Finance Digest for Week of December 25, 2006

WHAT U.S. INVESTORS SHOULD KNOW BEFORE INVESTING OFFSHORE

Before you delve into the offshore investment world, your number one priority should be figuring out the tax situation. How will your investments be taxed and what investments, if any, should be avoided because of the harsh tax consequences in the U.S.? It is amazing, but since 1992, I have heard numerous disaster stories about investors who actually made offshore investments immediately after opening a foreign bank account. They did not bother to check out the tax consequences before investing. Then later, they were shocked when they were hit hard by punitive taxes. And considering the tax consequences is even more important than it was 15 years ago. Since 1992, the U.S. has changed the way certain offshore investments are taxed.

The most onerous tax implication facing American investors is the QEF rule, or Qualified Elected Fund rule. Basically, a U.S. investor who purchases offshore mutual funds must now pay annual capital gains from that investment even if there was no distribution. Unlike the majority of U.S.-based mutual funds, which make year-end distributions, most offshore funds do not issue year-end per share capital gains, dividends, or interest income distributions. That means any investor holding an offshore fund must pay capital gains taxes every year, assuming he has gains, from a separate source of income. In my book, that is an onerous tax regime, making offshore mutual funds a bad investment for Americans.

However, Americans can defer offshore mutual fund taxes by investing in an offshore variable annuity or moving an Individual Retirement Account (IRA) offshore. This way, you get to defer taxes in the policy or account and hopefully, accrue some impressive long-term gains from some top-performing offshore funds. But outside of a tax-deferred solution, an investor should avoid offshore mutual funds because they are onerously taxed by the IRS.

International stocks are a different story altogether. International investors also make the mistake of buying U.S.-listed ADRs (foreign stocks traded as American Depositary Receipts) inside a retirement plan. Also, buying foreign-listed stocks from an offshore private bank will result in withholding of dividends. Both strategies, unfortunately, will result in losing that dividend tax credit – an IRA cannot recover that lost income held at source because an IRA cannot file a tax return. If you choose to buy foreign stocks, either domestically or from a private bank abroad, then make sure you buy these securities in a taxable account so you can reclaim the dividend withholding at source. The Bank of New York, the largest sponsor of ADRs in the U.S., offers a mostly free source of per share information, including current dividend distributions.

Foreign bonds also pose a similar dilemma to retirement investors. Going global with a portion, or even all your investment portfolio, can yield some impressive long-term results. But make sure you fully understand the tax implications of investing in foreign securities before investing a penny either in the U.S. or overseas.

SUB-PRIME DISASTER IN THE MAKING

A report by the Center for Responsible Lending, a Durham, N.C. based research group, predicted that 1 in 5 sub-prime mortgages originated in the past two years would end in foreclosure. While most on Wall Street dismissed this survey as overly pessimistic, it actually represents a rather rosy outlook. One of the report’s deficiencies is that it fails to account for how the foreclosures it does expect will impact those loans that it regards as safe. The secondary effects of the 1 in 5 sub-prime default rate will be a chain reaction of rising interest rates and falling home prices engendering still more defaults, with the added foreclosures causing the cycle to repeat. In my opinion, when the cycle is fully played out we are more likely to see an 80% default rate rather than 20%.

The main problem is that the majority of these loans were made to people who really cannot afford to repay them and were collateralized by properties whose true values were but a fraction of the loan amounts. Once the music stops and prices return to earth, borrowers who put little or no money down may decide to simply mail in their house keys rather than make additional mortgage payments. Why would anyone stretch to spend 40% of his or her monthly income to service a $700,000 mortgage on a condo valued at $500,000, especially when there are plenty of comparable rentals that are far more affordable? In addition, even those who can comfortably afford to pay may choose not too. Basically, a zero-down, non-recourse mortgage gives the borrower a free put option should real estate prices decline. The bigger the drop, the more incentive there is to exercise. Rather than throwing good money after bad, borrowers could simply return their over-priced houses back to their lenders and buy one of their neighbor’s deeply discounted foreclosures instead.

Also, the idea that sub-prime foreclosures will not affect the broader market is absurd. These loans simply represent the weakest links in the mortgage/housing chain. Once they break the entire chain falls apart. The added demand from these marginal buyers helped produce and sustain the bubble. Remove it and the bubble deflates. Also, falling home prices and rising interest rates effect every homeowner, and the temptation to walk away from an upside down mortgage is not restricted to sub-prime borrowers.

Bad Dreams

In the old days, say in the mid-‘90s, owning a home was called the “American Dream” for a reason. And the reason was that the first time the right side of a renter’s brain sparked an interest in homeownership, the left side would do a quick audit of the personal financial ledger and toss the idea straight into the mental dustbin, next to those New Year’s resolutions to avoid fast food and People magazine.

But the suppressed desire of owning one’s own home would surface again and again. The renter would dream about owning his own place, a place to lay his own head under his own roof with no Backstreet Boys harmonizing at full volume in the adjacent apartment. If the American dreams were vivid enough, the renter would begin to change behavior - saving more, spending less, working harder, and developing an opinion on the various shades of berber carpet. And if the dreams lasted long enough, the renter would one day awaken in the office of mortgage broker, dizzy from initialing stack of loan documents, and queasy from writing a 5-digit check to cover the downpayment and a series of closing costs that spit straight from a random number generator.

At last the American Dream comes true, only to be replaced by new dreams, like dreams of marching in the streets, bullhorn in hand, and leading an angry mob of likeminded mortgage holders to the steps of the mortgage company to demand, once and for all, that someone explain how taxes and insurance are calculated for escrow. But that was then. More recently the American Dream has been replaced by the American “to do” list. Today, once a renter fancies having a place of his own, he logs on to the internet and clicks on a banner ad, and with in minutes is touring neighborhoods with a loan commitment in hand. Who wants to dream about the future when the future is now?

The Center for Responsible Lending is who. They have seen the future and it makes them want to crawl in a tornado shelter. But they cannot do that just yet. Their mission is to curb lending abuses, an agenda that is keeping them too busy to duck and cover from the fallout they expect from the subprime lending boom. The subprime boom, of course, is a subset of the overall mortgage boom, which was facilitated by the new “financial efficiencies”, including allowing anyone who can walk in with an application to walk out with a mortgage commitment. The Center recently completed a study they claim is the first to figure out how many subprime mortgages have failed, and the first to get a handle on how many will likely fail in the next few years. And, last but hardly least, they predict financial repercussions for the subprime borrowers themselves.

The CRL wonders why more was not done to prevent the disasters already unfolding. With housing prices sinking and ARMs adjusting, the Center does not see a Happy New Year for many subprime borrowers. Ultimately, the Center predicts that 15.8% of subprime loans originated between 1998 and Q3 2006 will enter foreclosure. While they predict that “only” 9.8% of subprime loans originated in 1998 will fail, the Center projects that 19.4% of loans originated in 2005 and 2006 will be foreclosed upon. Losses from foreclosures are not just bad news for holders of the riskiest mortgage backed bonds. The Center estimates that homeowners have already lost $45.7 billion (largely in home equity) from foreclosures in loans originated from 1998 to 2004. It is no surprise that the Center expects this figure to increase. They estimate that 2.2 million households will lose their homes related to subprime loans made from 1998 through 2006, costing those families $164 billion.

Speaking of the end of the wealth creation cycle, homeowners now find themselves more leveraged than ever before – even after the boost in home prices from the housing bubble. The trend toward shrinking home equity stabilized in recent years as home prices increased at least as fast as mortgage growth. In the third quarter, however, even though home mortgage borrowing fell year-over-year, total outstanding mortgage debt managed to increase faster than home values. As a result, home equity shrank to 53.6% of real estate assets.

Thanks to the New Financial Era, home equity is no longer an abstract concept, but something tangible that a lender can hold on to in exchange for a mortgage equity withdrawal. As a result, a person might assume that slower growth in home equity growth might put a wrench in the practice of using the home as an ATM. Sure enough as Paul Kasriel, King of the Charts, pointed out in charts 10 and 11 of his recent commentary (PDF), there seems to be a relationship between shrinking home equity, reduced mortgage equity withdrawals, and – get this – consumer spending which is slowing on a year-over-year basis. Slowing consumer spending? Somebody pinch them and see if they are dreaming.

THE HOUSING BUST IS WORSE THAN EXPECTED. HOME DEPOT’S CEO HAS A PLAN FOR SURVIVAL

A housing collapse is under way, and that means terrible things for the economy in 2007. Or does it? To assess the damage we dropped in on the Home Depot, the retailer that gets a large chunk of its $90 billion sales (2006 estimate) from the building or remodeling of houses. A canary in the coal mine. Conclusion: This canary is a little short of breath but will survive.

Chief Executive Robert Nardelli says that a year ago Home Depot envisioned a housing decline of 5% to 7%. Construction of new homes in October was 28% below the year-earlier figure. Mortgage financing giant Freddie Mac says proceeds from cash-out refinancings are set to drop 40% this spring compared with the volume last spring – bad news for people selling houses and also bad news for people selling hi-def televisions. “We haven’t seen the worst of it yet,” says Nardelli from his Atlanta headquarters. “75,000 construction jobs are gone. We see these guys in our stores, competing with [established] contractors.”

Home builders like Centex, D.R. Horton and Pulte have written off close to $1 billion in raw land inventory. “I’ve never seen a pull-back so fast,” says Nardelli. “It takes them 18 months to remobilize. I’m not sure they can turn it on again. If this is a soft landing, it's not a plane I want to be riding on.”

Home Depot is not immune to the housing recession, but it can adapt. How will the retailer cope? One way is to pull in its horns on the retail side, cutting the schedule of store openings in the fairly well-saturated North American market. The other is to expand in slightly different directions. One is to get more deeply into the wholesaling of construction supplies. This means selling things like sewer pipe and roof trusses. The other is to expand abroad. A combination of reduced capital outlays and slightly higher leverage on the balance sheet will enable Nardelli to return money to shareholders via dividends and stock buybacks.

