Finance Digest for Week of February 12, 2007

HIGH ON LOEWS

James Tisch has tripled the company’s share price in three years. And still it is too cheap.

For most of three decades James (Jim) Tisch learned the art of investing at the hand of his famous father, the blunt-spoken, buy-it-cheap financier Laurence A. Tisch. Larry and his younger brother, Preston S. (Bob) Tisch, built the family business – Loews Corp. (NYSE: LTR) – on a patchwork of neglected and unloved assets in troubled or out-of-favor industries: tobacco in 1968, insurance in 1974, oil rigs and tankers in the 1980s and 1990s and natural gas pipelines in this decade.

Loews’s second generation of Tisches – Jim as CEO and, as cochairmen, his older brother, Andrew, and Bob’s second-born son, Jonathan – officially took over in 1999. But Jim would continue to have frequent talks with his father, who was just down the hall most days of the week. Larry Tisch was diagnosed with esophageal cancer in 2002. He died on November 15, 2003. Bob Tisch died of brain cancer on the same date two years later.

For months after his father died, Jim Tisch would rise from his desk to begin the trek down the hallway in search of a consult with his dad. He and his brother and cousin faced urgent business. Low oil prices had the company’s drilling rigs pumping out losses. Its Lorillard Tobacco was under siege with lawsuits seeking $145 billion in damages for smoking deaths. The Loews hotel chain still reeled two years after September 11. And CNA, the nation’s 7th-largest commercial lines insurer, had been battered with losses from asbestos claims and bad pricing. CNA was in danger of losing a substantial amount of its business. Wall Street doubted that the second generation could replace Larry and Bob and solve the problems facing Loews.

Larry Tisch would have been proud, however, of how his sons and his nephew have fared without him. Loews stock price has more than tripled in three years, driving the value of the family’s 30% stake up to well over $6 billion. “Five years from now the stock will be two times today’s level. I can see us growing 15% a year,” Jim says. The company has $5.6 billion in cash, up from $2 billion in 2003. Its net income is up 4-fold to an annualized $2.4 billion in the first nine months of 2006. The second-generation triumvirate have pulled this off by emulating Larry Tisch’s strengths: picking undervalued properties, avoiding debt and caring more about cash accumulation than net income. They also have avoided a repeat of the patriarch’s biggest mistake, which was to bet on the market’s direction. Larry Tisch ran up $2.5 billion in pretax losses from 1995 to 1999 shorting the S&P 500.

Jim Tisch is not shooting craps with stock futures – or with glamour stocks. “I understand buying an asset below its value, like an offshore rig. Just keep it painted. In the technology model you have to change it constantly to be able to compete,” he said. While Larry could be cryptic and guarded about his plans, Jim has wooed Wall Street with transparency. In four years he has staged six stock offerings in Carolina Group (largely Lorillard’s Newport cigarette business), hauling in $3.8 billion. He also has done two offerings of Boardwalk gas pipeline company, collecting $250 million. These sales and climbing oil prices ultimately fueled the rise in the stock.

This same transparency, however, could pose a problem. The numbers make it clear that Loews, despite its stock’s rise, trades at a discount to its likely breakup value (see table). One thing repelling potential raiders is some uncertainty over the corporate capital gain tax that would be owed in a liquidation. Still, says Jim warily, “They could make a killing if the offer was made with borrowed money.” In a later conversation he amends that, depicting the raider threat as a remote one. But is it truly remote? Nature abhors a vacuum and Wall Street abhors a discount. The Tisches do not control this company with any supervoting shares. The combined stake of those family members whose share positions are publicly disclosed comes to 22%. A tender offer at a premium might be hard for institutional shareholders to resist.

The Loews discount is Jim’s obsession. He monitors it minute by minute on his computer screen. Andy Tisch says the discount has prompted a steady stream of financiers to propose schemes to recapitalize the company. “None of them make sense,” Andrew says, because of tax problems. Wall Street views the company as a hodgepodge, and it is. In addition to Newport cigarettes, energy and insurance, its holdings splay out across hotels, gas pipelines and wristwatches. Thus the company as a whole gets short shrift from analysts who follow each distinct industry. When trouble arises in one sector, analysts in that field can sour on the whole company. The amalgam resulted from a willingness by the elder Tisches to invest anywhere they could find overlooked values.

Larry Tisch was known as a shrewd and incisive investor who could be unapologetically intimidating and frugal. In the late 1980s, when he had won control of CBS with just a 25% stake, he once chided his CBS Records chief for ordering a $5 bagel when they had breakfast at the Beverly Hills Hotel. He never wrote a memo, and he eschewed meetings in favor of the drop-by to get information. While Larry Tisch was intuitive and autocratic, Jim is low-key and more collegial. He consults with brother Andy and cousin Jon on every major decision. Andy watches over Bulova and Lorillard, and Jon runs hotels. Jim and Andy visit every hotel property Jon wants to buy before approving the deal. (All three men earn salaries in the $2 million range.)

Energy accounts for 33% of Loews’s $30 billion in assets. This diversification began in the 1980s, as a much younger Jimmy, with the support of his father and uncle, bought six tankers during a slide in oil prices, for $5 million each. The downside was limited. After all, these floating hulks would make nice pieces of scrap steel. That never happened. Loews sold the ships for $50 million apiece eight years later. Next energy play: drilling equipment. Being a wildcatter is risky. But selling services to wildcatters is not risky, at least not if you buy the hard assets during a down cycle. Ten offshore drilling rigs that Loews bought for $50 million in 1989 formed what became Diamond Offshore Drilling (NYSE: DO); Loews raked in $338 million taking a 30% piece of this operation public in 1995. These days Diamond leases out rigs at $200,000 to $500,000 a day, vs. a cost of $30,000 to $130,000 a day to operate one, and sits comfortably on an $8 billion order backlog. Jim lined up another energy bet after Enron’s collapse in 2001. He bought two distressed natural gas pipelines, Texas Gas Transmission and Gulf South, for cash of only $2.1 billion.

Restructuring the tobacco asset was Jim’s most sophisticated financial feat. Carolina is not a subsidiary but a tracking stock entitling holders to an interest in 62.3% of the cash flow that Loews receives from Lorillard. A little tax ingenuity came into play. When a corporation sells off an appreciated asset it must ordinarily pay tax on the gain realized. But there is no gain recognized when a corporation sells its own shares. And these Carolina certificates are shares of Loews, not of Lorillard. Carolina also provided Loews with legal advantages. If the cigarette company had gone public it would have had to have its own board of directors, potentially working at cross-purposes to the Loews board. Such complexities are not needed in an industry that is already a legal cesspool. Did Tisch sell too soon? Carolina shares came out at $28 in 2002. It now trades at $68 after five more tranches have been sold.

Never mind raiders. Might the Tisches themselves someday bust up the company their fathers built? They say absolutely not. But whether they are on the buying or the selling end of a Loews buyout deal they would presumably be better off if the corporation were not facing a stiff capital gains tax. The federal rate for corporations is 35%. A Loews lobbyist is trying to persuade lawmakers to give corporations the same 15% rate that individuals enjoy. Not an easy sale to a Democratic Congress, although a case could be made that cutting the tax would unlock values and increase federal tax revenues.

“My brother Andy says Larry would be incredulous that we hired a lobbyist, an investor relations firm and a vice president for strategy, and I totally agree,” says Jim. He probably would not be incredulous, or dismayed, that his son is standing pat for now. Jim Tisch is in no hurry to invest the Loews cash hoard. He recalls what he learned from his father. “When we buy a business we don’t think about how much money we can make – we think about how much money we can lose,” he says. “I like to sleep at night.”

EXPLOSIVE TECH

Gauging the technology spending cycle is a tricky business, a matter of some concern to investors considering shares of tech giants like Microsoft and Intel. On the other hand, innovative small-cap companies with the right products can still blossom even in the face of a tough technology cycle. And when a company has both great products and the tech cycle in its favor, growth can be almost magical.

Finding tomorrow’s tech winners begins with looking for disruptive products – products that can change industries or even create new ones. Seek out companies with double-digit net margins and both revenue and earnings growth of at least 30% a year. These are signs that customers want more and more of the product and are willing to pay more and more for it. How sustainable is that growth? Make sure the company has a substantial reinvestment in research and development to fuel future products and that it gets orders with big customers for those upcoming products.

Second, look for scalability. As sales accelerate, is the incremental cost of production much lower than the incremental revenue opportunity? For technology companies that develop and license intellectual property, incremental licensing revenue, minus selling expenses, is almost all profit. It does not cost anything to copy a disc.

Third, look for a high barrier to competitive entry. Ideally, we want patent protection or long-term design partnerships. Finally, does the valuation make sense? Do not pay a P/E ratio greater than the percentage points in the company’s projected future growth rate. Here are stocks that meet my criteria.

SimpleTech (10, STEC) designs flash memory. Unlike hard drives, this kind of data bank (akin to memory sticks you use to move files off your laptop) has no moving parts and thus is ideal for gear requiring a high tolerance to shock, such as avionic data recorders, industrial robots and scientific equipment. Until recently hard drives stayed comfortably ahead of flash in economics (capacity per dollar). But prices for flash memory have come down, and the gap has narrowed considerably. Expect to see flash drives begin to replace hard drives in notebooks and mobile PCs in 2007. SimpleTech trades at 16 times estimated 2007 earnings, which are racing ahead. I expect growth of 40% annually over the next two years.

