Finance Digest for Week of September 18, 2006

HOUSING SQUEEZE

The bad news keeps coming from the home front. Buyers are holding back, enough to send median sales prices down 2% or more in Cleveland and Minneapolis. KB Home recently slashed earnings estimates for the second time since June. Shares of home builders have fallen 40% in the past year. The head of Toll Brothers, a big luxury-home builder, says the downturn is the most troubling, and perplexing, in decades. The economy, after all, is still growing strongly. Well, at least for the moment.

The question: How much of a blow to the economy will shaky house prices deliver? Right now home prices nationally, even after recently weakening, are still up 10% in the year through June. But even if prices simply move sideways, the effect on the economy could be nasty. That is because, in the bearish view, all those people who treat their homes like a bank, using money they borrowed against rising home values to buy iPods or take vacations or eat out, will be crimped if values do not keep rising. That could ping the economy hard, given that consumer spending accounts for 70% of GNP. The softening of consumer spending would come on top of already falling spending on residential investment – building new homes or additions to old ones. A sharp reduction in residential investment, down, say, $100 billion in two years from $800 billion today, could trim 0.75% from GDP growth.

There is a lively debate among economists, however, over how strongly spending is linked to home values. If the link is weak, the housing slowdown will not hurt the economy all that much. Economists have looked at this pivotal question: Do people spend more if they have cash in their hands they have extracted from appreciated homes than they do with just the knowledge that their homes have appreciated? One side says this so-called wealth effect on spending is the same whether wealth is on paper or in cash: about 4 cents for every dollar increase in value. The other side says having the cash in hand often boosts spending by 50 cents.

The difference is big and suddenly important. Last year Americans took $678 billion in cash out of their homes through home equity loans, cash-out refinancings and the like, equivalent to 6% of disposable income. Barclays Capital chief U.S. economist, Dean Maki, an outspoken critic of home-as-ATM theorists, says consumers act prudently, putting most of the cash extracted from homes into stocks or bonds or paying off credit card debt. He points out that consumer spending growth has held steady through the home refinancing booms and busts. In this he is in accord with mainstream economic thinking. Maki is bullish: The recent dip in consumer spending to an annualized 2.6% growth rate in the second quarter is the bottom, he declares. Spending will now rise at a 3.5% annual rate in both the third and the fourth quarters, he forecasts. GDP growth next year: 2.9%.

On the other side is Jan Hatzius, Goldman Sachs’s chief U.S. economist. He cites a recent Federal Reserve survey that suggests people drawing cash from their homes do indeed spend about half on home improvement and consumer goods. A drying-up of this money over the next several quarters, then, would have an effect similar to a cut in wages. He predicts that the Fed, eager to soften the blow from America’s lurch to frugality, will lop 1.25 percentage points off the fed funds rate next year. His odds on a consumer-led recession: one in three. Hatzius is just as stubborn as Maki in his belief and is quick to remind critics he has already been proved right on residential investment. “There’s one side that has been wrong, and that’s the one that said housing is a sideshow,” Hatzius says. “So now they’re turning to another question: Is it going to cut consumer spending?”

You would think, with all the data available, the economists would have settled this one by now. But the practice of extracting cash from homes took off only a decade ago. So the Fed is to a large degree sailing in uncharted waters. So are investors whose growth forecasts presume that consumers will keep consuming.

The cupboard is bare.

Consumers in the U.S. have led the American economy, indeed the world economy, into prosperity. Now they will lead it into recession. The simple reason is that at some point America’s big spenders are going to run out of spending power. For a quarter-century consumer spending has grown on average a half percentage point per year faster than aftertax incomes. Borrowing has leaped. This has powered the U.S. economy and the many foreign economies that have no buyers for their excess goods and services except American consumers.

The U.S. savings rate decline coincided with the great bull market that started in August 1982. As time passed, people convinced themselves that they did not need to save any current income because everlasting stock appreciation would substitute. When stocks tanked in 2000-02, housing seamlessly took over this role as savings substitute. And housing is much more important to most Americans than the stock market is. Half of Americans own stocks or mutual funds; 69% of households own their own abodes. And homeownership is much more evenly spread. The top 10% of the income pile own 24 times as much in stocks as the bottom 20% but only 6.4 times as much in residence value. So the average Joe is better off now, even though stocks remain below their early 2000 peak.

And he will get hurt much more as the housing bubble deflates. For the moment, house sellers are holding out rather than cutting prices, you do not see much of a correction in prices – yet. It will take a 25% decline in the nationwide median single-family house price to reestablish its relationship with the CPI, incomes and rents. Speculator grief will get the media attention, but you should focus on the majority of homeowners who still have jobs and are making mortgage payments. They have used house appreciation to bridge the gap between income and spending. In this recovery’s 18 quarters real consumer spending has risen at a 3.1% annual rate vs. real incomes, as measured by the Fed, at only a 1% rate. To fill the gap, homeowners have refinanced and taken home equity loans.

A collapse in this funding does not need a collapse in house prices. A mere plateauing of prices will suffice. What is left to pay the bills? Not inheritances. Parents are living longer and incurring big medical costs. In 2004 the average boomer inheritance was only $49,000, hardly enough to finance high living in retirement. Also, 60% of all inheritance money went to the top 40%, who already had considerable assets. Other big funding sources are lacking as well. Consumers have no alternative to saving more of current income and borrowing less. This will reverse trends that have been so chronic that most do not realize they exist. Many investors will be shocked when the long-expanding credit card business shrinks.

Given what is happening to house prices, it is extremely likely that consumer retrenchment will precipitate a recession, probably around year’s end. The recession will spread globally as consumer demand for imports wanes. Corporate profits and stocks will disappoint. The index of home builder sentiment leads the S&P 500 by 12 months, and that index started to fall a year ago. In the longer run a consumer saving spree will pinch discretionary spending in areas like autos, appliances, cruise lines, hotels and other recreation and travel. On the plus side, declining inflation and interest rates will benefit many utilities, banks and others that pay high and increasing dividends. Individuals’ newfound zeal for saving will aid investment advisers, banks, brokers and others who help people invest. Aging postwar babies, of course, will consume lots of health care. Still, cost pressures will favor hardware and software companies that improve health care efficiencies over those that extend life at tremendous costs.

No, there will not be a hard landing for housing. It will be a crash landing.

Will there be a hard landing? No! Will there be a crash landing? Absolutely! Despite September’s short covering of homebuilders and value buyers trying to cash in on low P/Es and stocks selling at or below book value, a hard landing is now out of the question. We are in for a market crash. Read between the lines, or read actual comments for content. For those “value investors” buying the homebuilders because the P/Es are so low, I ask, What happens when there are no earnings? And for those “value investors” buying for the book value, I ask, What happens when the builders take massive write-downs to land, and burn up cash with carrying costs of unsold inventory?

But that is not even the heart of the current problems. For the last two weeks, I [the author is a real estate broker] have been receiving daily calls from desperate mortgage brokers, real estate attorneys, insurance brokers, title companies, and subcontractors looking for deals and work. This week, I spoke with a real estate attorney closing his office and returning to the corporate world. And several of the smaller builders have called me offering triple commissions to entice sales of their inventory. It does not end there.

Who will the housing crash affect? Everyone. Real estate agents will be first. As a group, they have made a ton of money during the housing boom, and they have spent millions on new cars, vacations, restaurants, clothes, and everything else that comes with excessive discretionary income. That is over now. Agents are not buying the luxury items that helped feed the economic boom, and they are cutting back on business spending like advertising and marketing. That hits the vendors and newspaper revenues. Take it a step further. With sales off 50% and more, all of the industries that have benefited from the boom will suffer loss of revenue and jobs at accelerated rates and massive proportions.

The flippers fed the housing boom, and they are washed up. Many flippers bought multiple properties. When in the history of the world have we ever seen the housing industry conduct business like a stock exchange? We had bidding wars. We had lotteries on new developments, just like we had allocations for new tech offerings during the late ‘90s. And just like the tech boom, the buyers were not making decisions based on fundamentals. Take a look at the recent Vonage offering, where buyers do not want to pay for their stock, because the price dropped after the IPO. The same thing is happening in the housing market, with thousands of buyers walking away from deposits, refusing to close on homes. That adds to the woes of the builders. And just like we saw a tech crash with everyone rushing to sell, we are now just starting to see flippers dump properties for 200-400% losses on their deposits. Add to the woes the fact that interest rates are up and most flippers bought using creative financing and low-rate ARMs.

But this is all old news for us. The other shoe is dropping now. Loss of hundreds of thousands of jobs created from housing will act like a virus and spread throughout our economy. As the primary players are affected and they cut back on spending, so will the secondary players in this market. These companies will be forced to lay off employees, and the cycle will grow like a virus. Is that it? Not a chance. With interest rates rising and job losses skyrocketing, the affordability index for homes drops in step. The buyers that are still in the market cannot afford the same home they could a year ago. So you have the flippers desperate to sell, the builders stuck with inventory of unsold homes, and now the group of sellers that are being foreclosed or simply decide to sell because they can no longer swing the monthly mortgage payments after losing their jobs.

Nonsense? Hardly. I spoke with a real estate agent the other day who has not sold a home in three months. His wife works for a title company and was just laid off. He is now sending out applications for a job in his former field of banking. He has been out of the field for five years, and is 54 years old. They have two kids in college and a hefty mortgage. Oh, by the way, they own three flip properties that they cannot sell. The attorney who is closing his office and returning to the corporate world is laying off six people in his office. The builder who called me this week employs about a dozen people, as well as a small army of subcontractors. He is closing up.