A few weeks ago Home Depot paid a reported $100 million to acquire the Home Way, a chain of 12 stores in northern China. China is a $50 billion home-improvement market growing 20% a year, and Home Depot knows and likes the territory. The Depot’s founders, Arthur Blank and Bernard Marcus, helped Home Way get off the ground in 1996.

In the U.S. Nardelli has been hard at work reversing years of underinvestment in aging stores. The chain was too busy opening new ones to really focus on the old ones. Nardelli is slashing new-store openings by 37% from 2005, using $350 million in freed-up capital to spruce up aging aisles. Its busiest 540 stores are getting refreshed displays of tiles, lock sets, fasteners and wood laminates. Push-button call boxes are being installed in 186 stores to make an associate appear within 60 seconds. In a four-store test, Home Depot is building 1,800-square-foot mezzanines to sell recession-resistant large appliances, from cheapo Maytags to the $2,750 midnight-blue LG Tromm washer-dryer set. And watch out, RadioShack. Home Depot is testing in six stores its Smart Home concept, an entire aisle stocked with electronic home gizmos. Shoppers will be able to activate subscriptions for cell phones, cable ,and satellite TV and radio.

Every retailer that has reached a certain size – Wal-Mart, Sears, McDonald’s – inevitably plateaus. This leveling off either destroys them or forces them into new ideas. Wal-Mart discovered groceries. Sears became a hedge fund. Home Depot’s next idea, HD Supply, is already in full flower. This is now a $12 billion business, 13% of overall revenue, that sells big orders to industrial and commercial builders. Its sales growth is slowing, too, but not as fast as the retail group’s, and the business provides welcome ballast. Much the way Home Depot put dozens of weaker chains out of business in the 1990s, HD Supply intends to outgrow and crush a very fragmented construction-supply industry.

Nardelli just returned from a six-week store tour. He met with 1,000 managers and got an earful. They want more workers, they want loyalty cards for their pro customers, they want more control over what goes at the end of the aisles. He insists the stores have never looked better, that help is more available and check-out is faster. A sneak peek inside the company’s “innovation center” reveals a wealth of eye-catching products. “It took Lowe’s 40 years to get where they are. We built a Lowe’s [that is, an incremental $43 billion of sales] in six years,” says Nardelli.

Will the housing sector survive this recession? Parts of it will.

SEEING THROUGH THE SILENT CRASH

The S&P Homebuilding Index has been cut in half since stock prices topped out last year, and that is in nominal terms ... never mind gold terms or in terms of the CRB. So we have got a crash going on in real estate. The rate of change in the median price of homes in the U.S. has made its lowest low going back to the 1940s, so we know this is a serious turn.

Most real estate analysts are saying, “Yes, it’s bad, but it’ll be temporary just like 1990 or 1974.” But the tremendous speculation and the dramatic reversal is much more like 1929 – 1926 to 1929 – than it is like those minor pullbacks. So we think this 50% decline is not a correction. It is the beginning of a much larger retrenchment.

It was a stealth top in real estate. This is very important. I doubt you can find an article from 2005 saying, “Oh, by the way, real estate is topping out.” They were all talking about the mania and rising prices. And if they were not rising any more in one area of the country, the articles changed their focus to another area of the country where it was rising. But overall, prices were topping out in the summer of 2005. Like every good peak, it was a stealth top that people were not noticing.

I think that is going on in the stock market in a huge way, with the real prices falling and the nominal prices holding up. Of course, now we are seeing the result of the real estate bubble that has burst. It is in headlines all around the country. “Real Estate Bubble Bursting”, “Housing Slump Puts Drag on Growth”, etc. I think you will soon see the same kind of headlines, but they will be relating to the stock market.

An article in The New York Times a month ago was talking about real estate in Arizona. The article says, “Until recently, people were camping overnight, begging to be the next number in the next lot in the next house. Not only are there few new customers to talk to, but many buyers who put down a deposit are not even bothering to come back for a walk-through.” It quotes a real estate agent who says, “All of the sudden they just don’t show up.” I think that is exactly the scenario that we are approaching in the stock market. People right now are camping out every night so they can buy in the morning, but soon enough, they just will not show up. We saw something like that happen in the NASDAQ after the big bubble there, but now we have got it across the board again in the blue chip areas and – if you understand Elliott – that is what we call a bear market rally.

Debating the Flat Earth Society.

One of the rules that scientists try and follow is to not debate the flat earth society. It simply lends credence to the idea that there is actually something to debate. For the same reason scientists will not debate creationism vs. evolution either. Occasionally, however, a flat earth society theory actually manages to come into popular belief. This is one of those times. Right now there is a widely held belief in “Goldilocks” and that corporate spending and construction will somehow pick up the slack where consumer spending and retail construction left off. Goldilocks is of course a fairy tale but to be fair, I did volunteer to rebut the Goldilocks theory as presented on the Salt Lake Real Estate Blog.

This debate came about when I informally responded to the Salt Lake Real Estate Blog on Silicon Investor (SL). SL then sent out a “challenge” along with a rebuttal to my brief responses. I was busy and failed to respond to the rebuttal in the required time. Shortly afterwards SL proclaimed victory. That notion will be put to rest now as we look at the main data points of his arguments (corporate balance sheets, real estate appreciation, building costs, and rents).

The amount of material supporting the notion that corporate real estate expansion is NOT about to pick up where residential real estate left of is massive. It was so massive that I had to break this rebuttal in half and each half is still lengthy. That of course is one of the reasons for the delay in responding. During the delay, additional supporting evidence came in further increasing the length. Part 1 of my response will discuss Corporate Balance Sheets and Real Estate Appreciation. Part 2 of my response will discuss Building Costs and Rents.

SCANDAL STOCKS

Want a cheap growth stock? Get one tainted by an investigation into options backdating.

A stock damaged by scandal can be a great buy. Consider Tyco International (NYSE: TYC), laid low by the larcenous behavior of its boss, Dennis Kozlowski. If you had bought Tyco shares in 2002, just after Kozlowski resigned under pressure related to a criminal investigation, you would be up 3-fold.

Options backdating is the latest scandal to roil Wall Street. Over the past year dozens of companies, among them Brocade (NASDAQ: BRCD), Home Depot (NYSE: HD) and Apple Computer (NASDAQ: AAPL), have confessed that executives backdated options grants to days when shares were cheap, giving the options an artificially low strike price. Fear that earnings might have to be restated or that executives could get ousted or arrested sent stocks tumbling. In some cases the selling was overdone. Shares of software maker Mercury Interactive declined 43% to $25.60 in five months after word hit Wall Street in June 2005 that the company had “misdated” options. A year later Hewlett-Packard agreed to buy Mercury for $52 a share.

Alexander Slusky, a managing partner of Vector Capital, a technology-focused private equity firm in San Francisco, thinks fears of options-related repercussions are exaggerated and that some companies with strong businesses are selling at low prices. Slusky’s group recently compiled a list for us of 85 companies under backdating scrutiny. His argument for looking at this list for buying opportunities? Restatements for backdating, as opposed to earnings fraud of the WorldCom variety, do not have a significant financial impact.

We refined Slusky’s list by kicking out companies with per-share declines in either sales or operating cash flow (roughly equal to net income plus depreciation) over the past three years. We also tossed out any stock that is not trading at least 15% lower than its 52-week high. Finally, to get on this list a company had to be cheap in relation to its growth rate. More precisely, we wanted to see an annualized growth in sales over the past three years that was higher, in percentage points, than the enterprise multiple. The latter is a sort of all-inclusive price/earnings ratio. You get it by dividing enterprise value (common market capitalization plus debt net of loose cash) by operating earnings (net before interest, taxes and depreciation). Here is the list.

MUNI BOND OPPORTUNITY

For municipal bond investors, the November 3 headline in the Chicago Tribune was apocalyptic: “Illinois Pension Nightmare”. Seems that the pension fund for state workers and teachers is short $45.8 billion. Illinois is hardly alone. Rhode Island, Connecticut and Oklahoma are among those in the pension stew. Each has over-committed and underfunded its obligations, a reflection of how easy it is for politicians to appease workers now while leaving the costs to be picked up by future generations of taxpayers. Pensions are only half the picture. State and city governments have also made hundreds of billions of dollars in promises to cover retiree health benefits. They have not come close to setting aside the money needed to cover benefits already earned.

As of December 15, new accounting rules require cities and states to report their nonpension retiree obligations. The numbers will be devastating. What do you, the investor, do about such a dark situation? Wait a bit before adding to your muni portfolio. These bonds soon will be cheaper and will deliver higher yields. But if you are a buy-and-hold investor, which is the best approach to bond investing, it is a pretty good bet that you can ride these bonds to maturity without fear of default. The historical default rate for full-faith-and-credit munis (not the riskier “revenue” bonds that fund enterprises like parking garages) is infinitesimal. Look at the biggest muni wipeouts in recent times: the defaults of New York City in the 1970s and Orange County, California in the 1990s. After all the shouting subsided, bondholders got back their principal. The Whoops bonds from Washington State that caused investor losses in the 1980s were revenue bonds tied to power plants.

But today’s muni issuers with underfunded pension liabilities are in sound financial shape. The state of Illinois has an AA credit rating. So the response of Illinois and the others to the pension shortfall will be to issue more bonds. The increase in supply will lower muni prices generally and boost yields. After investors absorb the reality of underfunded pensions, they will resume their buying and prices will recover. Expect an added stimulus over the next several years as investors anticipate higher tax rates on (nonexempt) interest, dividends and capital gains. That will make sources of tax-exempt interest all the more valuable. You want to get into munis long before that happens.

A 4.1% yield for a 12-year insured AAA municipal bond translates to a 6.3% taxable equivalent yield for investors in the highest federal tax bracket (now 35%). Aftertax, munis already beat the socks off taxable alternatives such as Treasurys, corporates, mortgage-backed securities and government agency paper.

