Finance Digest for Week of May 22, 2006

“THE OSTRICH OF OMAHA”

Michael Mandel, chief economist for BusinessWeek, is writing about the “Ostrich of Omaha”: “Buffett’s bearishness on the U.S. economy ignores how Americans’ hard work adds value at a steadily higher rate than trade adds debt. To be frank, I’m getting a bit tired of Warren Buffett’s pessimism about the U.S. economy. The so-called Oracle of Omaha, the second richest man in the world, was anti-New Economy in the 1990s. Now he’s downbeat on the U.S. dollar.

“In his latest letter to the shareholders of Berkshire Hathaway, Buffett wrote: ‘The underlying factors affecting the U.S. current account deficit continue to worsen, and no letup is in sight … Either Americans address the problem soon in a way we select, or at some point the problem will likely address us in an unpleasant way of its own.’ We don’t need this ‘voice of prudence’ from someone worth more than $40 billion.”

Somehow, that does not seem exactly right. Here, let us try this version: What we do not need is someone who is totally clueless about factors affecting the current account deficit giving Buffett a lecture about “fundamental market values” based on the nebulous idea of “hard work.”

Mandel continues. “Lucky for us, the Social Security Administration publishes a range of long-term forecasts going out to 2080, which take into account a variety of assumptions about demographics and productivity. Their most pessimistic forecast calls for a long-term growth rate of 1%, while their optimistic forecast projects that long-term growth will average 2.8% … It turns out that the market value of the U.S. economy is increasing by anywhere between $4-7 trillion per year. … By comparison, our trade deficit means that the United States is adding roughly $1 trillion in external debt each year … far less than the increase in the market value of the economy. From this perspective, we can keep this up forever. USA! USA! Other industrialized countries are not so fortunate. … My advice to Buffett is to apply the same sort of fundamental analysis to countries as he does to the stocks he owns. He might find that it’s the United States that is the better deal.”

Gee, “lucky for us” the Social Security Administration publishes a range of long-term forecasts. That is indeed lucky, or do I mean useless? Since when has any long-term government forecast been any good? I also have to wonder if Mandel thinks Buffett is supposed to feel “lucky” that Mandel is so generous with his advice. “It turns out that the market value of the U.S. economy is increasing by anywhere between $4-7 trillion per year.” This is a lot like looking at the stock market in 2000 and projecting future earnings growth as far as one can see forever into the future without considering whether or not the result is sustainable. Other than “hard work”, Mandel does not explain where this “market value” comes from. He does not look at production of goods or manufacturing and perhaps presumes we can keep borrowing forever while flipping each other’s houses at ever-increasing prices, living happily ever after. Working hard at flipping homes or working hard at passing the trash (risky loans) to Fannie Mae is not exactly productive, and certainly bombing Iraq to smithereens is not what anyone should call productive. Just as people were offering Buffett advice on “The New Economy” in 2000, we now have economists like Mandel explaining to Buffett how America “can keep this up forever.”

To any thinking person, that is just another version of “It’s different this time.” I have no doubt this proclamation from Mandel will prove to be as much a foresight as the June 2005 cover of Time magazine, “Why We’re Going Gaga Over Real Estate”, or the 1999 Economist cover story predicting $5 oil with a cover touting “Awash in Oil”. Actually, the best rebuttal to Mandel’s “It’s different this time” argument come from the May issue of The Richebächer Letter, with the headline “It Is Far Worse Than in 2000.” The letter concludes, “Our strongly held assumption that the U.S. economy is in a most precarious condition basically has two reasons. One is the extravagant size of the housing bubble, involving the whole financial system to an unprecedented extent. The other is the grossly ill-structured economy, replete with imbalances inhibiting sustained economic growth. Forecasts for the world economy are generally optimistic in the expectation that the U.S. economy will continue its global pull with continuous strong growth. We think the anemic and extremely unbalanced U.S. economic recovery is in its last gasp.”

Mandel practically taunts Buffett without considering the effects of globalization and what that that has done to real wages. He ignores a credit bubble, a housing bubble, and instead focuses on a cyclical recovery of stocks while making huge assumptions about “hard work”. Somehow, the busting of the housing bubble is of little importance to Mandel. Then again, perhaps he does not see that train wreck coming. Nor does Mandel look at earnings, book values, or dividends. In “The Big Chair”, John P. Hussman of Hussman Funds addresses some of those issues. “[T]he S&P 500 is richly valued on the basis of nearly every fundamental measure, including earnings when those figures are properly considered. The point is not to predict a near-term decline in stocks, but rather to emphasize that the long-term returns priced into stocks here are likely to be disappointing.” So what did Buffett miss, if anything?

The MarketWatch bulletin “Banks’ Mortgage Demand Weakens in Last 3 Months”: “Published quarterly, the Fed’s senior loan officer survey polls 57 domestic banks and 19 foreign banks about lending trends. Of the respondents, 11.3% said they’d eased home mortgage lending standards, while only 1.9% said they’d tightened them somewhat.” The interesting thing is that even in the face of rising foreclosures and bankruptcies, companies are still lowering credit standards. The fact that companies are acting reckless by taking on more and more risk in the face of deteriorating fundamentals is something that anyone but an ostrich should clearly be able to see.

More than likely, Buffett did not miss much if any of that and chose to be relatively bearish on a market driven by such forces. So who should believe? John Hussman, Warren Buffett, and Dr. Kurt Richebächer? Or Michael Mandel? Will the real ostrich please come up for some fresh air? Having your head in the sand clearly affects one’s thinking.

THE FORBES 2006 INVESTMENT GUIDE

Investment fads have a way of ending unexpectedly, leaving surprised investors in horrified shock. The end of the real estate craze has been predicted for some time, but now it finally seems real. Stephane Fitch tells us how you can prosper there, nevertheless. Tax maven Janet Novack warns of traps involved in renting out second homes and Matthew Swibel casts a critical eye on popular investing pools for commercial property.

In a special Retirement Guide, we examine how to figure out what you will really spend in old age – do not always believe planners’ gloomy projections – plus how to maximize your 401(k) and minimize your drug costs. We also take a critical look at another hot area, “self-directed” IRAs that invest in exotic things like tax liens. We also run our slide rule over 20 years of the wonderful and savage world of initial public offerings. You may be shocked by what you will learn.

Good buys? Alternative energy stocks, as chosen by champion earnings predictor Sanjay Shrestha. Lower Pentagon budgets could mean rougher times for defense stocks, but some military contractors still will thrive. We also unearth the most promising Japanese stocks now that Japan is finally recovering. We identify companies set to benefit from the coming boom in wireless telephony in India. And we find some companies in boring industries like cement and pulp and paper around the world that offer exciting returns. Fund investors should check out the best sector-neutral mutual funds, which are index-like portfolios that aim to beat the index. Hedge fund investors should read our cautionary tale about Phoenix Four, a hedge fund with a heavy dose of real estate. And as for the money you might fling at the dream of a lifetime, learn what it will take to start your own brewery.

Bernie Horn scours boring companies in dozens of countries, looking for cheap stocks promising exciting returns.

Mexican cement manufacturers. Japanese shipping companies. Pulp-and-paper makers. Dull as dishwater to most investors. “People don’t like them. They have low expectations for them,” says Bernard R. Horn, head of Polaris Capital Management, with $1.8 billion under management. But such unglamorous businesses have handsomely rewarded Horn’s shareholders. His $400 million Polaris Global Value Fund has returned an annualized 17.7% in the past five years, far outpacing the Morgan Stanley Capital World Index’s 6%.

From his office in Boston, Horn scours the globe, from Scandinavia to Mexico, in search of dull stocks that happen to be cheap. The first thing he looks for in a company is not net earnings but free cash flow, which he defines as cash flow from operations minus maintenance-level cap-ex. “It’s useless to use net profits to compare companies globally,” he says, as the figures can be easily manipulated or affected by local accounting and tax rules. A software company, for instance, could capitalize or expense the cost of software development, while steel companies’ tax rates could vary based on the country in which they operate. But, says Horn, “There is either cash, or there isn’t.”

REGIME CHANGE COURTESY OF THE IMF

In the months before the meetings of the IMF and World Bank in April, the IMF appeared to be in its twilight. Since the Turkish lira collapsed in 2000, there has been a dearth of financial crises (for the IMF to “manage”) and of countries to shower with cheap loans. Also, IMF borrowers from past crises – including Russia, Argentina and Brazil – have repaid their loans ahead of schedule. The IMF’s loan portfolio and operating income are shrinking. By its own estimates, the IMF will sustain operating losses of $600 million over the next three years. But governmental organizations never get the ax for operating losses. They do not even die in their sleep. They claim new purposes for themselves and flourish. Just look at the IMF.

It was established as part of the 1944 Bretton Woods Agreement and was primarily responsible for extending short-term, subsidized credit to countries experiencing balance-of-payments problems under the postwar pegged exchange-rate system. In 1971, when President Richard Nixon closed the gold window, he signaled the collapse of the Bretton Woods Agreement – and, presumably, the demise of the IMF’s original purpose. But since then the IMF has used every so-called crisis to expand its scope and scale. The oil crises of the 1970s allowed the institution to reinvent itself. Those shocks required more IMF lending to facilitate – yes, balance-of-payments adjustments. And more lending there was. With the election of Ronald Reagan in 1980 it appeared that the IMF’s crisis-driven opportunism would finally be reined in. Yet with the onset of the Mexican debt crisis more IMF lending was required “to prevent debt crises and bank failures.” That rationale was used by none other than … President Reagan. And then in the 1990s, currency crises in Mexico, Russia, Turkey, Brazil, Argentina and Asia expanded the IMF’s balance sheet, enhanced its clout and guaranteed full employment for its bureaucrats.

