Finance Digest for Week of April 24, 2006

FEEL THE FORCE

Did you know that we are in the midst of a bucking bull market? Look only at the S&P 500, up 4.2% in the first quarter, and you might miss it. Pay attention, instead, to the Morgan Stanley World Index, the best measure of the developed-country markets. It was up 6.6% in the quarter. You read it here first: Whenever the whole world stock market has gotten off to a good start, there has always been more good news for the remaining nine months of the year. In MSWI’s 37-year history there were 15 other times when the first quarter was up 4% or more. The second quarters were up 13 times. The collective nine months after those strong first quarters were negative only once. That was in 1987, a heck of a weird year that saw an extraordinary two-day collapse in the third quarter but still a return of 16.8% for the year. In fact, each of the 15 years saw double-digit returns. (A negative first quarter does not insure a negative year; it merely increases the odds of such a misfortune, to about 50/50.)

What is putting the wind behind the racing stock market? The force is historically cheap global valuations relative to long-term interest rates. This relationship between rates and PE ratios creates a bargain for corporate buyers of stock. Both corporations buying in a few of their own shares and acquirers taking over competitors in toto find their earnings per share enhanced. The accompanying buyback and takeover binges are shrinking the supply of equities. I have been describing this phenomenon since November 2004. But not thinking globally can cause you to miss feeling the force when you are in a country that is lagging, as America is now.

If you ask what happened in America when first quarters were up more than 4%, you get a basically bullish picture, but it is easy to miss, more ragged and inconsistent than the whole world’s. Any single country is more hit-and-miss, for the same reason that any single stock is more volatile than a portfolio of stocks. American markets are not as strong this year as foreign markets. I expect that disparity to widen for a while. Stocks are cheaper overseas than in America relative to each country’s long-term interest rates. Our interest rates, over both long and short terms, are higher than rates in most other nations. Our yield curve is much flatter, which is a drag on stocks (but not an indicator of a decline or economic weakness, unless the whole world’s curve is flat). Also, sentiment has been more dour outside America than in, allowing for more sentiment pickup overseas.

So follow the world market’s first-quarter signal. Take heart. Buy into this beautiful year. Keep thinking and buying globally, with a mix of good domestic and foreign stocks like these …

DESERT ROSE

Nahed Taher is raising a $10 billion private equity fund. And negotiating the fine print on a batch of mutual funds she will offer to focus on the volatile Saudi stock market. But the high-flying head of Gulf One Investment Bank still cannot drive her own car or vote. Taher lives in Saudi Arabia. The mere fact that Taher, an outspoken advocate of women’s rights in the archconservative kingdom, has such prominence shows that maybe, just maybe, this oil-rich country is ready to revamp its hidebound ways and become a good place for Westerners to invest. While foreigners are forbidden to own Saudi stocks, King Abdullah has called on the nation’s Capital Market Authority (its SEC) to permit non-Saudis to buy. Now the only ways outsiders can invest are via private equity pools like Gulf One’s or several Arab-owned mutual funds.

Taher, 39, sheds her head scarf when walking around Jeddah, where she lives, although she will put it back on in a more tradition-minded place like Riyadh. She is every inch the well-spoken, self-possessed investment banker, with a Rolodex and friendships that would be the envy of any of her peers on Wall Street or in the City of London. She is also very high on the prospects of her nation’s economy and equally upbeat on the entire Persian Gulf as a profitable region for global investors. “I see investment opportunity materializing,” says Taher. She has raised most of the initial $10 billion from investors throughout the Gulf region, including Saudi Arabia. “They believe in my vision,” she says.

Certainly, continued high oil prices are key to her vision of an expanding Saudi economy. Given the high global demand, pricey oil seems like a pretty safe bet. Yet what really encourages Taher is that King Abdullah, crowned after the death of his half-brother Fahd last August, wants to update the Saudi economic system. And to do it right this time. During the 1970s oil boom, when the kingdom last tried to broaden the economic base, Saudi petro-wealth went into government-funded boondoggles, and it all faded with crashing crude prices. Now, she says, there is a much bigger emphasis on private enterprise and a willingness to invite Western capital into the kingdom for both securities and direct spending. Not to mention increased financial expertise, and some hint at Western-style accounting transparency.

REAL ESTATE BOOM OR DOOM?

Whatever You Do, Don’t Say D-O-W-N

Sales of new homes plunged 10.5% in February, the biggest drop in nearly nine years, while prices fell and the number of homes on the market hit a record high. This has to be the real estate toboggan slide we have been expecting. In concert with the turn, the government is setting its sights on lenders. “Brokers who arrange home loans at high interest rates [are] drawing scrutiny from law enforcement authorities,” and federal regulators are cracking down on the Federal Home Loan Banks in a way that threatens to shrink a subsidy long enjoyed by thousands of lenders.” New rules proposed by the Federal Housing Finance Board would require the banks to retain more of their earnings as capital to build up a bigger cushion against potential losses. These news items mark a tidal shift away from the feverish “sub-prime” lending climate we profiled last summer. As Barron’s notes, “Teaser rates have expired. With house prices no longer soaring, [mortgage borrowers] can’t easily cash out or refi.” Keep our quote from last July in mind: “This time there is no mistaking who the Enrons of the bust phase will be. They will be the firms now peddling adjustable-rate, no-interest/nothing-down and assorted other types of ‘sub-prime’ mortgages.”

And still there is virtually no fear about home values. A recent national survey of homeowners by the L.A. Times shows “widespread faith in the real estate market.” A question about expectations for house prices asked only about the predicted amount of future rises and did not even include a category that allowed for expressing an opinion about any decline. The worst possible scenario, that prices would “stay the same” over the next 3 years, was selected by just 5% of homeowners. That total was less than the 6% who said they expect to see a rise of “31% or more.”

No matter how much talk of a bubble there may be, homeowners continue to demonstrate that they have no clue about the ramifications of one. Included in the survey were respondents with adjustable-rate mortgages, a quarter of whom said they “are not sure they will be able to make their monthly payments if interest rates go up.” Even among the financially strapped, the very concept of falling real estate prices is not a consideration. And, as the latest housing figures attest, this is in an environment in which prices actually are falling! The denial runs so deep, it is not even denial anymore. It is some kind of epic disconnect between the reality of a newly-falling housing market and an unwritten social contract that says home prices do not fall. Whatever this delusion is called, it cannot last much longer.

Make money in real estate.

That sound you hear is the real estate bubble popping. Or so thinks Wall Street. When new home sales slipped 10.5% in February, it gave fresh evidence of the long-expected end to the housing boom. Homebuilder stocks are down as a result. Maybe that is unjustified. The big builders will tell you that an industrywide falloff in home starts lets these well-capitalized companies steal market share from the small-time developers, who are still numerous.

Regardless, if there is any megabuilder whose now bargain stocks are worth the money, it is Pulte Homes (PHM), which at $39 is off $9 from its July 2005 high. The second-largest builder (in units) behind DR Horton, Pulte has a diverse geographic spread – the West, which includes California, and the Southeast, which includes Florida. And, in fact, Pulte’s new orders in 2005’s last quarter were up 10%, decent news considering that it takes a good half-year until those turn up as revenue. The big question is whether Pulte’s 2006 earnings growth can approach that of 2005, when net income leapt 51% to $1.5 billion. For what it is worth, the consensus forecast for Pulte’s earnings per share is up 10% this year, which is much slower than 2005’s 43%.

Okay, even if overall new-home construction falls into the abyss, Pulte has one strong suit that is unlikely to fade. The builderwts Del Webb unit, acquired in 2001, specializes in retirement communities, and demographics are on its side. This year Pulte plans to build 23 new Del Webb developments, totaling 41,000 homes. Its closings made up 32% of the company total in 2005, and that is expected to expand to 37% this year, says JPMorgan. Other good signs: Pulte’s PE ratio of 7.4, slightly less than the sector average of 8.7. Best of all, it is underleveraged compared with peers, with debt equal to 32% of assets vs. the sector average of 40%.

MUNICIPAL BONDS MAYBE NOT SO BORING

Through hurricanes, floods, tornadoes and 15 consecutive hikes in short-term interest rates, munis have remained rock-solid investments. Their coupons are free of federal tax and, if from your home state, usually free of state tax, too. Their 10-year cumulative default rate is tiny – only 0.04%, according to Moody’s. The muni market is large, with $2.25 trillion of outstanding debt, so plenty of choices exist. Munis are boring. They are too steady for the volatility-loving hedge fund crowd – to which I say, “Amen”. Many carry safeguards. A lot of them are insured. Others are backed by stashes of Treasury bonds or kindred federal obligations – “escrowed to maturity” in bond-speak. Still other munis are guaranteed with letters of credit from large banks.

Munis are especially attractive now that corporates are becoming less creditworthy as the companies borrow willy-nilly to buy back their stock. Too many corporates are degenerating into junk. Munis, when you factor in their tax-free advantage, can give you yields that beat those on investment-grade corporates, whose interest payments, of course, are taxable. The sweet spot for municipal bonds right now is in the 10- to 14-year maturity range. It is not worthwhile to go out an extra 10 years, because if you are lucky you will earn only four-tenths of a percentage point in incremental yield. My favorite munis are those that have been refunded, meaning the issuer replaces an old batch of munis with newer ones paying lower coupons. Cash from the newer bonds is invested in Treasurys deposited into an escrow account. When the first bonds mature (or can be called), the Treasurys are cashed in and used to pay off those bonds.

