Finance Digest for Week of March 26, 2007

SHOULD YOU STILL BUY VALUE STOCKS?

After a 7-year run value stocks are pricier than ever. When it is Jeremy Grantham saying that, it is time to think about buying growth stocks instead.

At the end of the 20th century some starry-eyed investors spied the dawn of a new paradigm. Technology, productivity and the Internet knew no bounds, and so it was impossible to pay too much for a stock like Amazon.com or Cisco. Meanwhile, value stocks – those trading at low multiples of sales or book value – languished.

Today the situation has reversed. Everyone, it seems, is a fan of value. What does that tell you? Probably that you should sell value stocks and buy something else – namely, growth stocks. You pay extra, of course, for companies with better prospects, but not much extra. In today’s market, traditional growth companies like Microsoft and Johnson & Johnson are comparative bargains.

For evidence that value stocks are overbought we can find no better witness than Jeremy Grantham, a famous fan of the genre. A fan, that is, when value is indeed cheap. But it is not cheap now, he says. Grantham is the professorial chairman of Boston money management firm GMO. He knows from experience that growth and value spurts tend to run in 5- to 7-year cycles, and it is time for a change. “The last time one market segment won this consistently was growth’s final run from 1999 into early 2000,” he says. “And we don’t have to tell you how that party ended.”

Grantham, 67, called the end of the 1990s tech bubble before it burst, and then he forecast the current heyday of value stocks. Grantham’s firm ($141 billion under management) has a stellar record managing money, mainly for institutions and a few wealthy folks. GMO has a handful of high-performing mutual funds, but with minimum investments of $10 million, they are out of the reach of most. Over the past five years, amid broad popularity of foreign investments, GMO International Intrinsic Value II clocked a 19.5% annual return, beating its benchmark, the MSCI Europe Australasia Far East index, by 4.9 percentage points. Its U.S. Intrinsic Value III portfolio had a respectable five-year annual return of 6.7%.

You have to admire GMO’s devotion to the number crunching that is the basis for its success. In 2001 GMO called the market turn by comparing the average price/book ratio of the 125 S&P stocks that had the lowest such ratios with the index as a whole. The historic average ratio for the bottom quartile is just over half that of the whole index. Then as the tech bubble burst, the lowest quartile averaged just one-quarter of it, which looked like a bottoming and heralded a turnaround.

If you had followed Grantham’s advice back in 2001, you would be content. He saw double-digit growth ahead for small and midsize value stocks, and that is exactly what happened (see chart). Value funds specializing in companies with small (averaging $1.5 billion) market capitalizations returned 13.6% annualized over the past five years, and midcap value reaped 13.4%. Large-cap value did not do as well as its smaller brethren (8.2%) because it has become a repository for onetime hot-growth companies like GE and Pfizer, which have joined the value ranks as their once towering P/Es shrank. Over the past five years small and medium-size growth companies returned more like 8% annually. Large-cap growth, by comparison, returned a miserly 3.4% annually during that time.

Grantham uses the same methodology as he did earlier in the decade to conclude that today’s value stocks are way overpriced. THe average price/book ratios for the cheapest 125 S&P stocks (in P/Book) are now at 65% of S&P’s P/Book. Moreover, value stocks are not only expensive relative to 2001, they are more expensive than at any time over the past 40 years. “Low price/book stocks do not win by some divine right,” says Sam J. Wilderman, a GMO partner. “They win when they are priced to win, and they have never been this rich.”

Small-company value stocks are riskier than the large company value because the small ones tend to have less stable returns and lower profit margins. Grantham warns that midcap value names are the riskiest yet, because so many investors took part in the small-stock boom that they have bloated the market value of a lot of smaller firms (small in revenues, employee count and so on) into the midcap range.

The explanation for the mid- and small-cap craze, says Grantham, is that the business climate of the past few years – featuring high consumption, high global growth in economic output and fat profit margins – has been so strong that it has spilled over to smaller companies. Their suddenly robust financial performance attracts inordinate Wall Street interest, especially for the relatively cheap small stocks. “So their profit margins have gone up more than the Mercks, the Eli Lillys and the General Electrics.”

What should an investor do? Search for buys in the lagging large-company growth category (see “The New Value Stocks” table). Stocks like Microsoft and Dell look like buys, given their earnings growth and their past P/Es. Lately the strategy of GMO’s U.S. value fund has been to take advantage of a change in the value game board. It tilts away from value stocks that have become overpriced and favors ones that have fallen from the growth category. Since few investors can afford a GMO fund, we have collected some alternatives.

The Yacktman Fund holds some dispirited names that could come back. Returning 12.5% annualized over the past five years, it easily bests the S&P 500. The fund’s leading holding is Coca-Cola, making up 9% of its net assets. The soda giant’s $48 share price is $10 less than in late 1999. The P/E has also slumped from 59 to 22. Sounds like a buy. In addition, the fund holds once lofty Microsoft.

On the other hand, in 1999 Boeing, Federated Department Stores and Harrah’s Entertainment were genuine value stocks, with P/Es ratios half the market’s 30. Now they are all trading at P/Es above the market’s average P/E of 17. For the moment their prospects look good. Boeing is enjoying a surge in airplane orders, Federated a revival at Macy’s, Harrah’s a boom in casino traffic. But do not expect their premium P/Es to last. The best idea? Sell now.

STOCK PICKING IS NEVER OUT OF STYLE

Small-cap fund managers are getting kind of antsy. And who can blame them? Small-cap funds have been performing well against the competition for years now. If you look back five years at all the domestic stock fund categories of mutual funds, small-cap value and small-cap blend are ranked as the 4th and 5th best-performing fund categories over that period. Only real estate, natural resources, and utilities did better. The average returns of funds in those two small-cap categories were 12% and 11%. Looking at the last three years, small-caps slipped in the rankings. Small-cap value and small-cap blend were 6th and 8th, respectively, but still posted strong returns.

The overall small-cap market was outstanding in 2006, though. The Russell 2000 Small-Cap Index was up 18.4% for the year. But that return masked a precipitous drop in the second half of the year, and now in 2007, the Index is only up 0.97%. We are not surprised that the Russell is barely above breakeven right now. Small-caps tend to prosper in times of economic growth, and lag when times are bad. And the signs for bad times are scaring everyone at the moment.

So, what does it mean for those of us devoted to the world of small-cap stocks? Well, not much really. You will hear many pundits advising investors to rotate out of a portion of small-caps into a greater portion of larger capitalization stocks. Our advice would be to continue buying the greatest stocks at deep values. Period. Over the long term, small-caps have a record of outpacing most other asset classes. But now, stock picking is critically important.

BENCHMARKS FOR GLOBAL MARKETS

How much money are you really making if your portfolio “beats the market”? When you break down the one, three and five-year returns of the 53 most established world markets, the results are appalling. Take the S&P 500, the world’s benchmark index. Beating the S&P has become like a golfing handicap, a number that gets bandied about (and maybe embellished a point or two) to impress any financial “mind” polite enough to listen.

For most, investing has become a game. The goal is simple: beat the S&P. But why does the S&P serve as the lone benchmark? What are these guys winning at our expense? When annualized returns are stacked up against one another, beating the S&P looks about as impressive as the #1 seeded North Carolina Tar Heels blowing out the #16 seeded Eastern Kentucky Colonels in the opening round of the NCAA tournament.

When an emerging markets manager pounds the fundraising pavement, why must he validate his investing success relative to one particular market? And why do we applaud an achievement that has zero correlation to the underlying investment in question? If Taipan Capital Management’s 20% return stems from 6 small-cap Thai stocks, why should we care if these returns beat the American index? That is a mistake.

If a private investor in Belgium or a money manager in Germany has made 80% investing on the Cairo exchange, then that is the standard that Wall Street should be measuring itself against, not the 9.82% 5-year return of U.S. exchanges. It is time for a different benchmark of success, whether we like it or not ...

IS IT TIME FOR A BOLD BET AGAINST THE MARKET?

In recent months two dozen subprime mortgage lenders have closed, failed or sold themselves in desperation. Home-building stocks have sunk again. And that favorite target of U.S.-economy Cassandras – retail stocks – have dropped on news that the indebted, inexhaustible consumer slowed his spending in February. But before you call your broker, remember that even the most prescient pessimists have lost big bucks going negative too early.

Prem Watsa, the head of insurer Fairfax Financial, made money betting against the U.S. stock market before it crashed in 1987, and again in 2000. Now he sees a credit crack-up coming. He is betting $276 million that spreads on credit default swaps will widen as delinquencies rise, and, indeed, that has happened recently. One problem: Watsa made the bet a few years ago and is 74% underwater.

Julian Robertson closed his hedge fund in March 2000 after two years of losses betting against tech stocks. Nasdaq began its long, sickening fall the next month. Larry Tisch, the late chief of conglomerate Loews (LTR) shorted the S&P 500 for several years in the late 1990s – then took his bet off and booked a $2.5 billion loss. Shortly afterwards the S&P began its dive.

Fidelity Magellan chief Jeffrey Vinik shifted 30% of the fund’s assets into cash and bonds. Stocks kept rising, and he resigned in disgrace. Within a month stocks dropped, bonds rose. Robert Wilson shorted Atlantic City pioneer Resorts International in 1978 on a hunch that profits at the casino would fall. They did – much later. He lost $10 million. Resorts, teetering on bankruptcy a decade later, was carved up by rivals.

