three percentage points. Powerful convergence trends are evident within virtually every major subset of the mix of global inflation.

It is not hard to figure out why. At work, in my view, are the all-powerful forces of globalization. Courtesy of ongoing trade liberalization, in conjunction with sharply declining communication and transportation costs, there has been a sharp increase in the tradable goods portion of world output over the past 15 years. Global trade has now climbed to nearly 30% of world GDP – nearly double the 17% share prevailing as recently as 1986. In my view, the globalization of pricing trends is a perfectly logical outgrowth of a world economy that is now being increasingly powered by a rapidly growing cross-border trade dynamic. Barring country-specific developments I believe that an increasingly powerful globalization overlay makes it very hard to for breakaway trends of divergent inflation to emerge as endogenous characteristics of individual economies.

A realignment of foreign exchange rates has long been associated with shifting inflation differentials around the world. In that vein, I have long argued that a weaker dollar should be seen as a critical outgrowth of America’s current account adjustment – central to the shifts in the world’s relative price structure that might be expected from a full-blown global rebalancing. While the dollar has moved up sharply so far this year, I would characterize this upturn as nothing more than a rally in the midst of a structural downtrend. What is especially noteworthy is that despite the 13% depreciation in the broad trade-weighted dollar since February 2002, the U.S. inflation rate has not budged. Many have argued that convergent forces of globalization are neutralizing the once powerful connection between currency realignments and inflation. I could not agree more.

All this is not to say that inflation convergence sits all that well with the global body politic. Recent protectionist rumblings are particularly disconcerting in this regard – especially U.S.-led China bashing. Needless to say, if the Washington consensus succeeds in repricing U.S.-Chinese trade flows – either by the imposition of trade sanctions or by forcing China’s hand on an RMB revaluation – the U.S. cost of Chinese imports will go up. For reasons just noted, however, America’s diminished currency elasticity does not necessarily spell a large enough surge in U.S. import prices that would then spill over to pricing of domestically produced goods. Instead, Chinese producers or U.S. distributors could temper the import price pass-through and elect to take the hit through profit margins. For these reasons, I do not think that intensified trade frictions would precipitate a reversal of global pricing convergence. Only in the worst-case scenario of frictions morphing into a full-blown trade war, would globalization, itself, start to reverse.

Central to the financial market debate is the case for accelerating U.S. inflation. With slack being absorbed by labor and product markets, unit labor costs apparently on the rise, the dollar arguably in the midst of a multi-year decline, oil prices near $60, and the growth outlook still solid, fears of a cyclical pick-up in U.S. inflation are understandable. However, the increasingly powerful forces of worldwide pricing convergence suggest that domestic attempts to exercise pricing leverage will encounter stiff global headwinds in a climate where non-U.S. world inflation is likely to remain subdued. Consequently, barring the unlikely reversal of globalization, I continue to believe that persistently low global inflation will prevent a meaningful deterioration on the U.S. inflation front. Needless to say, that has especially important implications for Fed policy and fixed income markets - underscoring what I still believe could be a surprisingly bullish outlook for bonds.

No bottlenecks without a bottle.

The more I ponder the inflation story, the more I become convinced that we need to come up with a new approach. In two earlier essays, I addressed the shifting composition of inflation (see “Inflation Phobia” July 15, 2005) and the cross-border convergence of pricing (see “Inflation Convergence”, July 18, 2005). In what follows, I explore some important shifts in the macro relationships that have long been at the heart of the inflation process. What emerges from this trilogy is a strong conviction that increasingly powerful forces of globalization have fundamentally altered the inflation outlook. Barring a setback to globalization or a major policy blunder, low inflation could well be here to stay for the foreseeable future.

At work, in my view, is the globalization of disinflation. Our old closed-economy models have been rendered increasingly obsolete by the emergence of far more powerful cross-border influences on pricing. As a result, in making inflation calls, we now need to pay less attention to country-specific shifts in unemployment and capacity utilization rates. Instead, we need to focus more on the global balance between supply and demand that shape the far more open models of globalization. In that broader context, the outlook for inflation remains very constructive, in my view. After all, it is hard to have bottlenecks without a bottle.

IT COSTS A LOT TO FIGHT A WAR ON TERROR

For all of the good news emanating from the U.S. recently, it is worth bearing in mind the huge ongoing financial strains the country continues to experience, as it seeks to confront the scourge of global terrorism. Ludwig von Mises once remarked that you could burn the dining room furniture and get passably warm. But you must not mislead yourself about what you are doing. The next time you go to sit down you might wish you had gone out and chopped wood. At some point Americans are likely to regret having borrowed so much against their bedrooms and kitchen appliances … but that point may still be many months in the future if we are to judge from the most recent net inflows supporting the U.S. dollar. But if their homes’ foundations are being chewed up by economic termites in the form of debt, that time may well be closer than the markets currently envisage to judge from this year’s ongoing strength in the dollar.

In many respects, the dollar’s current “success” on the foreign exchange markets appears to contain the seeds of its own destruction. Improved revenues appear largely a product of debt financed activity, which in turn are generating revenue gains that are probably unsustainable in the longer run. The strains of military overstretch is likely to exacerbate the problem and appear set to get worse as the “coalition of the willing” gradually becomes the “coalition” of the one. The dollar’s strength, therefore, appears no more than a summer respite. By the autumn, things may well look different to the forex markets again.