Since interest rates are going up, we are not seeing refundings anymore, but there are ample numbers of such bonds refunded a couple of years back that are available in the secondary market. If an issuer defaults, the Treasurys in the escrow account will make investors whole. This is like buying a tax-free Treasury. When buying a refunded muni, make certain you know when the old bonds can be called. Find out what the yield is to the various call dates. Also consider the possibility that, if interest rates rise, the bond will not be called, and you will be stuck with it for longer than you expected.

As with other investments, diversity is important here. Buy revenue, general obligation, special tax and sales tax obligations. And also diversify your secondary source of repayment. That is, buy bonds insured by Ambac, FSA, FGIC and MBIA, and do not forget escrowed issues. Shy away from the smaller municipal insurers. They are not as well capitalized.

TRUST ME! BLIND POOLS MAKE A COMEBACK

Steve Wozniak has bounced around without much success since parting ways with Steve Jobs after the two founded Apple Computer. So he was intrigued when he got a call last year from Gilbert Amelio, whom Jobs replaced after his return to Apple. A stock underwriter, Amelio said, wanted Wozniak and Amelio to put their names on an investment deal. The two men agreed to become officers of a shell company with no operations, called Acquicor Technology. In March Acquicor raised $173 million in a blank-check initial public offering – meaning investors gave management money for the purpose of making some unknown, future investment in a business. Once a business is acquired, Wozniak, Amelio and four other founders will own 19% of the resulting company, potentially worth $33 million, though they have only put up $2 million. “We stumbled into this. It’s easy and it’s quick,” Wozniak says.

Easy for them to make money, that is. Blank check offerings, a throwback to the “blind pools” of the 1980s, are proliferating. Since 2003, 51 have swallowed $4 billion of the public’s money, and another 19 are in preparation, according to Dealogic. The blind pools of a generation ago did not do much to enhance the reputation of the securities industry, since a fair number accomplished nothing but the enrichment of promoters (like Robert Brennan of First Jersey Securities), who got their fees irrespective of whether any legitimate businesses were acquired with the proceeds. The latest resurrection offers more protection to investors: The issuers of stock agree to keep most of what is raised in interest-bearing escrow and return the money if no deals are done within 18 months. Also, shareholders get to approve specific acquisitions. These days big Wall Street names like Citigroup, Merrill Lynch and Deutsche Bank are adding a bit of gloss by underwriting the pools.

An absence of fraud, however, does not by itself make a blind pool into a smart investment. Once the money is put into a real business, the public investors lose 25% or more of the value of their stake to insiders and underwriters. Only six of the blank checks have bought businesses so far. Already the National Association of Securities Dealers is inquiring into the activities of New York’s EarlyBirdCapital, which has underwritten more than half the recent blind pools, as well as San Francisco’s ThinkEquity Partners, which did the Acquicor deal. The chief executive of EarlyBird, David Nussbaum, has a bit of unhappy history with these vehicles. Now his firm is again drawing regulatory scrutiny, for undisclosed reasons.

Fortress America, a homeland security blank check started by former congressman and NBA player C. Thomas McMillen, raised $42 million last July after only a three-week road show. McMillen says Fortress America is a vehicle to do what he calls private-to-public arbitrage. A business might be worth only six times EBITDA when private but 10 times EBITDA as a public company. Think of that – a magical increase in the value of business assets.

THE BEST AND WORST PUBLIC COMPANY BOSSES

Next to the weather, everyone likes to complain about the huge sums America’s CEOs are raking in. The complainers have a point, of course. But we do not begrudge big pay packages – if the chief is delivering returns to shareholders. In our annual performance-versus-pay scorecard, we identify bosses whose companies have beaten the market and their peers – and those who have failed to produce.

Leading our list is John Bucksbaum of General Growth Properties, a real estate investment trust. Over the past six years he has been paid a modest $624,000 a year, while delivering a 37% annual return to shareholders. Give this guy a raise. At the bottom is Richard A. Manoogian, chief executive of Masco (NYSE: MAS), manufacturer of housing products like faucets, gutters and cabinets. While his stock has beaten the S&P 500 over six years, it stinks in comparison with Masco’s sector (which includes a number of big home builders). The boss has been collecting a paycheck averaging $9 million a year.

For our rankings we screened our database for executives with at least six years as chief executive and a six-year pay history. We found 189 bosses who fit the bill, and we rank them four ways. The first two, and most heavily weighted, are the annualized stock performance during the leader’s tenure and performance relative to the S&P 500 during that time. The third is the company’s stock performance (including dividends) relative to that of its industry peers over six years. The last factor is total compensation (including cashed-in options) over the past six years. Performance matters more than pay. With miserable enough results a boss can be rated a clunker even with a tiny paycheck. He should be paying the shareholders.

DOLLAR RISK TO GLOBAL ECONOMY OUTWEIGHS YUAN RISK, SAYS CHINA CENTRAL BANKER

Rather than monitoring the yuan, global financial institutions should watch the U.S. dollar, said Zhou Xiaochuan, governor of the People’s Bank of China. In an interview, Zhou said the yuan could rise at a faster pace, but that is not China’s way of economic reform. “Probably it could be a little bit faster but it is not the way of Chinese reformers to do things,” Zhou said. Chinese reforms must be “gradual” to balance competing interests and ensure that the financial sector is strong enough, Zhou said. He hinted that China could speed up the pace of appreciation in six months after a further review of the currency’s impact on the economy.

“Global trade, settlements and reserve assets are heavily reliant on a single currency,” Zhou said in remarks to the IMF. “The fund should give priority to establishing a surveillance and check-balance mechanism of the major reserve currency countries. Favorable conditions in the financial markets do not rule out the possibility of a sudden reversal in sentiment.” The lack of coordination in the G7 on monetary policy “could result in large and volatile movements of financial markets. We cannot ignore the risk of disorderly adjustments in financial markets.”

Coming a day after the Group of Seven singled out China for its inflexible foreign exchange rate, Zhou said it is up to the developed nations to use this period of strong growth to restructure their own economies to rebalance global trade and capital flows and to damp protectionism. “In particular, the developed countries, while enjoying low-cost imported goods and services, have to restructure their industrial sectors quickly to create job opportunities and export advantages to improve their competitiveness and dampen protectionism,” Zhou said in prepared remarks to the IMF’s policy-making committee. For its part, China has moved to “expand domestic demand, encourage consumption, open its markets, improve the exchange rate regime and restructure trade,” Zhou said.

China central bank advisor warns forex reserves face U.S. dollar risks.

China’s growing foreign exchange reserves, which are likely to hit $1 trillion this year, face huge risks from a possible U.S. dollar decline and China has to take urgent measures, a Chinese central bank monetary committee member said. Yu Yongding, the only non-government member of the committee and an economist with the Chinese Academy of Social Sciences, was cited by the China Business News as saying that China’s current management of the foreign exchange reserves, by investing heavily in U.S. treasuries, is neither profitable nor safe. “A large amount of China’s foreign exchange reserves is in the form of U.S. dollar assets, and any U.S. dollar depreciation or U.S. economy inflation could result in losses for China. We have to make preparations for that possibility as quickly as possible as a way to avoid such a bad scenario,” said Yu.

In addition, Yu said China’s heavy investment into U.S. dollar treasuries is actually providing cheap funds for overseas investors, thus allowing foreign investors to have enough capital to reinvest in China. “We are actually exporting capital to fulfill the saving-investment gap in the U.S., and we are sacrificing lucrative investment returns for low-yielding returns in U.S. treasury bonds,” said Yu. He acknowledged that the excessive foreign exchange reserve growth is adding pressure on the yuan to appreciate, but he added the government is reluctant to see a sharp yuan appreciation because this could hurt China’s exports sector, including that of the textile industry. “The yuan will be allowed to appreciate, but in a gradual manner,” Yu said.

Yu said the People’s Bank of China has to issue huge amounts of yuan to buy foreign exchange, and the central bank is forced to issue massive treasuries bills to soak up the excess liquidity. Otherwise, the money could flow into industrial sectors to make China’s already sizzling economy even hotter. But Yu added the current operations of the PBOC, mainly issuing treasury bills, are not sustainable because commercial banks would finally give up the low-yield central bank bills. Yu has been making similar comments on the PBOC's reserve policy since late last year.

A SOCIONOMIC VIEW OF CENTRAL-BANK CAUSALITY

Both supporters and critics of the Federal Reserve System agree that the first cause of paper money inflation and credit expansion in the U.S. since 1913 is the Fed. Conventional statements about social causality always treat the purported cause as an isolated force, as if it appeared from nowhere, with no antecedent causes of its own. Likewise, the Fed is taken as akin to the Law of Gravity, and all consequences flow therefrom.

Certainly the Fed is the primary engine of inflation via money creation and the fostering of easy credit through the banking system. But an engine and a first cause are different things. The motor of an automobile is the engine of locomotion but it is not the cause of it. Somebody built the motor in order that locomotion could occur. Likewise, people built the Fed in order that credit could be made easy. The socionomic insight provides a principle of social causation that requires an inversion of conventional statements of causality. To reverse the presumed direction of causality expressed in the first paragraph of this report, we may conclude that the proper reformulation is as follows: The Fed is not the root cause of money and credit inflation; the desire for money and credit inflation is the root cause of the Fed.

