Finance Digest for Week of September 17, 2007

OPPORTUNITY

There are gains to be had and losses to be avoided from deleveraging.

My August 13 “Bear Bust” column said the subprime slime would spread to other speculative areas that are overrun with highly leveraged hot money. That is precisely what is happening. Crude oil, copper and other commodities are slumping. Even gold, which is supposed to be the refuge in troubled times, is flat. Yields on junk debt, of established corporations, emerging market borrowers and leveraged buyout deals, show wider gaps over yields on Treasurys. The U.S. stock market is weak in large part because the buyout deals that were propping it up are on shakier ground. The asset-backed commercial paper market froze up. The only safe haven is Treasury paper.

Conditions got so bad in August that central banks flooded the markets with liquidity. Then the Federal Reserve cut the discount rate and urged banks to borrow. The only borrowers were four big banks that “volunteered” to take $500 million each. Federal funds rate cuts are coming but will not offset the fear and repricing of risk that is deleveraging financial markets.

This all comes as a huge shock to many investors who in recent years diversified into foreign markets, commodities, hedge funds and junk securities, expecting low or negative correlations with U.S. stocks. The theory made sense. After all, commodities leaped in the 1970s when inflation killed stocks and bonds. Those supposedly well-diversified investors did not realize, however, that diversification works only if everyone is not doing the same thing with immense leverage. Because then, when one market reverses, the hot money, chased by margin calls and cries for capital preservation, bails out of the others.

Diversification also promoted complacency, resulting in more risk and leverage. This added to the powerful speculation-spawning forces that were already in place: oceans of liquidity, zeal for yield and deceivingly low volatility in many markets. So, too, did securitization. Subprime mortgage lenders made loans with gay abandon because they promptly packaged them into securities and sold them, moving the risk to others. You can spread risk but you cannot eliminate it.

Hedge funds live on leverage, often borrowing 10 times their equity – 20 times when they issue asset-backed commercial paper to finance subprime-related securities. How else can they justify 20% performance fees for what is basically spread lending? Despite claims of unique strategies, many hedge funds converge on the same side of the same trades at the same time.

We are at the beginning of deleveraging, and there is money to be made from it and losses to be avoided. Start by dumping emerging-market stocks and bonds. U.S. consumers are headed for the storm cellars as the housing tornado gathers strength. The resulting recession, starting about year’s end, will spread globally as consumers slash the imports that underlie foreign economic growth. Despite the insulation of her financial markets, China’s economy is still driven by direct and indirect exports to the U.S. Chinese stocks traded in Hong Kong are excellent shorts.

Sell commodities in anticipation of further deleveraging and shrinking global demand, or short them using ETFs. I love copper as a short since it is predominantly produced in developing lands that need the export revenues to service their foreign debts. The supply curve is perversely inverted for suppliers like these: The lower copper prices go, the more copper they sell.

U.S. investment banks are vulnerable since they will probably take big writedowns on junk securities. The rating agencies will suffer from the lack of lucrative fees for rating subprime securities, loss of reputation for being oblivious to the gathering problems, and more regulatory oversight. Home builders, now selling at book, may drop to less than 50% of book, where they were in the early 1990s. And their book values will fall as they write off land options and suffer operating losses.

Exit all junk-related vehicles and even investment-grade bonds where the issuers are debt-ladened. Consider joining me in my best investment in decades, shorting junk by buying credit-default swaps. Swaps are insurance polices that pay off when junk goes south. Alas, this is an institutional game, so look for the rare retail funds that buy default swaps. For the less adventuresome, there is my longtime favorite, 30-year Treasury bonds.

HOW HARD A LANDING?

It will take months to judge the full impact of the August credit shock on the real economy – on job growth, production and home construction. The still open question is, how hard will the landing be? I expect we will muddle through with a global slowdown, short of a recession. But three factors could lead to a harder landing: (1) The massive letdown in credit conditions from the extraordinary 2003-06 period of excess liquidity creation. (2) Low real interest rates and dollar weakness, the drag on future growth from the disruption of the securitization process, an unexpected change in the outlook that is just beginning to impact growth. And (3) the Fed’s likely caution toward rate cuts.

The U.S. economy has many strong growth engines – flexibility, innovation, a healthy reliance on small businesses, more than 140 million remarkable workers and growing exports to meet the global boom. Growth data into August was solid. But at least one over-oiled engine broke in August – the securitization process used to connect commoditized borrowers to broad lending pools. The importance of this to credit markets had grown large in recent years, taking market share from the more traditional lending processes in which the borrower and lender know each other.

Securitization will rebuild itself over time, but with less horsepower and more costs--simpler derivatives, more careful risk assessment, less aggressive use of commercial paper and more regulation. Bank loans and equity capital can replace some of the credit market shrinkage. But even with these replacements, the change in the credit process, like sand in gears, will bring slower GDP growth, less profit and fewer new jobs.

No quick recovery.

Financial markets recovered relatively easily from shocks earlier in the decade, such as the California energy crisis, spikes in the price of gasoline, Hurricane Katrina and the downsizing of auto production. Despite the 2006 collapse in mortgage equity withdrawals and home building, new highs were set by July 2007 in jobs, personal income, consumption, profits and equity markets.

But the ongoing credit shock probably will not subside as quickly as earlier shocks. At a minimum the coming slowdown will likely be the deepest in the 5-year expansion. Many transactions, big and small, will be delayed or canceled as new, more expensive financing is sought. Loan losses have to be assessed, reported and absorbed by the various parties. Weeks into the shock, rudimentary short-term credit markets are still not functioning smoothly. The preference for ultrasafe Treasury bills, despite their low yield, remains intense.

Depending on confidence, the slowdown could easily turn into a recession. Some companies will reduce hiring and investment plans, which will circle back as job uncertainty and slower consumption growth. If job uncertainty turns into an actual reduction in U.S. jobs, then consumer resilience, a hallmark of this expansion, will fade.

A key variable in the hardness of the landing is the value created by all the past liquidity. If it was used well, the landing will be cushioned by past gains and should not be hard. In contrast with that of the 1970s, much of this decade’s excess liquidity was channeled into solid investments – stronger corporate balance sheets, profit-oriented investments abroad and major improvements in the capital structure of developing countries. However, another part of the hyperliquidity simply bid up the price of existing assets, whether commodities, bonds, land or antiques. Those prices will probably be tested severely in coming months as credit markets proceed with their restructuring. The hard-landing risk is that economic activity will slow until prices hit bottom, a self-reinforcing downturn.

As growth shows clear signs of slowing, the Fed will likely cut its funds rate. Lower rates will help some but probably cannot reverse the slowdown or counteract the losses already incurred. Nor can the Fed roll the clock back to the heady liquidity days of 2004-06. That environment combined very low interest rates with aggressive investors eager to embrace risk, neither of which is in sight today.

The Fed will probably be slow to cut interest rates in this downturn, just as it was slow to cut them in 2001 and slow to hike them in 2004 and 2005. The Fed will come up with many reasons for its current foot-dragging, e.g., headline inflation problems still linger from dollar weakness earlier in the decade. But more important, the Fed may also harbor the desire – too late, in my view – to fight “moral hazard”, the market’s assumption of rate cuts when problems arise. One constructive outcome of a slowdown, though unlikely, might be a resolution by the Fed to recognize changes in the value of the dollar as an indicator of tight or loose monetary policy. Instead of resisting moral hazard during downturns, the Fed should be working harder to avoid Fed-driven boom-bust cycles in liquidity.

FRIENDS IN NEED

At the macro level, inflation, not deflation, is the major risk from here.

“The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. ‘We lent it,’ said Mr. Harman, on behalf of the Bank of England, ‘by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power.’ After a day or two of this treatment, the entire panic subsided, and the ‘City’ was quite calm.” ~~ Walter Bagehot, Lombard Street

Lest anyone think that central bankers’ famously hard hearts instantly melt when their closest constituents start to shed tears, we should emphasise that it was only a coincidence that as soon as the National Australia Bank announced it was having to take A$6 billion in assets back onto its balance sheet from its place in the shadowy world of the SIV/Conduit, the RBA – which had already more than quadrupled the amount of excess reserves it provides to the system – stepped up and announced it would, in future, discount member bank paper, as well as MBS securities.

Nor was the Fed doing anything out of the ordinary when it reduced the new Lombard-style discount rate 50 basis points, lent the odd billion at the window for a 30-day period, and quietly relaxed regulations relating to the amount of support Citi and B of A are allowed to extend to their brokerage arms – even if it would provoke a minor seismic disturbance at the graves of Senator Glass and Rep. Steagall.

Previously, the inability of Canadian banks to fund their off-balance sheet vehicles had caused a spate of involuntary refinancings whereby the now-unrollable commercial paper was converted into long-maturity FRNs and the like. Hey presto! The Bank of Canada widened the list of collateral acceptable for its overnight cash injections to include bank paper, CP, and even single-A bonds. Well, they were probably planning to do that all along, eh?

It had nothing to do with the sharp rise in CDS spreads being suffered by the likes of the clearing banks in London, or with the threat posed to the UK’s very own sub-prime, buy-to-let punters by struggling mortgage lenders that the “Victorian” Bank of England finally succumbed to its critics and offered both to allow banks to increase the reserves they hold with it by 6% and to lend up to a quarter of the total at its base rate, rather than at its penalty rate a full percent higher.