HOW LOSERS WIN

Ralph Wanger is an expert investor … a true expert. Under his shrewd guidance from 1970–2003, the Acorn Fund (a mutual fund dedicated to small-cap stocks) produced an astounding 17.2% annualized returns. A mere $10,000 investment in 1970 grew to $174,059 by 1998. Last month, I hopped a plane to Chicago to meet with Mr. Wanger for one precious hour (interview summary here). But after the first 60 minutes of our conversation rushed by, he agreed to give me another 60 minutes of his time. That may have been the most valuable gift I have ever received. During my two hours with Ralph Wanger, he shared the three key investment tactics that propelled his fund to such dazzling gains:

Investment Insight #1: Stray from the herd every once in a while. One of the ways to “stray”, Wanger says, is to think long-term. The average holding period for an NYSE stock has fallen to less than one year! (See chart.) As recently as 1990, the average holding period exceeded two years; in 1975, it was over four. Investment Insight #2: Know when to sell. Says Wanger, “Make the reason you buy a stock so specific that you know when the reason is no longer valid.” Investment Insight #3: Understand that the stock market is a “Loser’s Game”. “Chris, if you do NOTHING else in your newsletter,” Wanger emphasized, “remind your subscribers every month that the stock market is a loser’s game.” (This article summary elaborates.) “The great secret of success in long-term investing,” says Wanger, “is to avoid the serious losers.”

But even if you manage to avoid big losers, it helps to own a winner or two from time to time. So, after bidding Wanger adieu, we took a peek at his latest quarterly reports to find out what he has been buying recently…

MURPHY’S TRADE: BUY BONDS

Capt. Edward A. Murphy is the man after whom Murphy’s Law is named. He was an engineer in the air force, working on a project to see how much deceleration a pilot could withstand in a crash. One day, he lost his temper with a technician. The guy had wired a switchboard incorrectly, says the legend, and when Murphy discovered the mistake, he cursed the technician saying, “If there is any way to do it wrong, he’ll find it.” There is an interesting approach to market forecasting that starts with Murphy’s Law as its premise. Those who follow this approach take the line that, if it can go wrong, it will go wrong, and when it does go wrong, it will take down the greatest number of people with it.

A look at the returns of over the last 3 years of U.S. and European stocks, bonds, and real estate, as well as at emerging markets, copper, gold, oil, Japanese and Asia stocks shows that the standard metrics used to measure the value of these assets are off the chart. There are no more obviously cheap stocks however you look at them, real estate prices bear no relation to rental yields, and bond yields do not even compensate you for inflation. Everything is up. Across the board, asset prices have been pushed higher by excess liquidity. The 2001-2 recession – aided by the tech wreck, Y2K, and 9/11 – pushed U.S monetary administrators to take drastic action. They cut interest rates to 46-year lows and flooded the markets with cheap credit. The cheap credit flowed into global asset markets like rainwater to a gutter, and pushed prices up everywhere.

Debt has been used as a way to prolong consumption and consequently, Americans as a whole owe large amounts of money. The majority is a debtor. Murphy’s Law says the majority gets it. Picture all that debt. Debt gets paid in cash. Cash is liquidity. The worst thing that can happen to a debtor is that liquidity dries up and he is unable to pay the interest on his debt. Bankruptcy ensues. Here is the debtor’s worst-case scenario, the Murphy’s Law prediction:

Bond traders keep pushing bond prices higher. This is exactly the kind of trade bond vigilantes like, because it puts the Fed over a barrel. The more prices on 10-year and 30-year Treasury bonds rise – prices the bond vigilantes control – the tighter the rope around the economy’s neck becomes. When short-term bond prices are higher than long-term bond prices there is no incentive for banks to make loans and they pull money out of the system. Liquidity dries up. Debt still needs to be serviced. The country will be screaming out for cash to pay its debts like a junkie screams for more drugs as he is being strapped to his bed. Anyone with debt feels the pain, and in America, that is most people.

A self-fulfilling circle will have been put in motion. Higher bond prices will choke the economy of even more liquidity as the curve inverts further. Consumerism will grind to a halt. The U.S. economy will hit a wall. Assets that went up will come down fast. You will get bankruptcies, profit warnings and unemployment. A cash crunch ensues. People panic and rush into safe haven investments. Treasury bonds are still the most trusted instruments in the world; they will be popular and their prices will spike even higher. People will talk about a bubble in bonds.

Here is the Fed’s problem. They will do anything to avoid this “deflationary” scenario and the bond market knows it. So by choking the economy, the bond market essentially forces the Fed to pump more artificial liquidity into the economy or face financial reckoning day. The bond market has a golden opportunity to put the Fed in this tight spot. Buying bonds is a bet they take it.

DEBT, DELUSION, AND DECEPTION

The skyrocketing wedge between debt growth and GDP growth is definitely the most spectacular and most frightening phenomenon of the economic and financial development in the U.S. In relation to lagging income growth, the wedge is considerably bigger. Yet it receives zero attention by the Federal Reserve and the permanently bullish consensus. Due to higher inflation, higher short-term rates and compound interest, ever-increasing amounts of credit are required to maintain their effects on spending and asset prices. Signs of a slowing global economy are abounding, led everywhere by the manufacturing sector. Downward surprises are chronic. The U.S. economy is no exception.

Our highly critical assessment of the U.S. economy is mainly determined by two extremely negative considerations: First, its chronic structural imbalances between consumption, saving, investment and debt creation have dramatically worsened since 2000; and second, both monetary and fiscal policies have virtually exhausted their stimulatory potential. There is little or nothing left for them to do when the economy slides back into recession. It is the particular feature of U.S. economic growth since the late 1990s that consumer spending has increasingly outpaced the growth of production. Its counterparts are a collapse of saving out of current income, weak business fixed investment and the soaring trade deficit. Actually, business borrowing goes mostly into mergers, acquisitions and dividend payments.

The most striking hallmark of this escalating divergence between consumption and output in the U.S. economy has been the exploding U.S. current account deficit, presently running at an annual rate of close to $800 billion. This is more than six times its amount of $109.5 billion in 1995. It seems that U.S. policymakers and economists have yet to realize that this deficit is the economy’s great income and profit killer. To offset the implicit huge drag on U.S. domestic production, employment and incomes, the Fed has kept its money and credit spigots wide open to create alternative domestic demand.

