Finance Digest for Week of October 9, 2006

AT LONG LAST, BULLISH ON GOLD!

We have been watching gold for quite some time. While others have been prematurely buying the dip for many months now, we have been on the sidelines. Gold and gold miners simply did not meet our guidelines for a good entry. Every rally was sold into. The three wave rallies appeared corrective. Sentiment had not washed out. In the last week, we have seen what we believe may be bottoming action. Physical gold has continued lower, while the $HUI has been reluctant to follow. In the past, this action has led to significant rallies. We do not know if this is the bottom (no one does), but we feel this is likely a bottom. From the sidelines, we watched the $HUI plunge from over 400 to under 280. The $HUI has retested this level (chart here), and we are pleased to be able to buy shares here just as many are finally throwing in the towel on this sector.

We are reluctant to propose individual issues, as opposed to our actual ETF recommendation below, but we will say that South African miners MAY outperform on the basis of the gold-to-rand ratio. Rather than place ourselves at the whims of the currency market, however, our recommendation centers on GDX, the AMEX Gold Miners ETF. Here is a weekly chart of GDX. The daily chart looks even more bullish. There are many open gaps down just begging to be filled as punters are tossing in the towel on this double correction that seems to have caught most everyone but us by surprise. If that top gap fills near $42, we will have a huge percentage gain. It is beyond our scope to delve into recommendations on junior miners (there are just too many to consider), but we can say that if we have bottomed, then the right juniors can easily outperform. As an alternative recommendation for those not wishing to undertake currency risks but desiring a single individual play on a gold major, consider something like Goldcorp (GG:NYSE).

The main point is that we are now finally bullish on this sector just as bearishness by everyone else may have hit an extreme. But please do NOT overleverage this sector right now. There could be another leg lower and physical gold could drop to $470 with the long-term trendlines still intact. Please leave room to add to this sector (higher or lower) as additional technical and fundamental data come in.

AUTUMN CHILLS THE GOLDILOCKS ECONOMY

Naturally, the passage of summer into autumn entails a chilling of the air. Less natural and more pronounced this year is the cooling of the macroeconomy. Profit and GDP growth, as well as, housing numbers and durable goods reports, point to falling temperatures. Fed rate hikes on pause and cooling commodity prices offer more evidence – if that were necessary. Thus far, the stock market’s response has been to heat up to August-like temperatures. Renewed geo-political risk suggested by recent events in Shanghai, Mexico City, Budapest and Bangkok be damned, the Dow is in record breaking mode. Could this be a sign of agreement with my cautionary thesis? The Dow is populated by larger more global and defensive firms with higher credit ratings than the S&P. Thus, some of its rise may be rotation from even more dangerous positions elsewhere in the U.S. equity orbit.

Sadly, it seems clear that most are driven by the goldilocks outlook. This “understanding” became popular in 2002. According to the goldilocks story, we will artfully and profitably dodge inflation and recession as we hop from sweet spot to sweet spot. It is a mutant form of the new economy/new era conception popularized and universalized in the heady days of the late 1990’s. The U.S. does not have to save. It can run huge external imbalances forever. The Fed can endlessly run expansionary monetary policy. There are no equity, bond, real estate bubbles. And we can have rapid growth without inflation. Goldilocks adherents believe this is being done as we thread the needle between various risks. How well does the macroeconomic data confirm this outlook?

Early winter would seem the correct analogy here. Housing starts, permits, mortgage applications, prices and housing company stock prices are down, foreclosures are up. Durable goods orders fell 0.5% in August, widely missing consensus forecast of a 0.5% increase. The September 29, 2006 Personal Incomes and Outlays release form the BEA reveals that August was a low point for wage growth and personal consumption expenditure. Only core inflation stayed strong. Earnings and spending growth were anemic while prices stayed high. This is the mirror image of goldilocks. It is fair to say that the Q2 corporate profit picture is defined by deceleration. The most recent data, like the first cold winds of autumn, are a reminder that winter is approaching. Stagnant earnings, pressured private consumption, decelerating profit growth and robust price inflation are showing up in the macro data.

So we are left to ponder a widely popular consensus on the economy that is influencing equity performance. It runs as follows: Eureka! The Fed has stopped tightening and the economy is still growing well and highly profitably. When rate increases slow we celebrate the end of inflation risk, despite the price change metrics reported. When GDP and profit numbers slow, we refocus on their strength in long run, global comparisons. Thus, the goldilocks consensus is sustained. The economy is not too hot, not too slow and just right!

Remember the Goldilocks story? Cool days and warm porridge lure Goldi into the bears’ house. There are two endings to the fairly tale. In the friendly version she wakes and flees in terror. In the harsher version she is eaten by the bears. Either way, advocates of the goldilocks economy may have much to learn from the fable they have invoked. The bears return in all the versions of the story.

Risks of recession continuing to rise.

Most major polls of economists have said the chances of a recession and its ill-begotten progeny, a bear market, are very low. While stock market bulls may take comfort in that, they should remember this: Not one recession in the past 50 years was forecast in advance by a major poll of economic forecasters, said James Stack, a market historian and editor of InvesTech Research. Recessions and bears can and often do arrive unexpectedly. Savvy investors simply cannot rely on assurances that the economy will not lapse into recession, generally defined as two consecutive quarters of negative economic growth. Recent polls of economists put the odds of this at less than 25%.

GLOBAL RESILIENCE: AT WHAT COST?

Convictions are deep that a $46-trillion world economy has acquired a new Teflon-like resilience. On the surface, recent events appear to bear that out. Despite unprecedented outbreaks of terrorism, mounting geopolitical instability, soaring oil prices, and the bursting of a major equity bubble, the global economy has hardly skipped a beat. In fact, by the IMF’s metrics, world GDP growth appears to have surged at a 4.9% average annual rate over the 2003-06 period – the strongest 4-year global growth spurt since the early 1970s. And most forecasters, including those at the IMF, are banking on a similar outcome for 2007. Is this resilience a new organic feature of an increasingly globalized world, or has it come at a much greater cost than widely appreciated?

I am firmly in the latter camp, that the world may have paid a very steep price for its newfound resilience. That price, in my opinion, is very much associated with the second-order effects of excess liquidity – namely, a profusion of asset bubbles, record disparities between current account deficits and surpluses, and a mounting protectionist backlash. In a myopic rush to celebrate the immediate dividends of faster economic growth, the costs of what it has taken to achieve that outcome have all but been ignored. As long as global growth remains strong and the liquidity cycle remains accommodative, I suspect those costs will continue to be finessed. But when the tide goes out and the global growth engine slows for any one of a number of reasons, an increasingly integrated global economy and its tightly interdependent financial markets could well have to come to grips with these costs head on. That remains the biggest potential pitfall of 2007, in my view.

Central banks have created a monster – not just liquidity-driven excesses in financial markets but also major cross-border imbalances in the global economy and mounting political tensions associated with those imbalances. Nor do I believe that the instability of this disequilibrium can be resolved through a mere normalization of monetary policies. Ultimately, a more meaningful shift to policy restraint will probably be required. At the same time, by waiting this long to face up to the excesses of the global liquidity cycle, the systemic risks embedded in world financial markets and the global economy have only gotten worse. A monetary tightening that goes too far risks a collapse in this proverbial house of cards. Yes, the world economy has been very resilient over the past five years – but at a real cost. Increasingly, the celebrants of global resilience are dancing on the head of a pin.

THE GREAT CHINESE PROFITS DEBATE

The profitability of Chinese businesses has suddenly become a cause célèbre. One group – led by the World Bank – argues that enterprise profitability has soared in recent years, playing an increasingly important role in boosting China’s already high national saving rate and current account surplus. The other side – spearheaded by Weijian Shan of TPG Newbridge and long one of Asia’s most successful investors – maintains that China’s national income accounts bias conventional measures of profitability to the upside, masking a decidedly subpar return on equity and a potentially serious bank-directed misallocation of capital. The debate is technical and it takes forensic analytics to wade through it. But it has very important implications for investors, China’s macro policies, and the Chinese economy.

There are three reasons why this debate is such a big deal. First, China is having a serious problem controlling an overheated investment sector. It make a huge difference if investments are funded internally through surging profits and retained earnings, as the World Bank argues, or if this is a bank-sponsored investment binge. In the former instance, an investment slowdown can best be engineered by policies that crimp internal funding. Alternatively, if runaway bank lending were the culprit, monetary tightening and/or administrative edicts would be more appropriate. Second, rate of return results are obviously of critical importance to investors in Chinese securities markets – both onshore and offshore. Profitless prosperity has long been a major concern of equity investors with respect to Chinese companies. Third, Chinese banking reform is at the top of the nation’s policy agenda – in part, because of the understandable fear of a serious and growing nonperforming loan problem. To the extent that the World Bank is correct, the current Chinese investment boom poses less of threat to the banks than would be the case under the Shan scenario.

Long ago, I realized that there is never a clear winner in these statistical debates. The numbers can invariably be sliced and diced in a variety of ways to validate a wide range of alternative hypotheses. In the case of China, there is an added twist – the statistics are a good deal shakier than in most other countries. Even in countries like the U.S., with well-developed statistical systems, the profits estimates have typically been the weakest link in the chain – subject to large revisions, to say nothing of frequent discrepancies with micro data gathered at the company level. I am astonished with the World Bank’s leaning so hard on a literal interpretation of what could well be the least reliable piece of Chinese macro data. Shan’s approach stresses the inherent implausibility of the World Bank’s findings. I have long been struck by one of the greatest contradictions of Chinese GDP growth: With fixed investment now fully 50% of Chinese GDP and still increasing at close to 30% per annum, it is actually quite astonishing that the overall economy has not been growing a good deal faster than the 10% average over the past decade. The explanation must hinge on the inefficiency of aggregate investment – consistent with Shan’s critique and very much against the grain of the World Bank’s conclusions.