If this re-statement is true, then a socionomist should be able to find evidence of it in the record of the formal structure of social mood fluctuation, which is best manifest in the fluctuations of aggregate stock prices. As we shall see, a review of that record suggests that the Fed did not appear out of nowhere at a random time but in fact was a product of social mood forces desiring an engine of credit inflation. We come to this conclusion because in three out of four instances, central-bank formation occurred at almost exactly the same place in wave structure, i.e., in the progression of social psychology. There is little question that the Fed was a product of a certain necessary social psychology, because it came into being only after decades of political opposition to the idea of a central bank. In the 77 years following the expiration of the second Bank of the United States, promoters of central banking in the U.S. lost all of their political battles. In 1913 resistance melted away, and proponents got their central bank.

GAS, DEBT COSTS POSE A DANGER

An animated e-mail making the rounds is titled “I Can’t Afford My Gasoline”. It is pretty cute. I laughed, I cried, and then I went to fill up my SUV. If animated e-mails are any indication, the pain at the pump is being felt. When you count energy and food costs – which all but the economists do – inflation is up at an annual rate of 4.3% through March, compared with a 3.4% rate at the same time last year. Pricing pressures have indeed accelerated. And “I Can’t Afford My Debt” might be the next cartoon forwarded to your inbox. Short-term interest rates will hit 5% within the next three weeks, which means the prime rate will hit 8%. That cannot be comforting to Americans shackled to $12 trillion of debt, a record figure that has more than doubled in the last 10 years.

Perversely, the stock market has been celebrating the double whammy of oil and bonds – that is bonds as in the bond market, where prices have been falling, but it could also represent bonds as in the shackles of debt. Households might be able to shoulder one or the other, but the Federal Reserve darn sure knows they cannot bear the burden of both. “Oil and Bonds” happens to be the title of a recent Morgan Stanley chief economist Stephen Roach’s missive. The focus of the report is not just what happens when the impact of the two is played out on a global stage. I recently caught up with Mr. Roach, who has been sounding the warning longer than anyone else on Wall Street on the dangers of a world economy that depends on the U.S. consumer for its lifeblood.

Mr. Roach is not blind to the fact that, as IMF chief economist Raghuram Rajan said a few days ago, the world has “never had it so good.” The global economy is growing at a dizzying rate of 4.9%. In the same breath, Mr. Rajan warned that this same growth, propelled by exploding global trade, is threatened by the huge imbalances it is creating. The gigantic U.S. trade deficit is the No. 1 culprit. Mr. Roach echoed his concerns. “The longer we go down this path, the greater the chance for a fracture. I continue to believe the American consumer is the weak link in the global daisy chain.” Mr. Roach’s fellow economist at Morgan Stanley, Dick Berner, figures higher gas prices could shave about $60 billion, or 0.6%, off U.S. disposable income this summer alone. “At the same time, higher U.S. bond yields could unleash a negative wealth effect taking a toll on a housing market that is already moving lower,” Mr. Roach added.

As for reassurances that the housing market could land softly, a la Great Britain and Australia? Mr. Roach pointed out that the U.S. consumer contributes 10 times more to the economy than do Australian consumers, and four times more than the British. “The consequences for the world economy are a lot more significant.”

FLIRTING WITH A HOTTIE

The crude oil market is throwing off more mixed messages than a budding romance. Crude’s alluring price profile seems to be saying, “Come and get it.” But at the same time, this lovely creature seems to be whispering in our ears, “I think it’s time for you to go.” Such ambiguity rarely leads to a satisfying outcome … not in romance, and not in finance. That is why we are inclined to stay clear of the oil market for a while. Crude oil has become one very hot commodity … enticingly hot. U.S. crude oil inventories are a hefty 11% above the 5-year average for this time of year. Natural gas inventories are also ample. Nevertheless, the price of crude continues to soar and the bullish speculators continue to pile into the market. According to the CFTC’s Commitment of Traders report, the so-called large speculators hold a record-high long position in crude oil. The chart below shows who has been taking the other side of the trade. The commercial traders hold a record-high net short position in crude oil.

As we have noted in several prior columns, the “Commercials” are considered the “smart money”, based on their tendency to position themselves correctly at important inflexion points. The Commercials’ massive short position, therefore, bodes ill for the price of crude … and for all those speculators who are betting on it to go higher still. The Marketvane survey of commodity futures advisors validates the bearish implications of the Commitment of Traders report. According to Marketvane, 76% of futures advisors are bullish on crude oil. This extreme reading is very close to the two-year high reading of 84%, and raises the likelihood that the overly popular crude oil market will become somewhat less popular very soon. All of these warning signs inspire us to turn our back on this red-hot commodity. We suggest you do the same for a short while. Go ahead and flirt with this “hottie”, if you must. But we hate to see you get hurt.

SO, YOU THINK YOU HAVE ABOUT WRAPPED THINGS UP?

Has the Fed About Wrapped Things Up? This apparently is the message being telegraphed to the markets. Tuesday, April 18, San Francisco Federal Reserve Bank President (and voting FOMC member) Janet Yellen caught the markets’ and media’s fancy, declaring that she was “highly alert” to the Fed’s tightening policy “going too far.” And with Wednesday’s release of the March FOMC meeting minutes came this zinger of capricious dovishness: “Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much.” On the back of this revelation, the Dow Jones Industrial Average gained almost 200 points and the broader market surged to new record highs. Definitely not to be outdone, the CRB and Goldman Sachs Commodities indices surged to new all-time highs, crude oil jumped to a record high, while Gold surpassed $640 and silver $14 an ounce.

Ms. Yellen was interviewed Wednesday on CNBC. In response to a question on the degree of Fed concern with rising commodities prices, Ms. Yellen downplayed the risk, stating that it was a reflection of the strong global economy. She immediately noted that the Fed was carefully monitoring “inflation expectations” and, in this regard, was comforted by the narrow TIPS (Treasury Inflation Protected Securities) bond spread. With the Fed blithely fixated on the TIPS market, investors and speculators across the globe are in a frantic stampede to acquire assets for protection against, and to profit from, what they must expect will be the most powerful ongoing inflationary forces in many years. At this point not all too surprising, the Fed is content to focus on one of the very few indicators not signaling a problematic monetary backdrop.

It is crucial for the Fed and investors to recognize that TIPS spreads are today an especially poor barometer of the predominant global inflationary pressures (explaining why they are losing significant relative value to commodities and global asset markets). The principal of a TIPS investment is protected only against the loss of monetary value associated with a decline in a narrow facet of inflation – the government’s measurement of an aggregate of consumer prices. Irrespective of the myriad problems with the methodology of the government’s calculations, this period’s gross inflation (loss of purchasing power) is manifesting in surging energy, commodities, and global asset prices generally – largely outside of CPI. TIPS spreads are today an especially deceiving indictor of general monetary conditions, and it is unbecoming of the Fed to give it significant weight in policy analysis. As astute analysts appreciate, financial sector earnings reports continue to be an excellent indictor of monetary conditions.

First quarter releases certainly corroborate the message of inflating international markets: global monetary conditions remain ultra-loose. As recipients of a little slice of each monetary inflation (new Credit, equity or derivative instrument), the major financial institutions are enjoying an unprecedented credit bubble blow-off windfall. Significant portions of this bounty go directly to compensation and stock buybacks. This compensation is a not insignificant element of the enormous asset bubble-related income bonanza today feeding the U.S. bubble economy. And the massive buybacks – Citi, BofA, JPMorgan and Merrill combined to repurchased 189 million shares DURING THE QUARTER – work to bolster stock market liquidity that works to sustain the credit bubble. And, you can be sure, giant pay packages and aggressive stock buyback schemes are not indicative of managements about to become more conservative in lending or market activities.

So, you think you have about wrapped things up, do you? Surely, the Fed has taken notice of the recent backup in market yields and a 5% 10-year Treasury bond. The Fed is also likely a little unnerved by the buildup in house and condo inventories and the specter of problematic burstings of some of the more conspicuous housing bubble markets (including Washington D.C.!). And, perhaps, the Fed is willing to privately throw up its hands and admit that it’s unwilling to rein in runaway global liquidity excesses. But please do not rush to signal to over-liquefied and overly speculative markets – not to mention overzealous lenders – that the “tightening" cycle is almost over. Hopefully, FOMC members took note of the drubbing the dollar – today, and for the foreseeable future, the system’s Achilles heel, an inevitable circumstance of the nature of ongoing credit bubble excess – suffered this week. The nature of the current global credit inflation (and attendant wholesale currency degradation) has manifested into a full-fledged flight to real assets sectors such as energy, metals and real estate.

The much trumpeted “resiliency” of the U.S. economy and banking system owes almost everything to the capacity for the U.S. government and financial sector to endlessly create debt instruments readily accumulated by domestic and foreign holders. Additionally, I believe a strong case can be made today that long-term yields would be significantly higher if it were not for the perception that the Bernanke Fed will aggressively cut rates at the first indication that the U.S. economic bubble and/or global asset market bubble are beginning to falter. The blundering Fed apparently not only believes that the U.S. economy is more resilient than in the past, it presumes it now has significant leeway to cut rates and “reflate” when necessary. But the financial world is changing rapidly and radically. The dollar is methodically losing its status as a stable and reliable reserve currency. At the same time, currencies generally are losing favor to real assets as stores of value. Understandably, market participants are questioning the will and capacity for central bankers and policymakers to stabilize the unwieldy global credit system.

With faith in the prospects for the dollar and global currencies in retreat, the U.S. is in the process of losing its invaluable competitive advantage issuing top-rated liquid securities. This has huge ramifications come the next period of financial dislocation. The Fed’s intent to aggressively cut rates and incite yet another bout of lending and leveraged speculation (credit inflation) will likely be obstructed by the unwillingness of foreigners to accumulate more dollar IOUs. Our foreign creditors will demand higher rates and much tighter monetary conditions, and the Fed’s dream of wrapping things up before it gets painful faces the reality that our creditors are increasingly tired of getting hurt.