THE DUCKS ARE QUACKING ON WALL STREET

Craig McCaw is having good luck with his timing this time around. In early March the wireless mogul dove between two market swoons to raise $600 million in an IPO for a high-speed, over-the-air data service called Clearwire that is supposed to break the broadband duopoly of cable and telephone companies. The Clearwire deal is classic McCaw: a futuristic technology fueled by a guy with a grand vision of the future but not too much focus on the bottom line. Investors went for the vision, buying 24 million shares at $25, the high end of their estimated range. Clearwire’s market valuation hovers near $3 billion, or 30 times revenue. McCaw’s 35% stake is worth $1.1 billion.

It took a few hours, but investors finally did take a gander at the profit-and-loss statement. Clearwire lost $284 million last year on $100 million in revenue, and the company is burning through cash faster than it can raise it. The shares are down 20% from their offering price. McCaw could still call it a victory, particularly given his spotty history and Clearwire’s iffy prospects. The losers may be us, a public suddenly so hot for growthy tech stocks that quality standards are starting to slip. Echoing the addled exuberance of 1999, the last few months have seen a dramatic rise in the share of moneylosing companies among all those seeking to sell shares to the public.

THE IRRELEVANT FEDERAL RESERVE

Milton Friedman won his Nobel Prize for demonstrating the centrality of monetary policy to an economy. As a profound believer in monetarism, I would be the last to question his wisdom. Nevertheless, there are times when other economic events have made any politically feasible monetary policy entirely irrelevant. In the U.S., we now appear to have arrived at such a time.

However misguided its policy, the Fed certainly cannot be said to have been irrelevant over the last decade. In 1995-2000, even after recognizing the dangers of an excessive speculative bubble, Alan Greenspan’s Fed continued to expand the money supply, and allowed the U.S. stock market to inflate to a level unparalleled in world history, more bubbly than 1929, more bubbly than the South Sea Bubble itself, and matched on a smaller scale only by the Japanese property and stock market craziness of the late 1980s.

Then after the stock market bubble burst in 2000, instead of allowing the market to deflate to a level at which it was once more properly valued, Greenspan pumped further liquidity into the system, reducing short term rates to a 1% level at which they were heavily negative in real terms. This created a housing and low quality mortgage bubble that was in some respects even larger than the stock market bubble, producing house prices in real terms far above those ever seen in the land-rich U.S., and leading to a mortgage default downturn of which we have only seen the barest beginning.

Nevertheless, at this point, the Fed has ceased to have any influence. Loose money, sustained for a decade, has produced bubbles in stocks and housing, both of which have been followed by damaging downturns, with much destruction of wealth. Having been overdosed with the drug of easy money, the U.S. economy has now become more or less immune to its effects, so that only a spectacular loosening or tightening of monetary policy by the Fed would be likely to affect an economic future that in most respects appears to be “baked in”.

Fed can neither raise interest rates nor lower them.

On the housing side, the sub-prime mortgage market has collapsed and no amount of Fed money creation, short of handing out $25,000 to every sub-prime borrower, is going to change that. Square miles of trees are being cut down to print editorials claiming that the sub-prime mortgage market is tiny, and will affect no other part of the economy. This is nonsense. The estimate given here two weeks ago of $980 billion in actual loan losses (which would represent well over $1.5 trillion of defaults) is looking increasingly realistic. Nothing the Fed can plausibly do at this stage will affect this, and it will inevitably cause a deep and grinding recession.

On the other side of the coin, I have been arguing for half a decade that the Fed should raise the Federal Funds rate to around 8%, the minimum level necessary to combat inflation which, when you correct for the distorted U.S. price statistics, is over 4% and rising. Without such a rise, real interest rates will remain below their equilibrium level and inflation will continue trending upwards. Does anyone believe the Fed will actually do this? If it did, it would simply be blamed for a housing collapse and an economic recession that are inevitable anyway.

Even in 1979, after several years of rapidly increasing inflation, with a predecessor railroaded out of office and with a President generally held to be economically inept if not illiterate, it took great political courage for Fed Chairman Paul Volcker to raise interest rates sharply and conquer inflation. He was further helped by the election victory of Ronald Reagan halfway through the process, and even then pressure against him from the new Administration was building up dangerously towards the end. If Jimmy Carter had won the 1980 election Volcker would have been forced to abandon the fight against inflation halfway. After all, the Federal Funds rate reached 19.3% and even 10 year Treasuries came to yield 15.3% before the process was completed.

Looser money will not help housing, but will flow into commodities and speculative finance.

It is in any case likely that the Fed’s next interest rate move will be downwards. This will do nothing for the housing sector, beyond slowing its decline somewhat. The inventory of unsold homes is too great, the downward momentum in prices too well established, and the number of unsound mortgages that will turn into defaults simply by the passage of time too extraordinary for housing to recover in any but the longest timeframe. While it does nothing for housing, a drop in interest rates, and the consequential further loosening in money, will flow instead to the sectors that are most eager for it.

Today there are two such sectors, the “alternative investments” world of speculative private equity funds and hedge funds, and commodities. More money into commodities (not to speak of Elvis memorabilia and other collectibles) will simply accelerate inflation further, until even Ben Bernanke has to do something about it. The effect of directing more money into hedge funds and private equity funds is more pernicious. Hedge funds have destabilized the world financial market, leaving it perilously vulnerable to the collapse of one of their many speculative shell games (such as the yen carry trade, apparently endangered earlier this month.) Private equity funds are doing even more damage, by breaking up stable and profitable companies, leaving them vulnerable to the next downturn and bereft of their better people and much of their long term assets. There can be no possible economic benefit, for example, in a breakup of Cadbury Schweppes, an icon of British quality, simply to satisfy the ravening maw of the aging raider Nelson Peltz, whose track record is long but distinguished only by the corporate mayhem he has wreaked.

It is possible that a sharp rise in inflation over the next few months will cause the Fed to reverse its perennial tendency towards monetary easing and raise short term rates but so what? If it moves interest rates 1/4 point at a time, it will not catch up with accelerating inflation, whereas even the first such move will be used by politicians and witless homeowners to blame it for the chaos in housing. It is thus not surprising that the Fed has not done anything for the last six meetings. Indeed there is very little point in its meeting at all, since it cannot move interest rates either way without getting blamed either for worsening inflation or the housing collapse, both of which are its fault, but only on a long term view.

You have to go way back to 1837 to find comparably catastrophic monetary policy errors.

Believers in the Gold Standard will tell you that the U.S. economy would be much better off with a fixed monetary base and no Fed. That may very well be so, but today we have the worst of both worlds, a Fed which is paralyzed, unable to act usefully in either direction, but whose past misdeeds are leading to a uniquely malign combination of deep recession and accelerating inflation.

The Great Depression was worse, but with all due respect to Friedman and Anna Schwarz’s Monetary History of the United States the Fed was only partly responsible for that. Yes, it contracted money supply after the failure of the Bank of the United States in December 1930. However the Fed did not pass the protectionist Smoot-Hawley tariff, nor was it responsible for the completely counterproductive and highly damaging income tax increase (the top marginal rate rising from 25% to 63%) passed by the lunatic Herbert Hoover at the bottom of a deep recession in 1932.

A closer parallel is the Panic of 1837, lost to memory in the mists of U.S. history, but unquestionably longer and more unpleasant than any recession other than the Great Depression. That was caused by Andrew Jackson’s defeat of the Second Bank of the United States, which balkanized the U.S. monetary system after the economy had been constructed on the basis of a central monetary authority and a single currency freely available throughout the growing country.

From 1837 until the National Banking Act of 1862, the United States effectively did not have a single currency. No central authority existed to print banknotes, and gold was scarce, so banks were forced to issue their own notes, and to take the notes of distant banks in payment – naturally, notes of rural banks were accepted only at a heavy discount. Without a common currency, trade was stifled, resulting in a recession that rivaled the Great Depression in depth and lasted for eight years. It is a sobering thought that when the currently pending problems have fully hit we may have to go back 170 years to find monetary policy errors equaling those of Fed Chairmen Greenspan and Bernanke.

Don’t uncork the Champagne just yet.

By omitting a few key words from their most recent statement, the Fed led Wall Street to the premature conclusion that the next move in interest rates will be down. With the economy clearly headed for recession, there is no doubt that the Fed would like nothing more than to do just that. However, given that it wants to pretend otherwise, and considering the damage it would do to the already shaky U.S. dollar, an actually rate cut seems highly suspect.

Rather than offering a true assessment of the current economy, the official statement that follows Fed meetings has become a political farce used primarily to placate markets. For the bond market and the dollar, the Fed pretends that inflation is still under control, and that the Fed remains poised to snuff out any inflationary sparks should they appear. For Wall Street, the housing markets, and the economy in general, the Fed pretends that the economic expansion will continue, but shows mild concern that growth might falter.

If the Fed were to admit that the economy was in trouble, the stock market would sell off, led lower by a collapse in the dollar and a potential spike in long-term interest rates. With its parsed language, the Fed preserves the pretense that all is well while simultaneously allowing for the possibility of future easing.

One of the biggest bones the Fed threw to the markets in its last statement was its failure to directly mention the problems developing in the mortgage market. This omission suggests that the Fed is not overly concerned with the subprime crisis, or the possibility of that weakness spreading into the broader mortgage market or the economy in general. In other words, a problem is not a problem until the Fed says it is. This ignores the fact that the Fed is reluctant to actually identify a problem, no matter how severe, for fear that such recognition alone might spark an even greater panic.