When it comes to China, I am an eternal optimist. My conviction is grounded in the nation’s unrelenting commitment to reforms and in the related push toward a market-based system. State-owned enterprise reforms remain central to this daunting transition. This has been a wrenching process – in many cases creating companies from an agglomeration of former government bureaucracies. It takes time for these efforts to bear fruit. A burst of newfound profitability from the Chinese business sector seems highly unlikely at this overheated point in the development cycle.

Investors flock to the world’s largest-ever listing, but ICBC reflects China’s murkier side as well as its promise.

If a single transaction could sum up the knowns and unknowns surrounding China’s red-hot economy, it would be the public offering of ICBC, the Industrial and Commercial Bank of China. The largest of China’s large banks and the last of the relatively healthy ones to list on an exchange, it is scheduled to price its shares on October 20th and to begin trading a week later. These dates, normally dry minutiae in a banker’s diary, are as eagerly awaited as national holidays in some parts of China.

On October 9th the preliminary prospectus was published like a bestseller, a 600-page door-stop that appeared in the office of every bank and hedge fund in Hong Kong. Anyone with a chequebook had an opinion. The new issue, which will be sold in Hong Kong and Shanghai, will almost certainly beat the record for an IPO of $18.4 billion set in 1998 by a Japanese mobile-telecoms operator. If priced near the top of the range (which is likely), the sale will pull in $22 billion, placing ICBC among the 10 most highly valued banks in the world, with a market capitalization close to $130 billion. Bets on ICBC will make, or break, careers. American institutional investors are expected to take the single largest slice.

Within an hour of the formal solicitation of bids by institutional investors, the entire order book had been filled. By the end of the first day investors had placed bids for three times the number of shares on offer. By the close of the next day it was nine times subscribed. A thin slice will be allocated for retail investors on October 16th. Normally, with a deal this hot, bankers and company officials would increase the size and price of the offering. But ICBC is subject to abnormal political considerations. China is eager to sell shares in a way that pleases investors and does not cause the government embarrassment, if for no other reason because it has lots more companies to auction.

A successful sale would be particularly gratifying for the government because for international investors, ICBC is something of a proxy for China itself – vast, diverse, growing fast, and with extraordinary scope for internal restructuring. It is by all relevant measures the largest bank in China and the Chinese banking market is even hotter than the country’s economy. ICBC’s profits doubled in the past two years. Its growth has also created extraordinary windfalls for some. Goldman Sachs was allowed to purchase a 5.8% stake in April for $2.6 billion, its largest investment ever. The American investment bank will possibly have tripled its money by the end of this month. Other American banks, denied a foothold in ICBC, are scrambling to make up for it wherever they can.

But ICBC, however valuable, also reflects the murkier side of life in the Chinese economy. Political considerations often come first, information is unreliable, and openness in the banking system is questionable. Only last year, the government injected $15 billion to cover rotten loans at ICBC. At the time, more than a fifth of the bank’s portfolio was, as bankers say, “non-performing”. Its size also carries a cost. In the past decade it has reduced the number of branches from 42,000 to 18,000, but may need to slim further. Unlike many Chinese banks, ICBC has not had substantial legal problems in its upper ranks, but there have still been scandals, reflecting the complexity of managing a vast institution in China.

Depending on the final price, ICBC will probably stand above two times its book value, slightly below its peers. This is a modest multiple for a good bank in a good economy, but higher than those for South Korean or Taiwanese banks, which do not have the same growth prospects. On the other hand, they are not shrouded in the same mysteries. In China, the sceptics (and they are rare) ask, what is book? How much are the assets really worth? Their voices, no doubt, will barely be heard amid the deafening clamour for shares.

LIKE JAPANESE SNOW AND INTESTINES, YEN IS UNIQUE

Japan is back from a 15-year funk, deflation is ending and its new prime minister is winning favorable reviews at home and abroad. Amid all this good news, the yen is, strangely, falling. It is hardly what you would expect in the world’s No. 2 economy, and it is more than a bit disorienting for investors. “Ever since May, the yen has confounded most market expectations,” says Callum Henderson, Singapore-based currency strategist at Standard Chartered Bank Plc. “At a time when Japan’s recovery remains on track and the Bank of Japan has removed quantitative easing and starting to hike interest rates, most people – including us – expected the yen to rally. However, it is fallen slowly, but steadily.”

The yen’s 4.4% drop versus the dollar and 7.9% drop against the euro during the past 12 months demonstrates the economy can be just as unique as Japanese snow and intestines. The reference here is to a couple of the more surreal Japanese trade disputes of the 1980s – one over snow, the other beef. Tokyo mulled slapping barriers on imports of foreign skis, claiming Japan’s snow was different. And restrictions on foreign beef imports were based on the contention that Japanese intestines were different. Hmmmm.

Now, add the yen to the list. It should be rising for at least four reasons. One, if investors are as bullish on Japan as many claim, Nikkei 225 Stock Average shares and the yen should be surging. Two, Japan’s trade surplus should push up the yen. Three, massive U.S. current account and budget deficits should leave the dollar vulnerable. Four, the BoJ is pledging additional rate hikes. So far this year, the opposite has been true. “It has fallen because of huge Japanese portfolio outflows which have to date dwarfed the current account surplus,” Henderson says. “We expect the yen to recover on the back of further BoJ rate hikes, but there is no question the yen is weak right now.”

The yen’s softness is giving new life to the so-called yen-carry trade, a strategy that exploits the gap between low Japanese yields and just about every other asset on the planet. Traders borrowing for next to nothing in yen invest the funds in higher-returning assets elsewhere, often at a hefty profit. Not everyone thinks the yen’s value had decoupled itself from economic fundamentals. The yen is weak, says Carl Weinberg, Valhalla, New York-based chief economist at High Frequency Economics, because Japan’s recovery “is mediocre and stalled.” On top of that, the need for fiscal reform – be it a reduction of public debt or higher prices – will keep the BoJ from raising rates markedly.

There is a broader Asian angle to consider here. It is thought that only a rising Chinese yuan will encourage Asian economies to stop holding down currencies to help exports. Yet the weak yen – and the belief that it is a kind of subsidy for companies like Toyota, Canon and Sony – may be far more pivotal. Were the yen to rise, other Asian currencies might follow suit. That would communicate confidence to investors, attract more foreign capital into stock and bonds markets and keep inflation under wraps. With the yen confounding Economics 101, that phenomenon could be a long way off.

GERMANY’S POLITICAL REVIVAL HAS RUN OUT OF STEAM

When German Chancellor Angela Merkel took power last year, many people painted a rosy scenario for Europe’s biggest economy. A pro-business government leading a grand coalition with the power to push through real change? It sounded precisely like the medicine needed to kick-start the German and euro-area economies. And now? Merkel’s government, led by the Christian Democratic Union and the Social Democratic Party, looks even less effective than its predecessor, made up of Social Democrats and Green Party members.

Investors have been betting big that Germany has changed fundamentally – and might even start to repeat the economic miracles of the 1950s and 1960s. They should think again. Germany’s political revival has run out of steam. It will not be long before its economy does the same. “They want to, and will, stay in power,” Thorsten Polleit, Barclays Capital’s chief economist for Germany, said in an e-mailed response to questions. “Little if any progress will be made.”

Recent numbers sound good. Certainly, the revitalized German economy is starting to pick up fans in the global investment community. In fairness that view widely shared. The benchmark DAX index has been powering ahead. It is up 12% this year and 21% over the past 12 months, putting it among the better-performing European bourses. And corporate Germany looks in better shape than it has for years. So what is the problem? The recent economic improvement reflects changes made three or four years ago – as well as a general cyclical improvement. To drive forward, the economy still needs more liberalization. And Merkel’s administration appears to have given up on delivering it.

CREDIT IS SUSPICION ASLEEP

This old saying sums it up. One day there seems to be endless liquidity and the next day none. Of course, the transition involves more than one day and it is usually accomplished as, one by one, various traders discover a sudden loss of liquidity whereby the bids for the hot games disappear, as does the credit needed to carry a losing position. The key to the transition has been simple – prices stop going up. More elaborate explanations have been provided by von Mises, who roughly observed that for a boom to peak the commercial banks do not need to call the loans, they just have to become a little concerned and stop making them.

Of course, the sudden loss of liquidity that marks the end of a boom and its effect on the credit markets has been on the financial scene for a very long time. For example, during just such a crisis in 1560 Sir Thomas Gresham wrote that credit conditions in the world’s financial center (Antwerp) were so tight that credit was not available, “even on double collateral.”

The term for readily available credit – “easy” – is Dutch and so is its opposite, “diseased” credit conditions. The transition to a dearth of credit seems suitable now. For this, the yield curve should have inverted and be working its way to steepening (done!) and credit spreads, after being remarkably narrow, should be turning to widening (not quite there yet). Preceding this, actual or momentum highs should have been set by the main items in the speculative play. Of these, housing merits a “done”, as do base metal and energy commodities. The general stock market, including the Nasdaq, set a momentum peak in the Spring.