Despite all this demonstrable innocence, the cynic’s prime entertainment these past few weeks has been the spectacle of individual bankers seeking to assure an anxious depositor-creditor base that their particular institution was sound – and would be back to merrily churning out further multi-million bonuses for its movers and shakers, if only everyone else would be as rational and “transparent” as they – at the same time that these same worthies were publicly bombarding their lenders of last resort with strident demands to stave off the coming apocalypse.

Isn’t life grand when those who have earned riches beyond the dreams of avarice in protesting all regulation and making an insincere obeisance at the altar of the free market are so swift to call for an inflationary, state-sanctioned bail-out at the first sign of trouble, so passing all the downside for their misfeasance surreptitiously onto society at large.

Even more breathtaking, perhaps was the sheer unblinking arrogance on display at the latest ECB press conference where the impression given was that Caesar’s wife was a nothing more than a cheap floozy in comparison to those who make up the governing council. They first tried to deny there was any link between the money market and the wider economy. If so, one would have loved to have heard a journalist ask the imperious M. Trichet, why do we pay the bureaucrats who gather in Frankfurt their handsome salaries to deliberate so intently about where to set interest rates if they are all so utterly irrelevant?

In fact, ironies abound when we consider the ECB, for this is an institution which insists on the stern sounding use of the phrase “strong vigilance” in its analysis. Yet this is also a bank which has simultaneously allowed its balance sheet to balloon alarmingly, growing it 70% in just five years and thus endorsing such an horrendous acceleration in M3 since 2004 that it has taken the aggregate to a 28-year high rate of increase, whether measured in real or nominal terms.

Quite what Jürgen Stark’s innermost thoughts on this phenomenon are, we can only guess, but it was he who delivered a speech the very next day underlining the fact that while Keynesians may not ascribe any importance to monetary trends as a forecasting tool (we should probably include Mr. Bernanke and friends here), the empirical evidence to the contrary was incontrovertible, as a reproduction of his graphs here helps make clear.

And yet, despite all this, the Bank was not only ready to postpone what had been a widely expected rate hike before the crisis hit, but to announce proudly that an extra long-term refinancing operation would be conducted – one, moreover, to be “of no preset size”! Given that this news was rapidly followed by a sizeable $31.3 billion reserve add from the Fed, it was perhaps no surprise that gold jumped by almost $16 to its intraday peak a whisker under $700/oz.

Indeed, while gold had fallen heavily in the initial dash for cash as the crisis broke (another clear proof that, much as we wish it were, gold is NOT money), since the Fed fired up the rotors on the Huey by cutting the discount rate, this exceptionally liquid, easily storable, totally fungible, scarce, real asset has risen over $50. It seems the realization has begun to dawn that all inflationary means will be employed in order to save large parts of the financial system from itself. Yes. Inflation, not deflation, still seems the risk ahead.

Indeed, with more and more assets being forcibly repatriated to bank balance sheets, and with the central banks showing ever more comfort with the business of monetizing said assets (even if this remains mostly indirect, as they repo only the least toxic stuff, for now), the already flighty monetary aggregates are set to take another giant bound skyward. The gain in U.S. M2 these past five weeks has been the fastest for a like period recorded in over two decades, barring only the 9-11 episode. Our own proxy for M3 – regressed from bank liabilities and money market mutual fund holdings – has been even more impressive in its acceleration. (Graphs here.)

This matters greatly because the implicit assumption of the masses is that rising inflation is not a realistic scenario because of (a) a confusion about the implications of the localized deleveraging raging through the non-bank sector and (b) a macro-economic refusal to admit that if enough money is pumped into a faltering economy in the wrong places, prices can rise even as jobs are lost and businesses shuttered.

So today, the key thing on which to focus is that the central banks have vowed they will keep the money markets open. Against a backdrop of expanding bank balance sheets and a decline in asset quality, that means they will, perforce, relegate the much-vaunted “price stability” part of their mandate to the background, sacrificing it to what they perceive to be the more pressing need to prioritize the restoration of that same mandate’s (frequently incompatible) “financial stability” component.

As we reallocate people and capital away from the housing industry, as many of the undifferentiated gamblers associated with the leveraged beta crowd and the cut ‘n’ shut credit merchants succumb to a gale of creative destruction, as one batch of credit-led malinvestments is painfully liquidated now that its constituents are being starved of oxygen, we can expect unemployment to rise and real output to struggle. However, if the surviving credit institutions remain able to mainline on sufficient central bank crack – if Leviathan itself starts trying to spend its way out of trouble as only it can – if money and credit can be found sufficient outlets (and, as Leland Yeager once said, you do not need a willing borrower of new money, only a willing recipient) – all this can still take place against a backdrop of generally rising prices.

Those prices may not be exactly the same ones rising today, of course, since many of such heretofore favored goods will inevitably lose their main sponsors in the shake-out. Nonetheless, nominal end demand can still be supported, if by no other means than through an increased dole and a higher headcount in an already swollen public secto, by extra subsidies and protections given to dead-beat industries, by the award of yet more, sprawling cost-plus defence contracts, and through the deficit financing of vast infrastructure programs.

All told, the lesson of the current era should be, as Charles Goodhart so pithily put it, “Deflation is a policy choice.” Accordingly, each investor should constantly intone the mantra: “Inflation is dead. Long live inflation!”

ALAN GREENSPAN ADMITS HE “DIDN’T REALLY GET IT” VIS A VIS SUBPRIME RISKS

Bubble dymanics dominate world financial system.

I found it ironic that during the same week Alan Greenspan admitted he “Didn’t Really Get It” when it came to the risks associated with subprime lending, Fed Chairman Bernanke publicly reiterated and expanded his “global savings glut” thesis.

It is worth noting that, following robust mortgage debt growth during the 1998-2000 boom, home mortgage debt growth accelerated to 10.4% in 2001, 13.0% in 2002, 12.5% in 2003, and then a blistering 14.9% in 2004. Mr. Greenspan now admits that he didn’t really “Get It” until late 2005, while Dr. Bernanke’s intellectual focus at the time was explaining how mounting U.S. Current Account Deficits were a phenomenon of global savings and investment dynamics. Both were more than intellectually content to sit back and marvel at U.S. economic “productivity” and the capacity of contemporary finance to inflate credit. Both also worked diligently to construct a framework rationalizing why the Fed need not pierce bubbles nor even go so far as administering a little “tough love”. Both are curiously oblivious – at least publicly – to the notion of pernicious credit and speculative excess.

There is no reasonable excuse for our central bankers’ failure to recognize and then move to check intensifying mortgage credit bubble dynamics by 2004 – at the latest. It was (and remains) similarly inexcusable to disregard the U.S. Credit system’s prominent role in financing rapidly escalating current account deficits and resultant worsening global imbalances. Fed funds began the year (2005) at a ridiculously low 2.25% and did not baby step above 4% until mid-December. Not surprisingly, total mortgage debt expanded a record (not soon to be broken) $1.462 trillion during 2005 (up another 13.7%) – having doubled in just about six years. Not just coincidently, the Current Account Deficit finished the year at an unprecedented $812 billion, twice the level of only four years earlier.

Clearer understanding of today’s challenging environment rests on sound analyses of the respective rapid doubling of U.S. mortgage debt and Current Account Deficits. I have for some time argued a “global liquidity glut” thesis. This historic liquidity overabundance emanated directly from U.S. Credit system excess, with resulting rampant global dollar liquidity flows working at the same time to devalue the dollar; inflate global currencies, markets and economies; and stoke a self-reinforcing energy and commodities boom. The endless glut of (depreciating) dollar liquidity both inflated global prices generally and unleashed domestic credit systems for unbounded – and ongoing – excesses round the world. Crude oil closed at $53.54, gold $442.13, and wheat $340 (trading today at $846) the afternoon Fed governor Bernanke first presented his “global savings glut” thesis (3-10-2005). International reserve assets have been expanding at about a 25% rate, while the Goldman Sachs Commodities Index sports a 2007 rise of 21.3%.

The “global liquidity glut” has fomented myriad bubbles – and the reality that seemingly all of the global ones remain very much in force empowers Chairman Bernanke to stick steadfastly to his “savings glut” theorizing. Yet “saving” does not fuel bubbles – excessive borrowings do. We just learned that the Q2 Current Account Deficit remained massive – at $191 billion despite booming exports. We can also presume that dollar weakness continues to encourage enormous ongoing speculative U.S. financial flows to non-dollar and commodities markets.

Conventional thinking has it that the world economic backdrop, outside of U.S. subprime and housing woes, is vibrant and sound. This favorable backdrop, it is believed, explains global equities markets resiliency in the face of mounting U.S. and global credit woes. The global credit bubble and “liquidity glut” perspective takes a quite negative view of the current global backdrop. Bubbles proliferate.

Admittedly, most global bubbles have been impervious to the bursting U.S. credit bubble. China is a case in point. Yet there are important unappreciated dynamics to contemplate. First, domestic credit bubble dynamics have become well entrenched around the world, especially with U.S. dollar impairment working to decisively limit the risk of currency runs in, say, China, Russia, Brazil, India, Asia and “developing” economies in general. The weak dollar and unrelenting U.S. liquidity outflows have nurtured quite atypical stability for a group of currencies that would otherwise suffer the acute vulnerability incident to overheated domestic credit systems, asset markets, and economies.