And how about my office? I have decided to lay off one of my team members. As much as it hurt to break the news to her, I have no choice. If things do not pick up within the next 30 days, I will be forced to lay off a second team member. Survival is at stake. And realistically, if things do not pick up within 90 days, I will close my office and concentrate on my other businesses. This is reality, and you are hearing it from the horse’s mouth.

Multiply these four micro-scenarios by thousands and you have a crash. A hard landing is out of the question at this point. The economists should be talking about how devastating the crash will be.

COMPARED TO WHAT?

A smart investor must learn to beware of bogus comparisons. And a lot are kicking around, particularly matchups against the S&P 500, the most commonly used market yardstick. As a benchmark of larger companies the S&P is quite valid, but you have to understand its limitations.

Some stock picker says his recommended list beat the market, as defined by the S&P 500. One question to ask: Does he lean to smaller companies? In such a case his apparent genius may reflect nothing more than the recent strength of small- and midcap stocks. In evaluating its own columnists’ stock-picking performance, Forbes deals with timing by comparing each stock to a hypothetical investment in the S&P 500 made on the same day. Not all statisticians are so scrupulous. Finally: Does the average give equal weight to small and large companies? That is okay if it is understood from the beginning that the customer will be putting identical amounts into all the positions, not okay if the person doing the averaging gets to decide at year-end whether or not the larger companies will be accorded more weight.

The S&P is weighted by the value of its 500 stocks. General Electric shares are worth a collective $351 billion, giving them, at 3%, the second-largest weight in the index (behind only ExxonMobil). One of the smallest companies by capitalization among the 500 is Dillard’s, the department store chain. Its shares account for 0.017% of the S&P. GE is 177 times as important to the market as Dillard’s. And that is probably justified, given that GE is much bigger, employs more people and makes a lot more in profits than does Dillard’s.

What if you had bought 100 shares each of the two stocks last Jan. 1, GE at $35.05 per share and Dillard’s (way down at number 490) for $24.82? Your total investment, not counting commissions, would be $5,987. Those 200 shares are now worth $6,680 – up 11.6%. Had you bought not 100 shares of each but amounts in proportion to each company’s capitalization ($5,648 and $34), you would have a return determined almost entirely by GE’s return – only 0.13%. And if you were bragging about performance, you might just take the liberty of averaging the two percentage returns, 0% for GE and 26% for Dillard’s, and claiming a 13% gain.

Whenever you see that this or that list has strongly outperformed the S&P over whatever period, it is usually because one or two $3 stocks have doubled. The small-cap issues have been on a tear for the past few years, while blue chips have lagged. Will this always be true? Of course not. Big and medium-size companies are the backbone of the economy and should get a big representation in your portfolio.

BROKEN CHINA

Out of a population of 1.3 billion, there must be one honest Chinese citizen. It defies belief that there would not be. Yet this singular uncorrupted individual is making himself scarce. Scandal chases scandal in the People’s Republic. Misdeeds seem especially prevalent in the bustling city of Shanghai, where a dustup surrounding the alleged misappropriation of assets from the $1 billion city pension fund has led to the forced resignation of three senior executives at the Shanghai Electric Group. And the Shanghai branch of Huaxia Bank has been exposed by a government audit in a scheme to underreport its nonperforming loans, according to Chinese news reports.

But the Chinese press, though sometimes damning, is sweetness and light compared with Chinese prospectuses. Tales of bribery and embezzlement fill the “risk factors” section of the offering documents of the big Chinese banks. You would swear you were reading the Shanghai police blotter. Insofar as the world depends on China’s growth, the state of the Chinese banking system is the world s problem. Late in the 1980s an American junk-bond borrower could shout its incapacity to service its debts from the rooftops. But in their state of boom-induced euphoria, the lenders stopped up their ears. So, too, in postmillennial China. The Bank of China, with assets of $590 billion, disclosed (on the eve of its springtime IPO) an impressive litany of in-house criminality, malfeasance and incompetence. But the stock was bid for as if the disclosures had been written in invisible ink. The prospectus relates that the number of “criminal offenses” committed within the bank jumped from 32 in 2004 to 75 in 2005.

In any case, it would come as no shock to a man or woman of the world to discover that doubtful loans were significantly higher than the sums officially acknowledged. Last spring a study by Ernst & Young put nonperforming Chinese bank debt as high as $911 billion, far greater than both the $164 billion to which the Chinese authorities admit and the $875 billion said to be in China’s national foreign-exchange war chest. The E&Y front office quickly disavowed its own analysts’ findings – on grounds that they were erroneous, maintains E&Y, certainly not because the firm also incidentally happens to audit the accounts of the Industrial & Commercial Bank of China. But others have arrived at conclusions not radically different.

The art of lending, a little like the art of piano playing, is practiced by many but mastered by few. The banking business is hard enough in a free economy. In China, where facts and evidence are routinely twisted to suit the needs of the Communist Party, the lot of a lender is treacherous indeed. “Due to limitations in the availability of information and the developing infrastructure of [the People’s Republic],” said the Bank of China’s prospectus, “nationwide credit information databases are generally undeveloped. In addition, financial statement disclosure and audit standards for corporate borrowers in the PRC may not be comparable to those in more developed countries.”

The Texas savings and loan debacle of the late 1980s and the New York City banking crisis of the early 1990s each occurred in a market economy organized under the rule of law. How much worse would things have been in a one-party state? The Bank of China is listed on the Hong Kong exchange, where it trades at the very fancy multiple of 25 times trailing net income. But this is not to say there is no way to invest in the future of Chinese banking. …

Is China on the brink? Why it matters for the United States.

China is now feeling the strain of almost a decade of torrid growth. Although there are plenty of worrisome signs, the conventional wisdom is that things will be fine through the 2008 Olympics. I have a slightly different view of the timing of a pullback in that country’s economy, which could be especially bad, given likely upcoming developments in the U.S. (and elsewhere in the world).

One example of prevailing opinion is that of James Jubak, a street.com guest columnist, who thinks that the Chinese economy is headed for “a train wreck,” having just passed “the point of no return.” Cheap U.S. money, operating through China’s mammoth trade surpluses and dollar reserves, has fueled a steroidal double-digit GDP growth that has even the local authorities worried. The result is that key industries such as cement and steel are seeing profit plunges because of price pressures caused by overcapacity. This is spreading to a number of areas, mainly the commodity producers dominated by state-owned-enterprises (SOEs), many of which are bankrupt in all but name, and are propped up by outstanding bad loans from state banks.

I believe that the crisis in the Chinese economy will not take place in 2009, after the Olympics as Jubak opines. It will take place before, in late 2007 or early 2008. What has been driving the Chinese economy is not the 2008 Olympics per se, but rather the anticipation of the Olympics, which will mostly end in 2007. The infrastructure buildup in advance of the hosting of the games has been giving a one-time artificial, and foreign-based, stimulus to the economy, creating a gap that domestic demand cannot fill. By early 2008 on the other hand, investment for the Olympics will be winding down, as attention turns to last-minute fine-tuning of the event itself, likely causing a sharp drop in aggregate demand at that time. And markets often move on anticipation of major events, not necessarily on the events themselves.

Massive environmental problems, bad loans to SOEs, widespread corruption and lack of underwriting standards and regulatory oversight and banks are all problems. Rapid growth has encouraged a “get rich quick” mentality, causing people to cut corners and bend the rules, creating widespread discontent among the hundreds of millions of people who are not participating in, and are fact harmed by, the recent “economic miracle”. This is causing protests, riots, and other events that threaten social stability. All this would not seem so critical if I did not believe that the U.S. will have a recession in 2007. This would be a result of our own, somewhat milder version of China’s problems, which would start with the impending bursting of the consumer bubble. Under ordinary circumstances, the U.S. economy should begin a comeback in 2008, after a cleansing period.

But the timing and degree of a prospective Chinese crash raises the stakes. In 1931, the U.S. was in a recession that then-President Herbert Hoover reasonably thought would soon end. The impending recovery was derailed by the collapse of the German economy, then the second most important in the world, not only because of its sheer size, but because of its connections to other countries in Europe. China’s economy plays a similar “second most important” role today because of her ties in Asia and elsewhere, and because its swings are larger than those of other, nominally larger, economies such as those of Germany and Japan. If a collapse of the Chinese economy comes hard on the heels of a deep U.S. recession in 2007-2008, the result could be a prolonged slowdown of global growth such as we saw in the 1930s.

Chinese yuan undervalued? Maybe it is overvalued.

Many economists who have gathered in Singapore for the IMF’s annual meeting this week agree China would alleviate global imbalances by allowing the yuan to strengthen. While estimates for how undervalued the currency is range from 10% to 40%, just about everyone says it would shoot higher and stay there if traders had their way.

What if the opposite was true and the currency of Asia’s No. 2 economy was overvalued? “The argument that the RMB is undervalued is questionable,” says Friedrich Wu, an economist at the National University of Singapore’s East Asian Institute. It is economic blasphemy even to suggest such a thing. There is cause for concern when virtually every economist in the world agrees on something. China faces an ever-growing number of risks that must be headed off to keep an economy growing at 11% from spiraling out of control.

The argument for a stronger yuan seems straightforward. China is running a large trade surplus, has almost $1 trillion of currency reserves and lots of capital is flowing its way. Yet think of the balancing act facing Chinese officials. They need to create millions of jobs to maintain social stability, slow the economy to avoid overheating, and pull off these daunting tasks without traditional tools. Monetary policy has little effect in China because it lacks what central bankers call transmission mechanisms. Without a vibrant secondary bond market, monetary changes do not have the potency they do in more developed economies. Neither does China have an effective fiscal policy that can be tightened in Beijing. That is why the focus has been on administrative steps to halt speculation – and why China is still barreling ahead.