Although credit conditions may seem benign, there is no reason to extrapolate complacency into the future. The following charts can provide critical perspective – particularly with the observation made by the WSJ on August 17 that some of the corporate borrowing (see chart) was used “to repurchase more shares and to make higher quarterly and special-dividend payouts.”

Then on September 23, The Economist wrote “Egging borrowers on are bankers, who sometimes admit to lending amounts, as a multiple of underlying cash flows, that are against their better judgement. This, they say, is partly because the competition to provide credit is so fierce.” The noteworthy feature is that this measure of borrowing peaked in the Spring at a spike high close to the peak high in 1999. The next chart shows just how extraordinary stock buy-back programs have been.

These charts provide an interesting overview on a borrowing mania. The record is indelible, as in getting to this condition cannot be erased by wishful thinking. In past examples, the condition has been unsustainable and, once again, the fallout will be significant. This reminds of exasperation recorded by an injured player as the South Sea Bubble collapsed in the Fall of 1720. “The poor English nation run a madding after new inventions, whims, and projects [promotions] … They can ruin men silently, undermine and impoverish, fiddle them out of their money by strange, unheard of engines of interest, discount, transfers, debentures, shares, projects, and the Devil and all of figures and hard names.” The key series to watch now is the treasury curve for steepening and gold’s price relative to commodities turning up.

TICK. TICK. BEWARE THE MORTGAGE TIME-BOMB

That ridiculously low-rate ARM seemed like such a good idea at the time. But now, payments will be coming due in a big, big way.

Mortgage rates have been trending down, but that will not do much to benefit those who signed up for low teaser-rate adjustable-rate mortgages in the past few years. An ARM charges an initial discounted rate for a period of time, after which it adjusts to market levels. When some types of ARMs with teaser rates of 2% or less reset, the rates are likely to jump to more than 6% – and even as high as 9%. That can mean a doubling in monthly payments owed for those homeowners saddled with the loans.

The jump in payments could be even bigger for some people. They could have a loan balance that is larger today than it was when they got their mortgage – a situation called negative amortization. And it is common with what are called “payment option” ARMs, because the initial teaser rate is a “payment rate” as opposed to an interest rate. That means the market-rate interest on the loan starts to accrue from the get-go and monthly payments are not enough to cover it, let alone pay down any of your principal. There may also be a trigger ceiling, meaning when the balance reaches a certain level – say 120% of the original balance – the introductory terms will end and the rate will reset upward. End result? A much higher interest rate on a bigger loan than the homeowner ever intended.

In the past two years, homeowners took out 1.3 million ARMs with teaser rates below 2%. Of those, 21.5% have negative equity, where the market value of the home is less than the amount owed. The number of people in that spot could go up significantly if home prices fall as forecast or if homeowners with teaser-rate-ARMs experience job loss, illness, divorce or a death in the family, which are the main causes of mortgage default.

If you are in a fix with your ARM, moving into a fixed-rate mortgage is the best thing you can do so long as you do not have negative equity. If you have gotten your ARM recently, call the servicing number on your mortgage bill, let them know you have been sold a bill of goods and ask them if they can “recharacterize” your loan – a process in which they change the loan to a fixed-rate product without going through all the steps (and costs) involved in a full refinancing. But if your lender will not let you recharacterize, which can be the case if your loan has been sold to someone else, you will need to shop around for the best refinancing deal. The latest average rate on a 30-year fixed is 6.30%, and 5.98% on a 15-year fixed. If fixed does not work, go for a longer term ARM.

And next time you want to buy a home with a mortgage, be sure to read all the documentation (footnotes included), ask lots of questions and, Certified financial planner Mari Adam said, remember, “When someone offers you a below-market or above-market rate, something is wrong.”

Mortgage standards tightened.

Federal regulators are casting a disapproving eye on mortgages that give borrowers low introductory rates but let them pile up more debt over the long run – a loan feature favored by hundreds of thousands of Californians. Starting this month, federally chartered lenders are being discouraged from qualifying buyers based on the low starter rates, when only the interest or a portion of the interest is due. Instead, they are being urged to evaluate the borrower’s ability to pay for the loan at the full rate. Regulators are trying “to add some discipline to the lending process,” said Richard Wohl, president of Pasadena-based Indymac Bank. “Whenever you do that, you’re going to have some [borrowers] that won’t have the product available to them.”

GREENSPAN BLAMES THE BERLIN WALL FOR THE HOUSING BUBBLE

We were missing that old fraudster, Alan Greenspan. What had become of him, we were wondering. But the man surfaced … like a beluga whale in Canada. Speaking to a private, audience he said that the house price bubble – and incipient bust – were not his fault. “I don’t think that the boom came from a 1 per cent Fed funds rate or from the Fed’s easing. It came from the collapse of the Berlin Wall,” Mr. Greenspan told his listeners. The Financial Times reports, “The former Fed chairman said the collapse of Communism in Eastern Europe and the shift towards more market-based economies in China and other parts of the developing world brought ‘billions of cheap labourers onto the scene.… This brought disinflation and lowered inflation risk premiums and long-term interest rates, creating a decline in real interest rates and equity-risk premiums.” In consequence, “the real market value of assets increased faster than GDP.”

There is undoubtedly some truth to what Greenspan says. But this is one of those occasions for which the word “disingenuous” must have been invented. Yes, global integration probably has reduced inflation expectations, thus permitting lower interest rates and higher asset values. But without the active aiding and abetting of the Fed, which set the Fed Funds rate under 2%, i.e., below inflation, for 35 months, the boom in housing prices would probably never have turned into a bubble. And millions of Americans would still be solvent today. Globalization may have lowered inflation rates, permitting lower interest rates. But globalization did not bring with it lending rates below the rate of inflation. Those negative lending rates were not imposed by Mr. Market, but by Mr. Market Manager Greenspan.

A negative lending rate is a marvel. It allows a speculator to borrow, knowing that he can repay less than he was lent. Negative lending is to the financial world what a negative-calorie dessert would be to Sara Lee or a negative-year prison sentence would be to a bank robber. You can imagine, dear reader, what mischief they would cause. Even at low real rates of interest, a borrower has to be careful. But what kind of care is needed when you are guaranteed to make a profit, merely by borrowing?

The actual effect of the Fed’s sub 2% rate is now history … well, a history that is still being written, one painful page at a time. That it brought about a huge bubble in housing prices is beyond question. It also helped sustain the whole U.S. economy, and, by extension, the economy of the whole world. It now appears that the bubble is deflating. The Fed is no longer giving away money. And the housing market is no longer bestowing big gains on homeowners.

If Mr. Greenspan were right, investors could expect high asset prices for a long time. Global trade, after all, is not likely to disappear any time soon. Why should house prices go down then? Or stock prices, for that matter? But now, even the Maestro concedes house prices are going down. Only, he says, it is because houses have become unaffordable. And he guesses that the worst of the housing slump is already behind us. He could be right. But an investor has to play the odds. What are the odds of making serious gains in stocks at today’s record prices? What are the odds of making serious gains in houses? What are the odds that Mr. Greenspan knows better? We wait to find out.

Biggest forecast home price declines are for largest markets.

The housing market will get worse before it gets better, according to an analysis by Moody’s Economy.com. In the survey of 379 metro areas, the study’s authors project that nearly 20 areas eventually could experience a “crash”, or a decline of more than 10% from peak to trough. The most hard-hit areas will be in California, the Southwest coast of Florida, and in Arizona and Nevada. Nationwide, the study forecasts a 3.6% decline in the sales price of existing homes.

The accompanying table shows only those markets among the 100 largest by population that are forecast to have declines. In an analysis that considered mortgage rates, the local job market and other factors, the study makes projections on when those markets would peak, when they would hit their worst point, and what the total decline would be.

VENTURE CAPITAL FIRM RETURNS MONEY TO INVESTORS, SAYS PROSPECTIVE RETURNS TOO LOW

The high-risk, high-return venture capital business may have turned into all risk and no return.

That, in a nutshell, is the message that a prominent venture firm delivered to its investors when it told them that it could not continue to take their money – at least not for the time being. “The traditional venture model seems to us to be broken,” Steve Dow, a general partner at Sevin Rosen Funds, said in an interview. Sevin Rosen, a 25-year-old firm that is among the most respected in the industry, was in the process of closing its 10th fund and had received commitments from investors for $250 million to $300 million, Mr. Dow said. But in a letter sent to those investors last week, Sevin Rosen said it had decided to abort that process. “We have decided to take the radical step of returning the commitments you have given us for Fund X,” the firm wrote.

Explaining its decision, Sevin Rosen, which has offices in Dallas and Silicon Valley, said that too much money had flooded the venture business and too many companies were being given financing in every conceivable sector. But excess of capital is only part of the problem, the firm said. In its letter, it bemoaned what it described as “a terribly weak exit environment,” a reference to the dearth of initial public offerings and to a market for acquisitions at valuations that it considers too low to deliver the kind of returns that venture investors expect. At a time when young companies like YouTube and Facebook are said to be entertaining acquisition offers in the $1 billion neighborhood, that pronouncement may seem surprising. But Mr. Dow said those “megadeals” were rare and were not enough to sustain an entire industry. “The venture environment has changed so that overall returns for the entire industry are way too low and even the upper-quartile returns have dropped to insufficient levels,” the firm wrote.

Sevin Rosen’s credibility is bolstered by the roster of companies it has helped lead to public offerings in the past, including Compaq, Lotus and Cypress Semiconductor. It has been describing adverse market conditions, to its investors and to the news media, for at least two years. But it finally decided that it could not be telling investors of a poor market for venture investing while continuing to take their money. “If we really believe that there are fundamental structural problems in the venture industry, should we raise our fund and just hope that the problems will get better?” the firm wrote. The answer was no.

