Finance Digest for Week of August 15, 2005

BENEATH THE SURFACE

Ah, for the perspective of the summer break. For me, it came just in the nick of time. Not much has broken my way over the past few months. The soft patch turned out to be shorter and softer than I had thought, as the U.S.-led global business cycle once again has demonstrated its time-honored resilience. This reflects what is by now an all-too-familiar theme: On the surface, the global economy seems to be doing just fine. Yet just beneath that seemingly tranquil surface, the imbalances and tensions are only getting worse.

The shock of the summer – or for that matter of the year – has been the unrelenting surge in oil prices. In real, or inflation-adjusted, terms WTI-based oil prices are now more than 25% above levels reached in the run-up to the first Gulf War in late 1990 and back to levels last seen in late 1982. Yet even more stunning than the price run-up itself has been the apparent resilience of the global economy to this full-blown energy price shock. Standard rules of thumb tell us that every $10 increase in oil prices should knock about 0.4% off GDP growth during the following four quarters. But after the briefest of soft patches this spring, the world proceeded to zig rather than zag, as the business cycle miraculously sprang back to life. Those who felt that $50 oil would derail the global economy have been dead wrong. Why worry about $60 or even $70?

The reason to worry, in my view, is that the cost of this cyclical resilience in the face of an energy shock is not without serious consequences for an unbalanced world. In particular, it has pushed the asset-dependent American consumer to a new state of excess. At first blush, there seems to be little reason to worry – according to our U.S. team, personal consumption growth is tracking a 5.5% gain in the current quarter. But consider the costs of that stellar accomplishment – a personal saving rate that has finally hit the “zero” threshold, debt ratios that continue to move into the stratosphere, and asset-led underpinnings of residential property markets that are now firmly in bubble territory. Courtesy of surging oil prices, these costs are now at the breaking point, in my view.

In the face of an unprecedented shortfall of labor income – with real compensation growth in the 44 months of the current expansion running $282 billion below the path of the typical cycle – consumers have not even flinched. Reflecting a new asset-dependent spending mindset – first arising out of the equity bubble of the late 1990s and more recently supported by the property bubble – U.S. households have been more than willing to draw their income-based saving rates down into unprecedented territory. While this penchant for spending may make sense in normal periods, it is the height of recklessness in the face of an energy shock. In the two oil shocks of the 1970s, the personal saving rate averaged about 9.5%, whereas in the oil shock just prior to the Gulf War of early 1991, it was around 7%. Today’s “zero” saving rate underscores the total absence of any such cushion. The only backstop available to support the spending excesses of American consumers is the saving that is now embedded in their over-valued homes. Yet with the housing bubble now in the danger zone, that is not exactly a comfort zone. Moreover, just as the energy shocks of the 1970s hit U.S. households at a point when their spending behavior had gone to excess, the same is the case in the present climate. It is another thing altogether in today’s era of excess – there is much more room and greater urgency for consolidation.

At the same time, a persistence of spending excesses by the income-short U.S. consumer also underscore the potential pyrotechnics of a major current account adjustment – yet another problem that was not evident during earlier energy shocks. The more consumers push income-based saving rates toward zero, the greater the depressant on national saving – and the greater the need to import surplus saving from abroad in order to fund economic growth. And, of course, the only way for a saving-short economy to attract that foreign capital is to run massive current-account and trade deficits. Today’s nearly 6.5% U.S. current-account deficit underscores America’s unprecedented external vulnerability in the midst of an energy shock. The more income-short American consumers keep on spending to defend their overly-indulgent lifestyles, the larger the U.S. current-account and trade deficits are likely to be – and the greater the possibility of an external funding problem that could result in a weaker dollar and/or wider cross-border spreads for U.S. interest rates.

So far, only the dollar – and possibly gold – seem to be sniffing out this possibility. The bond market, by contrast, remains well bid – rallying yet again in recent days even in the face of signs of increased cyclicality of the global business cycle. Two developments continue to underpin bonds, in my view – persistent signs of subdued inflation and the ever-present potential of an energy-shock-induced shortfall to economic growth. I do not know where oil prices are going. But I do feel strongly that an important macro threshold has now been breached – one that adds unmistakable tension to the world economy’s greatest imbalances. At the current level of oil prices, I suspect one of two things will happen – either the over-extended American consumer will finally cave or the long-awaited U.S. current account adjustment will finally unfold.

As always, duration matters. If oil prices fall back quickly and sharply, all will be forgotten and the consequences will be minimal. Unfortunately, that is a bet the financial market consensus has been making for far too long. All this points to what could be the biggest macro call that any of us will have to make for a long time – the capitulation of the unflinching American consumer. Needless to say, this would have profound implications for the rest of the global economy – largely a U.S.-centric world that is utterly lacking in support from autonomous domestic consumption.

Over the years, I have learned to be wary of betting against the American consumer. But the history of energy shocks argues to the contrary. Moreover, today’s saving-short, asset-dependent, overly-indebted consumer is far more vulnerable than in the past. After years of such warnings, investors, of course, have all but given up on that possibility. That is precisely the time to worry the most.

THE PRICE OF PROSPERITY

Stacy Lynch says the pressure is subtle, yet powerful. Soon after moving from Sacramento, California, to Collin County, Texas she first noticed it: As the proud owner of a 1996 Honda Civic, she said, she often heard remarks from the men she dated about her car’s “humble” nature. “I felt kind of poor when I moved out here, and I wasn’t,” she said. Her list of must-have items grew. “I’d go to work, and somebody would come in and talk about a new purse. I thought, ‘I deserve a new purse,’ and I’d go buy one,” she said. Her credit card debt shot to $12,000.

Ms. Lynch’s move to Plano put her in the richest county in Texas and among the wealthiest 1% nationwide. The county’s high median household income – about $71,500 annually – has provided entrée into the country club status long enjoyed by the moneyed suburbs of Chicago, Northern California, New York and Washington, D.C. But Collin County’s dollar signs can be deceptive. On average, Collin County residents have more credit card debt – $4,200 – and a lower net worth – $125,000 – than residents of other high-income counties throughout the country, according to a Dallas Morning News analysis of various economic indicators, including Claritas Market Audit.

Thousands of residents are financially prudent, whether earning big money or not. And more than 6,600 live in poverty and are locked out of an upper-middle-class lifestyle. Yet the county is full of young couples with children who take on excessive debt, in many cases simply to keep up the lifestyle of their friends and neighbors, the data analysis and interviews with dozens of residents and experts show. Bonnie Peterson, director of education and marketing for Consumer Credit Counseling Service of North Central Texas in McKinney, says, “There’s a whole subset of people out there who are trying to keep up with the Joneses and trying to better themselves, and they’re trying to do that at the cost of being in debt,” she said. There are women in debt counseling who insist they keep their weekly hair and nail appointments. “One guy didn’t want to give up his $500-a-turn golf membership even though he was unemployed,” she said.

Many families are struggling with materialism, debt and values, several Collin County-area church leaders said. More than half the county’s residents say they belong to a religion. The Rev. Doug Miller said he was shocked when he took over the helm at First United Methodist Church of Frisco and noticed so many 30-something people in big houses with stay-at-home moms shuttling the kids to soccer practice in gas-guzzling SUVs. “They all really do feel like they need these things, this 3,400-square-foot house with three kids,” he said. “I guess they do, if you have to have your own computer room, television room, playroom, bathroom. That seems necessary to keep a kind of homeostasis within the family.” The Rev. Henry Petter, pastor at St. Elizabeth Ann Seton Catholic church in Plano, said that it is no sin to be prosperous but that with great gifts should also come great gratitude and generosity.

Economic experts and dozens of residents said the environment encourages conformity, a desire to shop at the same stores, strive for the same goals to prove you have got your act – and your kids’ acts – together. An Allen man upgraded to a luxury Infiniti SUV to create an image with clients. A Plano mom spent $400 hiring costume characters for her 6-year-old’s birthday party. A McKinney couple living in a $180,000 home paid $50,000 to join an exclusive country club. Ms. Lynch, the transplant from Sacramento, now lives in Allen with her husband and says she has outgrown the feeling that she has to keep up. It took six months to pay off her credit card debt, but she did it.

Not everyone believes Collin’s debtors have such a lesson to learn. Michael L. Davis, who teaches economics and finance at Southern Methodist University’s Cox School of Business, said debt is not so bad considering where young professionals are in their lives. New-money people have not accumulated measurable wealth, and they might seem to be carrying too much debt relative to their net worth, he said. If wealth is based on “human capital” – meaning their potential earnings based on their skills and careers – then perhaps they are not in such dire straits.

Jim Dolinger is owner of Ritzy Kids, a children’s furniture store in Plano. Its Web site promises, “You’ll be the envy of the neighborhood.” The truly affluent will compliment the store and leisurely browse, he said. The pseudo rich will saunter while making sweeping gestures declaring they “absolutely must have this. People think others will like them if they pretend to be affluent,” he said.