Walking the streets of China and chatting to executives there, it is hard not to think the economy is growing much faster than the official rate. China also seems simultaneously on the verge of inflation and deflation. It is well-known that the furious pace of China’s inward investment could boost consumer prices. Far less attention is paid to China’s overcapacity problem. And let us not forget the hype factor. Perhaps the best analogy is the dot-com boom and bust of the late 1990s and early this decade. China could be described as the economic equivalent of that phenomenon. China is Asia’s New Economy and anyone who disagrees just does not get it.

Let us hope this view is right. China spiraling into financial chaos could make Asia’s 1997 meltdown look negligible. It is an economy that even Japan is relying on for growth. One wonders how China can thrive without a well-functioning bond market, a solid banking system, more entrepreneurship, greater domestic demand and freedom of speech. “Whether a currency is too strong or too weak is a function of your perspective,” says Stephen Jen, London-based head of global currency research at Morgan Stanley. “That is why currency valuation is so subjective.” So is economic forecasting. Many predict China will surpass Japan and the U.S. well before the middle of this century. Whatever happens, China still needs to avoid what no other industrializing economy has been able to … a hard landing.

Amid so many risks, is it really a given that China's currency should be 20 percent or even 40% stronger? Such views may owe more to a well-ingrained herd mentality about China’s promise than the true state of its economy. Once traders look under the nation’s hood, the yuan may very well sink under the weight of China’s challenges.

WHAT IS REALLY PROPPING UP THE U.S. ECONOMY

If you really want to understand what makes the U.S. economy tick these days, do not go to Silicon Valley, Wall Street, or Washington. Just take a short trip to your local hospital. Watch the unending flow of doctors, nurses, technicians, and support personnel. You will have a front-row seat at the health-care economy. For years, everyone from politicians on both sides of the aisle to corporate execs to your Aunt Tilly have justifiably bemoaned American health care – the out-of-control costs, the vast inefficiencies, the lack of access, and the often inexplicable blunders.

But the very real problems with the health-care system mask a simple fact. Without it the nation’s labor market would be in a deep coma. Since 2001, 1.7 million new jobs have been added in the health-care sector, which includes related industries such as pharmaceuticals and health insurance. Meanwhile, the number of private-sector jobs outside of health care is no higher than it was five years ago. Sure, housing has been a bonanza for homebuilders, real estate agents, and mortgage brokers. Together they have added more than 900,000 jobs since 2001. But the pressures of globalization and new technology have wreaked havoc on the rest of the labor market. Factories are still closing, retailers are shrinking, and the finance and insurance sector, outside of real estate lending and health insurers, has generated few additional jobs.

Perhaps most surprising, information technology, the great electronic promise of the 1990s, has turned into one of the biggest job-growth disappointments of all time. Despite the splashy success of companies such as Google and Yahoo!, businesses at the core of the information economy – software, semiconductors, telecom, and the whole gamut of Web companies – have lost more than 1.1 million jobs in the past five years. Those businesses employ fewer Americans today than they did in 1998, when the Internet frenzy kicked into high gear. Meanwhile, hospital administrators like Steven Altschuler, president of Children’s Hospital of Philadelphia, are on a hiring spree. Altschuler has added the equivalent of 4,000 new full-time jobs since he took over six years ago, almost doubling the hospital’s workforce. To put this in perspective, all the nonhealth-care businesses in the Philadelphia area combined added virtually no jobs over the same stretch.

The City of Brotherly Love is hardly alone. Across the country, state and local politicians, desperate for growth, are crafting their economic development strategies around biotech and health care. What they are waking up to is the true underpinnings of the much vaunted American job machine. The U.S. unemployment rate is 4.7%, compared with 8.2% and 8.9%, respectively, in Germany and France. But the health-care systems of those two countries added very few jobs from 1997 to 2004, according to the OECD, while U.S. hospitals and physician offices never stopped growing. Take away health-care hiring in the U.S., and the U.S. unemployment rate would be 1 to 2 percentage points higher.

Make no mistake, though. The U.S. could eventually pay a big economic price for all these jobs. Ballooning government spending on health care is a major reason why Washington is running an enormous budget deficit. Rising prices for medical care are making it harder for the average American to afford health insurance, leaving 47 million uninsured. Moreover, as the high cost of health care lowers the competitiveness of U.S. corporations, it may accelerate the outflow of jobs in a self-reinforcing cycle. And, if current trends continue, 30% to 40% of all new jobs created over the next 25 years will be in health care. That sort of lopsided job creation is not the blueprint for a well-functioning economy. For now, though, health-care hiring is providing a safety net in areas where manufacturing and retailing are no longer dependable sources of jobs.

INVESTOR LARRY GOLDSTEIN LOOKS FOR GEMS HIDDEN IN SMALL COMPANIES. THEN THINGS CAN GET UGLY

It is like a scene from the movie Other People’s Money, where the swaggering Wall Street buccaneer comes to pillage the little town’s staid, beneficent company. But Lawrence J. Goldstein, who jokingly likens himself to Danny DeVito’s invading financier, thinks the good folk of bucolic Goshen, N.Y. should be thankful he is trying to shake up slumbering Warwick Valley Telephone. A hard-driving Drexel Burnham alumnus who now heads asset-management firm Santa Monica Partners, Goldstein, 70, specializes in very small public companies holding gemlike assets that are little appreciated. In Warwick’s (NASDAQ: WWVY) case the gem is a hugely profitable 7.5% stake in an entity that sells wireless minutes to big telecoms. The cellular unit, Orange County-Poughkeepsie L.P., props up 104-year-old Warwick (market cap: $107 million), an old-style provider of landline services to small towns. Warwick’s earnings are erratic and without the cell partnership would be in negative territory.

For the past three years Goldstein has pushed Warwick to spin off the landline unit, forcing it to make do on its own, and to redirect the cash coming from the cellular venture into the pockets of Warwick shareholders. (Verizon Wireless, which owns 85% of Orange County-Poughkeepsie, is not taking sides in the dispute.) He had to go to court to have two of his candidates for Warwick’s board placed on the ballot. Goldstein and his right-hand man, Josh M. Eudowe, estimate their plan would bring a $2-a-share annual payout to Warwick stockholders, who now get 80 cents in regular yearly dividends. But many of these shareholders are Goshen-area people who have had Warwick stock handed down through their families for generations. Goldstein’s idea is bad, they say, because it would gut Warwick and throw the company’s 130 employees out on the street. Warwick’s shareholders happily voted down both Goldstein’s plan and his board candidates at the last annual meeting.

Even without such stiff resistance to change, Goldstein is playing a high-risk game by investing in tiny companies with thin market floats, some trading on the Pink Sheets. This means gaping bid-ask spreads that would kill in-and-out traders. The trick, he says, is to find the gem-laden Warwicks and hang on to them in hopes they can be turned around. “We will never vote with our feet,” he vows. If you want to follow his lead, check out the list of his holdings.

Goldstein’s firm has done pretty well. Since its 1982 founding Santa Monica Partners has taken positions in more than a thousand companies. It claims a yearly 16% return to investors over the past 24 years. The return is after paying a stiff 3% annual management fee and after Goldstein has pocketed a fifth of the profits. The firm manages $160 million. Goldstein pushes management to, in finance-speak, unlock the value of the assets. That does not always involve a fight. He is very happy with HMG/Courtland Properties, which owns a resort, hotel, spa and marina on an island off tony Coconut Grove, Florida. HMG qualifies as an REIT but eschews customarily high REIT dividends in favor of developing new properties on little-noticed vacant land it has bought. HMG’s market price is $10 per share. Eudowe estimates that the breakup value is at least $35.

On the contested investments, such as Warwick, how can Goldstein win with in-your-face tactics guaranteed to alienate other shareholders and management? Sheer persistence usually works. In the late 1980s he mounted proxy fights against a maker of baby items (bottles, toys) called the First Years. Earnings were declining because the company had too few products and too big a payroll, he contended. The Sidman family, with 52% of the stock, easily blocked his plans. Still, after a while the family had to concede he was right. It reduced salaries, instituted an incentive compensation plan and increased the product roster. Earnings picked up, and the company was acquired.

Lately he is brawling with the management of another small telecom that boasts a valuable cellular arm, North Pittsburgh Systems. Goldstein, along with celebrated ally Bulldog Investors (which led the successful court challenge to federal regulation of hedge funds), is pressing the company to put itself on the block. Selling now makes sense, because traditional telecoms, under siege from wireless, cable and others, will not fetch as much later, Goldstein reasons. Another of Goldstein’s investments is a little closer to home: FRMO, a consultant to hedge funds like Kinetics Advisors, which manages $2 billion. “The stock is now selling at $3.75 a share, but someday I’ll bet it is worth triple digits per share,” says Goldstein, ever alert for small things that can grow.

LARGE IS GOOD?

One of the more popular arguments against the existence of a small-cap size premium regards the dominance of the large-cap franchise. It is argued that small companies are inferior to large companies and therefore make poor investments. Among the factors cited for large companies being sound investments are recent technological advances such as just-in-time inventory and e-commerce, a financial landscape that ties together global markets more closely, and fewer layers of corporate management – resulting in more efficient operations than in past decades. Bear in mind, however, that these changes should benefit all firms, both large and small.

One pivotal component of the “large is good” argument relates to the economies of scope and scale from which large firms can benefit. They can leverage these economies to take a dominant market-share position, squeeze out inefficiencies, and streamline costs to yield greater profitability. The larger a firm becomes, however, the greater the challenge to operate it efficiently. The question then becomes whether senior management can corral middle management to push through its corporate goals effectively.