Many venture capitalists have voiced similar concerns for some time. And over the last few years, many firms have turned away far more money than they raised. But investors, perhaps hoping for a repeat of the eye-popping returns of the late 1990’s, have continued to put money into venture firms. At the end of 2005, venture capitalists had a combined $261 billion under management, more than at any time in the industry’s history, though some of it was raised in the Internet boom. Venture capitalists have given back money to investors before, but industry pundits say this is the first time that a top-tier firm has decided to scrap a sizable fund that was nearly complete.

In many ways, Sevin Rosen’s decision is based not on where the market for public offerings and acquisitions is today, but on where the partners in the firm think it will be in five or more years, the typical life of a venture fund. While Sevin Rosen has concluded that things are unlikely to change, many others disagree. Indeed, even as they say they wish there was less money in the business, and hence less competition for deals, many venture capitalists say they remain confident about their ability to make money for their investors.

ETF’S VS. INDEX MUTUAL FUNDS

ETFs resemble index-based mutual funds in that both represent baskets of securities that track the performance of an index. However, there are key differences between ETFs and index funds, including how they trade, what they cost and what they can do.

Trading: ETFs are bought and sold through brokers and trade throughout the day on an exchange, like stocks. Because the share price is published throughout the day, traders are able to buy or sell shares as they please. Index fund shares are purchased from the holding fund, and share purchases and sales are only priced once a day, at the close of trading.

Costs: ETF expense ratios are generally cheaper. For instance, the expense ratio for Vanguard’s Total Stock Market ETF (VTI) is 0.07%, compared with an expense ratio of 0.19% for the firm’s Total Stock Market Index Fund. However, many of the newer ETFs coming out are more expensive than the original plain-vanilla products. Second, because ETFs are bought and sold through brokers, investors have to pay a commission each time they trade. ETFs have no minimum investment requirements (though you do buy in whole shares as opposed to dollar amounts) and no fees for early withdrawals. But with an ETF you do have to pay the bid-ask spread, which can vary.

Pricing: Both ETFs and index mutual funds use the net asset value of the underlying holdings to calculate share price, but with ETFs, the price can be influenced by market forces, such as supply and demand. When this happens and an ETF starts trading at a premium or discount to its NAV, arbitrage mechanisms are used to bring the price back in line.

Tax efficiency: ETFs are generally more tax-efficient than mutual funds. When a large investor wants to cash out of a mutual fund, the portfolio manager often has to sell shares in the fund to raise the money. This generates capital gains which are taxable to shareholders. ETFs, though, are sold on the open market, so when an investor wants to cash out, he can just sell his shares without affecting other shareholders. (In some cases, an authorized participant – typically large institutional organizations, such as market makers or specialists – can exchange shares of the ETF for the underlying stocks, and since this is an “in-kind” transaction, no capital gain distributions are triggered.) ETFs may incur capital gain distributions if, say, the fund needs to sell securities when it rebalances. The ETF structure, though, often allows capital gains to be minimized or avoided altogether.

Capabilities: Because ETFs are securities, investors can use them in many of the same ways they would stocks. For example, they can set limit orders or sell ETFs short. Many ETFs have options listed on them as well. Among the various differences between ETFs and index mutual funds, the ones above are the biggies.

How to choose which sector ETF to invest in.

The rapid proliferation of new ETFs can be viewed as a good development, as it gives investors more options to choose from. But it can also make deciding between similar products challenging. For instance, Morningstar.com lists 24 ETFs that represent some slice of the technology market, 22 natural-resources ETFs, and 15 financials. There are a lot of products out there, and they are not all created equal.

Before buying an ETF, there are several things to consider, but two of the biggest questions you should ask are what exactly am I buying, and how much am I paying for it. While several ETFs may represent the same sector, the indices that they track can vary greatly in terms of which companies are included, number of holdings (which can affect volatility), how the securities are weighted and how long the index has been around. E.g., take a look at some of the financial-sector ETFs. One option is the Financial Select Sector SPDR (XLF), which tracks the financial stocks that are included in the market-cap-weighted S&P 500. The resulting portfolio includes 87 of the largest U.S. financial stocks – nothing to scoff at but a lower number than many of its peers. It is also particularly concentrated, with about 50% of its assets in the top 10 holdings.

Another choice is Vanguard’s Financials ETF (VFH), which tracks the financial stocks in the MSCI U.S. Investable Market 2500 Index. VFH includes a whopping 548 financial stocks, and unlike XLF it allocates assets toward micro-, small- and mid-cap stocks, and that diversification can make it less volatile. It is also a bit less concentrated, with roughly 38% of its assets in the top 10 holdings. Another product with a slightly different spin is the iShares S&P Global Financials Sector Index Fund (IXG), which tracks the S&P Global Financials Sector Index, a subset of the S&P Global 1200 Index. This ETF follows about 230 stocks, but unlike other financial-sector ETFs, it has a global focus, with almost 60% of its portfolio made up of foreign holdings. This adds an additional level of diversification to the ETF. In addition, this fund is less concentrated than both XLF and VFH, with only a quarter of its assets contained in the top 10 holdings. Several other ETFs are classified as financial-sector products as well, including (but not limited to) the recently launched PowerShares FTSE RAFI Financials Sector Portfolio (PRFF), the iShares Dow Jones U.S. Financial Sector (IYF) and the streetTRACKS KBW Capital Markets (KCE).

Costs, of course, are another important factor to consider. ETFs that track domestic, market-cap-weighted indices tend to have similar expense ratios. But when you start tracking indices that include international stocks, less-liquid stocks or use different methodologies to select and weight stocks, you are likely to see higher expense ratios. You may be willing to pay more for an ETF if you believe it will make up for the costs in performance, but once again, you have to really do your homework to make sure you know what you are getting.

XLF and VFH are both based on market-cap-weighted indices that primarily track domestic financial stocks with similar expense ratios – 0.24% for XLF and 0.26% for VFH. However, IXG, because it includes a high percentage of international stocks, charges 0.48%. The PowerShares FTSE RAFI Financials Sector Portfolio tracks an index that weights financial stocks based on fundamental measures such as sales, cash flow, book value and dividends. Because of this more complex weighting methodology, the fund charges up to 0.60%. In addition to expense ratios, you should also look at bid-ask trading spreads, because they can add to your costs.

There are many Web sites, such as Morningstar.com, that provide information and tools that can help you compare different products. But if you cannot find what you are looking for there, check out the ETF companies’ Web sites, where you should be able to locate the necessary information.

A dividend ETF that merits a look.

If you have done any research on ETFs in the last few months, you have probably glanced at more than a few so-called dividend ETFs – funds designed to one way or another have a higher yield than that of the broad market. There is one fund I know about that gets almost no notice, no news coverage and virtually no volume, the First Trust Morningstar Dividend Leaders Index Fund (FDL). This fund could be poised for good growth over the next year, especially because of its unique weighting toward mega-cap stocks, and I believe it deserves attention.

The ETF’s prospectus states that its stock-selection process is proprietary, but that for a stock to be considered, it must pay dividends that are qualified for the 15% tax rate, have five years of dividend growth and have a coverage ratio greater than 1. From there, the description gets even more opaque.

Unlike most dividend ETFs, FDL makes some relatively large bets on a few stocks. Bank of America is the largest holding, at 9.79%, followed by Citigroup at 9.36% and Pfizer at 9.07%. There are six stocks each with greater than 5% weight in the fund, and the top 10 stocks comprise 65% of the ETF. The other 90 holdings are spread across the remaining 35% of the fund. Like all dividend ETFs, FDL is heaviest in financials, at 36.7%, and utilities, which make up 13.1% of holdings. Unlike most other dividend ETFs, though, FDL is heavy in telecom and health care, which come in at 16.9% and 16.7%, respectively.

As the chart below shows, FDL has soundly outperformed both the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) and the iShares DJ Select Dividend Index Fund (DVY) for the last six months, which is the period of time FDL has been trading. I believe a big chunk of FDL’s lead can be attributed to its weight in telecom. Note that FDL yields 3.57%, compared to DVY’s 3.40% and PEY’s 4.27%.

FDL distinguishes itself through its weighting in mega-cap stocks – companies with market caps greater than $100 billion. The ETF has 50% of its assets in mega-caps, compared to DVY’s mega-cap weighting of 15.5% and PEY’s 8.5%. This mega-cap approach, while normally a potential hindrance, could be an advantage over the next year or so. Typically, mega-caps provide leadership toward the end of the stock market cycle, and with the current bull market having enjoyed a 3½-year run so far, it makes sense to think about this cycle ending. At other points in the market cycle, leadership would probably rotate to dividend ETFs concentrating on smaller companies, which brings up a closing point: ETFs, including dividend ETFs, are not necessarily “set and forget” investment vehicles. All dividend ETFs have unique structural differences, and knowing how they are affected by the market’s swings can benefit your portfolio’s bottom line.

This ETF hogs yield.

While there may never be a “Pokemon” or “Elmo” ETF, we are starting to see some humor in the naming of these funds. Just look at the recently listed Claymore/Zacks Yield Hog ETF (CVY). The fund seeks yield and is going after the existing dividend ETFs. The prospectus states that in addition to domestic common stocks, the Yield Hog will invest in ADRs, REITs, master limited partnerships (MLPs), closed-end funds and preferred stocks. This already makes it a different animal – the other dividend ETFs own stocks, period.