People new to high incomes go through a trial and error period and find ways to justify their spending to keep up with their neighbors, said Suzanne Shu, assistant professor of marketing at SMU’s Cox School of Business. “Having all that wealth is a new and exciting thing. They haven’t learned how to manage it all, and they get carried away,” she said. Until then, there sometimes can be an expectation that you should be able to enter The Shops at Willow Bend in Plano or Stonebriar Centre in Frisco armed with four credit cards and a devil-may-care attitude. It is the attitude made clear by the dark green BMW M3 convertible parked in front of Saks Fifth Avenue on a recent weekday afternoon. Its license plate and frame read: “I’m not spoiled. I’m well taken care of. I WANT.”

Having it all has its costs.

It was quite a birthday gift – a brand-new luxury SUV in the driveway. The 16-year-old boy’s father splurged, envisioning the day that his son would drive into the parking lot at Plano West Senior High School and bask in the admiration and envy of his classmates. But it took a while for that day to come. The sweet new ride did not roll for a year, waiting for its young new owner to get around to picking up his driver’s license. His lack of enthusiasm stunned his mother. She said she is afraid she and her husband have given him so much, the gift did not surprise him. “He’s grown up with everything he’s ever wanted,” she said. “He’s thinking the whole world lives the way kids in Plano do.”

She opposed buying such an ostentatious vehicle from the beginning, she said, but her husband insisted. He wanted their son to stand out, to have all the things he could not as a child. The boy’s parents grew up in poor families. When she was a child, she put cardboard in her shoes to make them last until her parents could afford new ones, she said. And she had to drop out of pep club because she did not have money for a letter sweater. She and her husband worked hard to make it into their $900,000 west Plano home. She said they are not teaching that same discipline to their son.

“People have this tendency to give their children way more than they should be giving them,” she said. “And then there’s this competition to fit in.” Her concern as her son heads to college is not about whether he is academically prepared, but whether he can manage his own expenses. His parents made him work last summer and requested he save some of his pay. When he collected his first check, he spent $400 on a LoveSac, a shredded foam sofa. While her son snatches up designer clothes and the latest movie releases, his mother looks for deals at TJ Maxx, Marshalls, and Ross.

She figures her son might have to “screw up and hit bottom” before he figures out life on his own, she said. He was accepted and will attend a four-year, out-of-state university this fall, but she wonders whether living on his own will help him appreciate the value of money. “[Kids] don’t want to start out with orange crates and cinder blocks to make their entertainment centers like we did,” she said.“qKids leave home from this environment, and they want everything we have.”

BOOM IN HOME PRICES IGNORES INTEREST RATE HIKES

Rising interest rates are supposed to be an economic sedative, but the hyperactive real estate market has retained its vigor even as the prime lending rate has climbed to a nearly 4-year high. One of the biggest reasons for real estate’s unusual behavior is that home mortgages are less expensive than they were 14 months ago when the Federal Reserve Board began to push up the short-term cost to borrow money. That inflation-fighting effort has raised the prime rate from 4% in June 2004 to 6.5% today, making it more costly to buy cars, appliances and almost anything else on credit. Meanwhile, home mortgages have remained a relative bargain. The average rate for a 30-year fixed-rate mortgage stood at 6.05% through August 11, down from 6.41% during the first week of June 2004, according to HSH Associates, an industry research firm.

Those low financing costs mean home buyers can qualify for larger loans – a major factor why real estate prices have continued their steady ascent in neighborhoods scattered across the country. The trend troubles Federal Reserve Chairman Alan Greenspan and many other economists, who worry that cheap mortgage money is contributing to a real estate pricing bubble that could trigger a traumatic recession. “It’s very hard to understand the psychology of any market,” UCLA economics Professor Edward Leamer said. “But it’s fundamentally clear that the housing market is in a fragile and dangerous situation.”

The risks of a real estate meltdown are not the same across the country because mortgages are not the sole factor influencing home prices. Other key considerations include an area’s desirability, the supply of available housing and the strength of the local job market. The housing markets most susceptible to a sharp downturn in prices are in California, Massachusetts and New York, according to PMI Group, a mortgage insurance provider. Based on a recently completed analysis, PMI predicted six major metropolitan areas face at least a 50% chance of enduring a drop in home prices within the next two years: Boston-Quincy, Massachusetts; Nassau-Suffolk, N.Y.; San Diego, Santa Clara, and Orange Counties, California; and a two-county area east of San Francisco.

Homeowners who have capitalized on the housing boom by borrowing against their properties are starting to get squeezed by the steady increase in short-term rates. Most home equity loans carry adjustable rates tied to the prime rate, which is widely expected to surpass 7% by year’s end as the Federal Reserve continues to clamp down on the economy. The average rate on a home equity loan is expected to reach 7.04% by the end of this month, up from 4.68% in June 2004, according to HSH Associates. That change is stretching more household budgets because more debt has been shifting to home equity lines of credit as the real estate boom creates more wealth. Through March, home equity borrowing totaled $911.4 billion, up 28% from $714.7 billion the previous year, according to Federal Reserve statistics.

It is difficult to predict how high mortgage rates will have to rise before home prices are hurt, but some industry observers believe the tipping point is somewhere between 7 and 8%. Meanwhile, current mortgage rates remain enticing, especially to buyers who remember when rates were still above 10% in the 1990s, said Denver-area real estate agent Bill Kosena. “Interest rates are extremely low,” he said. “I don’t know how it gets any better than it is.”

Home prices “extremely overvalued” in 53 cities.

Single-family home prices are “extremely overvalued” in 53 cities that make up nearly a third of the overall U.S. housing market, putting them at high risk of price declines, according to a study released today. The report, by Richard DeKaser, chief economist of National City Corp., examined 299 metro areas accounting for 80% of the U.S. housing market. DeKaser terms a market extremely overvalued if prices are 30% above where he estimates they should be based on historic price data, area income, mortgage rates and population density – a proxy for land scarcity. Based on those criteria, Santa Barbara, California, is the nation’s most out-of-whack market, with houses 69% overpriced. Rounding out the top five: Salinas, California; Naples, Florida; and Riverside and Merced, California.

College Station, Texas, is the most undervalued, priced 19% below where the data suggest it should be. Other inexpensive communities include El Paso, Odessa and Killeen, Texas, and Montgomery, Alabama. The highest-risk markets are in California; Southern Florida; parts of the Boston ar: the Long Island, New York, counties of Nassau and Suffolk; and Ocean City, New Jersey. The big culprit: in 85% of the cities surveyed, home-price gains outpaced income gains during the past year. In Bakersfield, California, prices rose 33% while incomes increased 3%. In 29% of areas, prices outpaced income growth by at least 10 percentage points. Just 2% of markets were in bubbly territory at the start of 2004, vs. 31% in the first quarter of 2005.

Some of the most expensive areas are not necessarily the most overpriced, according to DeKaser’s model. Pricey Honolulu, Hawaii, for example, is not in the top 53. DeKaser says his study does not mean big corrections are imminent, though he sees evidence the housing market could be at or near a crest. “For the U.S. as a whole, I expect we’re going to have an orderly correction. But that doesn’t mean it’s going to be equally orderly in all places,” DeKaser says. He says it is rare for property to depreciate, even in overvalued markets, without an economic shock such as rising unemployment. Price corrections might not occur at the same time, and declines in one area could be partly offset by gains elsewhere.

Even as real estate as a whole stays strong, some once red-hot markets have cooled. Which is next?

The Denver metro area went from consistent double-digit house price gains from 1998 to 2001 to little movement since. In the second quarter, single-family home prices in Denver rose just 2.7% from a year earlier, according to the National Association of Realtors. San Diego has slowed from 29.8% in 2004 to just 8.2% in the second quarter. Las Vegas from 48.7% growth to 11.2%. This may be just the beginning. According to Celia Chen, economist for Economy.com, there could soon be some major pullbacks in the most heated regional housing markets.

Housing booms occur in places with growing populations, vibrant economies, and expanding job markets. There is also often an X-factor – whether the area has limited room for expansion, Manhattan island being the classic example. That also explains why cities such as Dallas and Austin have had more modest home-price gains despite strong population and economic growth. When land gets too expensive, a developer can purchase land down the road for a lot less money. In Austin, prices have risen just 5.0% over the past 12 months. The median priced home there is $166,800. The scene is Dallas is similar.

Outside a few hot markets in the U.S., said Chen, there is no housing bubble. She points out that when comparing home prices to income, this ratio is quite small in most of the country: 2.4 to 1 in Wisconsin, 2.2 to 1 in Kentucky, and 2.9 to 1 in Illinois. Where that ratio gets badly skewed is in Massachusetts (5.9 to 1), California (8.3 to 1), and Hawaii (10.1 to 1). Only in about 20 metro areas, mostly located in eight states, does the relationship of home price to income defy logic, according to Chen. The bad news is that those areas accounts for roughly half the value of all the housing in the country.

California home buyers stretch to afford homes, says study.

Home-ownership in California has increased to a level not seen since 1960 but it is coming at a high cost and risk for home buyers, according to a study by the Public Policy Institute of California. To keep up with soaring home prices, Californians are setting aside a dangerously large share of income for house payments and taking on risky mortgages. The study found 52% of Californians who bought a home in the last two years spend more than 30% of their total income on housing and 20% of recent home buyers spend more than half of their income on housing. “That gets to be problematic,” said David Yeske, a certified financial planner in San Francisco and past president of the Financial Planning Association. “When your mortgage represents that percentage of your income, you’ve got no room for error if some other expense comes along.”