In an Op-Ed piece in The New York Times, David C. McCourt, Chairman of RCN Corporation, made a forceful argument that big is not necessarily better: “The most profound emotion running through the executive offices of the nation’s former telecommunications monopolies these days must be terror. The clearest example of this terror is the steady stream of megamerger announcements … If 100 years of business history has taught us anything, it is that Godzilla can’t marry King Kong and live happily ever after. … Federal Express was not born of a megamerger. Neither was Microsoft, Wal-Mart or Sony. Companies that become industry leaders are marked by strong values, clear goals and better ideas. … Moving from a destroyer to a battleship doesn’t just give you a bigger boat, it gives you a bigger boat to turn around. … Railroads didn’t become airlines. Western Union didn’t become AT&T. Horse-drawn buggy makers didn’t go on to lead the automotive revolution. These kinds of shifts don’t happen, because companies that dominate a certain technology find it close to impossible to cannibalize their own business to embrace the changes being imposed on them. … Unfortunately, the eyes of the terrified often see bigger as better, even when the reality dictates the opposite.”

Although McCourt clearly disagrees with the “bigger is better” argument, the “large company, good investment” mantra has been partly based on the superb stock performance of large companies in the latter half of the 1990s and much of the 1980s. In The Synergy Trap, Professor Mark Sirower of NYU assails the large-is-good argument by identifying the significant number of hurdles that firms face as they attempt to become megaplayers. Ultimately, many companies overpay to grow. As a result, even if a combination makes good business sense, management still faces tremendous difficulties in generating profitable results. The hurdles for these newly formed entities are significantly higher because of the premium they typically pay to achieve so-called synergies. Further, the value combinations tend to be overestimated. As a result, the odds are typically against a firm’s being successful by simply acquiring size or buying other companies to become a larger force.

Can the largest companies dominate the equity performance race over time, simply because they are “good” companies? Small-cap cycles in the past have not depended on large-cap stocks being inferior companies. The outperformance of small companies from 1991 to 1993 did not imply that large blue-chip firms such as Merck, Coca-Cola, and Microsoft were inferior businesses. A critical but faulty assumption is that great companies are synonymous with great stocks. The value of a firm is based on expectations of growth. If the market has already priced-in a rosy outlook for a company, what incremental or ongoing evidence drives existing valuations higher? If all good news has already been taken into account in the price of a company, the equity component of this company quite possibly is a questionable investment.

Whether or not market participants agree with the “large is good” hypothesis, the dedicated large-cap investor is likely to migrate to attractively valued large companies under extreme valuation conditions, such as when one segment of large companies is severely overvalued in comparison to the remainder of the market. As long as investors are opportunistic in their trading and buy companies for reasonable value, they are likely to trade out of overvalued companies, causing a rotation within their large-cap universe. This “value” rotation within the large-cap market implies a marginal shift toward smaller firms as well as cheaper stocks. The evidence clearly indicates that if a size swing occurs in the large-cap market, a concurrent rotation also occurs across the entire market. Stock prices in major markets such as the U.S., the U.K., Japan, and Australia, for example, consistently suggest that swings in size occurring in the large-cap market also ripple through to the secondary market.

This chart illustrates how rotations within the large-cap market appear to trace rotations in smaller capitalized firms. If large firms were simply better companies and therefore merited the exclusive attention of the equity market, the startling correlation between intra-small-cap and intra-large-cap cycles would not exist.

HEDGE FUND SAYS FUNDS LOST 50% ON NATURAL GAS TRADES THIS MONTH

Amaranth Advisors LLC, a hedge-fund manager with $9.5 billion in assets, warned investors that its two main funds fell almost 50% this month because of a plunge in natural-gas prices. “We are in discussions with our prime brokers and other counterparties and are working to protect our investors while meeting the obligations of our creditors,” Nick Maounis, founder of the Greenwich, Connecticut-based firm, said in a letter to investors. The funds, which had gained 26% through August, are down at least 35% for the year.

Amaranth, which made so-called spread trades that try to profit from price discrepancies among futures contracts, is at least the second hedge fund to be hurt by this year’s tumble in natural gas. Last month, MotherRock LP, a $400 million fund run by former New York Mercantile Exchange President Robert “Bo” Collins, went bust after natural-gas futures fell 68% from their December 13, 2005 peak. “To lose that much so fast, the traders involved didn’t have any stops” in place, said Robert Webb, a professor of finance at the University of Virginia and a former trader, referring to a type of trade designed to limit losses. “Sometimes spreads go awry.”

Gas bet gone bad torches hedgies in a $5 billion inferno.

Hedge fund Amaranth Advisors was clinging to life as its traders scrambled to sell holdings after a harebrained wager on natural gas cost the firm roughly half of its $9.5 billion portfolio. Across Wall Street, Amaranth’s brokers were trying to raise cash for the firm by liquidating its other bonds and stocks, traders said. And the fire sale is expected to continue the rest of the week.

Amaranth, started in 2000 by former Paloma Partners’ hedge fund guru Nicholas Maounis, was up nearly 30 percent before management fees this year, and its asset base had grown to a whopping $9.5 billion. After studying weather patterns and other data, Amaranth made an enormous wrong-way bet that a Katrina-like hurricane would cause the difference between summer and winter natural gas prices to widen dramatically. Instead, a mild hurricane season caused that spread to collapse, wiping out about $5 billion in value. “I can’t believe they bet the whole fund on a hurricane,” said one energy trader.

The losses are especially painful for Amaranth’s large institutional investors, including several pension funds, university endowments and fund-of-funds managed by big brokerage houses, including Morgan Stanley, Deutsche Bank and Credit Suisse. Morgan Stanley’s Institutional Fund of Hedge Funds gave $94 million to Amaranth in November 2004, which represented more than 5% of its fund, according to regulatory filings. Maounis will have to navigate some difficult seas in the next month, when some investors can begin pulling money out of the fund. Sources said Amaranth had devised so-called gates - which restrict client withdrawals to up to two years after investment. That will probably stave off a rush for the doors that would collapse a smaller fund. Still, about $1 billion worth of lock-up agreements will expire in the next two months, sources said. “I think Amaranth is going to die a slow and painful death,” said one source.

Amaranth’s risky business.

It appears risk management went out the window at Amaranth, the giant hedge fund that lost $4 billion on a bad bet on natural gas prices. The 6-year-old hedge fund’s big gamble that natural gas prices would keep rising paid off for much of the summer. But in a span of a week, all those paper gains, and more, went up in smoke. Last week’s sudden fall in the price of natural gas meant that the hedge fund ended up losing nearly four times as much as it had gained.

What made Amaranth’s gamble so disastrous is that it borrowed heavily from its brokers to bet on the spread between natural gas contracts. By one estimate, for every dollar of its own money that Amaranth put down, it used $5 in so-called leverage. That ratio can produce a big payday if a trader makes the right bet. But when a bet goes awry, all that leverage only magnifies the losses. There is also speculation on Wall Street that the hedge fund, led by Nick Mauonis, may have been trying to corner the market in long contracts on natural gas futures.

Michael Greenberger, former director of the division of trading and markets at the Commodity Futures Trading Commission, says he has heard that Amaranth made many of its trades on the over-the-counter market – away from the New York Mercantile Exchange, where trades could have been monitored by regulators. Greenberger says the natural gas market has become a pure speculators’ market subject to potential manipulation. He says he would not be surprised if the Amaranth debacle spurs a closer look into the high-risk, speculative trading going in the natural gas market. “I don’t know if Amaranth is going to be the last straw,” says Greenberger. “But Amaranth is not going to be the last problem.”

HEDGE, I WIN … FAILS, YOU LOSE

Hedge fund Amaranth Advisors managed to lose $4.6 billion – about half its entire value – in a matter of just a few days through a sensational miscalculation of the price of natural gas futures in the spring of 2007. Now we hear the figure has now grown to $6 billion. Star trader Brian Hunter bet the farm on the idea that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents, wiping out Amaranths’ 20+% yearly returns, in one fell swoop, to a 35% loss.

Hunter, a Canadian, had made millions for the firm after natural gas prices exploded in the wake of Hurricane Katrina. He was thought to be so savvy about gas futures that his bosses at Amaranth let him work out of his home in Calgary, where he drove a Ferrari in the summer and a Bentley in the winter. The jazzy wheels matched the snazzy wheeling … and the honeyed dealing at the American energy fund, where 1.4% of net assets went for “bonus compensation to designated traders” and another 2.3% was doled out for “operating expenses”. When an account made a net profit, the manager took care to cut himself up to 1.5% of the account balance per year in addition to a 20% cut of its net profits – less the traders’ bonuses and operating expenses. But when the account lost money, the managers suffered no penalty, though the investors still remained on the hook for the operating expenses and possibly for trader bonuses as well.

What kind of a gig is that? Where investors have to pay to play and then pay to lose, as well? What can investors be thinking when they see their accounts shrivel like anorexics on a fat farm while their managers grow sleek and prosperous in their Greenwich pads? The hedge fund world is famously populated by math whizzes, each one claiming to have solved Poincare’s Conjecture. But the important math of hedge funds is very simple: heads I win, tails you lose. The typical fund charges 2% of capital, plus 20% of the gains above a benchmark, often the risk-free rate of return – say around 5% today. So, a fund with a 10% return charges its clients 2% of capital, plus another 2% (20% of 10%) for the performance. Even a fund that is able to do twice as well as the benchmark – a difficult feat – only leaves the investor with a 6% return, net. When the fund takes a loss, the managers do not send out a letter offering to share 20% of the loss. No, they are happy to take a percentage of the profits, but not the losses. The essential math is not only easy...it is perverse. As demonstrated by Amaranth, fund managers have every incentive to take wild gambles. If the gamble pays off, they become rich and famous. If it does not, they are still the same math prodigies they were before.