Markets are demonstrating many of the characteristics one would expect when approaching a key inflection point: heightened volatility, spectacular short-squeezes, and palpable euphoria, along with some underlying angst that the more speculative stocks are gaining the most ground. There are also indications that the “smart money” is increasingly nervous and beginning to lighten up on some positions (including our currency). Yet it is amazing how many have completely bought into the notion of a golden age of permanent global prosperity, that the omnipotent Fed has everything completely under control, and that surging energy and commodity prices are but a sign of how wonderfully healthy the global economy is these days (ignoring that we are instead immersed in history’s greatest credit and asset bubbles). One should now be on guard for that exacting oscillation between “gee, things are just marvelously splendid” and the “oh my god, the end is near” – the unpredictable greed and fear seesaw – that will embroil global markets in a period of uncertainty and volatility.

INFLATION FEARS RETURN TO WALL STREET

Home sales are improving and consumer confidence is the best it is been in four years, but Wall Street did not celebrate. Stock prices fell and interest rates on bonds took their biggest jump since last July as traders looked at the fine print in the two reports and did not like what they saw. While sales of existing homes grew after three, down months in a row, the number of people putting their houses up for sale also grew. The bottom line is that the backlog of unsold houses is growing. At the rate they are selling now, it would take almost five months to move all the homes that are on the market – and that is if no new homes are listed for sale.

The consumer confidence report from the Conference Board was deemed worrisome for other reasons – exhuberent consumers threaten to fuel inflation. The closely-watched consumer sentiment gauge climbed to its highest level in four years, with an unexpected jump last month. The inflation threat implicit in that report immediately pushed up interest rates. The 10-year government bond, which serves as the benchmark for other bonds and loans jumped almost one-tenth of a percentage point to 5.07% – its highest in almost four years. Upward pressure on interest rates is so strong that several economists predicted the Federal Reserve will crank up rates to 5.5% – which is a quarter of a point higher than most experts had been predicting. The stock market responded by knocking down prices – starting with utility companies and other industries that are considered sensitive to higher interest rates.

BANK OF CANADA RAISES RATE 6TH STRAIGHT TIME, “MAY” ACT AGAIN

The Bank of Canada raised its main interest rate for the 6th straight time, and repeated it may boost rates again. Bond yields surged as investors bet on another increase next month. The quarter-point increase today brings the target rate for overnight loans between commercial banks to 4%, the highest since September 2001, and narrows the gap with the 4.75% U.S. federal funds rate. All 30 economists polled by Bloomberg News predicted the move. “Some modest further increase in the policy interest rate may be required to keep aggregate supply and demand in balance and inflation on target,” the central bank said in a statement from Ottawa. Canada’s dollar rose to 88.36 U.S. cents, up from 87.92 U.S. cents the day before. The currency reached 88.49 cents on March 2, the strongest since November 21, 1991.

BE CAREFUL WHAT YOU WISH FOR

The U.S. stock market has held up remarkably well in recent weeks, despite surging commodities and precious metals prices, bond yields hitting new 4-year highs, a shaky dollar, mixed economic data, and a downward spiral in presidential approval ratings. Not to mention a less-than-stellar outlook from corporate America, just as another earnings season gets under way. For the optimists, that suggests the market is still in a bullish, climb-the-wall-of-worry mode. Which means, in their eyes at least, that share prices will invariably move higher, signaling that things remain on a positive track, despite current developments.

Many seasoned observers, meanwhile, are scratching their heads, wondering just what they are missing. Especially in light of the fact that technical and seasonal factors remain unsupportive at best, the U.S. real estate bubble seems to be bursting, and the 3-year old rally is looking very tired. Perhaps the bulls are right, and the pessimists need to wake up to a new reality. One where they can move past their fears and join with those in the majority who are betting on an inevitable further rise in share prices that will be a precursor of still more good times to come. Then again, maybe the rose-colored-glasses set are wrong. Maybe what we are seeing now, in fact, are the early signs of something altogether different from what we have experienced before. The kind of thing that sclerotic, poorly-led, overleveraged, and often-corrupt “lesser-developed” nations have gone through – over and over again.

In other words, an economic and financial crisis, where the home currency plunges, interest rates surge into the double-digits, and the cost of energy, basic commodities, and a wide range of goods and services goes through the roof. And, curiously enough, where share prices – especially those of export-sensitive companies – often soar to dizzying heights, albeit in nominal terms, as beleaguered investors seek some sort of shelter from the ravages of inflation and foreign-exchange-related chaos. A situation that is largely familiar to those who live in places like Brazil, Argentina, Turkey and Zimbabwe. But not – up until now, at least – those who are from America.

Indeed, rather than being viewed as a cause for optimism and evidence of future economic vitality, rising stock prices in circumstances where the current account deficit is 7% of GDP, where total debt is three times output, and where there is xenophobic talk of tariffs and walled borders, may, in fact, represent something else. Namely, the desperation of those who fear being left impoverished by the economic bunker-buster that such imbalances have inflicted on similarly-situated nations in the past. In other words, those betting that U.S. equity prices will move considerably higher in the period ahead should be careful what they wish for.

MORE INVESTORS TAKE A SHINE TO BASE METALS

If you want to invest in soaring metals prices, ask yourself a simple question: Do you feel lucky? Analysts fret that the rise in copper, zinc and other metals is overdone, and that the chart of copper prices looks suspiciously like a chart of Internet stocks from those bubbly days of 1999. “Yes, this is a speculative craze,” says Richard Asplund, chief economist for the Commodity Research Bureau. “But that doesn’t mean it can’t keep going.”

Huge demand from China and other countries has pushed up prices for base metals: copper, zinc, aluminum, lead. Supply, meantime, has not kept up. You cannot just open a new lead mine. It can take years to open a mine once a productive lode has been found. That has not exactly been a secret on Wall Street, and some analysts are blaming commodities speculators for pushing up prices farther and faster than they would normally go. That could mean that much of the surge in base-metal prices is over, for now. If you are steeled for investing in metals, though, you have several options, none of which involve storing ingots in the basement.

STRAPPED INSURERS FLEE COASTAL AREAS

With the 2006 hurricane season starting in just five weeks, many home insurers from Texas to Florida to New York are canceling policies along the coast or refusing to sell new ones out of fear of another catastrophic storm. In the widest insurance retreat from coastal property since Hurricane Andrew slammed Florida in 1992, insurers as far north as Long Island, N.Y., and Cape Cod, Massachusetts, are shedding coastal homeowners policies to reduce their exposure. In Florida alone, insurers that are undercapitalized or fearful of losses have notified the state of plans to cancel more than 500,000 homeowners policies. With $2 trillion each in coastal property, Florida and New York lead the USA in coastal exposure, followed by Texas and Massachusetts.

Companies including Allstate, the USA’s second-biggest property insurer, say forecasts of more major hurricanes combined with soaring coastal real estate development have created unacceptable risk in some areas. Last year’s hurricanes cost insurers a record $60 billion in claims payouts. Now Allstate, which paid out a record $5 billion in hurricane claims last year, is canceling 95,000 policies in Florida and 28,000 in New York. “We’re examining our risk up and down the East Coast and Gulf Coast, given the changes that have occurred,” says Allstate spokesman Mike Trevino. It is not the only one. Insurers “are paring back their coastal exposure everywhere,” says Robert Hartwig, the Insurance Information Institute’s economist. That study found that cost prevented 41.1% of uninsured adults from seeing a doctor, compared to 9.2% of individuals with coverage.

More working Americans go without health-care coverage.

The percentage of working-age Americans with moderate to middle incomes who lacked health insurance for at least part of the year rose to 41% in 2005, a dramatic increase from the 28% in 2001 without coverage, a study found. Moreover, more than half of the uninsured adults said they were having problems paying their medical bills or had incurred debt to cover their expenses, according to a report by the Commonwealth Fund, a private health care policy foundation. The study of 4,350 adults also found that people without insurance were more likely to forgo recommended health screenings such as mammograms than those with coverage, and were less likely to have a regular doctor than their insured counterparts.

The report paints a bleak health care picture for the uninsured. “It represents an explosion of the insurance crisis into those with moderate incomes,” said Sara Collins, a senior program officer at the Commonwealth Fund. Collins said the study also illustrates how more employers are dropping coverage or are offering plans that are just too expensive for many people. About 45.8 million Americans did not have health insurance in 2004, according to the U.S. Census Bureau. The percentage of individuals earning less than $20,000 a year without insurance rose to 53%, up from 49% in 2001. Overall, the percentage of people without insurance rose to 28% in 2005 from 24% in 2001. The study also found that 59% of uninsured with chronic conditions such as asthma or diabetes either skipped a dose of their medicine or went without it because it was too expensive. One-third of those in that group visited an emergency room or stayed in a hospital overnight or did both, compared to 15% of their insured counterparts.

Collins said those statistics are significant because giving up medicines typically leads to more expensive health problems later. Treating people in expensive settings such emergency rooms places a financial burden on the health care system. HCA hoisted a red flag this week, when the the nation’s largest for-profit hospital operator said its earnings fell 8.5% in the first quarter after a 13% increase in uninsured admissions cut into revenue gains. The company said its provision for “doubtful accounts” rose to $852 million from $683 million a year earlier. The Commonwealth Fund’s study was bolstered by analysis of government data funded and released by the Robert Wood Johnson Foundation, a private organization that provides health care grants.