It is my view that today’s backdrop would be altogether different had it not been for aggressive and concerted central bank intervention. Huge liquidity injections – and, as important, assurances from Chairman Bernanke to use “all of the tools at his disposal” – kept the U.S. and much of the global securities markets from seizing up. As it was, the extent of acute financial fragility was perceived to require an immediate and bold marketplace onslaught that, ironically, worked to underpin most global bubbles. Certainly, not much froth was allowed to come out of global equities. No froth has been removed from global inflationary pressures. Lower global yields are destabilizing and portend only greater global monetary disorder.

It is the view of the Bernanke Fed (as it would have been of Greenspan) that a U.S. recession can and should be avoided. This is flawed and dangerous ideology. It is the market’s view that the Fed will lower interest rates to whatever level necessary to sustain the U.S. expansion. This is wishful thinking. Recent history has spoiled both the Fed and the markets. Today, recession cannot be avoided, and the weak dollar and robust global inflationary backdrop will limit the Fed’s flexibility.

The U.S. economy will not escape the harsh consequences associated with the bursting of a historic mortgage finance bubble. Our bubble economy has been left severely imbalanced and acutely vulnerable, and it is simply impossible to avoid major disruptions associated with an abrupt curtailment of mortgage finance. California will be the poster child for this unfolding dynamic, although it will play out throughout the country. I will reiterate my expectation that upper-end real estate – too frequently financed by ARM, Alt-A, teaser rate, reset and interest-only mortgages – will prove greatly more problematic than subprime. Commercial real estate will be anything but immune. We have only begun to experience upheaval from the mortgage bust, dynamics that will follow a similar path to the burst technology bubble – except the wreckage will be significantly more widespread and economic impact broad-based.

Unprecedented central bank interventions and, here at home, six-week bank credit growth have sustained financial system liquidity. I question the sustainability of both. There are great expectations for an impending revival in the securitization marketplace. The banks and Wall Street are praying. With an eye on California, I fear another (“jumbo”) leg down in the ongoing mortgage crisis and an increasingly vulnerable economy. Another eye is planted on the hedge fund community, where I suspect we are only another market dislocation away from serious withdrawals and reinforcing liquidations.

One, if not the greatest, errors in central banking was committed back in 2002 – with Messrs. Greenspan and Bernanke at their respective strict and intellectual helms. They mistakenly reckoned THE bubble had popped. Together they set in motion an aggressive post-bubble “mopping up” reflation, failing to appreciate that while the tech bubble had burst THE credit bubble was poised for “blow-off” excess. We are left today with an unbalanced bubble economy sustained only by ongoing and enormous credit creation.

Credits to sustain a bubble economy are inherently highly risky (think California mortgages or junk bonds) and it requires huge quantities of them. Bubble economies are replete with negative cash flow entities and others that become increasingly so as finance is curtailed and redirected. Today, the banking system is ill-prepared to play the role of lender of last resort for long. Moreover, the scope of required ongoing credit inflation ensures dollar vulnerability.

An important aspect of my negative current view is the disconnect between unwavering marketplace confidence in the Fed’s capacity to “reliquefy” and “reflate” and the reality of a limited arsenal and atypical lack of Federal Reserve control over unfolding developments. Greenspan and Bernanke expended tremendous ammo in a historic reflation fight that, in the end, was a totally wasted cause. They misjudged and enfranchised the most profligate and wasteful credit expansion in our history, while inciting a potent strain of inflation that now propagates largely outside of our control. They burned a major currency devaluation. A weaker dollar could have been a tool available to help soften today’s much needed financial and economic rebalancing. Unfortunately, they used that policy card for a reflation that greatly exacerbated excesses and imbalances at home, while initiating global inflation dynamics much to the detriment of our citizens, economy and currency. We have today much greater financial fragilities, disastrous economic imbalances, and a feeble currency ... whether the stock market chooses to discount it now or not.

FRAUD, FOLLY, AND CENTRAL BANKING

“It is fraud to accept what you cannot repay,” said Publilius Syrus way back in the first century B.C. But Syrus was merely a Roman hack ... and a freed slave to boot. So what would he know about collateralized loan obligations? No more or less than today’s Bank of England, perhaps. “British venture capital heavyweight John Moulton told a reporter,” says Sean Corrigan, “that at a recent breakfast meeting with Bank of England officials, none of them knew what a ‘CLO’ actually was ...”

Full disclosure: I would not know a CLO if it kissed me and took me out to dinner. Nor does The Economist, judging by its latest stab at explaining haute finance to its readers. But unlike the policy wonks on Threadneedle Street, the journalists on Southwark Bridge are not paid to jet out to Jackson Hole, Wyoming, while defending financial stability back in Britain. Nor is it their job to underwrite those lenders who have conspired in the Great Credit Fraud of 2002-2007 ... issuing loans to debtors with no serious hope of repayment.

“It is too soon ... to quantify the impact on the economy as a whole,” said Mervyn King, governor of the Bank of England, in an open letter sent to the British Parliament. “In the short term, some corporate loan rates will rise with interbank rates. Banks that are unable to sell pools of loans that they had securitized, or who need to support off-balance sheet vehicles, may cut back on new lending.”

What is a central banker to do? “The provision of liquidity support [by the BoE] undermines the efficient pricing of risk by providing ex-post insurance for risky behavior,” says King, entirely guiltless in getting us all here in the first place. “That encourages excessive risk-taking and sows the seeds of a future financial crisis.” No fooling!

So ... make free with financial support for the country’s biggest banks? Or let the market “reprice” their risk-taking and take a gamble on the nation’s financial stability instead? Put another way – and expressed so succinctly by the anonymous Mayfair hedge fund manager at FiNTAG.com – King’s choice is the same as Ben Bernanke’s: “Put rates up and win a Nobel Prize in Economics. Put them down and get a lucrative job at Lehman. Leave them as they are and look pathetically weak.”

“Mass delusions are not rare,” wrote Garet Garrett, nearly 2,000 years after Publilius Syrus scratched out his maxims in Latin. In Garrett’s 1932 tome, A Bubble That Broke the World, the editor of the New York Tribune noted how mass delusions “salt the human story. ... [But] a delusion affecting the mentality of the entire world at one time was hitherto unknown. All our experience with it is original.”

Garrett was speaking of the late 1920s bubble on Wall Street, but his words do more than just echo today. “This is a delusion about credit,” he went on. “And whereas from the nature of credit it is to be expected that a certain line will divide the view between creditor and debtor, the irrational fact in this case is that for more than 10 years, debtors and creditors together have pursued the same deceptions. ... In many ways, as will appear, the folly of the lender has exceeded the extravagance of the borrower.”

Fast-forward to September 2007 and has the folly of lenders exceeded the extravagance of borrowers once again? In June, some 30% of first-time homebuyers in Britain resorted to an “interest-only” mortgage, just so they could make the monthly payments and grab the keys to the door. That might sound like extravagance. But fewer than 1/3 of them presented an investment plan to their lender with a view to ever repaying the principal ... leaving 20% of ALL first-time buyers paying the interest alone, with nothing set up to cover the base debt itself. On the part of the lenders, that sounds like folly. Five years ago, just 5% of Britain’s first-time homebuyers opted for interest-only home loans with no plan for repayment.

“The market has it wrong in that it calls this the subprime crisis,” says Barry Wilby, former manager at Oppenheimer Funds, the $250 billion asset management firm. “I think it’s really a crisis in the underwriting and packaging of debt. That means it has implications for the extension of credit, because of the trust that people will have in institutions.”

“It’s a big psychological problem for capital markets,” Wilby warns, thinking no doubt of the spike in interbank lending interest rates – now at fresh 2o year highs just shy of 7% here in London, “which will result in a slowdown in credit extension, which I think will result in the slowing down of the global economy.”

Credit extension in the U.K. looks set to slow – fast! The Bank of England might not know a collateralized loan obligation when it sees one. But it said that the average variable rate mortgage issued in August rose by 0.25%, to a 9-year high of 7.69%. “Fears of Retail Bloodbath as Interest Rates Hit Home,” screams The Times in response. JJB Sports, a major High Street retailer, has cut its full-year forecast by one quarter. The CEO of Next, a leading U.K. clothes store, warns the real crunch could hit just as Christmas arrives.

Borrowing what you cannot repay is indeed fraud, but the great fraud of limitless consumer spending now looks utterly spent. Lending what you cannot hope to get back, on the other hand, is pure folly. And now that game is up too. You might want to check just who owes what to whom in your stock market portfolio.

U-turn raises heat on Bank of England governor.

Mervyn King will be forced to mount a public defence of his reputation as BoE governor after being driven into a striking policy U-turn in a bid to ease pressure on the UK banking system. The Bank’s change of heart came after a series of high-level meetings involving the Financial Services Authority, the Treasury and some of the City’s largest institutions, where concerns were aired that the crisis at Northern Rock could spread to other smaller lenders.

In an attempt to inject more liquidity into the system, the Bank has offered to lend tens of billions of pounds on 3-month terms to cash-strapped banks that provide mortgages. The move by the Bank, which had stood out among global central banks for taking a “tough love” line, came less than a week after Mr. King warned that such actions could sow “the seeds of a future financial crisis.”

Mr. King stands accused of helping Northern Rock founder by acting tough with UK banks, only to step in later with emergency funding and finally agreeing to the action that bankers believe would have been enough to have headed off the debacle before it hit the high street. Senior banking executives believe the recent crisis has also shown the frailty of financial regulation, where responsibility is split between the BoE, the FSA and the Treasury.