Over these four months, the real disposable income of private households edged up a miserable $37.7 billion, equal to an annual growth rate of 1.5%. Over the same four months, consumer spending in chained dollars surged by $75.7 billion, but with a steep downtrend: February $32 billion, March $28.6 billion, April $18.1 billion, and May $3 billion. There is no secret as to how the American consumer has been pulling this off. It is all about an economy in which demand growth through income creation has been increasingly replaced through inflating asset prices providing the collateral for ever-higher spending on credit. But income creation is not catching up; it is in dramatic decline. We are looking for the deeper macroeconomic causes behind this rapidly widening gap between consumer spending and consumer incomes. These reside in the two major structural imbalances, which policymakers and economists in the United States stubbornly refuse to regard as a problem.

The paramount reason is the soaring deficit in the U.S. economy’s current account, reported at $195 billion for the first quarter of 2005. These big income gains on the part of the surplus countries implicitly have their counterpart in a commensurately big income leakage on the part of the U.S. deficit economy. With its soaring current account deficit now close to $800 billion, or well over 6% of GDP, it would long be in deep recession. To offset this enormous trade-related income drag cogently requires compensating credit and debt creation to generate alternative demand. That is what the Fed has done with its persistent extreme monetary looseness. Thus the monstrous trade deficit has trapped the U.S. economy in a vicious circle of growing credit excess. But as the demand for manufactured goods is increasingly met by foreign producers, the alternate domestic credit creation increasingly feeds service jobs, of which a large part is low-paying. In short, easy money replaces the good jobs that emigrate by bad service jobs.

In our view, gross lack of investment spending with high multiplier effects is America’s second biggest macroeconomic deficiency. In line with Austrian theory, we regard capital spending as the critical mass in the capitalist process, generating all the things that make for true prosperity. Furthermore, capital investment is self-financing, and depreciations and their reinvestment create an endless stream of recurrent employment and income without any additions to debt. Investment-driven economic growth, therefore, has a very low debt propensity. In contrast, unproductive government and consumer debt automatically feed on themselves through compound interest. There was a drastic break in the U.S. economy’s debt propensity from the early 1980s, similar to the late 1920s, but considerably worse. In both cases, it had the same two causes: booming consumption and financial speculation.

The popular spin, trumpeted by Mr. Greenspan in particular, is that the U.S. economy possesses such extraordinary resilience and flexibility “that its imbalances are likely to be adjusted well before they become potentially destabilizing.” It is an absurd statement; because flexibility is the last thing the U.S. economy has shown in the past few years. Its one and only flexibility has been in the creation of a housing bubble and the associated credit bubble, while all the structural imbalances – rock-bottom savings, asset inflation and the monstrous trade deficit – have soared to new extremes.

Duly, the U.S. pattern of the economy’s downturn in 2000-01 has diametrically differed from the typical, cyclical kind. It was the first recession to happen under conditions of rampant credit expansion. But what distinguished the 2001 recession most radically from all past experience was its pattern. The downturn had centered on one single demand component – business fixed investment. With a plunge of 13.1% in 2001-02, it experienced its sharpest fall of all postwar business cycles. In an equally unusual fashion, consumer spending simultaneously surged by 5.8%. Clearly, the extraordinary developing consumer borrowing-and-spending binge moderated the economy’s downturn.

The following recovery has been just as diametrically different from past experience. With the lowest interest rates in half a century and the biggest fiscal stimulus in history, the U.S. economy’s recovery from its 2001 low has nevertheless been its weakest by far in the whole postwar period by any measure. Moreover, the normal V-shaped recovery remains grossly missing. Three aggregates of crucial importance for sustained strong economic growth show persistent, drastic shortfalls. These are business fixed investment, employment and real wage and salary income. Typically, past cyclical recoveries got their immediate, strong traction from pent-up demand for business fixed investment, consumer durables and housing generated by the prior tight money. This time, two critical components went badly wrong: Business fixed investment recovered meekly, and foreign trade went into an exploding deficit.

BANK RISKS BOOSTED BY BEGGAR-THY-NEIGHBOR LOANS

Ask central bankers which market poses the greatest potential risk to global financial stability, and they will probably point an accusing finger at the derivatives industry. They should be worrying instead about the plain-vanilla syndicated loans market. Banks are engaged in a cutthroat game of beggar-thy-neighbor, sacrificing fees and interest rates to lend to their customers in the hope it will win them higher-paying investment banking business in the future. That is fine when times are good, the economy is growing and few companies are defaulting. As a method of storing up trouble, however, guaranteeing cheap money for 5, 6, 7 years into the future is hard to beat.

The Fed itself is partly to blame for lax lending, a victim of its own success in managing the economy. About half of the banks in its survey “cited a more-favorable or less-uncertain economic outlook as a reason for their move toward a less stringent lending posture,” the U.S. central bank said. The Fed asked loan officers to compare current lending practices with those prevailing in 1996 to 1997, “a period thought to have been characterized by relatively accommodative lending practices.” Respondents said while they are charging less for money, their standards had improved, which they said was because “improved measurement and management of risk had increased their tolerance for risk.”

Increased trading in the secondary market, which allows banks to sell their loans to tune their range of obligations, was also cited as making institutions more willing to take on new loans at more favorable rates for the borrowers. A similar argument can be made for credit-default swaps, which allow lenders to buy insurance against a default by the companies they have lent money to. The secondary market, though, may close for business at the very time deteriorating creditworthiness prompts banks to scale back their loan books. A sudden surge in defaults could do the same to the credit-default swap market. Both markets are too young and lacking in history to be relied on at times of trouble.

We have been here before. In 1995, a U.K. engineering company called BTR Plc secured a 5-year loan of £500 million ($870 million) at the lowest rate ever achieved by a European company, paying a margin of just 11.5 basis points. Four years later, Siebe Plc bought BTR to create a new company dubbed Invensys Plc – which was loaded up with so much debt, it suffered a 7-step cut in its credit rating to B+. The loan market is starting to look like an accident waiting to happen. There are plenty of economists predicting a slower global economy starting next year. Banks may live to regret their profligacy.