SILVER: CALLING THE FREEFALLING

Before you say it. … Before you even think it. … We want to set the record straight and offer this observation: You are Barclay’s up the wrong tree. In case you have not heard by now, silver prices have been beaten and battered like a box of Betty Crocker cake mix in the past week, after all sell broke loose on April 20. On that date, the white metal plunged 19% in the biggest one-day decline in over two decades. And according to the fundamental “experts”, the number one reason for the freefall was “continuing uncertainty about when the Securities and Exchange Commission will declare the registration of Barclay’s silver Exchange Traded Fund effective.” (Globe And Mail, California) “ETA” anxiety “over the ETF,” begins an April 24 Associated Press, “causes prices to slump as the metal continues to grind its way through the US regulatory process.”

WDTS – as in, “We Don’t Think So”. The fact is, Barclay’s investment bank applied to list the planned iShares Silver Trust on the American Stock Exchange in June 2005. It then took 40 weeks for the SEC to actually approve the listing in March 2006. Yet in all of that time, silver prices had no problem going up from their $6.85 low to a 23-year high of over $13. Now, we are expected to believe that one month of waiting was long enough to put off the patience of investors? Not to mention the fact, as pointed out by the earlier Globe & Mail article, that getting an ETF up and running has always gathered moss. Investors have no reason to expect silver to get a quick pass.

Which begs the question: why has the white metal been seeing red? Well, in the April 18 Elliott Wave Theorist – published 2 days BEFORE the recent collapse – Bob Prechter presented three eye-popping charts of silver containing these compelling details: (1) Silver’s rise from 2001 to another long-standing uptrend in the market’s recent past. Side by side, the two rallies are “cousins, identical” in Fibonacci proportion and Elliott Wave structure. At this similar juncture, in that place in time, silver reached a significant top that saw prices plunge downward. (2) The major bottom and top trendlines of the last five years showing prices veering dangerously close to the next channel: marked directly below $15. (3) Two time-honored cycle patterns that place silver right in line with an imminent peak, confirming that a reversal was due at any moment.

17% down from its April 20 high, the question remains. Is the bull market in silver taking a much-needed breather?

THE REAL-ESTATE RACKET

In 1945, $5,000 would buy you a pretty nice house in most parts of the USA. According to the Inflation Calculator, that sum would equate to $52,500 60 years later, accounting just for the government’s destruction of the value of the U.S. Dollar. If someone has for sale a nice, well-maintained 3-bedroom ranch for $52k, please let me know. More likely, today it would go for around $300,000. Why the difference?

Over that period, that dollar-dilution or inflation rate has been almost exactly 4% a year. But if my estimate of 300/5 is correct, that rate of house-price increase is 7.06% a year, a real-money appreciation rate of over 3% a year – a rate that compares well with the real after-tax return on a bank savings account, yet you get to live in the investment! Why should a house grow in real value by 3% while most peoples’ second largest expense – the car – loses its value by perhaps 20% a year? Both become more expensive to maintain with age, although the car does fall apart a lot faster than the house. Both face competition from more elegant, fashionable and better-constructed modern equivalents. I smell government intervention. In a free market, such a thing would be very strange.

Location is a big factor in real estate, but we are talking averages here, so it is a stretch to claim that that alone would boost overall values by a real 3% a year. And I am not sure that the relative reputations of government schools can raise the price of all homes, but it sure does skew them. In a free market the supply of mortgage money would, rationally, be no more elastic than a bar of gold and therefore mortgages would be harder to get, and therefore home prices would be lower. Tax deductions are a big factor in the cost calculations. For the purpose of acquiring votes, Pols have since forever “allowed” home buyers to keep some of their own money provided they spend it to service a loan from a bank they license, and that is quite a big deal, especially at the start of the loan’s life. The Pols were not as generous as those voters may suppose. This deduction gives a powerful incentive to buy rather than to rent, and once the resident has a stake in the property, the Pol has hooked him into the income tax system. Should he ever resist it he will swiftly realize he is firmly anchored by his real-estate, for that can be forfeit if he declines to pay. Lastly let us not forget zoning. Zoning artificially restricts the housing industry, by political power – and it is by no means unpopular! Land use is restricted and manipulated as part of the political instead of the market arena. The price of building land is thereby boosted, and with it the price of housing is elevated way above its free-market level.

And the devil of it all is that homeowners are happy with the whole scheme! They are sitting in a gold mine! They are bombarded with offers of low-cost home-equity loans with which to buy Escalades and world cruises and every luxury modern man might desire. Can all this be anything less than the American Dream, fulfilled before our eyes? Well, yes it can. That dream is about universally available ownership, of home and other property; but true ownership does not actually exist, nor does fulfillment. And the cost of the illusion that has been fulfilled is that property pseudo-owners are locked up tightly with the entire political system: taxes local and national, and all the evil they purchase; the funny-money, government-controlled banking cartel; and even schools with which to indoctrinate yet another generation. And that is the American Nightmare.

Bankers, Bubbles and Fools

Central Bankers eventually make fools out of most investors, especially real estate investors. This is because they get to create capital (credit money) where none existed before (out of thin air). The infusion of credit money into an economy sends false signals to investors as to the time preferences of consumers and savers alike. This leads to the “boom-bust cycle” as well as making people save less and buy more (typically on credit). First credit expansion leads to an asset price bubble, then the market punishes the investors left holding the bag when the inevitable correction comes. The real estate market today is a case study in this type phenomenon.

The tight rein that producers typically exercise over their hard-earned savings is significantly more restrictive than the loose availability of credit money controlled by people who do not care (much less understand) where the funds came from. Consumers and investors, always on the lookout for a free lunch, typically line up to get a piece of this action. The structural balance of an economy is altered as capital resources are misallocated from production-oriented uses to consumer-oriented uses. This process undermines future potential earnings in favor of present consumption. Traditional investment criteria then are labeled “outmoded” and a New Era of Perpetual Prosperity is trumpeted such that some investments even become “fool-proof” or “can’t go wrong” opportunities. Like, say, condos in Florida.

The history of real estate booms and busts are fairly well known, yet in every boom the buyers come to truly believe that real estate prices “will never go down.” The bust is always blamed on “greedy speculators” and never on the “greedy bankers” who sent the false signals that fooled the speculators. What is seen are the actions of speculators while what is not seen are the actions of the enabling, nay, the encouraging credit money creators (state-sanctioned counterfeiters). To add insult to injury, the bankers will foreclose on real property for repayment of funds created out of thin air and then complain that they had to “write off” a portion of the loan. When this begins to happen more frequently, prices will come down. It appears to be happening now.

Usually a lot of stupid decisions are made when banks start giving away practically free money to people who do not have a clue what to do with it. People buy homes that they cannot really afford because they “qualified” for a monthly payment without any concern for the price. Novice investors come out of the woodwork buying “investment” homes like they were cars. This tendency increases as prices continue to escalate and a comfort level becomes predominate that the “market will automatically increase and erase any mistakes.” The “greater fool theory of investment” kicks in. When sales prices (or stock prices) cannot be justified by net operating income (or profit), then the market has been distorted beyond sanity. When the prices paid for investments are based on fantasies about the future instead of the demonstrated ability to produce income, then investors have been fooled. As this becomes apparent to the masses, then pop goes the bubble.

The sign of the end times is the red hot condo market. Condos are always the last product to get hot and the first to crash. The smart play right now is to sell your house, rent a nice place and put your proceeds into commodities such as oil, gold and silver. Within two to three years you will be able to buy twice the house you had for a fraction of the price you sold your previous one for (sell high and then buy low). I doubt that bankers will ever learn even after the coming debacle that will make the Savings and Loan Crisis of the late 1980’s look like a cakewalk. Just don’t let bankers and bubbles make a fool out of you in the process.

Not so stupid anymore.

“Few spending choices in life are as smart as buying a home.”

The above sentence was the lead in a Chicago Tribune new story last week. Not: “Few spending choices in life are as smart as buying something, anything, for your wife on your anniversary.” Or even, “Few spending choices in life are as smart as buying a home with a garage apartment for your mother-in-law.” No, the lead was brazen and to the point: The smartest thing a human being can do aside from installing a Tom Cruise and Katie Holmes news filter for the television to is buy a house. By implication, the dumbest thing you can do is rent, the only financial move more boneheaded than not listening to Jim Cramer.

The purpose of the reporter’s bold lead was to introduce a book titled The Automatic Millionaire Homeowner: A Powerful Plan to Finish Rich in Real Estate. The book is by David Boch, author of several similarly upbeat books on various topics, all of which ensure that the reader will “Finish Rich”. As his latest title suggests, Mr. Bach is a big fan of homeownership. He even tells the reporter, “People work their whole lives and save, save, save but buying a home and living in it will make them more money than anything else they do.” Either Mr. Bach has a lot a faith in real estate or very little faith in his readers’ investment acumen. He certainly has no faith in the slack-jawed renter, a person who rather would throw money down a toilet that he does not even own than take out a mortgage and start making money automatically.

But is the buy vs. rent decision really so clear cut? Not according to Dinkytown’s Rent vs. Buy calculator. This spiffy program incorporates mortgage payments, insurance, property taxes and even maintenance expenses. Here, the true cost of home ownership can be compared to the cost of renting. Dinkytown even accounts for money that the renter saves by making a smaller monthly payment and by not parting with a big downpayment. With the variables in place, Dinytown churns out a “break-even” period – the number of years you would have to live in a home before selling it and wind up spending the same of amount of money that you would have spent renting.