However, by late 2005 the IMF appeared to be in trouble again. The U.S. – the IMF’s biggest shareholder – was complaining that IMF Managing Director Rodrigo de Rato was derelict in not labeling China a currency manipulator. The Bush Administration started a whispering operation, against De Rato. In addition, the Bush Administration began a diplomatic campaign to turn other industrialized countries against China’s “fixed” exchange-rate regime. This strategy worked. On Apr. 21 the G-7 finance ministers and central bank governors issued a communiqué. For the first time, the Gang of Seven singled out China and its exchange-rate regime for criticism. Even though the “fixed” yuan/dollar system has contributed mightily to China’s stellar economic performance for over a decade, the Gang claims that China’s exchange rate is contributing to dangerous global imbalances. To help find a solution to this so-called problem, the IMF was given a new mandate: to start immediate negotiations between countries with the largest trade imbalances (read: the U.S. and China) with the goal of reducing the imbalances (read: raising the value of the Chinese yuan from 12 cents to a much larger sum).

This amazing turn of events would have come as no surprise to the British historian C. Northcote Parkinson. His 1957 classic, Parkinson’s Law, concludes that when the job for which a bureaucracy was organized changes or disappears, the industrious bureaucrats will find new work to do. Meddling in China’s successful economy and pleasing the IMF’s largest shareholder certainly qualify as hard work. But if De Rato cannot fend off the meddlers, one should hope that China stands its ground. China should not forget how the IMF aggravated the Asian currency crisis nine years ago by demanding that the Indonesian rupiah float. And float it did – downward. Beijing should also not forget former U.S. Secretary of State Lawrence Eagleburger’s assessment of the ensuing political regime change in Indonesia: “We [the U.S. government] were fairly clever in that we supported the IMF as it overthrew [Suharto].”

SURVIVING RISING INTEREST RATES

Should you fear rising long-term interest rates? The 10-year Treasury, which started 2006 at a 4.4% yield to maturity, now hovers near 5.1%. As I have been arguing for a while, the bullish case for equities hangs to a large degree on the fact that corporate share purchases – in the form of either cash takeovers or stock buybacks – have the effect of boosting earnings per share of the company buying the shares. And this phenomenon, in turn, depends on the fact that long-term interest rates are low. A chronic upward trend in long rates would do a lot of damage to stock prices.

The rise in long rates raises two questions. First, at some times in recent years when America’s long-term rates ratcheted up a bit, foreign rates did not, later pulling U.S. rates back down with them. Is that what is happening now? No. Long rates have been marching upward pretty much everywhere that counts. So this easy out from the rate threat is not really available. But there is another safety hatch. The second question: Is the rate rise big enough to indicate a trend? I may be wrong, but I think no trend is at work. The jump in rates is just statistical noise. A rise from 4.4% to 5.1% is a 16% increase in the interest rate on Treasury notes. Since May 2003 we have had four prior upward moves bigger than that, each of which later largely or completely reversed itself.

Even if you do not invest globally (which you should do, particularly this year) you will always be a better U.S. investor if you think globally. Overseas, too, the foreign long-rate increases are noso big as to indicate more than noise. In Britain, for example, 10-year rates are up 14% from their low early this year but had a 9% run in the middle of last year, 14% the year before and 33% in 2003. All these jumps fully reversed themselves. By my calculations, global long-term rates would have to almost double, to 7.2%, to choke off this bull market. Such an upward spike in rates – such a collapse in global bond prices, in other words – is unlikely.

UNPLEASANT SURPRISES: HOW SMART ARE ANALYSTS AT FORECASTING EARNINGS?

I have a long-running debate with the analyst community on this point. The analysts (and the people who circulate their numbers) think they are pretty good. I think they all too often miss by a wide margin, especially on high-multiple growth stocks, where a disappointment can send a stock reeling. Some individual analysts are very good. But what about the average earnings forecaster? In my last column I cited 41% as an average error. Thomson Financial compiles a database of forecasts and came back with a figure of 3.2%. Both of these figures are correct. I did not have the space to explain this wide gap in the last go-round, but here I do.

Thomson Financial and my statisticians are taking measurements from slightly different universes. The Dreman-Ilieva sample tracks estimates for an expanding list of companies (2,100 at the end) over a period of three decades. Thomson Financial was looking at S&P 500 companies only since 1994. In both cases we are examining “consensus” figures – that is, a mean of forecasts from all participating analysts – and in both cases we disregarded nonrecurring items. We are comparing latest prerelease quarterly earnings forecasts with the actual numbers. Some difference in results could come from the difference in the years studied and in the list of corporations (presumably the S&P members are more closely followed). But not much. The main reason for the huge disparity in how we view analyst skills has to do with the way the averages are calculated.

Thomson Financial looks at aggregate earnings for the whole S&P 500. Thus, if Google falls $500 million short of what is expected but American Electric Power delivers a positive surprise of $500 million, then the total is right on the money and Wall Street credits itself with a bull’s-eye. This is a reasonable way to look at forecast accuracy if all you are doing is buying an index fund. But if you are picking individual stocks, then this kind of “accuracy” is no good at all. The hit you will take on a high-multiple growth stock that disappoints will in no way be made up by owning shares of a cheap utility that overdelivers.

My method looks at the absolute value of percentage errors. If one consensus number overshoots by 20%, and another is too low by 20%, then that is an average error of 20%. I look at earnings per share and weight all companies equally. My average, it must be conceded, was pushed up by outliers. The median error in my database for 2004 Q3 was 7.7%. But even that kind of disappointment is enough to do a lot of damage to a hot growth stock. As the chart shows, the impact of earnings surprises on share prices is uneven. High-flying stocks get slammed by negative surprises and are helped only a little bit by positive surprises. Value stocks – the ones trading at low multiples of earnings – get boosts from positive surprises but are not much hurt by negative news. Disappointment is already priced into the shares.

I think you should be very leery of expensive growth stocks, especially when their prices are propped up by grandiose predictions of earnings gains that lie around the corner. If analysts cannot even get this quarter’s number accurately, how can we trust them to forecast two years out? Stick to value stocks and hope for positive surprises.

STAGFLATION LITE, CENTRAL BANKING NIGHTMARE, MAY AWAIT BERNANKE

Federal Reserve Chairman Ben S. Bernanke may be facing a central banker’s nightmare this year: “a mild dose of stagflation”. Surging oil and commodity prices, a falling dollar and mounting doubts about the Fed’s willingness to keep price pressures in check are all increasing the risks that inflation will quicken. At the same time, the Fed’s 2-year credit-tightening campaign is beginning to bite. With the housing market sagging and consumer confidence wavering, the result may be slowing growth.

Call it stagflation lite. The toxic combination last seen in the 1970s is bad news for consumers, companies and investors. Consumers find themselves squeezed by rising prices and diminishing job prospects. Profits take a hit as companies face mounting costs and diminishing demand. Investors’ portfolios shrink with a swooning stock market. It would also be bad news for President George W. Bush and his fellow Republicans, who have been counting on the economy’s strength to revive their sagging popularity ahead of November congressional elections.

“The Fed’s in a very precarious position. Inflation is going to be pretty high by their standards, while growth is going to be slowing,” says Stephen Cecchetti, former research director for the New York Fed and now professor of international economics at Brandeis University in Waltham, Massachusetts. “Price pressures are the strongest seen since the ugly 1970s and early 1980s,” says William Dunkelberg, a professor at Philadelphia’s Temple University who is also chief economist of the Washington-based National Federation of Independent Business.

Bernanke, 52, argues the economy now is different because inflation expectations remain contained. That is important because if companies and workers believe inflation is headed higher, their actions may help bring that result. Companies will raise prices while workers will demand higher wages. Some signs suggest inflation expectations are edging up. Some investors wonder whether the Fed has let price pressures build by concentrating too much on core inflation, rather than focusing on overall numbers that include food and energy costs. Others complain that the government’s pricing data has understated inflationary pressures by failing to take account of the 60% rise in house prices during the last five years. Instead, government statisticians use rents to measure housing costs.

If the scenario of sub-par growth and too-high inflation comes about, Bernanke and his colleagues will face unpalatable choices. Do they raise interest rates to squelch rising inflation and risk sending the economy into a tailspin? Or do they forgo increases in rates – even cut them – to cushion the declining economy and in the process run the danger of letting inflation accelerate? Economic historians such as New York University professor Thomas Sargent say it was the Fed’s mishandling of monetary policy, rather than the steep rise in oil prices, that was behind the economy’s performance in the mid-to-late 1970s. That may be enough to keep Bernanke and his fellow Fed policy makers awake at night.

Next time, inverted yield curve may signal U.S. slump.

The inversion of the Treasury yield curve earlier this year, dismissed by many market players as an anomaly, may soon prove to have been a preamble to a deeper, sustained dip in yields on long-maturity debt below their shorter-dated counterparts. And this time around, against the backdrop of a weakening housing market and the Federal Reserve’s inflation-fighting interest-rate hikes, analysts warn that such an inversion could be a harbinger of economic slowdown – and perhaps even recession. “If the curve reinverts, it will be because the Fed will be more inclined to control inflation and allow a little slackening of GDP growth,” said Jane Caron, chief economic strategist at Dwight Asset Management, in Burlington, Vermont.