California home buyers are assuming such risk because lenders have relaxed lending standards. That has helped lift the state’s homeownership rate, or the percentage of households owning their own homes, to 59%, compared with a previous peak of 58% in 1960. “Higher debt-to-income ratios are possible because more and more lenders are foregoing the fiscal practice of limiting housing costs to no more than 30 percent of income,” according to the study. “Instead, they are qualifying buyers for loans that consume 40, and even 50, percent of their income.”

Fannie Mae-day, Mayday?

While the U.S. housing market is red hot, the number one U.S. housing mortgage giant is not, not. As for why – the mainstream media would have you take your pick from a rapidly growing list of setbacks that have plagued Fannie Mae in the past year. Suffice to say, as an August 16 Bloomberg article aptly puts it, “So many shoes have dropped at Fannie Mae that the accounting investigation is beginning to resemble a centipede.” We cannot argue with that. What we can oppose though is the notion that Fannie’s foibles caused the company’s stock to fall.

In March 2002 we made this startling forecast: “When social mood turns down, Fannie Mae, ‘the government sponsored enterprise’ that have pushed home ownership into the depths of the population, will be extremely vulnerable. Fannie will probably be testifying before Congressional Committees for years to come. To stay on top of this debacle, keep an eye on Fannie’s stock price. A flurry of negative publicity coincided with the apparent completion of a wave 4 triangle. A final burst to one more new high would complete a longer-term, five-wave advance from the early 1990s. After that, it will be downhill.” This analysis came two years before OFHEO’s campaign to uncover Fannie’s “ethical lapses” began. And one month after this analysis, (in April 2002), Fannie Mae stock recorded a new high, initiating a major downtrend that has so far slashed 40% off its value. (Click here for a closeup.)

One in every five home loans in the U.S. is financed through the mortgage giant. No matter how you slice it, you cannot take the “mae” out of the housing mae-nia, not in the long run. If you want to know what is next for the housing bubble, keep an eye on Fannie.

Desperate house buyers increase foreclosure risk.

The meteoric rise in home prices has been accompanied by a sharp shrinkage in the size of down payments made by cash-strapped buyers, a trend that could portend a spike in future foreclosures, new research shows. 38.1% of home buyers who bought houses in the first half of 2005 put down less than 5% of the purchase price, up from 30.6% in 2000, according to a study by SMR Research, a Hackettstown, N.J., firm that tracks mortgage debt. 49.9% of buyers put down less than 10%, up from 44.8% in 2000.

Another potential red flag is the growing use of so-called piggyback loans. Traditionally, home buyers who did not come up with a 20% down payment had to pay an added cost each month for private mortgage insurance. But recently, more strapped borrowers are taking out two loans – one for 80% of the purchase price and a second, or piggyback, loan in the form of a line of credit or home equity loan. So far this year, nearly half (48.2%) of buyers used piggybacks, up sharply from 19.9% in 2001. The statistics suggest that many home buyers are stretching their budgets well beyond their means. The risk is that recent buyers have such minuscule equity in their homes that if prices fall, they could owe more on their mortgages than their homes are worth.

Americans’ ability to take on massive mortgage debt has been fueled by the availability of “exotic” mortgages, such as interest-only loans and adjustable-rate mortgages that provide borrowers with a lower monthly payment for a short period of time, says Dean Baker, co-director at the Center for Economic and Policy Research. “Home prices are going through the roof, forcing people to turn to exotic loans and unorthodox financing,” says Baker. “These people have no room for error.”

U.S. banks ease loan terms. Nontraditional mortgage originations rise.

U.S. commercial banks eased lending standards and terms for both commercial and industrial loans and commercial real estate loans over the past three months, the Federal Reserve said. U.S. branches of foreign banks, meanwhile, only minimally changed their standards, the Fed said. Domestic and foreign institutions both reported stronger demand for commercial real estate loans, the Fed added in its quarterly survey of senior loan officers.

Credit standards for residential mortgages were unchanged. But demand for mortgages to purchase homes strengthened in the past quarter, the Fed said, with 20% of domestic banks reporting stronger demand. Taken in July, the Fed survey asked banks about their mortgage businesses. About a third of domestic respondents said the share of “nontraditional” residential mortgages on their books was less than 5%, while another third said the share of those products was between 5% and 15%. Nontraditional mortgage products include adjustable rate mortgages with multiple payment options and interest-only mortgages. However, more than half of the banks surveyed said the share of nontraditional residential mortgage originations over the last year was higher than it had been the previous year.

Home on the (Las Vegas) Strip.

Even in this gaudy city a building painted black and pink stands out. It needs to, because the one-floor structure at the corner of the Strip and Sahara Avenue is a condominium sales center in a metropolis where more than 100 new high-rise residences are in the works. The Las Vegas skyline will be transformed by 6,000 new condo units now being built. Above is an artist’s rendering of the largest project, named for Ivana Trump.

The black-and-pink exterior was designed by the woman who is the namesake of the planned condominium. Victor Altomare, the developer, said simply, “It just screams ‘Ivana’.” That would be Ivana Trump, an ex-wife of Donald J. Trump. “Her fingerprints are all over this project,” Mr. Altomare said. “Pink is her color.” Although the condo itself, scheduled for groundbreaking in mid-2006 and opening 30 months later, will be a relatively sedate silver color, it will command attention as the tallest skyscraper in Las Vegas. Mr. Altomare estimates construction costs at $500 million. In a telephone interview, Mrs. Trump said she was an investor, but would not be specific about the amount.

Ivana, the building, is to rise 80 floors. It and other high rises under development are being hailed as the “Manhattanization” of Las Vegas. Konnel Peterson, a Re/Max broker who sells mainly condos, said, “Condos, not casinos, are the next big wave of building here. If successful, they’ll remake the skyline of this city and recast the Strip from a place to gamble on games to a hub of real estate investment.”

The size and scope of Ivana, the building, are big enough to compete with one guy in particular: the man she divorced in 1990 after 13 years of marriage. Mr. Trump, not known for self-deprecation, also has a condo project being built on the Strip. But, planned for 64 floors, his Trump International Hotel and Tower will be smaller than the one named for Mrs. Trump. Still, he swept aside comparisons in a telephone interview. “Trump International has the right location in the heart of Las Vegas Boulevard,” he said, referring to the street more commonly known as the Strip, “near Steve Wynn’s new resort and all the glamour that buyers are looking for.”

Mr. Trump said that Ivana, the building, may be too far north on the Strip, near the older downtown area of Las Vegas, to be successful. “It’s in the wrong place,” he said. His development has as a neighbor the Fashion Show Mall, with such stores as Neiman-Marcus. Hers is across the street from a discount store that offers bargains on T-shirts.

McMansion backlash.

The American home is getting bigger. And fatter. And, to some, uglier. Now, towns are fighting back. Chevy Chase, Maryland, an upscale suburb of Washington, recently announced a 6-month moratorium on home construction to make time to examine how to deal with the proliferation of oversized single-family houses. Call them what you will – starter castles, McMansions, monster homes – these houses have become increasingly visible in metropolitan landscapes. Many residents hate them. Todd Hoffman, town manager, said that more than 500 Chevy Chasers, a significant number in a community of just over 1,000 homes, signed a petition expressing their “concern about the effects of ‘mansionization’.” Folks in Chevy Chase are not alone.

Are these new homes really so gargantuan that they should attract such fear and loathing? Back in 1950, according to the National Association of Home Builders (NAHB), the average new house clocked in at 963 square feet. By 1970, that figure had swollen to 1,500 square feet. Today’s average: 2,400 square feet. One in five are more than 3,000 square feet. Oddly, as houses expanded, the number of household members shrank, from 3.1 people in 1971 to 2.6 people today. The average building-lot size contracted also, to about 8,000 square feet from 9,000 in the 1980s. So you are getting bigger houses on smaller lots with fewer people living in them.

Fueling the size craze is a long wish list of home features Americans desire. Some 87% prefer three or more bedrooms with 44% wanting at least four, according to the NAHB. About 85% of Americans want walk-in pantries, 77% desire separate shower stalls, 95% want laundry rooms, and 64% home offices. More than a third crave media rooms. Then there are exercise rooms, sun rooms, and dens. No wonder new homes have grown.

It is not necessarily the size that matters – location is a big part of it. Few people oppose McMansions in new suburbs with uniformly large homes, or to single monsters set apart on ample acreage. What raises hackles is Gulliver-sized homes on lilliputian lots. Many older, closed-in suburbs that are in demand for their easy commutes are already built out. Builders put in large homes on whatever shoebox-sized lots remain or knock down smaller houses and replace them with palaces. They fill in nearly to the lot line and build as high as regulations allow, dwarfing neighboring homes.