INDIGESTION ON WALL STREET

The ability to create credit now extends far beyond the reach of the traditional banking system. A revolution is transforming the credit markets, establishing links among borrowers and lenders that previously would have been impossible.

Every imaginable stream of future cash flow – from car and mortgage payments to the loans that fund private equity deals – can be “securitized” and sold to the highest bidder. Securitization is simply the process whereby a stream of future cash flow becomes pledged to a separate legal entity, which then divvies up the cash flow among different “tranches”, or classes, of creditors. The growth of securitization has truly altered the global economy, and most choose to focus only on the positives. But like everything in life, the securitization revolution has its positives and negatives.

One negative consequence is that financial markets are starting to shape the destiny of the real economy, not the other way around. Storied currency speculator George Soros was one of the first to speak publicly about the phenomenon of markets shaping economies. He calls it the theory of “reflexivity” and described it when testifying in front of Congress in 1994:

“The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly, because they do not merely discount the future; they help to shape it [emphasis added]. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal.”

In Soros’s view, the judgments and emotions of today’s financial market participants can alter future economic fundamentals. For example, as a company’s stock grows more coveted by wild-eyed speculators, its cost of capital gets lower and lower as its stock skyrockets. The higher its stock price, the more capital a company can raise by issuing a set amount of shares. So its ability to reinvest capital and grow – its future – is shaped by the whims of speculators.

Another negative consequence of the securitization revolution: The further a lender is separated from a borrower, the more potential there is for fraud on the part of the borrower and underestimation of risk on the part of the lender. Very bad loans tend to be made when this is the case, as those who have dabbled in subprime mortgages are discovering, and the process of discovering just how many doomed-to-fail mortgages were written is far from over. On one end of the lending chain are plenty of fraudulent “liars’ loans” yet to default, and on the other are plenty of lenders who do not fully understand the risks they are taking.

Bill Gross, the most accomplished bond fund manager in the world, recently published his views on the subprime debacle. In his July Investment Outlook, Gross acknowledges that securitization and derivatives diversify risk, and: “When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets ... The flaw ... lies in the homes that were financed with cheap and, in some cases, gratuitous money in 2004, 2005, and 2006. Because while the Bear [Stearns] hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere ... except for their mortgages, that is. Mortgage payments are going up, up, and up ... and so are delinquencies and defaults.”

The housing market will remain sluggish far longer than most expect. $800 billion of ARM resets can only add to the supply of distressed sellers in 2008. This will further depress an already sluggish housing market that is having enough trouble working through a huge supply overhang. To say the least, this scenario will weaken demand for securities backed by residential housing.

Up until now, hedge funds have been creating a great deal of the miraculous “liquidity” sloshing around the globe. By buying the highly leveraged equity and mezzanine tranches of collateralized debt obligations (CDOs), they have greatly strengthened the buying power that has been bidding up the prices – and lowering the yields – of risky debt instruments. Soros’s theory of reflexivity was at work during the financing stage of the housing bubble. Now it is working in reverse to “de”-finance the housing bubble.

The elevated demand for CDO equity creates a magnified increase in demand for CDO collateral – including junk bonds, corporate loans, and subprime mortgages. Higher demand for CDO collateral drives up prices for all types of debt, thereby lowering credit spreads and yields. After years of this phenomenon, we were in a situation where credit spreads – the extra bit of interest required by buyers of junk bonds to compensate for default risk – were at unprecedented lows. To top it off, holdings of CDO equity are being carried on the books of many hedge funds at “mark-to-model” values because there is no liquid secondary market for them.

The situation for the financial markets in the coming months is bleak. The economy is slowing, and the supply of debt instruments, especially CLOs to fund private equity buyouts, will expand by hundreds of billions of dollars in the coming months – just as demand for these instruments continues to soften. Increasing supply and decreasing demand is not a prescription for higher CLO prices.

Wall Street investment banks like Goldman Sachs and Bear Stearns have long outpaced traditional commercial banks in the race to originate the most profitable loans. Proliferation of CDOs has enabled the best salesmen on the Street to stuff all manner of debt down the gullet of formerly unsuspecting institutional buyers. But ever since these buyers started balking at creditor-unfriendly provisions like payment-in-kind (PIK) toggles, investment banks have had to retain far larger morsels of LBO debt than they had planned.

Indigestion tends to lower an appetite, and institutional investors’ appetite for junk bonds is spoiling just as Wall Street tries to serve them heaps of acidic securities. While CDOs have shifted risk away from the banking system by linking borrowers with lenders from around the world, they have not lessened default risk. They have merely transferred it to unsuspecting lenders that are just beginning to push back.

JAPANESE HOUSEWIVES SWEAT IN SECRET AS MARKETS REEL

Since the credit crisis started shaking the world financial markets this summer, many professional traders have taken big losses. Another, less likely group of investors has, too: middle-class Japanese homemakers who moonlight as amateur currency speculators.

Ms. Itoh is one of them. Ms. Itoh, a homemaker in the central city of Nagoya, did not want her full name used because her husband still does not know. After cleaning the dinner dishes, she would spend her evenings buying and selling British pounds and Australian dollars. When the turmoil struck the currency markets last month, Ms. Itoh spent a sleepless week as market losses wiped out her holdings. She lost nearly all her family’s $100,000 in savings. “I wanted to add to our savings, but instead I got in over my head,” Ms. Itoh, 36, said.

Tens of thousands of married Japanese women ventured into online currency trading in the last year and a half, playing the markets between household chores or after tucking the children into bed. While the overwhelmingly male world of traders and investors here mocked them as kimono-clad “Mrs. Watanabes”, these women collectively emerged as a powerful force, using Japan’s vast wealth to sway prices and confound economists. Many bought and sold stakes worth into the millions of dollars through margin trading, a potentially lucrative but risky form of trading that uses borrowed money.

Until the credit crisis, which began with troubles in the American mortgage market, the value of foreign currencies traded online by private Japanese citizens, including women, averaged $9.1 billion a day – almost a fifth of all foreign exchange trading worldwide during trading hours in Tokyo, said Kazuhiro Shirakura, an analyst at the Yano Research Institute in Tokyo. Now Japan’s homemaker-traders may become yet another casualty of the shakeout hitting the debt, credit and stock markets worldwide. If so, these married women could lose more than just an investment opportunity. They could also lose the newfound economic freedom that drew many to currency trading in the first place.

Some of the women used their own money, some used their husband’s, and some used a combination of both. But by trading, they challenged deeply held social prohibitions in Japan against money, which is often seen here as dirty, especially when earned through market speculation.

One reason Japan’s homemakers can move markets is that they hold the purse strings of the nation’s $12.5 trillion in household savings. For more than a decade, that money languished in banks here at low interest rates. But as the rapid aging of Japan’s population has brought anxiety about the future, households are starting to move more of it overseas in search of higher returns. A tiny fraction of this has flowed into risky investments like online currency accounts. Most of these accounts involve margin trading.

The housewife-traders were so secretive that many market analysts did not realize how widespread the trend had become until this summer, when the police arrested a Tokyo housewife accused of failing to pay $1.1 million in taxes on her foreign exchange earnings. While day trading of stocks has also taken off in Japan, the women say they prefer currencies because of the relative simplicity – currencies might involve only a handful of nations, while trading stocks might mean keeping an eye on hundreds of companies.

For a time, margin trading seemed like a surefire way to make money, as the yen moved only downward against the dollar and other currencies. But last month, in the midst of the credit turmoil, the yen soared as hedge funds and traders panicked. Ms. Itoh recalled that she had wanted to cry as she watched the yen jump as much as 5% in value in a single day, August 16. “But I had to keep a poker face, because my husband was sitting behind me,” Ms. Itoh said. She did not sell her position, thinking the yen would fall again. But by the next morning, only $1,000 remained in her account, she said.

Yayoi Kawakage, a 40-year-old homemaker who works part time at a real estate consulting firm, said she limited her losses last month to $500 because she sold her positions quickly. She said that if markets become less predictable now, many housewives would likely abandon trading.

Most of the half dozen homemaker-traders interviewed for this article said they were already trading again, and the rest said they soon would be – including Ms. Itoh, who said she would probably invest her remaining $1,000 in savings. “There’s no other way to make money so quickly,” she said.

RETAIL BARGAINS

As Christine Augustine meanders through the second floor of the flagship Bloomingdale’s store in midtown Manhattan, she examines the newly arrived fall merchandise from designer Marc Jacobs and scouts the leftover merchandise that is marked down in price. “There are only a few things left,” notes Augustine, a Bear Stearns retail analyst, with satisfaction. Selling at full price, of course, is better for profit margins. On the other side of the floor, Augustine, 37, notices a mannequin adorned in bright denim jeans. “Colored denim is the hot new trend,” she says. She can tell you that cardigans will be big, but twin sets will not, that dresses are still huge and will be popular into spring 2008.

Augustine should know. She used to work as a floor manager and women’s sportswear buyer at Bloomingdale’s (now part of Macy’s). So which gave her the better background for her current gig: the Harvard M.B.A. or the all-nighter she pulled folding hundreds of sweaters? Few of her peers can claim this perspective. As a buyer she learned how to create a merchandise mix, how to analyze sales and all about price management and stock reporting.