OIL STOCKS AT A “CLIMAX”

Which one of these does not belong? a.) Las Vegas, Nevada’s record-breaking, 116º summer temperature on July 18, b.) Hollywood starlet Sienna Miller, after she read her fiancé’s (actor Jude Law) July 18 public apology for “premarital infidelity with the nanny” – OR – c.) Crude oil prices on July 18. The correct answer: “C”. The other two choices fall into the category of “Things boiling over with burning intensity.” Check the energy news: On July 18, oil prices were doing anything but. In fact, before the day was done, crude prices stood at a 2-week low alongside deep setbacks in the Philadelphia Oil Service Index (OSX). And, according to the fundamental media, the fall in oil-related sectors was due to two main factors: 1.) The July 18 decision by OPEC to lower its forecast for fourth-quarter demand by 0.2%, and 2.) The July 18 downgrade of Hurricane Emily to a category one storm, which “looked set to pass by without causing much damage to the Gulf of Mexico.”

OK. So which one of those choices does not belong? Try, both. Fact is, oil prices – along with stocks listed on the OSX – have been headed south since July 12, slashing nearly 3% off their respective values before the July 18 “breaking” news press got around to pointing out the decline, long since in progress. Now, for those of less interested in excess supply and easing t-storms AND more in Elliott wave patterns, sentiment measures and technical indicators – the July 8 Short Term Update suggested that “a near-term decline” was starting for the OSX. That kind of insight will always belong.

Crude oil prices: two hurricanes, and a drop in supply leads to what effect?

The price for a barrel of crude oil reached $62.10 about two weeks ago (July 7). With two hurricanes, massive oil industry disruptions, and a fall in supplies you get one guess about what crude prices have done during the two weeks in question. They went down – as in about 6% since the July 7 high. You and I both know that the points above amount to EXACTLY the sort of scenario that the “experts” would use to “explain” a large increase in oil prices. This market did not do what it was supposed to do because of a simple truth: External events do not drive internal price trends.

Dollar advances … why, again?

“Dollar Advances After Greenspan Predicts Further Interest-Rate Increases,” said a headline in a major publication this morning (July 20). Read stories like this and you cannot help but think that Mr. Greenspan moves mountains every time he speaks. That is, until you check the chronology of today’s events. Mr. Greenspan’s semi-annual monetary policy testimony before Congress began at 10:12 a.m. But the USD began advancing on the EUR at 10 a.m. sharp – 12 minutes before Mr. Greenspan even opened his mouth. And when Mr. Greenspan’s testimony was almost over, so was the dollar’s brief advance. At 10:50 a.m., the EUR got the upper hand and sent EURUSD flying up almost 200 pips, erasing any gains the dollar had made.

If the expectation of further rate hikes was able to send EURUSD lower, should the Chairman’s public confirmation of that policy not have sent EURUSD crashing down? It should have, but those who think that markets are rational had better have tight stop-losses on their long USD positions this morning. The only rational explanation for today’s strong EURUSD rally is a sudden shift in market psychology. Elliott wave analysis could have prepared you for it. Here’s what our intraday update said about the pair at 8:35 AM today, an hour-and-a-half before Mr. Greenspan’s speech:

“08:35 ET/12:35 GMT
[EURUSD] Last Price: 1.2064
Medium Confidence: [consolidation, then up to challenge 1.2136]

“We’re still looking for this consolidation from 1.2097 to be followed by additional gains to challenge the next structural hurdle at 1.2136. Support at 1.2025/09 should be solid, but key support is the 1.1954 low.”

Why does news fool investors?

Day in and day out, we are all exposed to a steady stream of news stories that are supposed to drive stock market prices. But do they really? The short answer is “no”. And yet, every day, the news sure can fool investors. Bob Prechter has often talked about the absence of cause and effect between the news and stock market prices. Here is an excerpt from a 2004 interview.

The most important factor in the market strategy is learning to stand fast if your system tells you to do so, even when the news, your friends and the tape are screaming at you to do the opposite. Outside forces do not really affect the market and never have. The truth is that news is virtually irrelevant to explaining and forecasting market trends. I say "virtually," because there is a relationship in that social news lags market trends. There is some forecasting utility in that fact, but only if you have a trading method that recognizes degree, such as the Wave Principle or time cycles. Then certain types of news can be confirming indicators. In fact, some of the best analysts I know use certain types of media reports as market indicators. Paul Montgomery and Ned Davis use magazine covers, for instance. When a national general news magazine finds a trend so exciting that it makes the cover, the trend is generally one to three months from ending.

The psychology of human interaction is the basic fundamental. The one thing that never changes is the dynamics of social psychology. I think it was Bernard Baruch who said that the stock market was nothing but everyone’s combined hopes and fears about the future. I take it one giant step further and say that the market is the direct recording of the psychology that later creates the future.

ECONOMIC EXPECTATIONS: ANOTHER SURPRISE

Once or twice a month, a new economic number comes out and surprises everybody. Today in Germany, the Centre for European Economic Research (ZEW) released its July economic expectations index, which is “based on a poll of 294 analysts and institutional investors.” Despite analysts forecast for a “modest rise” this month, the index “rose unexpectedly sharply” – to the highest level in almost a year. Why? Here is one explanation: “The fall of the euro and robust global growth helped offset concern about the effects of high oil prices.” Whatever. The beauty of such “explanations” is that you can twist the data any which way you want. If the index declined instead, they would have said something like: “Despite the robust global growth and the falling euro, high oil prices dragged the economic expectations index down.” It is a very “flexible” approach, you see.

But why does economic news so often turn out to be “unexpected”, in the first place? Yes, economists are humans like the rest of us, and we all make mistakes, but is there not more to it? We think so. Economic news often catches many economists and investors off guard because they forecast future trends based on where those trends have been in the past. Here is what I mean. Last month, in June, the ZEW economic expectations index rose by a few points. So this month, analysts were expecting a similar-size increase. Of course, what they got was a huge – and unexpected – rally. Something similar happened in 2004, when the German business confidence kept falling for 9 straight months before bottoming out in September. Economists kept revising their forecasts lower and lower every month, and it worked well until the declining trend had stopped in September. And then came a surprise.