DivX (20, DIVX) develops software that compresses video into small data files for transmission over the Internet. From 2002 through 2005 DivX revenues increased at a compound annual growth rate of 130%. The company has strong margins already and incremental costs that are minimal as revenue grows. Expect growth of 45% annually over the next two years. It trades at 36 times my estimate of 2007 earnings. In the most recent quarter, DivX spent 114% of earnings before interest and taxes (my preferred metric here) on research and development. SimpleTech spent 36%.

These stocks could suffer if a company missteps or is simply outinnovated by someone else. Still, over the long haul a diversified portfolio of fast-growing tech companies, when purchased at attractive valuations, should yield favorable results.

HOUSING BOOM WILL LEAD GENERAL 2007 BOOM, SAYS KENNETH FISHER

For months now the debate has been over whether America will have a hard landing or soft landing, the answer hinging on how big 2007’s housing disaster turns out to be. There will not be any housing disaster. We will not have a landing at all, soft or hard. Right now the U.S. and global economies are both accelerating.

You can see right through the housing crash story by looking at the prices of housing stocks. The market knows what the economic worrywarts do not, which is that the housing sector is already making a comeback. In the last six months housing stocks are up 24%, well ahead of the overall market. If housing were destined to fall apart in 2007 these stocks would not be so strong now. Did you know that housing sales are up in the last few months, not down, and that inventories are lower than six months ago? We are accelerating, not landing. This is true not just in housing but also pretty much across the board.

The consensus forecast is for single-digit S&P 500 earnings growth tied to a slowing economy. Disbelieve it. Experts’ forecasts have been too low for four years and will be now. First, the accelerating economy will deliver earnings that exceed expectations. Second, the analysts polled for these consensus numbers never factor in the effect of corporate purchases of stock for cash. Whether a company is buying in its own shares or taking over another company, the acquisition of equity stakes (if done cheaply enough) raises earnings per share.

Not since the late 1950s have sustained fundamentals (low long-term interest rates and low P/E ratios) so strongly favored corporations shrinking equity. My firm’s count of last year’s buybacks and takeovers, net of new stock issuance, was $585 billion, or 4.5% of GDP. That will be even higher in 2007 as more players learn this game. Along with sales growth comes productivity growth. Companies are hiring but not in proportion to the gains in their top lines. The result is higher productivity, which feeds into rising profits and living standards. This is a time to own stocks. Here are some companies that will participate in the prosperous economy of 2007.

Home builder Pulte Homes (NYSE: PHM, 34) is the 2nd-largest U.S. homebuilder and in the top five in three-fourths of the largest markets. But its stock has lagged recently. At 11 times 2007 earnings and 60% of annual sales it is far too cheap. Toll Brothers (NYSE: TOL, 34, TOL) is half of Pulte’s size, more expensive per dollar of earnings, but less risky. It is the largest vendor serving the affluent end of the housing market, where qualifying for a mortgage is less of a hurdle. It sells at 19 times depressed earnings that will bounce back by 2008.

Oil may rise, oil may fall. Either way you can win with a pair of stocks ideally bought in tandem. One is the Norwegian energy company Statoil (NYSE: STO, 27). Investor misgivings about the Norwegian governmen’st 71% stake, the company’s recent purchase of Norsk Hydro’s energy business, and regulatory issues delaying the startup of new projects and holding the stock price down. But this is a good company, soon to be the world's largest producer of offshore oil and gas. It is cheap at 10 times likely 2007 earnings.

But falling oil prices help U.S. fertilizer maker Agrium (NYSE: AGU, 35). Its product line is boring – ammonium nitrate, phosphate and potassium fertilizers. No one sees this company as a reverse energy play. It takes a lot of energy to mine potash and phosphates. The nitrogen fertilizers come from natural gas. Falling prices for oil and natural gas will help Agrium more than they will hurt it by depressing the demand for corn ethanol (and thus for corn fertilizers). Buy Statoil and Agrium together. Your mini-hedge fund should do well no matter which way oil goes.

RIDING THE REIT BUYOUT WAVE

The M&A barbarians who have invaded the land of real estate are not yet finished. The biggest news is the duel to win Equity Office Properties, one of the nation’s largest office real estate investment trusts. Private equity juggernaut Blackstone Group is vying with Vornado, another office REIT kingpin, to land the largest deal in history. The victor will snag Equity Office’s portfolio of 581 buildings with 109 million square feet, much of it in two strong markets for commercial real estate, New York and Los Angeles.

Mergers and acquisitions mania led to 22 REIT takeovers announced last year in deals worth $103 billion, says SNL Financial. That is compared with 11 deals for $29 billion in 2005 and 8 worth $25 billion in 2004. In 2006 half the takeover bids were from other REITs or real estate companies, half from the private equity gang. The acquirers are awash in cash and helped by still low borrowing rates. The acquirers often are willing to pay significant premiums. Last October a division of General Electric bid $17 a share for Trustreet Properties, a restaurant REIT. That was 36% over the market price.

Understand that while the buyout party is not over, it has reached a late hour. The average REIT trades at 17 times the real estate version of earnings, called funds from operations (net income plus depreciation, minus nonrecurring gains). This is up from a 14 multiple in 2004. To justify buying into the sector at today’s prices it helps to compare the 6% earnings yield on REITs (the inverse of the 17 P-to-FFO) with the yield on inflation-protected Treasury bonds. These TIPS pay 2.4%. Still, they are a lot less risky than REITs. With the bonds, you do not have to worry about roof leaks and vacancies. Among private equity firms, REIT buyouts are especially popular. Blackstone has raised seven funds dedicated solely to real estate deals.

How can you try to take advantage of the REIT buyout trend? (1) Bet on REITs that are potential targets. (2) Buy ones that are especially well run and thus in a position to be buyers of weaker assets. These five possible targets are on the small side, thus are tempting to more acquirers. Our five each trade at deep enough discounts to net asset values, or NAV, to make them attractive.

The other strategy, to buy strong REITs that are not obvious takeover bait, is favored by real estate research firm Green Street Advisors’s John Lutzius. “Takeout candidates tend to be B students,” says Lutzius.

Public Storage (NYSE: PSA) is the largest self-storage company in the nation, with 2,100 centers. It has a 5-year annualized growth in adjusted FFO of 11.7%. AFFO is expected to grow another 26% this year. Because the company is trading at a 47% premium to NAV it is unlikely to attract the attention of any private equity firms. The company should see cost savings from its recent $5 billion purchase of competitor Shurgard. Simon Property Group (NYSE: SPG) is the largest shopping center trust, with 286 U.S. malls. So far private equity firms have shown little interest in retail REITs, which trailed the overall REIT sector by five percentage points last year. Simon’s earnings have grown a healthy 8% annually for the past five years.

INVEST WISELY! BUY ... COPPER?

Investing in copper is ludicrous you say? Ok, how about nickel or zinc? This is what got me started thinking about it: a penny just ain’t worth a penny anymore. Neither are nickels. It costs the Feds 1.7 cents to mint a penny and 8.3 cents to mint a nickel. Even a high school dropout cashier at the local Scarf and Barf can tell you that is just plain goofy. But hey, consider the cause: those government employees who flunked Everyday Mathematics.

Let’s get this straight. The Federal Reserve mints all our pennies and nickels. To pay for the minting they use the money obtained from our taxes. Of course our money is legally stolen from us by the powers that be, but that is another rant. And then, all these shiny new pennies and nickels get dumped back into circulation for us to squander in gumball machines ... or for us to age to a ripe old vintage in a pickle jar. When interest rates are high, spare change may be placed to advantage in an interest-bearing savings account. However, the Feds will tax any profits made that way. So why bother?

We are spending $17 to mint $10 worth of pennies and $83 to mint $50 worth of nickels! What the hell!? What kind of lard brain would spend more money for a product whose value is significantly less than that which it costs? Ok, no offense intended to collectors of art, Beanies Babies, Star Wars Memorabilia or even Hawaiian Aloha shirts!

See, a good Libertarian ought to know all about economics. Here is what I do know about money. I like the nickels sporting the Indian and the buffalo better than the ones imprinted with Thomas Jefferson. Nevertheless, it is obvious that the path towards financial security is paved in junk metals! There are a couple of catches. Uncle Sam has put a limit on our freedom to sneak those precious pennies and nickels out of the country. Shocking no? By law, we are not free to remove more than $5 worth of the worthless coins out of the USA to hide them in a Swiss bank lock box or launder them in the Cayman Islands! Uncle Sam can send pallets of cash to Iraq, but you and I cannot take our nickels and dimes to Zurich.

You may wonder what is the melting point of copper anyway? 1083.0 degrees C or 1981.4 degrees F. I guess that rules out melting them on the stove. Anyway, you do not have the freedom to melt or destroy your pennies and nickels! When it comes to suppression of freedom, the government has written the book. Uncle Sam has the perfect right to debase the currency. But, you do not.

The debasement of our currency has greater consequences than the loss of the penny and the nickel. Rolf Nef writes: “When empires fall, their currencies fall first. Even clearer is the rising debt of empires in decline, because in most cases their physical expansion is financed with debt.” Sound familiar? Meanwhile, for American citizens the penalty of willful destruction of pennies or nickels can pack a wallop. Debasing your cumbersome loose change can cost you up to $10,000 in fines or get you sent to the hooscow for up to five years ... or both!