So with the apparent blessing of the Fed, Wall Street can now borrow a page from the Las Vegas promotional playbook and claim that “what happens in sub-prime stays in sub-prime.” Unfortunately, like an out of work showgirl with a folder full of embarrassing photos, the problems with subprime will soon show up on everyone’s doorstep. Think of the Fed as a juggler trying to keep five balls in the air simultaneously. Those balls are the stock market, the bond market, the dollar, the housing market, and the economy. If the Fed tells the truth, all the balls will come crashing down. So it says what it needs to say to keep them all in play. However, my guess is the first ball to fall will be the dollar. Once the dollar breaks down the bond market ball will be that much more difficult to keep aloft. Once it falls, the rest will soon follow.

The bottom line is that waiting for the next rate cut is going to be a lot like waiting for Godot. The Fed wants everyone to think one is coming, but will likely never deliver the goods. If I am wrong and the Fed actually does cut, expect the easing cycle to be extremely short-lived, as an embarrassed Fed will be forced by the bond and currency markets to quickly reverse course.

GOLD SHARES IN A VOLATILE STOCK MARKET

While we remain extremely bullish on gold, it is important, even critical, to keep in mind that bull markets make anyone on the right side of the trade think they are smarter than they actually are. Consequently, it is when things are really going in your favor – as they have these many years now for anyone early into gold – that you have to be most on guard, because pride really does come before the fall. For proof of that contention, just think of those people you know who were profitably early into the dot-com bubble but failed to sell when the selling was good.

So, being on guard, I thought it worth revisiting the question of how gold stocks perform in a broader stock market crash. As you can see from the chart below, while gold stocks and the broader markets, represented by the S&P 500, can move together, they can also move in distinctly different directions. Look especially at the time period around the last big stock market meltdown in 2000.

While there were spikes in the volatility of gold stocks during the period, the general trend for gold stocks was solidly up ... at the same time that the general trend in broader stock indices was decidedly down. It is also worth noting that while the market suffered a solid thwapping (a technical term meaning a hard slap up the side of the head) during this period, the thwapping was not related to a monetary crisis, nor even any particularly dire economic fundamentals, but rather the panicked unwinding of a speculative bubble in dot-com stocks. By contrast, the crisis now closing in on us is all about a monetary meltdown ... a set-up that can only favor gold. Even so, the picture above paints a pretty clear picture of gold’s – and gold stock’s – role in a market crisis.

GOLDEN RULE: LOOKING FOR PROFITS IN ALL THE RIGHT PLACES

As a commodities trader for over 20 years, I have seen markets come and go. What is hot this month can often become what is not hot the next. One of the best skills a commodity trader can acquire is to be able to pick out the markets that are on the cusp of breaking out, and then get out of those markets before they fizzle. In the last few years, this ability has become even more difficult with the onset of electronic trading and myriad new commodity contracts, ETFs and hedge funds. Even so, some of the markets that have been around since futures contracts began are still the most viable and ultimately profitable. One of those markets is the precious metals, especially gold.

Late in 2006, I was visiting friends on the floor of the New York Mercantile Exchange silver pit. That day they were launching the electronic version of the gold and silver futures on the exchange. Since then, the electronic markets have virtually taken over and dried up liquidity in the open outcry trading pits. This is not because interest in the gold markets has waned – far from it. The reason is because interest has increased exponentially and the electronic markets make it even more attractive to a much broader segment of global investors.

Another major occurrence for gold’s growth has been the emergence of gold ETFs. These investment vehicles have allowed investors of all backgrounds to buy physical gold with the same ease with which they would buy a mutual fund. It is fair to say that with these new investment methods, gold has become even more attractive as money.

Lately, many investors are asking themselves the question is gold a buy-and-sell investment or a buy-and-hold for the long term? This very question may have been answered during the recent collapse of the markets. ETF trading was volatile, to say the least, but if we really look at what happened, there was no widespread sell-off of gold holdings in the ETFs. That would seem to indicate that a very large percentage of investors are using them as part of a buy-and-hold strategy. he recent pullback in gold was quickly made up as the broader market recovered, and that is a clear indication that the yellow metal may well be on the upswing of a new bull market.

One of the most important things for an investor these days is to be well diversified. A diversified asset base is key to long-term growth, period. And having a diverse portfolio means that it includes precious metals. In my opinion, gold will end up doing what it has always been known to do – gain in value over the longer term. Now that much of the fear about the yen carry trade and housing implosion is figured into the market, the long-term outlook for gold is shining bright.

FILTERING OUT THE NOISE

Sometimes when I turn the TV on and listen to the commentators talk about commodities I cringe. For years the media treated commodities as a secondary asset class, or worse, a form of legalized gambling. To some extent they still do. Their understanding of how the markets actually function is rudimentary at best. Some of these journalists are brilliant. They just do not understand how the commodities markets work.

I actually make use of the media and information superhighway every day. While I have colleagues who are deep philosophical thinkers who do not even own a TV, I have five computer screens in my office and two televisions. Does this make me non-philosophical and obtuse? No, because most of the time I keep the volume on the TV down, which improves my IQ immensely. Distractions of any sort when trading can be of little or no value. The TV blaring opinions that change moment-to-moment can be one of a trader’s most useless tools. I also feel that staring at a trading screen all day long is useless.

Markets move up and down and when they move against you, when the screen is totally red, emotion can creep in, and we all know how detrimental that can be. I suggest sometimes that you simply switch off the screen and do something else. Pet the dog, make a sandwich, go to the gym, make another sandwich ... My point is to leave the scene and clear your head, then come back and decide what to do. You may be amazed at what you find when you return!

Truthfully, the media can be an invaluable source of new information and also a good contra-indicator. In other words, if everyone on TV or in the press is talking about how strong copper is, or crude oil, it may be time to look for a downside move, not always, but sometimes. My advice is to use the news and information as a resource. Pull out what you need and leave the rest behind. The best plan is to pick one or two trusted information sources, then lay out your own disciplined game plan and stick to it. Alter it occasionally but never stray too far or too fast. You can always hit the TV’s mute button. You will preserve more of your sanity if you tune out all of the opinion and stick with the facts on which you should have based your trades in the first place.

In the world of commodities, figuring out which data NOT to look at can be just as important as knowing what you absolutely must follow on a regular basis. Each commodity is different. Certain reports carry more weight with traders than others. In addition, as a market changes and matures, certain reports may lose their relevance and new ones may come into play. For example, back when I started in the crude oil markets, everyone followed the American Petroleum Institute report (API), the benchmark report for oil inventories. Not anymore. These days, traders monitor the Energy Information Agency (EIA) report.

Key government reports have been around for as long as the markets and they rarely change. Unemployment numbers, trade deficit, GDP, consumer sentiment. These all are major indicators of the state of the economy, and traders should know when these numbers are going to be announced or published. Announcements here impact almost all markets, even the global ones.

I have found that the hardest part about any information or number is not only understanding what it means but, more importantly, anticipating how the markets will react to the data. The second part of this equation is a thousand times more difficult than the first. Commodities trading is like one big chess game. I advise being the knight, not a pawn. You always need to be flexible and agile when trading “off of the numbers.” Remember not to get tunnel vision and do not fight the trend after a number, chances are very good that the trend will win.

“Buy the rumor, sell the news” is a common traders’ saying, and for good reason. But once again this is not always the best advice. Sometimes what happens is that the markets will already “price in” the anticipated data. Another favorite old-time saying I used to hear was, “Those who trade headlines end up selling newspapers.” Here are some of the key reports professional traders follow ...

Like any tool in our trading toolbox, these reports can help us make an educated trading decision, but remember they are only one tool. Putting all of your eggs in one basket is never a good idea. Take the numbers with a grain of salt and try to anticipate how the market will react to any given number release. It is a good rule of thumb to be on the sidelines for any major announcement because trading ahead of a number is highly risky and often very unpredictable, but then again that is what many investors want. As you gain experience, you will be able to see where you want to be.

WHAT WiMAX, GIRLIE CALENDARS AND 17,457% RETURNS HAVE IN COMMON

It is the dream of every penny stock and small-cap investor. Actually, it is the dream of every investor, period. And it looks something like this. This is what can happen when a small WiMAX company (a provider of commercial internet access using fixed-wireless technology) does a reverse merger, or goes public through an acquisition. In this case, Towerstream (TWER.OB: OTC BB) of Rhode Island went public in a very stealthy manner – buying the assets of a miniscule publisher of calendars of female models, University Girls Calendar, Ltd. (formerly UGIR). The main reasons a company would go public through a reverse merger is that they are quick and cheap. The whole thing can be wrapped up in a month and only costs $100,000 in fees.

Under the calendar business model, this stock literally traded for 66 cents a share. That is the level UGIR shares were the day before Towerstream took over and the stock became TWER, and immediately opened at $6.00 a share. During the same trading session, TWER ran even higher, reaching $11 per share. I hate to look at hypothetical investment situations. It is too much like wondering what would have happened if you bought a winning lottery ticket. But looking at a hypothetical situation like that is not exactly pointless. That is just how some investment banks have opted to get paid for advising on reverse merger deals like this one. They have been able to buy shares before the deal closes, knowing what the new entity will be worth.

So what about Towerstream today? Is it fully valued? Is it a bargain? It stock is to watch, but there are many reasons not to buy it now.