SOME AMERICAN INVESTORS ARE DRILLING FOR OIL IN KURDISH-CONTROLLED NORTH IRAQ. ARE THEY NUTS?

Very quietly in September, under the watchful eye of the Kurdish Oil Protection Force, a crew funded by Prime Natural Resources of Houston started drilling for crude in northern Iraq. The idea was to reach a target depth of 9,500 feet in a Bina Bawi field around New Year’s and uncork what seismic studies indicate could be 500 million barrels of oil. Success would make Prime and its partners the first Americans to find new oil in post-Saddam Iraq.

Long before Big Oil piles in, Prime is making an audacious move at a very delicate time. The dispute over hydrocarbons is very much at the heart of the civil war raging in Iraq. Sunnis, who ruled under Saddam, want their share of oil riches, which mostly lie in the Kurdish-controlled north and the Shiite south. The factions seem close to agreeing how to distribute petro revenues – which might tamp down the violence – but are hung up on who would have final say, the feds or the regional government. Until that is settled, Uncle Sam does not want any oil company, American or otherwise, cutting deals with any group. Prentis B. Tomlinson, CEO of Calibre Energy, one of Prime’s partners, was summoned for a scolding by the State Department in the fall. “My response was, ‘I wish you had called me before we had made the investment,’” winks Tomlinson, 64. “Still, there’s no law that precludes us from being there.” But there is the lure of relatively quick and hefty profits. Early investors in Calibre, an OTC bulletin board stock with minimal operations, stand to pocket $100 million or so if an IPO becomes effective early in 2007. And there are other western investors in Iraqi Kurdistan.

Where is Big Oil? “The supermajors won’t go in yet. They can’t afford the headlines. What workers would they send there, and who would be willing to break the news to their family when they got killed?” asks Peter Newman, head of the oil and gas practice of Deloitte & Touche. “Plus, these projects are too small for the big guys.” Since 2003 there have been 375+ attacks on Iraq oil assets: pipelines blown up, engineers shot, fuel trucks set on fire. Iraq’s oil output is down from a prewar 2.5 million barrels per day to 1.9 million. Considering that Iraq’s estimated reserves of 150 billion barrels are second only to Saudi Arabia’s, oil economists think Iraq could easily produce 5 million barrels a day for many years. While the Kurdish areas are safer than the rest of Iraq, roughly half the nation’s postwar oil production deficit is traced to the very area where the wildcats are drilling.

Prime is a closely held, secretive company. Acquired a decade ago by the New York City hedge fund Elliott Associates, Prime has an old oil hand at the helm in Richard Anderson, 53. If successful, Bina Bawi will be Prime’s biggest investment. It has spent tens of millions of dollars evaluating seismic data and funding drilling crews, mostly Turks, Kurds and Romanians. Larger outlays will come once they find oil – typically for such projects, $300 million or more in pipelines and processing plants over the next decade. Few stand to make more money than early investors at Calibre. Before wildcatting in Iraq, Calibre was a tiny energy company controlled by veteran oilman Tomlinson, with a handful of oil and gas prospects in Texas. Even with such small operations, Calibre is still a very useful vehicle to its backers. In October it filed a prospectus to sell 71 million shares bought by 160 early investors but never publicly traded. (Only 4 million Calibre shares change hands today.) The offering is timed to coincide with the end of drilling at Bina Bawi.

While war rages, a handful of Western outfits are risking capital – and life – to explore and produce plentiful oil.

THE REAL FUTURE FOR CORN (AND A NOTE ON HONG KONG REAL ESTATE)

The Financial Times reported that Beijing ordered a halt to all future corn-based ethanol projects. “Food security” was cited as the chief factor. Not to be glib, but I would love to presume the Chinese based this move after reading the fearless prediction made here last week.

U.S. corn futures have risen 75% this year. Much of that rise can be attributed to the “ethanol” hysteria sweeping the country. I still believe ethanol to be a fad ... a trend whose long-term staying power may rival the impact of Pet Rocks in the 1970s. Any energy source that yields roughly 10% more energy than was required to produce it will not last all that long. And that is assuming we divert 10% of the world’s landmass, or the equivalent of all the land currently under cultivation, to grow enough biomass to meet the world’s energy needs.

But that is not to say I am not a long-term believer in corn. Well, not so much corn as the growing need for massive amounts of food and water. As the 5.5 billion people currently residing in emerging economies begin to rise among the ranks of the consuming class, the demand for these life-sustaining resources will only continue to grow. By 2040, the transfer in global economic power will have completed a dramatic shift. The five largest economies by GDP will soon include India and Mexico. Assuming population demographics remain constant, by 2040, China, India and Mexico alone will be responsible for feeding roughly 2.5 billion citizens. Arable land and potable water will no longer be deemed a disposable resource. But I am still not quite sure of the best way to play it.

Another note worth mentioning this holiday season: Sun Hung Kai Properties, Hong Kong’s biggest developer, paid $231 million, $5,409 per square foot, for a residential site on the central island’s coveted peak. The company plans to develop 8-10 residential houses on the site. Even before the foundations are laid, the average price of the houses in question would run at least $23.1 million just to cover the acquisition cost. Add in a return plus construction costs, and one might hazzard a guess that the market price for one of these homes starts at $30 million. Who can afford something like that? Well, when you consider CEOs from some of the top S&P 500 companies now earn up to $50 million a year, and considering compensation for leaders of the mightiest financial service firms has reached the $30-35 million range per annum, the market for potential buyers is certainly greater than one might think.

But America is not the only land of the rich. According to Forbes, China posts 15 billionaires and India can now claim 36. The entire Asia-Pacific region now boasts 115 members to this exclusive club. And that group will receive a natural bump when their fortunes, based in foreign currencies like the yuan, eventually rise against the dollar.

How does this relate to Hong Kong real estate? Money will flow where it is treated best, and you would be hard-pressed to find any other place in the world that treats money better than Hong Kong. The highest tax bracket comes in at 17%. Individuals are only assessed on annual employment income. Hong Kong’s estate tax holds a maximum rate of 15% on assets exceeding US$1.35 million. And here’s the kicker ... Hong Kong recently repealed its inheritance tax on property.

46 of the world’s billionaires, roughly 7%, made their money in real estate. 28% of those live in Hong Kong, Japan or Singapore ... and those markets are just getting started. If you cannot buy the assets directly, property stocks in those regions should perform wonderfully for years to come.

POSSIBLE TRIPLE-DIGIT GAINS BY MID-FEBRUARY FROM EMERGING DRUG COMPANY STOCK

When drug companies release information on the development of new drugs, investors pay close attention. Genentech released Phase 3 Avastin data on March 15, 2005, and the stock rallied from $47 to more than $100 in just months. Pfizer patented Viagra in 1996. It ran from $10 in 1996 to more than $50 after FDA approval, in just three years. And just this past July, when investors got word that Adeza Biomedical received priority review status, the stock spiked 13.3% in three hours ... and that was just a press release! So imagine what could happen to this $4 stock if it releases positive Phase 3 drug news for the prevention of preterm births in February.

As of late, Columbia Laboratories (CBRX: NASDAQ) wrapped up its enrollment in a 669-patient Phase 3 study to evaluate Prochieve 8% for the prevention of recurrent preterm birth. The trial is expected to conclude this month and results are due out mid-February 2007. Any positive news could draw a lot of investor attention to the stock. We have spoken in-depth about the issue with regard to Adeza Biomedical earlier this year. Unfortunately for Adeza, news that further FDA action was subject to the completion of more animal studies sank the stock. However, this is a positive for Columbia Laboratories, as it files Prochieve 8% for recurrent preterm birth based on results from the Prochieve preterm study. In August, the FDA’s Reproductive Drug Advisory Committee voted 20 to 1 that a reduction in the incidence of preterm birth at 32 weeks gestation is an adequate surrogate for reduced infant mortality and morbidity. This also bodes well for Columbia, because the reduction of preterm birth at 32 weeks is the primary endpoint of its Phase III PROCHIEVE preterm study.

Unbelievably, there is still not an accurate test to assist doctors in determining an accurate induction date, resulting in an increase in preterm infants. But there is a large and growing demand from the medical community to find an accurate way to predict induction dates, and is precisely why a solution is needed now. The U.S. premature birth rate grew to 12% in 2002, a 29% jump over the previous two decades, according to the FDA. The rate has increased as older women get pregnant and the use of fertility treatments grows, the FDA said. By 2003, 28,000 babies died before their first birthday because of preterm labor complications, according to the National Center for Health Statistics. And, according to TradingMarkets.com, “It is estimated that over $18 billion in costs were associated with preterm or low birth-rate infants in 2003.”

As of 2006, the reasons for preterm birth were still greatly shrouded in mystery, taxing the U.S. healthcare system and costing U.S. taxpayers up to $26.2 billion a year, or “$51,600 per infant,” according to Newsweek. According to The Washington Post, “scientists now say one-third of infant deaths are because of premature births – a much larger percentage than previously thought.”

Demand for a drug that could lower preterm birth numbers is there. Once a drug shows positive data, is approved, and goes to market, you can be sure that sales will skyrocket. Imagine what would happen to a small $4 company if it releases positive Phase 3 data in mid-February, gets FDA approval and goes to market. This could easily be a double-digit stock with those scenarios. CBRX looks like a solid buy under $5.50.

SWISS MARKETS: BREAKING THE CODE

Swiss banks store over one-third of the world’s total offshore funds. The banking sector is to Switzerland what big oil is to the Middle East, with the market cap of UBS alone exceeding that of Microsoft. When mass social mood is trending up (as mirrored by a coincident rise in stock prices), major money-making/taking institutions are held in high esteem. Secrecy is regarded as strength, autonomy an attribute, and issues of privacy a sign of integrity. Soon, the collective appetite for building wealth cooks up a number of hush-hush, wink-wink, nudge-nudge, say-no-more ways of giving everyone a piece of the pie.

