Finance Digest for Week of May 28, 2007

HYPERINFLATION

A plan that is the possibility for salvaging what is left of Zimbabwe.

In March prices rose by more than 50% as Zimbabwe entered the hell of hyperinflation. That was followed, on April 26, by a 98% official devaluation of the Zimbabwean dollar. Miners, farmers, tour operators, nongovernmental organizations, embassies and Zimbab-weans living abroad can now purchase 15,000 Zimbabwean dollars with a U.S. dollar. For others the official rate remains at 250 per USD. On the black market one get ZWD 35,000 per $1.

The economic destruction caused by a decade of the world’s highest inflation rate – and now hyperinflation – is palpable. The nation’s economy is starting to implode, the Reserve Bank of Zimbabwe is insolvent and Zimbabweans are streaming into South Africa in search of work. This will end, as do all hyperinflations, with a regime change – either a new monetary system, a new political setup, or both.

Just reflect on what happened during the world’s last hyperinflation. It began in January 1992, in what was left of Yugoslavia, and peaked in January 1994, when the official monthly inflation rate was 313,000,000%. (The worst month of Weimar Germany’s 1922-23 hyperinflation saw prices go up 32,400%.) The results were devastating. Long before NATO struck Yugoslavia in 1999, Slobodan Milosevic’s monetary madness had already destroyed its economy.

In 1999 Montenegro was still part of this mess, since its official currency was the discredited Yugoslav dinar. But the mighty German mark was the unofficial coin of the realm. As an economic adviser to Montenegro’s president, Milo Djukanovic, I repeated the great Austrian economist Ludwig von Mises’s description of sound money as “an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.”

President Djukanovic knew that the German mark would not only stabilize the economy but also pave the way for reestablishing Montenegro’s sovereignty. On November 2, 1999 he boldly announced that Montenegro was officially adopting the German mark as its national currency. The mark was replaced by the euro two years later. The Montenegrin economy stabilized immediately and began its steady growth amid falling inflation. By 2005 its GDP was growing at 4.1% and inflation had fallen to 1.8%. In May 2006 voters in Montenegro turned out in record numbers to give a collective thumbs-down to their republic’s union with Serbia. Montenegro was once again independent. And on March 15, 2007 Montenegro signed a stabilization and association agreement, the first step toward EU membership. President Djukanovic had cleverly inverted the process, effectively integrating Montenegro with the Eurozone from day one.

As President Djukanovic did for Montenegro, South African President Thabo Mbeki might just hold the key to stopping Zimbabwe’s collapse. He has been appointed by the Southern African Development Community – a grouping of the nine Southern African countries, including Zimbabwe – to mediate Zimbabwe’s economic crisis. With a bold stroke Mbeki could stop Zimbabwe’s monetary rot and at the same time promote the interests of South Africa and other members of the league. South Africa is at the center of the Common Monetary Area, which also includes Lesotho, Swaziland and Namibia. All three of these issue their own currencies but peg them to the South African rand at par. Moreover, the rand circulates legally in Lesotho and Namibia.

The 9-country league should propose that the rand common area be expanded to include Zimbabwe. A currency board, similar to the one that operated in Zimbabwe from 1940 to 1956 (it was called Rhodesia then) should be established. It should issue Zimbabwean dollars that would be fully backed by and convertible into rand at a fixed rate. The currency board should be initially capitalized by South Africa. In addition, the rand should be allowed to circulate legally in Zimbabwe. Adopting this plan is the only way to salvage what is left of an economic wreck.

THANK YOU FOR NOT LEGISLATING

“Do-nothing” Congress one more reason to remain bullish in 2007 and into 2008.

Stalemated legislators are good for the market. Have you ever seen a more gutless Congress than the one now in session? Well, okay, maybe the last one, the Republican one, was almost as gutless, but it is all the same bull market. The less that lawmakers can do, the less damage they can do. Last November, as the Democrats won control of Congress, you heard endlessly about how many things they would change this year. Health care, oil, impeachment, the Iraq war, taxes and on and on. A big first 100 days!

Now consider how much time House Speaker Nancy Pelosi has spent traveling, even in those first 100 days. And why shouldn’t she? She can get more done outside the Beltway than inside it. The Democrats have no margin to pass material legislation. In that regard they are in the same position as the GOP in 2005-06. The Democratic Congress has scarcely legislated at all. Markets love that. Gutless is great.

People of all ideological persuasions feel frustrated when Congress does not enact the laws that they think will improve society. But every change helps someone at someone else’s short-term expense. Every winner is matched with a loser. Now, it is a demonstrable fact that people are more displeased by a loss than they are pleased by a comparable gain. In fact, behaviorists have quantified this phenomenon: To offset an unexpected loss of magnitude X, the average American needs a windfall gain of 2.5 X. Apply this rule to the zero-sum nature of tax and economic legislation and you have a recipe for unhappiness with every enactment. You are pleased that Congress is handing you a subsidy for your solar panel. Your neighbor is twice as displeased about the taxes he will pay as a result.

In years when Congress is active, political risk aversion rises and, as it does, demand for stocks and bonds falls. Political risk aversion and stock demand are inversely correlated. For this year and next anything important that Congress passes, and there will be precious little of it, can be vetoed with impunity by our lame-duck President. What a beautiful world. Celebrate gutlessness! If you have not already done so, buy stocks. Stocks are so cheap I can do a whole column using only stocks that start with any single letter. This month features E.

Bermuda’s Everest Re Group (RE) is so cheap at seven times this year’s earnings that a hostile takeover is easily self-financed and markedly increases the acquirer’s earnings. In today’s takeover environment I would not expect it to remain on its own for long. I do not know if its directors agree or not, but they have certainly been buying stock for their own accounts.

I recommended Enbridge (ENB) in September at $32 per share. It is a better buy now, despite the $2 dollar gain in the price. The company runs the world’s longest pipeline and moves 75% of western Canada’s crude oil. It is also one of the only plays on the Canadian oil and tar sands, the globe’s largest energy deposit. The higher oil prices go, the better Enbridge does. At 11 times my estimate of 2007 earnings and a 3% dividend yield, what was once simply a growth-and-energy play could now also be a potential takeover.

Sweden’s LM Ericsson (ERIC) is the leading supplier of cell-tower equipment like antennas and transmitters. Make no mistake: Wireless is the future. Ericsson will grow. At 15 times 2007 earnings, it is cheap. In the stronger than expected global economy I expect industrial materials companies like Eastman Chemical (EMN) to do well. But if I am wrong about the economy Eastman should do well anyway, because its two key products, polyethylene terephthalate and acetate tow, are so heavily used in plastic bottles and cigarette filters – where demand does not fall in a slowdown. At 15 times temporarily depressed earnings, Eastman is a bargain.

SHORT SALES BREAK RECORD ON NYSE

Many see it as a bullish indicator.

Short sellers are betting against U.S. stocks like never before as the S&P 500 approaches an all-time high. That is making some of the biggest bulls even more optimistic. “What the short seller appears to be doing is doubling down,” said Kenneth Fisher, who oversees about $40 billion as chairman of Fisher Investments in Woodside, California. “You love to see it, because if you believe there is a basic driver to the bull market, they’re going to get run over.”

The amount of shorting – where traders sell borrowed stocks expecting to buy them back after prices fall – jumped to 3.1% of the total shares listed on the New York Stock Exchange this month. That is the highest since at least 1931, according to research firm Bespoke Investment Group LLC. The wagers represent billions of dollars that could be invested in equities if short sellers close their positions. The bears also reassure fund managers who get skittish when few traders anticipate the possibility of a stock market decline.

Leuthold Group, which advises two-thirds of the biggest U.S. money managers, uses data on speculators betting against stocks as an indicator for prices. The higher the short sales compared with the average monthly trading on the NYSE, the better the opportunity for profiting from owning shares, according to the firm. Leuthold’s ratio is the highest since at least 1998. “Ultimately you have to cover the short positions and that tends to create more of a buying frenzy,” said Andy Engel, co-manager of the Leuthold Core Investment Fund, which has outperformed 99% of similar funds over the past five years.

“The last time we were here (S&P all-time high) there was bloody optimism everywhere and enthusiasm about the future, and everything was going to go up,” said James Paulsen, who oversees $175 billion at Wells Capital Management in Minneapolis, “Today it couldn’t be any more opposite. It’s a pretty good environment.”

Losses are mounting for traders speculating on a drop in stocks. Hedge funds that focus on shorting lost 35% from September 2002 through the end of April, according to the Credit Suisse Tremont Hedge Fund Dedicated Short Bias Index. That compared with an 82% gain for the S&P 500 in the same period. “Short selling has never been more difficult,” said David Tice, whose $680 million Prudent Bear Fund has lost 23% including dividends since the start of the bull market. “We come in every day and sometimes we say ‘another day, another record.’ But we have seen this movie before, so we are highly confident.”

Tice, whose fund generated a 168% return during the last bear market, is shorting General Motors and Advanced Micro Devices, the #2 maker of computer microprocessors after Intel. U.S. interest rates that reached a 4-decade low of 1% in 2003 allowed consumers to spend beyond their means, padded corporate profits and set off a record wave of buyouts that inflated share prices, Tice said. Tice says the S&P 500 would have to fall at least 50% for him to consider dropping his bearish stance.