Of course there is always a good sporting chance the Feds will abolish pennies and nickels altogether. David Margolick opines that the penny’s face is insufficiently glorious for Old Abe and that all patriots should rush to liberate the 16th president from the common copper coin. Well, it looks like the U.S. Government will be doing the liberating in much the same style as they liberate foreign countries. The good news is that once pennies and nickels are no longer minted or in circulation, then they will really be worth something ... to collectors of worthless junk. All right Uncle Scam! Have it your way! But I am looking out for number one. You ain’t getting any more pennies or nickels out of my pickle jar!

WILL INDIA STAY MIRACULOUS?

The Economist’s leading article last week suggested that India’s long boom was about to end in a credit crunch. At first sight, this seems unduly pessimistic. China’s boom has not yet ended in disaster, so why should India’s? However, when India’s position is examined more closely one comes to the conclusion that, while a crunch is not imminent, India’s economic miracle is a lot more vulnerable than it appears.

In the past, Indian economic expansions faltered either because its payments deficit widened, leading to foreign exchange shortages, or because public finances spiraled out of control, sucking resources from the private sector and driving up interest rates. That poor trade and fiscal performance gave India a low credit rating. However, S&P recently raised India’s sovereign debt rating from BB+ to BBB-, an investment grade rating, indicating that things may have changed.

India’s current account deficit widened to $11.7 billion (3% of GDP) in April-September 2006 from $7.2 billion in April-September 2005. Indian central government revenues were up 27% in April-November 2006 from the previous year, while current expenditures were up 17%. The central budget deficit was 4.5% of GDP. The currently modest trade deficit is no threat while international liquidity remains high. Moreover India now has $178 billion of reserves, more than a year’s imports, enough to cushion it from global credit crunches. The budget deficit also appears to be under control as the tsunami of revenue is making it shrink rather than grow. In inflation, stocks and housing, the three traditional indicators of overheating, the record is more mixed. Indian bank credit grew 31% in the year to January 2007, the same rate as in the previous year. Broad money growth was 20% in the year to January 2007 compared with 16% the previous year. Both these figures would be somewhat worrying, although they can be expected to be exceptionally high in an economy enjoying such rapid growth, whose entire structure is being modernized.

The Mumbai Sensex 30 stock index closed last Friday up 55% since 31st December 2005. With a P/E ratio of 23 it looks thoroughly overvalued, but that does not distinguish it from most other stock markets worldwide. Housing is likely to continue booming for some time yet. As economies emerge, the newly wealthy and increasing foreign residents force house prices up towards Western levels. In India, with rapid growth and inequality rising through wealth creation, house prices could rise considerably further before unaffordability chokes the market. Thus there seem no indications of a crisis in the short term. In this respect, the Bear would for once disagree with the bearish view expressed by the Economist. In the medium term, however, the picture is much gloomier, largely because of Indian politics.

It is the repeatedly expressed belief of the Economist and the mainstream Western media that India’s current prime minister Manmohan Singh and the Congress Party have been responsible for the economically reformist steps that have allowed India to begin to achieve its economic potential. For them, the Bharatiya Janata Party government of Atal Bihari Vajpayee in 1998-2004 has been airbrushed out of Indian history, except for the occasional negative reference to its Hindu nationalist principles.

The reality is very different. Economic reform in India actually began when Indira Gandhi realized after her hard-fought election victory of 1979 that socialism was not going to work. Indeed, the seeds had been sown earlier still, with her forced sterilization policy of the middle 1970s. This was, not surprisingly, thoroughly unpopular but it brought home to ordinary Indians for the first time the huge adverse economic consequences excessive reproduction. As a result, Indian population growth began to decline, and economic growth per capita was higher in the 1980s than in the 1970s, if only because the population was increasing more slowly. Manmohan Singh indeed introduced further economic reforms as finance minister after 1991, but in a tentative fashion. Only after Vajpayee took firm control in 1998 did the reform process revive, with reform accelerating after 2001 as it began to show serious results.

Had Vajpayee won the election of May 2004 economic reform and privatization would have continued at a rapid pace, and India would now be well on the way to true prosperity, without a large budget deficit and resurgent inflation ,and with the country’s serious corruption problem through its overstuffed bureaucracy well on the way to being solved. Progress under Manmohan Singh since May 2004 has been much slower, since the government relies on the anti-capitalist Left Front to maintain itself in power. However the economy itself has continued to surge ahead, running on the reformist momentum and opening of the Vajpayee years.

Most alarming is India’s draft Five Year Plan, for 2007-12, which sets a target of 9% annual economic growth over the 5 year period – almost certainly too high, and indeed incompatible with a country still run by the absurd mechanism of a Five Year Plan. The Plan’s most ambitious wish list is reserved for the public sector, which is supposed to provide simultaneously for better infrastructure, better education, more help for the poor, more programs to eliminate discrimination and better healthcare – oh, and a better savings rate for the government, not that the Indian government has ever saved anything in real terms in the 60 years since independence. Needless to say such a public sector expansion would choke off economic growth altogether. The steroid-Stalinism of the Five Year Plan is wholly incompatible with a long term increase in India’s economic growth rate, or indeed its maintenance at current exalted levels. This will probably become apparent in India’s forthcoming Budget, to appear around the end of this month.

What form the ending of India’s economic boom will take is as yet unclear. Probably a sharp increase in inflation will take place, accompanied by major financing difficulties in the national and state budget deficits. Even though India’s financial position is currently manageable, it seems unlikely that this denouement can be delayed beyond the end of 2007. Thus in the medium term the Bear agrees with the Economist, although from an almost contrary rationale.

The crucial question for India’s long term future centers on the intelligence of India’s electorate. The worst possibility would arise if the BJP and its allies, following the retirement of Vajpayee in 2005, are unable to coalesce around an economically reformist leader, reverting instead to either disarray or to primitive Hindu nationalism. In that case economic reformists would effectively have been disfranchised, and India could expect many years of renewed economic decline. The “Hindu rate” of 3% economic growth would have returned, for the same reasons as in 1947-91.

Somewhat less bad would be the reelection of Manmohan Singh over an economically coherent BJP alternative. At least then Congress and its allies would be blamed by the electorate for continued economic decline, and reformists in the BJP or elsewhere would be correspondingly strengthened for the following election in 2013-14. A bad decade for the Indian economy probably, but not a bad century. Only if the BJP and its allies were to conquer the forces of reaction and return to power on a policy of restarting the economic reforms that were under way in 2001-04 could India return to rapid economic growth. Even then there would probably be a 2-3 year period of monetary stringency and public spending cuts before the economy righted itself.

India has a great chance to enjoy rapid economic development and take its rightful place within a couple of decades among the world’s wealthy, albeit with a substantial remaining impoverished and under-educated rural proletariat. However, the Indian electorate’s decision in 2004 to remove Vajpayee has meant that a further period of economic chaos may have to be endured before renewed progress can occur. Countries can either have Five Year Plans or economic miracles, but not both in the long run.

WISHFUL INFEASIBILITY: FINE ART AND THE BUBBLE IN MONEY

“... If you like your theatre absurd, keep an eye on the fine-art market in London ...”

“Good art speaks truth, indeed is truth, perhaps the only truth,” wrote Iris Murdoch in The Black Prince – and seeing how Peter Doig’s White Canoe (1990) was deemed good enough to fetch $11.3 million at auction on February 7, that must mean the only truth today is inflation. Sotheby’s midweek sale of contemporary art in London netted £45.7 million all told – some $90 million. Indeed, it was “the most successful contemporary sale ever staged in Europe,” as the auction house gasped in its press release. Doig’s “early masterpiece” set a new cash record for a work by a living European artist, bagging five times its reserve. Altogether the evening’s sales ran up to 60% higher than the pre-auction estimates of only four weeks before. How is that for art appreciation!

It proved quite a week for London’s wealthiest art lovers and their dealers, in fact. Monday, February 5, Sotheby’s achieved its highest value auction ever in Europe, knocking down Impressionist & Modern Art for a total of $173 million. On Tuesday night, Christie’s achieved $177 million with its own Impressionist and Modern auction. Wednesday brought Sotheby’s Contemporary sale, followed by Christie’s auction of Post-War and Contemporary art on Thursday. That netted $138 million, including a new Francis Bacon record, nearly double the previous high of $30 million hit in November.

Four days ... one city ... $578 million. And do not forget Sotheby’s commission on top! Sotheby’s and its only serious rival – the privately-owned Christie’s – both bill their vendors 5% of the hammer price. They also charge successful bidders for the pleasure of watching the gavel come down, an innovation begun more than three decades ago. And in the last month both auction houses have hiked their buyer commission rates to 20% of the first $500,000 – up from $200,000 previously – plus 12% of the remaining hammer price. Caveat emptor applies, in other words, even if the art is to your taste. White Canoe is not all that bad, but you would not know it from its description by Saatchi Gallery.

This bubble has got nothing to do with the paintings, of course. Sotheby’s and Christie’s between them control 90% of the world market in art, furniture and jewelry investment via live auctions. But even the business of helping Russian billionaires make newspaper headlines with their disdain for cash can be tough. That is why, following the slump in fine art sales that came with the collapse of Japanese real estate and equity prices in the early 1990s, Christie’s and Sotheby’s colluded in what the European courts called “secretive meetings” to rig commission rates in their favor, replacing competition with inflated fees that defrauded vendors out of an estimated $450 million.