THE SMOOTH FLOW OF CREDIT

The smooth flow of credit is “essential for a healthy economy,” Federal Reserve Chairman Ben Bernanke said last week. Chairman Bernanke made this fundamental point at the opening of the Richmond Fed’s 2007 Credit Market Symposium. Unfortunately, the critical role of the “smooth flow of Credit” receives scant attention these days in the age of perceived perpetual liquidity abundance. Instead, modern finance is today fixated on derivatives and the capacity for these instruments to effectively transfer and disburse risks. Little heed is paid to how profoundly derivatives and Wall Street “structured finance” impact the scope, directional flow and stability of finance through securities and asset markets and real economies.

Fundamental to the “smooth flow of Credit”/finance is the nebulous issue of liquidity. The liquidity issue was central to presentations at this year’s Credit Market Symposium, and Fed governor Jeffrey Lacker opened a panel discussion on “Liquidity risk in Credit markets” with a definition:

“As a monetary and banking economist, I often wince at the word ‘Liquidity’. It’s a notoriously difficult word or concept to define crisply. It is a word and set of ideas that’s thrown around with abandon, especially in the financial press. ... it is never obvious what that means beside interest-rates are low ... In the context of credit markets ... I will offer this [definition] ... It has to do with the risk of the price you will get from trying to sell the stuff you have got ... The risk that it is not the price you want.”

While defining Liquidity is no easy task, it is one of those “I know it when you see it” things. I would also argue that, these days, the more important analytical focus should be with the myriad risks associated with excessive (inflationary) buying power rather than prospective markdown risks from asset liquidations. Certainly, there should be no disputing the extraordinary U.S. and global markets liquidity backdrop. Despite the Fed having raised interest rates 17 times in two years, the capacity to aggressively expand credit – especially riskier loans – with minimal impact on its price (or risk premiums actually declining!), along with the wherewithal to significantly bid up global asset prices, only increased over time. Markets became more “liquid”.

The source of the buying power – the “liquidity” – is not all that ambiguous. We are coming off another year of record U.S. credit and current account deficit growth, along with synchronized robust credit expansions ongoing across the globe. Here at home, the financial sector continues to expand at double-digit rates and, in fact, growth notably accelerated late last year. It is worth noting that primary dealer “repo” positions, as reported by the New York Fed, have increased about $280 billion y-t-d (to a record $3.73 trillion). Global central bank balance sheets are experiencing unprecedented expansion. This ballooning also having accelerated as of late. Additionally, there is little indication that the global leveraged speculating community has toned down its aggressive posture or that the boom in global derivative markets has begun to wane – subprime notwithstanding.

Such rampant credit expansion certainly creates the appearance of a fluid and well-functioning system. The key challenge for policymakers is not to extrapolate current liquidity abundance – as evidenced by narrow bid/ask spreads and meager risk premia – but to work diligently to assess the stability and sustainability of current financial Flows. Indeed, acute credit excess and accompanying aggressive risk embracement are too often precursors for an abrupt reversal of financial flows and impending liquidity dislocation (e.g., subprime). And how can a boom in credit derivatives (doubled each year for the past five years to $20 trillion) not be quite alarming? Fundamentally, any facet of Financial Sphere growth of such magnitude should be analyzed with great judiciousness.

That derivatives allegedly neither add to nor subtract from the stock of financial risk in the economy, but rather just redistribute it, is a fundamental analytical flaw carried forward from the Greenspan era. The Fed may disregard reality, but derivatives clearly foster heightened risk-taking, speculative leveraging, financial credit growth, and credit excess, generally. And ballooning derivatives markets have become absolutely fundamental to liquidity (over)abundance. They certainly facilitate the transfer of risk, but they tend to fashion a dramatically unsmooth flow of credit, while transferring credit and market risk to participants with little willingness or capacity to absorb the type of losses induced by severe market declines. Clearly, derivatives were integral to the flood of finance into the subprime mortgage space. Marketplace risk perceptions were drastically distorted during the boom, and we are certainly seeing similar dynamics at play today throughout corporate and M&A finance.

I acknowledge the notion that derivatives and other credit market innovations work to make markets both more efficient and more resilient and that they help allocate capital to its highest return. I just adamantly disagree. Analytically, I would instead stress the proposition that credit and speculative excesses foremost inherently distort market pricing mechanisms. The process of ongoing excess promotes, throughout the Financial Sphere, unsustainable financial flows, unrealistic expectations, and increasingly weak and susceptible debt structures. In the Economic Sphere, the inflationary process promotes a misallocation of resources and structural maladjustment. The focus on “liquidity” should be with its distorting inflationary effects during the boom and not the inevitable price markdowns experienced with the onset of the bust. Contemporary finance has mastered the art of incredibly efficient credit expansion and incredibly efficient leveraged speculation, but at the (surreptitious) expense of market efficiency.

Perceptions that contemporary finance enables highly effective risk management have been instrumental in fomenting the credit boom. And, importantly, the expansion of financial sector assets and liabilities is at the epicenter of system liquidity creation, liquidity abundance that has flowed with great inflationary vigor to corporate profits, cash flows and equity prices. It is certainly no coincidence that corporate earnings have inflated concurrently with derivatives markets and leveraged speculation.

Any serious discussion of derivatives and contemporary risk intermediation should devote significant time to the proliferation of trend-following “dynamic hedging” strategies. This entails managing hedging-related risks as the markets move, generally acquiring underlying financial assets when the markets are rising and then selling when they are declining. And the more prominent the role of derivatives on the upside the more likely the event of liquidity dislocation on the downside.

This remains the most incredible period in financial history. A strong case can be made that the traditional credit cycle has turned – an especially momentous development considering the scope of previous mortgage credit bubble excesses and attendant economic imbalances. Can we, then, infer that the liquidity cycle has similarly turned? Are they not one and the same? Well, in the age of contemporary Wall Street securities finance, they are not. And the case that the liquidity cycle has turned is not yet as convincing.

To this point, there are few indications of waning derivatives growth. Or a slowdown in financial sector expansion. Or a meaningful moderation in global credit growth. Worse, there is ample evidence of Wall Street’s keen desire to push the envelope of leveraged speculation in preparation for the (non-financial) credit slowdown-induced Fed easing cycle. Central bankers should be in no rush to appease. Cutting interest rates would likely temporarily accomplish a few things, but promoting a smooth flow of credit would definitely not be one of them.

An Unprecedented Speculative Spree

A study recently published by the Bank for International Settlements, “Monetary and Prudential Policies at a Crossroad?”, says: “Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth. The serious costs of financial repression around the world have been well documented. But financial liberalization has also greatly facilitated the access to credit ... more than just metaphorically. We have shifted from a cash flow-constrained to an asset-backed economy.”

Though we basically agree with the analysis and the conclusions of the study, we radically disagree with the idea that “Financial liberalization is undoubtedly critical for the better allocation of resources and long-term growth.” The indispensable first condition for proper resource allocation at a national as well as global scale is avoidance of excessive money and credit creation. In many countries, and in particular in the U.S., they are excessive as never before. If Mr. Bernanke complains about irregularities of M2, this is nothing in comparison with the fact that credit and debt growth in the U.S. has exploded for more than two decades. When Mr. Greenspan took over at the helm of the Fed in 1987, outstanding U.S. debt totaled $10.5 billion. In less than 20 years, this sum has quadrupled to $41.9 billion. And this significantly understates the rise in debt because, e.g., the debts of highly leveraged hedge funds are not captured. In 1987, indebtedness was equivalent to 223% of GDP – already pretty high. Lately, it is up to 317%.

There used to be a very stable relationship between money or credit growth and GDP or income growth. Growth of aggregate outstanding indebtedness of all nonfinancial borrowers – private households, businesses and government - had narrowly hovered around $1.40 for each $1 of the economy’s GNP. Debt growth of the financial sector was minimal. This relationship started to breakdown in the early 1980s. Financial liberalization and innovation certainly played a role. But the most important change definitely occurred in the link between money and credit growth to asset markets. Money and credit began to pour into asset markets, boosting their prices, while the traditional inflation rates of goods and services declined. The extreme case at the time was Japan.

Do not be fooled by the sharp decline in consumer borrowing into the belief that money and credit has been tightened in the U.S. Instead, borrowing for leveraged securities purchases (in particular, carry trade and M&A financings) has been outright rocketing, with security brokers and dealers playing a key role as the main borrowers. A large part of the money came from the highly liquid corporations. There is no reason to wonder about low and falling long-term interest rates. There is not the slightest check on borrowing for financial speculation. There is epic inflation in Wall Street profits.

All this confirms that financial conditions remain extraordinarily loose. Even that is a gross understatement. Credit for financial speculation is available at liberty. Expectations for weaker economic activity only foster greater financial sector leverage. Apparently, the financial sector intends to make the greatest possible profit from the coming decline of interest rates, promising further rises in asset prices against falling interest rates. There is nothing new about such speculation. New, however, is its exorbitant scale.

U.S. policymakers and economists have been preoccupied with worries about possible harmful effects of the exploding trade deficit. They appear obsessed with the conventional wisdom that free trade is good and must always be good under any and all circumstances, as postulated in the early 19th century by David Ricardo. Only they are disregarding some caveats of Ricardo’s. For equal benefit, first of all, balanced foreign trade is required. “Exports pay for imports” was a dogma of classical economic theory. With an annual current account deficit of more than $800 billion, the U.S. economy is definitely a big loser in foreign trade.

One wonders what can stop this unprecedented speculative binge. Pondering this question, we note in the first place that the gains in asset prices – look at equities, commodities and bonds – have been rather moderate. To make super-sized profits, immense leverage is needed. We think the speculation is unmatched for its scope, intensity and peril. Plainly, it assumes absence of any serious risk in the financial system and the economy.