Anthony Bolton, who helped turn Fidelity International Ltd. into the largest U.K. mutual fund company, said this month he is shorting some shares in the U.K. Special Situations Fund because too much money is being spent on mergers and acquisitions. “I can’t tell you when it is coming but I can tell you the precursors are there” for a slump, Bolton said at a dinner in London.

Leuthold’s research suggests those concerns are overblown. The firm’s NYSE short-interest ratio stood at 1.46 when the S&P 500 reached its peak in March 2000, and fell to 1.39 in January 2001, a full 21 months before the S&P 500 bottomed. Now, the ratio has stayed at 2.94 for two months. The company, which attributes the increase to the number of hedge funds using short-selling strategies during the past decade, considers a ratio above 2.45 bullish and below 1.8 bearish. Some investors say the growth of hedge funds also makes the information less useful for predicting market performance. “You have to take that with a grain of salt,” said Russ Koesterich, who helps manage $1.8 trillion at Barclays Global Investors in San Francisco. “More participants are shorting. That may be having some impact on distorting the data.”

BEWARE THE STYLE CORRECTNESS POLICE

When it comes to investing, the end of the quarter is often a time when people reassess and rebalance their portfolios. From mutual funds to pensions, making changes to an investment plan is relatively easy, sometimes as simple as a click of the mouse. The good news is, when considering what you own or what you might want to buy, there are many fine tools in the investment world, including the performance grades that Forbes awards in its fund guides and on its Web site. And a lot of consultants are there to help individual investors and pension plans with their selections.

Many of these people turn to style guidelines, under designer labels like Russell, Wilshire, Morningstar or others. These systems place each mutual fund into a category. In my view, too often many well-meaning financial consultants are overly dependent on such artificial constructs, to their clients’ detriment. They often ax good funds that do not adhere to the tyranny of style boxes. As a result long-term absolute returns may suffer.

While I do not mean to inflate the practice of style-pigeonholing into a cosmic issue, nobody elected the category kings. Even Donald Phillips, the Morningstar managing director who helped mastermind his service’s style boxes, argues that the boxes should be descriptive, not restrictive. Certainly I have a vested interest in this topic, since I manage funds. Morningstar characterizes my flagship, Ariel Fund, as a “midcap blend”, with “blend” meaning a mixture of value and growth. I do indeed prefer small and midcaps, because I believe they are more likely to be inefficiently priced. But blend? I am just looking for value. Any successful manager will pounce on a good opportunity, regardless of whether the style police say he should not.

When a portfolio manager moves outside the guidelines, though, he is scolded for “style drift”, as if he had broken some rule of nature. Yet style drift can occur naturally when a manager sees small- and midcap stocks outgrow their categories, just as children move up a size in clothes. What intelligent investor wants to stunt a portfolio’s growth just to fit it into a category? Further, value often can be found right next door to a manager’s core category. The important factors in assessing a possible stock purchase are valuation and a company’s underlying business fundamentals.

The early pioneers who shaped the mutual fund world – Sir John Templeton, Peter Lynch, John Neff, William Ruane, Ralph Wanger – searched for value wherever they could find it. They were not investing for their critics. In my view, independent-minded investors can do well buying stocks which defy easy characterization.

“IF YOU WANT TO BE A WOLF, RUN WITH WOLVES”

Elliott Wave International is proud to present an interview with Mr. Roberto Hernandez, a maverick trader and “a true Elliott wave expert,” as his mentor, Dick Diamond, calls him. Roberto graciously agreed to describe for EWI’s readers some of his favorite personal trading techniques, which to a large measure are based on wave analysis. Roberto spoke with us on the phone from his office in Mexico City on May 18.

EXCHANGE TRADED FUNDS SUFFER AS “SPECIALISTS” WITHER AWAY

The rapid disappearance of stock-exchange trading floor “specialists” is starting to hurt the booming ETF business. Specialists are the elite traders who, for many years, have helped maintain orderly trading amid the chaos of the floor. Now they are a vanishing breed as electronic trading gains acceptance – the New York Stock Exchange has seen its specialists decline more than 30% since last year. That is bad news for ETFs, which resemble mutual funds but trade on an exchange like a stock. Specialists have a unique role in bringing ETFs to market ...

BIG DROP IN HOME PRICES PREDICTED

Most industry watchers agree that home prices will continue to slide before they recover, but now some economists say they have got a long way to fall before bouncing back.

David Wyss, chief economist at Standard & Poors, has forecast a price drop of about 8% for the 24-month period through Q4 2008. Housing prices will suffer from a “significant increase in defaults and foreclosures,” he said, with affordability still a major issue. Wyss worried how hard the slump will hit already highly inflated housing markets. He said its impact on areas like South Florida, where much of the buying is speculative investment in second homes, could be big. “You don’t need a second home,” Wyss said.

Celia Chen, Moody’s Economy.com’s director of housing economics followed Wyss’s lead. “We also have an 8% decline in median house prices [for the 24-month period ending March 31, 2008], which is consistent with what David Wyss had.”

“That is quite a bold forecast,” Lawrence Yun, economist at the National Association of Realtors, said of Wyss’s prediction. NAR is predicting a much less severe total decline of 1.4% through the slump – prices have already declined three straight quarters – and that a recovery will start to take place in early 2008. “The run up,” Yun said, “was an investor-demand driven boom, and it was followed by an investor-driven collapse.” He noted that speculative investors in a rising market drove up prices and are now taking profits or unloading slowly appreciating properties. Buying as an investment fell by 29% in 2006, according to NAR stats. That slide, which began in 2006, will last through the end of this year, Yun said. “Now with the investor-purchase cycle out of the way, traditional factors will drive sales,” Yun said, including economic growth, job creation and population growth, as well as a demographic sweet spot: Boomers are reaching both peak earning years and the time of life when they start to buy second homes.

On the investment side, a look at the real estate derivatives market in the form of the S&P/Case Shiller index and futures appears to offer some support for Wyss. An average of the 10 housing markets listed showed a drop of 1.7% in the index from March 2006 through February 2007. Futures trading is indicating a steeper decline: 3.9% for the 12 months through February, 2008, for a total of about 5.6%. But many industry experts put little faith in the futures stats produced by trading in the Shiller derivatives. They believe they are too-thinly traded to represent the sentiment of the entire market and that traders are not objective enough.

A SCARY PROPOSITION

May 25 Financial Times: “Highly solvent SWF seeks mutually rewarding relationship. That might sound like an advert in a singles column but it is in fact shorthand for what is rapidly becoming a huge force in global markets and economies. A vast arsenal of money to invest in markets is fast being built up by the swelling ranks of so-called sovereign wealth funds (SWFs), schemes set to invest the growing foreign exchange reserves and savings of countries from Norway to China. Driven by trade surpluses unequalled as a percentage of the global economy since the beginning of the 20th century, official reserves held by some governments are now astronomically high and there is pressure to earn a better return by putting the money with specialized investment agencies. Morgan Stanley estimated in March that the total funds at the disposal of SWFs may be as high as $2,500 billion, already around half the gross official reserves of all countries. By comparison, the global hedge fund industry is thought to manage about $1,500 billion to $2,000 billion of assets ... How and where this massive – and often secretively managed – pool of funds is deployed will be one of the big investment themes of coming years. The evolution of these funds will have huge implications for financial markets.”

May 25 Market News International: “The potential rise in Chinese foreign exchange reserves to $2 trillion sometime next year is a ‘scary’ proposition, People’s Bank of China advisor Fan Gang said ... But Fan ruled out any sharp appreciation of the yuan to counter the accumulation of forex reserves, insisting that doing so against a continually depreciating dollar would have only a limited and short-term impact. ‘We don’t want to go (with) those big jumps in revaluation, because if we do this next year, or the next year, two years later it will come again, because the U.S. dollar will continue to fall. ... The practice of devaluing the U.S. dollar, Fan asserted, began in the 1960s with the German mark and continued in the 1970s with the Japanese yen. ‘Now it’s the turn of the Chinese currency. This is an international problem,’ he affirmed. ‘Because the U.S. prints money to buy things.’ He said that China’s growing current account surplus is a ‘really a serious issue’ ...”

It is scary. Global credit and speculative excess are these days as rampant as they are conspicuous. And as the number sympathetic to the Bubble hypothesis grows, I guess we should not be all that surprised by the genesis of an illusory notion that Bubbles “are great for the economy.” It adds only more support for the view that, once they catch a head of steam, inflationary excesses will surely take on powerful lives of their own. This is especially true when the prevailing inflation is in asset prices.

It is most regrettable that the Federal Reserve (and Wall Street “mavens”) has been fixated on aggregate measures of (“core”) consumer prices instead of the actual underlying monetary (credit) inflation. It is flawed doctrine being discredited before our eyes. Importantly, a stable monetary environment would have safeguarded our current account from ballooning to today’s unmanageable Deficits. I do not mean to suggest that our trading partners are not without some responsibility. But the Chinese and others can make a very strong case today for pinning blame for global imbalances on our financial excesses and inflationary policy biases.

There is inevitably a high price to pay for inapt policies that explicitly disregarded money and credit, stubbornly refused to address asset inflation and bubbles and, worse yet, promised aggressive reflations as needed. Today, we negotiate and prescribe policy from a sadly weakened stature. After all, how can we earnestly stipulate fair trading practices when, as Fan Gang noted, “the U.S. prints money to buy things” – and floods the world in dollar liquidity in the process?