CHINA’S CENTRAL BANK WARNS OF PROPERTY BUBBLE

China faces a potential property “bubble” whose bursting could leave banks with huge losses, the central bank said in a report signaling that efforts to curb rising real estate will continue. Average real estate prices in China rose by 14.4% in 2004 over the previous year and by 12.5% in the first quarter of 2005. Prices in cities like Shanghai have risen still faster, although they have moderated in recent months following government moves to cool the property boom. “Property price inflation can easily result in prices soaring out of line with real values and thus cause a bubble,” said the report, posted on the Web site of the People’s Bank of China. “Once the bubble bursts, it can cause a contraction in the real estate sector and significant losses for banks,” the report said. Alarmed by signs that ordinary citizens have been priced out of the market, China’s leaders have made controlling property prices part of their strategy of reaching out to families left behind in the country’s rush to affluence.

This spring, the government began acting to curb speculative real estate investment that it says has pushed prices to unsustainable levels. Local governments like Shanghai boosted taxes on real estate transactions and ordered banks to limit credit for property deals, among other measures. Vice Premier Zeng Peiyan urged continued efforts to curb speculative demand and increase construction of affordable housing.

THE TRUTHS ABOUT INFLATION

The problem with averages is summed up by the line about the man with his head in the oven and his feet in the freezer who, when averaged, had a normal temperature. This line helps clear up some, but not all, of the confusion about U.S. inflation. The consumer price index rose 0.5% in July, driven by a 3.8% jump in energy prices. It was the biggest rise in three months, but below some forecasts by analysts. Excluding food and petrol (and most Americans would surely love to exclude these items from their calculation), the “core” CPI edged up a mere 0.1% last month – a rather subdued picture.

When market participants fret about the direction of the economy, they point to signs that are not easily reconciled: runaway inflation or a sluggish environment of pervasive deflation. Is one of these views correct, or are both wrong? While the deflation scare of 2003 was foolishly misplaced, the correct answer about the economy may be that both pictures have elements of truth. The U.S. economy is seeing pervasive deflation in areas affected by globalization, such as apparel and consumer-technology products. These components offset more inflationary areas such as energy, healthcare and housing. So the 1.8% annualized decline in apparel partially offsets the 3% annualized rise in housing and the 14.2% annualized rise in energy.

These examples shed light on the part of the inflation picture that is not explained by the average-temperature man. Housing up 3%? Energy up 14.2%? If one can find a place in America that has seen such subdued price increases, it should brace itself for an influx of new residents. The CPI is an inadequate gauge of inflation in America. The housing gauge relies heavily on “owner’s equivalent” rent figures that diverge wildly over the shorter term from the housing prices they are supposed to reflect. Meanwhile, any real-world measure used by average Americans would put energy’s rise above 14.2%. While the inflation picture the CPI presents may adequately reflect the average-temperature man, it seems fairly clear that it greatly understates how high the average temperature of inflation is rising.

Excluding everything, there is no inflation at all.

Americans who avoided driving, eating, drinking and smoking in July experienced no inflation whatsoever. Unfortunately, everyone else felt a serious pinch.

Getting to the “core” of inflation propaganda.

Yesterday the Labor Department reported that July Consumer Prices rose by 0.5%. Today we were informed that July producer prices rose an even sharper 1%. Though these are very serious numbers, indicative of a chronic inflation problem, government officials, Wall Street strategists, and the financial media tell us not to worry. Excluding energy prices, the so called “core” CPI rose a benign 0.1% and the “core” PPI a somewhat less benign 0.4%. Measuring inflation while excluding energy prices makes about as much sense as dieters weighing themselves while excluding all the fat around their stomach, hips and thighs. Just how did this ridiculous concept get started in the first place?

Food and energy prices have historically been quite volatile, up big one month, down big the next. To prevent economists from jumping to erroneous conclusions the concept of the “core” CPI was developed. It has been argued that by looking at the monthly numbers without these volatile components, economists get a more accurate read on the true impact of inflation on consumer prices. Excluding food and energy in no way implied that such prices were not important components of the indexes, just that their prices tended to be more volatile, and hence less relevant on a monthly basis.

In 2002, when oil prices began their steady ascent from $20 per barrel, the common wisdom held that the rise was a temporary phenomenon based on global terrorism and the build up to the Iraq War. As a result, economists began ignoring the actual CPI in favor of the “core” as everyone knew that rising oil prices were a temporary phenomenon. Based on that false analysis, at least it made some sense to exclude rising oil prices, since the belief was that higher prices would ultimately be reversed. However today, with oil prices above $65 per barrel, and more economists having resigned themselves to the inevitability of even higher oil prices in the future, why is anybody still looking at the core?

Since 2002, oil prices have been anything but volatile. They have in fact been quite predictable, rising steadily for four years. In such an environment, excluding them when measuring inflation is a farce. As oil prices continue to rise, and Asian currencies continue to appreciate, expect higher production and transportation costs to exert significant upward pressure on U.S. consumer prices for years to come. However, do not expect such price increases to show up in official CPI statistics, as the Labor Department has a tool called hedonic adjustments to fix that.

STOCK OPTIONS: LEGALIZED EMBEZZLEMENT

An espresso bar that rarely sells an espresso may represent a kind of aesthetic tragedy, but it is a capitalistic triumph. Just ask Starbucks’ shareholders. An espresso-filled porcelain demitasse, garnished with a lemon twist, may delight coffee purists, but it irks coffee capitalists. There is no money to be made selling cheap espressos in cups you have to wash and reuse. Gaudy, 20-oz. coffee-based creations, slathered in whipped cream and caramel syrup, and served in throwaway plastic cups, produce much higher profit margins. It is no accident, therefore, that the world’s most successful espresso company sells very few actual espressos. Thanks to corporate innovations like the Venti Green Tea Frappuccino, the Starbucks Company has rewarded its shareholders handsomely over the years.

Unfortunately, many other U.S. corporate innovations – like the executive stock-option grant, for example – have abused the very shareholders they purport to benefit. Innumerable American corporations have lavished option grants on their top executives, in the process establishing a kind of legalized, systematic embezzlement. Because these “incentive” bonuses divert corporate wealth toward company officers, they divert corporate wealth AWAY from the minority shareholders. A small diversion would not be so bad, but the diversions are anything but small. In some extreme cases, option grants claimed more than 40% of a company’s market value. Overall, this so-called “overhang” still represents more than 15% of the market value of the S&P 500 companies, according to the Investor Responsibility Research Center.

Worse still, the economic cost of these grants has rarely appeared on a corporate income statement. Until very recently, companies routinely buried the cost of option grants in the fine print of their SEC filings. And almost no company would deduct the true cost of option grants from their reported earnings. Last year the S&P 500’s “operating earnings”, the flattering, quasi-fictional results imagined by Wall Street analysts, totaled $66.62. But after applying GAAP standards to these quasi-fictional earnings, and adjusting them for the cost of stock options, the S&P’s actual earnings dropped to only $55.25, according to James Montier, equity strategist at Dresdner Kleinwort Wasserstein. That earnings number would put the S&P 500 on a rich PE multiple of 22 times earnings.

Happily for us minority shareholders, the years of legalized embezzlement are drawing to a close. Increasingly, as the chart above illustrates, shareholders are voting to reject corporate stock option programs. In 1988, for example, less than 5% of all stock option plans received a “nay” vote. But that percentage hit nearly 25% last year. Stock option plans have not yet become as rare as a Starbucks double espresso … but they should be.

RETIREMENT ANXIETY ON THE RISE

About two-thirds of American workers expect to work full or part time after retiring from their main job, according to a newly conducted survey that found rising anxiety about retirement income. The survey of 800 Americans, conducted in May and June by the John J. Heldrich Center for Workforce Development at Rutgers University, found that 66% expect to be doing some kind of work when they reach retirement age. While that is down from the nearly three-quarters who expected to keep working the last time the survey was conducted in 2000, the reasons those surveyed expect to keep working has shown a significant shift.

The latest survey found that 24% plan to work full time or part time because they need the money, almost double the 13% who expected to do so in a 2000 survey. The percent that said they intend to work part time or to pursue an interest similarly fell to 27% from 44% that expected to do so in the 2000 survey. In addition, the survey found that 12% believe they will never be able to retire, up from 7% that believed that in the 2000 survey.

The survey finds a growing gap as to what workers believe is the ideal retirement age, and when they expect to have the financial resources to retire. For example, in the most recent survey, 91% said they would ideally like to retire by age 65, but only 63% expect to retire by then. In the 2000 survey, a similar 89% ideally wanted to retire by age 65, but at that time 82% of those surveyed expected to be able to retire by then.

Part of the retirement anxiety comes from doubts about government retirement programs. Half of current workers age 44 and younger disagree with the statement, “Social Security and Medicare will still be available to me when I retire.” In addition, 40% of workers ages 45 to 54 also disagree with that statement. Despite these doubts, the survey found 35% of current workers saving nothing to supplement their retirement income beyond Social Security benefits.

ARE POLITICS ABOUT TO GET INTERESTING IN JAPAN?

The determination of Liberal Democrat Prime Minister, Junichiro Koizumi, to push through his beloved postal privatization bill has triggered political upheaval in Japan. The PM has expelled from the party the 37 LDP rebels who had voted against his bill in the lower house, and will send in some of his strongest candidates to fight them in their constituencies with the aim of driving them from office altogether. With a split in the governing LDP ranks, and an invigorated and relatively unified opposition – the Democratic Party of Japan (DPJ) – emerging for the first time in over a decade, the prospects for a genuinely competitive election are finally at hand. But will this change anything?