The first inclination might be to conclude that CVY will not appreciate in value because of its willingness to take in things like preferred stocks and closed-end bond funds, which typically trade in a very narrow price range. However, according to Claymore, the Zacks Yield Hog Index, the index underlying CVY, “selects companies with potentially high income and superior risk-return profiles … the objective is to outperform on a risk-adjusted basis the Dow Jones U.S. Select Dividend Index, which underlies the iShares DJ Select Dividend Fund (DVY).” Results of a back test of the fund vs. the Select Dividend Index illustrate that the Yield Hog index enjoys significantly higher total returns over five years (16.37% vs. 11.00%), three years (19.3% vs. 15.38%), one year (10.32% vs. 8.79%), and year-t–date through August 31 (12.13% vs. 9.57%). As the chart below shows, $10,000 invested in the Yield Hog index would have easily outpaced the same amount held in the Select Dividend index over the five-year period from 2001 to 2006.

Claymore says it cannot be specific about yield, but it has set a general goal of doubling the yield of the existing stock-dividend ETFs. DVY yields 3.38%, the PowerShares High-Yield Dividend Achievers Fund (PEY) yields 4.25%, the streetTRACKS SPDR Dividend Fund (SDY) yields 2.91% and the WisdomTree High-Yielding Equity Index Fund (DHS) yields 3.96%. So the Claymore fund could yield between 6% and 8%.

According to the fund’s most recent literature, there are 147 holdings in the Yield Hog’s portfolio. Two of the top three holdings are covered-call closed-end funds – the S&P 500 Covered Call Fundand the Small Cap Premium Dividend and Income Fund. Both of these holdings have slightly more than a 1% weighting each in the fund. In scanning the list of holdings, one finds such things as an emerging-market debt fund, Pfizer (PFE), PetroChina (PTR) and Nationwide Health Properties (NHP). This is a very diverse mix indeed.

CVY’s P-E ratio is 11.1, compared to 14.7 for DVY, and its price/book of 1.68 is also lower than DVY’s 2.62. (This data might well be taken with a grain or two of salt because of some of the unusual holdings in CVY.) The betas are very similar: 0.87 for CVY and 0.85 for DVY. Finally, according to the Claymore literature, CVY’s standard deviation (also a measure of volatility, where a lower number indicates less volatility) of 12.5 is slightly lower than DVY’s 12.7.

For investors willing to include a dividend ETF in their large-cap allocation as a way of introducing yield, this fund has the potential of being a better mousetrap. In general, I like to give something a few months of trading to get a feel for what it will do on a day-to-day basis. At a minimum, this fund merits serious consideration.

New ETF hits gold in materials sector.

I was generally negative about the materials-sector ETFs last year. I thought they were too heavy in chemical companies and too light in mining stocks and yield. In addition, the funds owned U.S. stocks only, lacking vital international exposure. Now iShares has launched the iShares S&P Global Materials Index (MXI) fund. After some examination, it appears that this is a way for investors to gain exposure to the materials sector without taking on the risk that comes with owning an individual stock.

Foreign stocks make up 76% of MXI’s portfolio, with the U.K. (16%), Japan (12%) and Canada and Australia (9% each) holding the top international spots. U.S. companies weigh in at 24%. MXI’s subsector makeup is roughly 30% miners, 33% chemicals, 17% steel and aluminum and 14% in things like paper, wallboard and cement. The rest of the fund is a mix of other materials-sector components, such as potash and cellulose. The 30% in mining is much more of that subsector than you will find in MXI’s domestic cousins. Simply put, MXI, through its strategy of increasing exposure to mining and mining services companies, appears to offer a more diversified approach to the materials sector and stands a better chance of taking advantage of future sector uptrends. When I wrote about XLB, VAW and IYM in 2005, my concern was that the funds would not allow holders to capture a big move in gold or the mining stocks, and that is exactly how it played out last spring. Part of the problem, of course, is that there are fewer mining stocks in the U.S. than in other countries.

Despite being such a small portion of the market – less than 3% of the S&P 500 – the materials sector can be complicated. We saw firsthand last summer, in the wake of hurricanes Katrina and Rita, how leveraged the chemical companies are to the price of oil. You do not need to be an expert in the sector to know that mining shares tend to be volatile and that picking the “wrong” name in the group can be very damaging to your portfolio. MXI, by having about one-third of its holdings in the mining group, clearly provides better diversification within the materials sector and is a more complete product.

The future will bring a lot of new ETFs, and most of them will probably not have much utility, but I predict that 10% to 20% of them will bring something innovative and useful to the table, and MXI is an example of that.

Too many ETFs?

In 2005, 100 exchange-traded funds premiered in the U.S. With an entire quarter left in 2006, that figure has already been matched, and most observers expect it to be eclipsed by the end of the year. Some industry followers estimate that 100 new ETFs could hit the market between now and the end of the year. But is this necessarily a good thing?

One camp says it is. This group reasons that with thousands of mutual funds on the market, compared with a few hundred ETFs, there is plenty of room for the space to grow and fill untapped niches in the market. Some also argue that by tweaking the traditional index-based ETF model or adding a new twist, they can provide investors with better products. The other contingent, let largely by industry analysts, believes that most of the necessary gaps in the market have already been filled and that many of the ETFs now launching are targeted at very small audiences, or are moving away from what the product is all about.

And this, they say, poses some risks. For one, the introduction of many new – and often esoteric – ETFs means there is a greater possibility that less sophisticated investors will end up in the wrong product. In addition, many observers are concerned that a good number of these new ETFs will not be able to accumulate sufficient assets, a situation that could cause many of them to fold. When the day comes that there are 500 U.S.-listed ETFs on the market, “I still think that 20 of them are going to have 50% of the market,” Paul Mazzilli, director of ETF research at Morgan Stanley, says. That means a lot of ETFs are going to be left out in the cold – something that, to an extent, is already happening.

According to Mazzilli, as of last week, there were 320 ETFs trading. Of those, he says, 81 had fewer than $50 million in assets, and 38 had fewer than $25 million. Recent data puts total ETF assets at $363 billion. The largest ETF, the S&P 500 SPDR (SPY), has around $57 billion in holdings, or 16% of the total market share, followed by iShares MSCI EAFE (EFA), which has around $31 billion in assets, or 9% of the market. Rounding out the top three is the Nasdaq 100 Trust Shares (QQQQ), which has $18 billion, or a 5% share.

First Trust Dow Jones Select MicroCap (FDM) has been out for over a year, yet has only $18 million in assets. In addition, the streetTRACKS DJ Wilshire Mid-Cap (EMM) has been out since November and has only $16 million in holdings. And last month, the SPDR O-Strip ETF shut down altogether. At the time, it had around $5 million in assets. Ronald DeLegge, publisher and editor of ETFguide.com, says, “The problem is that small funds in the ETF space do not work. … Expense ratios and profit margins are so tight that you need economies of scale. … At some point – as this business matures – as with traditional mutual funds, we will see product start to merge or liquidate.”

HARD TO JUSTIFY THE NASDAQ 100 ETF AS AN INVESTMENT, BECAUSE OF ITS HIGH VALUATION

It is expensive vs. both the S&P 500 and its constituent sector ETFs.

The Nasdaq 100 Trust (QQQQ) is one of the most successful ETFs ever created, with assets under management exceeding $17 billion and boasting the highest average trading volume of any ETF listed in the U.S. Despite being wildly popular, “the Qs” have also been one of the most disastrous investments of recent years, still trading well below their listing price in 1999. The fund’s precipitous drop in 2001-02 reflected the bursting of the tech bubble and has little to do with the future prospects of the current constituent companies, which is, after all, what the stock market is supposed to discount. Could it be that the Qs, which have made a partial recovery from the depths of despair in 2002, are now cheap enough to make them a good investment?

Unfortunately, it is hard to justify the QQQQ as an investment because of its valuation. The trust is currently trading at a P/E of 26.7 times estimated 2006 earnings of $1.52, compared with a P/E of 15.3 times for the S&P 500 SPDR (SPY). But the real kicker is that exposure to the technology, consumer discretionary and healthcare sectors, which account for 96% of assets in the QQQQ, can all be had for cheaper through purchase of the respective Select Sector Spyders – as can be seen in this chart. Granted, the Sector SPDRs do not offer identical constituents in identical proportions – they can include NYSE-listed stocks which by definition the Nasdaq 100 tracking stock cannot. Nonetheless, stocks within the same sector are likely to be highly correlated, and QQQQ trades at a steep premium to each Sector SPDR.

Proponents of QQQQ will argue that the 100 companies which comprise the index offer fast earnings growth. That is true … when profits are growing. But good times do not last forever, and when the punch bowl disappears, companies in QQQQ are likely to experience a much bigger decline in profits than a broader and more seasoned index like the S&P 500. Indeed, recent warnings from Nasdaq 100 constituents Yahoo and Red Hat may prove a harbinger. This chart shows historical net margins for the S&P 500 and the Nasdaq 100. Times are good, and companies in the Nasdaq 100 index have collectively earned double-digit profit margins for the past two years and appear likely to do so again this year, a dramatic turnaround from the losses suffered in 2001-02. In comparison, companies in the S&P 500 have slightly lower margins now, but were able to maintain decent profits through the last recession.