It is rather foolhardy to expect the Chinese to implement radical policy adjustments (including major currency revaluation) that they view, on the one hand, as highly risky and, on the other, as unlikely to rectify (U.S.-induced) imbalances. And how can you blame them? Our policymakers are resolutely averse to decisive policy action (with the exception, of course, of aggressive easing). Moreover, the Chinese look to Japan's experience and believe the dire Japanese predicament has been very much the outcome of allowing domestic policies to be dictated out of Washington. For a variety of reasons, Chinese policymakers are a different breed than their Japanese counterparts. They will act in what they believe is in the best interest of the Chinese, and they will not respond favorably to outside pressure. They are steadfast and today hold a strong hand.

50 years from now, when economic historians look back at this period, my hope is that they recognize that U.S. financial excess was the fountainhead for the massive – and increasingly unwieldy – global pool of finance/“liquidity”. This week from Alan Greenspan: “In the United States the greatest threat that we have to our market capitalist system is the increasing degree of income inequality.” He has often in the past made similar warnings regarding the risk of rising protectionist sentiments. I can only hope that at some point an understanding emerges that income equality, protectionism, and other serious “threats” to Capitalism are the inescapable handiwork of protracted credit inflation and attendant bubble excesses. It is certainly time to rethink bullish notions related to “globalization” and “international flexibility” and recognize that we must take responsibility for returning our financial and economic houses to some semblance of order.

Let us return to the “scary” thought of Chinese reserves hitting the $2 trillion mark next year. Massive current account deficits and escalating dollar outflows to play global markets now combine for a parabolic surge in dollar liquidity outflows to the world. And from foreign official comments and the emergence of these so-called “sovereign wealth funds” it is equally clear that there is now a major shift afoot to “diversify”. It is no longer a safe bet that dollar flows will be recycled predictably back almost exclusively into the comfortable confines of the Treasury and agency marketplace. On the margin, global “official” flows have an increasing appetite for “risk assets”, a major reversal that will go anything but unnoticed by the enterprising global leveraged speculating community.

And it is all quite illustrative of the powerful dynamic of inflationary excess begetting only greater excess. For some time, escalating dollar outflows and requisite foreign central bank recycling made Treasury/agency yields unattractive (the “conundrum”), squeezing the leveraged speculators further into riskier assets. The resulting credit boom then engendered only more enormous dollar flows to be recycled, along with greater outperformance of global risk assets vs. U.S. Treasuries. Not surprisingly, the central banks (and “SWFs”) desire a piece of the action, exacerbating the flood of finance into global equities, M&A, CDOs and structured instruments, junk bonds and leveraged loans and other higher yielding instruments.

I am not going to claim any great insight into possible ramifications for ballooning pools of finance prospecting the world for better returns. I will suggest it is historic and warn it is precarious. I will proffer that this unfolding dynamic (ongoing heightened credit availability, marketplace liquidity, and inflationary biases) will in general necessitate higher global official short-term interest rates. The U.S. bond market, in particular, has been positioned for a faltering economy and Fed rate cuts – a scenario less likely near-term because of the unfolding extraordinary global liquidity and risk-seeking backdrop. And I can appreciate that savvy bond fund managers would hesitate remaining on the wrong side of this official Treasury for Risk Asset Trade. I also ponder the possibility (and ramifications) that the “SWFs” are now consciously seeking opportunities to hedge against rising inflation. So much for the myth of stable inflationary expectations.

Such a backdrop would also be expected to support the runaway booms in the heavily populated economies of China, India, Russia and elsewhere, ensuring little respite from pricing pressures throughout the global energy and commodities complex. Today, it is almost a case of mounting global inflationary pressures everywhere outside of manufactured goods prices (held in check by credit-induced overinvestment).

I will suggest as well that we have entered a dangerous period of bubble-on-bubble excess. Despite several years of significant stock market inflation – three-year gains of 46% for the Russell 2000, 51% for the S&P 400 Mid-Cap index, and 40% for the Wilshire 5000 – liquidity abundance has nonetheless nurtured a fanciful view that U.S. equities remain “undervalued”. The bulls today trumpet the case that U.S. stocks are cheap in real terms (S&P 500 at “only” 18 P/E) and relative to global equities prices. The reality of the situation, however, is that years of U.S. bubble excess have significantly inflated “fundamentals” such as corporate earnings and cashflows and personal incomes, along with global asset prices generally. Bubble-on-bubble excess today inflates the perceived reasonable bounds for valuation to extremes, on top of an earnings base that is acutely vulnerable to a post-bubble collapse. Yet perceptions hold that market risk is today much lower than during the 2000 bubble.

As we now witness, financial excess inflicts its most seductive distortions to underlying “fundamentals” during the late phase of credit bubble excess. There is an argument that lingers to this day that stocks were not overvalued in the late ‘20s. Yes – while P/E ratios were modest right up to the 1929 crash, underlying boom-time earnings had become grossly inflated and vulnerable. Similar dynamics are at play today. I fully expect corporate profits, personal income, and government tax receipts to all prove highly susceptible to the inevitable credit cycle downside.

Some choose to define bubbles as a divergence between asset prices and underlying “fundamentals”. I would instead stress how profoundly and surreptitiously late-stage bubble dynamics distort fundamentals – as both credit and asset prices lose their moorings to anything of stable value. It is when the pendulum inevitably swings back and the market places cautious multiples on post-boom earnings (that can be abruptly sliced “in half”) that create devastating losses for unsuspecting “investors”.

I am with Fan Gang on this: I find the current direction of things scary.

COMMUNISTS INVADE PRIVATE EQUITY

The People’s Bank of the People’s Republic of China has told the Chinese people that thenceforth it would not be quite so free and easy with The People’s money. Having previously told the people that it was glorious to get rich, they might have warned the people that getting rich without working is not always as easy as it looks. But they let the opportunity pass without mentioning it.

The Middle Kingdom is an old place. But it is fairly new to the ways of modern market capitalism. In fact, the ways of modern market capitalism, circa 2007, are new to us all. No man alive has ever seen quite this level of happy delirium. Still, the Chinese – who have never seen a market crash up close ... or even a real bear market ... or an economic depression that was not caused by their own politicians – are especially guileless ... and easy marks. The whole country bustles with the hope of easy money. Widows and orphans line up at brokerage accounts to open day-trading accounts. 300,000 new accounts are opened every day. Though Shanghai stocks are up 180% in the last 19 months, they are still buying. Trading volume was recently clocked at 10 times the rate of six months ago. One Mr. Hua, found by Reuters, expects nearly 50% gains per year from his stock account!

When the announcement of tighter bank reserve requirements came out, the people greeted it with alarm. Chinese stocks sold off. Then, a few days later, investors recovered from their brush with sanity and bid up stocks to a new record high. Asia’s richest and shrewdest investor Li Ka-shing concludes: “[This] must be a bubble.”

“We have actually now bubbles everywhere,” Marc Faber, who oversees $300 million in assets, told Bloomberg News. “We have bubbles in real estate, in equities, in bonds, in commodities, in art prices and totally useless collectibles. So, this bubble is huge and includes just about any asset in the world.”

Everyone now expects to get into heaven without ever dying ... and to be the one sucker in history to get a better-than-even break. Let The People have their illusions. The Chinese leadership has a folly of its own. China is buying a giant piece of a giant bubble, shares in the private equity giant, Blackstone.

Blackstone is in the business of making deals, and clearly has the wind at its back. The lenders from whom it borrows, and the public from whom it buys and to whom it sells, act more like patsies than counterparties. Japan and Switzerland lend at almost zero interest. And then investors, from whom Blackstone presumably bought an asset at a bargain price, take it back, after Blackstone has worked its magic, at top dollar. And the deals are coming fast and furious.

And now, here comes the investor with the largest cash pile in the entire world – China – into the private equity market. Here we pause to draw breath. We have before us a group of unreformed Marxists buying shares in what must be capitalism’s most capitalistic institution. “What does it mean?” we are tempted to ask. We do not know, but we think we hear the deep laugh of the gods, who appreciate irony more than slapstick.

“The capitalists will sell us the rope we use to hang them,” predicted Lenin. But it is not that simple. Instead, the Chinese sold the rest of the world – particularly Americans – thingamajigs and gew-gaws, taking America’s paper money in exchange. Now, the government of Mao and Zhou and Deng has about $1 trillion on hand. What can it do with that kind of pile? This is enough to buy a controlling interest in all 30 of the Dow Jones Industrials.

The Chinese are not dopes. They have had their long spell of political madness. They have turned their interest to money and now they are going a little mad there too. So, they are not buying rope, but assets. The communists will not hang the capitalists at all. They will merely replace them, becoming rentiers themselves, by giving back their dollars in payment for America’s remaining factories, brands, resources, and companies. And then, maybe the new owners will let us shine their shoes and do their laundry.

But even more interesting than the practical effects of this move is the theory behind it. Democracy, Communism, and Modern Portfolio Theory all rest on the same claptrap – that The People are geniuses and saints. All the theories agree that there is no higher source of wisdom, virtue, or pricing than the will of the heaving masses. If the voters want to do something foolish, who can tell them not to? And if stock buyers put a price of $40 on Blackstone shares, no other price really counts.