Why do investors think they can get anywhere in such a game? The quick answer is that investors are not thinking. In the late stages of empire, thinking becomes a vestigial function – about as useful as an appendix. And as liable to be cut out in a crisis. Instead, investors rationalize – and theorize – to justify the excesses and extravagances of the imperial economy. Better returns, they say – though hedge fund returns have been so abysmally low that their money would have slept sounder tucked up in a cozy money market account. Different market, they argue – claiming that the new conditions demand provocative trading rather than stodgy buying-and-holding. Don’t marry your stocks, they warn. Just shack up for a few months and unload them when the next hottie comes along. But the fast moving floozies have all been on the street too long already. They are overpriced and overworked, and will go down faster and further than the market when it goes down. The hedge funds have smarter managers, claim investors. And here, finally, they might have a point. Who but a real sharpie could have come up with such a clever scheme? Hedge fund clients might be dripping in red the past few years, but the fund managers themselves are in clover.

If vanity were gravity, Greenwich, Connecticut would be a black hole. The puffed-up twits who manage most hedge funds contribute to more unwarranted bluster per square foot there than in any place outside North Korea. Greenwich sucks in money from all over the financial world and turns it into … nothing. In this respect, Amaranth is only following the hedge fund playbook. Deals for hedge bosses are so sweet that Warren Buffet claims the funds are not really investment vehicles at all but compensation strategies – ways to keep star managers in their multimillion dollar digs while the funds themselves turn in lower and lower returns: sub-10% on average, and in some cases, pushing below 5%. In 2005 some 848 hedges closed down their business, says one consultancy firm.

Today, hedge funds have spread like a tropical parasite so that there are now 8000 or so of them, infesting even institutional investors and pension funds, and sucking in total assets of about $1.2 trillion. You would think this would give at least the pros in the business some pause. Yet, Morgan Stanley, for example, pumped 5% of its $2.3 billion fund of hedge funds into Amaranth. And, Goldman Sachs’s fund of hedge funds also admitted that an anonymous energy-related investment – guess who? – had wiped off a chunky 3% off its monthly return.

Hubris and excessive risk run through the entire sorry episode. Like LTCM – the energy firm that blew up in 1998 – Amaranth held such large positions in the market that it could not unravel its positions. Like LTCM, Amaranth seemed certain it would never fail and boasted of its “fearlessness” on its website. Like LTCM, Amaranth was hazy about what it was doing and how. But unlike LTCM, the financial community is reacting with odd indifference to Amaranth’s fiasco. Amaranth’s blow-up does not affect as many institutional investors and banks and other financial VIPs, as LTCMs did. Only its rich clients have to endure the pangs of portfolios sliced neatly in half.

Maybe so. Maybe not. We think of the typical hedge fund manager. Not yet 30, no experience of a real bear market, let alone a credit contraction. The man thinks only of the new house he will build in Greenwich, if his bets pay off. He imagines that he will take his place alongside George Soros and the Quantum Fund. More likely, he will join Brian Hunter in the pigweed.

THIRST FOR CASH THAT THREATENS A CRASH

The crash in May of exotic currencies and stock markets across the world already seems no more than a bad dream, a momentary disturbance to the Goldilocks bliss now assumed to be the normal state. Bombay’s Sensex index of Indian equities has roared back 32% since June as foreign investors turn a blind eye to a poisonous fiscal deficit (state and federal) of 9.3% of GDP. The Turkish lira has rebounded 13% and funds are again snapping up lira bonds, tempted by yields of 19%. Conveniently forgotten is Turkey’s current account deficit of 7.7% of GDP and the need to roll over $52 billion in foreign debts this year.

Ahmet Akarli, Goldman Sachs’s Turkey expert, said London traders had jumped back into the Istanbul markets as soon as the U.S. Federal Reserve signaled an end to rate rises. But, “We don’t think these prices are sustainable over coming months. As soon as there is trouble, Turkish debt will be the first to sell off again,” he said.

The spreads between low-grade and blue chip bonds in the U.S. and Europe have been compressed to razor-thin levels – again – while the Chicago VIX index, which measures risk appetite, has halved from 24 in June to just 13, a near-record level of complacency. Iceland, too, is back. The krona has regained most of 17% lost in this year’s “Geyser crisis”, itself the trigger for investor flight from high-yielding currencies as far away as New Zealand and South Africa. The hedge funds, abetted by Japan’s yield-hungry pensioners, cannot seem to resist the temptation of borrowing in Tokyo at 0.3% to relend via the “carry trade” in Reykjavik at a mouth-watering 13.9%.

Iceland’s central bank has been tightening viciously, bent on choking off 8.6% inflation and a housing bubble. It may succeed in short order, which should give pause for thought. Merrill Lynch says growth will collapse from 7% last year to zero in 2007. Richard Thomas, the group’s banking expert, said Iceland was still an accident waiting to happen. “Most of the problems we identified earlier this year are still there. The banks have used foreign debt to invest heavily in equity, and this money still has to be paid back,” he said. “Imbalances take a long time to unwind and as we’ve seen in earlier banking crises, the icy winds of systemic risk can blow away profitability in a single puff.” Iceland’s banks have to roll over foreign debt maturing by the end of 2007 equivalent to 130% of GDP.

The exuberant carry traders already seem to have forgotten the pain suffered when the Bank of Japan began this March to drain some $300 billion of excess liquidity, ending its 6-year policy of emergency stimulus. The yen surged, setting off a chain reaction. Two years of carry trade yield vanished in an instant. Kingsmill Bond, a strategist at Deutsche Bank, said, “There is still a risk of currency crashes. The key risks are Turkey and Hungary.”

Philip Poole, an economist at HSBC, said the Fed’s July pause in interest rate rises had dispelled fears of a global monetary squeeze. Crucially, Japan is also coming off the boil, pointing to a slower pace of rate rises from the current 0.25%. He said, “The market focus has switched away from inflation, but people are still expecting a soft landing in the US. We think they are failing to price in substantial risk to the global economy.” Rating agency Fitch said it now has five countries on watch for “macro-prudential stress”, up from two last year, using a set of indicators – Iceland, Azerbaijan, South Africa, Russia and, surprisingly, Ireland, where the ratio of private credit to GDP has reached 190%, the world’s highest. The denouement for Ireland may not be pretty, since it gave up control of monetary policy when it joined the euro.

Richard Fox, the author of the Fitch report, said, “We’re still in a global upswing but this lending cycle is already starting to turn in some countries. Credit growth has been zooming across the whole of Eastern Europe and that has tended to be a precursor to banking troubles.” Fifteen economies are now above their 15% annual “speed limit”. Over the past year, credit growth has been 49.7% in Lithuania, 46.3% in Estonia, 41.1% in Ukraine, and 46.1% in Kazakhstan, where property prices are up 900% in five years on the back of an oil boom. “Russia is enjoying a high oil price now but nothing goes on forever.” The Moscow bourse, which has risen 1,800% since 1999, now shows early signs of breaking down.

Opinion is divided about Russia, now cushioned by a current account surplus of 10% of GDP and the world’s third biggest reserves of $260 billion, rising at $12 billion a month. It is unrecognizable from the basket case with just $14 billion of reserves that defaulted on $40 billion of bonds.

The next credit crisis may have little in common with the Tequila, Asian, and Russian debacles of the 1990s. As Russia, China, South Korea, Indonesia, and Brazil, all amass a war chest of reserves to free themselves from the strictures of a mistrusted IMF, the locus of financial risk is shifting to the epicentre of the global economy. David Bloom, global head of currency strategy at HSBC, said, “It is the U.S. that we are worried about as the housing market turns down. The U.S. needs nearly one trillion dollars of foreign money each year just to stand still. If people around the rest of the world start keeping their money at home for any reason, the dollar will face a serious decline and we think it will kick in later this year. The risk has moved from the outskirts to the heart of the system, and it's now pressing on the very aorta of capitalism.”

COMMODITIES AS AN ASSET CLASS

In a low-return world, high-yielding commodities have become the siren song of the asset-liability mismatch. Well supported by seemingly powerful fundamentals on both the demand (i.e., globalization) and the supply sides (i.e., capacity shortages) of the macro equation, investors have stampeded into commodity-related assets in recent years. Once a pure play as a physical asset, commodities have now increasingly taken on the trappings of financial assets. That leaves them just as prone to excesses as stocks, bonds, and currencies. This is one of those times.

Previously, I argued that Chinese and U.S. demand were both likely to surprise on the downside – outcomes that would challenge the optimistic fundamentals still embedded in commodity markets. I also hinted that the asset play could well reinforce this development – largely because commodities have now come of age as a legitimate asset class in world financial markets. The sociological context is key to this dimension of the issue. Virtually every major institutional investor I visit around the world – from pension funds and insurance companies to mutual fund complexes and hedge funds – has a large and growing commodity department. The same is true of foreign exchange reserve managers and corporate treasury departments of multinational corporations. One major Wall Street firm is now run by a former commodity executive, and another has turned over management of its global bond division to the architect of its thriving commodity business.

Like all such trends, the expansion of the commodity culture is rooted in performance. It is not just the physical commodities themselves – most commodity-related assets in cash and futures markets have also delivered outstanding relative returns. For several years, the so-called commodity currencies of Australia and Canada have been on a tear, and big commodity producers like Russia and Brazil have led the recent charge in high-flying emerging markets. Within the global equity universe, the materials sector has been the number-one ranked performer over the past year. There is the growing profusion of commodity-related ETFs. Meanwhile, Commodity Trading Advisors (CTAs) now collectively manage over $70 billion in assets – more than three times the total three years ago.