Between 1989 and 1991 – when Tokyo’s various asset bubbles burst and began dragging the whole Japanese nation into deflation – the turnover in fine-art auctions worldwide sank by 60%. Things steadily improved as the S&P and then Nasdaq picked up where the Nikkei had left off. But gross sales slipped again as equity prices declined, down more than 25% between 1999 and 2003. For Sotheby’s in particular, the DotCom Crash proved expensive. It began losing money in 2000, even with the U.S. anti-trust fines of that year ($203 million) excluded. Sotheby’s finally recovered to report a profit for FY 2003, after the European and Tokyo stock markets had finally turned higher. But the Board only got round to re-instituting a dividend last August, after a gap of six years. “After the [collusion] scandal died down, Christie’s and Sotheby’s quietly adjusted their commission rates, independently, so that there were discreet but not big differences,” says art dealer and consultant Christopher Wood. “Christie’s and Sotheby’s are such close competitors and similar firms that whatever one firm did, the other was bound to follow. They didn’t need to collude.”

Fast forward to February 2007, and there is no need to rip off the Russian oligarchs or City bankers behind this week’s record sales. The “wishful infeasibility” of London’s art market will do that all by itself. Nor is anybody accusing anyone of anything besides “depth and strength” in the bidding today – not even exploitation of a duopoly. Even before last month’s commission hike, the bubble in financial sector bonuses let Sotheby’s gross $104,000 whenever the hammer came down for $500,000 or more. “Such incremental revenue dollars, with no associated costs, should drop entirely to the operating income line,” according to a note from Wedbush Morgan Securities in January. It failed to use the words “rent seeking”, but if you are the right side of the money bubble today, you do not want to moralize.

“The percentage of [U.S.] GDP attributable to corporate profits is near a multi-decade high,” Barron’s recently reported. “Corporate gains tend to benefit the affluent through strong dividend growth, capital-gains income and high-salaried jobs, while restraining working-class wage growth. Ajay Kapur of Citigroup calls such economic trends Plutonomy – a global economy disproportionately geared to the rich.”

The butlers and parlor-maid stocks serving today’s global overlords have outperformed the S&P for the last 21 years, according to The Daily Telegraph in London. But Citigroup continues to recommend 24 firms set to cash in further as the über-rich throw their money around. Sotheby’s is right up there with Four Seasons Hotel (FS), Tiffany (TIF), Polo Ralph Lauren (RL) and Coach (COH). For a sector apparently awash with high-spending clients, however, there is little sign of cash trickling down to investors. Sotheby’s trades for 25 times trailing earnings, about average for this selection. And none of these stocks now yields more than 1%. The only attraction, therefore, must be capital gains, inflated by the stock market buzz around yet further asset-price inflation in prime real estate, private jets and fine art.

But there will only be fresh meat for the gavel to beat as long as Wall Street and the Square Mile keep paying ever more in bonuses. Ten of the 53 buyers in last Monday’s auction were first-time purchasers of Contemporary Art at Sotheby’s, says the auction house. Analysts at Barclays Wealth Management reckon that, all told, one in ten City bonuses this New Year will be spent in part on investing in art and antiques. So while the ultra-high-net worth buyers rely on strong energy prices to fund their collections – the Russian art market rose 2,365% in the five years to 2005 – the newbies in the art market are raising their hands straight after clocking off for the day at Goldmans, JPM and the rest. As the financial markets go, therefore, so goes the art market.

“Luxury spending is the first thing to fail when the oxygen goes out of the economy,” wrote Robert Hughes for Time magazine in 1990. Air was still gushing out of Japan’s asset-price bubbles, and “art [was] the canary in the mine shaft.”

“The Japanese are awash in money,” one New York dealer had said in 1989. Now their cheap money pump – flooding the bond, commodity and derivative markets with carry-trade Yen – is washing across Old Masters and New Pretenders alike yet again. “All art,” Iris Murdoch also noted, “deals with the absurd.” If you like your theatre absurd too, keep an eye on the art market.

Is the art market bubble about to burst?

Not yet. On January 31 and February 1 Christie’s auction house sold a total of $21 million worth of jewelry and art in Dubai. It was the first time ever an international auction house had held a jewelry sale in the Middle Eastern tourist and retail mecca, and the second sale of art. Among the hot lots were a 17-carat diamond ring that brought $1.2 million and a painting by Maqbool Fida Husain, considered the Picasso of India, that fetched $442,000. Buyers included Indians, Chinese and Russians, as well as many from the Gulf states.

The robust Dubai results support the proposition, promoted by the auction houses, that the 3-year-old bull market in high-end art and collectibles is deeper and broader than past booms because it is fueled by such a wide swath of newly minted collectors. Christie’s sold $4.7 billion worth of collectibles in 2006, up 36% from 2005, while rival Sotheby’s (NYSE: BID) sold $3.6 billion. The houses compete on their guarantees, the floor amount promised to the seller, and by negotiating a seller’s commission. They do not compete on buyers’ fees. Both houses recently raised the break point on the sliding commission scale paid by buyers. For an item hammered down at $500,000, the commissions can now total $125,000 – $25,000, say, from the seller and $100,000 from the buyer, up $24,000 from a year ago.

CURRENT TRENDS IN FOREIGN CURRENCIES

What follows is Part I of a focus on currencies including the U.S. dollar index, the yen, the euro, the British pound, and the Canadian dollar. There is a special emphasis on the yen. This analysis covers five factors:

1. Technical analysis
2. Politics
3. Commitment of traders (speculation vs. hedging) of currency futures
4. The carry trade
5. Fundamentals

Let us kick off with the technicals. Forex traders will note that charts (Yen/USD, EUR/USD, CAN/USD, USD Index weekly, and USD Index monthly) marked with an asterisk are inverse of normal trading pairs. This was done to put all the currency pairs in the same frame of reference (e.g., a weakening chart on a currency pair is bullish for the U.S. dollar and U.S. dollar index). The charts show that we are at a significant inflection point on the U.S. dollar index, the yen, and the euro.

The Financial Times is reporting, “U.S. Congress Takes Aim at Tokyo Over Yen”: “Powerful House Democrats are pressing the Bush administration to persuade Tokyo to strengthen the yen, claiming the currency’s weakness is bolstering Japanese imports at the expense of U.S. manufacturers.” The Democrats in Congress believe that higher prices on goods from Asia (nearly everything but food, energy, planes, and weapons) will be a good thing. It will not. The Democrats also must think that higher prices on goods will bring back manufacturing jobs to the U.S. They will not. Michigan Rep. Sander Levin, chairman of the House Trade Subcommittee, says, “Japan is clearly following policies to maintain a weak yen.” Like we are not doing everything in our power to maintain a weak dollar? Does any country want a strong currency? Competitive currency debasement is everywhere you look.

Takatoshi Ito, a member of the Japanese cabinet’s council on fiscal and economic policy, said, “Japan has not intervened since March 2004.” That is the fact. And oddly enough, the yen did not plunge until Japan stopped intervening. That goes to show you two things: 1) A primary trend in currencies or anything else cannot be defeated by manipulation, which is something gold bugs need to remember when screaming about these conspiracy theories purported by the Gold Anti-Trust Action Committee, and 2) sentiment was so universally bearish on the U.S. dollar by the spring of 2005, with numerous magazine covers and the shoeshine boy telling everyone that Gates and Buffett were short the dollar, that the dollar was bound to rally. While cautioning against underestimating the shortsightedness of legislative bodies in general, this jawboning is more than likely nothing more than frustration by Congress and this administration that we can no longer bully the world markets into doing what we think is in our best interest (and on that, we are not even right).

Bloomberg is reporting, “Paulson, in Congress, Sides With Japan on Yen”: “Henry Paulson’s defense of Japan’s currency policies over the last week is forcing traders to pay more attention to a U.S. Treasury secretary than they have in years.” Supposedly, Paulson is watching things “very, very carefully.” So what? Is the U.S. going to sell dollars and buy yen? Wouldn’t that be fun? (Especially if Japan reacted as it did before, by selling yen to buy dollars.) Let’s now turn our focus on speculation as defined by the Commitments of Traders reports (COTs).

Commercial traders and noncommercial traders have to report their open interest in futures (in this case, currency futures) once a week. Those results are summarized in COT reports. A quick glance at any report will show noncommercial, commercial, and nonreportable positions. Think of commercial traders as either producers or hedgers. In the case of something like gold, the commercials will be the miners. But they could also be jewelry makers. In short, the commercials represent someone wanting to hedge future costs from rising or producers wanting to lock in prices at which they can profitably produce. In the case of currencies, the commercials might be importers or exporters not wanting to take on currency risk. The commercials might also be big trading houses wanting to hedge exposure to various markets for one reason or another. Commercials are thus hedgers.

Think of the noncommercials as the big hedge funds speculating one way or another (long or short) in a commodity or currency. The nonreportable positions would be a small trader speculating one way or another on currencies or commodities. Trading size determines reportability. Investopedia offers advice on using the COT report: “... commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning. Noncommercial data, on the other hand, are more reliable, as they capture traders’ positions in a specific market.” It goes on to delineate three primary premises on which to base trading with the COT data: (1) flips in market positioning may be accurate trending indicators, (2) extreme positioning in the currency futures market has historically been accurate in identifying important market reversals, and (3) changes in open interest can be used to determine strength of trend.

If you are still with me, let us look at a few snapshots from the most recent currency COT reports. Noncommercials – big speculators – are short 128,526 contracts in the yen – betting it will fall lower, or that if it rises, they can make more elsewhere. This is part (but likely only a small part) of the infamous “carry trade” (shorting the yen and investing elsewhere, typically U.S. Treasuries). The carry trade in the yen will unwind at some point. It will be yen supportive and dollar negative when it happens. That increases (but that is all) the likelihood that the recent trendline break in the yen is a fake out.