Now she follows so-called broadline retailers, meaning large department and multiline stores ranging from Nordstrom to Sears. And to her eye this is a good time to buy some of the department store stocks. The fear on Wall Street that consumers are tapped out has kept these shares cheap. Unlike other industries retail is a straightforward one to follow. “It is very tangible,” says Augustine. “I go into a store and make an assessment, which can be very anecdotal. That’s why it is important to visit stores regularly.”

She has a bunch of undervalued favorites that could be taken over, with the exception of Wal-Mart. Their real estate is one very enticing feature. So is how they do business. While buyouts are on hold during the current credit squeeze, she believes many department store chains will be back in play once the situation eases up.

It is how Augustine gauges a company’s retail prowess – its fashion sense and merchandising skill – that makes her opinions worth heeding. She soured on Sears, for instance, once she saw it had built up too much inventory. Under the control of hedge fund operator Edward Lampert since 2005, the company has scrimped on capital spending and marketing.

She pays special attention to Wal-Mart. Every week for the past five years she has visited a Wal-Mart outlet around the country, walking the aisles with her checklist. How full are the parking lots? How clean are the stores? How well stocked are the shelves? How much of the apparel has been marked down or put on clearance? Are there enough of the basic items that customers always want to buy: paper towels, laundry detergent, bottled water? Next she looks around for other items that have been put on sale. Too much on sale is a bad sign. Wal-Mart aims to be the price-cutter to begin with, hence a markdown means bad purchasing decisions.

Before calling it a day, she counts the number of cash registers that are open, as well as the number of people waiting in line at each register, and then calculates how long it will take them on average to check out. “It’s ideal if only one or two people are in line with one-third of the registers open,” she says. “But I will give the store a low score if a customer has to wait in line for 20 minutes.” If the store seems short on staff and the end of a quarter is near, that is a red flag to Augustine. “It may mean the store is cutting back on payroll expenses to make sure it makes its numbers.” Augustine’s report is sent out every Monday morning to Bear Stearns’ institutional and retail clients.

She thinks that overall Wal-Mart is on the right track. Operationally, as her visits show, the company has lost none of its edge. Sure, the giant has been hammered by everything from allegations that it underpays workers to worries about gas costs, warier consumers and overexpansion. But Augustine notes with approval that the chain is slowing its new store openings to concentrate on what it has – and is also buying back shares.

At retailer J.C. Penney, long a dowdy underachiever, Augustine is happy to see things finally getting spruced up. Macy’s has a similar middlebrow position (Bloomie’s is the exception). The company had growing pains after it bought some stores from now defunct May. Augustine values Macy’s real estate highly. The chain owns 70% of its stores, which would make it very enticing to a private equity buyer. The strongest performer of her faves is Nordstrom, the high-end retailer, which enjoys the best same-store sales growth. At 17 times trailing earnings, it is on sale.

INVESTING WITH A 7-2 OFF SUIT

When the market hand us a 7-2 off suit, we have to make the best of it. Sometimes it is hard to figure out how to protect yourself in a shaky market, but there are a few ways to make it out alive. Using a simple screen, you can find some pretty safe bets. You may think that to play it safe you cannot make money. Not true.

We sometimes lean toward the more risky investments because of the better payoff, but that is not always the case. We like solid companies, with strong balance sheets and considerable growth. In times of market turmoil, that is exactly what you should look for.

There are a few criteria that we look for to get us through tough times in the market. The first thing we have to look at is how well the company is growing. I like to use a hearty 25% revenue growth rate to make sure the company is still in the high growth stage we like. To make sure the company is in a financially healthy position, I always consider the debt-to-equity ratio. Here I want to have debt less than half of shareholders’ equity.

Finally, just like any investor or mutual fund, it is sometimes smart to have a larger portion of your investment capital in cash. Regular companies are no different. If the market is acting up, it might be smart to wait for the bottom before reinvesting that capital in investments or even acquisitions. So here, I look for a cash position to be 50% of the company’s total assets. With these three criteria we get a small-cap screen that looks like this.

I ran this screen just to see what would come up, and I was not surprised. Of the 30 stocks that came up, many had done very well in the past three months, when everything else seemed to tank. Three names stuck out to me from the list were Life Partners Holdings (LPHI), AspenBio Pharma (APPY), and Basin Water (BWTR).

I had recently seen Life Partners on a list of market performers, and sure enough in the past three months it had rocketed up 95%. Life Partners is a financial services and life insurance company, which specializes in life insurance policies for the terminally ill and the elderly. This can be a pretty risky play, but LPHI seems to be doing just fine. AspenBio is a biotech company with their entire product pipeline in the development stages. The stock just got a boost by jumping from the Bulletin Board to the Nasdaq Capital Markets Exchange last month, which boosted shares up 15% in a week. Basin Water is a water treatment company in the right place at the right time, with the water concerns we have here in this country (and everywhere else in the world, for that matter). This well-water-treatment company gained 68% over the last three months.

No matter what the market throws at us, we just have to be prepared with a backup plan. The market may take a little bit to turn around. That is okay. As long as a company has a strong balance sheet and some top-line growth, it should be all right. It might even make you a buck or two. So the next time you hear someone complaining about the stock market, you can say “No sweat. I got this one.”

ETHANOL WILL EVAPORATE

A recent study by Iowa State University says owners of new ethanol plants will see returns evaporate by next year as ethanol prices plunge. I agree. Recently, I took a long driving trip through the Midwest, visiting farms and ethanol plants along the way. I find it much more useful talking to farmers than just reading government-manipulated statistics. It is abundantly clear that ethanol from corn is not going to last. I estimate that the ethanol revolution will dwindle by the end of 2008, based on my observations and discussions with various farmers.

The building boom in ethanol plants is likely to go bust by the end of 2007 because of reduced return on investment, increased supplies of ethanol and, ultimately, falling prices. Some analysts estimate that returns will be zero or negative by 2008. On my recent trip, I counted no fewer than five new ethanol plants under construction in Minnesota, which is already home to 16 plants – and that is just the tip of the iceberg. There are 78 new plants under construction nationwide.

In terms of investing in ethanol, whether in shares of a company like Pacific Ethanol (PEIX) or in corn futures, there are still plenty of profits to be made. In fact, much of the money made in ethanol has been in small caps. The U.S. ethanol industry, with the help of billions of dollars in government subsidies, has brought enormous riches for investors. Just take a look at what this little ethanol producer, Bluefire Ethanol Fuels (BFRE: OTC BB), has been able to do in only its first six months on the market.

Some of the 16 ethanol plants in Minnesota paid for themselves within two years, all made possible because of the 51-cent-a-gallon subsidy. The plants that are already established may be OK, but new plants that have lots of debt are likely to be the first casualties. Most states now require a 10% blend of ethanol with gasoline, and that has helped to drive the demand much higher. Now corn growers are lobbying for an even higher percentage requirement, but automakers are reluctant to comply.

For now, it seems a safe bet to ride the wave of demand corn-based ethanol is providing, but keep an eye on the exit. The next interesting market will likely be biofuel made from soybeans or other grains, not corn. As energy prices continue to climb, however, ethanol production will continue. That means there will be many opportunities for investors and futures traders to benefit from the ethanol boom ... while it lasts.

PENNY STOCK COFFEE MAKERS

Without coffee, humankind would probably grind to a halt. People would be cranky. Productivity would plummet. Early morning appointments and deadlines would fade from our hazy brains. So in order to keep the wheels of society spinning freely, we (or at least many of us) drink coffee each day. And we tend to get our coffee in one of just a few places: in our homes, at a coffee shop, at convenience stores or at the office.

Green Mountain Coffee Roasters (GMCR) might be the biggest coffee sleeper of them all in the convenience stores and office categories. With a $769 million market cap and amazing top- and bottom-line growth, Green Mountain is slowly making Vermont a coffee hotspot – and stealing some thunder from Seattle. Take a look at the Green Mountain chart for the past year.

Starbucks (SBUX), on the other end of the spectrum, is on every suburban corner in America. Starbucks is an event. It is a social thing, like going to the neighborhood bar where everyone knows your name. In my opinion, their coffee is merely OK, or as a friend once put it, “outstandingly average”. I think Starbucks – apart from their “average” coffee – is dropping the ball by trying to press the issue of expansion. Have a look. With 145,000 employees and an expansion rate that rivals McDonald’s franchises back in the good old days, Starbucks might be overextending themselves, watering down a brand that as recently as two years ago seemed limitless in potential.

Actually, watching Starbucks undergo some tough times makes me smile. Kind of like how any conscience-driven American consumer has to view, with benign pleasure, dozens of ex-employees getting together and filing a class action suit against Wal-Mart for their horrific mistreatment of employees. In short, it is fun for the small-cap opportunities when the big guys step in a pothole.

A potentially slipping Starbucks is also good because it means even more daylight for Green Mountain. Forbes has for each of the past three years named Green Mountain one of the “200 Best Small Companies in America”, making them a genuine lion in waiting and an approaching problem for competitors like Starbucks. Green Mountain serves over 7,000 wholesale accounts, and has thousands more accounts served indirectly by distributors. They sell coffee direct to the consumer via their website. They sell organic and free trade blends. They have seasonal lineups. And all their coffees taste great – no matter where you get them.