Significantly, the consultants are now urging institutional investors to implement a major increase in their asset allocation weightings to commodities. A recent Ibbotson Associates study recommends that commodity weightings in a multi-asset balanced portfolio could be increased, under conservative return and risk-appetite assumptions, to a high of nearly 30%. That would be more than three times current weightings and greater than seven times the estimated $2 trillion value of current annual commodity production. The Ibbotson analysis praises commodities for their consistent outperformance and negative correlations with other major asset classes – going so far as to praise commodities for actually providing the protection of “portfolio insurance”. It concludes by stressing “There is little risk that commodities will dramatically underperform the other asset classes on a risk-adjusted basis over any reasonably long time period.” Laboring under the constant pressure of the asset-liability mismatch, yield-starved investors can hardly afford to ignore this enthusiastic advice.

This transformation from a physical to a financial asset alters the character of commodity investments. Among other things, it subjects the asset to the same cycles of fear and greed that have long been a part of financial market history. From tulips to dot-com and now probably U.S. residential property as well, the boom all too often begets the bust. Yale Professor Robert Shiller puts it best, arguing that asset bubbles arise when perfectly plausible fundamental stories are exaggerated by powerful “amplification mechanisms”. That appears to have been the case in commodities. In this instance, the amplification is largely an outgrowth of the China mania that is now sweeping the world – the belief that commodity-intensive Chinese hyper-growth is here to stay. I believe that the Chinese authorities will succeed in cooling off an over-heated economy, and in engineering a well-publicized shift toward more efficient usage of energy and other commodities. The potential for post-housing bubble adjustments of the American consumer could well be the icing on this cake. The recent data flow hints that such adjustments are now just getting under way.

Meanwhile, the performance of commodity-based financial assets – energy funds as well as those asset pools with more balanced portfolios of energy, metals, and other industrial materials – is starting to fray around the edges. While most of these investment vehicles have outstanding 3- and 5-year performance records, the one-year return comparisons are now solidly in negative territory for many of the biggest commodity funds. For both relative- and absolute-return investors, negative comparisons over a 12-month period are raising more than the proverbial eyebrow. As usual, the “hot money” has been the first to head for the exits, but more patient investors may not be too far behind. Shiller-like amplification mechanisms could well compound the problem. Just as they led to near parabolic increases of many commodity prices in March and April, there could be cumulative selling pressure on the downside – taking commodity prices down much more sharply than fundamentals might otherwise suggest.

For my money, there is far too much talk about the globalization-led commodity super-cycle. It gives the false impression of a one-way market, where every dip is buying opportunity. Yet commodities as a financial asset are as bubble-prone as any other investment. As is always the case in every bubble I have lived through, denial is deepest when asset values go to excess. That is very much the case today. After three years of extraordinary outperformance, denial over the possibility of a sustained downside adjustment in commodity prices is very much in evidence – underscoring the time-honored sociology of an asset class that has gone to excess. Meanwhile, China and U.S.-housing-related fundamentals are going the other way. The herding instincts of institutional investors could well magnify the price declines – when, and if, they emerge. All this suggests there is still plenty of life left in the time-honored commodity cycle.

Barton Biggs always used to chide me that “Dr. Copper” was his favorite economist – possessing an uncanny knack to provide a real-time assessment of the state of the global economy. I suspect that the good doctor has now taken his or her finger off the pulse of the real economy and spends far more time looking at Bloomberg screens. Pity the poor patient – to say nothing of the doctor!

What is behind the meltdown in the commodity markets?

“A Trend in Motion will stay in motion, until some major outside force knocks it off its course.” After climbing to a 25-year high of 365.45 on May 11th, the Reuters Jefferies Commodities (CRB) Index began to show signs of fatigue in June and July, and then stumbled into a free-fall in August and September. With the CRB index slicing below its 4-year upward sloping trend-line in early September, chart watchers would probably agree that a peak in the bullish cycle has been reached.

For the past five years, the Reuters CRB index closely tracked the up-trend in global stock markets. The Morgan Stanley Composite All-Country World Index reached a six-year high of 1407 on August 11th, up 100% from its lows in October 2002. Both asset classes were energized by the global economy’s 5% annualized growth rate in Q2 2006, its best performance in 30-years. At its peak frenzy, traders figured that worldwide demand would soon outstrip the worldwide supply for key industrial commodities, such as crude oil, copper, iron ore, nickel, and zinc.

So what major outside forces knocked the “Commodity Super Cycle” off its upward course, and then led to the latest plunge in the CRB? The CRB has moved drastically out of alignment with the global stock markets! The CRB index is 16% off its 25-year highs, with the king-pin crude oil and gold markets 20% lower, yet the global stock markets were left unscathed. Is the latest down-turn in the industrial commodities signaling the onset of a global economic recession, led by a U.S. housing slump or a hard landing in China, and not yet reflected in the global stock markets? Or did the rout in the CRB simply wipe out a swath of speculative froth – a classic shake-out of over-extended long positions, and presenting bargain hunters with new opportunities to make money in a longer-term secular bull market?

The major forces that have rattled the Reuters CRB index within such a short period of time, to its lowest level in a year and a half include, (1) Global central bankers are lifting interest rates in unison, and slowly draining global liquidity. (2) Beijing is tightening its grip on the yuan money supply, leading to exaggerated fears of a hard landing for China’s economy. (3) Crude oil traders unwound a $15 per barrel Iranian “war premium” after Europe’s big-3 signaled a split from the Bush administration’s campaign for UN economic sanctions against Iran. (4) Weaker crude oil prices triggered a rout in the gold and silver markets.

The historic slide in the CRB took place since August 8th, even after three major players, the Federal Reserve, the Bank of Canada, and the Bank of Korea ran out of ammunition, and the Bank of Japan was handcuffed by the ruling LDP party. But other central bankers picked up the slack in the battle against the “Commodity Super Cycle”, led by China and the ECB. Higher interest rates are still on tap for Australia, China, the Euro-zone, England, India, South Africa, and Switzerland in the months ahead, to keep commodity traders on edge.

The most influential driver behind the CRB’s plunge since August 8th, however, was the unwinding of the Iranian “war premium” which had inflated the price of crude oil by as much as $15 per barrel this year. Iranian negotiators have skillfully split the British, French and the German coalition away from the Bush administration’s hard-line stance for economic sanctions against Iran. Iran’s rulers have always relied on the Russian and Chinese veto to any economic sanctions, but now there are signs the Europeans are also seeking a way out, once the moment of truth had finally arrived. Without the imposition of UN sanctions or the threat of military action against Iran, crude oil succumbed to the laws of supply and demand. U.S. stockpiles of crude oil were 327.7 million barrels last week, or 18% higher from two years ago, when crude oil was trading at $45 per barrel. Unleaded gasoline prices tumbled 65 cents a gallon since August 1. Crude oil traders are beginning to view the Bush team as a paper tiger in dealing with Iran. Other traders think the gloves will come off after the U.S. Congressional elections on November 7th, when whispers of a U.S. military adventure could grow louder. In any case, China’s crude oil imports rebounded 15% to 11.8 million tons in August, which could put a floor under the market at $60/barrel.

Gold tumbled under $600 per ounce last week, in line with a weaker crude oil and CRB index, telegraphing lower headline inflation in G-7 oil importing countries in the months ahead. Gold has also been pressured by fears of by ECB sales ahead of a Sept 26th fiscal year-end that limits sales to 500 tons per year. So far, European central banks have only sold an estimated 340 to 360 tons this year. With central bankers coordinating their tightening moves, there has been little volatility in the foreign exchange markets to influence the price of gold. Instead, gold traders are focusing on crude oil and other key industrial commodities for clues about the future direction of inflation. Supporting the gold market however, is speculation of eventual Chinese central bank diversification into gold. With pressure mounting on Beijing to revalue it yuan upwards, China could quietly build a gold position in a declining market. Fan Gang, a member of China’s central bank monetary policy committee said on August 29th, “The U.S. dollar is no longer a stable anchor in the global financial system, nor is it likely to become one, therefore it is time to look for alternatives.”

Robust base metals and energy prices, which draw investment to Canada’s resource-heavy stock market, have been key factors behind the Canadian dollar’s 40% rise against the U.S. dollar over the past four years. But commodity and oil prices have turned south and the CD$ has yet to fully adjust. Capital flows could reverse if there’s an exodus from Canada’s oil and gold sector. Furthermore, Canada lost 16,000 jobs in August, the third consecutive monthly loss, suggesting that the Bank of Canada’s rate hike campaign has peaked at 4.25%, and rates might be too high. However, any BoC rate cuts would probably be coordinated with the U.S. Fed, which could start cutting rates in 2007, to engineer a “soft landing” for the U.S. economy.

MORE ON VOLATILITY AND THE VIX INDEX

My essays on volatility and the VIX index have generated quite a bit of interest. On August 22, I addressed a comment and question from one reader regarding his experience trading the VIX option. Since then, we have received other correspondence. So, I thought I would use today’s column to comment on three more emails on this stimulating subject.

Please explain “VIX”, asks one reader. VIX stands for the Chicago Board Options Exchange Volatility Index. It is a measurement of the expected volatility (up-and-down movement) over the next 30 days in the S&P 500 Index. The VIX Index is constructed from near-the-money puts and calls on the S&P 500 Index in the two months closest to expiration. For more information on the VIX Index, take a look at my earlier columns on the subject.