Forecasting the future trends based on the recent past only works while the “trend is your friend.” But at market turning points it is useless, because the stronger the previous trend has been, the more strongly economists believe it will continue. And the resulting “surprise” takes everyone by storm. That is why making investment decisions based on the news so often does not pay. The news only tells you what has already happened.

WHEN THE HOUSING BUBBLE BURSTS, WILL PRESIDENT BUSH PRACTICE MUGABENOMICS?

We have all heard it before. There is nothing like a hurricane, earthquake, tsunami, or war to help spur economic growth. Politicians, reporters, Wall Street analysts, and economists (save for the Austrians) marvel at how natural and manmade disasters bring people together to rebuild homes, office buildings, factories, and infrastructure. Demand is kick-started for lumber, concrete, masonry block, electrical wiring, windows, asphalt, and the list goes on. Contractors, subcontractors, supply houses, and other businesses increase demand for labor; hence employment is stimulated as well. Heck, look how Japan and Germany emerged as economic powerhouses after World War II. By gosh, war, natural disasters, and general destruction do have a silver lining – it is called economic stimulation. Of course, this is all bunk and amounts to nothing more than the broken-window fallacy. As Henry Hazlitt conveys in his masterful book Economics in One Lesson: “…the broken-window fallacy, under a hundred disguises, is the most persistent in the history of economics.” And persist it does.

In Zimbabwe, this fallacy has taken on a novel disguise. Zimbabwe’s president, Robert Mugabe, has ordered the destruction of thousands of homes for the sake of cracking down on crime and spurring Zimbabwe’s economic regeneration. To economists, politicians, and Wall-Street types, President Mugabe must look like a genius – bring on the Nobel Prize for economics. In his prize lecture, Robert Mugabe can simply restate what he has already told his people: “We are constructing brand new houses, mending those which require to be mended, where it is necessary to destroy some. But the thrust is a reconstruction one, a positive thrust to rebuild things…” Indeed, let us all embrace the joy of government-induced domestic destruction so that all may prosper. At this point, Nobel committee members leap to their feet and give Nobel laureate Robert Mugabe a standing ovation – as Paul Krugman watches with envy. The sheer genius of turning government forces against its own citizens, to destroy thousands of homes and leaving over 300,000 homeless surely will create the aggregate demand necessary – for housing, furniture, appliances, etc. – to put Zimbabwe back on the road to prosperity. Mugabenomics is legitimized by the Swedes.

So what if America’s housing bubble bursts, due to rising interest rates, and the economy starts slipping into an inflationary depression? Americans with interest-only mortgages, adjustable rate mortgages, and reverse amortization mortgages will be clamoring for relief. Freddie Mac and Fannie Mae will teeter on the precipice of insolvency. The banking system will find itself in a mortgage-default crisis which will make the S&L debacle look tame by comparison. Alan Greenspan will be tempted to flood the banking system with liquidity (in order to bring down short-term interest rates) but this may add fuel to the fire (i.e. driving up inflation) thus causing mortgage rates to rise even more rapidly. All the while, construction companies, supply houses, realtors, mortgage brokers, bankers, real estate developers, equipment dealers, etc. are all laying off employees … as it is a matter of business survival. Since letting the depression run its course and going back to the gold standard are not options any modern central banker or president will ever consider, perhaps the answer is Mugabenomics – Paul Krugman is writing scathing editorials imploring President Bush and Alan Greenspan to let the “productive destruction” begin immediately.

After consulting with Nobel laureate Robert Mugabe, President Bush declares a “War on Economic Depression.” While addressing the nation, with Alan Greenspan and Donald Rumsfeld at his side, President Bush carefully lays out his plan to revitalize America’s economy. He has ordered the evacuation of San Diego, Los Angeles, San Francisco, Seattle, Tampa, Miami, New York, and Boston – much like a hurricane evacuation. Each city, consequently, will be carpet bombed until it is as flat as a pancake. Secretary of Defense Donald Rumsfeld chimes in and describes how every B-52, B-1, and B-2 bomber is at the President’s disposal. In turn, Alan Greenspan describes how the “creative destruction” of the free market will be supplanted by the “productive destruction” of government. As the carpet-bombing campaign begins, which was almost unanimously approved by Congress (only Ron Paul voted “no”), President Bush reasserts his confidence in his plan. Let the productive destruction begin! Broken-window fallacy be damned.

END GAME: HYPERINFLATION

Modern monetary systems operate on the ability to turn debt into money. Mises’ business cycle theory showed that this process results in unsustainable distortions in the productive structure of capital and of relative prices between different capital goods. Mises also showed that, left to market forces, the credit expansion would unwind in a credit contraction as relative prices corrected. However, central banks have for the most part been unwilling to let the system correct. Instead, they respond with a further round of inflation, trying to solve problems inherent in the relative structure of prices by increasing aggregate demand.

A debate has been going on recently on several web sites among those who accept the preceding premises but disagree whether the inflation process can be pursued to its ultimate conclusion – hyperinflation – or whether market forces will at some point prevent further inflation and cause a credit collapse – deflation. The deflation scenario consists of a cascading chain of defaults wiping out the leverage in the system and leaving physical currency as the only safe store of value. Advocates of the inflation view start by accepting the premises of the deflation outcome, but believe that the Fed would intervene and try to generate inflation rather than standing aside and watching the system implode.

There are two ways of getting rid of debt that cannot be repaid: default or inflation. Debt can be inflated away. Historically there have been far more hyperinflations than deflations. The Fed has made it clear in a series of speeches that they are ready to monetize anything and everything by turning on the printing press and buying assets, gold mines, or whatever else it takes to prevent nominal prices from falling. The reader of the Fed’s papers and speeches will find a series of progressively more effective techniques for destroying what purchasing power remains in our money. From beginning to end these methods span the range from the unsound to the bizarre and terrifying.