It has been right many years to be cynical about Japanese politics. We ourselves have long commented on the uneasy melding of an increasingly sophisticated first world economic system and standard of living with an unresponsive third world political system mired in corruption, deceit and public non-accountability. The hope must surely be that this election will constitute another step toward normalizing the Japanese polity, driving it further away from Third World style political nepotism and corruption. In this regard, post office privatization is undoubtedly important. With its trillions of yen in assets, the post office has long been at the heart of the “iron triangle” between businessmen, politicians and bureaucrats – perhaps the defining characteristic of Japanese politics since the end of the Second World War. For the postal-savings system, and the Fiscal Investment and Loan Programme (FILP) which the deposits held within it financed, represented the epicenter of post-1945 LDP pork-barrel politics in particular.

On the other hand, it is not the important only issue for the Japanese people. There is the broader question of Japan’s symbiotic relationship with Washington (which has been intimately tied up with the latter’s economy, given the sheer size of Japan’s U.S. dollar holdings). Yet seldom have Japanese voters questioned how, or been given the opportunity to query, why Japan has effectively ceded so much management of its monetary and financial affairs to Washington, why it has articulated few foreign policy decisions without Washington’s active approval, or even why it continues to support American aims even when they apparently run counter to national interests?

By way of example, consider that Japan’s net foreign assets, most of which represent claims on the U.S., is estimated by many market observers to be on the order of 50% of American net foreign debt. This ratio has fallen in the last 10 years because even Japan’s seemingly endless ability to keep accumulating American assets has not matched Washington’s insatiable ability to create yet more IOUs. Perpetually accommodating the latter’s financial profligacy, Japan today is faced with the invidious choice of writing down over $1 trillion in foreign exchange assets (by refusing to buy more Treasuries and thereby causing a dollar crash) or continuing with the status quo in the forlorn hopes that the U.S. will one day get its economic house in order. While deferring this Hobson’s choice, its policy makers remain locked into some sort of symbiotic “death embrace” with Washington. Surely, this is an area ripe for public discussion, but it has hardly been broached thus far on the campaign trail.

It is worthwhile noting that in the absence of this extraordinary monetary munificence on the part of the Bank of Japan, the burden of U.S. foreign policy adventurism would have rested solely on the shoulders of the U.S. taxpayer, which may well have circumscribed American actions in the Middle East and beyond (with its attendant implications for Japan). In fact, throughout the post-war period, Washington has continued to exercise immense indirect power in Japan from the creation of its “Peace Constitution” onward. Most observers of the country like to pretend that Japan is a fully independent country, but its recent actions leave it open to the charge that it is a mere military protectorate, a colony whose main “contribution” to the global economy has been to underwrite American economic and foreign policy, even at a cost of destroying the country’s own national savings.

This issue has been broadly overshadowed by the furore over the Koizumi administration’s attempt to force through privatisation of the post office and the resultant political impasse. Although initially deemed a bearish event for the Japanese economy, the stock market’s push to fresh 4-year highs suggests the opposite. The rationale is that Koizumi has successfully called the bluff of the LDP old guard dinosaurs who, apparently, never expected him to follow through on his clear threat to dissolve parliament if post-office reform failed to pass the legislature. With the 37 LDP members of the Lower House who voted against the bill now expelled from the party, the coming election is seen as a clear-cut vote for or against reform. We shall see. There has historically been much talk in the past of purging the LDP of its reactionary wing, but we do not see many emerging Japanese Thomas Jeffersons hidden behind them.

In fairness to Japan, its political deficiencies are hardly all self-inflicted. America’s policy makers have historically exhibited little confidence in the ability of the Japanese to alter their own nation’s course by themselves and, indeed, have effectively helped to frustrate the development of a genuine democratic culture. It is therefore unsurprising that the political system itself has become stultified and its population disengaged and apathetic. The corollary applies as well: as a consequence of Japan’s political atrophy, it is unjust to heap criticism at supposedly clueless leaders, who have basically done what they were told to do at the behest of their paymasters in Washington.

It would be most encouraging to see the Japanese debate the issues in the context of a general election, although it would no doubt discomfit many in Washington, in spite of President Bush’s newfound enthusiasm for the spread of real democracy across the globe. In reality, if Mr Koizumi does secure a new substantial mandate, it will likely catalyze the neo-conservatives’ attempt to turn Japan into what they like to call the “Britain of the Far East” – and then use it as a proxy in checkmating North Korea and balancing China. What the U.S. does not want is for a politically independent Japan to become the “Switzerland of the Far East” – that is, choose neutrality between East and West with a less pronounced American/U.S. dollar foreign policy orientation.

So while this election potentially represents a very important moment in Japan’s political evolution, it is just as easy to view the ultimate outcome as ensuring the status quo: a continued colonization of Japanese politics and perpetuation of a global credit bubble that Japan’s ultra-accommodating institutions have done so much to keep alive. It certainly does not follow inevitably that that a Japan willing to rearm, confront China, and further underwrite Mr. Bush’s war on terror with greater enthusiasm will inevitably prove to be a more self-confident fully functioning democracy. Quite the opposite in fact, which would be no surprise given that in Japan, appearances almost invariably supersede reality.

A SHORT COURSE IN COOKING THE BOOKS

I much prefer a stock to go down, not up, right after I have bought it. You might think that is weird. But my attitude is very simple: I only buy stocks that fit my investment criteria – stocks I have sound reasons to expect will rise in value over time. And I only pay what I consider to be a bargain price. So if a stock I like goes down, it is an even better bargain. And if there is something I like better than a bargain, it is a better one.

This is, of course, the opposite of the kinds of companies Wall Street analysts usually like. They want companies that consistently report higher earnings, predictably and consistently, quarter after quarter. So when one of their companies misses its target, even by a fraction of a cent, the stock gets hammered. From this perspective, is it fair that WorldCom chief Bernard Ebbers is the only one going to jail (via the poorhouse)? And Ken Lay and Jeffrey Skilling (Enron) are the only people who are on trial? After all, for several years they gave Wall Street – and, presumably, investors – exactly what they wanted. Predictably, consistently, and most importantly, every quarter. For this achievement they were lauded. They were “heroes of Wall Street” until they fell – or should I say, crashed – from favor.

And where were those so-called watchdogs, the “Guardians” of investor interests back then? Well, Wall Street analysts and brokers, those self-appointed prognosticators of investment value, were falling over themselves to see who could blow their trumpets loudest for Enron, WorldCom and their ilk. And unlike the U.S. Army – which in those old Western movies always appeared over the hill just in time to rescue the beleaguered heroine from a fate worse than death at the hands of the Indians – the SEC (as usual, I might add) roared into town with its guns blazing, its lawyers firing writs and its enforcers slapping miscreants in handcuffs long after the horse had bolted … I mean, the money had flown the coop. So now, courtesy of the SEC, Ebbers is going to jail, with Lay and Skilling quite likely hot on his heels.

Once again, the SEC has succeeded in its mission of protecting investors. Or has it? If you were unfortunate enough to be a shareholder of WorldCom or Enron, you might feel a sense of revenge at seeing these CEOs sent to jail – but it will not do your wallet any good. Fact is if you want to protect your money, as an investor you are on your own. There is no need to follow Ebbers, Lay and Skilling and go outside the law to “manipulate” earnings. There are lots of areas where there is plenty of legal discretion to over- (or under-) state earnings.

There is just one problem with using completely legal shenanigans to inflate current earnings, you incur an addition cost. Tax. The higher your profits today, the bigger your current tax bill. That does not matter too much if you have persuaded analysts and investors to focus on pseudo-measures of profit performance like EBITDA (earnings before interest, taxes, depreciation and amortization). Then your earnings can look great … even if they will not cover your annual interest bill! That is just one more tool you can use dazzle Wall Street, ramp up your stock price, and cash in your options at an inflated price – all, ultimately, at shareholders’ expense. You see, every dollar that a company pays out in tax is one less dollar for shareholders, and one less dollar it can invest to make shareholders more money in the future.

So if your aim is to increase shareholder value in the long term, you will be as conservative as you can legally be in minimizing today’s earnings (and taxes). This is exactly the business model of one of the world’s best-managed insurance companies: Warren Buffett’s Berkshire Hathaway. Buffett is as conservative as you can get when it comes to money, so you can bet he is pushing his reserves against future estimated losses to the limit, so making Berkshire Hathaway – as a friend of mine described it – “a giant tax shelter”. Completely, 100% legally! And it is also what makes a great investment: a company whose management is focused on maximizing shareholder value in the long-term – even if it does not bring them any friends on Wall Street in the short term.

The SEC will only protect you by putting shady CEOs in jail after your money has long gone to “money heaven”. If you are investing for the long-term, your money will be much safer if you take the time and trouble to invest only in companies whose management puts shareholders’ interests first. And (among other things) takes every legal avenue available to reduce taxes and other expenses now so they can make much more money for you in the future. Be aware that such companies are unlikely to be current Wall Street favorites, as the last thing they are trying to do is ramp up the stock price next quarter. But if you have done your homework, and the stock falls after you have bought it, like me, you will find yourself very happy to buy even more. Of course, if you are speculatively inclined – and can spot the next Enron or WorldCom as they are on the way up – you can ride the momentum to a small fortune … so long as you bank your profits before they disappear!