In our view, the obvious major risk for speculation is in the economy – that is, in the impending bust of the gigantic housing bubble. The breaking of the housing bubble will hurt the American people far more than did the collapse in stock prices in 2000-02. The U.S. economy is incomparably more vulnerable than in 2001. Another big risk is in the dollar.

TWO SPILLOVERS

The bursting of two bubbles seven years apart holds the key to the macro outlook.

While different in many respects, the sharp swings in the dot-com and housing markets share one thing in common. The initial belief was that any spillovers would be limited and that the rest of the economy and financial markets would remain unscathed. Just as that view turned out to be wrong in the early 2000s, I fear a similar outcome today.

There are two ways to look at spillovers – contagion within an asset class and repercussions from one sector to another in the real economy. Both are obviously important. Seven years ago, the asset-market excesses were most acute in the so-called pure Internet plays – a collection of over 350 companies that had a combined equity market capitalization of over $1.1 trillion in late 1999, or 6% of the total value of U.S. equities. When the dot-com bubble burst in early 2000, most were confident that the remaining 94% of the equity market would be relatively well insulated. In the end, of course, nothing could have been further from the truth. The broad S&P 500 index tumbled some 49% in the ensuing 2 1/2 years.

Today it is subprime mortgages – a relatively small segment of the home loan market that accounts for only 11% of total outstanding securitized mortgage debt. The consensus view is that the other 89% of the mortgage market is in good enough shape to weather any storm. On the surface, the relative dispersion of delinquency and default rates seems to support this contention. Subprime delinquencies rose to 13.3% in 4Q06. By contrast, for prime loans, the past-due portion stood at just 2.6% in late 2006.

In terms of the asset effects, the key issue is whether the credit problems will spread up the quality spectrum – reminiscent of the contagion from dot-com to broader equities some seven years ago. It is obviously too soon to know with any certainty, but the latest results of the Fed’s Senior Loan Officer Survey on Bank Lending Practices are not exactly comforting. In early 2007, the portion of respondents that were tightening overall mortgage-lending standards rose sharply. Moreover, this latest tally represents sentiment as of January 2007, before the full force of the subprime carnage broke out into the open. This is a fairly clear indication, in my view, that the problem is spreading.

The contrasts between the spillovers in the real economy in the aftermath of the two bubbles could well be of even greater importance to the macro call. Seven years ago, the spillover risks were concentrated in business capital spending, a sector that made up about 12.5% of the U.S. economy at the time. In the aftermath of the bursting of the equity bubble, business capital spending fell 16% from its late-2004 peak to its early-2003 trough. By contrast, over the same nine-quarter period, the rest of the economy increased by 5%. Today, the potential spillover risks are concentrated in personal consumption – a sector that makes up about 71% of real GDP, or nearly six times the size of the capex spillover sector that was the defining characteristic of the last post-bubble shakeout.

Therein lies the case for a post-bubble macro contagion that could end up being a good deal worse over the next year than it was seven years ago. Moreover, real GDP growth has already slowed to just 2% over the past three quarters, vs. the 3.7% annualized pace of the previous three years. Yet this downshift is largely an outgrowth of a steep recession in homebuilding activity, together with collateral impacts of a recent downtrend in business capital spending. The American consumer has barely flinched, with average gains of 3.2% in real consumption since mid-2006 representing only a modest downshift from the astonishing 3.7% growth trend of the past decade. Should the consumer move into a more meaningful period of consolidation – precisely the risk as equity extraction from residential property now slows in a post-housing-bubble climate – then macro contagion could become an increasingly serious problem.

The forecasting landscape has long been littered with carcasses of those who have been dumb enough to bet against the American consumer. From time to time, there have been unconfirmed sightings of my skeletal remains in that heap. The lesson for the bruised and battered forecaster is to pick your spots carefully in betting against the American consumer. I strongly believe this is one of those times.

With the property-related wealth effect now going in the other way in a rapidly softening housing market and with labor income generation not picking up the slack, consumers are under mounting pressure to pull back. That pressure is compounded by record debt burdens, record debt service ratios, and negative personal saving rates – the latter an indication of the extent of the disparity between excess consumption growth and subpar income generation. In a framework that allows for consumers to draw support from both income and wealth effects, the implications of a bursting of the housing bubble are painfully obvious.

Just as the capex spillover was the defining feature of the post-bubble climate seven years ago, the extent of any consumer retrenchment in today’s economy will undoubtedly be the defining characteristic of the current phase. Spillover risk is also likely to dominate the Fed policy debate and bear critically on the state of world financial markets. At a minimum, I believe that consumption growth will have to slow 0.5% below the pace of income generation – sufficient to enable the personal saving rate to start rising once again. If growth in disposable personal income holds to its 11-year trend of 3.2%, that would imply a 2.7% growth pace for growth in real consumption expenditures ... enough to knock 0.7% off underlying GDP growth over the next year. If income growth weakens, more likely in a post-housing shakeout, the consumption hit on GDP growth could be in the 1.5% range. That could push GDP growth towards 1%, easily into “growth-recession” territory and not all that far from an outright downturn. I would place about a 40% probability on an outright recession scenario in late 2007 and early 2008.

As bubble follows bubble, it has become exceedingly difficult to disentangle fluctuations in asset markets from shifts in asset-dependent real economies. To the extent an inflation-targeting Fed uses growth risks as a proxy for inflation risks, a monetary easing may seem to make a good deal of sense if spillovers come into play. Yet in the end, of course, a monetary easing that is tied to a deteriorating growth outlook for an asset-dependent economy also turns out to provide support to the underlying asset class itself. That is the “Fed put” in a nutshell – a de facto targeting of asset-dependent growth risks. It would take a Volcker-like toughness to bring this insidious process to an end. Yet both Greenspan and Bernanke seem to be cut from a very different cloth.

The Coming of the Second Wave

Imagine a column of water in the Pacific Ocean, 4,000 meters deep and seven kilometers wide. And it is heading toward you literally at the speed of a bullet. A volume of seawater traveling at that speed is classified as a Tsunami – the biggest and most devastating of all ocean forces. The 7th most devastating natural disaster of all time is the 2004 tsunami in the Indian Ocean that killed 287,000 people. Now imagine that the pattern of that tsunami’s formation, its growth, and its ultimate destructiveness perfectly mirrors an industry in our country. And the damaging effects of the industry to which I am referring on the U.S. economy have yet to make landfall ...

It is astounding how closely events of nature mirror events of business. It should not be much of a surprise, really. Leaders in finance have used the physical world to help describe and predict the events of finance for decades. The most famous example of this in my mind is the Nobel Prize winning work of Fisher Black and Myron Scholes. They adapted a heat transfer equation from physics to explain and value options contracts.

MIT economics professor Xavier Gabaix, along with a team of physicists from Boston University discovered that the movements of the stock market follow a mathematical pattern similar to earthquakes. These findings could allow traders to protect their investments by pinpointing periods when market volatility is likely to be significant. “The frequency of crashes such as those in 1987 and 1929 follow patterns,” says Gabaix. Although the method is far from certain, “we can still predict – better than with other methods – whether it will be a big move or a small one. And that information can be useful.”

The patterns that give us clues of huge equity market changes and devastating earthquakes are known as power laws. Power laws define mathematical relationships between the frequency of large and small events. Typically, the larger the event, the less frequently it happens. The importance of these power laws is in the way they describe nature as well as artificial constructs.

What I am worried about is something that will affect everyone in America, not just stock investors. It will be the second wave downwards in housing that will catch everyone off guard and send the economy into a sharp, protracted consumer-led recession. And that second wave is about to hit.

Housing peaked in summer of 2005 right along with the cover of Time magazine proclaiming “Home $weet Home – Why we are gaga over real estate”. Since then home sales have fallen dramatically nearly everywhere and price drops in the bubble areas such as Florida, Massachusetts, Phoenix, Las Vegas have been as large as 25% or more taking into consideration incentives, interest rate kickbacks, and even “free” vacations and cars. Building permits in November dropped 31% from the year earlier level. Nearly all of the homebuilders have had high cancellation rates and have also been taking big writeoffs on land. Would any homebuilder be dumping land if it thought the bottom was in?

It has now been over 18 months since housing peaked in the summer of 2005. The average decline in housing starts from peak to trough is about 46 months. By that standard this decline has a long ways to go yet. Foreclosures are at a fairly low rate, but the rate of change however that is alarming. They increased 51% nationwide last year. Foreclosures increased 94% last year in California. In Nevada the increase was 175%. There has been some excitement as of late by a small bounce in homebuilder sentiment as well as a small bounce in new home sales. This is like looking for starfish on the beach during the trough that precedes the big wave of the tsunami.

New home sales do not take into consideration cancellations and cancellations have been soaring. Sales are overstated and inventories are massively understated. Builders are now scrambling to finish projects and unload as much inventory as possible before the next wave hits. That second wave will strike when massive layoffs occur as the current projects are being completed followed by a decline on a lagging basis of commercial real estate. Already we are seeing an impact in residential construction employment. But do we really need more Walmarts, Pizza Huts, strip malls, nail salons, grocery stores, Home Depots, Lowes, and restaurants that follow? I think not. Commercial business hires people and lots of them. When that buildout ends, and we are at the beginning of the end now, there is going to be no source of jobs to replace those service sector jobs going forward.