In Q3 2007, total net sales were up 73% from the same quarter last year, the direct-to-consumer arm of the company shipped 42% more pounds of coffee than the year before, and the “resellers” arm increased shipped pounds by 147%. Resellers here include companies like Keurig, which may even operate a K-Cup machine in your coffee break room at work. Net income for the quarter has nearly doubled year-over-year, and Green Mountain continues to come to new locations each day. Next time you are in the convenience store on the way to work, see if you are buying Green Mountain coffee. They are growing right now and raking it in like Starbucks used to.

WHERE OUR GRANDFATHERS WOULD LOOK FOR THE ALCOAS OF TODAY

Go east, young man.

60-odd years ago, keeping your head above water meant saving a dollar. In the 1940s, when my grandfather bought shares of companies such as General Electric and Alcoa Aluminum, his main goal never involved generating a fortune overnight – only to make sure he had enough income for tomorrow.

You see, my grandfather was a child of a dying generation ... a group of people for whom the Great Depression was much more than a chapter or two in the 13th edition of some unmarked high school history book. Today, most kids in America will learn the basic facts of the Great Depression, but the most valuable piece of knowledge – a realization that is essential to all Americans today – will not appear in their textbooks, not even as a footnote.

My grandfather emerged from the Depression humbled. His “American Dream” was intact, but tempered by the precious wisdom that nothing material in this world is infinite. For every “dream” there also exists the opposite, equally possible, scenario. That is what we are facing today. With each passing day, we add $2.43 billion to our record high national debt, and the dollar continues to fall in value, further eroding our already insufficient retirement savings.

What are most Americans doing about it? They are consuming even more, even if that means dipping into their savings or taking on debt they will never be able to repay. Why? Because it has to do with an economic struggle – an innate and uniquely American fear of being left behind (or, even worse, completely left out). It has to do with an individual’s fight for their particular piece of the proverbial American pie. Our political icons constantly remind us of achieving the “American Dream” and becoming an “ownership society” as if to say you can do better, achieve more and thus find happiness.

Its roots go back to the great bull market that followed World War II. That glorious economic expansion gave birth to America’s first legitimate middle class ... a group of people whose last names were scribbled onto University rosters for the very first time. Every American family could now have a house with a yard, a new Oldsmobile or even a Cadillac. The “American Dream” was reborn and recast, unfettered by a cautionary tale not even one generation old.

If you could not keep up with your neighbors, then new companies such as Visa and MasterCard could help you out. Madison Avenue hit its stride and showed the “Joneses” where to use their new plastic. And here we find ourselves today, back to where my grandfather and his peers found themselves 60 years ago – blindly teetering on the precipice of another American nightmare.

Let us pay homage to what our grandfathers experienced, and maybe we can avoid a similar fate. If my grandfather were alive, where might he look to find the Alcoas and GEs today? He would tell me to beware of U.S. small-cap companies dependent on the U.S. consumer. The S&P 500 consists of companies that earn 50% of their sales from overseas, so if their earnings look good, it is not necessarily because the U.S. economy is good.

If grandfather were around today, he would look east. He would find people similar to him ... people who save and produce. He would look to Japan, Korea, Singapore, and Hong Kong. That is where he would direct my own search to make sure that, no matter what happens in the U.S. economy and markets today, I will still have the income I need tomorrow.

CONTRARIAN OR VICTIM

In natural resource investment markets, one can be a contrarian or one can be a victim. The choice is one’s own. Having once been a victim, I chose the other path.

Natural resource industries are cyclical, volatile, emotional, over-regulated and capital-intensive. That is the good news. If you accept markets for what they are, while other speculators operate in ignorance, you have an advantage in the market. Being a contrarian is hard. That is the other good news. Most speculators cannot act in contrarian fashion, for reasons we discuss later.

During the first of this year, the prevailing sentiment among natural resource investors was that the sky was rosy for the sector. Emerging markets, particularly China and India, were driving resource demand, as billions of people aspired to the western lifestyle. Meanwhile, politically-inspired supply constraints like “NIMBY-ism”, nationalism and resource taxation constrained new supply initiatives, making existing capacity more valuable. Meanwhile, absurd monetary and credit practices increased the appeal of real, tangible assets. The only answer to that combination of circumstances was an aggressively positive attitude towards natural resource investments, ESPECIALLY because the stocks were performing well.

What has changed? Are resource stocks now a “sell”? Have we, in 60 days, restored the productive capacity of industries that suffered from 25 years of underinvestment? Has the political and social unrest in Iran, Venezuela and Nigeria subsided to the extent that raw materials consumers are comfortable with their reliability as suppliers? Have absurd monetary and credit practices become less of a concern to anyone?

What has changed? Perception and the price of opportunity! Many of you have experienced one or more resource cycles. For others, this is your first voyage. Down cycles in the resource business are messy affairs. The current cycle has been no different. The small-cap stocks, for example, are becoming even more volatile than they have traditionally been, driven by several interconnected phenomenon. First, the markets are now international, with Asian, Middle Eastern and European money flowing into and out of very thin markets, often buying and selling for reasons unrelated to the real prospects of the individual underlying equities.

Large institutions, particularly open-ended mutual funds, are big players in tiny markets. In times when the public perceptions of these markets is good, money flows into resource and small cap funds and is deployed by newly minted investment geniuses into increasingly irrationally priced equities. As perceptions change and the money disintermediates, managers must liquidate increasingly cheap positions. These managers do not have the luxury of selling what they want. They sell what they can. Smaller institutions like hedge funds and liquidity funds have been huge players in these markets, and as their performance falters they too migrate from being aggressive buyers to aggressive sellers.

Finally, individual participation in equity markets is at an all time high, with millions of bull-market-spawned, internet-wired speculators trading speculative equities with less than perfect knowledge about the businesses that underlie those trading vehicles. The information most of the participants rely on for their investment decisions is delivered by the markets themselves, the blind leading the blind. The mob bids up the market, the mob sells the market down. What is the rational speculator to do? Buy stocks on sale.

Volatility is not just a condition, it is a tool. If it is a tool that you are unwilling or unable to utilize, you should consider a different investment medium.

Markets are emotional too, and that is also good news! We are programmed to seek pleasure, and avoid pain. We hate to be wrong alone, seeking solace in the crowd. Our expectations for the future are set by our experiences in the immediate past. When we experience success in a market, we experience pleasure, and as pleasure seekers we are eager to repeat the sensation. We feel smart, confident, even smug. Bluntly, we confuse a bull market with brains. When markets get cheap on our watch, our most recent memory is pain, which we seek to avoid. We either blame the market, the government, the Moslems, the Trilateral Commission, or rarely, ourselves. But, eager to avoid blame, no price is too cheap ... until at last it is no longer cheap, and we muster up the courage to re-enter.

In the short term, markets are a voting machine, a measure of the mob’s emotion and prejudice. Letting a mob, whose median intelligence and access to information is less than your own, dictate your actions is tantamount to assigning yourself a large handicap. In the long term, markets are weighing machines, swinging on a pendulum between undervalued and overvalued. Being a pawnbroker to the mob, buying goods on sale when the mob is depressed, and selling back marked up goods when the market is elated, is what markets are for. Do what is rationally easy, not what is emotionally easy. If you cannot find much to buy rationally, start selling. If a market goes “no bid”, put one up.

I personally see us in the mid-stage of a broad bull market in resources. At this instant, we are in a “wall of worry” correction. The world has woken up to the potential of resource markets, expectations have been frothy, but the inevitable supply increases that crush a market have not occurred, and will not occur for some time, because of the huge capital investments and long lead times inherent to these industries. I think most of the free money (the stealth bull market) has been made. My strategy will be to cycle out of popular sectors (Uranium), into unpopular sectors (Canadian natural gas), buy panics (hello, anyone listening?), and sell rallies.

Supply increases have not yet occurred, although the capital spending cycle has rendered them inevitable. Demand, even in the face of strong price increases, is very strong. Emerging market demand is part of that story, insidious inflation is another factor. If we adjust the prices that we experienced 40 years ago, or 20 years ago, to constant dollars, we see that commodity prices are high only in nominal, not in real terms.

Finally, the credit conundrum is, well, a conundrum. On the one hand, there is no doubt that part of the resource demand is artificial, a response to a liquidity-driven boom. More rational credit supplies can and will impact the broad economy, with profound implications for commodity demand. Limiting mortgages to people who can afford to pay back the loan will constrain demand for building materials. On the other hand, the idiotic increases in the money supply we are seeing now will make money worth less, and “stuff” worth more.

So where does this leave us? Right where we started: being contrarians, or victims. Being a contrarian is better.

Contrarian or Victim, Part II

We are in the mid-stage of a broad bull market in natural resources. Therefore, my strategy will be to cycle out of popular sectors, like uranium, and into unpopular sectors like Canadian natural gas. In other words, I will sell frothy rallies and buy panics. The broad resource markets are in the midst of a classic “wall of worry” correction. Small-cap (“junior”) resource stocks, in particular, are flirting with multi-month lows. This selloff provides both risk and opportunity. Let us take a closer look.

FIRST: The junior resource markets as a whole were, and still are, insanely overpriced. Only about 10% of 5000-odd junior companies have any real value (but very few investors have the ability or the will to discriminate between the good, the bad, and the ugly). The uranium mania is a classic example of this. In 2000, the price of uranium was very cheap. It had to go up. But because uranium had been dormant for so many years, nobody cared. When the price did go up, people began to care ... and eventually became obsessed. About 550 “uranium” companies now litter the investment landscape. The vast majority (maybe 500 of the 550) share two serious faults: First, they have no uranium. Second, they have under-qualified management. After a 25-year “bear market” in uranium, there are only perhaps 30 qualified exploration teams left to run 550 companies.