What is remarkable is that every punter knows it is not true. Every one of them tries to make money by taking advantage of the masses’ imbecilities. An investor buys a stock, believing he sees something in it that the rest have missed. Every bet he makes says: “I am smarter than the whole lot of you.” Blackstone’s business, too, rests on the presumption that The People have erred. The company pretends to “add value” by finding a company that the people have mispriced. Blackstone buys it, then reorganizes it, borrows against it, and pays itself millions in fees. After this shake up, when the company finally comes to rest in The Peoples’ own brokerage accounts again, it is presumed to be a more valuable enterprise.

But is there any asset or investor left on this whole planet that has not already been shaken up, and now trembles with money lust? Is there a single fragile leaf left anywhere on this sorry ball that does not flutter in the hopes of turning to gold?

GOING BALLISTIC: THE HARD FACTS ABOUT PARABOLIC SPIKES

Living through a mania is supposed to be a once in a lifetime event. For example, the French, who lived through the implosion of the Mississippi Scheme, and the English, who lived the South Sea Bubble collapse in the 1720s, did not see the same parabolic rises again during their lifetimes. Or for a more recent example, consider the parabolic rise of the Nikkei to its all time high in 1989, the aftermath of which has since changed the disposition of the Japanese toward their stock market. As we mentioned in The Nikkei: Raiders of the Lost Ark, Japanese nationals have a different view of their stock market than foreign hedge fund managers: “Although there is a problem in that [Japan’s] stock market is supported primarily by foreign investors, Japanese nationals make up 95% of its government bond market.”

And yet, while the NASDAQ is still valued at less than 50% of what it was seven years ago, investors seem more than willing to get in or stay in “for the long term.” For those, like us, who “cannot see the collective wisdom of the market,” who think that things like debt, sharply falling retail sales, sharply falling housing sales, and wars with no end matter, we need to get over our worries and realize that the Dow is going up and that nothing else matters but ... price. After all, the Dow is hitting all time highs, and if we missed out on its 13%, 1600 point rise over the last 10 weeks, we must be fools. There is no time to ask questions – just fire the trader, manager, or newsletter that does not “get it”, and move on. As in all credit induced manias, at the end of the day the only thing that matters is recent – and I do mean recent – performance.

Jeremy Grantham explained this mindset in his recent quarterly letter to his institutional clients: “The more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you.” As all true contrarians know, this is when making decisions opposite of the herd is the hardest, and yet, as history has shown, this is when it often proves most rewarding. So let us look at three variables that all investors should be evaluating right now to resist the siren’s song of higher equity prices as we pass through this ever-rising sea of debt.

Lessons from 2004 to 2006

In June of 2004, we released Special Edition: Parabolic Rises with this chart, produced by Elliot Wave International, clearly revealing a parabolic spike in the price of silver. As this chart shows, after hitting $8.50 two weeks later, silver dropped 36% in just five weeks to $5.45, and would not surpass its previous high until December of 2005. Then, in another parabolic move silver went to $15.21 into May 11, 2006. It then decline 38% in a little over four weeks, and has not reached that price since (see chart). This is not about bashing silver. Frankly, right now, I can see some compelling arguments for being long or short silver.

The main purpose of these charts is to show that when the price of anything goes parabolic, even though it is fun to run to your computer screen every day, it is a clear warning to employ contrarian thinking and resources. Bullishness has run to extremes and price levels could experience a sharp enough downdraft to warrant severe caution. In July of 2005 we released a newsletter called Teenage Investing (PDF), displaying a number of charts and pictures from a wide variety of sources. As you can see, the parabolic rise in housing stock was clearly unsustainable. After topping at 1325 on July 20th of 2005, the index fell 47% to 702 one year later, and currently trades around 765.

A Look at 2007

So, what parabolic rises today tell investors that markets could change violently? The Shanghai Stock Exchange in China would certainly qualify. Since the middle of 2005, its annualized rate of growth has increased from 70 to 291 to 526%! Clearly, unsustainable. And though its growth is dwarfed by the Shanghai, the S&P 500 has begun to move in parabolic form. As shown, its annualized growth rate has gone from 14.5 to 34 to 74% annually. Sustainable? We think not.

And as these rises are taking shape, rather than address the unsustainable nature of parabolas, many bearish advisors believe that as long as the Fed inflates the money supply, which is currently growing at an annualized pace of 13%, this flood of credit will continue to drive up equity prices. History and science show that nothing could be further from the truth. For example, on April 16th Greg Weldon, of Weldon’s Money Monitor, cited a report from the People’s Bank of China revealing the largest growth of commercial lending in China’s history. In Q4 2006 China’s commercial loan volume was 425 billion Yuan. During the first quarter of 2007, it topped 1,423 billion Yuan, a 335% increase in 90 days! How likely is this performance to repeat for several more quarters?

As with the housing market, eventually bubbles grow so large that they require enormous reserves just to maintain their current shape. They become so large that they are unable to grow, much less grow at their previous astronomical rate. For those who doubt, I ask, how much would the dollar need to depreciate and inflation need to rise to move the Dow to 20 or 30 thousand? How much of a decline in consumer savings or a rise in housing prices and a decline in inventory would it take to bolster retail or auto sales? At some point, the stress on the system will become too great and a rapid reversal will begin.

The Black Swan

In his new book, The Black Swan, Nassim Nicholas Taleb expands on a concept he addressed in his first book, Fooled by Randomness. In the opening, Taleb addresses three attributes of the Black Swan:

“First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.”

And when we understand this concept, we realize why anticipating the rare event is critical, and that any model that does not address this risk is dangerously incomplete. Parabolic rises contain within themselves the warning of a price breakdown. As such, I strongly encourage you to help your clients and friends to stop extrapolating our current conditions into the indefinite future, and to stop repeating the phrase, “Well you have been saying that the markets were going to decline for a long time, and nothing has happened yet.” The real science of price movement and the pragmatic restrictions of debt overhang reveal the fallacy of such a mindset. But, emotions can cloud our judgment and make us rationalize the most reckless of actions.

The truth about tulipmania.

When the economics profession turns its attention to financial panics and crashes, the first episode mentioned is tulipmania. In fact, tulipmania has become a metaphor in the economics field. Should one look up tulipmania in The New Palgrave: A Dictionary of Economics, a discussion of the 17th century Dutch speculative mania will not be found. Guillermo Calvo, in his contribution to the Palgrave instead defines tulipmania as: “situations in which some prices behave in a way that appears not to be fully explainable by economic ‘fundamentals.’”

Economic historian, Charles Kindleberger, in spite of referring to tulipmania as “probably the high watermark in bubbles” gives the episode scant treatment in his Manias, Panics, and Crashes: A History of Financial Crises (1989). Kindleberger’s view of tulipmania may be gleaned from a footnote on page seven of the second (1989) edition. “Manias such as the tulip mania of 1634 are too isolated and lack the characteristic monetary features that come with the spread of banking after the opening of the eighteenth century.”

It is highly probable that Kindleberger’s view was the supply of money in 1630s Holland did not undergo the sudden increase needed to create a speculative bubble. But this paper will present evidence to the contrary. The supply of money did increase dramatically in 1630s Holland, serving to engender the tulipmania episode.

GOLD DOES NOT TRACK THE S&P 500 ... OR AT LEAST IT DID NOT UNTIL NOW

Pigs don’t fly. Chickens don’t kiss. Gold does not track the S&P 500. That is just the way things are ... or, at least, the way things WERE. Pigs still do not fly, of course, and chickens still don’t kiss (at least not well), but gold DOES track the S&P 500 ... for the moment. What does this quirky development signify? And what does it portend?

Or to combine these two questions into one very pointed question: Since gold has been following the stock market to the upside, would gold also not follow the stock market to the downside? The answer to this question probably resides within the CAUSE of the curious correlation between gold and U.S. stocks. And that cause, broadly speaking, is “liquidity”.

Simply defined, liquidy is that vast pool of cash, credit and derivatives that animate financial asset prices. Increasingly, this vast pool is controlled by hedge fund managers, private equity firms and all the other professional investors who strive to justify their hefty fees. As these heavy hitters scour the globe to extract “alpha” (excess return) from the financial markets, they toss their “buy” orders at any asset class that offers a compelling potential return. All the world’s major financial assets, therefore, are floating on the same vast sea of liquidity – U.S. stocks as well as Chinese stocks, Kansas farmland, Brazilian bonds and yes, even gold.

Historically, gold and U.S. stocks have tended to diverge from one another. Whenever the S&P zigged in one direction, gold would zag in the other direction. This reliable non-correlation has emboldened cautious investors throughout the ages to allocate at least 10% of their portfolios to gold. Today, cautious investors continue to allocate a large portion of their wealth toward gold and gold stocks. But gold may no longer be the all-weather hedge that its admirers expect. Gold’s behavior relative to stock prices has changed. A lot. “The observed tendency of gold to go up when stocks go down is no longer observable,” remarks James Grant in the May 18 issue of Grant’s Interest Rate Observer. “For a shining example of how things used to work, one need look no further than the events of October 18, 1987. On the day of the crash, the S&P fell by 20.5%, while the gold price rose by 3.4%.”

Even more recently, gold has maintained it reliably contrary performance relative to stocks. “From the opening months of the year 2000 until just recently,” Grant relates, “gold and equities went their separate ways. While the Nasdaq fell by 45% and the S&P rose by just 11%, the gold price climbed by 133%.” But something has changed. Gold has joined the “investment mainstream,” says Grant. Gold and equities now dance arm in arm.