Another reader complained about “poor pricing” of the VIX options. As I said on August 22, my primary purpose in discussing the VIX Index was not so much to furnish you with a pure volatility trading play. Rather, I wanted you to have at your disposal a widely followed volatility metric to use as an additional technical indicator to make better trading and investment decisions. I typically monitor the VIX to gauge the overall level of fear or complacency in the market at any particular time, in light of the S&P 500’s recent price behavior – but do not underestimate the VIX’s ability to forecast, or at least confirm, market turning points. Nevertheless, as a trader I understand that sometimes you have a strong conviction about something other than the direction of a stock, ETF, or market index. And if you have a strong conviction about volatility, you want the opportunity to capture a profit if your forecast is accurate. So, I understand the annoyance the reader experienced in trading the VIX option.

The problem in this case was in buying a VIX option with six months until maturity. The VIX Index is based upon options with an average of 30 days until expiration. Although the VIX is constantly updated, options with six months until expiration are not in synch with the time frame underlying the Index. That divergence in timeframes, plus the added guesswork involved in attempting to project volatility levels into the distant future, is what probably caused those options to fail to attract sufficient trading interest. A lack of trading interest results in a lack of liquidity and poor option pricing. If you are interested in making a pure play on volatility, the simplest way is to trade VIX options closer to expiration with a large amount of open interest. You can also trade the VIX futures or create a strategy combining VIX futures and options. Otherwise, just use the VIX index as another – good – technical tool.

Given the way longer-dated VIX options are priced, it is not advisable to trade in and out of them. Over the long run the bid/asked spreads will just kill you. If you have a strong conviction about the long-term trend in volatility, you can buy a longer-dated VIX option. Just be prepared to hold it until close to expiration when the option will be much more liquid and be priced better. If you do not want to put all your eggs in one basket, or if you want to hedge yourself, you can trade around a longer-term VIX option with shorter-term ones. Or, as I said earlier, you could employ a strategy combining VIX options and VIX futures. But if you follow this last approach, you might first wish to consult a knowledgeable broker.

VIX options are “European style”, meaning they can only be exercised on the settlement date. By contrast, most stock, ETF, and index options are “American style” options, meaning they can be exercised prior to settlement. The Chicago Board Options Exchange (CBOE) explained to me that since the VIX option price is based upon the price of the VIX futures (it is one-tenth the value), limiting the opportunity to exercise the options until the futures settlement date makes it easier to settle the options, especially when there is a spike in volatility. They said the VIX option premiums would be more expensive if they traded American style. Keep in mind the price of the VIX Index is based on options on the S&P 500 Index. Those S&P 500 Index options also trade European style.

There is also one last point to consider. An in-the-money VIX option may not fully reflect its intrinsic value, when measured against the current price of the VIX, because the price of the option is based upon the VIX futures contract, rather than the VIX Index.

IT IS A DOGMA-EAT-DOGMA WORLD

I was planning to write some more about the Jurassic salt beds beneath the deep waters of the Gulf of Mexico, but my editor has asked me to write about the public perception of Peak Oil. To my way of thinking, the Jurassic salt beds of the Gulf are very much related to Peak Oil, but that is perhaps my own geological way of looking at things. He wants me to discuss the policy impact of Peak Oil, so that is the subject of this article. As for the Jurassic salts, they have been down there for about 100 million years, so if I have to wait a few more days to write about these fascinating geological formations, it will not matter in the long run.

But first, dear readers, allow me to discuss the geology of east Greenland. The East Greenland Caledonides are the remnants of an ancient mountain range that rose up during Silurian and Devonian time, about 400-435 million years ago. The range extends about 800 miles, roughly north-south, along the eastern coast of Greenland. The mechanism by which these Caledonides came to be separated by great distance and oceanic basin from the essentially identical ones of Scotland and Norway is called plate tectonics. This term encompasses the processes of large-scale uplift and movement of a portion of the crust of the Earth. This dynamic process is what shapes the face of the Earth. This is why there are continental landmasses and deep ocean basins. It is why there are islands like Hawaii or Iceland. This is a process that appears to have been going on for billions of years, since the Earth cooled from its original accretion. What we are left with is the evidence in the ancient rocks.

The rocks are the facts. And as any good detective can tell you, “Follow the facts.” This was what the late professor of geology John Haller (1927-1984), author of the comprehensive and utterly definitive, albeit rather obscure, book published in 1971 entitled Geology of the East Greenland Caledonides did. He could put one finger on a spot on a map of one locale, such as Norway, and put another finger on another spot on a map of Greenland and explain how the rocks were essentially identical. Professor Haller had developed his geological information during the 1950s and 1960s, when the first indications of plate tectonic theory were just being refined and publicized. The theory was still considered “frontier”, involving oceanography, geophysics, cartography, seismology, remote sensing, mineralogy, and many other related fields. The whole scientific effort was controversial, leading to many an argument in both faculty lounges of universities great and small and on the pages of the finest peer-reviewed journals of the day. People had their scientific suspicions, but could anyone really say anything with complete certainty?

So what did professor John Haller think of his own evidence of the ancient connections between the distant parts of the Caledonides? Haller was, first and foremost, a scholar of plate tectonic theory. Haller certainly understood the implications of his own scientific research. Still, he was careful about saying that one thing “proved” another thing. He read the learned journals, listened to the heated discussions, reviewed the large-scale maps and smaller-scale rock samples. And Haller always stuck to the facts. Deep down, I think that he knew where the scientific evidence was leading, but he was a careful man from the land where they make Swiss watches and a proponent of the scientific method. One of Haller’s favorite ways to characterize the scientific debate was to smile shyly, and say, “This is a dogma-eat-dogma world.”

I thought of professor John Haller immediately when I saw the headline in The Wall Street Journal, “Producers Move to Debunk Gloomy ‘Peak Oil’ Forecasts”. So it appears that Peak Oil theory is beginning to gain some traction, and some credibility among policymakers in both the U.S. and abroad. This could lead to policy incentives that discourage future reliance upon oil, and further lead to policy incentives that encourage the development and use of alternative forms of energy. And thus some key players in the oil business are becoming more focused in their efforts to “debunk” the Peak Oil concept. Peak Oil is no longer a fringe concept being discussed by a handful of small-time players at the margins of intellectual respectability. Peak Oil is becoming part of the mainstream in science, economics, politics, and policy. This may just be because the evidence of the rocks is starting to make sense. This is what happens when you follow the facts.

I think that this latest news from the front lines of policy debate is actually quite good. Peak Oil has developed a credible scientific basis, and the evidence from the oil fields of the world has begun to withstand the initial rounds of cavalier dismissal, if not pathological denial. And the ominous implications of Peak Oil are of such high risk and severity of outcome that the concept has popped up on the radar screens of the highest-level political and economic decision-makers in the world. When it comes to Peak Oil, you simply cannot afford to bet against it. That is, if you lose the bet, you lose it all. And that is a lot to lose.

Peak Oil has moved out of the farm-club competition and is now in the major leagues. The question is can Peak Oil and its theorists and proponents hit that big-league pitching? Can Peak Oil stand up to “debunking” by the likes of Exxon and Saudi Aramco? Can the likes of Exxon and Saudi Aramco stand up to the hard evidence of Peak Oil? After all, “This is a dogma-eat-dogma world.”

RUSSIAN BEAR READY TO MAUL WESTERN OIL MAJORS

The biggest Western investment in Russia to date – the $20 billion Sakhalin-2 oil and gas development off the Siberian coast – was plunged into turmoil after the Kremlin said talks over Gazprom taking a stake in the project had stalled. The bombshell came as Shell, which is the lead company in the project with a 55% shareholding, faced the very real prospect of being stripped of a key environmental licence for its development of Sakhalin-2, throwing the future of the entire project into uncertainty.

Shell has been in talks with Gazprom for more than a year about swapping 25% of its interest in Sakhalin-2 for a half share in one of the state-owned Russian gas company’s onshore fields in central Siberia. But yesterday, Gazprom said the talks with Shell over a possible asset swap were off. No ifs or buts, just a closed door. The company said there had been “no movement in the past year” and signaled it was no longer worth talking.

Sakhalin, a starkly beautiful island in Russia’s far east that is closer to Tokyo than Moscow, is famous for its dearth of good news. Ask a Russian and they will tell you – its crime rate is higher than elsewhere in Russia, it used to be a sprawling Tsarist penal colony, and in 1995 an earthquake killed about 2,000 people. The question that was being asked yesterday was whether the Kremlin’s tough line spelt seriously bad news for Shell or whether it was simply a negotiating ploy to extract better terms from the deal for the Russian government and its people. For there is no doubt that, having welcomed foreign investment into its oil and gas industry with open arms, the Kremlin is now keen to exercise more influence, if not direct control over its vast natural resources.

The revenue-sharing agreement that underpins Sakhalin-2 was signed in 1993 and allows Moscow to get a slice of the profits only when the project finally comes on line. So far Russia has not received a rouble, apart from the delays, and has been told that the cost of bringing the oil and gas ashore has doubled to $20 billion, delaying the moment when Kremlin Inc. can begin reaping serious profits still further. Analysts say that Shell seems to think it can act as if Russia was frozen in time in 1993 when the deal was first signed. The original agreement was inked at a time when Russia was on its knees and when then President Boris Yeltsin was borrowing as fast as he could. With near-record oil prices and a booming Russian economy today the situation is very different though and if there is one thing Moscow is not short of it is capital.

One Western oil expert said, “Shell is in difficulty because when it did the original deal with the Russians it got extremely sweet terms. There is tremendous resentment in Russia about the terms of that deal which are now seen as far too favorable to Shell. The oil price was a lot lower and the Russians needed Western investment. Now that the oil price has rocketed the Russians want a better deal and they are determined to get it. They are seeking to achieve it through the medium of their state-owned oil companies.” Adam Landes, an oil and gas analyst at Renaissance Capital, argues that investors should not take fright but rather realize that Russia has changed and is a very different country from that in 1993. “Russia is signaling that it wants investment, both foreign and Russian, but it wants business done on its terms,” he said. For the moment, that message appears to have been lost in translation, though.