Some deflationists have questioned the willingness of the Fed to act. But in the “welfare state of credit” to use Jim Grant’s phrase, debtors far outnumber creditors. In a crisis, there is always an intense demand for the government to “do something”. Another deflationist argument is that wage competition from China is deflationary, and that inflation cannot occur in the U.S. as long as there is wage competition. This argument confuses two entirely different economic phenomena. The inflation/deflation question concerns changes from the money side. An increase in the supply of computers, for example, causing a fall in the price of computers, is not deflation, or at least it is not credit deflation. In the same way, wage competition due to an increase in the supply of skilled labor in other countries might result in a fall in the wages of competing labor in the United States, but it is not credit deflation and does not lead to credit deflation or prevent bank credit expansion. The deflation arguments that depend on the low real prices of Chinese goods either misunderstand the difference between real and nominal prices, or assume that the process of China providing vendor financing for the over-spending U.S. consumer can go on forever.

By some estimates, the U.S. trade and government deficits are equal in quantity to around 100% of the total world’s total savings. But that does not mean that the U.S. is borrowing all of the savings in the world. Instead, central banks are printing a portion of the money that they use to purchase U.S. debt. The Fed has in effect able to export of U.S.-dollar inflation because other central banks are willing to do the job of monetizing debt. Could this prevent a dollar exchange rate crisis? Yes, with all the major central banks inflating, they could possibly stave off a dollar crash in terms of the exchange rate but then we would experience world-wide hyperinflation: a crash of all currencies against goods.

Could “it” - deflation – happen here, asks Bernanke? One cannot entirely rule out the possibility. It is hard to see just how it could happen. Inflation is always the easy way out. In the age of activist governments, it is difficult to imagine the Fed standing aside and watched the banking system become insolvent. It is far more likely that one day we will tune into CNBC and hear “Don’t worry about that black helicopter hovering over your home. It is not here to enforce the Patriot Act IV, but to drop bales of freshly printed bills onto your front lawn.”

Diatribes of a Deflationist … Why They Are Wrong – link.

A deflationist responds: hyperinflationists’ case is full of holes.

Not only do I think we will see price deflation (certainly in assets like stocks and houses), but I also believe the destruction of credit (and money) in the next down cycle will be enormous. A rising oil price is NOT the “hyperinflation answer” for many reasons, in theory and, as the UK has proven, in actual practice. Furthermore, if the recession is deep enough (as I suspect it will be), oil prices are likely to fall, peak oil or not. For the record, I am convinced that oil prices are going to rise over time, to substantial new highs, from these levels near $60. That timeline is a long one, however, and near term, I expect flattening or declines as the worldwide recession kicks off.

There is a nice chart in David Petch’s article showing inflation headed up for something like forever, and I would be remiss if I did not address it. Be very, very careful about extending trends to perpetuity. They don’t get there. I offer the NASDAQ bubble as proof. Marc Faber warns about that in his excellent book Tomorrow’s Gold. It should be on everyone’s reading list. I also recommend The Dollar Crisis by Richard Duncan. My thinking has been heavily influenced by both of these authors.

Finally, let me state the possible scenarios leading to inflation as best as I can, since no one else seems willing to take it on. I do not think hyperinflation was ever voluntarily and purposely attempted (to bail out consumers), but that seems to be what is suggested by all the “helicopter drop” scenarios. Threat, yes, but in practice, no. Thus I find both of the above scenarios to be absurd. The Fed and the powers that be will not voluntarily destroy themselves. Will they fight deflation? Yes. Will they fight deflation to the point of destroying themselves? No. That would not only require printing presses, but action from Congress as well. The scenario is simply not consistent with a Congress that passed “bankruptcy reform” to keep consumers indebted forever.

Bottom line: I expect to see a prolonged period (5-12 years) in which deflation is predominate, interspersed by temporary stock market rallies, with long-term interest rates slowly sinking to 2.5% or so.

RENMINBI NO LONGER PEGGED TO THE DOLLAR

“Public Announcement of the People’s Bank of China on Reforming the RMB Exchange Rate Regime.” This was the announcement that came across the screens this morning. Finally! China had announced that they no longer would peg the renminbi to the dollar. This had been the news that investors have waited for over two years to hear. The “floating currencies” of Asia are moving stronger vs. the dollar on the news, and should continue as this new renminbi exchange rate regime unfolds.

I view this move by the People’s Bank of China as simply symbolic at this point, as the the PBOC gets to soothe the feathers of the U.S., and slam the door on the fingers of the currency speculators. However, as I have explained to our customers in the past, this will lead the other countries in the region to allow their currencies to gain vs. the dollar. We have already seen evidence of this in the announcement by Malaysia that they would also drop their currency peg to the dollar! Here is the skinny on the move…

Malaysia scraps ringgit peg, adopts managed float.

Malaysia abandoned its fixed exchange rate policy and adopted a managed float system after China scrapped its currency peg. “The ringgit will be allowed to operate in a managed float, with its value being determined by economic fundamentals,” the central bank said on its Web site. “Bank Negara will monitor the exchange rate against a currency basket to ensure it remains close to fair value.” The ringgit is not expected to deviate significantly from the current prevailing level, it said.

Malaysia fixed the ringgit at 3.8 to the dollar on September 2, 1998, during the Asian crisis, after a devaluation of the Thai baht in July 1997 sparked a slump in the currencies of Southeast Asian nations. Speculators drove the ringgit to a record low of 4.885 per dollar on January 7, 1998. The ringgit traded at about 2.5 against the dollar before the onset of the Asian financial crisis.

China’s announcement on yuan the start of long process, analyst says.

China’s announcement that it would free the yuan from its peg to the U.S. dollar met a cautious welcome from officials who hoped the change might benefit European economies that have been battered by cheap imports. “China is complying with the demands of the G-7 (Group of Seven) countries’ finance ministers and central bankers,” said German Finance Minister Hans Eichel. “The measures taken by China could contribute to a balanced growth of the Chinese economy.” The Chinese government surprised markets by announcing that the yuan will now allowed to trade in a tight band against a basket of foreign currencies, but did not specify which ones. The government strengthened the yuan to a rate of 8.11 to the dollar, compared to the 8.28 it has been set at for more than a decade. The move could push up the price of Chinese exports to the U.S. and Europe.