DOES GOSSIP SERVE A PURPOSE?

Maybe you have heard the adage, “Great minds talk about ideas, Average minds talk about things, Small minds talk about other people.” It is the sort of thing my English teacher-grandmother used to say, a perfect blend of snobbishness and wisdom. Repeat it at your own risk, however: The New York Times saw fit to tell the world otherwise in an article with the headline, Have You Heard? Gossip Turns Out to Serve a Purpose. “There has been a tendency to denigrate gossip as sloppy and unreliable,” declares an anthropologist with a three-part name, “But gossip appears to be a very sophisticated, multifunctional interaction which is important in policing behaviors in a group and defining group membership.” Wow. Stupid me. All those twangs of guilt that made me slow to dish the dirt on friends, family, and colleagues, when I could have been “policing behaviors in a group and defining group membership”?

Yet now that we have got that cleared up, I am still left to wonder: Why did a 1500-word article about the benefits of gossip fail to offer even one real example of someone who benefited from gossip? It did tell of a group that made “crude cracks” about a group member behind his back, and of a rancher who “complained to other ranchers that his neighbor had neglected to fix a fence, allowing cattle to wander and freeload.” Problem is, mean jokes and warnings to neighbors ain’t gossip – unless the New York Times has written its own dictionary.

Of course it is true that gossip has always been a staple of journalism, and that many news dailies run pieces from a “gossip columnist”. But not the New York Times, not ever. So why would the nation’s paper of record, whose professed standard is “news that’s fit to print”, run a piece that endorses gossip (and on the “Science” page, no less)? Put simply, “discord”, “malevolence”, and the “tendency to criticize” come with the negative mood of a bear market, whereas concord, benevolence, and the tendency to praise reflect a bull market. The psychology is real, and observable, and large enough to show up in countless places – from the stock market to what we say about others.

PRICKING A BUBBLE, AUSTRALIAN STYLE

Ian Macfarlane, Australia’s central bank governor, has declared victory in the fight to deflate one of the world’s more obvious housing bubbles. That Australia had a speculative time bomb on its hands became clear a few years back. In the last six months of 2002, for example, Sydney house prices rose as much as 50%. Not long after that, the Reserve Bank of Australia stepped up efforts to cool things down. Macfarlane, 59, is so confident he has succeeded that he is even speaking in something approaching English, a rarity in the obfuscation-happy world of central banking. “We’re not expecting to change monetary policy in the near term,” Macfarlane said on August 12. “And when we look further into the future, we no longer see a clear probability of it moving in one direction rather than the other.” It does not get any clearer than that. Nor does the enviable state of Australia’s economy, which Macfarlane has taken to calling “nirvana”.

What Macfarlane achieved in Asia-Pacific’s 5th-largest economy is the fabled and rarely attained soft landing after a bout of fevered growth. Australia, in its 14th straight year of expansion, grew 1.9% in the first quarter, less than half the 4.1% pace in the year-earlier quarter. The laws of economic gravity suggest it is easy to forget that this nation of 20 million is in the midst of the longest run of job growth in 10 years; its jobless rate of 5% is a 29-year low.

Things are hardly unraveling. That is especially true when you consider how well Macfarlane handled Australia’s housing mania relative to other bubble-afflicted economies like the U.S. Last March, Macfarlane and his colleagues at the central bank got considerable grief for raising short-term interest rates to a four-year high. That campaign, coupled with carefully calibrated efforts to talk down the property market, has proved remarkably successful. Observing trends in Australian markets, it seems that many investors too are convinced that the central bank is pulling off a most difficult monetary balancing act, pricking an asset bubble without devastating the economy. The Bank of Japan failed miserably in that pursuit in the late 1980s. The Federal Reserve did not do much better early in this decade.

Australian monetary policy is proving more potent than the U.S.’s because of the nature of its interest-rate system. Home mortgages in Australia are typically floating- or variable-rate and price off the central bank’s overnight rate. U.S. mortgages are often fixed and set off longer-term securities. As such, Australia has avoided a situation where bond yield increases are not keeping pace with rate hikes – the dilemma Fed Chairman Alan Greenspan faces.

The real secret of Macfarlane’s success is credibility. Under his leadership, Australia avoided the worst of the 1997 Asian crisis. His handiwork since the mid-1990s also set the stage for the boom that is still unfolding. It has earned Macfarlane a Greenspan-like mystique with locals. A high degree of credibility means traders and investors may be quicker to heed Macfarlane’s pronouncements and rate moves than Greenspan’s. That has given the central bank leeway to raise rates less often. The Reserve Bank has tightened once this year; the Fed has moved at its last 10 meetings. The result is minimal fallout in Australia’s asset markets.

It is also worth noting Australia is holding its own even amid the Australian dollar’s 7% gain over the last 12 months. Neither Macfarlane nor Treasurer Peter Costello is panicking. In the rest of Asia, central banks here worked frantically in recent years to weaken currencies. Australia is an exception to the rule. It is a sign of confidence.

Macfarlane does not get all the credit for Australia’s prosperity. The national budget is in surplus, keeping a lid on interest rates. His predecessor, Bernie Fraser, experienced his own Paul Volcker-like battle against inflation. Yet since becoming governor in September 1996, Macfarlane’s policies helped lower 10-year bonds yields from 8% to 5.23% today. Not only has the central bank helped drive Australia’s boom – it is also avoiding ugly side effects like inflation or sky rocketing asset prices. It is a feat much of the rest of the world could learn from.

IS RETAILING STARTING TO FALTER?

Several retailers reported second quarter results over the past week. Overall, results have been strong, but investors have been jittery. Since March 2003, retail stocks, as measured by the Morgan Stanley Retail Index have doubled. While some of the increase has been from multiple expansion, most of the gain has come from spectacular earnings growth. Earnings for the aforementioned index have increased by 57% since the summer of 2003. Retail stocks have also outperformed the overall market this year. While the S&P 500 has advanced less than 1%, the Morgan Stanley Retail Index has increased 10%.

Retailers have kept inventory levels in line with sales. This has been more due to strong consumer demand than better inventory management. Without excess inventories, retailers have not had to discount merchandise and have enjoyed higher gross margins. The impressive results over the past two years got the attention of investors. If growth starts to slow, retailers could be in a pinch. Inventories will grow, putting pressure on gross margins, plus stores will not be able to leverage SG&A. This is what happened in late 2002, which caused the group to lose about one-third of its value.

WHEN TO SELL?

Some of the best advice novice investors almost never receive is this: Do not ever get into a trade without deciding in advance how and when to get out. An exit strategy often gets overlooked because novices are too impatient and busy figuring out how to enter a position. But that is only half of a successful trade. Planning an exit point may not seem that important, but it is. Experienced traders know how difficult it is psychologically to close a position, whether you are losing OR winning. When you are losing, you hope that your luck will soon turn around– so you wait. And if you have already made some profit, you start second-guessing yourself: What if I get out too early and leave a lot of money on the table? And so you wait again. In either case, waiting too long could destroy you. A small loss today may turn into a gaping hole in your portfolio a day later. And if you do not take your profits on a winning position soon enough, the market may reverse and give your spoils to a more nimble player.

Because knowing when to sell is part art, part science that is mastered only by a few. The most popular approach to timing the markets is short and simple – don’t. Just buy and hold. It worked for your grandfather when he bought that IBM stock in the 1960s, and it will work for you, too. Just do not jump around too much, goes the conventional wisdom. “Buy and hold” works great if you are lucky enough to find another IBM. But for the rest of us, our money is sitting in 401Ks, pension and mutual funds where the only control we have over what stocks go into our portfolio is by choosing a “conservative” or “aggressive” box on the application. And over the past five years, “buying and holding” stocks in an average mutual has earned a puny 1%. Which, after fees, translates into an average loss.

Needless to say, many investors are looking for ways to take a more active role in managing their money. Most turn to watching economic data for clues on market turns. But fundamental analysis – which is mostly what you see on financial TV – is of little use when it comes to market timing. Really, how does a quarterly GDP or a monthly unemployment number help you to know if your investment is ripe? What is left is technical analysis – something that professionals have used for years. Elliott wave is one of the methods. It helps you identify the trend, stay with it, and anticipate trend reversals – all in one “package”.

Speaking of trend reversals, European stocks have gained an average of 30% over the past 12 months. Many bourses are close to the upward price targets we set for them a year ago. And if you have stayed with us for this long rally, it may be time to start thinking about an exit strategy.

IF YOU MUST OWN REITs …

To the lengthening list of reasons to distrust real estate securities, please allow me to add one more: merger and acquisition (M&A) activity is picking up in the REIT sector. Shortly after M&A activity in a given industry heats up, the industry often becomes stone cold. … especially if the acquirers are paying for their acquisitions with stock instead of cash. REITs have enjoyed an amazing 5-year run, as the chart below clearly illustrates. The MSCI REIT Index has more than doubled since 2000, compared to break-even or negative returns from the broader market indexes.