A quick look at what the noncommercials are doing with the British Pound shows a chart that is about as lopsided as it gets. There seems to be mammoth one-sided speculation on the British pound versus the U.S. dollar. This will get unwound at some point, and in contrast to the yen, an unwinding of these contracts should be U.S. dollar supportive when it happens. Timing the reversal is, of course, the issue. For whatever reason, hedge funds are short 80,646 contracts on the Canadian dollar. The unwinding of this trade would be supportive of the Canadian dollar and that similarity to the yen suggests a possibility that the recent breakdown is a potentially false one.

Speculation on the euro is not as massive, nor is it as one-sided, as some of the others. However, small speculators (nonreportable positions) are substantially long (relative to small spec positions), with commercials net short 65,632 contracts and the big speculators long 45,330 contracts. The unwinding of those contracts would likely be supportive of the U.S. dollar. The aggregate value of these contracts might not seem like such a big deal, at least as compared with the yen. But one must also look at the relative weighting of currencies within the U.S. dollar index, and that is where the rubber meets the road. Those expecting a huge rebound in the yen to sink the U.S. dollar index are likely barking up the wrong tree. The yen is only 13.6% of the index, while Europe (the euro and pound) comprise 69.5% of the weighting, with the euro a whopping 57.6%.

What is the carry trade? The San Francisco Fed in an article entitled, “Interest Rates, Carry Trades, and Exchange Rate Movements” answers: “In the most common version of this strategy, an investor borrows a given amount in a low-interest-rate currency (the ‘funding’ currency), converts the funds into a high-interest-rate currency (the ‘target’ currency), and lends the resulting amount in the target currency at the higher interest rate ... According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. ... In practice, however, investors in international financial markets do seem able to make profits through such strategies...”

The COT numbers on the yen might seem huge. But the $13.2 billion bet on shorting yen futures is, in all likelihood, peanuts in the grand scheme of things. Consider Brad Setser’s excellent article, “A Trillion Dollars Gets My Attention, Whether It Comes From the PBoC or the Yen Carry Trade”:

“Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets ... Just how large the carry trade is, nobody really knows... But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years. ... Bottom line: A ton of people – the Japanese government and Japanese ‘real money’, as well as the leveraged community – are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.”

In September 2006, MarketThoughts.com had an interesting article called “The Yen Carry Trade Revisited”:

“The second great yen carry trade began in the summer of 1995 and it did not end until October 1998 – when the yen ended its decline by rising 15% in a week ...

“As for the current yen carry trade, there is little evidence to believe that much of the borrowed yen went into commodity speculation – as the decline of commodity prices in the last four months has generally not led to a higher yen. More likely, the typical profile of the latest yen carry trade participant is as follows:

“1. A speculator who borrows or shorts yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., U.K., or countries in the euro zone. The days of using this money to invest in higher-yielding countries in ‘peripheral’ developed countries like Iceland and New Zealand has definitely ended – given the crash in both of these currencies earlier this year.

“2. A Japanese investor (e.g., a pension fund, a life insurer, or an individual investor) who converts his money from yen to U.S. dollars (or the euro or the pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged – which again puts further pressure on the yen. ...

“So the $64 trillion question is this: When will the yen carry trade end? On a purchasing power parity basis, the yen is undervalued against the U.S. dollar, but massively undervalued against the euro. That being said, things can always get more extreme before reversing – especially when it comes to the financial markets.”

So now we have Japanese life insurers speculating in the carry trade. Isn’t that special? One possible answer to the “$64 trillion question” (When will the yen carry trade end?) is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the yen is a real one. Those following along carefully will note that is the opposite of what I suggested earlier in reference to the COT data (i.e., an unwinding of the futures positions is dollar negative on balance).

Fundamentals.

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there.
• Gold has never gone to zero, and barring a Star Trek-like replication device or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero, either.
• In the meantime, the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and foreign direct investment. The much ballyhooed trade deficit is far down the list
• When it comes to the yen, the interest rate differential between Japan and the U.S. or Japan and Great Britain is substantial
• Japan is also sitting on a national debt of 150% of GDP. What that will do to interest payments if rates rise rapidly should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is yen negative.
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3, but a much lower interest rate than the U.S.’s. That is euro negative versus the U.S. dollar.
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound, as expected rate hikes in the U.K. may not occur.

Everyone has a tendency to look at problems in the U.S. in isolation. As you can see, the issues are both many and complex. There are a lot more to currencies than the one-sided view often heard that “The U.S. dollar sucks.” This has been an attempt to look at things from as many angles as possible.

From a purely technical standpoint, I would have to suggest “Trust the trendline breaks on the charts.” From the standpoint that things almost always get crazier than anyone thinks, I am inclined to believe the yen is likely to sink further and then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade, one should be watching those charts carefully.

From a political standpoint, I am rather unimpressed with Paulson even as others seem to be going gaga. From the standpoint of the U.S. dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the euro. Ultimately, however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing, in whatever direction you are doing it, seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

WILL CRIME DECIDE THE FATE OF SMALL-CAPS THIS YEAR?

Here is an ominous leading economic indicator. Researchers have sifted through nearly 25 years of reports on violent crime. And when they were combined with a study of U.S. economic cycles from the National Bureau of Economic Research (NBER), the conclusions were compelling, if also a little macabre. Violent crime, the data shows, trends higher at the start of a contraction in the business cycle and typically stays there during the early stages of a recovery.

It is not just violent crime where this pattern holds. It turns out that petty and grand larceny follow a similar trend. Barron’s reported that stickups rose significantly in 1973, 1980, 1981, 1990, and 2001. These were all years that the U.S. entered recessions. Call this the Les Miserables Indicator if you like. When even a good man is stealing, the economy must be awful. Anecdotally, here in Baltimore where we are headquartered, violent crime got off to a stronger start this year than the Orioles typically do.

You are probably asking yourself what this has to do with small-caps. Well, crime aside, we think small-caps are going to have another good year in 2007. Fed Chairman Bernanke sees the U.S. economy actually expanding over the next two years, with domestic growth improving with some firming of the housing market. Whether Bernanke is right about 2007 and 2008 or the police blotter tells the true tale, I want to be invested in small-caps no matter what the economy gives us the next two years. Here is why.

When I look back over the decades, as far back as the 1920s, small-cap stocks have typically gained about 13% per year. Compare that to the 10% gained by blue chips over the same period of time. Over many 10-year periods, small-caps trounced large-caps by as much as 50 percentage points! The lesson here is that if you want to make a fortune, odds are that keeping your capital invested in the stock market for long periods of time is a good idea. If you want to make an even bigger fortune, history suggests having a significant portion of your portfolio concentrated in small-caps.

That 3% difference between small-caps and large-caps comes at a price. Small-caps often do not pay a dividend, and they usually are not as mature as businesses as large caps. It makes them riskier, and that is partly why their returns are superior. But if we look back again over the last century, we see that small-caps really shine over large-caps when the U.S. economy is growing. And for the majority of the last 80 years, the U.S. economy has been growing. Let us hope Bernanke is right. And do not obsess too much over crime stats. Instead, buy the best small-cap values you can find.

Making profits from various life events.

Valentine’s Day has come and gone ... thank goodness for the latter. Unfortunately, I would sell the naming rights to my first-born son to avoid the former. It is not a pleasant thought, I know. But frankly, I could not care less. You see, my family has been in the retail flower business for over 20 years. My father bought the business to give his wife an afternoon activity ... a creative outlet of sorts, nothing more.

Most people associate flower shops with nothing but positive associations. Occasions like Valentine’s Day and Mother’s Day are certainly big. And if you have ever seen the flower bill for even the average wedding, you would think florists were running the greatest racket since the Dutch Tulip Mania of the 17th century. But sad the truth is that flower shops are not built for any holiday season. They are in business for funerals, which account for roughly 75-80% of annual revenues. As the shop’s accountant once said, “We live for funerals.”

People in the flower business know this quite well. They cannot rely on seasonal holidays, birthday balloons, or even the senior prom to keep business running strong. The reason? Flowers are luxury items. They are completely positively income elastic. Meaning, as disposable income decreases, quantity demanded decreases (and the reverse). As an economic indicator, you would be hard pressed to find another business that accurately measures the sensitivity of a change in a consumer’s income than flower shops. Unlike jewelry and other more notable luxury items, flowers have a very limited shelf life. So when things get tight for Roy, flowers are undoubtedly the first to go. Even with funerals, what do you think goes first: the flowers or the coffin? You get the idea.

So when revenues from this Wednesday’s festivities do not even cover the day’s cost of labor, you know Johnny Credit Card is becoming legitimately tight. Crime is up (see immediately above) and the flower business is down. If my statistics on flowers and the ones on crime do not convince you, perhaps the fact that the percentage of U.S. companies that failed to meet earnings expectations reached its highest level in more than two years. 22% of the S&P failed to meet Q4 earnings estimates. That is a significant milestone considering most U.S. companies, unlike their European counterparts, set their own yardsticks to analysts.