SECOND: Many important market players are incompetent. A 20-year “bear market” in resources has thinned the ranks of competent participants in resource financial services. The brokers and investment bankers are increasingly “fee whores”, rather than gate-keepers, and the level of professionalism among many institutional investors would be laughable, had it not become tragic. Well informed investors, therefore, hold a distinct advantage in the marketplace.

THIRD: The market is liquidity-driven. Global flows of liquidity – from the Japanese Central Bank bailout of its finance industry to the U.S. Fed’s bailout of the American mortgage industry – have left the world awash in paper currencies. This great deluge of liquidity sloshes around in the global financial markets, causing huge gains whenever it pours into a given sector ... and causing huge losses whenever it empties out. During the last couple of years, a lot of “dumb money” has been flowing into uranium companies with no uranium, run by people who cannot even spell “uranium”. A bunch of that “dumb money” is going to go to “money heaven” – it will disappear into the same thin air out of which it was created. The evaporation of vast quantities of “dumb money”, along with the evaporation of easy credit, has led to a severe liquidity crisis in several financial markets, notably, the junior resource markets, which are generally very illiquid, even during the best of times.

FOURTH: The market and its participants suffer from irrational expectations. After several years of a raging bull market, participants have come to believe that inordinate success is a condition they have a right to expect. Investment conference participants often boast that they use the maximum margin available, and ask the speakers, “What do you have that will triple in 90 days?” The probable answer is that the questioners’ upcoming capital losses will be the most likely “triple” of all. This market has good money left in it. Don’t spoil it for yourself with idiotic expectations.

The factors that caused the euphoria in resource markets earlier in the year are still present, but now they are available at a discount. We need to learn to profit from cyclicality, not become its victim. We need to cherish volatility, not fear it. We need to remember that we do not have to emulate the stupidity of the mob. In essence, we must employ common sense, and buy financial assets on sale.

The month of August was “wake up” call for resource investors. And now that the markets have bounced back a bit, we have got a nice opportunity to examine our investments from a fresh perspective. Take this opportunity to review the reasons you became a resource investor and/or speculator. Are those reasons still valid in your view? Do you have the emotional strength to be a contrarian, using cyclicality, welcoming volatility, buying panics, and selling rallies? If not, do yourself and your broker a favor, and close your account. If this sector still entices you, then use this recent panic as a slap in the face. Sell the securities that are not absolutely “best of breed” in terms of management, balance sheet and asset base. Sell even those that are best of breed if they are very overpriced.

Consider making tax loss sales in September and October, as the market recovers, so that you can offset gains taken earlier in the year. Be very, very exacting with each of your investments. Look at your total personal balance sheet. Are you where you need to be, or would like to be? Are you over-exposed to resource stocks? Are you overly speculative? Do you have sufficient liquidity?

I suspect that the response of global central bankers’ to the unfolding credit crisis will be to pump massive liquidity in the global monetary system, i.e., “print” money. This response will be bad for ALL fiat currencies. As the dollar devalues, I believe others must and will follow. More currency from thin air devalues the existing supply. So own some gold. Gold is a medium of exchange, the best in recorded history, and a store of value. Gold is also catastrophe insurance. Own it first as insurance. Speculate on the high-quality gold stocks, buying panics, and if you like, selling rallies.

Own energy. Conventional oil and gas is reasonably priced, given the supply/demand balance. Again, focus on “best of breed”, not “story stocks”. Buy on the basis of net-enterprise-value vs. net-asset-value. In addition, buy corporate efficiency, based on operating margins and reserve acquisition efficiency. Speculate on the junior Canadian gas producers. This sector is cheap, but it will take two to three years to work out.

Remember, it is irrelevant whether we like these conditions or not. We must use market volatility to our advantage or be used by it. The choice is ours!

BEWARE – BERNANKE FED CAN IGNITE HYPERINFLATION!

“You unlock this door with the key of imagination. Beyond it is another dimension, a dimension of sound, a dimension of sight, a dimension of mind. You’re moving into a land of both shadow and substance, of things and ideas. It’s a journey into a wondrous land, whose boundaries are that of imagination. That’s a signpost up ahead, your next stop, the ‘Twilight Zone!’”

Rod Serling was a multi-talented man and a prolific writer. His television series The Twilight Zone ran for five seasons in the early 1960s and was extraordinary, winning three Emmy Awards. As the host and narrator, and writer of more than half of 151 episodes, he became an American household name and his voice always sounded a creepy reminder of a world beyond our control.

Nowadays, there are numerous signposts indicating that inflation in the U.S. is getting out of control. The U.S. M3 money supply is 14% higher than a year ago, its fastest growth rate in 35 years, the U.S. Dollar Index is plunging to 15-year lows, gold is surging toward $725/oz, a 28-year high, crude oil is cruising above $80/barrel, wheat prices have doubled to $8.75/bushel, an all-time high, and the Baltic Dry Freight Index has zoomed 300% higher to stratospheric levels.

It is like entering “a fifth dimension beyond that which is known to man, that lies between the pit of man’s fears and the summit of his knowledge,” Mr. Serling explained. Could it be that the 5th dimension that lies ahead is hyperinflation, and the reignition of the “Commodity Super Cycle?” Money is still pouring into commodity indexes to diversify portfolios, amid recent financial market turmoil, reaching $120 billion at the end of the second quarter, up 50% from a year earlier. Food and energy prices are sharply higher from a year ago, and this time, the surge in these “volatile components” of inflation is not a flash in the pan. But remember, you are in the “Twilight Zone”, where perception is more important than reality, and emotions often trump logic. “There is nothing so disastrous as a rational investment policy, in an irrational world,” explained John Maynard Keynes.

Watch the dollars and cents in the commodity markets.

When operating in the “Twilight Zone”, traders should focus on the dollars and cents that flow through the global commodities markets, for real-time indications about the direction of inflation, and not rely on inflation stats conjured up by government apparatchniks. Since the Fed’s last rate hike to 5.25% in June 2006, the Dow Jones AIG Commodity Index has been trapped in a sideways trading range between the 160 and 180 levels, but still up 6% from a year ago.

But on September 18th, Fed chief Ben “B-52” Bernanke, finally showed his true colors, exposing himself as a radical inflationist, by slashing the fed funds rate a larger than expected half-point to 4.75%. The Bernanke Fed panicked, lost its cool, in a desperate attempt to bailout Wall Street brokers who peddled toxic sub-prime U.S. mortgage slime around the world, and saddled banks and hedge funds around the world with losses to their balance sheets that can exceed $150 billion.

To defuse the credit crunch and still fend off inflation, Bernanke could have chosen the middle ground, by simply lowering the discount rate by a half-point. Instead, Bernanke chose the most aggressive action, by slashing the fed funds rate. Looking at the chart above, what impact would a series of Fed rate cuts have on the DJ Commodity Index?

What is the worst possible investment to own during a series of Fed rate cuts? During DJ Commodity Index’s great bull run from 2003 thru mid-2006, when it climbed 56% to a 24-year high, there was simultaneous bear market for U.S. Treasury Notes, when measured against the price of gold. This is the predicament that China finds itself in today, with an estimated $900 billion stashed away in rapidly depreciating U.S. bonds, which have collapsed from 85 cents on the dollar to as low as 39 cents today, when measured against an ounce of glittering gold.

Can the Fed reinflate subprime mortgage slime?

Toxic U.S. sub-prime mortgage slime, has infected the biggest brokers on Wall Street, bond mutual funds, and the world’s largest banks. Its latest victim is Northern Rock, the UK’s 5th-largest mortgage lender, now bracing for a takeover after its shares collapsed and its customers lined the streets to withdraw their money. Last week, Northern Rockconfessed that has a £275 million exposure to U.S. subprime mortgage slime. It also has a £325 million position in structured investment vehicles, requiring an advanced degree in calculus to figure out.

About 5 million adjustable-rate U.S. mortgages are slated to reset in the next 18 months. More than 2 million of these ARMs are subprime and as many as 600,000 subprime borrowers could lose their homes, weighing on an already weak housing market. Already, there are glaring signs that the U.S. economy might be headed for a recession. [See “The Recession is Here”.] Former Fed chief “Easy” Al Greenspan said he expects “as a minimum, large single-digit percentage declines in U.S. house prices from peak to trough, and would not be surprised if the drop was in double digits.”

Harvard University economist Martin Feldstein, advised the former Princeton economist “B-52” Bernanke to come to the rescue of subprime borrowers, with the same old magic formula ... printing more money, devaluing the dollar, and lowering the fed funds rate. Since the credit market crisis unfolded in early August, the Bernanke Fed has pumped $292 billion of morphine (repos) into the banking system, the most since the 9-11 terror attacks. Not all the morphine has been withdrawn however, and as a consequence, the growth rate of the M3 money supply expanded to 14% in August, and gold has jumped to $725/oz.

Greenspan sees higher inflation, reinforcing gold rally.

Some Fed officials deny the linkage between the explosive growth of the M3 money supply, which the Fed is trying to hide from the public, and inflation. But surprisingly, it is Greenspan, would pegged the U.S. fed funds rate below the inflation rate for three years, who is ringing the alarm bells about a resurgent gold market. Greenspan advised Bernanke to avoid cutting rates too aggressively because “the risk of an inflationary resurgence is greater now” than when he was nurturing the subprime mortgage mess. “As economic globalization winds down, the forces that have kept prices down will disappear,” he said.