CRACKS IN THE FAÇADE

How many Americans are saddled with mortgages they cannot afford on houses that are losing value? The answer matters to anyone who bought high-yielding mortgage-backed securities when a booming property market made mortgages look safe. It also matters to investment banks, which packaged the securities and often own subsidiaries that originate mortgages. It may determine whether America’s economy falls into recession. It could even affect the outcome of next year’s elections.

Most of the damage so far is in the “subprime” mortgage market, which lends to people whose income is too low, or whose credit history too patchy, to qualify for an ordinary mortgage. On March 13th the Mortgage Bankers Association reported that 13% of subprime borrowers were behind on their payments. Is this a mere irritant in America’s vast economy, or the start of something much worse? Opinion on Wall Street is divided. Most argue that the mortgage mess, though a blight on anyone caught up in it, will not spread. Growing numbers of pessimists disagree. They think the subprime squeeze marks the start of a broader credit crunch that could drag the economy into recession. Stephen Roach, the famously gloomy chief economist at Morgan Stanley, recently called subprime mortgages the new dotcoms. Just as the implosion of a few hundred internet ventures in 2000 sparked a much broader stockmarket correction and an eventual recession, so the failure of the riskiest mortgages may distress the rest of a debt-laden economy.

To try to assess who is right, you need to know the share of mortgages potentially at risk. And you need to understand the channels through which subprime defaults could spread to the wider economy. America’s residential mortgage market is huge. It consists of some $10 trillion worth of loans, of which around 75% are repackaged into securities, mainly by the government-sponsored mortgage giants, Fannie Mae and Freddie Mac. Most of this market involves little risk. Two-thirds of mortgage borrowers enjoy good credit and a fixed interest rate and can depend on the value of their houses remaining far higher than their borrowings. But a growing minority of loans look very different, with weak borrowers, adjustable rates and little, or no, cushion of home equity.

Subprime borrowers – long shut out of home ownership – now account for 10% of all mortgage debt, thanks to the expansion of mortgage-backed securities (and derivatives based on them). Low short-term interest rates earlier this decade led to a bonanza in adjustable-rate mortgages (ARMs). Ever more exotic products were dreamt up, including “teaser” loans with an introductory period of interest rates as low as 1%. When the housing market began to slow, lenders pepped up the pace of sales by dramatically loosening credit standards. Wall Street cheered them on. Investors were hungry for high-yielding assets and banks and brokers could earn fat fees by pooling and slicing the risks in these loans. Standards fell furthest at the bottom of the credit ladder. America’s weakest borrowers were often able to buy a house without handing over a penny.

Lenders got the demand for loans that they wanted. Amid the continuing boom, some 40% of all originations last year were subprime or Alt-A. But as these mortgages were reset to higher rates and borrowers who had lied about their income failed to pay up, the trap was sprung. A new study by Christopher Cagan, an economist at First American CoreLogic, based on his firm’s database of most American mortgages, calculates that 60% of all adjustable-rate loans made since 2004 will be reset to payments that will be 25% higher or more. A fifth will see monthly payments soar by 50% or more. Few borrowers can cope with such a burden. When house prices were booming no one cared. Borrowers refinanced or sold their homes. But now that prices have flattened and, in many areas, fallen, those paths are blocked.

The greatest difficulties threaten borrowers whose house is worth less than their mortgage. Just under 7% of all American homeowners had this “negative equity” at the end of December 2006 estimates Mr. Cagan. Higher payments and negative equity are a toxic combination. Mr Cagan marries the statistics and concludes that – going by today’s prices – some 1.1 million mortgages (or 13% of all ARMs originated between 2004 and 2006), worth $326 billion, are heading for repossession in the next few years. Only 7% of mainstream adjustable mortgages will be affected, whereas one in three of the recent “teaser” loans will end in default. Mr. Cagan’s study considers only the effect of higher payments (ignoring defaults from job loss, divorce, and so on). But it is a guide to how much default rates may worsen even if the economy stays strong and house prices stabilize. Mr. Cagan’s work suggests that every percentage point drop in house prices would bring 70,000 extra repossessions.

The direct damage to Wall Street is likely to be modest. A repossessed property will eventually be sold, albeit at a discount. As a result, Mr. Cagan’s estimate of $326 billion of repossessed mortgages translates into roughly $112 billion of losses, spread over several years. Even a loss several times larger than that would barely ruffle America’s vast financial markets. In theory, the chopping up and selling on of risk should spread the pain. Indeed, banks so far smell an opportunity to buy the assets of imploding subprime lenders on the cheap.

Although subprime is a small direct threat to Wall Street it could still inflict pain on bankers – and the broader economy – in other ways. Investors are shunning subprime and all mortgages that seem risky. Lenders’ reluctance and tightening loan standards may combine to form a classic credit crunch. No one is sure how dramatic, or lasting, the pull-back will be, but Credit Suisse thinks the number of originations in subprime markets could fall by some 50% in the next couple of years and Alt-A loans may fall by a quarter. Even if the shift is confined to America’s riskiest mortgages (and there is little evidence yet of tighter lending standards spreading), its effects may climb up the housing ladder.

Just when some would-be buyers find it harder to borrow, rising numbers of repossessions will increase the supply of homes for sale. Falling demand and soaring supply bodes ill for construction and house prices, the main ways housing affects the broader economy. Builders have already cut back. The pace of housing starts is down 33% from its peak in January 2006. Job losses in construction and related industries, which have so far been mild, are likely to rise sharply. A glut of unsold homes will also push down prices, particularly in areas such as California and Florida, which had a disproportionate share of riskier loans. House prices have already been falling in parts of both states, as they have in Midwestern states, such as Michigan, where manufacturing industry has shed jobs in recent years. Will those declines accelerate and spread?

By many measures, America’s house prices are still too high. David Rosenberg of Merrill Lynch points out that the ratio of income to housing costs is still some 10% worse than its historical norm and 20% worse than levels at the end of the last housing downturn in the early 1990s. Take out a chunk of potential borrowers. Add in some repossessed homes and house prices could be hit hard. Wall Street’s gloomiest seers think average house prices could fall by 10% this year. If so, the economy could well enter a recession.

Such a dramatic drop in national house prices this year is possible, but not yet probable. Unless repossession forces a sale, homeowners prefer to sit tight when markets are weak. If house prices stagnate, consumption may suffer a little, but not too much, so long as jobs stay plentiful and wages grow. If so, the mortgage crunch will be a grinding drag on America’s economy – one that unfolds over several years, hitting some people and some regions hard, but not, in itself, a macro-economic disaster.

The consequences of the housing market’s troubles may be felt more sharply on Capitol Hill than at the Fed. Politicians, particularly the Democrats now in charge of Congress, are clamoring for quick action. Hillary Clinton has declared the market “broken”, accused the Bush administration of standing by and demanded something be done. Chris Dodd, chairman of the Senate Banking Committee and another Democratic presidential candidate, is also up in arms. George Bush often boasts about rising rates of home-ownership under his watch. Hundreds of thousands of repossessed homes, many of them from borrowers who are black and poor, would be politically incendiary.

Few doubt that the subprime mess was, in part, a regulatory failure. But now the mistakes have been made, the biggest risk is that populist politicians rewrite the rules hamfistedly. Fraudulent activity should be punished. The vulnerable need protection from predatory lenders. But an ill-conceived swathe of new “consumer protection” could easily make matters worse. If restrictive regulation scared investors away from the subprime market for good, that really would hurt the poor.

Subprime warnings ignored despite earlier credit card troubles.

As the mortgage industry’s subprime sector confronts a loan meltdown, lenders need only look for guidance to the credit card business, which got into similar trouble a few years ago offering plastic to riskier borrowers.

The scalding some credit card companies took in 2000 and 2001, when large numbers of subprime card holders had problems paying, could have served as a warning to mortgage lenders. Instead, subprime mortgage lenders followed the pattern right into financial distress. Several have in recent weeks ceased lending or filed for bankruptcy. In both mortgage and credit card lending, competition for new pools of customers led to more aggressive marketing and lending to borrowers who were increasingly risky.

DAVID STOCKMAN IS CHARGED WITH ACCOUNTING FRAUD

About a month before his company filed for bankruptcy protection, the chief executive of Collins & Aikman, a maker of vehicle instrument panels and floor mats, made a last-ditch attempt for a loan. The chief, David A. Stockman, the former Michigan congressman and budget director for President Ronald Reagan, got on the phone in early April 2005 with bankers from Credit Suisse. The parts supplier had about $110 million in liquidity, he told the bankers, according to court papers. He reassured them that his forecasts were sound.

But according to an 8-count indictment, that was not true. The company had already borrowed so much that it could not take on new debt without violating existing loan agreements. It had exhausted its credit. Based on Mr. Stockman’s assurances, Credit Suisse gave Collins & Aikman $75 million. By May, however, all of it was gone. The board forced Mr. Stockman to resign and the company filed for bankruptcy protection five days later.

Mr. Stockman, 60, of Greenwich, Connecticut, and three others – J. Michael Stepp, the CFO; David R. Cosgrove, the controller; and Paul C. Barnaba, director of purchasing – now face charges that include bank fraud and conspiracy and obstruction of justice. All four defendants pleaded not guilty in Federal District Court in Manhattan. All were released on bond. Four other former company employees have pleaded guilty to similar charges and are expected to cooperate with prosecutors. Collins & Aikman is cooperating with the government and will not be prosecuted.