SMALL CAP STOCK INVESTING IN AN EXPENSIVE MARKET

Dr. John Hussman is one of the great fund managers alive today. His Strategic Growth Fund has averaged a 13.39% annual gain since it was started in July 2000. In today’s era of overhyped profit expectations, a 13% annual return may not turn most novice investors on. But to the seasoned professional, this is an accomplishment worthy of great praise. Since July 24, 2000, the S&P 500 has averaged a negative 0.75% compounded annual return, the NASDAQ has shed 11% a year and the red-hot Russell 2000 has averaged a 7.32% gain. Hussman also soundly pummeled his peers over the same time frame. According to Morningstar, Hussman’s fund was the best in its category over the last five years – #1 out of 99 competing funds.

The key to Hussman’s success is threefold. He invests in companies with strong cash flows and attractive valuations. He takes an acceptable amount of risk based on the overall market climate. And he insists on long-term perspective. Hussman admits that in the short term, anything can happen. The Strategic Growth Fund underperformed the S&P 500 by 50% in 2004. While investors are quick to get up in arms about such a tragedy, Hussman was just fine with the results. The good doctor judges his performance over a full market cycle -- meaning from bull to bear market runs. After all, it is easy to make money in a bull market. Everything rises (a la 2003). But it is much tougher to survive an ugly bear market and walk away with both your wallet and dignity intact. That is where Hussman, and his shareholders, thrive.

When valuations are rich, Hussman hedges against the possibility of a falling market. He buys long-dated put options against the major market indexes in combination with buying great businesses on the cheap. As a result of that powerful combination, the biggest drop his fund has ever experienced was a 7.0% fallout during the bear market of 2000-02. Meanwhile, the S&P 500 fell as much as 47.4% during that same time. And the Russell 2000 fell as much as 37.9%. If you started with $10,000 in July 2000 and put that money with Hussman, you would be sitting on $21,074 today. You would have more than doubled your money. Meanwhile, that same $10,000 invested in the S&P 500 would be worth $9,564. Or said another way, even after four years of rising stock prices, you would still be down from the last bear market. That, my friends, is the difference between losing only 7% versus 47%.

So what does Hussman think about the current market environment? In his latest annual report, he makes it very clear that the market is not an attractive place to be right now. Despite strong earnings growth and fat profit margins over the last four years, valuations suggest the coming years will be tough – especially in the small-cap sector. In fact, Hussman declares that if you look at price-book, price-dividend and price-revenue ratios, “Valuations are at levels rarely seen in history, except during the late 1990s market bubble.” When such conditions have existed in the past, the average returns have lagged those of low-yielding Treasury bills. Of course, the mainstream is quick to point out that corporate earnings (for S&P 500 companies) have grown double digits for the past 16 consecutive quarters. And as long as profits continue to grow, we are in no danger of a downturn – no matter what valuations are. Maybe the mainstream is right. Maybe we should all be bullish about the future. Or maybe not …

The latest Conference Board’s CEO Confidence Survey, a quarterly survey asking corporate leaders whether they are bullish or bearish on the economy, fell to its lowest level since 2000. In other words, despite the incredible profits their companies have been cranking out for the last four years, the men and women running those companies are not so sure the future will be as bright. Profits cannot rise at a double-digit clip forever. And with four years of ridiculous growth behind us, combined with rising interest rates and a falling U.S. dollar, corporate executives are not certain they can maintain this bullish trend. They are nervous. Now, this is just one survey, but insider buying is also at a 6-year low right now. Quite simply, the managers running the companies we invest in know this recent earnings trend is not sustainable.

As I have been preaching for months, now is the time to be careful. Now is the time to weed out the speculative stocks in your portfolio that are rising only because of short-term momentum. There are hundreds of small-cap stocks worth owning – despite the overall extended market conditions. The key is to stick to your guns and invest in cash-generating, inexpensive and fundamentally sound companies with simple businesses.

INVEST IN THE GOVERNMENT’S BEST-KEPT REAL ESTATE SECRET

Residents of a posh Tampa Bay, Florida, community thought they lived in a quiet, well-managed property. Until February 2006, when they found out they do not actually own part of the land in their residential development. Worse still, they owed taxes on the land. According to the Dallas Morning News, “Many of the residents of the subdivision thought they owned the lake behind their $300,000 homes in this Tampa Bay community and were shocked to hear that the original developer actually owned it and had let the taxes lapse.” The delinquent land was then seized and put up for sale. Then a tax lien investor (more on this in a minute) bought the lake and the land around the lake for just $1,000. Now, the investor is selling the same land back to the residents of the community for $30,000 a head!

Local governments rely heavily on property taxes to fund their activities. And when communities such as this Tampa Bay development fail to pay taxes, the government either sells the property or sells a tax lien. And you can make money from tax lien certificates. Governments want the property tax due to them, but are not in the business of seizing and selling homes. So all counties in the U.S. issue tax lien certificates. When you buy a tax lien certificate, you are buying the tax liability on a property. The government gets its dues through the sale. The delinquent taxpayer must pay you a state mandated “interest” in order to release the lien. Your gain is the state-mandated interest payment for your investment in the tax lien. And if the taxpayer does not pay up, you get title to the property – at a significant discount to market value, too. Not a bad deal.

Expert tax lien investor Bryan Rundell, from his Web site RogueInvestor.com, informs us that counties place liens on any property with delinquent property taxes and sell the tax debt to investors. The county gets their money, delinquent property tax owners get a little extra time to pay their overdue property taxes, and investors get a low risk, high return investment. How high? Each year, tax lien certificates in Illinois pay 36%, Indiana pays 15% and Iowa 24%. Attorney and professor Lillian Villanova says it is important to keep one thing in mind. “Your goal is to find properties that are worth far more than the back taxes owed. This would virtually guarantee one of two things: Either the owner will find a way to pay the taxes to avoid losing the property, or you will obtain a property that can be sold at a profit. If you keep to that conservative mindset, you are assured success.”

Now is the best time to invest in tax lien certificates. The real estate boom has peaked out and foreclosure rates are sky high. Foreclosure rates have risen in 47 states this year. That means the delinquency rate on property taxes is also high. So you have more opportunities than ever to buy tax lien certificates. Reading Villanova’s article “Tax Lien Investing Basics” is a great way to get started. For nationwide tax lien auction information go to TaxLienAuctions.com. Just remember that a tax lien is a illiquid investment, locked in until redemption. Never buy a tax lien without inspecting the property first.

ANNIE OAKLEY, THE BUTTERFLY EFFECT, AND YOU

In the late 1800s, Buffalo Bill’s Wild West Show was a dazzling display of horsemanship, gunplay and other cowboy skills. One of its acts involved the sharpshooting of the great Annie Oakley. Dubbed “Little Sure Shot”, Oakley had an amazing routine – she would shoot out lit candles, for example, and the corks of wine bottles. For her grand finale, she would shoot out the lit end of a cigarette held in a man’s mouth at a certain distance. For this, she would ask for volunteers from the audience. As no one ever volunteered, she had her husband planted among the spectators. He would “volunteer” and they would complete the dangerous trick together.

Well, during one swing through Europe, Oakley was setting up her finale and she asked for volunteers. To her shock – and the surprise of everyone involved with the show – she got a real volunteer. The proud young Prince (soon to be Kaiser) Wilhelm bravely stepped down from among the spectators, strode into the ring and stuck a lit cigarette in his mouth. Reportedly out late the night before enjoying the local beer gardens, the unexpected appearance of this famous volunteer unnerved her. But the show must go on. She took aim and fired … putting out the cigarette, much to Wilhelm’s amusement.

Thus, she also created one of historians’ favorite “what if” moments. What if her bullet went through the future Kaiser’s left ear? Would World War I have happened? Would the lives of 9 million soldiers and 6.6 million civilians have been spared? Would Hitler have risen from the ashes of defeated Germany? All sorts of questions come to mind. Scientists call these kinds of episodes “frozen accidents” – points in time when small changes would have led to dramatic consequences. Eric Beinhocker relates Oakley’s tale in his new book The Origin of Wealth – which is, in part, a look at the unpredictable nature of markets.

The market itself is an accumulation of these frozen accidents. Stock prices do not always move smoothly from one tick to the next. Seemingly imperceptible changes at the margin can lead to outsized changes in stock prices. The classic metaphor for this process is that of a butterfly flapping its wings in Brazil setting off a chain of events leading to a hurricane in Texas.

Take Gold Kist, the nation’s third largest chicken producer, for example. The stock was more than cut in half from its high. A man gets sick in Asia, setting off a chain of events that puts the entire American chicken industry into a depression as prices of chicken meat tumble – even though you cannot get bird flu from eating a cooked chicken and even though there was never any reported instance of bird flu in the U.S. In this case, the value of the business held up much better than the stock price. Pilgrim’s Pride realized that and made an offer to buy the company – at a 50% premium.

The market, as with life, is full of surprises. No one can predict these things consistently. The market is too dynamic, too complex. Beinhocker advises an adaptive mind-set, highly pragmatic, which “values tangible facts about today more than guesses about tomorrow.” As investors, you can make that uncertainty work for you. Focus on what you are getting for your money today. Look to back that purchase price with loads of tangible assets and/or a super-strong financial condition. Then your portfolio will be better equipped to handle those instances when a sure shot misses its mark.