This system goes off without a hitch until the lowest of low, the employees who everyday handle millions and billions of other people’s money start to get greedy and decide to Robin Hood-wink the really rich in ways that line the pockets of the poor – all going unnoticed until mass social mood begins to reverse, along with a downturn in stocks. When this happens, those illicit practices once overlooked are now exposed. The financial realm sees an explosion in “slack bull market accounting scandals and outright fraud,” with those blindly deceived asking, “What went wrong AND how do we punish those responsible?”

In 1996 the Swiss Market Index (SMI) was putting the finishing touches on a multi-year uptrend that pushed prices into record high territory. Also, the Swiss government was ordering a major inquest into the conduct of Swiss Banks during the Nazi regime in Germany regarding funds “deposited or stolen from victims of the Holocaust.” As the investigation into Swiss Bank practices gained steam, the SMI started to lose strength. The investigation culminated in a $1.85 billion settlement in 2000 between several Swiss Banks and Holocaust victims. The SMI went into 50%+ sell-off from July 1998 to February 2003.

Flash ahead to December 18, 2006 and we have the “biggest alleged fraud in Swiss private banking history” on our hands as one “reclusive German millionaire” claims millions of dollars in damages in a twin civil and criminal suit against Citibank (Switzerland). The details of the case seem more like a James Bond script than real-world drama – double-crossing employee transfers client’s money into her own personal account, falsifying “periodic performance data” to reflect a healthy balance. More importantly, though, is what its occurrence now means for the Swiss Market Index, no matter how unreal the situation may seem.

WILL THE BEARS WIN A MAJORITY OF THE 2000’S?

After a terrible 1990s – Bulls won 9 years to 1 – the Bears scored a rare trifecta in 2000-02, with the New York stock market down in each of the three years. Since then, Bear life has been less satisfactory, but on the decade so far, counting 2006 as a Bull victory, the Bears lead 4-3 on the DJIA, the Bulls lead 4-3 on the S&P 500 Index (2005 was a split verdict.) Will the Bears win the decade?

The markets certainly are not forecasting so. Implied volatility in the Chicago market for stock options futures is close to a record low, implying that investors have very little fear of a sharp market reversal, but expect instead the remarkably smooth uptrend of the last few months to continue. Treasury bond yields have also trended down in the last few months, and Federal Funds futures are forecasting that the Fed will begin to cut rates in the second quarter of 2007. U.S. economic growth appears to be slowing, and there seem to be signs that the U.S. housing market is bottoming out. Meanwhile, Wall Street price-earnings ratios are moderate. So why should anything go wrong?

Federal Reserve Chairman Ben Bernanke unquestionably favors a bit of inflation and a quiet life. For the next few months, he may get it. Notable in the hoop-la that greeted the news that November’s consumer price inflation was 0.0% was a lack of skepticism about the figures. The Cleveland Fed Median CPI, announced later the same day, ticked up again to 3.7% year-on-year. This indicator, which the Cleveland Fed believes to be a better measure of “true” inflation than either the official or adjusted CPI, has been rising steadily from the middle 2s over the course of 2006. Better hidden still was a BLS press release of November 14, announcing that “quality improvements” in 2007’s automobiles and light trucks over 2006 had caused the BLS to remove $151 from 2007’s car prices and $392 from light truck prices, to take effect in October’s PPI and November’s CPI. On closer inspection, most of the “quality improvements” consisted of federally mandated safety changes, warranty improvements and changes to audio equipment. The unexpectedly high PPI for November announced this week indicated that November’s CPI was indeed an unduly massaged figure, and that inflation remains a real and present danger.

Nevertheless, that is not what the market believes, and if Bernanke believes it, he’s hiding the fact very well. Consequently, we can expect no interest rate increases in the next few months, possibly even cuts, while long term bonds continue to trade at yields far below their equilibrium real level. While we have cheap money, and corporate earnings far above their normal level as a share of GDP, the stock market will remain elevated. In such an environment, hedge funds, private equity funds, mergers and evil shall continue to flourish as a green bay tree. Since continued low real rates of interest will mean continued high economic activity worldwide, continually escalating commodity prices, and eventually a sharp increase in inflation that even the BLS cannot hide, this state of affairs will not last forever. Once inflation has become apparent to all, bad debts in the housing market will sap confidence, interest rates and risk premiums will rise, several large hedge funds will collapse, the dollar will fall out of bed, corporate profits will drop or a combination of all five, and the stock market will react like Wile E. Coyote several seconds after he has trotted over the edge of the cliff.

From then on, even evil and the Goldman Sachs bonus pool will have trouble surviving. Once confidence has been lost, the imbalances that have bedeviled the U.S. and world economies since 1996 will assert themselves. The dollar will fall far enough to reduce the U.S. payments deficit to a manageable level. Interest rates will rise far enough to give investors an adequate return above inflation, with a bit to spare in case the BLS is still fudging the figures. House prices will drop far enough that they become a screaming buy, even given the higher interest rates. The U.S. consumer will panic about his retirement and start saving 20% of his salary, as he should have done all along. Corporate profits will drop drastically, as interest rates rise, the dollar drops, consumer spending collapses and the government frantically raises taxes in an attempt to bring the budget closer to balance.

Internationally, increasing risk premiums will adversely affect many emerging markets, particularly those with large debts. Currently, emerging market risk premiums on debt are at an all-time low, at only 1.72% above U.S. Treasuries of the same maturity on the Morgan Stanley International Index. That is insane. Not only are investors being paid insufficiently for taking very substantial emerging market risks in places such as Latin America (default) or Thailand (exchange controls, political instability and government ineptitude), but they could generally get better returns on stocks in the same emerging markets, or indeed in sounder ones such as Taiwan and Singapore, where there is little debt. The very low risk premiums on emerging market debt are almost certainly the result of activity by highly leveraged hedge funds, borrowing for example low interest Japanese yen and investing in emerging market bonds. The existence and size of these funds is yet another reason to be thoroughly bearish on the world financial system currently; they are an accident waiting to happen. Once the market cracks, Argentina will default again – yawn – but so will a lot of other countries that had been thought sound.

The one exception to the carnage in emerging markets may be those few markets where liquidity is high and hedge fund investment low, in particular the major oil exporters such as Saudi Arabia. The Saudi market is down 60% from its February peak and now represents good value, since in a crisis the huge pool of Saudi liquidity will tend to return home, driving up the domestic market. However, to invest in Saudi Arabia you have to live there, a price those of us with a taste for fine wine or single-malt whisky may not wish to pay even in a major world recession.

It will not be the 1930s, because we will have inflation. This will prevent asset prices from falling as low as they might, will raise the equilibrium level of stock prices closer to their current level, will allow companies to cheat consumers and shareholders and the government to cheat everybody in pricing, profit reporting and taxes respectively, thus reducing the deflationary effect of collapsing profits and fiscal balances. Nevertheless, the downturn will not end quickly, as excesses that have taken more than a decade to build up will take at least half that to unwind. Whenever reality strikes, and the market ceases running on mindless euphoria, we can thus expect 5 years of declining stock prices, declining house prices, rising unemployment, rising federal budget deficits, continual squeeze on corporate earnings and successive bankruptcies. How deep the drop goes, how quickly the U.S. begins to climb out of it, and what state the country will be in when it does so will depend on politics. Since George W. Bush leaves office well before the bottom can have been reached, and Ben Bernanke’s term of office ends in January 2010 unless he is extended (which, if things have gone wrong he will not be) we can have no idea of how those political decisions may be made other than by staring, horrified at the collection of Presidential candidates vying for our votes in 2008.

As for Bear chances, they depend on how long the correction is delayed. If euphoria persists into 2008, or long enough into 2007 that the market has still risen on balance at year end, then the likely Bear result on the S&P 500 Index for the decade of the 2000s is 5-5, with 2008 and 2009 joining 2000, 2001 and 2002 as Bear years. Only if reality hits in early 2007, or hits very sharply in late 2007, will 2007 be a Bear year too and give the Bears a victory over the decade. Of course, 5-5 was all the Bears managed in their best ever decade, the 1930s. It is tough lonely work, being a Bear.

A bear believes that the bulls are “on serve”.

As a resident bear, I am not yet ready to concede that we are in a secular bull market. I will, however, acknowledge, that the bulls are “on serve”, for the next year or two, to use a tennis phrase. In tennis, having the right to serve (put in play) the ball is a decided advantage, so players alternate serves between games, sharing this advantage. Between two almost evenly matched players, whoever serves will win most games, by “holding serve”. But in the typical seta and match, the better of the two players will win an occasional game while the other person is serving, a result that is known as “breaking serve”. This means that the slightly better player will likely win a set by getting a majority of the games with a score of say, 6-4. If a player both holds serve and breaks serve consistently, the result could be a more lop-sided 6-0 tally that clearly demonstrates who is the better player.

In the U.S. stock market, the “serve” is determined by the election cycle, with bears getting the “serve” in the first two years, and bulls getting the “serve” in the last two years. Despite “having serve”, bears like me lost in 2005 and 2006 – the bulls “broke my serve”. The next two years in the election cycle, 2007 and 2008, feature the bulls on serve. During the pre-election years – e.g., 2007, 2003, 1999, 1995, etc. – when the incumbent party is pumping up the economy to maximize the chances of reelection, the market is more likely to rise.

Still, there are a couple differences between the stock market and tennis. The first is that order of magnitude counts in the stock market, more than in tennis. Suppose there was a three set match, where one contestant posted set scores of 6-4, 0-6, 6-4. The first contestant would win the match, two sets out of three, even though the second contestant actually won more games, 14-12. Most investors are more concerned about the cumulative size of their wins rather than the frequency. The second difference is that the bears in the stock market win the ties, because of inflation. From 1966-1981, the market went up in nine of 16 years and essentially went nowhere in nominal terms. But the bears were more nearly correct, because the market went down big time in inflation-adjusted terms.