Lee Ferridge, chief currency strategist at Rabobank in London, said he did not expect China to reveal the basket of currencies that it is pegging the yuan against, a strategy already taken by the Singaporean dollar. “It’s the first stage in the process,” he said. “We have got a managed float now and a level against the dollar. This is the start of the process of the full convertibility of the yuan, which will take many more years.” Hans Redeker, global head of foreign-exchange strategy at BNP Paribas in London, said the move was “outright bad news” for the dollar, because it will mean an adjustment in currency reserves in favor of Asian and European currencies. But Holger Schmieding, head of European economics for Bank of America in London, said the effects on Europe were likely to be small. “They’ve made a political gesture to the U.S., where protectionist pressures had been rising, but I don’t think that this will have a dramatic impact on global trade flows.”

THE “REAL” BOOM!

Let us assume that an investor is looking for one asset, which he could buy and hold for the coming 10 years. This individual is extremely busy with his work, so he does not have the time to closely monitor his investments on a regular basis. He is simply looking for an undervalued asset-class, which he could buy and forget for a decade without any sleepless nights. His plan is to invest his money in only one asset-class and he intends to cash in on the profits in 2015. So, which asset-class should this guy invest in? Should he buy U.S. stocks, Asian stocks, perhaps bonds or even leave his funds in cash?

First, let us look at an underlying philosophy. As an avid student of economic history, I have realized that all assets go through multi-year economic cycles commonly known as bull-markets (boom) and bear-markets (busts). These cycles surely follow each other as night follows the day. During a bull-market, an asset goes from depths of undervaluation to overvaluation. A bull-market usually ends with intense public participation, optimism and euphoria. On the other hand, a bear-market takes an asset on its long journey from extreme overvaluation to acute undervaluation. A bear-market usually ends with “blood on the street” or deep, dark despair. As a money manager, it is my job to identify, which assets are in a bull-market and those that are in a bear phase.

Looking back through history, it is now easy to see that if the above investor had to buy one asset in 1970 for the next 10 years, he should have bought commodities. For those who are not familiar, commodities went through an enormous boom during this period. The boom, which started off as a gradual bull-market (as they all do) erupted into an enormous mania in the late 70’s as investors kept piling their cash in commodities while completely ignoring the prices they were paying. If our investor friend was looking for one investment theme in 1980 for the next 10 years, he should have bought Japanese stocks and real estate. During that period, Japanese assets soared exponentially as the world became amazed by the “Japanese miracle”. At the peak of the bubble in 1990, Japanese real estate was worth four times the value of all property in the United States! During the roaring 1990’s, our investor should have put all his money in American assets. During that period, the world’s super-power came alive as the world fell in love with the U.S. All you had to do was to buy any American asset and the bull-market would have done the work for you. The technology-heavy NASDAQ rose from almost 500 in 1990 to over 5,000 at the turn of the millennium. Everyone was convinced that the “New Era” had arrived.

After having gone through the various asset-booms of the past three decades, I would like to point out that they all had one thing in common – the eventual bust. Commodities peaked in 1980 and declined for two decades; Japanese assets peaked around 1990 and are still deflating after 15 years; NASDAQ collapsed in 2000 and despite record-low interest rates, American stocks have failed to better their all-time highs recorded 5 years ago. The brutal truth is that no asset-class goes up or stays depressed forever. This is one fact that every investor must keep in mind when speculating or buying for the long haul. The current housing boom will be no exception.

So, let us address the original question: “Which asset-class will boom over the coming decade?” I am of the opinion that commodities will prove to be the best performing asset-class. Therefore, our above investor should park all his funds in commodities and when he returns in ten years time, he should be sitting on a huge profit. Why have I chosen commodities out of all the assets? For the simple reason that in 2001, commodities were the cheapest they had ever been in the history or capitalism. So far, industrial commodities such as metals and energy have done exceptionally well. However, agricultural commodities such as sugar, corn, wheat and orange juice have not gone up as much and are still close to their all-time lows adjusted for inflation. Over the coming 18-14 months, I expect agricultural commodities to provide the best returns. What will happen to the depressed wheat prices when the 1.3 billion Chinese start consuming more bread, cakes and pasta?

Despite a strong run by commodities since 2001, the investing public remains skeptical. People are concerned that China’s economic slowdown will have a negative effect on the demand for commodities. I disagree with this theory because the previous bull-market in the 1970’s also took place amongst an economic recession and rising geo-political tensions in the Middle East. Today, things are no different. Geo-political tensions are rising, inflation is becoming a concern, demand is rising and supply is extremely tight. Noting all of the above and as a capital preservation strategy, I strongly advocate an investment in commodities for the coming decade.

INVESTING WITHOUT EMOTION … LITERALLY?

At long last the evidence is in: It may take a mild loss of sanity to become a trader in the markets, but you have to be a downright psychopath to actually succeed. “It’s possible that people who are high-risk takers or good investors may have what you call a functional psychopathy,” claims a neuroscientist in a Wall Street Journal article. “They don’t react emotionally to things. Good investors can learn to control their emotions in certain ways to become like those people.” This is one of several conclusions the come from a just-published study, “conducted by a team of researchers from Carnegie Mellon University, the Stanford Graduate School of Business and the University of Iowa.”

Of course, behavioral economists have done several studies in recent years which plainly show that investors are usually their own worst enemies, as greed and fear lead them to make irrational choices. Yet the research described in the WSJ story took the novel approach of studying people who, because of stroke or disease, were literally less capable of feeling the emotions that accompany investing. These of individuals “had normal IQs, and the areas of their brains responsible for logic and cognitive reasoning were intact,” but they were less able to react emotionally when making investment choices.

So how did they do? Well, they consistently outperformed the “normal” study group in the investment game staged by the researchers. “The emotionally impaired players were more willing to take gambles that had high payoffs because they lacked fear. Players with undamaged brain wiring, however, were more cautious and reactive during the game, and wound up with less money at the end.” Now, real-world investing is obviously not a game, and the promise of a higher payoff should not by itself lead traders to take a greater gamble. What this study does is add to the ever-growing body of evidence that shows that you cannot give yourself the benefit of the doubt when it comes to making “rational” choices.