The lesson here is if we were indeed heading for a couple of quarters of negative GDP growth, you would be wise to hold small-cap stocks with very negative income elasticity. Meaning, as disposable income decreases, the quantity demanded for a particular company’s goods or services increase. Economists call these items inferior goods. Inexpensive foods like Campbell’s soup and mass-market beer are viable substitutes for Petit Filet and French wine. Keep an eye out for small-cap stocks that produce these goods.

WHO’S BEEN SLEEPING IN OUR BEDS?

A recently popularized concept dubbed the “Goldilocks economy” sounds nice in theory, but sorely lacks historical precedent. But Wall Street and the financial media have hijacked the children’s bedtime story of “Goldilocks and the Three Bears”, using it as a metaphor to explain the current economic environment. If we take this metaphor to its logical conclusion, we see that it has big, positive implications for precious metals investors.

Here is how the story goes: Fed Chairman Ben Bernanke, having broken into the three bears’ house, is faced with a choice of three bowls of porridge: one “too hot”, one “just right”, and one “too cold”. His academic background gave him the knowledge to choose this “just right” bowl – a bowl characterized by low inflation and 2-3% economic growth. Had Bernanke chosen Papa Bear’s “too hot” bowl, maintaining an easy monetary policy too long, inflation would now be out of control and the economy would be growing 5-7%. Had he chosen Mama Bear’s “too cold” bowl, he would have tightened monetary policy too much, inflation would now be turning negative, and the economy would be heading into recession.

So what is the moral of Wall Street’s story, now that we are in the midst of a “just right” economy? We should all invest in index funds and watch our savings yield real returns above 10% per year all the way to retirement. But it is interesting how the nonmetaphorical version of this bedtime story actually ends. Wikipedia provides a synopsis: “Goldilocks is still asleep in the baby’s bed when the bears return home. They wake her up, and depending on the brutality of the storyteller, either kill her or scare her away. The moral of the story can differ as well; a general theme is that the privacy of others should be respected.”

Taking this metaphor to a more plausible conclusion – the Fed has broken into the house, sat in the chairs, ate the porridge, and slept in the beds of every individual saver of U.S. dollars. This institution constantly injects new floods of cash into the banking system by “monetizing” government liabilities (mostly T-bills). With each new dollar created, the value of each existing dollar held by savers declines in value.

Will the Fed ultimately reach the same fate as Goldilocks, running away from the wrath of savers in a panic? Probably, but it will take a monetary crisis to wake savers up from their hibernation and recognize that the Fed is the primary enabler of inflation, not the “inflation fighter” that so many have come to believe. The ultimate moral of Wall Street’s version of this bedtime story is to buy and hold a position in gold to guard your savings from inflation.

The Goldilocks concept rests on the erroneous assumption that inflation will begin to boil over once economic growth climbs above some arbitrary threshold. But this concept exists only in the minds of academics and in economics textbooks. Real economic growth – the kind that produces “wealth” in the true sense of the word – actually exerts downward pressure on the CPI, provided that the money supply remains stable. It is only logical to assume that a growing supply of manufactured goods and services when forced to compete for a relatively fixed quantity of customer dollars will drive down prices.

Those charged with maintaining the value of paper money will follow scripted responses to each bubble’s pop or hiss: cheapen money yet again. The future environment for gold mining equities remains as bright as ever. In the case of computer manufacturing, productivity gains are measured by how fast prices fall each year. Wealthy elites were the first to enjoy the benefits of PCs back in the 1970s and 1980s. But as new competition surmounted the low barriers to entering this business, PC supply accelerated, while prices and profits fell. Today, the lowest-cost producers dominate this market. This example runs counter to the “Goldilocks” concept. By visualizing the Dell business model, you can appreciate how complex factors of production and competition can combine to produce improving products at lower prices. Why does an economy of increasing goods and services productivity require an ever-increasing money supply? The general price level would nearly always fall in a free market economy without such an out-of-control fiat currency backdrop.

But Fed officials do not see it this way. They believe they can set the temperature of the economy as if they were preheating an oven. History shows time and again that the Fed allows the formation of credit bubbles by lowering the price of credit to artificially cheap levels. At the first sign of a credit bubble imploding under its own weight, this highly regarded institution actually compounds its original mistake, creating another bubble by lowering the price of credit yet again.

As complex adaptive systems, economies will react differently to each bubble’s aftermath. Nevertheless, it is pretty apparent that the global economy has passed the “point of no return” in terms of writing off its bad debts, rebalancing its imbalances, and beginning afresh. So at the top of the Fed’s playbook is a plan to rescue the housing and stock markets with a heaping dose of stimulus at the first sign of real distress.

SUBPRIME MORTGAGE LOANS IN FOCUS

I have long argued that “Unlimited Finance” is the bane of free-market capitalism. Of course, such a notion sounds absurd as the world frolics in a sea of global credit and liquidity excess. To most, “bull markets” and various other asset inflations are proof positive of the economic system’s underlying soundness.

The subprime mortgage space is only the latest example of the perils of profligate finance. Remembering back to the tech/telecom bubble, it was a case of massive liquidity excess promoting over/mal-investment, profligacy, chicanery and fraud. Yet latent fragility was allowed to compound as an onslaught of late-cycle speculative finance artificially inflated industry profits and cash-flows. The eventual bursting of the technology bubble then abruptly and radically altered industry liquidity, profits and credit standing. A system that had so carelessly nurtured companies’ dependency to easy access to marketplace finance summarily cut off the lifeline. Dynamics within the expansive mortgage finance bubble are thus far – and not surprisingly – following a different course. My focus will be the “big picture” (broader credit, market and economic impacts), knowing that others (noteably Jim Grant) are doing a most admirable job covering subprime industry developments.

The “blow-off” stage of the mortgage finance bubble led to unprecedented excesses, no doubt about that. Scores of uninformed borrowers with meager incomes and little savings were enticed into the responsibilities of homeownership by a combination of surging home price inflation and offers of ultra-low “teaser” and/or adjustable-rate mortgages with minimal down-payments. Many loan originators were enticed into lending to poor credits for the easy profits garnered by selling these loans to Wall Street for pooling and securitizing. These pool operators were attracted to these suspect mortgages because of the insatiable demand for higher-yielding “structured” products.

Bubble dynamics were driven by the Fed, borrower, originator, Wall Street financial “alchemy”, and the speculator/investor community. And I would further argue that the massive recycling of U.S. current account deficits and global dollar liquidity flows back into Treasuries, agencies and investment-grade securities played a decisive role in distorting securities prices and returns, squeezing the speculator community into a self-reinforcing (and ongoing) bubble in risky credits.

In the context of credit system blunders, 2006 was a historic doozy. After several years of increasingly egregious excess, the mortgage industry proceeded to open its arms extra wide. Never have so many atrocious credit risks been offered such a handsome opportunity. Clearly, many slipshod originators catered to these suspect credits, and this dynamic helps explain why an extraordinarily large number of these new mortgages – “Vintage 2006” – have quickly turned delinquent or fallen into default. 2006’s extreme mortgage credit system largesse can be explained by a multitude of “Unlimited Finance”-related factors, certainly including perceptions that the Bernanke Fed would hastily initiate an easing cycle come the onset of housing market weakness.

I found the market’s reaction to the recent HSBC and New Century subprime bombshells intriguing. Outside of the subprime lenders and the broader financial sector, the market brushed off the news. I think I follow the basis for marketplace complacency. The subprime market is only a small segment of a huge mortgage market, and there is as yet little indication of serious impending mortgage problems outside of the riskiest credits. And there are some key company and industry “specific” issues. For one, subprime had degenerated into the ultimate credit cesspool.

A strapped subprime borrower with payments about to reset higher – and with minimal or negative home equity – is at the mercy of the marketplace to refinance and stay afloat. Akin to the leveraged telecom company in 2001/02, the marketplace closing the loan window is immediately catastrophic for the subprime borrower. Again corresponding to the telecom debt bust, tightening credit conditions quickly lead to escalating credit losses and further credit tightening and losses.

At the same time, however, the vast majority of the mortgage market operates with risk essentially nationalized (through GSE and government guaranties). Employment is strong and incomes are growing robustly, underpinning the capacity of existing borrowers to make payments and new borrowers to sustain inflated home prices. In contrast to subprime, most “prime” mortgage borrowers are not today at the mercy of the marketplace. The vast majority have not fallen behind on their payments. Credit conditions have not been forced tighter. The “prime” mortgage market continues to abound with cheap finance. For a large portion of the mortgage market, things have not been much better.

The trend that emerged in 2006 – trouble at the fringe of housing and mortgages actually promoting heightened excess in corporate credits – is still in play. Junk bond spreads narrowed for the week, while risk premiums outside of lower-tier mortgages generally remain near historic lows. Importantly, mortgage developments so far have been a non-event with regard to general marketplace liquidity. So far combined total mortgage, corporate, financial sector and global debt growth remain more than adequate.

The markets should begin to demonstrate heightened concern for the financial ramifications of imploding subprime lenders. To this point, failures have been small players with minimal market impact. If major operators find themselves confronting the traditional subprime liquidity squeeze, this so far isolated credit event could pose unknown contagion risk. One or more major failures would likely prove a meaningful blow to the ABS and credit derivatives market. Additional uncertainty with respect to the degree of leveraged speculator exposure to subprime credits, credit indices and other derivatives might also be expected to weigh on the markets. Any general tightening in the CDO market would likely mark a key inflection point in marketplace liquidity, with major systemic ramifications.