My cautious optimism for 2007 is supported by one of the bulls’ main arguments: that the strong earnings growth of the past few years has dramatically lowered P/E multiples. On the other hand, I am basically of the view that the U.S. economy is fundamentally weaker today that in was in 2000. Hence my belief that we will not go anywhere near a new high in P/E ratios, or even reach inflation-adjusted levels of that year (which would imply a lower multiple of higher earnings). I am mentally “capping” the Dow at 14,000, unless we have a double-digit inflation that makes 16,000 the new 14,000.

Under other circumstances (i.e., if the Presidential election had just occurred in 2006), I would probably be a bear right now. Stocks have gone up in every pre-election year for the past century except 1907, 1931, and 1939. The first year featured the short but severe Depression of 1907 that ultimately led to the creation of the Fed in 1913 (because J.P. Morgan & Co., the nation’s de facto central bank in 1907, could not do the job). The second year was in the depths of the 1929-1932 bear market that signaled the onset of the Great Depression. The last year marked the start of World War II. So a market decline in a year like this could have very serious implications. Even I do not think that it will get that bad. In 2008, with the election year “wind in their face”, as in 2000, the bears are somewhat more likely to “break serve” next year. But if my cautious optimism for the coming year proves to be unwarranted, it is likely to mark the start of another Great Depression. Or World War.

Long view of stock mania’s downside.

In 1997, I undertook a study of financial manias. Manias are episodes of relentless financial speculation that involve substantial infusions of credit, wide public participation, and which drive values to unprecedented levels. A pertinent observation is that a mania is always followed by a collapse so severe that it brings values to below where they were when the mania began. The apparent reason for this outcome is that so many ordinary people entrust their fortunes to the mania that its reversal brings widespread financial distress, which feeds on itself to force an immense liquidation of investment media. If the U.S. stock market is going to fall far enough to retrace a substantial portion of the uptrend from at least 1932 and to retrace the price advance that it has undergone during its mania, then it will fall far enough to cause a significant contraction in the economy.

The proper models for the developing economic experience are those that accompanied the stock market setbacks of 1720-1722 in England, 1835-1842 and 1929-1932 in the U.S. and from 1990 forward [to 2003] in Japan. In two of those cases (1720-22 and 1929-1932), the contraction was a relentless, acute, brief, all-out depression. In the other two cases (1835-1842 and 1990-date), the economy contracted over a longer period in two or more steps, with recoveries in between. Either style of progression could happen now.

Japan’s retrenchment has been long and slow because most of the rest of the world’s economies continued their investment manias and economic growth, allowing vigorous trade to provide support during the first decade of its economic decline. When the rest of the world’s economies falter, they will lack a group of healthy trading partners to mitigate the speed of their contractions. For this reason, the developing contraction in the U.S. and around the globe will likely be far swifter than Japan’s experience to date.

In holy matri-money.

The Katie Holmes-Tom Cruise wedding was not the only holy matri-money of late, as 2006 saw the value of U.S. financial unions soar to a rice throw away from the all-time record set in 1999. You say TomKat. We say Comcast, Google, U.S. Bank, Harrah’s, Clear Channel, and on and on in the slew of big-name companies that felt the itch to get hitched. “This is an unprecedented time,” as far as the frequency and force of corporate deal-making goes – observes one recent news column.

We would hardly be going out on a limb to point out that today’s M&A frenzy looks a lot like the consolidation craze of the late 1990s. Back then, U.S. stocks were enjoying a powerful rally to levels unlike any they had ever seen, with the DJIA surpassing 10,000 for the first time in history. The run-up in equities gave CEO’s the ammunition they needed to take-over, buy-out and merge, plus acquire at a record pace. Under the mainstream breath, words such as “manic”, “mania” and “madness” were being uttered while then Fed Chairman Alan Greenspan spoke of a dangerous “irrational exuberance” taking hold.

Flash ahead to now and we see the DJIA rocket 16% in 2006 to a new, all-time record with a 6-year high in the S&P 500. M&A activity speaks for itself, and under the mainstream’s breath, words such as “manic”, “mania” and “madness” are being uttered. Of course, the mainstream would like to put as much distance between ONE element of 1999 and 2006 as Tom Cruise has between himself and Oprah’s couch cushions: the 2000 stock peak and subsequent 3-year long bear market.

“Everything that CEO’s are saying, everything that credit markets are doing, we continue to see the economy growing& That bodes well for deal activity in 2007.” (AP) “Funding for purchasing remains cheap.” That is because the yield spread has more than HALVED since July 2002. The five most active sectors – finance, telecommunications, energy, healthcare, real estate – “remain cheap.” That is because most of them have endured severe setbacks in the last few years. “The deals today are made in cash.” That is in large part due to the fact that 35% of 2006’s acquisitions involved private-equity firms, the biggest percentage ever. Fact is, private equity businesses get most of their money from “hefty loans” granted by banks. Translation: the deals today are made with DEBT.

In the end, mergers and acquisitions take place for the same reason that marriages do: because the parties involved BELIEVE that a) the future is bright AND b) two halves will be “bigger, stronger, and better” than one. One look at a U.S. M&A value vs. S&P 500 chart and you will know whether the honeyboon period on Wall Street will continue happily ever after.

SHORT THE EXCHANGES

There is nothing better for piling up the cash to pay Wall Street bonuses than a hot stock offering. And since the market recovery began in late 2002, some of the hottest IPOs have been in securities exchanges themselves. Exchanges are the new Internet. That is, they are presumed to be capable of growing higher than the blue sky. That would make them good shorting candidates ... if only you could get your hands on some borrowed shares.

The first exchange to go public was Chicago Mercantile Exchange Holdings (NYSE: CME, 530). Note the Internet-flavored three-digit stock price. The Merc, which used to trade farm products such as butter (and churned up numerous scandals along the way), moved into more exotic fare with futures on currencies in 1972, interest rates in 1976, and the S&P 500 in 1982. The Merc first offered its shares to the public in late 2002, and since then the stock has appreciated 15 times. One large reason is that commodity and stock index prices have been going up nicely, and with bull markets you get both more trading volume (exuberant people like to trade) and more dollar value per trade. That means more dollars in fees. Adding to the enthusiasm for this particular exchange is the proposed merger with its upscale rival, the Chicago Board of Trade. The Merc now goes for 46 times the money it is presumed to have earned in 2006. The S&P 500’s multiple is a mere 18. Once volume drops, as it surely will, the Merc’s stock price will collapse.

Another sizzling trading stock is the Intercontinental Exchange (NYSE: ICE, 104), the leading electronic global futures trader with a broad array of over-the-counter energy products. Energy, of course, has been strong of late. This exchange, which went public in November 2005, has won investors’ affections with a planned buyout of the New York Board of Trade, a deal that will broaden its reach into futures and options on goods ranging from cocoa to cotton, as well as currencies. Intercontinental goes for 43 times 2006 earnings. That is rich, but Intercontinental is expected to see a 25% earnings gain in 2007. Even if oil and gas prices hold at current prices or increase (as I expect), energy prices will probably show less volatility than they do now. That translates into reduced opportunities for traders to make profits and reduced trading volumes. This has happened innumerable times before with other hot commodities. Among Intercontinentalwts customers are perhaps 500 hedge funds that make big bets on energy, in the manner of dearly departed Amaranth Advisors. How many of these hedge funds will be around in five years?

NYSE Group (NYSE: NYX, 99) operates the storied New York Stock Exchange, as well as its all-electronic exchange, Arca, the nation’s largest. The market is excited that the NYSE is about to expand its reach across the Atlantic with the pending acquisition of Euronext, which runs bourses in five European countries. This is a good company, but how can it be worth 58 times consensus 2006 earnings? Bear in mind that the NYSE is drifting away from floor to electronic trading by necessity more than by design. This old institution is losing market share to Nasdaq. While the NYSE’s new electronic platform should raise volume, commissions there are thinner.

Too bad that shorting NYSE Group’s stock is so difficult. For some reason the shares are hard to borrow, even though 156 million of them are lying around. Recently my firm tried to short the stock through six of the largest brokerage firms, and was told no stock was available to borrow. My suspicion is that the brokerages, all of which have large positions in the stock through their ownership of Big Board seats, do not want to see the price go down and thus keep their shares out of reach. In lieu of shorting you might try to buy put options on shares of the exchange companies. Options are available for the NYSE Group. Alas, the puts are pretty expensive.

CHINESE RED-CHIPS SOAR INTO ORBIT, IS GOLD NEXT?

2006 was a year of extreme volatility in the global money markets. Once again, the biggest stock market winners were the emerging giants of Brazil, China, India, and Russia, the so-called BRIC countries. Together, the BRIC account for 50% of the world’s population, yet their rapidly growing economies account for only 13% of global economic output. The four emerging markets have been star performers, while European, Japanese and the U.S. markets lag behind their blazing trail.

The global economy produced around $36.7 trillion in goods and services in 2006, with emerging economies expanding an average 7% this year, largely as a result of high commodity prices, and booming demand in China and India, the World Bank said. The pace of expansion in emerging economies could remain above 7% in 2007, lead by 9.5% growth in China, 8.5% growth in India, and exceeding the 2.6% average growth rate of high-income countries in Europe, Japan, and the U.S.