As this chart illustrates, gold’s recent correlation with the S&P 500 is both quite pronounced and quite aberrational. A negative reading on this chart indicates an inverse correlation between gold and the S&P 500, whereas a positive reading indicates a positive correlation. So the greater the negative number, the greater the tendency of gold and the S&P to move in opposite directions, and conversely. For the better part of two decades, gold exhibited an inverse correlation or non-correlation with the S&P. But over the last few months, the gold/S&P correlation has swung from consistently negative to sharply positive. Gold might as well be a member of the S&P 500.

So now that this historically non-correlated asset has begun fraternize with enemy, so to speak. As such, the next sharp downturn in the stock market might coincide with the next sharp downturn in the gold price – at least for a while. But sooner or later (probably sooner), gold’s contrary tendencies will likely reassert themselves. A few months of uncharacteristic correlation with stocks does not automatically erase gold’s legacy of non-correlation and wealth preservation.

“The history of paper money is the history of debasement,” Grant reminds us. ”So we goldbugs accumulate gold, not so much as a hedge against the unknown but as an investment in the preordained. Paper money loses value. That is its fate.” But while fate almost always shows up where it should, it almost never shows up WHEN it should ... or when an investor hopes it will.

“It might be that this joining of hands of previously estranged classes of investment assets [has been] an aberration, and that a long-term, committed buyer of gold can safely ignore it,” Grant concludes. “But I fear it’s no fluke ... If I’m right about this, gold may disappoint its many fans in the next bear stock market – that is, before the derangement of the world monetary system furnishes the fundamental cause for even higher prices in the years to come.”

APPETITE FOR DESTRUCTION

Each morning I pick up the Financial Times and turn to the back of the Companies & Markets section to check in on world equity markets at a glance. I scan every major international index for stocks with single digit P/E ratios. The theory is simple. I am scanning for companies with exceptionally strong earning power. You can roughly estimate a company’s earning power per share by taking the inverse of its price/earnings ratio. A stock with a P/E ratio of 8 can be said to have earning power of 12.5%.

Benjamin Graham points out that there is a margin of safety in an expected earning power considerably above the going rate for bonds. So a 12.5% earnings yield on the stock offers you the investor a 7.5% average annual margin over the 4.85% bond rate. So after finding 10 or so stocks, I would jump to the other side of the page to compare these earnings yields to the returns offered on their respective benchmark government bond. If I found a decent spread, I would dig deeper. That is a simple approach any reader can do over some wheat toast and a cup of coffee.

As I was working my way from Taiwan to Thailand it struck me that the number of single digit P/E ratios across the globe has dwindled dramatically. Finding multiple securities that fit the bill used to be an easy task, especially in cases like Thailand and Israel where political risk carried significant weight. South Korea also offered up its fare share. That is no longer the case. There were fewer than 80 today. And most of that bunch snuck in the 9+ category. Hardly the impressive double-digit earnings yield I am looking for.

I equate this phenomenon to something colleague Eric Fry touched on (see article immediately above). The cause, broadly speaking, is “liquidity”. Eric points out, “Simply defined, it is that vast pool of cash, credit and derivatives that animate financial asset prices.”

The point is, the world’s sudden appetite for risk seemingly knows no bounds. This seeming impenetrable attitude has combined with mounds of excess cash to catapult stock prices across the globe well over the 20 times earnings mark. And not just emerging markets. Inflated asset appreciation is taking place in mature markets like Japan, Hong Kong, Switzerland and the U.S. All four markets have P/E ratios above 20. A price-to-earnings ratio of 20 offers a 5% earnings yield, or roughly, the same earning power as a government bond except these stocks carry significantly more risk.

Successful investing will require a combination of patience, realistic expectations and, most importantly, buying shares of businesses at the right prices. I cannot stress that enough. As investors, we are looking for a margin of safety – companies trading near or below their intrinsic value with established earning power. That is basically it.

It does not take a financial genius to recognize that the Chinese market cannot go up forever. Brace yourself for the inevitable fall. It does not take a white-shoed, Wall Street banking analyst to realize that shares of Bank of China should not trade for 35 times future earnings.

Mark Twain once said: “History doesn’t repeat itself, but it often rhymes.” I doubt even he could imagine our tendency to repeat the same reckless behavior by paying too much for securities would happen so quickly. Our appetite for greed equals our appetite for destruction. Despite even our most blatant examples of irrational market exuberance (dot.com land, sub-prime lenders, etc.), many investors are already aggressively making the exact same mistake all over again by simply paying too much for a business. They fool themselves into believing that there is a greater fool prepared to pay an even greater price. They rationalize their behavior by saying it is different this time. It is never different this time. But around and around we go.

MONEY IS FLOODING THE WORLD MARKETS

Central banks live by a simple financial principle: Whenever economic activity stagnates or declines, they quickly lower their interest rates and expand their credits. But when business seems to improve, they hesitate and vacillate in removing the rate cuts. The consequence is a permanent addition to liquidity. According to calculations of the German central bank, between the end of 1997 and September 2006 the stock of world money nearly doubled, but nominal economic production rose only by some 60%. Such an imbalance is bound to either cause consumer prices to rise or create price bubbles in stock, loan, or real estate markets. When they finally burst they are likely to inflict many personal losses and force businesses to repair and readjust.

Every week we may hear and read about new corporate mergers and acquisitions. Flush with cash, private equity firms are ever ready for more deal-making, bidding for and acquiring another company. The merger and acquisition boom is buoying stock prices across the board, which is benefitting most investors. Moreover, as some corporations are being taken private and others are engaged in stock buybacks, thereby reducing the overall supply of corporate shares, the stock market is enjoying an extraordinary boom which many investors hope will never end.

Some economists point to the bursting of the bubble in 1929 which led to the Great Depression of the 1930s. They also remember the bursting of the Japanese bubble in the early 1990s, which kept the Japanese economy depressed for nearly a decade. And they cannot forget War II and postwar monetary policies which, by the beginning of the 1970s, had flooded the world with U.S. dollars. Some countries finally removed their currency ties to the dollar, and the oil-exporting countries cut their supplies of oil, which caused raw-material prices to soar. In the early 1980s, it took major Federal Reserve restraint to restore some measure of stability and several years for business to repair some damage and allow the American economy to expand again.

Government planners and central bankers are making the same mistakes yet again.

At the present, government planners and central bankers are making the same mistakes all over again. They all seem to like low interest rates, thereby rendering capital artificially cheap. In a free economy, interest rates play a role similar to those played by prices and wages. The market rate of interest is a gross rate usually consisting of three distinctive components: (1) the pure rate, (2) the depreciation rate, and (3) the debtor’s risk premium. The pure rate is the very core stemming from man’s very nature which forces him to view economic phenomena in the passage of time. He ascribes a lower value to future goods and conditions than to present provisions. The difference is the pure rate. The depreciation component appears whenever government or its central bank inflates, thereby depreciating the currency. The debtor’s risk premium, finally, reflects the reliability and trustworthiness of the particular debtor.

Central bankers rarely pay attention to the market rate. Their policies are guided by popular doctrines calling for stimulation of national employment and income. They seem to be unaware that all rates other than market rates give false signals to producers and consumers alike. They cause maladjustments. With recent rates below the market rate it cannot be surprising that total American debt has surged by several trillion dollars. The Federal Reserve System, together with some 7,900 commercial banks, provided the funds. Foreign central banks and commercial banks invested their dollar earnings in nearly one-half of the federal government’s debt.

Such credit expansion, unsupported by genuine savings and capital formation, generates illusionary gains making people believe that they are more prosperous than they actually are. Stock and real estate prices soar, tempting people to spend their gains, improve their homes and build mansions. Actually, they all – businessmen and stockbrokers, executives and workers – may consume their material substance. But no matter how low the Fed may set its rate, the boom is bound to come to an end as soon as the maladjustments inflict losses on business. As more and more businesses face difficulties or even fail, the readjustment begins, forcing them to respond to the actual conditions of the market.

Today, the Fed is doggedly ignoring the market rate of interest. It continues to direct the credit expansion, which not only has turned housing into a large bubble and rekindled the stock market but also has given rise to a voluminous foreign trade imbalance. Both domestic and foreign maladjustments are inflicting growing pains on commerce and industry. Some economists believe that central banks may have a ready escape from the dilemma in the gradual return to higher rates of inflation which forces bond holders to bear the most losses. Optimists even like to point to the impact of globalization, which seems to limit the inflationary effects to real estate and the booming mergers-and-acquisitions market. But most economists are fearful of a recession which is a normal part of a business cycle. Government is then bound to embark upon employment programs and assume increased public welfare responsibilities. It may even reduce some taxes, increase its budget, and force its central bank to lower interest rates another notch. The rate of inflation is bound to soar.

A few pessimistic economists are convinced that a devastating economic cataclysm lies ahead. They usually point to three threats that may have a serious impact on the American economy. (1) There is the burgeoning tower of public and private debt resting on a foundation of greed and overindulgence. (2) There are a multimillion-dollar list of promises to a retirement system and a vast building of government guarantees and promises that are bound to be unkept. (3) There is a world of complex derivatives, the value of which depends on something else, such as stocks, bonds, futures, options, loans, and even promises. They all, according to these economists, will be the victims of the coming cataclysm.

Pessimists underestimage the capacity of government and central bankers to hide the consequences of their policies.