The bottom line is that the markets are now likely facing a bout of heightened uncertainty. The credit default swap, CDO, and “credit arbitrage” markets have grown tremendously since the last bout of liquidity ambiguity. How these markets will operate in the event of some general financial sector tumult is all too unclear. That the “liquidity” markets are these days extraordinarily bifurcated between the loose corporate and “prime” mortgage arena and the increasingly tight “non-prime” creates significant uncertainty.

The expectation has been that tightened mortgage Credit conditions would sway the Fed into easing. But recent comments from Fed officials certainly lead one to believe that they are content to focus more on upside liquidity risks, while allowing subprime excesses to, in the words of Mr. Poole, “come home to roost.” Hopefully the Fed demonstrates resolve, as the most problematic systemic fragilities are being exacerbated by ongoing Unlimited Finance available throughout markets in corporate credits, securities leveraging, and for (over)financing asset markets globally.

Accounting reflects housing market reality.

“Subprime” mortgage lending is a disaster unfolding before the eyes of financial market participants. Subprime refers to the practice of providing home mortgages to those with spotty credit histories in return for a few extra basis points of interest. The Mortgage Lender Implode-O-Meter Web site has gained a wide following as an online obituary for the most aggressive, irresponsible lenders. This site, maintained by concerned citizen Aaron Krowne, latest headline flashes the statement “21 lenders have now gone kaput” since about December 2006. Krowne really cuts to the chase in his description of the unfolding disaster:

“It appears what had to give is now finally giving: the latest subprime loans are going delinquent the quickest, and it seems likely that their prior kin will soon follow (and many of these will likely end up in foreclosure). Further, I expect a large swathe of prime loans to go bad (the prime/subprime distinction is quite fuzzy anyway). Originators cannot handle the buybacks, and so when challenged by them are immediately folding [emphasis added]. The phenomenon is just getting started. What will the banking industry – often all or part owners in these enterprises – do? Stay tuned.”

Most of these companies concentrate on the “origination” side of the lending business, because it is considered the sweet spot. You simply approve your customer’s credit application, perhaps buy some sort of “credit enhancement”, and sell the mortgage to Wall Street, where it will be bundled together with similar mortgages and sold to some poor sap managing a bond portfolio at an insurance company.

One subprime lender in particular, New Century Financial (NYSE: NEW), has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future. New Century is a “canary in the coal mine” for the entire mortgage industry. Its recent struggles should not be ignored as company-specific. NEW stock is a good gauge of the credit market’s willingness to fund high-risk mortgages. The availability of subprime credit is drying up as fast as this stock is falling.

So what does Mr. Krowne mean when he says, “Originators cannot handle the buybacks?” New Century’s latest 10-K explains: “We sell whole loans on a nonrecourse basis pursuant to a purchase agreement in which we give customary representations and warranties regarding the loan characteristics and the origination process. We may be required to repurchase or substitute loans in the event of a breach of these representations and warranties. In addition, we generally commit to repurchase or substitute a loan if a payment default occurs within the first month or two following the date the loan is funded, unless we make other arrangements with the purchaser. The majority of our whole loan sales are sold on a servicing-released basis.”

Last week, New Century announced that it has not been accounting properly for what it calls “early payment defaults”. Scores of borrowers are defaulting before the ink on their mortgages even dries. So now New Century is responsible for repurchasing untold numbers of loans backed by collateral of questionable value. To make matters worse, NEW is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines are likely to balk at extending credit at the time New Century needs it the most. In a final toss of cold water on the widely anticipated housing recovery, NEW management says that these “early payment defaults” have not bottomed, and had in reality reaccelerated in Q4 2006.

Many aggressive mortgages are turning sour so fast that, hopefully, regulators and accounting authorities will crack down on the aggressive accounting tactics that have inflated New Century’s earnings figures. Other suspected earnings inflators are Countrywide Financial, Downey Financial, and FirstFed Financial. Most of their loans may be “performing” now, but a big chunk of them will stop performing in the near future. The housing market is fresh out of greater fools to bail out overleveraged speculators. At such time, most of the earnings that have been booked from these toxic mortgages will be erased. Nobody seems to have a clue what the real earnings are in this business, since executives have plenty of leeway to play around with “lost reserves” accounting, making earnings what they want.

On the same day as New Century’s announcement, mortgage giant HSBC Holdings announced a major increase in loan loss reserves, which will directly hit earnings. HSBC’s press release explains: “The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable-rate mortgages reset over the next few years from their original lower rates. ...”

HSBC and New Century executives are sending very clear messages about future mortgage default risk, so why are two key purchasers of default risk choosing to merge? And why does their accounting not reflect worsening real-world conditions?

Mortgage insurer MGIC Investment (NYSE: MTG) announced that it will be merging with rival Radian Group to form “MGIC Radian”. Wall Street seems to love the deal, sending MTG up sharply. But the market is missing the forest for the trees by celebrating the cost savings of this deal. The “forest” is the risk in the existing book of business and the “trees” are the operational cost savings (i.e., redundant worker layoffs). On the post-announcement conference call, both management teams extolled these cost savings and that popular buzzword “synergies”. But I expect that they will regret being distracted by a complex integration when they should have battened down the hatches in preparation for this year’s mortgage defaults. So I found it interesting that Radian CEO S.A. Ibrahim, who will become MGIC Radian’s CEO in a few years, cannot wait to lead the charge into even more exotic credit insurance markets.

Neither management team mentioned risk on the call – only opportunities. Would the analysts on the call bring it up? A grand total of two questions out of about a dozen focused on reserve accounting and risk in the existing books of MGIC and Radian. Goldman Sachs analyst Andrew Brill asked, “Do both companies use similar claims factors in their reserves? What have you factored in terms of reserve changes that might be needed as the books get combined?” Management basically reiterated their reserve accounting policy of looking through the rearview mirror at the wonderful boom times in the housing market. This is likely to come back and bite them. Another analyst, probably from the buy side, asked the only other difficult question. By the end of this conference call, you can tell which analysts are helping management sell MGIC stock to the public with softball questions and which analysts are really trying to properly balance risks and opportunities.

In a presentation a week earlier, MGIC CEO Curt Culver stated confidently that the trend in future defaults will be highly correlated with the job market. He expects MGIC to emerge from the subprime disaster unscathed because the company did not overly expose shareholder capital to the riskiest mortgages. But this housing cycle went far beyond any past cycle. Near the peak of the housing bubble, a huge proportion of buyers were investors with no intention of ever moving into the homes they were buying. This inflated purchase prices and lowered the margin of safety for buyers actually intending to move in.

A great example of how merger accounting can misrepresent reality is the experience of Tyco International investors. Wall Street loved former CEO Dennis Kozlowski’s voracious appetite for acquisitions, hailing the company as the “next GE”. Until early 2002. Then, the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up. This rollup strategy included an accounting tactic called “bootstrapping earnings”: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy, “old economy” industries. After the books closed on these acquisitions, Tyco would automatically show higher earnings per share.

How was this wave of acquisitions treated on Tyco’s balance sheet? Whenever an acquiring company pays a premium above the target company’s tangible book value, the difference usually ends up as “goodwill”, an intangible asset on the acquirer’s balance sheet. Tyco’s intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001 – a big red flag. How could investors possibly asses the intrinsic value of the underlying businesses? Tyco is not a software company, in which nearly all assets are contained in minds of programmers and lines of code. As such, the explosion of intangible assets was not justified.

It turns out that a good chunk of Tyco’s performance in the 1990s was function of a virtuous feedback loop: high investor expectations led right back to even higher expectations as diagrammed here. Now, Tyco management is splitting up the company into separate operating units. Apparently, the magic of “synergies” no longer applies.

Tyco is an extreme example of the shenanigans that can occur behind the smoke screen of complex acquisition accounting. While Tyco is a portfolio of manufacturing businesses, New Century is a portfolio of subprime mortgages, and the new MGIC Radian will be a portfolio of insurance policies on $290 billion worth of home mortgages, they all share the common trait of being difficult to value. Merger accounting will make it even more difficult to value. MGIC and Radian both trade for 9-10 times earnings, so “bootstrapping” will not be a factor here. Changes to loss reserves are the factor that really moves the needle on EPS in the mortgage insurance business.

I would not be surprised to see MGIC management slip in an impairment charge or increase loss reserves as the MGIC and Radian financial statements join in holy matrimony. Merger accounting would provide a convenient diversion. I will be watching closely for management to update their accounting to match reality in the housing market.

LINEAR FORECASTING: THE CONFESSION

The Congressional Budget Office published a report this past November, titled “CBO’s Economic Forecasting Record”. The 46-page document was the CBO’s assessment of its own forecasting record from 1976 through 2004. I should note that I admire any person or group willing to perform a regular self-evaluation. The CBO’s look at its own work was from a conservative and heavily statistical perspective, not surprising for economists who do long-term macroeconomic forecasts. They made direct comparisons between their own accuracy and error rates and those of the OMB (Office of Management and Budget) and of the Blue Chip consensus (a private forecasting group). The CBO also evaluated possible bias in their forecasts.

Boiled down to a sentence, the report was downright clinical. That said, one thing definitely caught my eye. In a discussion of “The effects of business cycles,” the report said, “As the [CBO] track record shows, forecasters collectively tend to err during periods that include either turning points in the business cycle or significant shifts in the trend rate ... [CBO] forecast errors tend to be larger at turning points in the business cycle and when there are shifts in major economic trends.”