China’s Enterprise H-share index of mainland companies listed in Hong Kong, wins the gold medal for market appreciation across the globe in 2006, posting a 92% gain so far this year. Most foreign investors interested in China’s companies have bought the H-shares, or mainland companies that list in Hong Kong or New York and comply with international accounting and governance rules. The H-share index is fueled by a 29% annualized increase in industrial profits, and a 17% increase in the Chinese M2 money supply. China’s economy is expanding at a 10.4% rate this year, the fourth straight double-digit annual gain. Chinese traders have discounted several more years of double-digit gains for the local economy, with the H-share index eclipsing the psychological 10,000-level on Dec 27th. China’s stock markets went ballistic on 12/27, when the China Securities Journal revealed that Beijing plans to set a unified corporate income tax rate of 25%, and will scrap the decade-old preferential tax rate of 12% for foreign firms. The expected corporate tax reform will enhance the earnings of most domestic banks by between 10 and 20%. But Chinese banks are not cheap, and trade at a sector average of 2.5 times their forecast book value in 2007, a 20% premium to the 2.1 average of global emerging market banks.

China is the emerging economic super-power of the 21st century, and has moved into fourth place, ahead of the UK economy, quickly catching up to #3 Germany, but still far behind Japan and the U.S. Beijing’s foreign currency reserves have soared to $1 trillion, and are on course to reach $1.5 trillion by 2010. Capitalization of the Shanghai Stock Exchange reached 6.3 trillion yuan and the Shenzhen Stock Exchange amounted to 1.7 trillion yuan, making China the largest emerging stock market in the world. China’s capital market equals 40% of its GDP, up from 18% in 2005. Chinese stock markets soared last week, when the U.S. Treasury Department, under Henry Paulson, refused to label China as a currency manipulator, and instead agreed to steps by Beijing to let its yuan currency rise in value against the US$ at a snail’s pace. It is not wise to try to pick a top in a frenzied Asian stampede, but traders should carefully elevate their protective sell-stops along the way, while Chinese red-chips mimic the U.S. Internet craze of the late 1990’s.

Hong Kong brokers say the recent market rally is driven by excessive liquidity as plenty of hot money is waiting to buy IPO stocks in Hong Kong and in mainland China, but the market may need a consolidation in January. The People’s Bank of China is printing huge amounts of yuan in exchange for foreign currency entering the country from trade surpluses with the U.S. and foreign direct investment. China’s 7-day repo rate erupted to as high as 3.9% on 11/20, amid fears that the Chinese central bank was ready to take strong action to drain yuan liquidity. On 10/27, the PBoC had lifted bank reserve requirements by half-point to 9%. But the 7-day repo has since plunged to 2.05% once traders realized that the PBoC was bluffing, and was going to drain enough liquidity to bust the bubble.

Hong Kong’s benchmark Hang Seng index hit a record of 19,665 on 12/27, hitching a ride to the soaring Mainland stock markets. A free trade agreement started in January 2004 between Hong Kong and China, has reinforced China’s influence as a key driver of Hong Kong’s economy. One third of China’s external trade goes through Hong Kong, and re-exports account for 92% of Hong Kong total exports. Hong Kong is Asia’s main trading hub and one of the world’s most open economies. Business environment is favorable to foreign investments: simple legal framework, soft taxation and above all, almost no customs duties and no non-tariff barriers. Hong Kong is the second destination for foreign direct investments in Asia, and is the second largest Asian money market and the world’s fifth largest banking center. Hong Kong surged past New York this year and became the world’s #2 place, after London, for companies to float new stock listings. Shanghai is not close to being able to match Hong Kong, and that is why a parade of China’s biggest banks decided to launch record-breaking IPOs in Hong Kong this year. If China becomes a large economy rivaling the U.S. over the next 20-years, then Hong Kong could outpace New York and London.

Zhaojin Mining Industry, the largest gold miner in the eastern Chinese province of Shandong, raised HK$2.19 billion, in an IPO in Hong Kong last week. Individual investors ordered about 530 times the shares originally offered to them. The orders for Chinese gold miner shares reflected growing demand for protection against a falling U.S. dollar against the yuan.

The Shanghai Gold Exchange lowered the size limit for trading in gold bars this week, from one kilogram ($20,000) to 100 grams to expand the market to small private investors. The SGE is also developing derivatives, including futures, options and investment funds for gold, according to the Xinhau news agency. Sales of gold bullion and gold bars account for 10% of gross gold consumption in China. China is the #3 consumer of gold after India and the U.S. Chinese gold demand in 2005 exceeded 300 tons, 80% of which went to the jewelry industry.

According to the World Gold Council, China’s central bank has 600 tons of gold holdings, equivalent to about 19.3 million ounces. Gold accounts for less than 1.3% of the central bank’s foreign reserves. Instead, the central bank holds about 70% of its $1 trillion of forex reserves in U.S. bonds, which is keeping U.S. mortgage rates low and cushioning the deflating u housing bubble. Beijing must continue to buyU.S.u bonds with its export earnings, if it wants the Bush administration to veto any protectionist legislation that might come out of the Democratic ledU.S.u Congress in 2007. U.S. military spending on the invasion and occupation of Afghanistan and Iraq now totals well over $600 billion and is costing U.S. taxpayers $8 billion a month. Therefore, the Bush administration will continue to ask Beijing and Tokyo to finance the U.S. deficit and hold onto their U.S. bonds, despite the hollowing out of the U.S. manufacturing sector. China’s central bank issued a warning on 12/7, about the risks of U.S. dollar weakness. East Asian holders of U.S. dollars face the risk of a dollar devaluation, said Chinese deputy central bank governor Wu Xiaoling on 12/24.

Looking forward, some of the big questions are how high can Chinese stocks fly, and what is the biggest downside risk to investing in the Chinese markets today? Where will China diversify its forex reserves in 2007?

GOLD STOCKS DID WHAT THEY NEEDED TO DO, DID YOU?

Bull markets pull back. They attract buyers as they go up who do not really know what they are doing. They see stocks go up, sit back and think they should buy, do not, then buy at the top because they are afraid they will miss out. You saw this in classic form in gold stocks last March and now you just saw it again happen at the beginning of December.

And of course every time this occurs you get a pullback that shakes out the loose hands and recharges the bull market for another move up. And over the past three weeks we have had a classic pullback in gold stocks. As I have been writing over the past few years, the XAU gold stock index tends to pull back to its 50-day moving average every six weeks when it is in an uptrend. It also tends to retrace 30% or 50% of its gains on pullbacks too. Last Friday the XAU went through its 50-day moving average and then hit the 1/3 retracement level before rallying into the close, to create a potential candlestick reversal.

Now we know what the gold stocks have done, but I am wondering what you are doing? Are you one of the people who buy at the top and then sell out during times like we saw last week? If so then you need to start to get your thinking right and think backwards from the way you have been thinking. You need to realize that gold stocks are un a bullish uptrend and the best way to take advantage of that is not by being an emotional manic investor, but to use technical indicators and a careful game plan to time better entry and exit points. This is not mad money folks. It is slow and steady.

You need to start to buy dips and sell into strength when the time is right. I did not sell at the beginning of December, because I think we have much higher to go, but at some point I will and I expect to have huge profits when I do, along with other gold investors who do not get shaken out of the market every time there is a temporary pullback.

RIDE THE RIGHT BULL

Are the bond investors being fooled into believing that inflation is not a problem? Or are the equity punters wrong about the coming interest-rate cuts and a soft landing in the U.S.? Perhaps, the commodities camp is stupid and we are in fact witnessing a gigantic bubble in natural resources.

Amidst all these diverse views, my own money lies in the inflationary camp (commodities and emerging-market equities) and I suspect that the bond-investors will be the ones who get badly hurt. After all, central banks around the world continue to churn out a ridiculous amount of paper, otherwise known as money. Inflation – money-supply and credit growth – is spiraling out of control and all this excess liquidity is causing prices to rise all around us, thereby diminishing the purchasing power of our savings. So far, central banks (through their propaganda and skewed inflation figures) have managed to keep the public’s inflationary fears under check. However, once the masses wake up to the inflation menace, there will be a stampede out of “paper” causing interest-rates to soar and the bond-market will sink like a rock. The same drama unfolded during the 1970’s, and I suspect history will repeat itself over the coming years.

Those who believe in a deflationary collapse do not understand our monetary system. Banks are in the business of lending money and inflation benefits them immensely. The hidden agenda of the central banks and politicians is to create and encourage inflation, while telling the public that they are in fact fighting inflation! Despite the hikes since 2004, the Fed Funds rate is still close to the bottom of its 30-year range. So, the notion that the interest-rate is “too high” is totally absurd. I would argue that given the degree of inflation we have seen in the U.S. since 2001, the Fed Funds rate is shockingly low. More importantly, if my assessment about the markets is correct, commodities (especially gold and silver) will advance over the coming months and test their highs recorded earlier this year in May and the U.S. dollar will decline to its low recorded in December 2004.

The prime objective of any central bank is to protect its merchandise (the currency it issues) and the Fed will do everything in its power to prevent a total collapse of the U.S. dollar, such as increasing interest rates at the cost of the U.S. economy. Such an unexpected move will probably send the financial and property markets into yet another painful correction phase during the next summer. On a brighter note, we still have a good stretch ahead of us and I expect the markets to remain strong until towards the end of Q1 2007. At this stage, our managed accounts are fully invested in the commodities complex and emerging-markets. However, depending on the market conditions prevalent early next year, we will start to lock-in our gains by going into money-market funds and bonds for a few months.

Monetary conditions play a crucial role when it comes to investing, so let us examine the international reserves. Despite the highly advertised monetary tightening, our world is awash in liquidity. Non-gold international reserves held by foreign central banks have soared to $4.75 trillion – a rise of 14.5% over the past year. Emerging nations hold a record $3.37 trillion (21% growth over the past year) of those reserves. The developed nation’s central banks hold a near-record $1.38 trillion – a miniscule 1.5% growth-rate over the past year. It is clear to me that the developing nations are now financing the industrialized nations and all this liquidity will provide a cushion and reduce the impact of any major financial crisis. Moreover, the money supply is growing at a furious pace in most nations and this should also prevent a prolonged weakness in asset-prices at least in the immediate future.

EMBRACE THE U.S. TRADE DEFICIT?