Long-maturity debt is particularly reactive to inflation, which erodes a bond’s value over time. Earlier this year, a combination of low inflationary pressure and steady foreign buying helped yields on longer maturities stay low, while those on shorter maturities – which respond closely to official interest-rate moves – were lifted by Fed increases. Many market observers are skeptical that the wafer-thin curve flip late last year, followed by a shallow inversion in February and March, pointed to an economic slump. “The first time we had the inversion was a head fake,” said David Ader, U.S. government bond strategist with RBS Greenwich Capital. “It was not based on the economic outlook per se.”

DECLINING DOLLAR REFLECTS U.S. POLICY FAILURE

The conventional wisdom in Washington is that President George W. Bush has not been rewarded politically for a mostly booming U.S. economy. Indeed, his approval rating in the public opinion polls is now somewhere in the low 20s, despite the fact that the indicators reflecting the resilience of the U.S. economy – inflation (low), interest rates (relatively low), consumer spending (relatively high), unemployment (relatively low) - should have helped transform the current White House occupant into a popular president.

Most pundits explain that paradox by suggesting that Mr. Bush’s policy failures in Iraq, his dealing with Hurricane Katrina, a series of scandals involving officials and Republican lawmakers, and recent rising energy costs have counteracted any positive effect that the booming economy should have had on his standing in polls. But pollsters also point out that notwithstanding the good economic news, most Americans are uneasy about their long-term prosperity as a nation.

In a way, the anxiety among Americans reflects concerns over the continuing effects of globalization on the American economy and society – the slow erosion in the U.S. manufacturing base, rising illegal (and legal) immigration, and the financial and human costs involved in maintaining the preeminent U.S. global military position. There is, however, another indicator that may explain why Americans seem so irritable these days. That has to do with the value of the U.S. dollar falling 28% against other currencies between 2002 and 2004. It then bounced back slightly, only to fall again against the euro and the yen in recent weeks. Representative Ron Paul, a Republican, who is the leading “goldbug” on Capitol Hill, traces today’s financial problems back to the removal of gold backing from global currencies. He argues that the real measure of just how far the U.S. dollar has fallen can be found in the price of gold, which has reached a 25-year high of more than $700 per ounce.

“It’s much more accurate to measure the dollar against a stable store of value like gold, rather than against other fiat currencies,” Mr. Paul writes. According to him, the declining U.S. dollar as measured by the rising value of gold will continue “until the American people demand an end to deficit spending by Congress and unrestrained creation of new dollars by the Federal Reserve and Treasury department.” Or to put it differently, “voting” for gold is a vote of no confidence in the ability of the Administration and Congress to control the budget and trade deficit, the Fed’s ability to control the money supply, and by extension, the ability of Washington to pursue its hegemonic policy in the Middle East and elsewhere. “Our creditors, particularly Asian central banks, are losing their appetite for U.S. Treasuries,” Mr. Paul writes. The long-term significance will sink in when Americans understand that the steady erosion of the value of the U.S. dollar means they will all be poorer in the future.

WHAT DOES THE HIGH PRICE OF GOLD MEAN?

As we ponder our lot today, it cannot be over-stressed that the system under which we labor is as inherently inflationary as any of which even the wildest monetary crank could dare to dream. Though things were bad enough when commercial banks held only fractional reserves of something as inflexible as bullion, they are now no longer constrained by any effective reserve system whatsoever. Rather they must only comply with the protocols of the Basel capital standard and, in truth, this is no standard at all.

Banks were supposed to be able to lend only a multiple of their capital. What this neglects to add is that, as liquidity swells and credit abounds, the banks who give rise to this can effortlessly create their own capital from thin air simply by borrowing it from one another and from selling bonds or stock to those whose loan accounts they themselves have just credited! Add in the fact that our twisted ingenuity has employed our globe-encircling computer networks to construct an ever more extended fantasy of asset speculation on the foundations of ever thinner slivers of “capital” – and the capital markets operate not so much on an equity base as on the thinnest of junior-lien varnishes!

This is a world, then, in which an asset such as gold may justifiably rise to match the increase in the quantity of paper money – but it is also one in which such an asset can itself become the medium within which easy money incubates yet one more bubble, as may have happened sometime in the past nine months. In such a world, it is vitally important that we do not confuse money – especially today’s money, near limitless in its supply – with wealth, whose own supply is, by its very essence, severely limited. Nor must we ever forget that “capital” is not simply a digital entry, tapped effortlessly into the computer of some financial clearing house, but that it is a useful, productive resource that needs to be hewn from the earth, processed, and assembled – not in the hushed, marble halls of banking, but in the harsh and unforgiving environment of mines and quarries, fields and forests.

Financial history provides copious illustrations of the essential truth that, at root, all inflations are matters of financial excess and it is hard to escape the conclusion that we are currently in the process of adding yet another chapter to this hefty tome. Indeed, we would forcibly argue that, for its scale, spread, speed, and sheer ferocity, the present inflation – not just of money, but of all forms of credit and of the manifold derivatives constructed thereon – is beyond all parallel. To support this contention, we can draw attention to the exuberance in the financial markets – not least the record-setting flood of debt-financed takeovers and buyouts – but also to the rise in the prices of houses, office blocks, objets d’art, diamonds, autographs, metals, soft commodities, energy products, formerly exotic stocks, and – until very recently – just about every variety of bond. Ask yourself whether the prices of all these disparate entities are rising, or whether the price of money is falling?

Before an audience of gold bugs, I am fairly convinced that, this far, I have been preaching to the converted – even if I hope that I have based my sermon on a slightly different text. However, there is one concept being banded about here glibly and without notice, which I cannot help but deplore. So, at last, let me come out and say it – much though I wish it were true – and as readily as I accept that it once was true, Gold is NOT today “money”. Nor, regrettably, under our present political system and amid our existing cultural milieu is it ever likely to become one again. Money is the present good most readily accepted in voluntary exchange – accepted without quibble or discount (and, ideally, without compulsion) in final settlement of a trade by a sufficiently large preponderance of economic agents as to be effectively universal. The second quality of money – the store of value – is only an admirable adjunct, a desideratum, and one much more an aspiration than an inevitability. Therefore that gold is not money must surely be incontrovertible.

It would be an act of folly to bet on an imminent end to this present feverish rally, just as it would be an equal and opposite act of misjudgment to get carried away and start Googling targets higher and higher into the stratosphere every time the ticker grinds northwards. Estimations of present worth are difficult enough without introducing the uncertainties of the future. To say, as has been said here today, that gold is bound to appreciate against one paper currency or another (without specifying which or when) is not to say much at all. Nor is this sufficient to demonstrate that gold represents the best medium by which to preserve one’s capital under all circumstances.

Forecasts, I believe, can only be made on two time scales and even then, never more than qualitatively. On the short (and inherently sharp) end, there are those who have developed a feel for market positioning and who can scent its tactical vulnerabilities. There are those who are attuned to the changing state of the herd’s delusional mindset and can decipher how it is being guided by its own continually revised body of post-hoc myth. These, the people who used to be called “tape-readers”, have the knack of making just enough sense out of the surrounding cacophony to trade profitably and with sufficient regularity for this to be beyond the confines of blind chance. Unfortunately, I am not one of them.

Conversely, over a long haul the basic economic verities are undeniable and ineluctable. Eventually, the chickens do come home to roost. Reluctantly, I cannot fail to conclude that we are on a path toward ever less personal liberty and to ever greater violations of the sacred rights of private property. It is, by necessity, a path to monetary adulteration and to a creeping corruption of body and soul. It is a path beside which Atlas may, indeed, be seen to shrug. In such a world, it is likely to be the case that people will, from time to time, seek to acquire holdings of a relatively scarce, high value-by-weight, easily fungible, liquid, storable, real asset as an alternative to their holdings of a much less scarce, eroding value paper asset, such as comprises today’s money. In such a world, gold may therefore command a higher price than it did in more innocent times when the side effects of our ongoing decline were less severe and when the prospect of our fall was much easier to ignore.

If you hold that this kind of dread and defensiveness explains at least part of the metal’s rising price, it is hardly a cause for universal rejoicing. For, though it is understandable that gold’s long-suffering believers now feel gloriously vindicated, we must temper our present glee with the thought that the rally being enjoyed may be no more than a waypoint on our road to a self-imposed and wholly unnecessary ruin.

CONSPIRACY THEORIES AND THE GLOBAL STOCK MARKET MELT-DOWNS

Do you believe in conspiracy theories? Sometimes they are difficult to refute. Such was the case last week, just after the Euro had soared towards a 12-month high of $1.30, and the British pound, itself ridden with large trade and budget deficits, stood mighty tall at $1.90, with traders setting their sights for $2 for the pound. The U.S. dollar lost 7% in just six weeks against America’s main trading partners, and was 28% lower since January 2002, to stand just 1% above its 1995 low. Then on Sunday May 14th, currency traders in London, picked up an obscure report from the UK’s Observer newspaper, that indicated the IMF was in behind-the-scenes talks with the EU, Japan, the U.S., China and other major powers to arrange a series of top-level meetings to tackle imbalances in the global economy, and address the dollar sell-off that was rattling global stock markets.