Not surprisingly, therefore, M&A activity has picked up dramatically. Last year, for example, there were 14 REIT acquisitions, worth a total of nearly $20 billion. So far in 2005, the pace continues, with 7 transactions pending or completed. The acquisitions continue, despite that fact that few values remain in the REIT sector. Keven Lindemann, director of real estate research at SNL Financial, points out that almost all of the 128 publicly traded REITs he follows carry very rich valuations. Of these publicly traded REITs, only 17 trade at a discount to their net asset value (or NAV, which represents an estimate of the value of the underlying real estate a REIT owns). And of these 17, only five of them sell for more than 10% below their NAVs. The nearby chart presents this select group.

On a net asset value basis, these are the cheapest REITs on the market. These REITS would seem to be good candidates for acquisition. If you must own REITs, this is as a good list to start your research with as any. Keep in mind that in the REIT world, hostile takeovers are rare. That Is because insiders often own a good chunk of stock and can block acquisitions they do not support. Most REIT acquisitions happen with the aid of willing management and an amenable board of directors.

It is interesting to note that the NAV discounts themselves do not appear all that large. There are only two companies in the table above with a discount larger than 20%. On the flip side, many REITs trade at substantial premiums to NAV. NAV is not the end-all of REIT analysis, but it is a good place to start. And now that so many REITs sell for prices well above their NAVs, the sector would seem to offer less reward than risk. The fact that so many REIT managements are taking advantage of their inflated share prices to acquire other REITs is another worrisome sign. For those of us who use dollar bills to conduct our investment activity, buying an almost cheap stock is no better then eating an almost fresh fish. Unfortunately, the values available in the REIT sector are not quite as fresh as they used to be … or ought to be.

A MODERN DILEMMA

The argument favoring the current fiat system is that the demand for it grew out of barter, the need to facilitate ever-higher volumes of trade. Given the lack of control over how much fiat money is placed in circulation – after all, it is based on nothing – we can only expect that the currency will continue to lose value over time. The model of fiat money is supported and defended with arguments that consumption is good for the economy, even with the use of vacant monetary systems. But there is a problem: The predictions of these models are at odds with the historical evidence. Fiat money did not in fact evolve … by means of a great leap forward from barter. Nor did fiat monies ever emerge out of thin air. Instead, fiat monies have always developed out of some previously existing money.

Can we equate the problems inherent in fiat money with the effects of inflation? We have all heard that saving for retirement today is problematical because, by the time we retire, we will need more dollars to pay for the things we will need. By definition, this sounds like the consequences of inflation. But inflation is not simply higher prices; it has another aspect, which is devalued currency. We have to pay higher prices in the future because the currency is worth less relative to other currencies. That is the real inflation. Higher prices are only symptoms following the debasement of currency. If we examine why those prices go up, we discover that the reason is not necessarily corporate greed, inefficiency, or foreign price gouging. At the end of the day, it is the gradual loss of purchasing power, the need for more dollars to buy the same things. That is inflation. And fiat money is at the root of the problem.

The intrinsic problem with fiat money systems is how it unravels the basic economic reality. We know that it requires work to create real wealth. We labor and we are paid. We save and we earn interest. Government, however, produces nothing to create wealth so it does so out of an arbitrary system: fiat money. How much more work is involved in printing a $100 bill as compared to a $1 bill? Not only are ordinary people at home being deceived, but foreigners who accept and save our “dollars” in exchange for their goods and services are also being cheated.

So are we “cheated” by the fiat money system? Under one interpretation, we have to contend with the reality that the dollar is not backed by anything of value. But as long as we all agree to assign value to the dollar, and as long as foreign central banks do the same, is it not OK to use a fiat money system? The problem becomes severe when, unavoidably, the system finally collapses. At some point, the Federal Reserve – with blessings of the Congress and the administration – prints and places so much money into circulation that its perceived value just evaporates. Can this happen? It has always happened in the past when fiat money systems were put into use. We have to wonder whether FDR was sincere when, in 1933, he declared that the currency had adequate backing. It was not until the following year that the president raised the ounce value of gold from $20.67 to $35.

It was the plan of the day. First, the law required that all citizens turn over their gold to the government. Second, the value of that gold was raised nearly 70% to $35 per ounce (after collecting it from the people, of course). Third, the president declared that currency printing was being liberalized – but it is backed by gold, so it is not a fiat system. This may have been true in 1933, but since then – having removed ourselves from the gold standard – the presses are printing money late into the night. The gold standard has been long forgotten in Congress, the Federal Reserve, and the executive branch.

The belief on the part of government, rooted in an arrogant thinking that power extends even to the valuation of goods and services and monetary exchange, has led to a monetary policy that makes utterly no sense in historical perspective. Having gone over entirely to a fiat standard, government has chosen to ignore history and those market forces that ultimately decide the question of valuation, in spite of anything government does. If monetary policy were left alone and allowed to function in the free market, what would happen? Perhaps governments ultimately do follow the market by adopting the gold standard, as we have seen repeatedly in history: going on the gold standard, moving to fiat money, experiencing a debasement, and then returning to the gold standard.

Jeffrey M. Herbener observed: “The fly in the ointment of the classical gold standard was precisely that since it was created and maintained by governments, it could be abandoned and destroyed by them. As the ideological tide turned against laissez-faire in favor of statism, governments intent upon expanding the scope of their interference in and control of the market economy found it necessary to eliminate the gold standard.” Today, we live with that legacy. While historians marvel at the “end of history” and the triumph of free market economics, the Fed maintains “price controls” on the very symbol of economic freedom – the U.S. dollar itself.

Four Waves of Gold Buyers in America Over the Last 40 Years. When Will There Be a Fifth?

I sold my first gold coins in the fall of 1959. It was a scant 25-years after FDR had demonetized gold. The Feds used deceit and threats to hoodwink the public into turning in their gold coins. Confiscation, they called it. Theft is a more accurate description. Next stop was the melting pot where the molten gold was cast into 400-ounce bars, and then stored as part of the country’s gold reserves. At least that is what they tell us. Fortunately, heroic “bootleggers”, anticipating the government’s criminal action, shipped significant quantities of America’s coined legacy to the safety of Swiss Bank vaults. (To this day, 75-years later, we purchase American gold coins stored in those vaults.)

Most of the customers seemed infected by a collective amnesia. Not only were the gold coins gone, any recollection of them seemed gone as well. The coin dealers suffered the same amnesia. True, we handled gold coins everyday and knew their market value, but they might as well have been relics from an earlier civilization. It never occurred to me that these golden treasures had served as money in my lifetime.

The “First Wave” of customers punctured that blissful state. These folks had not forgotten “real money”. Having survived “hot and cold” wars, they were “keepers of the flame”. Some were “Birchers”, others were disciples of E.C. Harwood and Leonard Read. My Second Wave of Customers, ca. 1969-81, realized things were not working as they used to. They were cultural conservatives and receptive to “hard-money” viewpoints. This 1982-99 period covered the “Mother of all Bull Markets” for the U.S. dollar and the equity markets worldwide. Frankly, with the exception of a brief influx of new people due to Y2K, there was no Third Wave of Customers. The Third Wave ended with the collapse of the equity markets. Now we see a Fourth Wave of customers, and although it is only a trickle, they are different. We have lawyers buying Krugerrands and I get a dozen inquiries a day asking if gold coins can be placed in IRAs. The urgency to preserve assets is cutting across political lines.

AS INTEREST RATES CLIMB, DEBT BECOMES DILEMMA

Consumers who freely piled up debt when interest rates were falling soon could wake up with a financial hangover. The costs of carrying consumer loans, from home-equity loans to credit cards and auto loans, have been steadily rising ever since the Federal Reserve began its more than yearlong campaign to boost short-term interest rates. Last week, the Fed raised its target rate for the 10th consecutive time, to 3.5%, and showed no signs of letting up. Because rates on most consumer loans are tied to the prime rate – now 6.5%, compared with 4.5% a year ago – average rates have risen alongside the Fed’s moves. Home-equity lines of credit, for instance, have risen two percentage points in the past year.

Granted, today’s consumer-loan rates are nowhere near the levels of the early 1980s, when the prime rate – the benchmark for many loans - was as high as 21.5%, or even throughout the 1990s, when the prime rate averaged around 8%. Rising rates are expected to gradually put an end to the era of feel-no-pain borrowing. Already, the Fed’s moves could add $15 billion in interest expenses to U.S. households over the next year, says Mark Zandi, chief economist at Economy.com, an economic-forecasting firm.

For one, consumers have been feasting off low rates for some time. Overall, U.S. consumers hold nearly $11 trillion in debt, up from $6.8 trillion in 1999, according to the Federal Reserve. To be sure, households’ net worth, bolstered by appreciating home prices, also has risen over the period, to about $49 trillion from $42 trillion. The major shift is that consumers are piling up more adjustable-rate debt – meaning their monthly payments will move in tandem with interest-rate increases.