We are not in the doom-and-gloom camp about the economy. But if the Nasdaq’s profit margins are at or near a peak as they appear to be, then earnings growth will be limited to sales growth. In an economy that at some point will likely slow over the next few years, and may already be slowing, companies in QQQQ could suddenly find it very hard to deliver earnings growth that even keeps pace with, let alone exceeds, earnings growth in the S&P 500. That might prompt investors to question anew whether QQQQ is worth its 74% premium to the S&P 500, and, in turn, could have them heading for the exits like its 2001 all over again.

GOOGLE BUYS WEB VIDEO LEADER YOUTUBE FOR $1.65 BILLION

Google, the most-used Internet search engine, agreed to buy YouTube Inc. for $1.65 billion in stock, adding the largest video-sharing site on the Web and an audience that watches more than 100 million clips a day. In less than two years, San Bruno, California-based YouTube has catapulted from startup to Internet icon with 34 million monthly U.S. visitors. YouTube will operate independently, Google said.

The purchase, Google’s largest, underscores the pressure on the company from startups such as YouTube and friend-finder Facebook.com, which are creating new markets for film clips and social networking. The acquisition also builds on Google’s strategy to add more content to attract advertisers. “This is the quick entry for Google into becoming Google TV,” said Allen Weiner, an analyst at market researcher Gartner Inc. YouTube is “this huge TV-like platform that includes a significant amount of content.”

In total visitors, the purchase vaults Google to second place among U.S. Internet companies from third. The two brands combined had 101 million visitors in August, according to Nielsen//NetRatings. Yahoo! sites had 106.7 million and Microsoft’s MSN Internet division had 98.5 million. Shares of Google rose to $431.50 in extended trading after the announcement, and have gained 3.4% this year.

Spending more than $1 billion on an acquisition is a departure for Google, which has typically bought smaller startups such as mapping software maker and the creator of a Web-based word processor. Google had $9.82 billion in cash and marketable securities as of June 30 and generated sales of $6.14 billion in 2005. YouTube’s business fits Google’s strategy of using Internet content as a platform to sell ads. Advertisers and media companies are piling into sites like YouTube and MySpace.com to reach more users. YouTube viewers on average spend 26 minutes on the site each month, according to Nielsen. YouTube already uses ads sold by Google. Before the merger announcement, Google and YouTube separately struck agreements with three of the world’s largest record companies to add music videos on their Web sites.

YouTube was founded in February 2005. Technology that allows people to easily upload and share videos has spurred its popularity. More than 65,000 videos are uploaded to the site every day. “With YouTube’s traffic and buzz, Google could quickly try to build its position as the video advertising clearinghouse online,” UBS AG analyst Ben Schachter wrote. “It’s just the kind of bet we’d expect from Google.”

Dot-com boom echoed in deal to buy YouTube.

A profitless Web site started by three 20-somethings after a late-night dinner party is sold for more than a billion dollars, instantly turning dozens of its employees into paper millionaires. It sounds like a tale from the late 1990’s dot-com bubble, but it happened yesterday. Google, the online search behemoth, agreed to pay $1.65 billion in stock for the Web site that came out of that party – YouTube, the video-sharing phenomenon that is the darling of an Internet resurgence known as Web 2.0.

YouTube had been coveted by virtually every big media and technology company, as they seek to tap into a generation of consumers who are viewing 100 million short videos on the site every day. Google is expected to try to make money from YouTube by integrating the site with its search technology and search-based advertising program. But the purchase price has also invited comparisons to the mind-boggling valuations that were once given to dozens of Silicon Valley companies a decade ago. Like YouTube, those companies were once the Next Big Thing, but some soon folded.

Google, with a market value of $132 billion, can clearly afford to take a gamble with YouTube, but the question remains: How to put a price tag on an unproven business? “If you believe it’s the future of television, it’s clearly worth $1.6 billion,” Steve Ballmer, Microsoft’s chief executive, said of YouTube. “If you believe something else, you could write down maybe it’s not worth much at all.” The success of the YouTube acquisition will probably lie in embedding video advertising into the clips that millions of people watch everyday from their computers. So far, YouTube’s management has been reluctant to include advertising within clips, for fear of alienating users.

In the conference call to announce the transaction, there were eerie echoes of the late 1990’s boom time. There was no mention of what measures Google used to arrive at the price it agreed to pay. At one point, Google’s vice president, David Drummond, gave a cryptic explanation, “We modeled this on a more or less synergistic kind of model. You can imagine this would be hard to do on a stand-alone basis.” The price tag Google paid may simply have been the cost of beating its rivals – Yahoo, Viacom and the News Corporation – to take control of the most sought-after Web site of the moment. It was also perhaps the only price that two YouTube founders and their big venture capital backer were willing to accept, given that they most likely could have continued as an independent company.

“The Google-YouTube deal has to feel a little like the 1990’s, but it isn’t,” said Dmitry Shapiro, chief executive of Veoh, a YouTube competitor. Arguing that online video represents an entirely new medium, he said, “If you knew then what you know now and you had the chance to acquire Amazon or eBay – which weren’t making any money either – you would have bought them.” Of course, YouTube has also been compared to Napster, whose music-sharing service was eventually shuttered after a series of lawsuits. While YouTube has made some deals with content providers, its users have uploaded millions of copyrighted clips, leading some to question whether Google is inheriting a legal minefield. YouTube has said it is different from the old Napster service because it removes content when a copyright holder complains. Mark Cuban, who founded Broadcast.com, an early audio and video site that was bought by Yahoo, is skeptical of Google’s legal position, writing on his blog, “I still think Google lawyers will be a busy, busy bunch.”

Can good advice lead to a bad decision?

Recently I caught some of the Q&A that followed Ted Turner’s speech to the National Press Club. Turner is arguably the foremost blowhard of our time, yet even he can be worth listening to when he gives a serious reply to a serious question about business. Such was the case when asked about getting good business advice. Turner said that, yes, he does seek counsel when making important decisions. But he quickly pointed out that good advice can still lead to a bad decision. His case-in-point was the $156 billion AOL Time-Warner merger in 2000. Turner said that at the time, he was all for the merger. So was every one of the wise men he spoke with, as were the board of directors, the teams of lawyers and number crunchers, major shareholders, blah, blah. Still, said Turner, this overwhelming consensus was proven dead wrong. The merger was a disaster. Good advice led to a bad decision.

All this came to mind as I read the headlines about Google’s $1.65 billion purchase of YouTube. It is not just that the phrases describing Google/YouTube deal were so familiar – they clearly were. “We’ll be able to leverage the technology and resources.” … “We believe the combination will create this very new and interesting global media platform for users, content providers and advertisers.” … “We modeled this on a more or less synergistic kind of model.”

Okay dude, whatever. Anyway, it is not just the clichés. It is that YouTube is showing us what we have heard before – as in, YouTube is a video version of the model Napster first used to allow the public to share audio recordings. If you cannot remember how that turned out, look it up. (Hint: lawsuits, bankruptcy.) But Napster is ancient history, and the AOL Time-Warner merger downright prehistoric. The financial press is unanimously thumbs-up on Google/YouTube. The only dissent I have seen came from the charmingly candid billionaire Mark Cuban. He said that, given the potential copyright lawsuits, only a “moron” would buy YouTube. Cuban soon modified the remark by noting, “Moronic would be the understatement of a lifetime.”

“This time it’s different,” or, “Nothing new under the sun”? We know what the psychology is saying.

WHAT MAKES SILVER SUCH A POPULAR CAR COLOR?

Social mood. When Henry Ford first started manufacturing his Model T early in the 20th century, he actually offered it in various colors. That is right, social mood was positive in the years around 1909, and consumers were in the mood for colors, writes Mark Galasiewski of The Socionomics Institute. Ford dispensed with colors in 1915 as social mood declined and World War I consumed the nation. For the next 11 years, car buyers had only one color choice for their Model T – the famous black.

Since 1998, the biggest story in automobile color has been the rise and then the absolute dominance of silver. Silver entered the top three in 1999, displaced white as the most popular color in Europe and North America in 2000, and became the No. 1 color globally in 2001. The color has less precedence than others as a meter of social mood, having first emerged as an automobile finishing in 1974. But its history since then suggests that silver is a “post-peak” color that precedes deeper pessimism in the future. Color consultant Leatrice Eiseman says that silver is “elegant, loves futuristic looks, cool” – a perfect description of post-peak complacency, in our opinion. At the risk of overanalyzing a limited series of data, we note that silver has a peculiar habit of peaking some years after major stock market tops and some years before final bottoms in sentiment.

While silver continues its current 6-year reign as the #1 color choice, it is declining in popularity in favor of a fuller palette of true, high-chroma colors. Silver is also giving way to its sister neutral color – medium dark gray. Significant 5% gains were seen in 2005 color trends for gray in complex formulations that show color infusions of various color hues. Gray, like blue, on automobiles shows no consistent pattern of correlation to the stock market. But the recent use of gray to dilute the brightness of other colors suggests that the negative mood trend is beginning to reassert itself.

FALSE SIGNALS AND UNREALISTIC HOPES

Against the background of everything else happening in the financial markets is the apparent circumstance of peak oil. Even The New York Times joined the chorus in a Sunday editorial, saying, “Our demand for petroleum products strains the limits of the global capacity to supply them. In past decades, if a pipeline broke in Nigeria, Saudi Arabia might compensate by setting workers to pumping more oil. Now, with little additional capacity, rising prices are necessary to balance out supply and demand.”

No more increasing capacity is peak oil. It is as simple as that. We now have 9½ months of “rearview mirror” action to look back and see that world oil production has retreated from its all-time high of just over 85 million barrels a day (mbd) achieved in December 2005. For 2006, production has remained in the 84 mbd range every month reported so far, while demand has exceeded that.