Fearing a surprise rescue package for the U.S. dollar, London currency traders began to lock in profits from the Euro’s six week old rally to just shy of $1.30. As always, the first line of defense in the currency market is jawboning, and finance officials in Europe, Japan, and the US were out in full force, talking the Euro and Japanese yen down, and the U.S. dollar up. Timely jawboning by G-7 finance ministers, helped to keep a lid on the Euro just below $1.30, and rescued the dollar at 109-yen. G-7 central bankers understand that a weaker US dollar can exert upward pressure on the cost of U.S. imports, which rose 2.1% in April, and account for 17% of Americans purchases. And a sharply higher Euro and Japanese yen against the dollar also subtracts from profit margins of European and Japanese exporters, which is unraveling the EuroStoxx-600 and Nikkei-225 stock market rallies. European and Japanese central bankers have worked very hard to inflate their equity markets for the past four years to stimulate consumer demand through the “wealth effect”.

G-7 central bankers and finance officials are also alarmed by gold’s spectacular surge against all major currencies over the past eight months, a clear signal that global investors have lost confidence in the purchasing power of fiat (paper) currency. A global flight from G-7 government bonds and into gold since September 2005, has lifted bond yields to multi-year highs in Japan and the U.S., the world’s largest debt markets, and in a long delayed reaction, triggered big shake-outs in global stock markets in mid-May. However, a guardian angel came to the rescue a half-hour before the London a.m. gold fix on May 15th, by unloading a big chunk of the yellow metal, hitting all bids $35 per ounce lower to the $680 level. Within hours of the gold sell-off, dazed gold traders were hearing Japan’s finance minister Tanigaki and the ECB’s Noyer threatening intervention on behalf of the U.S. dollar, and conducting jawboning exercises about the virtues of currency stability for the global economy.

Then on May 19th, leaving gold bugs on a sour note heading into the weekend, US Treasury Secretary John Snow insisted on CNBC television that the Bush administration still backed a strong dollar. Gold tumbled as low as $638 per ounce on May 22nd, on concerns that the Bernanke Fed would back up the Treasury’s rhetoric about a strong U.S. dollar, by lifting the fed funds rate 0.25% to 5.25% at its June meeting. “I have full confidence that Chairman Bernanke and the Federal Reserve are committed to price-stability and understand that this is their number one priority,” Snow added. In retrospect, Bernanke helped plant the seeds of the latest dollar crisis on March 21st, when he signaled that the Fed could live with a weaker dollar to help correct the U.S. current account deficit.

The big-3 central banks and their finance ministries still have the ability to jawbone foreign exchange rates, or if necessary, execute outright intervention to battle with speculators. However, the most shocking development in the global markets over the past few years was the natural evolution of a worldwide de facto gold standard that is just starting to impose discipline upon abusive central bankers. In other words, brazen attempts by central bankers to inflate their equity markets by pumping up their money supply, has been matched by higher gold prices. For instance, the emergence of the gold vigilantes in Europe became evident in September 2005, when the price of gold rose above a four year resistance area of €350 per ounce, and zoomed to as high as €570 on May 11th, 2006.

Interestingly enough, the gold market closely attached itself to the monetized EuroStoxx index, and then outpaced the EuroStoxx to the upside. In other words, the impressive EuroStoxx-600 rally was just an optical illusion in hard money terms, and was more reflective of the ECB’s ultra-easy money policy. If the ECB was forced to lift its repo rate above the true rate of inflation, both gold and the EuroStoxx index would begin to unwind some of their speculative froth. The ECB is aware of the inflation situation, but did not lift a finger to counter the explosive growth in M3 at their monthly meeting in April and May 2006. However, the ECB’s strategy blew-up when benchmark 10-year German bund yields began to take their cue from rising gold prices, reflecting higher inflation in Europe.

When left to their own devices, free of central bank intervention, global markets tend to exaggerate moves and increase volatility in bonds, stocks, currencies and commodities. However, markets do have internal self-correcting mechanisms that can eventually reverse over extended movements or deflate asset bubbles. All too often however, central bankers try to postpone the eventual day of reckoning, through intervention, interest rate adjustments and jawboning exercises, but in the end, there is no place to run or hide. The markets will prevail!

To protect the dollar’s status as a world reserve currency for oil exporters, the Bernanke Fed is under pressure to lift the fed funds rate by a quarter-point to 5.25% in June. Failure to do so, could spark a renewed assault against the dollar, and re-ignite inflation fears, lifting gold prices and U.S. bond yields. However, a tighter Fed money policy could also deflate the U.S. housing bubble, the greatest source of savings for many U.S. households, and risk an economic slowdown or recession. Fed chief Bernanke told Congress that his March 24th decision to stop reporting the M3 money supply measure was designed to save the U.S. taxpayer’s money. However, the yield on the US Treasury’s 10-year note has surged 40 basis points higher, since the Fed abandoned M3 reporting. Without the transparency of M3 reporting to monitor the Fed’s money printing operations, traders sold U.S. bonds and turned to gold in April, as a safe haven from the U.S. central bank. Gold vigilantes to bid the yellow metal $260 higher to as high as $730/oz, which in turn, persuaded the U.S. bond vigilantes to jack-up 10-year Treasury yields by 80 basis points towards 4.19%, the highest in four years.

It would probably take a sustained global stock market sell-off of 10% or more to knock the “Commodity Super Cycle” and gold off their 4-year upward trajectory. Evidence of a slowdown in the booming Chinese and Indian economies, caught in the downdraft of a global economic slowdown, and signs that G-7 central banks are tightening their money supplies in a meaningful way, are also pre-requisites for calling an interim top in commodity indexes. The catalyst for a sustained global stock market decline might be weaker U.S. housing market.

The end of excessive monetary stimulation by the big-3 central banks – the Fed, the ECB and the BoJ – and fears that mounting inflationary pressures worldwide may require more aggressive rate tightening has unsettled global financial markets in recent weeks. Morgan Stanley’s All-World stock market index has fallen about 8% fallen from its early May peak. Buoyant commodities also have gone into retreat. The global stock market melt-down has whipped up fears of a global economic slowdown and weaker demand for the stars of the “Commodity Super Cycle”. Undoubtedly, bargain hunters could emerge from the sidelines to pick up battered blue chip stocks after a brutal correction. If correct, bargain hunting rallies in global stock market indexes could also be accompanied by gold rallies and a battalion of other commodities markets. That in turn, would exert upward pressure on inflation and global bond yields. It is going to be a lot tougher to make money in the global stock markets in the months ahead, under the regimen of a de facto gold standard.

Gold is a proven itself to be a more viable hedge against monetary inflation than blue chip stocks, and has greatly outperformed global stock market indexes for the past four years. However, gold and other commodities are not immune from big melt-downs in global stock markets. Within the context of a 4-year bull market, gold exhibited wide swings and big corrections along the way.

Are the big-3 central banks ready to tighten their money supply to combat inflation? Can the bank of Japan lift its overnight loan rate above the ridiculously low level of zero percent, over the objections of the ruling LDP party? Is Jean “Tricky” Trichet about to lift the ECB’s repo rate by three-quarter points to 3.25% as futures markets predict? Is Fed chief Ben Bernanke prepared to deflate the U.S. housing bubble with rate hikes beyond the neutral rate of 5.00%?

Emerging-market stocks slump 10th day, longest rout in 8 years.

Emerging-market stocks declined for a 10th day, the longest losing streak in eight years, as investors fled riskier assets around the world because of sliding commodity prices and rising interest rates. India’s Sensitive Index plummeted more than 10%, triggering one-hour trading halts on both the Mumbai Stock Exchange and the National Stock Exchange. Shares recouped most of their losses after the government said banks will help investors meet calls for cash.

The Morgan Stanley Capital International Emerging Markets Index, which tracks shares in 26 developing markets around the world, fell 2.6% to 766.22, 13% less than the record close set May 8. The 10-day decline is the longest since a 10-day losing streak ended Aug. 13, 1998. Christopher Bellew of Bache Financial in London said that Monday’s slide was “a continuation of the bubble-bursting in commodities and energy markets last week.”

Emerging-market bonds, U.S. junk debt diverge on commodity concerns.

Emerging-market bonds are lagging behind junk-rated debt in the U.S. this month, as the riskiest securities end more than five years of trading in tandem. The markets moved in lock-step about 93% of the time from the end of 1999 through April, according to Merrill Lynch. The correlation stopped this month as commodity prices plunged, increasing risks for investors in developing nations from Indonesia to Brazil that depend on sales of raw materials for exports. Bonds sold by junk-rated companies barely moved because the U.S. economy is expanding and corporate defaults are the lowest in 20 years.

High-yield, high-risk bonds, those rated below Baa3 by Moody’s and BBB- by Standard & Poor’s, typically move in the same direction as emerging-market bonds because they are considered among the riskiest assets. Both are also are the most vulnerable to rising interest rates and slowing economic growth. The global default rate for junk corporate bonds fell to 1.08% in April, the lowest in 20 years, according to S&P. So far this year, junk bonds have returned 3.3%, according to Merrill’s index of 1,850 securities with a market value of about $613 billion. Developing-economy debt is up 1.8%, using Merrill’s Global Emerging Market Sovereigns index, which has 194 securities with a market value of $215 billion.

How Japan sank the market.

Remember that old Wall Street saying, “Don’t fight the Bank of Japan”? If you want to know what has rattled stock markets around the world and when you can expect it to end, study the BoJ. What? You thought the saying was “Don’t fight the Fed”? How yesterday. Right now the Bank of Japan, not the U.S. Federal Reserve, is the most important central bank in the world. It is the BoJ that is calling the tune for the world’s equity markets.