After playing with the calculator for a while, say long enough for darkness to preempt any lawn mowing, it is easy to see that the key to making the “buy” decision a slam dunk is the little slot for the home appreciation rate. A double digit appreciation rate can cover a lot of real estate commissions, property taxes and insurance. Just like Mr. Bach says, it makes you rich automatically.

But a slower appreciation rates makes the rent vs. buy decision a closer call. By comparing $1,000 a month rent to a $200,000 house that appreciates only 3% per year (with a 6.5% mortgage rate, a downpayment of about $15,500 and 3% property taxes), the breakeven period is 16 years. And that is with maintenance expenses of just $1,200 annually. A true amortization of the cost of new appliances, heating and a/c maintenance, plumber visits, and the latest power tools from Home Depot would likely put that figure much higher. In fact, if that maintenance figure doubles to $2,400 a year, the “buy” decision never breaks even during the life of the mortgage. In other words, the renter would be better off staying in the apartment than trying to get rich automatically. At least until the mother-in-law moves in.

INVESTORS FORGIVING OF RUSSIA? OR FORGETFUL?

“Investing in Russia [is] like entering a rich gold field studded with land mines: laced with veins of rich treasure, and riddled with pockets of pure poison.” ~~ Mark Mobius, Passport to Profits

In my more optimistic moods, I look out over the world and think about places like China and India. I look at the bubbling-up emerging markets in Africa, the Middle East, Eastern Europe and South America. And I think of all the potential in places like that. I think of all the economic growth ahead of them, all the untapped and budding investment opportunities. Then I read what investors were thinking 50 years ago. And I get pessimistic, because they were thinking the same thoughts. Indeed, their comments still retain their freshness today, decades later. That shows you, among other things, how progress is hard fought and far from certain. Worse, the same moves tend to replay over and over. And always with a bad ending for investors.

It was only a couple of years ago, 2004, when investors lost their shirts in Yukos – the biggest oil company in Russia. The Russian government seized Yukos for back taxes totaling more than $30 billion. The move was widely regarded as a political act, checking the ambitions of its billionaire CEO. Investors howled, but at the end of the day, foreign investors lost over $6 billion. You would think after that experience, any mention of Russia would be like (as P.G. Wodehouse once wrote) trying to cheer up Napoleon by talking about winter sports in Moscow. You would think any mention of Russia would hurl investors into alternating fits of rage and despair. Not so. Investors are forgiving or forgetful or both.

Now there is a new Russian belle capturing moneymaking imaginations. It is state-owned oil giant OAO Rosneft. What makes this all the worse is that this, in part, is the old Yukos. Rosneft is the company the government folded Yukos into. In other words, it stole this asset from investors and is now going to turn around and sell it back in an IPO. The Rosneft IPO could be the biggest in history – at more than $20 billion. This for a 49% stake in Rosneft, while the government retains a controlling 51% stake. Vladimir Putin as your partner? Not me. Incredibly, investors are lining up to get a piece.

Admittedly, the Russian stock market has been among the best performing in the world of late – over the last 12 months, the RTS index (a common benchmark of Russian stocks) has risen 137%. I came close to recommending a Russian company – Tatneft, a Russian oil and gas company – last year. Tatneft was actually an NTAV stock a year ago (trading for less than its net tangible asset value). It closed on April 1, 2005, at a price of $34.30. Yesterday, it was $120.82. Yet I do not regret the decision to pass over Tatneft. For one thing, the financial statements available were old and the disclosures were terrible. It was hard to know what you owned if you bought Tatneft. Over time, passing on companies like this will save you a lot of money – because your winners will not compensate for the inevitable disasters. I did not buy technology stocks in 1998, either. They went up in 1999 and finally flared to their glorious peak in 2000 before getting seared like the wings of Icarus and tumbling back to earth. Russia is a snake pit, where you can lose your entire investment seemingly overnight because of government confiscation and corruption.

Why the enduring attraction to Russia? Russia’s magnetism can be summed up in two words: “cheap assets”. Russia is still the largest country in the world, in terms of land area. And buried amidst all that are rich veins of natural resources – Russia is a veritable storehouse of Mother Nature’s useful goodies. I like Jim Rogers’s line in his most recent book, Hot Commodities: “The bright spot in the world’s oil picture, according to most analysts, is Russia – additional proof, in my opinion, of how bad things really are.” To me, investors lining up for a shot at an old dilapidated outfit like Rosneft – with all its shady aspects – is a sign of a market that is getting up there in the thin air of speculation. Investors have more money than they have good ideas. Someone is bound to lose.

Hint: It will not be the Kremlin.

DIVERGENCE OF PLACE: MONEY AND MOUTH

Let us look at the money and the mouth to see where the money is headed and where the mouth is loudest. Congress and pundit pronouncements center on the strength of theU.S.u economy and the sunshiny future for America. But investment flows, public, private and international, suggest something very different. No example is clearer than the two recently unveiled massive preemptive actions undertaken ahead of the coming wave of insolvency. This is an issue of global importance as monetary expansion slows in the U.S., Australia, Europe and Japan – thus, globally. As the cheap money tide recedes you will be shocked to see many have been swimming without bathing suits. On the eve of our 16th quarter point Fed hike it is hard to argue the direction of rate change. Less cash for rolling over debt and higher carry costs portend trouble. The responses?

The World Bank announced today that the Multilateral Debt Relief Initiative has been approved, clearing the way for cancellation of International Development Association (IDA) debt to some of the world’s poorest countries. Starting on July 1, 2006, IDA is expected to provide more than US$37 billion in debt relief over 40 years. Voting on the initiative remains open until April 28. I will reserve for another day the issues with this trumpeted generosity from the World Bank. Today I would like to juxtapose this to the generosity being offered to the debt burdened American public that buys more from Wal-Mart and Exxon every year than the GDP of Sub-Saharan Africa times two: In the view of Nancy Rapoport, dean of the University of Houston Law Center and a bankruptcy expert…. “Fewer people are going to be able to get out of debt under this new bankruptcy law,” she says. (Source here.) What the World Bank’s and the law school dean’s comments make clear is that debt forgiveness is in transition. What a difference a year makes. One door is opening and another closing.

I would argue that there is symbolic value in these two decisions. Taken as rational and cut from the same cloth – easily argued but not without possible merit – these laws represent global economic shifts rather nicely. As S&P 500 profits de-link from U.S. macroeconomic performance, and offshore revenue and profit rise toward and above U.S. revenue and profit, changes are in the offing. Different needs and strategies for the U.S. and the rest of the world emerge and are passed into law and policy.

The passages of the World Bank Multilateral Debt Forgiveness Initiative and the Bankruptcy Abuse Prevention Act of 2005 signal divergence between the directions of money and the running of mouths. The future for American consumers involves the quest to repay debt. The future for offshore areas may involve the extension of debt to facilitate spending. The inevitable, approaching and long overdue reduction in U.S. debt-fueled consumption will be a huge challenge to the global economy. The extension of debt to other areas will be an essential component of weathering the storm. Producers the world over will face decline, default and trouble in their top market. Credit provision to other buyers will be essential. Meanwhile, collecting on the old debt granted to American households will become paramount. This low road is well traveled by less developed countries. It may well be clogged with refugees from over-leveraged American consumers. How else would one make sense of these two major recent credit developments?

Mouths speak of America’s bright future, the money is betting on future growth offshore. Hedge funds, private equity and mutual fund flows increasingly head offshore for enhanced growth opportunity. Off-shoring and new foreign capacity built by U.S.-based multinationals proceed apace. Pundits promise opportunity but the legal structure morphs for a confrontation over massive debts. Money and mouth are not in alignment. Which way are you betting?

GLOBAL FINANCIAL INSTITUTIONS WOEFULLY UNPREPARED FOR WHAT COULD BE AHEAD

The world has avoided a major financial crisis for more than seven years. This is due more to luck than design. With oil prices surging, central banks leaning against the upside of the liquidity cycle, and global imbalances mounting, that luck may now be running out.

The four institutional pillars of the global financial and economic architecture – the IMF, the World Bank, the WTO, and the OECD – have lost their way. These huge bureaucracies, who collectively employ about 16,000 individuals with administrative expenses that easily total around $2.5 billion per annum, are hopelessly out of step with the new character and unprecedented hyper-speed of today’s IT-enabled globalization. Globalization is occurring at such lightning speed that the world’s antiquated policy architecture will, I fear, be incapable of dealing with the inevitable next strain of global problems. The financial crisis of 1997-98, with a currency contagion that spread around the world like wildfire, was but one example of an unprepared world. Unfortunately, as evidenced by the extraordinary compression of emerging market debt spreads, those lessons are now all but forgotten. Meanwhile, oil prices are at levels that were unimaginable just a few years ago, and one nation is running a current account deficit that hit an annual rate of $900 billion in the fourth quarter of 2005 – a shortfall that is actually larger than the GDP of all but nine nations in the world today.

Ever-myopic financial markets play the momentum game more than ever, but policy makers always fight the last battle. Maybe a new global architecture will suffer the same fate. But rest assured, the current one does not have a clue. With oil prices surging, the liquidity cycle turning, and global imbalances mounting, the risks of a disruptive adjustment to the global economy are rising. No one is in charge to prevent what could be a dire outcome – or to suggest how to pick up the pieces.

Rebalancing legitimized!