Texas oil man Jeffrey Brown, a commentator at TheOilDrum.com, the outstanding oil discussion group on the Internet, makes the point that Saudi Arabia is at the same point statistically (in terms of ultimate recoverable reserves) that Texas was at in 1972 when production there peaked. The world’s four greatest oil fields are in depletion – Burgan (Kuwait), Daqing (China), Cantarell (Mexico), and Ghawar (Saudi Arabia) – and these have accounted for over 14% of the world’s oil production. Ghawar alone accounts for over 60% of Saudi Arabia’s production. The North Sea has peaked and production there is “crashing”. Venezuela has peaked and its oil is low-quality heavy crude. Indonesia has peaked and is now a net oil importer. Nigeria’s political chaos is making production increasingly difficult-to-impossible. Production in the Canadian tar sands is not making up for losses elsewhere. Discovery of new oil (including Chevron’s largely hypothetical deepwater “Jack” finds) is barely covering a fraction of the world’s consumption. And so it goes. …

Where finance is concerned, the basic implication of peak oil is pretty stark: an end to industrial expansion, i.e., “growth”. All the alternatives to oil will not keep the industrial economies expanding – they can only slow down a contraction, and only marginally so. Finance is a system that uses paper markers to represent the hope and expectation for the expansion of wealth. These markers are currencies, stocks, bonds, option contracts, derivatives plays, and other certificates that are traded in open markets. If there is no longer any hope of increased wealth in the world, then all those tradable paper markers become losers. Their value unwinds and imagined piles of wealth evaporate into thin air.

The unwinding process depends on the psychology of the people who own these certificates. If they do not understand the global oil situation and its implications, then they will continue to hope for and expect expanded wealth, and thus continue to regard their paper certificates as credible markers of value. And that is largely the case at the moment, since most of the playas in the financial markets are not paying attention to the peak oil story, or do not believe it is for real. Two special and transient circumstances are now propping up the financial markets. The main false signal is that with the 20% crash in oil prices since the panic buying (hoarding) of June and July ll is well on the global oil scene. There is no real supply problem, hence no threat to the continuing expansion of industrial production and its associated wealth-generating activities.

The second special and transient circumstance is that so much wealth has already accumulated along the way to peak, that financial markets take on a life of their own – as existing wealth “invests” itself in more paper markers hoping and expecting to “grow” into even more wealth. In simply bidding the markets up, the system has spun off even more gobs of presumed wealth. Some of this “liquidity” – say, in the checking accounts of people who work for Goldman Sachs – has found its way into Manhattan condominiums, or Aspen McMansions, and filtered through the system to everyone from the lawyers who write up the pre-nuptial agreements to the guys who sell the furniture to the people who drive the delivery trucks that bring it to the door, to the men laying tiles in the new bathrooms.

The basic insanity of a system that presumes vastly increased wealth where none will occur, has led to further distortions in finance. The most obvious one is the so-called housing bubble. The misplaced extreme expectation in the ever-increasing value of paper wealth, led to the hijacking of the mortgage market by financial “players”. The level of abstraction in these rackets – their distance from the reality of productive activity – is self-evident. But they were so successful that the profligate creation of ever more mortgages became an increasingly reckless and irresponsible enterprise. The reckless reassignment of lending risk into ever more abstract layers of deferred obligation, and the ease of credit that ensued, allowed millions of ordinary people to acquire real property on unrealistic terms, which had the affect of bidding up the price of houses that these owners will eventually have to surrender for nonpayment. That process is now underway. The reckless creation of mortgages had the further effect of stealing demand for house-building from the future. There is now a massive over-supply of total existing houses while the pool of suckers for new ruinous mortgages has shrunk to zero. Similar excesses in all the other lending and debt sectors, including “non-performing” credit card obligations and government deficits, will also unwind and thunder through the system.

Meanwhile, the false signal from the oil markets that has been broadcasting for eight weeks will come offline and a new signal will come on as prices go back up. The pause in bidding for future oil induced by the panic over-buying of the summer will end. As the price of oil goes back up, the financial markets will get a new signal that running industrial societies has just gotten more expensive again. Meanwhile, the air will be coming out of millions of mortgages, and the loss of value will spread among “players” holding these bundles of mortgage debt. The inflated value (high price) of these assets will deflate. As this occurs, there will be far fewer wage earners putting up additional houses, fewer furniture sales, fewer trips by delivery truck drivers and fewer tile-jobs in the McBathrooms.

This is why I view the fall melt-up of the stock markets as a swan dive. We are at the apogee now, just as the world is at the apogee of its oil production. I confess, I thought the reality of our economic predicament would be recognized by the players and their markets sooner than it has. It turns out the chief luxury of the final cheap oil blowout has been the artificial support of unrealistic hopes and expectations.

ORANGE JUICE SOARS AS FLORIDA CROP MAY BE SMALLEST IN 17 YEARS

Orange-juice futures soared to a 16-year high after the U.S. government said Florida’s orange crop will be the smallest in 17 years as cold temperatures and lingering hurricane damage hampered fruit growth. Florida, the world’s second-biggest orange grower behind Brazil, will produce 135 million boxes in the 2006-2007 season, down from 147.9 million, the final revised estimate for last season’s crop, the U.S. Department of Agriculture said in a report. The forecast was the first for a harvest season that began this month and ends in June. “The trees are still trying to recover from back-to-back hurricanes,” said Andy Taylor, vice president of finance at Peace River Citrus Products. “Some trees are very sparsely fruited. That is the hurricane hangover from the last two years.”

The bulk of Florida’s oranges are harvested from October to June. The crop set a record of 244 million boxes in the 1997-98 season.

DUMB AS A BRIC?

It has become fashionable in the last few years to express enthusiasm for emerging market investment by focusing on the “BRIC” economies (Brazil, Russia, India, China), a term first coined in a 2003 paper by Goldman Sachs, which looked for the potential economic superpowers of 2050. This is a dumb idea for two reasons: (1) There are other emerging markets that are at least as attractive as these four, and (2) at least two out of the four BRICs show no significant signs of emerging into anything very interesting by 2050.

China is probably the most likely BRIC to emerge into an economic superpower by 2050, and even with China the chance is no more than about 50-50, though the country’s 1.3 billion people make the country important in any event. Of course, if China’s current economic growth rate continued to 2050, or even slowed somewhat, it would be an economic behemoth. But there are number of reasons to suppose that China’s growth cannot be projected in a straight line. There is almost certain to be one or more huge discontinuities between China’s present position of poverty and rapid growth and its hoped-for destiny of wealth. During these discontinuities, Western investment is likely to be held hostage by the Chinese authorities to ensure that the West does not adopt draconian trade barriers. With growth uncertain, the Chinese stock exchanges dominated by state-controlled companies and property rights not firmly established, investment in China is by no means a sure thing.

Like China, India has enjoyed rapid growth in the last few years, and is thought likely to be one of the dominant economies of 2050. Unlike China, it is already a democracy, and so has no political transition to endure. However its current government, while led by the economically sober Manmohan Singh, is dominated numerically by the anti-capitalist elements in the Congress Party and the left. Congress’s refusal to reform further and love of subsidies (for fuel, for example) and public spending in general has caused the public sector deficit, central and state, to spiral to almost 10% of India’s GDP. This is a disgraceful performance in a period of record Indian economic growth and suggests that when things get tough, a government funding crisis is almost unavoidable. Meanwhile, Indian domestic consumption has been fueled by a record credit boom, resulting in a rapidly increasing balance of payments deficit. Thus when the present period of excessive international liquidity comes to an end, India will be faced with a currency crisis and a budget crisis, in other words the two problems which had held the countries’ economic growth down for decades. The current Indian government is economically clueless and the Indian stock markets’ current sky high level (over four times the level of 2002-03) is due for a sharp correction. India will only achieve its rightful destiny of prosperity if its electorate has the sense to find a pro-market, competent government – a prospect that is doubtful given recent and past history.

Russia’s chances of transition to one of the major pillars of the world economy by 2050 must be rated as negligible. For one thing, the country’s population is declining, as the miserable Russian male population subsides into alcoholism and forgets to reproduce. While Russia may be geographically enormous by 2050, including possibly a number of Middle Eastern oil producers, it is unlikely to be wealthy, except in armaments. Since Russia has no respect for private property, and will not let you buy shares in Kalashnikov, with its unique brand identity and world quality sales force in the form of the former KGB, it is unlikely to provide investors with growth opportunities.

Finally, we have Brazil, now as always rated a growth opportunity for the future, the same position it has occupied since approximately 1500. One’s confidence in Brazil’s future is not increased by the London Times’ reminder that in 1912, there was general worldwide conviction that the future belonged to Argentina. (The Lei Roque Saenz Pena, passed that year, enfranchised the rootless immigrant ghettoes of Buenos Aires and over time ended that dream.) Brazil’s annual productivity growth in the last 15 years has been 1.0%, not bad by Latin American standards but hardly suggesting rapid economic emergence. It has the advantage of natural resources, but it has always had that advantage. Absent big changes, Brazil in 2050 will be populous but poor, as it is today.

The above discussion suggests that the four BRIC countries are by no means certain to enjoy the rapid economic growth that would lead them to an assured 2050 destiny as economic superpowers. China and India have a reasonable chance of such emergence, but are far from certain to achieve it while in Brazil and Russia such emergence is very unlikely indeed without a complete change of the country’s current economic policy and indeed political structure.