Views that should be dismissed as bullish tripe are instead accepted by top policymakers and academics.

Financial historians will reflect back on this period’s prevailing complacency, especially with respect to the massive U.S. trade and current account deficits, with astonishment and disbelief. Yet for now years of credit and asset inflation – parceling out unimaginable financial rewards along the way – have Wall Street reassured that “There is Simply Not an Imbalance Not to Love.” The Street now appreciates that massive and intractable trade deficits provide the fountainhead of global liquidity overabundance. Moreover, the markets keenly recognize that the Bernanke Fed (like Greenspan’s) is content to acquiesce to deficit and liquidity excesses. There is today no constituency for reining in the bubble(s).

This week’s release of a record quarterly current account deficit ($225.6 billion in Q3) garnered little attention from the media and even less in the markets. This despite the deficit having now reached $900 billion annualized, or 6.8% of GDP. For perspective, the deficit for all of 1998 was $229 billion. At $877 billion, the current account deficit over the previous four quarters compares to 2005’s $812 billion, 2004’s $664 billion, 2003’s $537 billion, and 2002’s $506 billion. And it is worth noting that Q3’s deficit was up 36% from Q2 2004’s $166 billion, back when the Fed commenced its “tightening” cycle.

Bear Stearns’s chief economist David Malpass provided commentary this week to The Wall Street Journal – “Embrace the Deficit”. Mr. Malpass did a commendable job articulating Wall Street’s dangerously flawed analysis of credit bubble-induced imbalances: “For decades, the trade deficit has been a political and journalistic lightning rod, inspiring countless predictions of America’s imminent economic collapse. The reality is different. Our imports grow with our economy and population while our exports grow with foreign economies, especially those of industrialized countries. Though widely criticized as an imbalance, the trade deficit and related capital inflow reflect U.S. growth, not weakness – they link the younger, faster-growing U.S. with aging, slower-growing economies abroad. Since the 2001 recession, the U.S. economy has created 9.3 million new jobs, compared with 360,000 in Japan and 1.1 million in the euro zone excluding Spain.”

The 2006 backdrop has been noteworthy for the continued rapid expansion of the U.S. current account deficit despite the marked economic slowdown at home coupled with continued overall robust growth abroad. This outcome should provoke recognition and alarm with regard to our economy’s deep structural shortcomings. But with stocks up double-digits and the economy plugging along, the “analysis” will naturally propound that deficits are in fact constructive. I can understand why Wall Street would hope to convince us that demographics and “sound” U.S. growth are the principal factors, although in reality they have very little to do today’s runaway global trade imbalances. Look instead to the credit bubble.

Mr. Malpass: “Supporting the ‘solid-growth’ view are rising global stock markets, strong growth of corporate profits, the narrow credit spread between Treasurys and riskier bonds, and low interest rates relative to inflation and to growth ... The trade deficit and a low ‘personal savings rate’ are key parts of the bond market’s multi-year pessimism about the U.S. growth outlook.”

I am aware of very few indicators – certainly including exuberant global equity and debt markets, booming corporate profits, and meager credit spreads – that are not consistent with the view of rampant global liquidity excesses. It is disconnected analysis to subscribe “multi-year pessimism” to bond prices, when booming equities and shrinking risk premiums are distinctly non-pessimistic. Credit, liquidity and speculative excess explain inflating asset prices without analytical conflict.

Mr. Malpass: “Like young households, many companies also spend more than they produce, using bonds and bank loans, some from foreigners, to make up the difference. They add employees, machines, supplies and advertising before they produce. Growing corporations are expected to be cash hungry. This leverage is treated as a positive for companies but a negative for countries, a key inconsistency in popular economics.”

This protracted credit bubble would be much less perilous if our nation was expanding debt to finance sound investment. Or, if our mounting foreign borrowings were funding wealth-creating capacity our current standard of living would not be so susceptible to the whims and fragilities of finance and global financial markets. Instead, we are the subprime borrower living beyond our means, yet for now luxuriating in our competitive advantage in issuing AAA securities in exchange for endless imports. These days, the vast majority of new debt liabilities issued to our foreign creditors are collateralized by inflated asset market prices (chiefly real estate and securities). This creates a Ponzi bubble dynamic where the perceived soundness of the underlying debt issued is dependent upon unrelenting credit and speculative excess (and resulting asset inflation).

Mr. Malpass: “While the net foreign debt of the U.S. is growing (the result of capital inflows), household net worth is growing faster, meaning foreigners are investing in the U.S. too slowly and conservatively to keep up with our growth. Their capital mingles with domestic savings, providing $2.7 trillion of net international capital to combine with $27 trillion in net U.S. household financial savings as of Sept. 30.”

This is especially shaky analysis. U.S. household net worth has been expanding rapidly owing to credit-induced home price and securities markets inflation. The $2.7 trillion of debt instruments we have created to pay for imports is no more “capital” in the traditional meaning of the term than the $27 trillion of debt held by households is national “savings”. Our economy consumes more than it produces, financing this deficit through the endless inflation of additional debt instruments. Wall Street can stick with the fanciful tale that our trade deficits are instigated by “capital” inflows. It is, however, clearly a case of credit excesses fostering over-consumption and mal-investment, creating progressively unwieldy dollar liquidity outflows to the world (that, by their nature, must be recycled back to U.S. debt instruments).

It is a safe bet that trade deficits will grow until our foreign creditors and/or global markets impose some discipline on our credit system. Foreign (largely dollar) reserves have increased more than $750 billion this year, placing the bullish notion of insatiable demand for (private-sector) U.S. investment on rather suspect analytical footing. The necessity of foreign central bank operations (after receiving dollar instruments from their domestic companies and financial institutions) to recycle massive U.S. current account and investment/speculative flow imbalances governs the unparalleled “official” accumulation of U.S. debt instruments. This should certainly not be analyzed in terms of a positive U.S. “investment” backdrop nor should the interest payments monetized (added on to existing debt obligations) be confused with the concept of “return on investment”.

The U.S. bubble economy has been sustained in 2006 only through the massive expansion of credit (certainly including securities finance/leveraging!) – more than last year but less than next. The trade deficit has evolved to become one of the prevailing unavoidable consequences of the credit inflation required to hold the downside of the credit cycle at bay. Of course, Wall Street, politicians, and the Bernanke Fed will work in earnest to avoid the downside of credit excess. And, the way these credit booms work, things tend to run amuck on the upside when they are turning most susceptible to faltering to the downside.

As difficult as it is for me to accept, “they” really have come to embrace the trade deficit. I guess “they” have no choice. As is often said, “people will believe what they have to believe.” All the same, it has been stupefying to witness over the course of many years the seed of this spurious notion mature into a full-fledged national self-deception – ripening to the point of achieving ratification from top policymakers (including our Fed chairman), affirmation from the financial markets, and acceptance throughout. Students of economic history are all too familiar with the repeated bouts of turmoil, wreckage and revulsion – the legacies of absolutely ridiculous notions that somehow came to be readily embraced in the heat of intoxicating booms. Reading Mr. Malpass’s piece, and knowing that his views would be anything but dismissed as bullish tripe, left me again with that uncomfortable feeling that we are living today in one of those extraordinary periods that will be studied and contemplated for many decades to come.

A BRIEF HISTORY OF SHORT FUSES

In a discussion of how violence is rising around the world, I realize it may be bad manners to note that everyone seems to have ... well ... a short fuse. That said, the metaphor works. More than once, within a brief time an unremarkable incident has provoked a long and disproportionate spasm of violence.

Race riots that began in Paris in October of 2005 quickly spread across France and into several other EU countries, lasting several weeks. Less publicized (in the U.S.) were race riots in Sydney, Australia in December of 2005, with crowds numbering as many as 5,000, and attacks on houses of worship. More recently we have had wall-to-wall coverage of the cartoon riots, fueled by one instance in a tradition nearly as old as the printing press itself: A graphic image that politically lampoons a prominent somebody. In this case the prominent somebody happened to be the final prophet of Islam, a faith whose adherents apparently embrace (shall we say) dissimilar traditions regarding politics, print media, satire, and graphic images.

Oh, and I suppose I should note that state-sponsored encouragement of the p*ssed-off masses has not helped much, either, but I am not a big believer in trying to offer rational explanations of irrational behavior. If you think you can figure out why rioters in Damascus burned down the Chilean embassy, please do. Solve that one and maybe you can write a whole book about people who (1) object to a depiction which implies their prophet is violent, and (2) register their displeasure by gathering into a mob and burning down a bunch of stuff.

All the above – and a lot more – has something in common. That thing is collective psychology, manifested by anger, inexplicable violence, irrationality ... the stuff of short fuses. Most importantly, this mass behavior follows a pattern, and patterns are understandable. Social mood is at work across and within cultures, and in activities that lots of people take part in. Like the stock market, for example.

CONQUER THE CRASH? WHAT CRASH?

Some people have asked me recently, “Hey, Bob [Prechtor], you wrote this book a few years ago, Conquer the Crash, and sure, the Dow dropped 30% and the NASDAQ was cut in half afterwards, but they are back up. What happened to the crash?”

Well, for one thing, if any of you have been following my work, you know that I am very big on psychology. You will notice a line at the top of my book. It says “New York Times bestseller”. The book came out when the Dow was at 10,600, but it did not become a bestseller until the Dow was breaking 8,000 on the way down. Of course, by the time any book becomes a bestseller, including mine, it is probably going to be very close to a turn.

I think you might remember all the books that came out in the very late 1970s, The Crash of ‘79 and books about depression. Of course, it was one of the greatest buying opportunities of all time. So it does not matter just that someone wrote a book called Dow 36,000, which I think came out in 2000. The book was a bestseller, which was a real hint as to what the overall psychology was.

However, I have got a better answer than that, at least in my opinion. I think there is a crash going on, but it is silent. Here is an example of what I am talking about. It is the Dow Jones Industrial Average, with one big difference. Instead of pricing it in dollars, which have lost a tremendous amount of value due to the extreme increase in credit, we are measuring it in real money: that is, ounces of gold.