This economist, who has observed central bank policies since the 1950s, is in basic accord and feels sympathy for these pessimists. They seem to have a clear view of the principles of money markets and the policies conducted by governments ever since they discarded the natural money order, that is, the gold and silver standards. But these pessimists tend to ignore the countless ruses, devices, and stratagems used by government officials and central bankers to hide the consequences of their policies. Long before there will be a financial Armageddon, there will be a myriad of government regulations, controls, edicts, and rulings that hide the consequences of monetary policies. Policies will be readjusted frequently to cover the actual effects. Given the public confusion and unfamiliarity with monetary policies and their consequences, a large majority of the public is likely to accept official explanations and welcome the regulators and controllers.

The voices of reason may eventually be allowed to get the American economy moving again, by allowing wages and prices to readjust to market forces. They may even have to conduct a currency reform, that is, issue new money at various ratios to the old. Most countries all over the globe have suffered currency reforms in recent decades. It would be a new experience for Americans.

We cannot tell what the future will bring, but we must always prepare for it. This economist is bracing for a gradual increase of political controls over economic life, leading to countless maladjustments, distortions, and stagnations. But this trend of policy and its harmful effects is contravened by the world-wide movement toward globalization. As trade doors open all over the globe and business capital is free to move to friendly countries enjoying rapidly rising levels of productivity and living, it will be difficult for American political controllers and regulators to hold on to their powers and move toward a command system. They cannot douse the light of economic freedom shining in so many places.

SHIPSHAPE!

Trade between Asia and the rest of the world is booming so fast that port facilities around the world struggle to handle the volume. Looming is another congestion crisis such as the one that happened three years ago. In the summer of 2004, container ports around the world choked-up because they simply could not keep up with the surge of containers from abroad. The problem was particularly bad on the U.S. West Coast.

People in the shipping business have voiced concerns about the long-term efficiency and capacity of U.S. ports. With forecasts calling for container traffic to double over the next 15 years, things look to get worse before they get better. Indeed, it seems a repeat of 2004 is in the offing.

China alone accounts for one out of every four shipping containers handled worldwide. The problem is the rest of the world cannokeep pace. Local residents and environmental groups oppose bigger ports, and labor unions often fight efficiency efforts if those efforts will cost them dues-paying jobs. The union issue is a big one. In 2002, a large strike shut down 27 West Coast ports, led to $15 billion in losses and took 100 days to clear the resulting cargo backlog. America’s ports are not as efficient as ports in other parts of the world. According to research by Accenture, America’s ports lag the efficiency of those in Hong Kong and other leading Asian ports by four or five times.

The result of this congestion is a great boom in shipping rates. In particular for the dry bulk carriers – those that haul grains, ore and other dry goods. Peter Georgiopoulos, chairman at Genco Shipping, recently opined, “The last time there was a really big dry cargo boom was after the Second World War, as Europe and Japan had to be rebuilt. We are coming to something similar to that – but India and China are bigger than Europe and Japan were after the Second World War.”

Last June, I recommended Horizon Lines (HRZ) to my subscribers. HRZ is in the middle of this whole thing. Its president and CEO, Charles Raymond, has been outspoken about the problems in our ports. He told attendees at a recent conference, “It is no longer a question of if our nation’s transport infrastructure will start to fail, but when.” Raymond has a solution: short sea shipping, or shipping along our coasts and inland waterways, which is what Horizon could provide. Raymond says, “Short sea is not the only answer, but an answer we must explore now.” As our major ports get overly congested, short sea shippers like Horizon Lines can move cargo from congested ports to others with available capacity. This is something the large vessels entering the major ports cannot do. Horizon Lines will have the ships as early as 2008 to launch short sea shipping services.

Horizon has been a winner for us, up about 130%. The only regret I have is that I did not pick up another shipper or two. Several have doubled since last summer. But there will be other opportunities, not only in shipping companies, but also in ports and other ancillary businesses and infrastructure elements.

Shippers are also exploring alternative routes. Some have introduced services to Mexico’s port of Lazaro Cardenas, where containers are then shipped by rail to the U.S. There is also a new port in the works at Prince Rupert, on the coast of British Columbia. It is 1,100 miles closer to Shanghai than Southern California and shippers have access to the U.S. via an uncongested railroad line. Maybe this is why Buffett likes railroads – they are part of this cargo boom. Then there is expansion of East Coast ports, which China accesses through the Panama Canal.

There is one other area that also looks interesting. Take a look at the airfreight companies. Ocean freight has been growing faster than airfreight in recent years, but airfreight should triple its traffic load over the next 20 years, according to independent estimates. As a result, the world’s air freighter fleet should double over that time. Last September I recommended ABX Air (ABXA). Recently, it has slipped below my buy-up-to price of $7. It is a more speculative idea, but an interesting one, given the backdrop for freight. The stock also trades for only about 10 times this year’s earnings estimate. It is another way to gain some exposure to the biggest boom in cargo since World War II.

WEATHER ROULETTE

Let’s play weather roulette. Not that we have a choice in the matter, really. So we might as well play. Every year about this time, Mother Nature starts to whip up storms in the Gulf of Mexico, and farmers in the Midwest begin to worry about getting enough rain. This year is no different, weather-wise. But it feels a lot different, commodity-wise. Grain prices are already sky-high. So any setbacks during the summer could produce dramatic action in the trading pits of Chicago.

In general, I am bullish on grain prices – not because of what I know, but because of what I cannot know: the weather. Since demand is very firm in most grain markets, the main price influences should be on the supply side. That is where the weather comes into play. Already this year, adverse weather trends delayed corn plantings in the Midwest. I saw it firsthand. In late April, I went out to Illinois and Indiana to see some farms for myself. I visited during what is traditionally the busiest planting week, but due to all the cold, wet weather, barely anything was going on. Every day the crops did not get in the ground meant a bigger chance of lower-than-average yields. As we now enter summer, new challenges arise.

A lot is on the line. Many of these hard-working growers have planted corn from “post to post”. For many of the farmers, the input costs to get the crops in the ground have been staggering. Seed, fuel, new equipment, fertilizer ... All of these expenses seem justified because of the “promise” of a big payday when that golden crop is harvested and driven to the nearby ethanol plant. But this is a dream that could become a nightmare for many farmers if the weather does not cooperate.

When I looked out over the vast corn and soybean fields, I saw many of the larger farms had irrigation systems – those massive, sprinkler-like things that roll down the fields. Many smaller farmers, though, do not have that equipment. When July temperatures spike, and if La Nina fulfills her promise, irrigation will be an around-the-clock necessity. Those irrigation machines run on fuel. A lot of it. That expense could add a ton to the bottom-line cost for this year’s crops.

Meanwhile, down in the land of Dixie, they are actually trying to grow corn too, in cotton states like Georgia. It sounds crazy, as the climate is completely wrong, but the allure of cashing in on that ethanol bonanza is strong. How nuts has it gotten? I read early in the year that an old orange juice processing plant in Florida was being converted to an ethanol refinery. Equally crazy, it is actually possible to get government subsidies to grow corn in Nevada.

The fight over water is going to become so intense in the Midwest, Southeast and Southwest, and this will be an absolute disaster for the country. The average ethanol plant uses 100 million gallons of water a year. Farmers irrigating all those fields use millions of gallons of water. Already, major fights over water rights are starting, and the battle lines are being drawn.

If temperatures climb to record levels this summer and water supplies become even scarcer than they already are, the outlook for farmers is grim. This is a problem that cannot be solved. You cannot build a factory that can create a substitute for water out of switch grass or anything else. This is a problem that will get a lot worse before it possibly gets better. We may be adding a water-related stock to our portfolio very soon. In the meantime, we will be watching the weather ... literally.

THE RETURN OF POLITICAL RISK

The assaults on foreign investors by Russia’s Vladimir Putin and Venezuela’s Hugo Chavez highlight one inexorable fact: political risk is back, and it is here to stay. International investors who seek to analyze risk by purely economic means ignore it at their peril. Political risk never entirely disappeared. Even during the holiday-from-history nirvana of the 1990s there were countries like Serbia, North Korea and Congo where your money was not safe. Nevertheless, it is not a coincidence that political risk has reared its head again recently. Political and economic developments have combined to make it do so.

In the 19th century, political risk was a minor problem, concentrated largely in Latin America where early versions of Latin American populism reared their head from time to time. Contrary to popular memory, the West did not generally sort it out by means of a flotilla of gunboats, although the bombardment of Alexandria in 1882, rescuing as it did Prime Minister William Gladstone’s £53,000 investment in Egyptian bonds, was a notable exception to this. The great majority of 19th Century defaults were due to the country concerned running out of money, rather than to any overtly hostile activity on the part of its government.

World War I was bound to make a huge mess of international obligations, as was the inflation that followed in Germany and the economically catastrophic break-up of Austria-Hungary. However the Soviet default on Czarist bonds and nationalization of foreign-owned assets was a different matter. Here was a major economic power, active in international markets for the previous century which not only defaulted on debt (as did Austria-Hungary and, though inflation, Germany) but also seized foreign-owned assets without compensation. From then on, political risk became a continuing problem in the 1920s and 1930s, as bond defaults that were often due to economic circumstance were accompanied by asset expropriation.