“Inflation in the United States could rise to a rate of between 4% and 5% a year,” Greenspan said. Greenspan also predicted that inflation will also rise to 5% in Europe: “The 5% inflation level is more fitted for an economy that functions on a paper standard, where the currency is not linked to gold. The Fed could keep inflation lower, but to do so, it might have to raise interest rates into the double-digits.”

Gold has been patiently waiting for the Bernanke Fed to cry uncle, and start cranking-up its money printing machines. Since the Fed halted its 2-year rate hike campaign on June 25th 2006, the price of gold has climbed by 32%, and for most of this year, has been relatively stable, amid strong demand in Asia and the Middle East, and steady inflows into ETFs, such as GLD. Expectations of an easier Fed policy have crushed the U.S. dollar, and discouraged other central banks from raising their interest rates, adding new sparkle to gold against all paper currencies. Newmont Mining’s Pierre Lassonde suggested prices could top all-time highs of around $850/oz next year.

Can Saudi Arabia contain crude oil at $80/barrel?

Gold demand from the Arabian Oil kingdoms is rising and this is no accident, with the price of crude oil climbing above $80 per barrel, and the US$ Index sinking below the psychological 80-level, stoking higher inflation in the Persian Gulf. Most ominously, the U.S. dollar is sinking to 15-year lows, even before the Bernanke Fed speeds up the growth of the M3 money supply into “The Twilight Zone”.

Though oil prices have quadrupled since 2002, when adjusted for inflation the price is still below the $90-a-barrel peaks of the Iranian Revolution in 1979. Could this explain why the Dow Jones Industrials and other global stock market indexes have not shuddered at the sight of crude oil soaring to $82 per barrel?

OPEC has agreed to boost its oil output by 500,000 bpd to temper any speculative rally in crude oil above $80 per barrel. So far, the initial reaction in the oil market to Riyadh’s gesture is “Too little, too late.” “I think higher oil prices have a lot to do with risk premium from geopolitical uncertainties,” said Saudi central banker Mohamed al-Jasser. “There is no shortage of oil in the market and we have not turned back anyone who demanded oil from us,” he said. If correct, then oil companies might be hoarding oil. Why?

The world must “must prepare for the worst” – including the possibility of war – over the Iranian nuclear crisis, French Foreign Minister Bernard Kouchner said on September 16th. If the end game with Tehran over its nuclear weapons program is finally around the corner, how would Mr. Bernanke, the radical inflationist, react in a “Twilight Zone” episode in which crude oil jumps to $100 per barrel? Would it preclude the Fed from lowering the fed funds rate due to spiraling inflationary pressures? Do not be surprised if “B-52” Ben argues that a weak U.S. economy and doctored inflation statistics justify a further easing in Fed policy, pouring more gasoline on the flames of inflation, in the event of a confrontation with Iran.

Agri-flation on the warpath.

Rising prices of agricultural commodities including wheat, soybeans, corn, and milk have helped stoke global inflation. This trend, referred to as “agri-flation”, shows up in prices for farm products which reached record levels in 2007. A Food Commodity Index, which tracks a dozen agricultural raw materials used by food companies including wheat, barley, milk, cocoa and edible oils, show cost inflation of 21% this year – the biggest increase since the index started almost a decade ago.

In the past 12-months, the price of milk futures have soared 70% in Chicago, and in most of Europe is up 50% this year. Wheat jumped to a record $8.75 per bushel on the Chicago Board of Trade, up 45% since the beginning of July on signs of strong demand for dwindling global supplies. Global consumption has exceeded production for the 7th time in 8 years. More global demand for corn to produce ethanol, which is now blended with gasoline, helped push corn prices to a 10-year high in February. Soybean prices are expected to hit their 2nd-highest average mark ever this year, and highest since 1983, says the USDA.

Much of the surge in soybeans to $9.60/bushel is linked to the Bernanke Fed’s devaluation of the U.S. dollar. The EU wants biodiesel to make up 6% of transportation fuels by 2010 to reduce dependence on crude oil, and a stronger Euro provides greater purchasing power to buy soybean oil. At the same time U.S. farmers are switching more acreage from soybeans to corn next year. Global oilseed production for 2007-2008 is projected at 399 million tons, down 5.4 million tons from 2006-2007.

Soaring food prices have propelled China’s consumer inflation to 6.5%, its fastest pace in 11 years. But judging from the bubble in Shanghai red-chips, Chinese inflation is probably running in the double digits. The ruling Communist Party is aware that raging inflation has touched off social unrest in China in the past. Inflation was driven by an 18.2% leap in the cost of food, which accounts for a third of the consumer price basket.

China has 20% of the world’s population but only 7% of its land is arable. China has lost 6% of its arable land in the last 20 years of breakneck industrial growth. China became a net importer of food in 2004, and just as China’s growth has fueled the explosion in world prices for crude oil, iron ore, copper, steel and shipping, the impact of greater Chinese demand for food, particularly beef and pork, is just starting to be felt.

The People’s Bank of China (PBoC) raised interest rates for the second time in less than a month on September 13th, amid soaring food prices, excessive bank lending and massive bubbles in the property and stock markets. However, the PBoC deliberately pegs the 1-year bank deposit rate far below the inflation rate, encouraging savers to shift money from bank deposits and into the Shanghai and Shenzen stock market. Beijing is expected to continue raising interest rates and lifting the reserve rate requirement in the coming months as well as issuing more special Treasury bonds to drain liquidity from the financial system. However, further baby-step rate hikes will not put the PBoC ahead of the inflation curve anytime soon.

In addition to higher prices for raw materials and grains, global shipping rates are going thru the roof, with shippers having little difficulty passing through their increased costs to importers. The Baltic Dry Index, which measures dry bulk shipping rates on 40 shipping routes, for commodities such as coal, iron ore, cement, grains and sugar climbed to an all-time high of 8,477 last week. The global economy has expanded by 5% or more for the past four years, its best performance since the early 1970s, and ship owners and operators have enjoyed the strongest marine transportation market in three decades. The Baltic Dry Index is trading close to 10 times its lowest level, hit in November 2001.

HELICOPTER BEN EARNS HIS WINGS

Coming at a time when rate increases were needed to combat the sinking dollar and surging gold, oil and other commodity prices, Ben Bernanke’s 50 basis point cuts in the Fed funds and discount rates this week may go down as the most irresponsible move in Fed history. To America’s creditors around the world, whose mountains of dollar reserves will be debased by lower rates in the U.S., this action amounts to the monetary equivalent of “let them eat cake.” My prediction is that rather than doing so, they will just throw it back in our faces, and refuse to continue funding our deficits.

Wall Street bulls have heaped praise on the Fed, at times calling the rate cuts courageous and brilliant. From their response, you would have thought that Bernanke’s solution was akin to Einstein’s breakthroughs on relativity. In the first place, what is so brilliant about cutting rates? My five year old could do it and would gladly accept payment for his service in popsicles.

Furthermore, a 50 basis point cut was not an act of bravery but one of cowardice. The brave thing to do would have been to raise rates and allow market forces to purge the economy of the imbalances built up during the Greenspan bubbles. It would have taken some real courage to level with the American public and let them know that our profligacy has consequences, rather than pretending it can ride to the rescue with a wave of its magic wand and a crank of the printing press.

If Bernanke really had any guts he would have assured our creditors that they will be repaid with real purchasing power, and that the Fed was willing to put some teeth in our alleged “strong dollar policy”. His capitulation proves that this phony policy was pure propaganda all along, merely designed to fool foreign creditors into holding our paper.

Those who believe the Fed should reduce interest rates to ward off a recession or stabilize home prices simply do not understand the situation. More credit is not the solution: it is part of the problem. Our economy is on the brink of disaster because irresponsible Fed policy encouraged Americans to borrow and spend too much and created an unprecedented national real estate bubble. The last thing the Fed should do is entice Americans to borrow more money they cannot repay, buy more imported products they cannot afford, and attempt to blow more air into the deflating real estate bubble. Cutting rates now only assures that we will dig ourselves into an even deeper hole. In the end, it will be that much harder for us to get out, and we will be that much worse off when we finally do.

Although they may slow the process down for a few quarters, the rate cuts will neither prevent the recession nor keep house prices from collapsing. But they will cost us dearly. The dollar’s fall, which had been held somewhat in check by the possibility of a hawkish Fed, has accelerated in earnest now that the curtain has been pulled back. Unlike previous bouts of Fed easing, this time any additional liquidity will not artificially pump up the economy or the housing market, but merely accelerate the rise in consumer prices and eventually push up long-term interest rates as well. With the dollar in free-fall, will foreign savers really want to buy our mortgage backed securities, or lend us any more money at single digit interest rates?

The most comical spectacle of all has been Alan Greenspan’s attempt to steal the spotlight. During his media blitz to promote his new book, he simultaneously disclaimed any responsibility for the problems we are now facing while forecasting that both inflation and interest rates would eventually rise to double digit levels. He even admitted on 60 Minutes that he personally had already diversified his own assets out of the U.S. dollar. I guess it is fairly easy to read the writing on the wall when you are the one with the spray paint. Greenspan sowed the wind. Unfortunately the entire nation is about to reap the whirlwind.