It peaked in July 1999. Check out the left side of the chart, from the bottom in January 1980, all the way up to the peak in July 1999. As you can see, that was a very steady advance with very few interruptions. This was the real bull market in Elliott wave terms. In fact, I published a book called Beautiful Pictures, which makes the powerful argument that the peak in January 2000 was the true end of the bull market. The Dow has made a new high, but the main thing to point out is that in real money terms, that was unquestionably the high in the real bull market, in other words, what we call the impulse wave. Everything that has been going on since is part of a bear market.

If you recall some of the great quotes from the Dow Theorists of the past, one thing that they are fond of saying is that bear markets are tricky affairs. They can fool people in a lot of ways, and that is what is going on here. After the peak, we had the initial drop, somewhat of a recovery, then a double collapse. But look, the Dow priced in real money made a new low – not a new high – in May this year. So it is incredible that in the same year that the newspapers are reporting a new all-time high and celebrating, in real money terms the Dow has made a new low for the bear market.

Now, to put this in perspective, had we, the United States, changed from paper money to real money in 1999, this is the exact picture that would be shown in The Wall Street Journal of the DJIA since that time. Of course, that is not going to happen any time soon. We are in a credit society, and that is the way it is. The question is, what is the ultimate resolution?

2006 WRAP-UP

I view 2006 was a decisive year in credit, market and economic analysis. The ongoing credit bubble - certainly stoked this year by the perception of a timid “tightening” cycle’s imminent reversal prior to it ever having achieved actual tightened financial conditions – fueled sufficient liquidity to inflate U.S. financial stocks, along with a global M&A bubble, an unprecedented global liquidity glut, prevailing stock market speculation and inflation, and other inflationary distortions the world over (including ballooning central bank reserves and resulting rampant securities market speculation and inflation).

As an extraordinary year comes to its conclusion, determined analysts today have a clearer appreciation that it was, in reality, not a susceptible U.S. housing bubble fomenting U.S. and global imbalances. Instead, left to their own devices, the same systematic credit and speculative excesses that cultivated the tech/telecom bubble – and then the mortgage finance bubble – simply gravitated to myriad burgeoning bubbles, including securities leveraging, global M&A, and credit default swaps (and other credit “arbitrage”) to list only the most conspicuous. Bigger and more powerful than ever.

2006 should have marked a major inflection point in the U.S. credit cycle. The bursting of housing bubbles was poised to restrain system credit and liquidity excesses, in the process checking American overconsumption. In short, 2006 should have seen the initiation of the long-overdue adjustment process, with at least some moderation in global imbalances. Ironically, the obvious financial and economic fragility associated with a vulnerable mortgage finance bubble created an eagerness to position for Bernanke’s maiden easing cycle, an intense market bias that worked with other key dynamics (notably dollar liquidity recycling) to place a low ceiling on market yields. Financial conditions turned only looser.

This year almost marked the emergence of inflationary pressures in traditional narrow measures of aggregate consumer prices. The CPI posted a 4.3% y-o-y gain in June (4.1% in July), although a sharp reversal of energy prices and pressure on auto prices helped push y-o-y price gains back down to 2.0% by November. And while personal income will likely end the year with a better than 6% gain, the consensus has become convinced that heightened inflationary pressures were no more than a fleeting issue.

When it comes to perceived inflationary risks, the markets this year came to fully accept that “globalization” will forever prove a cure-all for any degree of financial excess. I take a much different view, holding that unlimited global finance and resulting monetary disorder are fueling epochal “investment inflation”. With the liquidity spigot wide open, the Asian Financial/Industrial Revolution ran unabated during 2006. In particular, investment in industrial capacity accelerated in booming China and India, a historic dynamic that worked to keep a lid on global manufactured goods prices.

Heightened “investment inflation” did, however, create acute inflationary price effects throughout the metals arena. It was definitely the year of the industrial metals. Nickel gained 150% during 2006, zinc 127%, lead 57%, silver 45%, copper 41%, and aluminum 25%. Gold ended the year with a solid 23% rise. Crude peaked at $78.40 in mid-July before ending the year almost unchanged. We were left to contemplate how high energy prices might have spiked had there been another treacherous hurricane season or geopolitical event. Amaranth and, to much a much lesser extent, the energy commodities bulls experienced the downside of monetary disorder and highly speculative markets.

The story of the year, however, was the global securities markets that luxuriated in monetary disorder’s “upside”. Where to start ... With their economy awash in liquidity (sourced globally and domestically) and the government placing increased pressure on housing speculators, the spirited Chinese bustled right on over to the friendly stock exchange. The Shanghai Composite index ended 2006 with a gain of 130%. Hong Kong’s Hang Seng index jumped 34%. Nearby, Taiwan’s major index increased 19.5%. Stocks in Singapore surged 27.2%, Vietnam 144.5%, Indonesia 55.3%, Malaysia 21.8%, Philippines 42.3% and Sri Lanka 41.6%. The Japanese Nikkei’s 6.9% rise increased 2-year gains to 51.4%. Less impressive, the South Korean Kospi Index gained 4%, while Thailand’s SET index declined 5.9%. Fueled by enormous global financial flows coupled with runaway domestic Credit growth, India’s Sensex Index surged 46.7%. The global inflationary backdrop supported the Aussie and Kiwi economies and markets. Australia’s major equities index jumped 19.0% and New Zealand’s 20.3%.

Robust Credit and liquidity expansion throughout 2006 supported major asset inflation throughout Europe. As for stocks, UK’s FTSE 100 rose 10.4%, France’s CAC 40 17.5%, Germany’s DAX 22.0%, Spain’s IBEX 31.8%, Italy’s MIB 16.0%, the Swiss Market Index 15.9%, Netherlands’ Amsterdam Exchange’s 13.4%, and Sweden’s Stockholm 30 index 19.5%. The smaller European markets posted even greater gains. The major equities index in Ireland rose 27.8%, Portugal 33.3%, Belgium 23.7%, Denmark 12.2%, Finland 17.9%, Norway 33.6%, Austria 21.7%, and Luxembourg 33.0%. Despite a weakened currency, much higher interest rates and a lot of nervousness, Iceland’s ICEX gained 15.8%. Stocks in Poland gained 41.6%, Czech Republic 7.9%, Hungary 19.7% and Bulgaria 48.3%. Russia’s RTS Index surged 70.8%, increasing 2-year gains to 221%. Stocks in Ukraine gained 41.3%, Croatia 60.7%, Slovenia 37.9%, and Estonia 28.9%. Greece equities rose 19.9%, while the Turkish stock market declined 1.7%.

Other spectacular periphery market gains included Morocco 56.7%, Namibia 46.7%, Botswana 74.2%, Nigeria 38.7%, and Kenya 42.1%. Meanwhile, stock markets throughout the Middle East suffered from bursting bubbles. The Kuwait market dropped 9.2%, Saudi Arabia 52.5%, Jordan 32.6%, Qatar 35.5%, and the UAE 43.3%. Yields in Mexico, Brazil and throughout much of Latin America dropped to record lows. Equity markets rocketed ahead. For the year, the Mexican Bolsa surged 48.6%, the Brazilian Bovespa 32.9%, the Argentine Merval 35.5% and Chile’s Select Index 37.1%. Venezuela’s major equities index surged 156%, Peru 168%, Costa Rica 77%, Bermuda 25%, and Colombia 17.3%.

No doubt the international equities boom was supported by (and lent support to) the global M&A boom. According to Dealogic, global mergers and acquisitions reached $4 trillion this year, fully 20% higher than the previous record established back in 2000. Private equity spent a record $750 billion, easily doubling 2005’s record. Asia, Europe and North America all enjoyed record M&A activity. According to Thomson Financial Services, total global debt issuance jumped 14.1% from 2005 to a record $6.95 trillion. Total securities issuance rose 16% from 2005 to $7.64 trillion. Total U.S. debt issuance increased 10.1% this year to $4.09 trillion. Despite the housing slowdown, ABS issuance increased 4.4% to $1.22 trillion and MBS issuance 2.2% to $1.01 trillion.

The bottom line is that the largest economy in the world – custodian of the global system’s “reserve currency” – has reached the point where only enormous credit growth and financial sector leveraging are capable of maintaining inflated asset markets and sustaining sufficiently moderate economic expansion. This historic predicament is fomenting escalating global monetary disorder. Disregard all the “soft-landing” talk as nonsense. While housing and auto sectors were in downturn, the expansive “services”/finance dominated U.S. economy remained firmly entrenched in bubble dynamics.

As we Wrap-Up this most challenging year of analysis, the issue has become more well-defined: The sustainability of the U.S. credit and economic bubbles. And, no doubt about it, these bubbles did handily endure 2006. But at what cost? The slowdown in housing only allowed greater availability of real and financial resources to build more retail space, hotels, casinos, sports venues and such. Rampant liquidity excess ushered in Telecom & Internet Bubble Part II. Instead of beginning to brace for the inevitable downside of the credit cycle, ultra-loose “money” enticed the system into embarking on the greatest expansion of risky credits and the most outrageous speculation in credit-related instruments/derivatives the world has ever known. At what cost? Well, a nearly $900 billion current account deficit along with unprecedented speculative flows (to play global markets) literally inundated the world with liquidity.

Despite favorable interest-rate differentials, booming securities markets, moderate economic expansion, and a massive Chinese-led central bank accumulation of dollar securities – the U.S. dollar once again struggled. The year comes to a close with a troubling dichotomy. On the one hand, there are today’s fervently bullish perceptions with regard to the underlying soundness and resiliency of the U.S. economy and prospects of another banner year for U.S stocks in 2007. On the other hand, there is ominous dollar weakness, with the worn greenback exhibiting the erosion from yet another year of bubble-induced non-productive debt expansion.