After World War II, there was a short burst of defaults by the unfortunate countries of Eastern Europe that were sucked into the Soviet empire, and by China going Communist in 1949, after which political risk died down considerably. From time to time a country such as Cuba or Angola would go Communist, but generally foreign assets were safe from anything but the occasional nationalization with full compensation, as with the British steel industry in 1949 and again in 1965. The Francois Mitterrand government in France, in retrospect not a particularly extreme bunch, caused much more frisson in 1981-83 than it would have done 50 years earlier when it nationalized the French banking system, some of which was foreign owned.

After the Berlin Wall fell, it seemed that political risk had more or less disappeared. Communism and socialism appeared to have been discredited by history, with even those countries like China that remained nominally Communist giving more and more emphasis to private property and achieving rapid growth by doing so. Meanwhile Eastern Europe and most of the former Soviet Union opened their economies to private ownership. Although the security of private property in those countries remained shaky for many years, there appeared to be little evidence of backsliding in any country into which a rational person would have invested.

Nevertheless since 2000 the tide has clearly turned, with first Argentina and more recently Venezuela and Russia being the most obvious examples of expropriation. It is worth looking at what changed, and whether the new instability is permanent.

The first and most important new factor has been cheap money, and with it an upsurge in investor enthusiasm for risk. Whereas even in the late 1990s investors remained cautious about political risks in emerging markets, and were suitably scarred by the Argentine debacle in 2001-02, the continued overexpansion of the world’s money supply since then has caused normal caution to be abandoned altogether in search of extra yield. The J.P. Morgan Emerging Market Bond Index (EMBI) has soared, reducing the average yield spread above U.S. Treasuries on such bonds to well under 2%, remarkable for an index which is concentrated 50% in the un-emerging economies of Latin America and another 16% in the distinctly dubious Russia.

When investors are eager to lend and invest new money, there is little point in expropriating them, but also little damage from doing so. The action of Ecuador’s new finance minister Ricardo Patino, calling in Argentine consultants to advise him on debt default and then announcing proudly that the consultants had advised him it was not worth it, instead he should go out and borrow some more money first, is typical of the unpleasant new era in its gross disregard of private property rights. There can be little question that even when destruction of property rights is not imminent, as in this case, it awaits only the next economic downturn.

The second factor that has changed since 2000 has been the resurgence in oil prices and commodity prices generally. While in some few cases such as Indonesia this has caused a distinct improvement in the economic prospects and living standards of many impoverished people, in most cases it has simply enriched a tiny and unattractive elite. More important, it has appeared to demonstrate to those seeking an alternative to capitalism that if your country has natural resources, it can avoid capitalism altogether and expropriate the value of those resources to government boondoggles, armaments and corruption.

For this is the true dirty secret of human development: Capitalism, the economic system that develops economies and produces unimaginable riches, is deeply unattractive to the majority of people. In a democratic system, any demagogue offering a plausible alternative to capitalism will find his electoral path magically smoothed. Any transitional difficulties as in Russia or long term problems caused by state ownership of resources as in Venezuela will offer opportunities to blame capitalism for the problem and offer some form of statism as the solution. If the economy’s main revenues flow through the government, as in oil producing countries, it becomes impossible to wean either the government or the electorate off a state-directed model.

Even in successful capitalist economies, such as Britain and the U.S., it is notable how quickly the political system ditched Ronald Reagan and Margaret Thatcher, replacing them not with other capitalists but with soft-centered populists of the Third Way, Tony Blair and Bill Clinton. Such leaders purported to offer the soft ideological pabulum of socialism without sacrificing the real benefits of the free market, an attempt to have it both ways that was irresistibly attractive to ill-educated electorates. Socialism is not dead, it will never die – while the majority of voters are ignorant of economics it can suffer only the most temporary of setbacks.

Vladimir Putin and Hugo Chavez both took office at low points in their countries’ fortunes, and benefited from a sharp appreciation in the price of their most important resource. The interesting question is what happens when the period of cheap money and high oil prices – which are of course interconnected – comes to an end. In the short term, there will unquestionably be more expropriations of private property, some of them in very unlikely places where investors had never previously felt threatened. If the oncoming recession is a deep one the apparent “failure” of the capitalist system will bring electoral success for numerous crazed and dangerous demagogues, as it did in the 1930s. Wlectorates almost never have the sense to turn towards capitalism rather than away from it in periods of economic difficulty.

Then the level of political risk will depend on the response of the major capitalist economies to their citizens’ foreign investments being seized. One possibility is that as in Russia in 1998 or Argentina in 2001-02, the response of the international financial institutions, statist themselves, will be to provide short term cash to the looters and ease their path back to the conduits of international money. In that case the property seizures will appear to have been justified, and the looting governments as in Argentina will enjoy several years of apparent recovery based on consuming other people’s resources.

If that happens, political risk will again have become endemic in the system, and the globalization of international debt and equity capital will go sharply into reverse, as in the 1930s. Trade barriers, exchange controls and a reluctance to invest abroad will become the norm. Needless to say, the world will by this course be pulled onto a much slower growth track, if indeed overall economic growth continues at all.

If on the other hand the West responds aggressively to looting, cuts off looting countries from sources of international capital and restricts their access to trade finance, then looting governments may quickly find their local popularity dissipate, after which something better may emerge. (The only difficulty here would be those looting countries like Russia that have massive nuclear armaments, for whose governments World War III may seem an attractive alternative to loss of office.) In this case, a sharp distinction will rightly be drawn between those countries that seize private property and those that do not, for whom trade avenues and international credit will remain open. By rewarding good behavior, the West will thus reduce the prevalence of bad behavior.

Cynical as I am about the competence and motivations of the current political classes, I would bet on the first rather than the second of these two outcomes. But in human life, there is always hope.

THE WISDOM OF WARREN BUFFETT AND CHARLIE MUNGER

There are two events that strain the capacity of Omaha, Nebraska, to accommodate visitors. One is the College World Series. The other is the Berkshire Hathaway Annual Shareholders Meeting. More than 27,000 people filled Qwest Center on Saturday, May 5. All of them came to hear two remarkable investors, Warren Buffett and Charlie Munger. The duo sits before the assembled throng and tirelessly answers questions put to them. In two parts, this extended Q&A runs about five hours.

There are the inevitable grandstanders with their political statements and nutty questions. Then there are the sappy odes of hero-worship. There also seemed to be a lot of Germans asking technical questions about how Buffett and Munger calculate “intrinsic value”, as if making billions investing was an engineering problem. Investing is not like building BMWs. Despite these distractions, enough sensible questions slipped through such that the duo seemed to touch on every major issue on the financial scene today. From my notes, I have stitched together some of the comments I found most interesting or wise.

On the housing market woes, Buffett noted how Berskshire’s housing-related businesses are getting hit. Unlike many overeager investors today, who feel compelled to run into burning buildings by buying flaming housing-related stocks on the theory that the worst is over, Buffett offered a contrary view: “My guess is that it continues for quite a while.” These guys think in glacial terms. Long-term is a lifetime. Therefore, “quite awhile” could mean at least “years”.

On the private equity bubble – which involves so-called private equity firms raising huge pools of money and then borrowing a lot more to buy whole companies – Buffett noted a great flaw in the scheme. Private equity firms have a “great compulsion to invest quickly.” That way, they can go out and raise another fund and keep the fees coming in. Basically, private equity firms are paid for activity, not results. And the nature of the business means that we will not know who is successful until many years have passed. Buffett said the “score card is lacking.”

On management compensation schemes, Buffett put the issue in perspective: “There are more problems from having the wrong management than having the wrong compensation structure. It is more important to have the right people.”

On the record level of corporate profits in America, Buffett acknowledged the all-time high. He noted it is a weird world we live in where companies are getting 20% returns on tangible capital in a world where the long-dated T-bond is yielding 4.75%. “At the moment, Corporate America is living in the best of all worlds.” History shows that these episodes do not last. Munger added that much of the record profit growth stems from the massive financial center, a fact that “has no precedent.”

On the best way to become a better investor, Buffett advised: “Read everything you can ... after that, you have to jump in the water.” He said the difference between investing with play money and investing with real money is like the difference between reading a romance novel and doing something else.

On the health care mess, Munger said: “It is too tough.” Buffett added, “We look for easy problems.” That may sound like a cop-out to some, but it is the core of a brilliant idea about the nature of good investing. Buffett commented how their success is not because their winners were any bigger than anyone else’s. It is that they managed to avoid big setbacks. He mentioned a guy who was smart 99 times out of 100, but that 100th time did him in. You must avoid that.

On derivatives, Buffett noted how derivatives increase leverage – a “largely invisible leverage.” That could make a crash or downturn even worse, like adding gasoline to a fire. This is one of the big risks in the market today – the heavy derivative use by many firms. These instruments are untested in a crisis. We really do not know how they will act or what they will cause people to do. Buffett invoked the 1987 crash as an act of forced selling. “We may not know where the danger begins or ends” with regard to derivatives. Munger added that the accounting for these instruments was deficient. People are getting paid for profits in which they are taking huge risks, like the proverbial picking up pennies in front of a steamroller.

On the increasing short-term thinking of market participants, Buffett talked about an “electronic herd” that thinks decisions in their portfolio must be made every day or every hour. “Nothing evil about it, but it means they are playing a different game ... and it has different consequences than a buy-and-hold environment.”