However the main problem with the BRIC concept is not the countries concerned but the idea of limiting investment to only the largest emerging economies, and then publicizing the limitation in the hope that other emerging market investors will follow your lead. In a period of excessive world liquidity such as the present, this simply produces a bubble of overvaluation, as a tsunami of speculative money overwhelms these fairly illiquid securities markets. It is a recipe for almost certain long term loss. Until emerging economies have reached the level of Taiwan, Singapore and South Korea, with wealthy societies and substantial investment pools of their own, they will be subject to wild swings in and out of fashion, combined with periodic currency, fiscal and banking crises. They are thus risky, and the main investment criterion – apart from a government that appears to have at least some handle on how to develop the economy – avoid Venezuela and Argentina, therefore – should be that they be cheap and overlooked by large international speculators.

Small markets are much more likely to provide such opportunities than large ones, since the speculator pools have little interest in markets they cannot get in and out of in size. In Eastern Europe, Croatia, Georgia and Bulgaria (which has had only about a 10% run-up since EU membership was confirmed – Romania is up about 30%.) In Latin America Colombia and maybe Chile – quality of government is vital to avoid loss there. In Africa there may well be possibilities (South Africa is not one of them) though markets there remain extremely small and illiquid. In Asia, Pakistan, Malaysia, Thailand (down substantially on the political crisis) and Vietnam all appear potentially more interesting than India or China currently. Having said that, with world liquidity very high now is not the best time to invest in emerging markets. Nevertheless I made good money in Croatia in high-liquidity 1999, when the local market was, contrary to almost every other exchange in the world, in deep depression on political uncertainty and NATO bombing the neighbors. So the golden rule is: the more obscure and unfashionable the emerging markets opportunity, the better it is likely to be. You will have your ups and downs, but you are almost certain to outperform the BRIC-lovers.

MORE REASONS A MONETARY CRISIS IS INEVITABLE

Even a casual observer can see that the Fed is now caught between a rock and a hard place. If it lowers interest rates to head off the economic devastation that would come with a collapsed housing bubble – housing is estimated to have, directly and indirectly, contributed 57% of U.S. economic activity over the past 5 years – the Fed risks triggering a wholesale rush by foreigners to dump their trillions of U.S. dollars. But if it raises interest rates to protect the dollar, the Fed risks turning an economic downturn into the most serious recession since the 1930’s. It is our view that, for a number of reasons, not the least being that we are soon to enter the presidential election cycle, the government will take the course of inflation.

A couple of other factors lead us to that view. One is demographic. The first-born baby boomers are turning 60 this year, and they and their little brothers and sisters will soon have their hands out for the Social Security and Medicare entitlements they have been promised. But the boomers represent an extraordinary bulge in the age profile of the U.S. population. The bulge means that the share of the population receiving government retirement benefits will grow, while the share of the population paying for them will shrink. To paper over this gross imbalance and still keep the entitlement checks going out, deficits will have to increase at a stupendous rate – and the engine of monetary creation will have to ramp up to entirely new and increasingly dangerous levels.

The second factor promising more inflation is the “Forever War” against Islam – already being called World War Three in many quarters. The dollar has been a casualty of every U.S. war. War costs are paid for with deficits, and the deficits translate into rising price inflation every time.

These are not problems the Fed can sweep under the rug. Fed Chairman Bernanke is an academic with a reasonable understanding of the technical details, but his career bias has been to dodge recessions by cranking up the presses that print all those $100 bills. “Helicopter Ben” is the nickname he earned for facetiously proposing to drop cash out of helicopters to stave off a deflation. We are convinced that the Fed will return to loose monetary policies, masked by ongoing tampering with the CPI indicators and by obfuscating the truth about the money supply. That is the path of least resistance. In the short run, no one gets hurt, and it delivers the U.S. government its daily fix of billions needed to keep the ship of state afloat.

Monetary expansion will buy some time, but then the real trouble starts. A loose monetary policy eventually produces price inflation. As the inflation becomes noticed, foreign holders will lose confidence in the dollar. Then, as they head for the exit, the Fed will face a stark decision: Either raise interest rates to economy-crushing levels to save the dollar, or let the dollar collapse and tolerate even worse inflation a little further down the line. There is room in the Fed’s lifeboat for the dollar, and there is room for the economy, but there is not room for both. Bernanke has already all but announced that it will be the dollar that gets thrown overboard.

While no one can say how long it will take for a monetary crisis to emerge or what will ultimately trigger it, now is the time to acknowledge the risk – and in fact the likelihood – that it will occur in the next few years. That potential is confirmed with each newsflash telling us that the housing slump is accelerating and that signs of recession are appearing. Those are code words for the Fed to begin pumping more paper money into the system.

SMALL-CAP PHARMACEUTICAL HAS BIG POTENTIAL

Back in May 2005, company insiders at ViroPharma (VPHM: NASDAQ) bought 233,500 shares of their own stock. They were obviously banking that their novel drug, Vanocin (which treated acne and various skin conditions) would be accepted by the FDA. It was. And the stock rose from $3 to $24! Now another biopharmaceutical company may be on the verge of similar profits.

NeoPharm, Inc. (NEOL: NASDAQ) is a biopharmaceutical company that researches, discovers and commercializes cancer drugs. Its lead drug therapy, currently in Phase III clinical trials, is something called cintredekin besudotox (CB). CB is a recombinant protein that targets deadly brain tumors in adults, known as glioblastoma multiformes (GBMs). GBMs are terribly aggressive tumors. They essentially have tentacles that spread and mix with normal functional brain tissue, wreaking havoc on the body and growing uncontrollably. Most people diagnosed with this form of brain cancer die within one year, despite aggressive surgeries, radiation and chemotherapy. Over the last 20 years, there has not been any significant treatment for GBM patients.

CB is made up of a single molecule composed of two parts. One part bonds to deadly tumor cells. The other part is absorbed into the cancer cell – killing it. Unlike radiation treatment, CB does not harm healthy brain cells. Healthy brain cells do not have the receptors that are necessary for the CB molecule to bind to them. So far, in a series of blind trials, patients treated with CB lived for an average of 55.6 weeks versus 28 weeks with currently available treatments. Evidently not a massive breakthrough, i.e., a cure, it is nonetheless twice as effective as the current treatment.

Because of the clinical trial results, CB has received orphan drug designation in Europe. It has been fast-tracked by the FDA. Several other renowned groups have also partnered up with NeoPharm, including the National Institute of Health and Nippon Kayaku (to market CB in Japan). Of course, there is no guarantee that CB will be approved by the FDA. If CB is rejected, NEOL’s stock price will certainly crash and burn. But based on insider buying patterns, it seems this tiny company has a nice shot at success.

Since the beginning of this year, insiders (including the CEO, CFO, chairman of the board, a director and a couple VPs) have purchased 322,782 shares for prices ranging from $4.85-10.20. And in the last 30 days, insiders have spent $390,000 on NEOL stock for their own portfolios. This is the most amount of insider money invested in any 30-day period in the company’s history. Think they are confident about CB’s future? It seems the FDA is hell-bent on bringing CB to market. And with partnerships with the NIH and Nippon, management appears to be gearing up for potential licensing and marketing deals. Keep an eye on NeoPharm, Inc. This could be the next big story in biopharmaceuticals.

SOME BOTTOMS ARE NICER THAN OTHERS

Some bottoms are better than others. Some lead to substantial capital gains. Others merely deceive investors and lead straight to capital losses, because they are not really bottoms at all. They just appear to be. The charts below depict two different bottoms, or potential bottoms – one in the coal sector and one in the oil refining sector. We find the latter of these two potential bottoms to be more alluring than the former.

Why? Oil refining margins have stopped falling. Coal prices have not. Since topping out in early August, The S&P Coal Stock Index and the S&P Oil Refining Index have both tumbled more than 22%. And both of these indices are attempting to “bottom out”. We are psychologically prepared to embrace either one, or both, of these potential bottoms. But for the moment, we prefer the bottom in oil refining.

The coal sector’s potential bottom features a “capitulation low” on September 25th that survived a “re-test” on October 4th. The big-volume rally on October 11th suggests that the worst might be over for now. However, the buyers of coal stocks will want to keep an eye on coal prices. Even though stocks like Peabody Energy (NYSE: BTU) have jumped 20% from their September 25th lows, coal prices continue to slip. Such price divergences do not necessarily doom a rally attempt … but neither do they instill confidence. In other words, the price action in coal stocks like Peabody suggests that coal prices will also begin to rally relatively soon. But if they do not soon recover, Peabody’s rally attempt will quickly fizzle.

Meanwhile, the bottom that appears to be forming over in the oil-refining sector seems a little prettier than the coal sector’s. Like coal stocks, oil refining stocks dove to a capitulation low on September 25th. Similarly, oil refining stocks re-tested their lows on October 4th and have been attempting to rally ever since. Unlike coal stocks, however, the rallying oil-refining sector enjoys visible fundamental corroboration: Refining margins are also moving higher. Refining margins are actually leading the rising price of oil refining stocks. Since hitting a low of $3.69 a barrel on September 20th, average national oil refining margins have rebounded to $6.24. That is a far cry from the $20-a-barrel they were earning in August, but at $6.24 a barrel oil refining remains an extremely profitable business. And yet, most of the major refining stocks like Tesoro (NYSE: TSO) sell for less than six times earnings. For perspective, the S&P Coal Stock Index sells for 18 times earnings.

If you are gonna chase after bottoms, therefore, why not choose the one in the oil-refining sector?