At long last, global rebalancing is center stage in the world policy theater. That is an important conclusion to take out of the results of April’s power councils – the G-7 meeting as well as the annual gathering of the full complement of some 184 members of the IMF. This is good news for an unbalanced world. It is not, however, the silver bullet for dealing with a very tough problem. The road to global rebalancing is likely to be long and arduous, and the new approach still has some problems. But as someone who has led the charge in worrying about the pitfalls of an unbalanced world, I am delighted that the Wise Men have finally seen the light.

Policy makers have always communicated in strange and almost ritualistic ways. All caveats aside, there can be no mistaking a very important message sent on 21 April by the G-7 finance ministers and central bank governors after their recent meeting in Washington: Global imbalances have now been officially anointed as a major concern by the stewards of globalization. Not only were they given prominent mention in the official G-7 communiqué, but they were also the focus of a rare “annex” to the statement. In G-7 circles, that is about as loud as an alarm ever gets.

The annex lays out three basic principles that shape the G-7’s approach to global rebalancing: One, it is a shared responsibility – policy jargon for saying “no” to scapegoatting and pinning the blame unfairly on a nation like China. Two, rebalancing requires, first and foremost, a realignment of global saving and investment flows, thus identifying disparities between current account surpluses and deficits as the major source of global instability and clearly putting the U.S. at the top of the problem list. Three, the G-7 annex stresses that rebalancing strategies must be designed with an aim toward maximizing sustained economic growth –in my view the weakest element of the G-7’s proposed strategy as its emphasis may obscure the heavy lifting that will ultimately be required of an effective global rebalancing strategy.

This latter point deserves elaboration. Economic growth has become the elixir of political angst – the perceived remedy for all that ails a nation’s economy. Pro-growth politicians win elections (and re-elections) while the anti-growth set is doomed to a quick oblivion. Growth has become such an important part of the policy rubric that it has spawned its own theoretical framework – supply-side economics. A broad array of pro-growth policies – especially tax cutting – has come into fashion as the rising tide that lifts all boats. Supply-siders believe that self-financing budget deficits, narrowing income inequalities, and surging productivity are all part of the growth miracle. Never mind America’s gaping budget deficit and the recent widening of disparities in the U.S. income distribution – the pro-growth principles of supply-side economics have taken on almost a religious fervor in Washington and on Wall Street.

America’s current account deficit – the world’s most serious imbalance – is, first and foremost, an excess consumption problem. I make that statement on the basis of three facts. (1) Tradable goods imports by the U.S. are currently 89% larger than its exports of tradables. That means exports now have to grow twice as rapidly as imports just to hold the U.S. trade deficit constant. (2) Tradable goods imports now account for a record 37% of U.S. expenditures on goods. The faster U.S. domestic demand grows, the faster imports will grow, implying that faster growth exacerbates the U.S. trade deficit and global imbalances. (3) U.S. consumption is currently holding at a record 71% of U.S. GDP – a huge breakout from the 25-year average of 67% that prevailed over the 1975 to 2000 period.

These three points imply that it will be extremely difficult for the U.S. to accept its role in the shared responsibility of global rebalancing without coming to grips with its excess consumption problem. And that could well spell slower economic growth in America. Such a conclusion not only flies in the face of the pro-growth principles of the G-7’s newly-articulated rebalancing strategy, but it is also very much at odds with the supply-side policy biases that currently dominate the Washington consensus.

As an unabashed champion of the imperatives of global rebalancing for longer than I care to remember, I believe the 21 April communiqué was something close to an historical breakthrough. In my view, it is unconscionable that the stewards of globalization could have allowed the world’s imbalances to reach such dangerous proportions. There is one element of this new rebalancing agenda that continues to gnaw at me – the insistence on Chinese currency flexibility as an important element of the global adjustment process. I definitely believe that China has an important role to play in global rebalancing. I also think that China accepts its responsibility to do just that. But large currency movements – especially for a poor country with a still shaky financial system – borrow a page right out of the script of the “yen blunder” that Japan acceded to in the 1980s. Global rebalancing needs enlightened policies from China, not a replay of the painful mistakes that led Japan astray 20 years ago.

Globalization is a complex and challenging transformation of the world order. The stewards of globalization have been asleep at the switch – allowing unprecedented imbalances of trade and capital flows to mount. The G-7 and the IMF have finally come together to recognize the dangers of these problems. In doing so, they have rejected (thankfully) the “new paradigm” views of those who argue that imbalances are a perfectly sustainable attribute of a new world order. Notwithstanding my quibbles, this is excellent news for an unbalanced world. If the G-7 strategy works, it is also good news for financial markets. In particular, a successful rebalancing should lower the risks of a global hard landing – tempering the fears of a crash in the U.S. dollar and/or a related sharp increase in real long-term U.S. interest rates. So far, the hope is all on paper – buried in the rhetoric of a communiqué. Now it is time for the heavy lifting.

WILL RATES TRIP UP EMERGING MARKETS? MAYBE NOT, SAYS ANALYST

Just like corporations, emerging economies have used low interest rates to clean up their countries’ balance sheets. But as global rates rise, the risk increases that even these strengthened economies – and their stock markets – will stumble. “If confidence were to falter for any reason, the subsequent venting of the pressures stemming from the massive U.S. external deficit may be swift and severe – with important spillover effects on other markets,” Morgan Stanley economist Stephen Roach said.

Bank Credit Analyst, a Canadian research firm, explained, “The argument is that in the past, higher borrowing costs would send developing markets into a vicious cycle of capital outflows, weak currencies and rising interest rates, which would cause extensive damage to their economies.” However, BCA said, that old reasoning dismisses the fact that “domestic interest rates have become less sensitive to global monetary tightening thanks to reduced foreign indebtedness and increased national savings.” Moreover, a slowdown in the U.S. necessarily implies that interest rates here will decline, thanks to the Fed, mitigating the rate risk on emerging nations.

BCA goes a step further in defusing Mr. Roach’s concerns: The fact that global imbalances exist dictates that they can persist. Though other countries’ surpluses do not reduce the ultimate risk to the U.S. economy – its own current account deficit – they do help explain one source of our deficit’s support. Many of these dollars find their way into our U.S. Treasury market, which in turn keeps our borrowing costs low. “It is not in the interest of either the U.S. or the rest of the world to rapidly undertake the adjustments that would be required to reduce global imbalances,” BCA said, “suggesting they can be sustained for the next few years without threatening the global economy or financial markets.”

Of course, all this good will goes out the window if inflation rises meaningfully and the Fed is forced to combat pricing pressures. Interest rates are about as high as the U.S. economy can bear. If rates keep rising, they will derail the teetering U.S. consumer. Once again, BCA is sanguine. “Imports as a share of world GDP have risen by 10 percentage points in the past decade, to nearly 30%. The relentless competition from imports is dampening global goods prices and overall inflation. As long as globalization trends remain in place, global inflation will stay low.” BCA’s bottom line? “We do not think downside risks to growth have become significant enough to derail the rally in emerging markets equities.”

BERNANKE BETS HIS REPUTATION, FORESHADOWS INTEREST-RATE PAUSE

Federal Reserve Chairman Ben S. Bernanke is putting his reputation on the line by betting he can suspend interest-rate increases without prices spinning out of control. In telegraphing to Congress a pause in the cycle of rate rises, Bernanke, 52, broke with predecessor Alan Greenspan’s tendency to keep options open at turning points in policy. After nudging rates higher at every meeting for almost two years, the Fed is heeding an internal forecast that calls for growth to slow. “He has gone with a very gutsy approach,” said Brian Sack, senior economist at Macroeconomic Advisers LLC in Washington, who formerly worked in the Fed’s Monetary Affairs strategy unit.

A wrong guess could lead to an acceleration in inflation and encourage firms to pass on rising energy costs to customers, eroding the credibility the Fed built under Greenspan and Paul Volcker. Prices paid by consumers rose 3.4% in March from a year ago, up from an average 2.6% since 2000. “That’s his risk right now,” said William Ford, former president of the Atlanta Fed. “You can go back to the 1970s, when Fed chairmen really blew it when we had the last energy crisis by pumping in money and letting inflation get out of hand. He has to be very careful not to do that, or to create the image of somebody doing that.”

Two-year Treasury notes – the most sensitive to interest rate expectations – jumped, and traders cut bets on the likelihood of the Fed lifting its main rate to 5.25% by July. Yields on longer-maturity Treasuries, more sensitive to inflation, did not fall as much because of concern that a pause would spur consumer prices higher. “Even if in the committee’s judgment the risks to its objectives are not entirely balanced, at some point in the future the committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook,” Bernanke, who took office in February, said in testimony before Congress’s Joint Economic Committee. The Fed has not revealed the numerical details of its internal forecast, making it difficult for analysts to see what will temper the economy’s pace.

Any miscalculation by Bernanke may also pose a risk to the Republican Party, which is fighting to hold on to majorities in the House of Representatives and Senate in November. President George W. Bush nominated Bernanke, a former Princeton University economist, as Fed chief after he served as chairman of Bush’s Council of Economic Advisers and a Fed governor. “The political implications are pretty rough,” said Diane Swonk, chief economist at Chicago-based Mesirow Financial Inc., which manages $27.3 billion. “If he gets it wrong and we end up either with too much inflation or with a sharp slowdown in growth, by November, you’ve got a lot of people in Congress pretty nervous.”

A stunning display of pricing power by guess who?