Over the last week, you have heard all of the talking heads focus on the U.S. Federal Reserve in their effort to explain the selloff that began on May 13. The market decline is a result of worries that U.S. inflation is in danger of spinning out of control and that the Federal Reserve will have to raise interest rates at its June meeting and beyond. But bonds actually rallied on some days when stocks were sinking. Gold also behaved oddly. The metal is the classic inflation hedge, and yet gold sold off on these inflation worries – if that is what they were. And finally, there was the strange behavior of the U.S. dollar. You would expect the dollar to sink against other global trading currencies as investors sold dollars to find safer havens in euros and yen. But instead, the U.S. dollar has actually stayed steady against these currencies.

This is where the Bank of Japan comes in. You cannot understand why some asset prices have tumbled and others have stayed solid if you do not know what the Bank of Japan has been doing over the last few months. The Bank of Japan has been taking huge amounts of liquidity out of the global capital markets. In the last two months, the bank has taken almost 16 trillion yen, or about $140 billion, in cash deposits out of the country’s banks. The country’s money supply has fallen by almost 10%. The Bank of Japan is not finished pumping out the liquidity that it had pumped in. That should take a few more months. And when it is finished, the Bank of Japan is expected to start raising short-term interest rates.

The return of economic and financial health to Japan is bad news to the speculators who have used cheap Japanese cash to make big profits by buying everything from Icelandic bonds to Indian stocks. The momentum in many of the world’s riskier markets was a result of ever-increasing floods of cash – borrowed at 1% in Japan and multiplied by leverage as speculators turned $1 of capital into $3 or more of borrowed money. Hot-money investors know new inflows of cash are needed to keep the momentum going, and it looks like the supply of money flowing into these markets might diminish. The moves to date by the Bank of Japan are not enough to radically diminish global liquidity, but they are enough so that the investors who have fed some of the world’s riskier markets understand that the trend has turned. Speculators are not about to wait until they actually see signs that cash flows are dwindling. They take profits at the first sign that the trend may be changing.

What we have witnessed since May 13 is a global flight out of more leveraged and more speculative investments. Speculators attracted by the momentum of the gold, copper and silver markets have sold – and are still selling – rushing to get out before other speculators could liquidate their positions. Emerging equity markets have sold off for the same reason. What the BoJ has done is set off a global resetting of investors’ risk tolerance. With Japanese interest rates so low and Japanese cash so abundant, speculators, traders and investors have been more and more willing in the last few years to take on risk at increasingly low premiums.

Risk tolerance does not get reset in a day. Excess liquidity has, by no means, been removed from the global financial markets. But the speculators know that money is gradually getting more expensive. Rallies can count on less hot money to fuel their final stages. Getting out earlier in rallies starts to seem wiser. Some risks are just not worth taking. The correction that began on May 13 is part of the process of resetting risk tolerance and recalibrating risk premiums. It is not likely to last terribly long. Frankly, I think the turn in this correction is not that far off, and it is probably time to look for a buy or two. The volatility can be scary, but it is just the way that, in the short term, the financial markets adjust to new fundamental conditions, such as a change in global liquidity.

STILL BETTING ON DEFLATION

“We would need to see a lot faster wage growth – growth at or exceeding the current 3% core CPI rate – before I would think about buying a piece of the inflation is coming back story. … I definitely don’t see it right now. … What we have, in other words, is almost pure cost-push inflation – instead of the wage-price spiral that made the ‘70s such an interesting time to live through, financially speaking. At some point, presumably when the extra disposable income derived from that last mortgage refi runs out, households are going to have to suck it in. Indeed, it looks like it’s already started – retail sales are weakening and the Amazon-sized river of imports flowing in from points east (or west, if you live in California) has actually slowed a bit. Meanwhile, job growth has decelerated, jobless claims are creeping up, and housing starts finally appear to be, well, stopping.”

That, indeed, is the heart of the matter. Everyone is in some sort of “inflation scare” AFTER 16 consecutive rate hikes. Does this make any sense? I suppose it does to those that are perpetually gloomy on the U.S. dollar or U.S. Treasuries, who probably now feel vindicated by this blip up in Treasury yields. It all comes down to wages, housing, and jobs. Without meaningful rises in employment and wages, the former above the birth rate and the immigration rate (both illegal and illegal) and the latter above the TRUE cost of living, inflation really does not have a chance. Yes, at 1%, we had sustainable inflation. An incredible housing boom was the result. The better question (looking ahead) is, “What now?”

I have been asked countless times what it would take for me to throw in my “deflation towel”. Oddly enough (or perhaps not), most of those questions have come in the last few months right on the verge of victory. Unlike Stephen Roach (a Morgan Stanley permabear who suddenly and without reason turned bullish about two weeks ago), I am not reversing course here. Is that illogical? I think not. I have many times stated what will change my mind. It is really simple: wage increases, job growth, and housing that does not bust. I see little reason to change course now. In fact, Treasuries are probably a screaming buy.

Most people screaming “inflation” do not know what it really is. Those that think “inflation = price increases” are sadly mistaken. In fact that is one of the reasons why we see repetitive bubbles being blown by the Fed. One of the reasons for these repetitive bubbles is the Fed does not itself know what inflation is. It thinks they can micromanage the economy, when all it is doing is chasing its tail, due to the lagging effect of its actions. At some point, and I think we are at that point right now, a sort of economic zugzwang is reached. In economic terms, there is no magic mirror. Bernanke is trapped in Wonderland, but, unlike Alice, has no way out. Bernanke gets to choose between hyperinflation and deflation. The moment he cannot run fast enough, the U.S. economy will implode. If he runs too fast, the value of the U.S. dollar, as well as the Fed’s power, will come to a very abrupt stop.

In effect, Bernanke is in zugzwang, and he does not even know it. Eventually, Bernanke (like the Bank of Japan) will have to choose deflation. The reason is simple: Hyperinflation will end the game, which in turn would eliminate the wealth of the Fed, as well as all of its power.

WAKE-UP CALL FOR CENTRAL BANKING

I worry increasingly that history will not treat the recent record of central banking kindly. Inflation may well have been conquered – a conclusion financial markets are actively debating again – but that was yesterday’s battle. Over the past six years, monetary authorities have turned the liquidity spigot wide open. This has given rise to an endless string of asset bubbles – from equities to bonds to property to risky assets (emerging markets and high-yield credit) to commodities. Central banks have ducked responsibility for this state of affairs. That could end up being a policy blunder of monumental proportions. A new approach to monetary policy is urgently needed.

Modern-day central banking was born out of the Great Inflation of the 1970s. Led by Fed Chairman Paul Volcker, monetary authorities became tough and disciplined in their efforts to break the back of a deeply entrenched inflationary mindset. Price stability became the sine qua non of macro stabilization policy. Nothing else really mattered. Without inflation, it was argued, economies could realize extraordinary efficiencies that would enhance resource allocation and maximize returns for the owners of capital and providers of labor. Who could ask for more? The subsequent disinflation was a major victory for central banking. It was also a major victory for the “monetarists” who argued that inflation was everywhere and always a monetary phenomenon.

In retrospect, central banking’s finest hour came in the early days of this struggle – in the immediate aftermath of the wrenching monetary tightenings that were required to break the vicious circle of the inflationary spiral. Unfortunately, the authorities have been much less successful in “managing the peace” – steering post-inflation economies toward the hallowed ground of price stability. By focusing solely on the inflation battle, there is now risk of losing a much bigger war. That is what the profusion of asset bubbles is telling us, in my view. The great triumph of central banking rings increasingly hollow in today’s bubble-prone environment.

What happened? For starters, circumstances changed – in particular, circumstances that a one-dimensional monetary policy framework was ill-equipped to handle. Two developments are key in this regard – IT-enabled productivity growth and globalization. Both of these structural developments had – and continue to have – powerful disinflationary consequences. Fixated on CPI-based targeting – or some variant thereof – central banks missed the trees for the forest. Focused on formulistic linkages between policy instruments and inflation, they failed to allow for the structural pressures that reinforced an increasingly powerful disinflation. America’s Federal Reserve was different. Under the leadership of Alan Greenspan, the Fed was quick to jump on the productivity story. But its reaction may well have sown the seeds for today’s problems. The Greenspan-led Fed not only stayed easier than might have otherwise been the case but also sent a powerful “buy” signal to equity market participants.

The rest is history – and a potentially painful one at that. By consciously ignoring the perils of a mounting asset bubble – a stunning reversal, of course, from Alan Greenspan’s original warning of “irrational exuberance” in the stock market in December 1996 – the Fed became entrapped in the dreaded multi-bubble syndrome. Stressing that it had learned the lessons of Japan, the U.S. central bank was aggressive in easing in the aftermath of the bursting of the equity bubble. A new Governor by the name of Ben Bernanke led the charge at the time in arguing that the U.S. central bank should use every means possible to avoid an unwelcome post-bubble deflation. The price-targeting Fed had no compunction about turning the liquidity spigot wide open. And so the miracle drug that was used as the cure for the first bubble created a dangerous addiction – systemic risk, in financial market parlance – that has fostered a string of asset bubbles. Unfortunately, that addiction has yet to be broken.