The market will show no mercy to your emotions. This is why we use a method that helps provide the discipline that must accompany successful investing. At the same time, realize that price trends always have and always will be driven by emotion. You want to understand that emotion, rather than contribute to it. We measure that emotion on the price charts, even as our method reveals the trends.

“FUNDS OF FUNDS” MAKE HEDGE FUNDS EASIER FOR NOVICES, BUT COST MORE

Hedge fund strategies used to be accessible only to the ultra-wealthy, but now, anyone with an annual income of $200,000 can buy entry into a “fund of funds”, an investment fund tied to hedge funds, for as little as $25,000. This may seem like good news to many investors, who are hearing the siren call of hedge funds because of disappointing returns in other asset classes. But is this kind of fund a good investment for hedge fund newbies? The answer depends on how much money you have and how much risk you are willing to take.

A fund of funds is simply a portfolio of individual hedge funds. Some funds of funds are strategy-specific, so that you can buy a portfolio of long/short equity hedge funds. Others are more diversified. But all of them provide exposure to hedge funds, which generally will not take less than $500,000 for a direct investment.

Many funds of funds require minimum investments in the hundreds of thousands of dollars, but some firms are launching funds that give investors exposure to hedge funds at a much lower cost of entry. Last fall, Credit Suisse registered a series of funds of funds with the SEC; these require minimums of $50,000, as does J.P. Morgan’s Multi-Strategy hedge fund and Deutsche Bank’s DB Hedge Strategies fund. Merrill Lynch’s Multi-Strategy Hedge Opportunities Fund requires a $25,000 minimum, as does Rydex’s registered fund of funds. But these low-minimum funds of funds have drawn mixed reactions from hedge fund experts, who say that some look a bit too much like mutual funds to add value to an investor’s portfolio. “The number of managers and the underlying cost structure gets to be very similar to a mutual fund,” said Mark Bloom, managing partner of MB Investment Partners, a New York-based wealth management firm.

The most commonly-cited drawback to funds of funds is that they charge an extra layer of fees. Any gain investors earn from underlying hedge funds will only be assessed after each fund manager has taken a 20% cut of gains, plus management fees of 1 to 2%. Funds of funds managers typically charge another 10% for performance and another 1% for management. Randy Shain, cofounder of investigative due diligence firm BackTrack Reports, said fund of funds managers provide a critical layer of due diligence between the hedge fund managers and investors. Shain said funds of funds use his firm’s services to do background checks on hedge funds and said he is impressed with how rigorously they screen potential investments. A far more common danger, however, is manager mediocrity, and that can be much harder to spot if a potential investor does not know what to look for.

Even funds of funds managers can be vulnerable to error. Some institutional funds of funds invested in high-profile hedge fund failures Beacon Hill and Lancer Partners. That is why it is important for investors to do their own due diligence on the funds of funds managers themselves. Benjamin Poor, senior analyst at Boston-based research and consulting firm Cerulli Associates, said investors should ask funds of funds managers why the firm thinks it has expertise in selecting managers, what value it adds for investors and how frequently investors can expect to hear about how their investment is doing.

JUNK DEBT BUYERS BEWARE

As is the case in society, there are haves and have-nots in corporate America. Just how wide the chasm became apparent over the weekend in a report in Barron’s. According to Stephanie Pomboy of MacroMavens, “while high-quality borrowers sit on record cash hoards, their financially strapped siblings have exploited the market’s appetite for yield, taking junk issuance to 62 percent of the total.” That gives new meaning to the phrase “caveat emptor”. Confirmation of the threat to corporate lenders came in a report by Fitch Ratings this week. The Fitch study showed that “those most prone to default” – those at the bottom of the credit-rating ladder – “may be falling behind better-rated companies in key credit metrics.”

That is a tad alarming given the amount of junk populating present-day Investmentland.

GREENSPAN ERA TAUGHT PEOPLE TO GAMBLE

The Alan Greenspan era, which is drawing to an end, deserves to be remembered as the era in which many millions of Americans were forced to become gamblers. That it was also an era when many of those gambles paid off should not obscure the fundamental change. When Mr. Greenspan took over the Federal Reserve from Paul A. Volcker in the summer of 1987, the stock market was hot and there were warnings of a price collapse. The crash arrived, but what seems remarkable now is just how unimportant that was. No recession followed.

One reason for the mild economic impact was that the world of 1987 was still largely one in which people who played the stock market wanted to play the stock market. Those who did not could lock in perfectly reasonable returns without taking much risk, for example by investing in Treasury bills. As Mr. Greenspan took office, banks were advertising one-year certificates of deposit at more than 8%, more than double the annual inflation rate. But the most important fact for average Americans was that they were likely to have defined-benefit pension plans from their employers. In such pensions, the company put money into stocks and bonds to pay for benefits, and it took the risk that the investments would not work out.

All that has changed. Within the S&P 500-stock index, 75% of the companies still have defined-benefit plans, but more and more of them are legacy plans, closed to new employees and no longer accumulating benefits for workers who are in the plans. Most private-sector workers now have defined-contribution plans. Such plans can work out well, but there are no guarantees. Workers may or may not make wise (or lucky) investment decisions. They may choose to cut back on contributions when times are tight, making an adequate retirement income even less likely. What all this has meant is that workers whose parents viewed the stock market as something for rich people to play now find themselves forced to take part in it.

Stocks rebound, but pensions have not.

Stocks improved last year, which you might think would help solve Corporate America’s pension problem. The trouble is, it has barely made a dent. A vast majority of pension plans still face massive cash shortfalls, according to statistics to be released by Standard & Poor’s. While that may worry retirees, it is primarily a concern for investors, because if something does not change, companies will need to divert cash into their pension plans rather than do such shareholder-friendly things as buying back stock or increasing dividends.