Consumers may not feel the full squeeze of rising rates for another two or three years, experts say, giving households time to whittle down their debts. Households may start buckling under their debt loads starting next year or in 2007, when many option adjustable-rate mortgages and interest-only loans begin to reset at the higher interest rates. Here is what is happening to consumer interest rates on everything from credit cards to home-equity loans and lines of credit …

CAFTA RHYMES WITH NAFTA

I am a solid capitalist, one who was once a staunch advocate of free trade. However … In 1992, when discussions of the North America Free Trade Agreement were running hot and heavy, I sensed something was amiss. Debate on this mammoth undertaking became particularly animated and surely polarized during the Presidential debates that year. Frankly, Ross Perot made a lot of sense in his criticism of what in the not distant future would become a fait accompli. NAFTA advocates excused away Perot’s negative views as an attempt to hurt his perceived arch enemy, then-incumbent President George Bush The First. But much of what Perot was talking about made much more sense, at least to me, than what was coming from either Messrs. Bush or Gore.

For one thing, and an exceptionally crucial one, it was obvious few people in Congress had read this voluminous document. What sealed the deal, though, as far as I was concerned, was listening to Al Gore in particular talk about how America and its workers would be protected from potential abuse – after the fact – because the U.S. would assure it when negotiating NAFTA’s so-called “side agreements”. These involved hugely critical areas to the U.S. – to Canada also – ones covering pollution, working conditions, etc.

Another selling point of the day from which I derived great discomfort was the idea that an especially good reason for championing NAFTA, although one having little directly to do with trade, was the very beneficial impact it would have in stemming the flow of illegal immigrants from Mexico. After all, wages and the standard of living south of the U.S. border would rise so fast that Mexicans simply no longer would want to flood into the U.S. Of course, illegal immigration from Mexico is much worse now than it was then. At any rate, I wound up opposing the passage of NAFTA. Moreover, that was the point in time at which I decided that if NAFTA had come to represent the embodiment of free trade, I no longer could be a free-trader.

“Free trade” means the same to me today as it always has meant. To succeed, “free trade” and “fair trade” must be synonymous. What I have come sadly to accept is that the plethora of politicians of marginal quality in this country, exacerbated greatly by the brothel-like climate in Washington created by zillions of dollars dispensed by lobbyists, make “free trade” that also is “fair trade” something that simply is not achievable. Now along comes the Central America Free Trade Agreement or “CAFTA”, and to be honest, I was summarily opposed to it. Its selling points had much too familiar a ring. …

A GLOBAL INVENTORY POP?

Inventory adjustments have long dominated the ups and downs of the business cycle. As the evidence rolls in, it appears that the major economies of the world moved in lock-step precision to prune inventories in the second quarter of 2005. Most forecasters now believe that adjustment clears the decks for a strong cyclical snapback in the months ahead. That may be wishful thinking. In the context of an energy shock, any inventory-related impetus to economic growth may turn out to be surprisingly muted.

In a firming final demand climate – very much in evidence in the 2Q05 stats for the U.S., Japan, and even Europe – inventory corrections are normally short-lived. Businesses respond to upbeat demand prospects typically by bringing production schedules back into closer alignment with firming sales – triggering a growth-enhancing resumption of inventory accumulation. In the bigger inventory cycles, when stocks are liquidated sharply, you can even get a growth kick without renewed restocking; all that is needed is just a reduction in the pace of the inventory drawdown – an outcome that cannot occur without a lifting of production levels.

There are two potential glitches to the case for a vigorous inventory snapback in the current period – the first, and most important, being the energy shock. To the extent that sharply rising prices of energy products prompt any cutbacks in final demand or alter demand expectations by businesses, production adjustments could well be deferred. Recent signs of distress in the global retail business are worrisome in that regard. A second consideration that might temper the classic inventory snapback is math: The degree of outright inventory liquidation was actually quite small in 2Q05. While the growth subtraction from the inventory adjustment was large, that is mainly because the rates of accumulation were so rapid in the preceding quarters. The powerful snapbacks of the classic inventory cycle usually follow deep liquidation. By contrast, shallow liquidation means businesses do not need to be all that aggressive in lifting production to bring destocking to an end.

In a still U.S.-centric global economy, the American consumer is the functional equivalent of the “pace-setter” for global demand, and, as such, could well hold the key to the global inventory cycle. On the surface, all signs are “go”. But it boils down to the same old question we have been debating for years: Can U.S. consumption continue at this torrid pace in the face of a chronic shortfall in labor income, a zero personal saving rate, record levels of indebtedness, and an asset-dependent spending mindset? In my view, which is far more pessimistic than that of our U.S. team, the energy shock has finally pushed the long over-extended American consumer to the breaking point [see lead article summary on this page]. Not only do the excesses of discretionary spending in the current period bear an eerie resemblance with those prevailing prior to earlier energy shocks, but personal saving positions are in far worse shape. Add in the likelihood of downside pressures from a post-bubble residential property market, as well as the lagged impacts of the Fed tightening cycle, and I remain convinced that this is one of those rare times when it pays to bet against the ever unflappable American consumer.

In that vein, I think we will be able to look back on the 5.5% gain in real consumption expenditures in the current quarter as the high-water mark for U.S. consumption growth for quite some time. If that is the case, any global inventory snapback could well be muted and investor hopes of an increasingly cyclical growth climate could then be dashed. That is bad news for equities and the dollar, but good news for inflation and bonds. The risk in all this is painfully evident to anyone who has had the audacity to turn negative on the American consumer – that U.S. consumption continues to plow ahead, irrespective of the concerns I have noted above. I can hardly rule out such a possibility – and if that turns out to be the case, an inventory-related U.S. and global growth spurt could well unfold in the second half of this year that would be bullish for equities and bearish for bonds.

I concede that my case against the American consumer now sounds tired and worn – a very frustrating place for any forecaster to be. The last time I had a feeling like this was in late 1999 and early 2000, when the new-paradigm-mania took the equity market to excess. But a major test is now at hand as saving-short, asset-dependent, and overly-indebted U.S. households are getting hit by a full-blown energy shock. My sense of discipline and experience – to say nothing of an incorrigible stubborn streak – tells me this is not the time to flinch on a very tough macro call. We will know soon enough.

Crude Oil Prices: A “Roll of the Dice”?

Two weeks ago, a major financial newspaper featured an “Outside Audit” that sought to expose shortcomings in mainstream coverage of crude oil. The headline read, “Oil Forecasts Are a Roll of the Dice”, and the opening paragraph pulled the rug out from under analysts who depend on supply and demand data to make their predictions: “You may know as much as the oil experts. Nobody – not even those who get paid to prognosticate – has a real handle on the push and pull that goes into figuring how much oil people need, how much can be pumped and how much can be refined.”

In 2004, world oil demand grew 3.3%, the biggest change in 23 years. However, world oil supply surged 4.2%, providing an average surplus of 500,000 barrels per day. But as you know by now, the seemingly bearish imbalance did not mean much to the market: Prices jumped 34%. Last week’s EIA report cited a 2.8 million barrel build in crude stocks and a 2.1 million barrel decline in gasoline inventories. Traders supposedly ignored the first number and focused on the second, so crude prices surged $1.83. This week’s report showed a much smaller build in crude – just 300,000 barrels – and a much larger 5 million barrel decline in gasoline. Both numbers were more bullish than last week, yet oil plunged $2.83.

Back before prices surged 17% in 16 sessions, before the latest episode of “profit-taking”, editor Steve Craig was NOT thinking about “supply worries” in his energy analysis. Instead, he was thinking about what really matters, namely the psychology of the market as reflected by the price patterns.

INFLATED ASSETS

Your editor and his three kids spent a few days at the Broadmoor Hotel in Colorado Springs, much of it by the hotel’s picturesque infinity pool (and somewhat less picturesque water slides). Then, yesterday, the four of us departed the alpine serenity of the Broadmoor for the gaudy glitz of the Mandalay Bay Hotel in Las Vegas. After spending a few days at both of these upscale hotels, two distinct phenomena become immediately apparent: 1) Large breasts are in a bull market. 2) The luxury hotel industry is faring quite well.

Immediately after 9/11, 5-star hotels routinely charged 2- and 3-star rates … and still the room went begging. But plush accommodations go begging no more. The overall occupancy rate among U.S. hotels increased in 2004 to 61.3%, as room rates also increased. Luxury hotels posted the biggest gains of any segment. Manhattan’s pricey hotels fully reflect the trend. At 83.2%, overall occupancy rates reached close to the historical peak achieved in 2000 (at 83.7%). The revenue per available room (RevPar) among luxury hotels in Manhattan shot up a stunning 22% in 2004. As occupancy and room rates have soared, so have the shares of all major hotel companies. Not surprisingly, many hotel industry insiders expect the good times to continue for many more years … if not forever. (We beg to differ). U.S. hotel room construction starts in 2005 (the number of hotel rooms beginning construction) will soar more than 20%, the largest increase since 1997. Once again, high-end hotels are leading the advance.

As a not-quite-luxury traveler, your editor mourns the loss of his cheap accommodations. But he does not doubt that the lodging industry will miscalculate future demand once again, and build one or two hotels too many. In the event, 5-star rooms might once again become available at 3-star prices, for a while at least. As an investor, therefore, your editor would steer clear of most lodging stocks. The bull market in breast augmentation shows no sign of exhaustion. But the bull market in upscale lodging looks ready to drop a cup size or two.