In a news conference yesterday, Michael J. Garcia, the U.S. attorney for the Southern District of New York, singled out Mr. Stockman as the leader behind the effort to mislead lenders, investors and auditors. “They resorted to lies, tricks and fraud,” Mr. Garcia said. “In the end, Stockman and his co-conspirators were unable to hide the truth.” Mr. Garcia depicted Mr. Stockman as unable to come to terms with the failure of a company he helped revive. Mr. Garcia added, “Stockman stuck with it at the cost of the invested public, the financial integrity of the company and the truth.”

Mr. Stockman’s lawyer, Elkan Abramowitz, said that the charges were exaggerated. “This is not an Enron or a WorldCom,” he said. “He tried to save the company, and that’s the kind of thing you want a CEO to do.” In a statement posted on his lawyer’s Web site, Mr. Stockman said he and Heartland Industrial Partners, the buyout firm he founded that owned a large stake in Collins & Aikman, lost $360 million – more than any other investor. Mr. Stockman maintained that he went to great lengths to resuscitate the company.

Charles A. Ross, a criminal defense lawyer in New York, said that Mr. Stockman’s personal losses were critical to his defense strategy at a time when other accounting fraud cases have shaken public trust in executives at failed companies. “He put his money where his mouth was in terms of trying to turn the company around,” Mr. Ross said. “That’s an important fact that differentiates this from other accounting frauds.” The SEC has also filed a civil complaint.

The indictment accuses Mr. Stockman of orchestrating an effort that duped Collins & Aikman’s lenders, exaggerating how much money it was due in its accounts receivable so it could obtain more credit. The indictment describes a company that went to great lengths to conceal its ballooning debt. When it got too far behind on its bills, it lied, telling one lender that a computer glitch was the reason it did not complete a financial report, court papers said. Mr. Stockman, himself, is accused of directing employees to create fraudulent invoices to show millions of dollars worth of receivables so the company could borrow more.

THE BLACKSTONE OFFERING MAY SIGNIFY A PRIVATE EQUITY MARKET TOP

We can feel it in our bones. Something is happening here. First, the alternative asset management firm Fortress Investment Group goes public and trades up to previously unheard-of valuations for companies in the investment arena. Next, the private equity colossus Blackstone files for its own IPO, with the potential of generating a huge payout for its chairman, Stephen Schwarzman.

These self-motivated, intelligent individuals are trying to tell us something important. The question is, do we have the ability to look beyond their words and actions and intuit motivation? Greed, uncertainty and fear. What are the implications? That the equity markets are in trouble? That the credit markets are on the verge of a sharp sell-off? That we are at the dangerous stage of a private equity bubble?

My assessment is that we are in a private equity bubble of sorts. However, it is not one that has ghastly implications for the overall market but, instead, will have negative outcomes for those invested in private equity funds – and certainly for those buying into the public shares of private equity management companies such as Blackstone.

Blackstone is a great firm. Going public will bring even greater riches to those at the top. That said, great riches have already been captured by those up and down the management hierarchy. This is not the case of a go-go high-technology firm that generates little free cash flow and requires an IPO or a sale to crystallize value for its shareholders. Blackstone has been and will continue to be a cash machine that can distribute substantial sums to its minions every year. Therefore, either an IPO or a leveraging of the balance sheet is simply a means of extracting even more cash from the business. Given the friendly nature of today’s equity markets, going public offers the best risk/reward decision for Blackstone’s existing shareholders. This is an opportunistic step driven by the state of today’s equity markets and other considerations such as the state of the private equity market.

Hundreds of billions of dollars of new deal capacity has been created by private equity firms in the past 12 months. This is a classic case of too much liquidity chasing too few opportunities, giving rise to stretched debt-to-cash flow multiples, club deals where multiple private equity firms share risks and rewards and the re-emergence of complex debt instruments that give great flexibility to the private equity issuers but scant protection for debt investors. This cycle we have seen repeated every 20 years or so, the difference here being the scale and number of private equity firms and the leveraged capital at their disposal.

As long as the debt markets co-operate, all is well. But when debt investors wake up to the fact that they are systematically underpricing risk, the highly leveraged deal structures simply will not work. Deals will still get done because private equity firms need to deploy their capital to build franchises and justify their fees but leverage ratios will fall and returns will decline. Bad for the overall market? Not really. Bad for private equity investors? Certainly. And now there will be one more constituency at the table – investors in the public equity of these private equity firms. Here is the rub.

Mr. Schwarzman and his colleagues at Kohlberg Kravis Roberts, Texas Pacific Group, Apollo, and others thinking about following in Blackstone’s footsteps, all understand that the risk/reward calculus of the private equity business (largely being borne by debt holders in today’s frothy environment) could shift rapidly, closing a historically attractive window for them to monetize their franchises. They see the private equity bubble and want to extract value before it pops. But where does that leave the rest of us?

1931 REDUX?

Last week, I read with great interest the piece by Doug Kass’s (the resident TheStreet.com bear) on 1937 déjà vu, based on similarities of technical patterns between then and now. That is a scary proposition, at least if one remembers what lurked around the corner. But 1937 is not the analogy I would use. But I think that Doug’s asking questions regarding the right decade, the 1930s, and will reiterate a question I have asked before: “Is this 1931?”

Why not say that 2007 will be like 1937 or even 1929? A superficial response would be that 2007 is a pre-Presidential election year, like 1931, whereas 1937 and 1929 were post-election years. A better answer is that 2007 could represent a potential fundamental economic turning point in a similar manner to 1931. That is because the 1929-1932 crash actually took place in two stages. In the first stage, from late 1929 through the end of 1930, the market corrected the overvaluation excesses, relative to then-prevailing fundamentals. Specifically, the Dow pulled back from 381 to under 200, which represented fair value for the time. In the second stage, from 1931 to mid-1932, the market fell to 41, nearly 90% off the 1929 peak, because the fundamentals themselves collapsed, with my estimate of “investment value” of the Dow (based on book value and dividends) falling from 202 at the end of 1930, to 82, at the end of 1932.

A similar set of events may be unfolding this decade. The bulls rightly point out that we have had our correction of earlier valuation excesses. This took place primarily as a result of the (first) bear market of 2000-2002, together with recent earnings growth in excess of stock price gains. But they may be underestimating the potential for a collapse in fundamentals such as earnings and dividends. Recent stateside growth has taken place because consumers have been willing to spend in excess of wage growth (and able to do so because of easy money and a buoyant housing market that led to “capital” income). With housing now in a tailspin, this source of “income” is gone, at the same time that overleveraged consumers are now demanding higher wages in their role as employees, to compensate. Both effects threaten to crimp corporate profit margins, as happened in the 1930s.

The remaining ingredient in the 1930s, and possibly now, was the rising cost of imports, as many other countries elected to “opt out” of the global economic system. All this could lead to a second (down) leg of the bear market. Yes, the Fed did manage to head off this event from occurring right after 2002, but it may have been a case of delaying, rather than preventing, the inevitable.

More recently, subprime lending seems to have been the “canary in a coal mine”. It would be nice if the collapse of New Century Financial was “merely” a case of one imprudent, overleveraged lender getting its just desserts. But the fact of the matter is, New Century has stopped making loans (with Novastar and Accredit Home Lenders headed the same way) because other lenders will no longer fund it. This echoes a 1930s event called disintermediation, which in its rawest form, consists of everyone putting their money under a mattress. This threat is made worse by the fact that hedge funds hold much of the existing subprime paper in the form of “mortgage-backed” securities. When the credit spigot is turned off at the (subprime) margin, it may force homeowners to dump their houses at distressed prices, reducing the value of real estate generally, and making formerly sound loans, unsound, causing another round of domino effects. The resulting credit losses would severely crimp overall corporate profits, independently of any knock-on effects that may result from the likely job losses in the mortgage and housing industries.

Can we look to the Fed for relief? The Fed has headed off some pretty major threats, like Long Term Capital, Y2K, and the turn of the century bear market. Those involved serious, but singular, issues. But what if there are several major problem areas to be dealt with at the same time? And what happens if there is series of events that require conflicting prescriptions, e.g., a credit collapse that necessitates a fight against deflation, while a spike in oil prices and/or falling dollar creates inflationary pressures?

My best guess is that the U. S. economy is just strong enough to weather the collapse of the housing bubble and the resulting concomitant decrease in consumer spending. But stateside growth will have been pushed so close to the brink by all this, that one more nudge would push it into negative territory. That shock could be exogenous, a terrorist attack or a hedge fund collapse, or something systemic, such as an unraveling of the Chinese banking system as a result of the bad loans linked to capital goods overspending in that country. All this could bring about a market crash. Based on events (so far!), I do not see it happening this year. But “not in 2007” call has no margin of safety.

THE SHANGHAI BUBBLE AND EURO-YEN TUG-OF-WAR

“Free markets for Free men” was a slogan etched on the floor jackets of several traders at the Chicago Mercantile Exchange in the 1980’s. But today, the slogan for traders is “Rigged markets for Central bankers”, who try to move currency and stock markets with their control of the money spigots and timely “jawboning” to the media outlets, when markets become unruly. Today, trading in currencies, precious metals, and stock market indexes has turned into a game of central bank watching.

Right now, two of the most important pieces of the global market jig-saw puzzle are the Shanghai Stock Index bubble and the tug-of-war over the euro/yen “carry trade”. What happens in Shanghai can have a big influence over China’s monetary policy, and is of great interest to commodity traders and Asian stock markets. The upcoming battle over the euro/yen exchange rate can have a big influence over Japanese monetary policy and stock markets in Europe.

How will Beijing deal with the Shanghai bubble?