What can be done? In the end, there must be more to monetary policy than a single-mined preoccupation with price stability. Once “zero inflation” is close at hand, the monetary authority needs to become more nimble and broaden out its goals. In a low-inflation climate, monetary authorities should be especially wary of fostering excess liquidity that plays to the asymmetrical risks of asset bubbles. Instead, policy should become predisposed more toward tightening than accommodation. This is where the debate currently rages in central banking circles. America’s Federal Reserve is increasingly isolated in arguing that asset markets should be ignored in the setting of monetary policy. In fact, its new chairman is the academic high priest of inflation targeting. Asset bubbles are, at best, an after-thought in a strict inflation-targeting regime. Therein lies the potential for a strategic policy blunder: The U.S. central bank has yet to develop an exit strategy from the multi-bubble syndrome that the Fed, in its zeal for inflation targeting, has spawned.

Moreover, as one bubble begets another, excess asset appreciation has become a substitute for income-based saving – forcing the U.S. to import surplus saving from abroad in order to sustain economic growth. And, of course, the only way America can attract that capital is by running a massive current-account deficit. In other words, not only has the Fed’s approach given rise to a seemingly endless string of asset bubbles, but it has also played a major role in fostering global imbalances. The multi-bubble experience of the past six years is a wake-up call for central banks. A new approach to monetary policy is urgently needed.

A Monetary policy double standard.

This may sound like a naive question from someone who, for better or worse, just does not understand things the way most economists do, but why should contemporary U.S. monetary policy deemphasize rising energy prices while at the same time placing so much importance on falling prices of imported goods from Asia? While Fed policy may affect the demand for these goods, they have virtually no control over the supply side of the price equation, yet one is important in formulating monetary policy while the other is not nearly so.

Energy prices have been soaring in the last year or so and Herculean efforts have been made by the financial media in general, and economists in particular, to distract attention from the 21 percent rise in the price gasoline and other increasing energy costs by constantly pointing to the “core” CPI which excludes these items. The theory with the “core rate” is that it is somehow a better indicator of “underlying inflation”, whatever that is. Consumers have enough “regular inflation” in their face every time they fill up their tank or write a check to their doctor – they probably do not want to hear about “underlying inflation”. The original purpose of the “core” CPI was to strip out volatile components that caused wild month-to-month fluctuations in the price indices but this could be readily accomplished with something as simple as a moving average. The emphasis on its use as a superior indicator of price trends seems to be more of a statistical slight of hand or misdirection, successfully deceiving the American public who are just now starting to notice higher prices.

But why should monetary policy makers care about energy prices at all? While interest rates can have some impact on the demand for energy, they certainly do not affect the supply. If oil prices were to double overnight as a result of some massive supply disruption which was expected to persist for years, why should the Federal Reserve raise interest rates? Would that not just make a bad situation worse? It seems that whatever has happened with energy prices lately, the answer has always been the same – “inflation” is benign and the Fed does not have to tighten aggressively.

The corollary regarding falling prices on imported goods from Asia is no less perplexing. A few years ago, as home prices began their multi-year double digit increases there was concern of “deflation”. There was concern that somehow something bad was going to happen because consumer prices were not rising fast enough. As it turns out, most of the downward price pressure was the result of companies like Wal-Mart and countries like China – highly efficient companies selling goods from Asian manufacturers where low prices are enabled by high productivity and low labor costs.

Looking within the CPI, the Recreation category for example, you find items like televisions and toys declining by 20 or 30% over a period of years, while prices for movie tickets and cable service rose by similar amounts. Consumer goods that were imported from Asia were falling while domestic services were rising, yet the final calculation showed that overall prices in the CPI were rising at only a 1% rate, which was apparently too close to zero, necessitating prompt and heavy-handed action. This resulted in monetary stimulus, the likes of which the world had never seen before, being applied to the largest economy in the world in the form of ultra-low interest rates. This begat the carry trade, mortgage lending excess, a housing boom, and huge trade imbalances.

But why should monetary policy makers care about falling import prices? If a hundred million Chinese workers came down from the countryside and were willing to work for free, and the price of DVD players then fell from $40 to $4, should some special consideration not be given to this development rather than lowering interest rates in fear of the falling prices resulting in “deflation”? It seems that whatever has happened with the price of imported goods, the answer has always been the same – “inflation” must not be allowed to go too low.

There has clearly been a double standard in monetary policy in recent years. As energy prices rose, interest rates were raised slowly, grudgingly, because “core” inflation was not affected. When prices of imported consumer goods fell, interest rates were lowered sharply to ward off deflation. The Fed had little control over either of these changes in price, yet it diverted attention from one while reacting boldly to the other. Stable prices, as measured by the contorted consumer price indices, are no longer sufficient to formulate effective monetary policy, unless of course the massive debt and huge imbalances that we find today are indeed the desired result.

You do not need a gold standard to limit the supply of money, but when you have a government that continues to spend more than it brings in and monetary policy that is formulated to always err on the side of lower interest rates while masking rising prices, excess money and credit creation and their attendant asset bubbles will result. It is quite possible that this will go down as the greatest failure in the history of modern central banking.

NEW INDEX OFFERS WINDOW ON TO U.S. HOUSING MARKET

Economists were provided with a new tool to assess the cooling U.S. housing market this Monday with the launch by the Chicago Mercantile Exchange of futures and options tied to changes in residential real-estate prices. The prolonged boom in house prices, alongside the rise of more complex mortgage products, has raised concerns about the severity of the emerging slowdown and its impact on consumer spending. The CME hopes to attract institutional clients such as builders and mortgage investors seeking to manage their exposure to an asset class which grew to $21.6 trillion last year, larger than the U.S. equity market and approaching the scale of outstanding corporate bonds.

The importance of the housing market’s fortunes saw Ben Bernanke, chairman of the Federal Reserve, weigh into the debate for the first time last week. He said recent data suggested a very orderly and moderate cooling, providing reassurance to homeowners and reflecting recent comments from housebuilders, who expect a soft landing, similar to the corrections seen in 1994-95 and 2001. “There is plenty of evidence that the US housing market is starting to flag,” said Nigel Gault, director of US research at Global Insight, an economic consultancy. “The question is not so much will the housing market slow but by how much?”

The contrasting fortunes of regional markets has been the main problem with earlier attempts, including one in the UK, to construct a housing futures market. The new CME index will track house-price movements in 10 U.S. cities, using an updated version of the Case-Shiller model developed in the 1980s. Robert Shiller, Yale economist and expert in behavioral finance who helped develop the measure, has also been one of the leading bears on the housing market. While some economists argue it still fails to capture regional differences and the impact of items such as home improvements, proponents claimed it does provide an accurate assessment of the broader market.

“This is probably as good as it gets,” said Russell Andersson, co-founder of HedgeStreet, which launched its own housing derivatives 18 months ago. The HedgeStreet product provides retail investors with an opportunity to speculate on likely house-price movements. Mr. Andersson said the most activity had been focused on hotspots such as Miami and San Diego. Miami has seen a 140% jump in average selling prices over the past five years, and a sharp slowdown over the past five months. The signs of slowdown and market volatility may be just what the CME needs to attract users. A key challenge for the CME is to build up liquidity in the product – a task which some believe could take two years. David Hale, a Chicago-based economist who sits on the CMEs academic advisory board, expects initial interest to come from local traders, followed by institutional buyers and hedge funds, with the latter providing a potential risk. “There will be a temptation to blame the [futures] market,” said Mr. Hale, outlining a scenario in which hedge funds speculated on a sharp drop in a booming market such as Las Vegas.

The Big “What If?”

It is long past time to talk about housing markets losing their sizzle. They have already begun to turn down in the most-bubbly markets on the East and West coasts. Now we have arrived at the truly difficult part of any real estate boom-and-bust cycle – the time when prices hang in the balance. Will they go up any more, will they plateau or will they – collective shudder – go down? This uncertainty particularly worries those who have bought some investment property – say, a second home or condo – and are having trouble selling it. Is it time for them to face their inner fear that they might have to sell their property for less than what they originally paid? Worse yet, what if the property does not sell even then?

It is hard to be prepared for the history you do not know to repeat itself. In fact, ElliottWave.com points out that people choose to see only one side of the price equation. Even as sales of new homes drop and the number of homes on the market rise, still there is virtually no fear about home values falling. Yet, you do not have to have lived through a housing bust yourself to appreciate the effects. Just think of someone you know who lived through the bust in the Houston oil patch during the 1980s, or the Northeast condo bust in the late ‘80s and early ‘90s, or Atlanta’s real estate bust in the 1970s. Most property owners then twisted in the wind, waiting, waiting for prices to turn back up. Many of them could not hold onto their property, and the people who picked up the pieces at rock-bottom prices became the next land barons.

That brings us to the big “What if?” What if that investment house or condo you bought does not sell? Plan B is usually to rent it, but what if you cannot find renters? Do you just hold on and keep paying the mortgage and other carrying costs, or do you throw the towel in and sell at a loss to whomever will buy? The real problem is that markets can move much slower than we expect, which makes it all the more difficult to decide what to do. When a market starts to turn, it does not have to be quick. It is more likely to be slow and painful. Slow housing market busts can slowly boil investors who do not have the cash flow to hold onto their properties until the market turns again. There are only a hardy few who can hold on through a protracted bust or who are able to absorb a loss and move on to the next investment. In the meantime, though, many people who own property will suffer from the effects of mental anguish and indecision.