I find these acknowledgements to be amazing in for two reasons. First, it an implicit recognition that their methods and models are linear – they are simply not equipped to do much more than project today’s trend into tomorrow. But second and more importantly, all this brought to mind something Bob Prechter said years ago: “There is a subtle way to tell a potentially useful forecast from a useless one. Most published forecasts are at best descriptions of what already has happened. I never give any forecast a second thought unless it addresses the question of the point at which a change in trend may occur.”

NERVOUS WRECK OF A CENTURY

The Panic of 1893 occurred somewhere in the middle of a nearly a dozen financial panics that erupted between 1819 and 1929. That is an average of one every 10 years or so. As centuries go, that one was a nervous wreck. Each of these panics came before economic contractions and depressions. The Panic of 1893 was the worst economic crisis to hit the U.S. to that point, and the social mood that caused both the panic and the economic crisis was visible in U.S. and British societies in ways that are instructive today.

Science loses influence to magical thinking in periods of negative social mood. The Society for Psychical Research was founded in London in 1882 and had a Committee on Haunted Houses. Its membership grew rapidly and included leading British scientists, educators, writers and politicians. Doctors on both continents went broke as medical care became unaffordable and a “do-it-yourself” patent medicine industry expanded.

Advances in science had revealed the invisible forces of electricity and magnetism. The knowledge that Hertz’s electromagnetic waves could travel invisibly through the ether seemed to confirm the existence of another plane of reality. Marconi’s wireless communication across long distance appeared absolutely supernatural at the time.

Darwin’s theories had upset the Victorian religious world-view and caused some to embrace science as their new religion, and others to seek proof of the afterlife in spiritualism. In the mid-1890’s, as negative mood took hold, Britain had 150 Spiritualist societies, but by 1908 there were nearly 400. Families frightened themselves with Ouija boards. Holding séances became a common pastime. The era was notable for a rising discontent with the widening disparity between rich and poor. A clamor for the vote from the women’s suffrage movement was met by hostility.

Anarchism was the terrorism of that era, and spread throughout Europe. Two Italians were arrested for planning to blow up the Royal Stock Exchange, and an Italian man assassinated the president of France with a knife. French anarchists roamed London with their own guidebook.

The Panic of 1893 was an early move in what would be a Cycle degree bear market that culminated in World War I. Here is what The Wave Principle of Human Social Behavior said about the period: “Overall, World War I was a larger war than the associated bear market appears to have warranted. However, it was clearly preceded by a long bear market environment of increasing social frustration. The stock average in 1914 was little higher than it was in 1889, a full 25 years earlier. During that time, stock indexes had three major setbacks of 40% to 60%.”

Negative social behavior is always present in society, but during periods of negative social mood, the behaviors reach higher levels. The overall trend of human progress is up, but the long-term “wall of worry” is subject to some long-duration panic attacks. These nervous wrecks can affect more than just your finances.

SPILLOVER RISKS

One of today’s great paradoxes is the perceived lack of spillovers. Macro theory stresses interrelationships within economies, between markets, and across borders. Yet most financial market participants now believe in the theory of containment – that disruptions in one sector, one market, or even one economy can, in effect, be walled off from the rest of the system. Whether it is the bursting of the U.S. housing bubble, carnage in sub-prime mortgage lending, or a slowing of Chinese investment, these events are quickly labeled as “idiosyncratic” – unique one-off disturbances that are perceived to pose little or no threat to the larger whole. The longer a seemingly resilient world withstands such blows, the deeper the conviction that spillover risk has all but been banished from the scene. Therein lie the perils of a dangerous complacency.

The post-housing-bubble shakeout of the U.S. economy is an important case in point. There is little disagreement on the wrenching adjustments that have already unfolded in this sector – a 25% drop in new home sales, a 35% plunge in housing starts, a 16% annualized decline in homebuilding activity over the past three quarters, and a reduction of 110,000 jobs in the residential construction industry from its recent peak. But the broader U.S. economy barely flinched – at least, so far. Even in the face of a mild slowdown of 2.3% annualized real GDP growth in the two middle quarters of 2006, the economy still expanded by 3.4% over the four quarters as a whole. Such are the footprints of what many call the “two tier” economy – a weak housing sector (maybe autos too) accompanied by persistent resilience elsewhere.

I do not question the facts as they have unfolded – other than noting the obvious distortions to seasonally adjusted construction data during periods of unusually warm winter weather. What I do question is the conclusion that this shakeout is not likely to have significant spillover effects on the broader U.S. economy. The most obvious candidate remains the seemingly invincible American consumer, whose real spending growth accelerated to a brisk 4.4% annualized clip in the final period of 2006. I continue to cling to the seemingly discredited notion that it is only a matter of time before the consumer responds to the carnage in the U.S. housing market. The bulk of the income effects are yet to come. As building activity is brought down into alignment with now depressed rates of new home sales and housing starts, commensurate adjustments can be expected in labor input. If that occurs, consumers will be squeezed by the coming housing-related shortfall of purchasing power.

Asset effects are also likely to keep putting pressure on American consumers. A personal saving rate that has now been in negative territory for two years in a row leaves little doubt of the asset-dependent support to U.S. consumption. With nationwide house price appreciation now slowing dramatically, and likely to slow a good deal further in the months ahead, consumers will have considerably less in the way of excess asset appreciation that can be used to support spending and saving. Net equity extraction from residential property has already fallen from 8.5% of disposable personal income in late 2005 to 6.5% in late 2006. That is especially worrisome with debt ratios at record highs and income-based saving rates at record lows.

Looking through the noise of energy-related gyrations to headline prices and inflation-adjusted household purchasing power, I remain highly skeptical of the consumer resilience call in a post-housing-bubble climate. And if the consumer finally fades, as I suspect, capital spending will be quick to go as well. I draw no comfort from ever-abundant coffers of corporate cash flow. If the demand outlook turns shaky due to spillover effects from housing to consumption, businesses will rethink expectations of future pressures on capacity utilization – and cut back plans to expand capacity accordingly.

There is also an important financial dimension to the spillover debate – underscored by the rapidly evolving carnage in America’s sub-prime mortgage lending business. Like virtually every other credit event that has unfolded in the past several years, our credit strategists have been quick to label the sub-prime mortgage problem as idiosyncratic. While spreads have blown out in this relatively small segment of the U.S. mortgage market, spreads for higher rated mortgage credits have been largely unaffected. Again, I do not dispute the facts as they have unfolded so far. My problem comes in extrapolating this resilience into the future. With resets on floating rate mortgages likely to put debt service obligations on a rising path for already overly-indebted U.S. homeowners, the case for increased default rates and collateral damage on prime mortgage lenders looks increasingly worrisome. Indeed, as the recent warning from HSBC just indicated, it is not just the small specialized lenders that are now being hit. Spillover effects are quickly moving up the quality scale on the financial side of the post-housing-bubble shakeout story, and their potential for impacts on the broader economy can hardly be dismissed out of hand.

Halfway around the world, a comparable issue is evident with respect to the Chinese investment slowdown. There can be little disputing the facts of a major slowing of Chinese investment activity – a year-over-year growth rate that was running at close to 30% at the start of 2006 but that ended the year at 14%. Notwithstanding this, most still believe nothing can stop China’s growth juggernaut. However, with investment easily the largest sector of the Chinese economy – close to 45% of total GDP in 2006 – it is almost mathematically impossible for sharply slower investment growth not to have impacts on the broader economy. While 15% growth in industrial output is still quite vigorous, it does represent a meaningful cooling off from earlier overheated gains.

I take the recent softening of commodity markets as further validation of the spillover effects of China’s investment slowdown. With China accounting for about 50% of the cumulative increase in global consumption of base metals and oil since 2002 – fully 10 times its 5% share of world GDP – a China slowdown represents a very important development on the demand side of economically sensitive commodity markets. And as Chinese investment slows, cross-border impacts are likely in the other big economies of Asia – especially Japan, Korea, and Taiwan. Similar ripple effects should be felt by China’s natural resource providers – especially Australia, Brazil, Canada, and parts of Africa. It is difficult to see how a meaningful deceleration in the global economy’s major source of economic growth will not produce significant collateral damage elsewhere in the world.

Modern-day macro is a theory of interdependence – linkages both within and between economies. Spillovers are the norm, not the exception. Consequently, if an economy is hit with a major shock – like the bursting of the U.S. housing bubble or a cooling off of Chinawts investment surge – it is very difficult to contain the damage before it spreads elsewhere in the global macro system. It would take an acceleration of growth in the resilient sector(s) to offset the impacts of slower growth in the shocked sector – highly unlikely for either the U.S. or China.

The biggest risk of all may be the geopolitical spillover. Middle East security expert Kenneth Pollock underscored the risk of cross-border spillovers in the aftermath of civil wars. He argues that was true in the case of recent civil wars in Afghanistan, the Congo, Lebanon, Somalia, and Yugoslavia, and could well occur in response to the current civil war in Iraq. Pollack warned that as Iraq veers out of control, pan-regional spillover effects in Iran, Israel, Saudi Arabia, Jordan, Kuwait, and Turkey could well be unavoidable. Such a possibility could not only further destabilize an already volatile part of the world but could wreak havoc with oil prices and the broader global economy.

Financial markets have learned to shrug off spillover risks in recent years. An ample cushion of excess liquidity has been key in defusing the potential impacts of massive current account imbalances, soaring oil prices, the bursting of the equity bubble, and an escalation of terrorist activity. Most investors are now of the view that spillover risk is inconsequential for such a Teflon-like world. History does not treat such complacency kindly.