On global warming, Buffett said, “The odds are good that it is serious, but I am not a scientist. I cannot say I am 100% or 90% certain, but it would be foolish to say that certainly it isn’t a problem. Once it manifests itself to a significant degree, it is too late to do anything about it. I think you should build the arc before the rains come. If you are going to make a mistake, you should err on the side of the planet ...” To which Charlie Munger replied, “Carbon dioxide is what plants eat, and so generally it is a little more comfortable to have it a little warmer instead of a little colder. It is not as though vast groups of people trying to move to North Dakota from southern California. It is not at all clear that it would be worse for mankind in general to have the planet a little hotter ... You’d have to be a pot smoking journalism student to think it will be a calamity.”

On fears of a crash or meltdown or bad things happening in the market, Buffett offered wise words: “Something bad will happen, but you could go back at anytime in the last 100 years and say the same thing ... You can freeze yourself out indefinitely.” Every investor must play the hand he is dealt.

On different investment structures, Buffett said, “Investment results are not a matter of form.” Hedge funds, mutual funds and private equity firms – none create good investment returns. People making good decisions do. Buffett talked about reading the annual report of a big oil company. He mentioned on more than one occasion that finding and development costs were the most important things to know about an oil company. On ethanol, Munger said, “The idea of running cars on corn has got to be the dumbest idea I’ve ever heard.”

On investing in metals as protection against inflation, Buffett said, “We do not look at metals as protection against inflation.” The best protection against inflation is your own earnings power. The second best is to own a wonderful business. On the long-term decline of the dollar, Buffett said the “fundamental forces of the dollar’s decline are very strong.” Americans did not have to think about currencies before. That world has changed.

On commodities in general, Buffett said, “We have no opinion on commodities.” Munger added, “We are going to invest in businesses, not commodities.” They invest in companies because they think there is value, not because they have an opinion on the commodity. “If I thought oil was going higher, I’d go buy oil futures.”

So there you have it. Some of the wit and wisdom from two of the world’s greatest investors.

SWIMMING NAKED

Just because you CAN do something, does not mean you SHOULD. That is what I am always thinking when I watch the annual hotdog-eating contest on Coney Island. And that is also what I am thinking when I watch investors flock to financial manias. For every hotdog-eating “winner”, there must be dozens of losers with gastro-intestinal discomfort. The financial markets are no different. Every mania produces a handful of winners ... and thousands of losers.

But manias are seductive. Profitable investing seems effortless. Money is very easy to make and very hard to lose, as long as you continue to trust the mania. (Experienced investors can never bring themselves to trust a mania, however, which is why the “dumb money” always seems to excel during these manic phases). But the world is not configured to make EVERYONE into a millionaire. Instead, it reserves that status for a few lucky – usually cautious – individuals. Therefore, when “everyone” is making money, “everyone” is usually about to start losing money.

Over the last few months, the stock market has been treating investors very generously. Too generously. Money-making has been easy. Money-making has become so easy that an entire industry has sprouted to capitalize on the phenomenon. That industry is called “private equity”. Because private equity firms are paying rich premiums for public companies, investors begin to imagine that the stock market is “underpriced”. Therefore, they bid up share prices of the companies that they think the private equity firms might buy. These trends feed on each other until, before you know it, you have got a mania.

“What we know is that private equities, like hedge funds, have taken on a speculative mentality,” observes our colleague, Bill Bonner. “Deals are put together ... then flipped from one private equity firm to another. The objects of their attention – actual, profit-making companies – are loaded down with debt so the private equity investors can take out the profits. And then, the deals are sold back to the public – at a big premium. As more and more money chases quick profit, standards slip; the deals degenerate ... from super-prime to subprime. Until investors come to their senses.”

“Every public spectacle is amusing in its own way,” Bonner continues, “but all have the same basic theatrical elements: each begins with legerdemain or an outright lie, it progresses into a farce, and ends in disaster.” Private equity investing begins with the lie that borrowing money to buy richly valued companies is an intelligent investment strategy. It becomes a farce when investors buy certain stocks, just because they think a private equity firm might buy the company later for more money. It will end in disaster when, at some unknown point and in some unknowable way, the mass stupidity ends ...

Financial markets are not as cyclical as they are tidal. Bull markets ebb and flow. As share prices respond to these tidal currents, investor exuberance surges for a time, then recedes. High tide lends buoyancy to almost every stock, while concealing the flaws of misguided investment strategies.

But as the tide of easy money and exuberance ebbs, billions of dollars of stock market wealth wash out to sea. Only then do we discover which investors have been swimming naked. It is now high tide in the U.S. financial markets. Junk bonds, and junky stocks, float on the high tide of optimistic expectations. Atop these buoyant currants, the S.S. Private Equity charts a profitable and seemingly safe course.

The delusion that private equity funds will buy out any and all companies trading on public exchanges is growing in popularity. Those that buy into it believe that an expensive, overbought stock market should remain on a permanent upward trajectory until deal after deal removes every last share from public hands at premium prices. The real factor behind the wave of private equity deals – and the calls for higher stock prices across the board – is bond investors’ insatiable appetite for income and their complete disregard for default risk. They are pouring money into anything not nailed down, including the “me too” private equity funds that are setting up shop as fast as mortgage brokers were in 2005.

Ray Dalio from Bridgewater Associates explains in a recent Barron’s article: “Hedge funds and private-equity firms today are like the dot-coms in 2000: Ask for money and you’ll get it. They bid up the prices of everything. The amount of money flowing is almost out of control, and it’s making everything overvalued. A client of mine said it’s like there are 11,000 planes in the sky and only 100 good pilots – an accident is bound to happen. Just like the dot-com bust, the winners and losers will be sorted out ... practically all good managers are closed to new investment.”

Too much money is in the hands of mediocre managers. So I was not shocked to see one of these private equity funds, Madison Dearborn Partners LLC, decided to take a flyer on IT products distributor CDW Corp. CDW basically resells computers, software, and networking equipment to small businesses and government agencies. A leveraged buyout of a low-margin distribution business is an investment with very little room for error, but MDP lowered their chances of success even further by paying such a high price – 12 times EBITDA. ConocoPhillips sells for 4 times EBITDA. Which business would you rather buy and hold on a levered basis for the next 5 years? MDP’s offer was facilitated by its ability to raise debt on very attractive terms. The chart below depicts the stock price of CDW and the 12-month yield of the Blackrock Corporate High Yield Fund (COY). As you can see, these two lines tend to move in opposite directions. What does this mean? Two things.

1. Investor appetite for risk has been increasing for years. In other words, risky stocks like CDW have been trending higher, at the same time that junk bond yields have been trending lower.
2. Risky ventures, like private equity firms can obtain financing on very attractive terms. COY’s chart is a gauge of investors’ willingness to loan money to companies like Madison Dearborn for this deal. COY holds a portfolio of high-yield (“junk”) bonds.

Five years ago, investors demanded a 15% return to buy the Blackrock High Yield Fund. Today, thay demand only about half that amount. Clearly, the buyers of COY are not too concerned about delinquencies or defaults from the high-yield borrowers. But just because you can raise debt to fund the purchase of CDW does not mean you should.

CDW’s weathered management team has very good reasons not to load their balance sheet up with debt – inventory obsolescence, economic exposure, and high working capital requirements to name a few. But regardless of these risks, Madison Dearborn wants to make a leveraged bet on the PC upgrade cycle, which is shaping up to be disappointing considering the lukewarm reception of Windows Vista and inventory gluts in key areas of the PC food chain. Fred Hickey, editor of The High-Tech Strategist, is very bearish on the IT sector. He has followed it closely for decades and anticipates big earnings disappointments in the coming months. In his latest issue, Hickey summarizes his outlook in a single sentence:

“A buildup in PC inventories due to weaker-than-expected acceptance of Vista, lower-than-expected cell phone unit sales at the world’s top handset makers, a year-over-year decline in total cell phone industry revenues, a slowdown in the high-end computing and storage markets, a sequential collapse in Apple’s iPod sales and an unexpected fall in year-over-year iPod revenues, a very weak printer market, continuing inventory challenges and soft sales at the contract manufacturers, soft auto sales, slowing big screen TV sales, sharply lower-than-expected digital satellite radio sales at retail, and continuing softness in telecom equipment due primarily to the ongoing carrier consolidations, are all consistent with the notion that the U.S. economy is heading into recession, led by the not-so-resilient consumer.”

It will be interesting to see how a debt-laden CDW will weather the next cyclical downturn in the computer hardware industry. As Warren Buffett’s said at the Berkshire Hathaway shareholder meeting earlier this month: “Investors in private equity funds lock up their money for 5-10 years and buy businesses that do not price daily. It takes many years for the score to be put on the board and the investors can’t leave.”

We may not see the “score” of the CDW deal for a few years. But, no matter the score, I will bet the partners at Madison Dearborn will fare better than their investors. Buffett bluntly explained why cash seems to be burning holes in the pockets of private equity: “If you have a $20 billion private equity fund and get a 2% fee, you are getting $400 million a year. But you can’t raise another fund with a straight face until you have invested it, so there is a great compulsion to invest it quickly so you can raise another fund and get more fees.”

Another classic Warren Buffett quote applies here: “It’s only when the tide goes out that you get to see who’s been swimming with their trunks off.” At the current high tide, many believe that easy credit can fund the buyout of any company at any price. But as surely as low tide follows high tide, tighter credit conditions will suck imprudent private equity deals out to sea, drowning many investors in the process ... and exposing the flaws of an investment strategy that values momentum and pole vaulting.