Homeless

Ben Bernanke and Alan Greenspan both agree that the housing boom is over and that it will begin an “orderly” decline. We agree that the housing boom is over and that home prices will begin to decline, but we are not so sure about the “orderly” part. Many homeowners will find comfort in assurances from the present and former Fed Chairmen. We do not. Greenspan’s impressive resume does not include any awards for market timing. After warning against the “irrational exuberance” that launched the young bull market of the 1990s, Greenspan became a credulous acolyte of the Nasdaq’s bubble-era valuations. Indeed, he extolled this enormous asset bubble as the fruit of a “productivity revolution”. If he failed to recognize the largest asset bubble in history, why should we expect him to recognize any other bubble?

Home price might indeed dip serenely. On the other hand, home prices might become as disorderly as stampeding soccer Hooligans. No one can say … and suggests that the “less orderly” portion of the housing cycle might be fast-approaching. Throughout the seven months that prospective buyers streamed through your editor’s home, it became increasingly clear that the prospective buyers were becoming increasingly price-sensitive, and picky, and arrogant. Before our very eyes, literally, we watched the balance of power in the housing market shift from seller to buyer. To wit: the first individual to bid for our home, offered only 80% of the asking price, and not a penny more. Your editor, who was feeling more fear than greed, did not dismiss the offer out of hand. But after weeks of attempting to reason with this unreasonable party, he dismissed the offer. Fortunately, a second offer arrived … at 90% of the asking price. To which your editor replied, “Sold!”

A home is a wonderful thing to own, but it is also a wonderful thing to sell. Especially when prices are slumping and buyers are disappearing, and time is of the essence. We would not dare to suggest that seller of your editor’s home got a better deal than the buyer. We would only point out that the seller endured many sleepless night before closing the deal. “Hey, now that I’ve sold my house,” your editor queried a local real estate agent, “I’ve gotta ask; what’s really happening in the housing market here?”

“It’s not good. … It’s really not good,” came the reply.

“How does it compare to last year?”

“There is no comparison. Last year we had a typical springtime market. This year we had nothing.”

“So what type of homes are selling?”

“Not much. … A few entry-level homes are selling. But nothing over $1 million. If I were you, I’d rent for a while when you're out in California. This housing market’s gonna get worse all over the place. So I’d just wait it out.”

Sounds like a plan.

View from Silicon Valley: The next zero days.

Two months ago we documented how median house prices in Silicon Valley make most of their annual increases from February to April. February of this year checked in with a +$17K gain and March registered +$12K with 80%+ of each gain “miraculously” showing up in the last two or three days of each month. Regardless, April needed to show big gains if annual 18-20% increases were to be maintained. It is now 60 days later, so how are prices doing? April’s negative $10K either kills the bulls case for perpetual and inevitable gains for Silicon Valley housing, or they at least have to admit their case is bleeding. The fact this week’s paper includes a graph showing the highest number of single-family houses listed for sale in the last two years is more salt in the bulls’ case. Figure another 60 days and we may experience actual negative y-o-y prices. If we have not grabbed the bull’s attention yet, maybe that will finally do the job.

STUDY FINDS “EXTENSIVE” FRAUD AT FANNIE MAE

Fannie Mae engaged in “extensive financial fraud” over six years by doctoring earnings so executives could collect hundreds of millions of dollars in bonuses, federal officials said in a report that portrayed a company determined to play by its own rules. Regulators at the SEC and the Office of Federal Housing Enterprise Oversight, in announcing a settlement with Fannie Mae that includes $400 million in penalties, provided the most detailed picture yet of what went wrong at the congressionally chartered firm. They portray the DC-based mortgage funding giant – a linchpin of the nation’s housing market – as governed by a weak board of directors, which failed to install basic internal controls and instead let itself be dominated and left uninformed by CEO Franklin Raines and CFO J. Timothy Howard, who both were later ousted.

The result was a company whose managers engaged in one questionable maneuver after another, including two transactions with Goldman Sachs that improperly pushed $107 million of Fannie Mae earnings into future years. The aim, OFHEO said, was always the same: To shape the company’s books, not in response to accepted accounting rules but in a way that made it appear that the company had reached earnings targets, thus triggering the maximum possible payout for executives including Raines, Howard and others.

The settlement closes regulators’ civil probe into Fannie Mae’s accounting scandal, the result of the company’s misstating earnings by about $10.6 billion from 1998 through 2004. SEC Chairman Christopher Cox and acting OFHEO director James B. Lockhart III said they now will turn their focus to individuals, including Raines and Howard, to determine what role former and current executives played in the accounting fraud and if they should be forced to forfeit millions of dollars in what the regulators called “ill-gotten” compensation. They said the Justice Department is continuing a criminal probe.

Fannie Mae – arrogant, chastised and not reformed.

The Fannie Mae story keeps getting more sordid. A 340-page report by the company’s federal regulator May 23 detailed the sins of the U.S.’s biggest buyer of home mortgages, portraying its management as Team Arrogance and making it clear the company was far from being reformed. Fannie Mae’s board reinforced rather than curbed the culture under former CEO Franklin Raines that issued fraudulent earnings reports and padded executives’ income, the investigation by the Office of Federal Housing Enterprise Oversight found.

Daniel Mudd, chief operating officer from 2000 to 2004 and Raines’s successor as CEO, failed to properly investigate claims of misconduct brought to him by other Fannie Mae employees, the report said. Executives in the Office of the Chairman refused to give directors unrestricted access to Fannie Mae managers, according to OFHEO. And Ann Kappler, senior vice president and general counsel until last December, made “false and misleading” statements to Fannie Mae’s audit committee, the report said. OFHEO said company representatives tried to get members of Congress to stymie the probe into Fannie Mae’s accounting misdeeds, which now stand at $11 billion and may go higher. Fannie Mae’s lobbying efforts in Washington often met with success. The report cited a 2004 memo from Mudd to Raines, saying the “old political reality was that we always won, we took no prisoners and we faced little organized political opposition.”

In atonement for its misbehavior, Fannie Mae agreed to pay $400 million – $50 million to the U.S. government and $350 million to a fund for defrauded Fannie Mae shareholders. OFHEO also ordered the company to limit its mortgage portfolio to the level at the end of 2005, which was $727 billion. Congress may now legislate curbs on Fannie Mae and its rival Freddie Mac. The best move would be to order the two giants, which own or guarantee about 40% of all U.S. mortgages, to break up into four or five separate companies. That would reduce the risk to the mortgage market should one company get into financial difficulty and avert a massive bailout by taxpayers in a collapse.

INVESTOR ANGER OVER RETROACTIVE OPTIONS AWARDS SEEN MOUNTING

The unfolding scandal over the timing of stock option awards to U.S. executives exposes a weakness in past pay practices and will likely spark a wave of fresh shareholder anger as the list of companies under government scrutiny grows. Federal prosecutors and enforcement officials at the U.S. SEC are investigating whether companies violated laws or accounting rules through the practice of “backdating” options. Options backdating involves manipulating the grant date of a stock option award to make it more valuable to the recipient. “If people were found to be purposefully backdating, it’s a really bad thing to do,” Marc Siegal, director of research at the Center for Financial Research & Analysis. “It’s scandalous and does nothing but enrich the people that do it.”

Although 2002’s Sarbanes-Oxley laws put an end to the practice by requiring executives to notify the SEC within 48 hours of exercising options, fallout from the practice is an ugly reminder of corporate greed and that damage it can cause to investors. “It’s an unwelcome reminder that boards allowed these practices to happen,” said Patrick McGurn, special counsel at proxy advisory firm Institutional Shareholder Services. “From a shareholder perspective, this is the worst of both worlds. You paid for it sometime in the past and now you are paying a penalty on top of that.” Shareholders first pay when the executives pick a lower, more favorable grant date and then they pay again “when companies have to restate their earnings, pay fines and legal fees.”

ETHANOL: HOPE OR HYPE?

As the price of oil and gas has continued to spike, consumers have been left wondering – who is coming to the rescue? The PR campaign du jour would have Americans believe that ethanol is the Great Green Hope. “We’ve got to go from a hydrocarbon economy to an economy that’s no longer dependent upon oil, and that’s where we’re headed,” President Bush told NBC’s Brian Williams in a recent interview. “The ultimate solution is to promote ethanol.”

As the president pushes ethanol as a solution to the energy shortage, corporate America is embracing ethanol to pitch its products. But at the University of California at Berkeley, geoengineering professor Tad Patzek is not buying any of it. He thinks ethanol is a pretend solution that is, in fact, making our energy situation much worse. “I think we’ve entered a period of collective madness,” he said. “And some way we need to get out of it.”

PE RATIOS ARE FORECASTING THE FUTURE, ANALYST SAYS, AND IT IS ONE WITH LOWER STOCK PRICES

Ed Easterling is a self-described optimist. That is why the president of Crestmont Research, a Dallas-based firm that analyzes the financial markets and the hedge fund industry, hopes it really is different this time. But the charts that Mr. Easterling pores over tell him the stock market is headed south. What is impossible to see, Mr. Easterling says, is how deep and prolonged the downturn will be. His hope is that the damage will not be as bad as history suggests, that it will be different this time. Then we can move on to the fun part – the next bull era in the stock market.

“Right now we’re in a cyclical bull market that started in early 2003 within a secular bear market that started in 2000. Despite being in a secular bear market, we turned bullish in 2003 because so many factors had lined up in an extreme way. But recently, the market metrics have shifted to the extreme, but in a different direction. As a result, I’m concerned that we are at the end of the cyclical bull market and that a cyclical bear market will start soon,” he says.