Inflation in the U.S. remains under control in large part because competition prevents American companies from raising prices. There are exceptions, of course. One of them is a stunner: railroads, whose revenue historically has been at the mercy of the economy. Demand was so great in the first quarter that Union Pacific, the biggest U.S. railroad, was able to raise its rates by 13% as shipments rose 4%. Norfolk Southern, another of the four dominant U.S. railroads, raised its freight rates by 12% in the first three months of the year after increasing them by that amount in 2005. As a rough comparison, U.S. wholesale prices of consumer goods and capital equipment rose 3.5% in the 12 months through March.

High prices have brought big profits and long-lagging rail carriers are now acting like growth companies. Union Pacific initially predicted first-quarter profit of 80 cents to 90 cents a share. It quickly raised its forecast to $1 to $1.10 a share – and finally reported $1.15 a share on April 20. Norfolk Southern reported a 57% increase in first-quarter earnings to $305 million, or 72 cents a share. Burlington Northern Santa Fe Corp. reported a 28% increase in profit for the period to $410 million, or $1.09 a share. Canadian National Railway, the fifth-largest North American railroad, with track running down the middle of the U.S. to New Orleans from Canada, has increased its quarterly dividend by 30% and split its stock.

The Standard & Poor’s 500 Railroads Index, which is made up of the shares of the top four U.S. carriers, had a total annual average return – including dividends – of 19% in the five years ended on March 31. That is almost five times the 4% rise for the broad-market S&P 500 Index. Union Pacific shares trade at 23 times the carrier’s earnings in the previous 12 months compared with an average of 18 times for companies in the general market index. The carriers have easily passed along their own rising costs for fuel. Other industries – airlines, for instance – have not been that lucky. Mergers that reduced the number of big U.S. railroads to two in the East and two in the West may be the key here. It is virtually impossible to form a new rail company, while new airlines start up with just a few used jet planes.

The benefits from reduced labor costs and deregulation may have reached their limits. Railroad prospects from here on might depend more on economic cycles and management ingenuity. For one year at least, this much was certain: Norfolk Southern’s pretax profit margin for 2005 was 25% of revenue. In fiscal 2005, Hewlett-Packard, the Silicon Valley-based computer and printer manufacturer, had a pretax margin of 5.7%.

WHAT THE PRICE OF GOLD IS TELLING US

The financial press, and even the network news shows, have begun reporting the price of gold regularly. For 20 years, between 1980 and 2000, the price of gold was rarely mentioned. There was little interest, and the price was either falling or remaining steady. Since 2001 however, interest in gold has soared along with its price. With the price now over $600 an ounce, a lot more people are becoming interested in gold as an investment and an economic indicator. Much can be learned by understanding what the rising dollar price of gold means.

The rise in gold prices from $250 per ounce in 2001 to over $600 today has drawn investors and speculators into the precious metals market. Though many already have made handsome profits, buying gold per se should not be touted as a good investment. After all, gold earns no interest and its quality never changes. It is static, and does not grow as sound investments should. It is more accurate to say that one might invest in a gold or silver mining company, where management, labor costs, and the nature of new discoveries all play a vital role in determining the quality of the investment and the profits made.

Buying gold and holding it is somewhat analogous to converting one’s savings into $100 bills and hiding them under the mattress – yet not exactly the same. Both gold and dollars are considered money, and holding money does not qualify as an investment. There is a big difference between the two, however, since by holding paper money one loses purchasing power. The purchasing power of commodity money, e.g., gold, however, goes up if the government devalues the circulating fiat currency. Holding gold is protection or insurance against government’s proclivity to debase its currency. The purchasing power of gold goes up not because it is a so-called good investment. It goes up in value only because the paper currency goes down in value. In our current situation, that means the dollar.

One of the characteristics of commodity money – one that originated naturally in the marketplace – is that it must serve as a store of value. Gold and silver meet that test – paper does not. Because of this profound difference, the incentive and wisdom of holding emergency funds in the form of gold becomes attractive when the official currency is being devalued. It is more attractive than trying to save wealth in the form of a fiat currency, even when earning some nominal interest. The lack of earned interest on gold is not a problem once people realize the purchasing power of their currency is declining faster than the interest rates they might earn. The purchasing power of gold can rise even faster than increases in the cost of living.

The point is that most who buy gold do so to protect against a depreciating currency rather than as an investment in the classical sense. Americans understand this less than citizens of other countries. Some nations have suffered from severe monetary inflation that literally led to the destruction of their national currency. Though our inflation, i.e., the depreciation of the U.S. dollar, has been insidious, average Americans are unaware of how this occurs. For instance, few Americans know nor seem concerned that the 1913 pre-Federal Reserve dollar is now worth only four cents. Officially, our central bankers and our politicians express no fear that the course on which we are set is fraught with great danger to our economy and our political system.

The belief that money created out of thin air can work economic miracles, if only properly “managed”, is pervasive in D.C. For at least four generations our government-run universities have systematically preached a monetary doctrine justifying the so-called wisdom of paper money over the “foolishness” of sound money. Many central bankers in the last 15 years became so confident they had achieved this milestone that they sold off large hoards of their gold reserves. It is fascinating that the European central banks sold gold while Asian central banks bought it over the last several years. Since gold has proven to be the real money of the ages, we see once again a shift in wealth from the West to the East, just as we saw a loss of our industrial base in the same direction. Though Treasury officials deny any U.S. sales or loans of our official gold holdings, no audits are permitted so no one can be certain.

The special nature of the dollar as the reserve currency of the world has allowed this game to last longer than it would have otherwise. But the fact that gold has gone from $252 per ounce to over $600 means there is concern about the future of the dollar. Instead of dwelling on the dollar price of gold, we should be talking about the depreciation of the dollar. In 1934 a dollar was worth 1/20th of an ounce of gold – $20 bought an ounce of gold. Today a dollar is worth 1/600th of an ounce of gold, meaning it takes $600 to buy one ounce of gold.

The number of dollars created by the Federal Reserve, and through the fractional reserve banking system, is crucial in determining how the market assesses the relationship of the dollar and gold. Though there is a strong correlation, it is not instantaneous or perfectly predictable. There are many variables to consider, but in the long term the dollar price of gold represents past inflation of the money supply. Equally important, it represents the anticipation of how much new money will be created in the future. This introduces the factor of trust and confidence in our monetary authorities and our politicians. And these days the American people are casting a vote of “no confidence” in this regard, and for good reasons.

There is no single measurement that reveals what the Fed has done in the recent past or tells us exactly what it is about to do in the future. Forget about the lip service given to transparency by new Fed Chairman Bernanke. Not only is this administration one of the most secretive across the board in our history, the current Fed firmly supports denying the most important measurement of current monetary policy – the monetary aggregate known as M3 – to Congress, the financial community, and the American public. Though M3 is the most helpful statistic to track Fed activity, it by no means tells us everything we need to know about trends in monetary policy. But ultimately the markets will figure out exactly what the Fed is up to, and then individuals, financial institutions, governments, and other central bankers will act accordingly. The fact that our money supply is rising significantly cannot be hidden from the markets.

Part of this reaction will be from those who seek a haven to protect their wealth – not invest – by treating gold and silver as universal and historic money. This means holding fewer dollars that are decreasing in value while holding gold as it increases in value. A soaring gold price is a vote of “no confidence” in the central bank and the dollar. This certainly was the case in 1979 and 1980. Today, gold prices reflect a growing restlessness with the increasing money supply, our budgetary and trade deficits, our unfunded liabilities, and the inability of Congress and the administration to reign in runaway spending.

False trust placed in the dollar once was helpful to us, but panic and rejection of the dollar will develop into a real financial crisis. Then we will have no other option but to tighten our belts, go back to work, stop borrowing, start saving, and rebuild our industrial base, while adjusting to a lower standard of living for most Americans. Counterfeiting the nation’s money is a serious offense. The founders were especially adamant about avoiding the chaos, inflation, and destruction associated with the Continental dollar. That is why the Constitution is clear that only gold and silver should be legal tender in the U.S. In 1792 the Coinage Act authorized the death penalty for any private citizen who counterfeited the currency. Too bad they were not explicit that counterfeiting by government officials is just as detrimental to the economy and the value of the dollar.

In wartime, many nations actually operated counterfeiting programs to undermine our dollar, but never to a disastrous level. The enemy knew how harmful excessive creation of new money could be to the dollar and our economy. But it seems we never learned the dangers of creating new money out of thin air. We do not need an Arab nation or the Chinese to undermine our system with a counterfeiting operation. We do it ourselves. Today we hear threats from some Arab, Muslim, and far Eastern countries about undermining the dollar system – not by dishonest counterfeiting, but by initiating an alternative monetary system based on gold. Wouldn’t that be ironic? Such an event theoretically could do great harm to us. This day may well come, not so much as a direct political attack on the dollar system but out of necessity to restore confidence in money once again. Historically, paper money never has lasted for long periods of time, while gold has survived thousands of years of attacks by political interests and big government. In time, the world once again will restore trust in the monetary system by making some currency as good as gold.

Economic law dictates reform at some point. But should we wait until the dollar is 1/1,000 of an ounce of gold or 1/2,000 of an ounce of gold? The longer we wait, the more people suffer and the more difficult reforms become. Runaway inflation inevitably leads to political chaos, something numerous countries have suffered throughout the 20th century. The worst example of course was the German inflation of the 1920s that led to the rise of Hitler. Even the communist takeover of China was associated with runaway inflation brought on by Chinese Nationalists. The time for action is now, and it is up to the American people and the U.S. Congress to demand it.