The 9% plunge in the Shanghai stock market on February 27th, was widely blamed for igniting the $1.5 trillion global stock market shake-out. Within hours of the Shanghai plunge, the Dow Jones Industrials fell as much as 550-points, forcing the U.S. Treasury to issue a plea for calm. Yet the market which ignited the global panic in the first place, was the first to recover and then rumbled to new all-time highs. The Shanghai Composite Index climbed to a new all-time high four weeks later, overcoming heavy profit-taking, and is now beginning a new leg up.

The Shanghai index has already tripled since May 2005 and is up 17.5% so far this year, with many stocks trading at multiples above 40 times earnings, the most expensive in Asia. Yet without a tighter Chinese monetary policy, the Shanghai A-share market could inflate into a Nasdaq-like bubble, and if it should burst from much higher levels, it could deal a big blow to China’s economy, and have a chilling effect on Hong Kong-listed stocks. But it remains an open question of how far Beijing is actually willing to tighten its money spigots to keep this raging bull market under wraps. A determined central bank with enormous financial resources can eventually gain the upper hand over market speculators, if it is willing to pay the price. So far this year, Beijing has launched three salvos aimed at local stock market operators, but has not yet pricked the market bubble. The latest attempt was unleashed on March 16th, when the PBoC hiked its deposit and lending rates by 0.27%. But China’s money markets are still flush with cash.

China’s economy expanded 10.7% in 2006, led by a 27% surge in exports to a record $969 billion, and notching up double-digit growth for the 4th year in a row. One of the ingredients to China’s stunning success is its manipulation of the yuan, which is undervalued on a trade weighted basis by 35%. China earned a $177 billion trade surplus last year and attracted $63 billion in foreign direct investment. The Chinese central bank prints massive amounts of yuan to buy the foreign currency that is flooding into the country. For the past four years, China’s M2 money supply has increased between an annualized 13.5% to as high as 21.5%. China’s M2 is 70% higher from four years ago, and its economy has grown by over 40%.

Beijing’s mixed blessing with a cheap U.S. dollar.

But the PBoC has not raised interest rates high enough to slow loan demand, which is essential to bring its M2 money supply under control. M2 growth jumped to an annualized 17.8% in February from 15.9% in January. So Shanghai red-chip speculators are inclined to bid share prices higher, with so much easy money floating around in a red-hot economy. China’s leaders have opted into a gentleman’s agreement with the Bush administration, buying large amounts of depreciating U.S. bonds, in return for assurances of a Bush veto against protectionist legislation from angry Democrats in Congress.

Yet for China, its massive investment in U.S. T-Notes, when measured against gold or yuan, has sunk to a 6-year low. And matters are only going to get worse, with Beijing forced to shoot itself in the foot, by devaluing its U.S. dollar assets by about 5% this year against the Chinese yuan. But by Beijing’s calculations, the benefits outweigh the costs, after figuring for net interest income and its massive trade surplus with the U.S.

But it will become much harder for Beijing to support the U.S. dollar, once the Federal Reserve begins to lower the federal funds rate and injects more US dollars into the banking system. Former Fed chief “Easy” Al Greenspan said on March 15th, there was a risk that rising defaults in sub-prime mortgage markets could spill over into other economic sectors, raising the odds of a recession. Greenspan, who helped create and nurture the sub-prime loan debacle in the first place, said much of the strength in U.S. consumer spending over the past five years could be traced to capital gains, both realized and unrealized, on surging housing prices. If U.S. home prices turn south, due to rising loan defaults and foreclosures, it could sink the broader U.S. economy towards zero percent growth.

It is quite a balancing act for Beijing, printing yuan on the one hand to cushion the dollar’s downfall, while raising bank reserve ratios and interest rates on the other hand, to slow down bank lending. So far, the PBoC has printed enough yuan to limit the dollar’s depreciation to just 1% since the beginning of the year. But the slow rate of yuan appreciation might not satisfy the U.S. Congress, which is crafting protectionist legislation against Chinese imports this year. And by printing massive amounts of yuan to offset hot money and trade inflows into the Chinese currency, the PBoC risks generating higher inflation and a bigger stock market bubble in Shanghai. What a tangled web we weave!

The tug-of-war over the euro/yen “carry trade”.

“The fact that the Bank of Japan did not raised interest rates hardly surprises me,” said EU finance chief Jean Claude Juncker on March 20th, after the BoJ left its overnight call rate target at 0.50%. “We think that Japanese growth is without doubt picking up. We think that the yen exchange rate must reflect the fundamental facts of the Japanese economy. Our Japanese friends know that. And we are watching them.”

Juncker’s opposition to a weaker yen was backed up by European Central Bank chief Jean “Tricky” Trichet who spoke before the EU Parliament on March 21st. “I have signed the G-7 communique, a very important text, signed by the Americans, the Japanese, the Europeans, and we have all said we are going to continue to keep a very close eye on exchange markets and cooperate as necessary,” he said.

After watching the Japanese yen sink by roughly 65% against the euro over the past five years, European finance and trade officials are alarmed by Tokyo’s “cheap yen” policy, and want the BoJ to raise its interest rates to shore-up the value of the yen. Japan’s near-zero interest rates and severely undervalued currency are at the root of the estimated ¥40 trillion ($440 billion) “yen carry” trade, and massive distortions in global bond and stock markets. Tokyo’s ruling elite did capitulate to heavy European pressure and agreed to a quarter-point BoJ rate hike to 0.50% on February 21st, the second increase in five years. But it is hard to get Tokyo to wean itself off low interest rates. “For now, the BOJ will maintain easy monetary conditions, while monitoring economic and price conditions,” BoJ chief Fukui told parliament on March 26th. But European finance ministers know that Japan’s low inflation figures are fraudulent, and are not buying Tokyo’s deflation fear-mongering any longer.

Japanese exports to the EU have doubled over the past five years, while European exports to Japan fell 8% during the same time period. If the euro’s appreciation against the Chinese yuan and Japanese yen is left unchecked, European exporters could suffer in world markets from price handicaps with Japan and cut-throat competition with China. The clash over the volatile euro/yen “carry trade” between European and Japanese monetary officials is likely to escalate, with the ECB telegraphing a quarter-point rate hike to 4.00% in the months ahead to counter its exploding M3 money supply, while Japan’s FX chief is pressuring the BoJ to keep its powder dry. Speculation of a unilateral ECB rate hike, not matched by the BoJ, is behind the euro’s strong rebound from ¥151 on March 5th to as high as ¥157.5 on March 26th. But Japan’s economy was sizzling at a 5.5% annualized rate in Q4 2006, and the “jawboning” signals from Japanese finance officials can change at a moment’s notice, to guide the euro/yen into the secret trading range agreed upon with Europe.

At least for now, the direction of the euro/yen exchange rate has become a key driver of the EuroStoxx-600. Europe’s top blue chips have been heavily pumped up with Japanese steroids, or cheap-yen margin loans, and have displayed an 88% degree of correlation with the euro/yen so far this year. On March 15th, Bundesbank chief Axel Weber warned against the practice of trading European stocks with money borrowed in yen, but few traders are listening.

European finance ministers are finding it difficult to combat the market’s addiction to the yen carry trade, since the world’s biggest addict is the Bank of Japan itself. Tokyo’s ministry of finance controls $884 billion of foreign exchange reserves, which are mostly held in U.S. dollars. The MoF borrows yen in Tokyo by selling short-term government paper, and then buys U.S. dollars in the currency market. The MoF is paying an interest rate of 0.58% on its intervention financing bills, while earning a 5.05% return in 3-month U.S. T-bills. As a result, Japan earned about ¥3 trillion in interest income last year, far outstripping its interest expense of ¥460.6 billion. But if the BoJ is forced to raise short-term interest rates to placate Europe, the MoF’s interest expense could rise. The spread would get squeezed further if the Fed lowers US$ rates.

Acknowledging that most of Japan’s official reserves are in U.S. dollars, Finance chief Koji Omi told a parliamentary committee on March 23rd, “We have no plan to substantially change the composition.” But some Japanese lawmakers say the government’s $884 billion intervention fund could be used to help pay down some of Japan’s $6.7 trillion national debt, equaling 155% of GDP. Japan is projected to incur $177 billion in interest expense on the debt in the fiscal year ending March 31st.

The possible unwinding of the yen carry trade has made European stock markets skittish, but what other powder-keg that could ignite in the future, and trigger another big Euro-Stoxx Index shake-out? Which markets are most impacted by the Shanghai bubble? Which foreign stock market is the first to telegraph the next likely move for the global stock markets?

Asia developing economies fueling asset bubbles with their huge foreign currency reserves, warns Asian Development Bank.

They could put them to better use by retiring debt or buying higher-yielding investments, the ADB said. Ifzal Ali, ADB chief economist, said the current level of reserves held by Asian developing economies – $2.28 trillion – was excessive. “These reserves, unless sterilized, lead to increases in money supply, which in turn, lead to bubbles in assets,” Mr. Ali said. “Across the region, we are seeing asset bubbles both in housing and equity markets.”

Mr. Ali suggested that Asian developing countries use their reserves for retiring debt, investing in infrastructure or providing funds for social needs. He added that returns could be boosted by investing in equities or other instruments, rather than focusing heavily on U.S. Treasuries and eurozone bonds. By investing even half their reserves in instruments yielding an extra 500 basis points such countries “would generate a $50 billion fiscal dividend equivalent to about 0.8 per cent of regional GDP,” Mr. Ali said. He said developing Asian countries should follow the example of Singapore, South Korea and China to put together investment plans.