A secular bear market? “We are and we will be for as long as it takes to get price-to-earnings ratios, or P/Es, back toward historically lower levels. This can happen in relatively short brutal periods or in extended choppy periods. I like to refer to the period Warren Buffett sometimes mentions – that in 1964 the Dow was at 875. And in 1981 the Dow was again at 875. Although cyclical bear markets are periods of significant declines, secular bear markets are relatively long periods of below-average market returns. … If I had to draw a parallel, it would be to 1972. The market was approaching a new high, as it is today. And the P/E was about 18, as it is today. Volatility was low, and the market was in the first half of a secular bear market, as it is today. What happened next is history.”

“At the end of the day, the trend in P/Es is the single most important determinant of investors’ returns. If inflation moves higher, P/Es will fall. And, if we get deflation, P/Es will also move lower. Inflation has been fairly stable over the past few years, and that justified relatively high P/Es. But that may be about to change. The only way to get to the next secular bull market is to break below the average P/E.” Deflation!? “Yes. The risk right now is the fear people have that inflation is coming back. This could cause the Fed to raise short-term interest rates higher than they should. With the prices of commodities and housing as high as they are, if you were to see a simultaneous pullback in their prices, we could easily slip into deflation.”

“In every other case since 1900, secular bear markets have ended when the P/E dropped to a single digit. Even though it’s never happened before, I’m hoping we just go down to a 12 or 13 and start back up from there.”

Conditions in the financial markets are eerily similar to pre-October 1987 crash.

A report by Barclays Capital says the run-up to the 1987 crash was characterized by a widening U.S. current-account deficit, weak dollar, fears of rising inflation, a fading boom in American house prices, and the appointment of a new chairman of the Federal Reserve Board. All have been happening in recent months, with market nerves on edge last week over fears of higher inflation and a tumbling dollar, and the perception of mixed messages on interest rates from Ben Bernanke, the new Fed chairman. “We are very uncomfortable about predicting financial crises, but we cannot help but see a certain similarity between the current economic and market conditions and the environment that led to the stock-market crash of October 1987,” said David Woo, head of global foreign-exchange strategy at Barclays Capital.

Apart from the similarities in economic conditions, during the run-up to the 1987 crash there was a sharp rise in share prices worldwide and weakness in bond markets, Woo pointed out. “Market patterns leading to the crash of 1987 resemble the markets today,” he said. Gerard Lyons, head of research at Standard Chartered, noted that, “The volatility is explained by tighter liquidity conditions, markets pricing in more for risk and dollar vulnerability. But people forget that this is not a case of emerging-market economies being in trouble as in 1997-8. They’re in good shape.”

Why the market bears are roaring.

I checked in with my favorite timers: Veteran tape reader Stan Weinstein of Global Trend Alert, Paul Desmond of Lowry’s Reports, Bob Drach of Drach Market Report and Tom McClellan of McClellan Market Report. Here's the two-minute version of their views.

Weinstein expects a minor rebound from recent lows, but says the highs of the cycle have been made and that a “baby bear market” is commencing. He thinks the Nasdaq may sink as low as 1,900 to 2,000 by the fall. After that, he expects a solid rebound into 2007. Desmond has been saying for some time that the current bull market is very, very long in the tooth. He is looking for a recommencement of the “secular”, or long-term, bear market that began in 2000 and was interrupted by a “cyclical”, or intermediate-term, bull phase that started in 2002. Drach is heavily negative on the broad market and has been nearly all year. He sees a great disparity between high-quality and low-quality stocks and does not expect to give an all-clear signal for several weeks, if not months. Drach has an especially impressive record of calling bottoms, so when he gives the whistle, I will let you know.

McClellan, who I think is the best intermediate-term stock-market timer going these days, is actually a lot less bearish than the rest. He called for the mid-May weakness a few weeks ago as the market was making highs, and now believes the selling will end some time (this) week. His cycle work suggests the market will then advance to new highs by the end of June, and then “chop sideways” through the summer into a soft spot, but not a crash, in the fall. His most interesting forecast is for crude oil and energy stocks to bottom in June and then advance through the end of the year, culminating in $100-a-barrel oil and $4-per-gallon gasoline. I will keep track of all these forecasts over the next four months and report back if any of them change.

Meanwhile, the mysterious Mr. P – an expert on market cycles – was bullish for a year through the end of April, but he has since turned seriously bearish. For those of you just tuning in for the first time, he is the veteran research director of a major global macro hedge fund on the East Coast who shares his views with me from time to time. Mr. P, to whom I grant anonymity, is often very right – and even when he is wrong, he can make you money. Why is he negative on the market now? A couple of things. An arch-conservative, Mr. P has become highly concerned about the loss of confidence in President Bush, both domestically and overseas. Because Mr. P deals with major European, Arab and Asian investors all the time, he understands how important foreigners are to our stock market. To get the market moving dramatically higher, Wall Street needs incremental new inflows from overseas money managers. Foreign investors are very sophisticated about U.S. politics. Most have gone to the best schools in America, travel here frequently and pay a lot of money for top consultants. They are not naive. Foreign investors care a lot about leadership.

When events transpire to make our government appear less secure, foreign investors get nervous. They do not necessarily withdraw funds. They just send less, which has the effect of making a rising market pause. So what is the issue now? It is not just that the Bush administration is suffering from the weakest polling numbers in recent years. It is that foreign and other sophisticated investors smell the potential for major changes following the midterm elections, including the possibility of a Democrat takeover of Congress and the potential for tax-law changes and impeachment hearings and history has shown that investors do not like the impeachment process one bit. The dreadful bear-market years of 1973 to 1974 are the classic example, yet you really only need to look back to 1998 and 1999 at the Clinton impeachment process. There should be little doubt that if the Democrats’ message finds a receptive ear among the public, Mr. P says, there will be investor-paralyzing hearings well into 2007. It is therefore a good time to get cautious on most industrials and consumer cyclicals. He sees the potential for a slide of as much as 20% over the next nine months.

Of course, from a cyclical point of view, this makes sense. The midterm election year of a second-term president tends to be one of the most dangerous for the market. Where it really gets ugly is when you notice that there is only one other precedent for the twin demons of low presidential approval and a midterm election year happening at the same time. That was in 1974, when the market would ultimately slide 45% to a 12-year low amid the Watergate scandal, impeachment hearings and the resignation of President Nixon, not to mention a gasoline-supply and price shock.

Mr. P also frets over “neo-mercantilism”. Mercantilism was the main paradigm that characterized world trade in the 16th and 17th centuries before capitalism shifted into high gear. It is a view that politicians, not business leaders, should guide international trade – and that trade policy should serve strictly political ends. Modern mercantilists include Vladimir Putin of Russia, Hugo Chavez of Venezuela, Evo Morales of Bolivia, and in some regards, the governments of Germany, China and Japan. Mercantilism is an unsettling type of economic warfare – an attempt to restore power to governments that was stripped from politicians by capitalism. You could almost call it the “weaponization of finance”. If it swells, much of the market freedom that we know today will shrivel, he fears, as countries withdraw into their shells and restrict world trade.

On a more practical level, Mr. P says his models show that the industrial metals are four times more expensive than they have been historically, and consumer durables are twice as cheap as they normally are. He believes the gap will close, which means he thinks you should at least take advantage of the recent surge to sell your aluminum, zinc and nickel stocks.

WHY DOES THE TECH INDUSTRY TEEM WITH INDUSTRY ANALYSTS?

During the Internet-stock bubble in the late 1990s, there were more technology-industry analysts on Wall Street than you could throw a laptop at. Today there are even more. The tech industry is flattered by such attention even though tech stocks have lost a lot of their luster and Wall Street firms employ fewer stock analysts overall than they did during the go-go days of the previous decade.

One big reason for this head-scratching state of affairs: Big investment banks still prefer to nurture industries whose stock offerings will produce fat underwriting fees, even after a landmark 2003 settlement was supposed to sever a link between analysts’ pay and banking deals such as underwriting of initial public offerings of stock. Also, some stocks trade more than others, regardless of the health of the underlying companies. Technology, along with telecommunications and health care “are currently the most overrepresented sectors on Wall Street,” says Francois Trahan, chief investment strategist at Bear Stearns and the author of a recent report on “orphan stocks”, those companies that receive little or no analyst coverage.

Industries represented in the Standard & Poorwts 500-stock index that get the least attention from Wall Street research departments, according to Trahan, are energy, utilities and financial companies – including some of the Wall Street firms themselves – even though the prices of energy shares, for example, have been soaring on the back of oil prices. The average number of analysts per tech stock in the S&P 500 nearly doubled to 23.53 by the end of April from 12.36 in January 1996 and was still 22% higher than the 2000-2001 average of 19.25 analysts per tech stock, according to Trahan’s report. By the first quarter of 2000 – near the height of the Internet bubble – the total stock market value of S&P 500 tech stocks peaked at well over $4 trillion. Today it is about $2 trillion.

The hiring of analysts “is still driven to a large extent by banking business, particularly IPO volume,” says Michael Mayhew of Integrity Research Associates LLC, a consulting firm that helps money managers and investment banks get quality securities research. “Regardless of what everyone says, the profits all come from one pot.” Trahan says he notices anecdotally that “there is a disproportionate number of tech analysts on the Street.” He surmises it is because “it’s easy to get people excited” about technology stocks, but “this could change in a couple of years” as investment banks and research firms start hiring more analysts for the energy sector.