W.I.L. Finance Digest for Week of March 10, 2008

THEY STILL DON’T GET IT

Peter Schiff, author of Crash-Proof: How to Profit From the Coming Economic Collapse, has full rights to a round of "I told you so's" at this point. He notes that the apologists for the system and the former bubble still do not get it, which bodes ill for a rational set of policy initiatives issuing forth going forward.

Prior to my last appearance on CNBC in October 2007, I had made more than 50 appearances on the network over the prior two years. In those segments, I repeatedly exposed the superficiality of our prosperity, described the American economy as a "house of cards", pointed out that borrowing and spending were a ticking time bomb rather than a viable plan for long term economic health, and explained how investors could prepare for the tough times ahead. At the time, those forecasts were met with ridicule and led to my being nicknamed "Dr. Doom". Now that these predictions have come to pass, most on CNBC now claim that no one saw it coming!

In my 2006 and 2007 on-air appearances, to a chorus of sneers and laughter, I predicted the bursting of the housing bubble, the collapse of the subprime mortgage market, the credit crisis, tightening lending standards, waves of defaults, bankruptcies and foreclosures, weakness in financials, retailers and homebuilders, stagflation, surging gold, oil and other commodity prices, soaring federal budget deficits and a collapse in the value of the U.S. dollar. You would have thought that some of the reasons I gave for making those predictions would now be given some credence. They have not.

The current line at CNBC is that, prior to the "unexpected" contagion emanating from the subprime mess the U.S. economy was experiencing a "Goldilocks" era of optimal health. They now believe that if the Fed and the Government can divine the right combination of fiscal and monetary policy, Goldilocks will once again be blissfully picking daisies ... or more precisely, buying SUVs. Unfortunately, as I said then, Goldilocks was, and still is, a fairy tale. In fact, the unfolding economic disaster is a direct consequence of the misguided faith placed in that absurdly optimistic parable. And since they were incapable of diagnosing the disease, is it any wonder that their cures are completely ineffective?

This lack of understanding is further confirmed by the skepticism with which the mainstream financial community still regards my diagnosis. For example, in a February 22, 2008 article in TheStreet.com, entitled "Dr. Doom Zeros in on Inflation", Mike Holland, a CNBC regular leveled two common criticisms often used to discredit me. Holland says "investors who listened to Schiff throughout the recent bull market missed out on some attractive returns in the stock market" and "A broken clock is right twice a day. If you say things are going to be bad long enough, eventually you're going to be right."

What attractive returns does Holland think my clients missed out on? Those who followed my advice invested in foreign stocks, bonds and currencies, as well as precious metals, oil and other commodities. Investors who listened to me instead enjoyed much greater returns by participating in the real bull markets. It is amazing how few people have managed to figure this out!

The "stopped clock" analogy is one I have been dealing with for years. Those using it maintain that my early warnings invalidate my forecasts. It is precisely because my warnings were so early that they were so valuable to investors. In addition, such charges assume that the current downturn is unrelated to those warnings and that my critique of the U.S. economy was inaccurate until now. My critics, the real stopped clocks, still do not understand that the phony prosperity they were defending and that I was challenging lies at the root of the current crises. When the bubble was still inflating it is understandable that those trapped inside viewed me as a stopped clock. However, now that it has burst, it is amazing how many still cannot get the soap out of their eyes.

THE TRUE COST OF THIS CRISIS

“Don’t just do something. Stand there!”

There is no evidence that central bank interventions and bailouts reduce costs -- in fact they increase costs. And that is according to the World Bank. Of course any non-rigged study would inevitably have reached the same conclusion.

How to keep your head when everyone around you is losing theirs?

"Steer clear of the new gold rush," urges Jason Zweig, a senior columnist at Money magazine. "Don't give in," says Janice Revell, another senior hack at CNN's glossy monthly. "Step out of the stock market, even temporarily, and you may miss the whole point of owning stocks."

"Aw, just lend! Lend! LEND!" screams the Federal Reserve. Sporting its usual crystal meth grimace, it is stumping up $200 billion in Treasury bills for desperate New York brokers to kick-start the world's capital markets. And now they can use flakey mortgage-backed bonds as collateral.

Stepping in "to address liquidity pressures" like this -- and getting your chums at all the other top central banks to do the same -- looks like the next best thing to buying mortgage-backed bonds altogether. But while central banks surely do not want to become "home buyer of last resort," it has got to be better than doing nothing. Right? Acting early and often must work out cheaper in the end. Mustn't it?

Well, you will never guess what. As anyone who ever fell for interest-free vendor financing knows only too well, the cheapest option -- always and everywhere -- is to avoid spending any money at all. As a professional economist would put it, "We find no evidence that accommodating policies reduce fiscal costs." That is how two senior economists at the World Bank put it in a 2002 report studying 30 years of systemic banking crises across 94 countries.

Borderline crises hit 44 nations. And on average, the World Bank economists found, "governments spent an average of nearly 13 percent of GDP cleaning up their financial systems" as a result of the bailout programs they tried to implement. "Indeed, each of the accommodating measures examined," they continued -- citing "open-ended liquidity support, blanket deposit guarantees, regulatory forbearance, repeated (and thus initially inadequate or partial) recapitalizations, and debtor bailout schemes -- appears to significantly increase the costs of banking crises."

Weird like pineapple on pizza, do you not think? Because the seven central banks jumping to hit the panic button this week are all members of the World Bank. They actually helped found it back in 1944. More than that, the central banks led by Ben Bernanke, Jean-Claude Trichet, Mervyn King, and the rest all figure in this 2002 report. All except the Swiss National Bank, that is ...

1. S&L USA: The slow-motion savings and loan collapse in the United States destroyed some 1,400 institutions and took another 1,300 banks with it between 1984-1991. Direct cost to the U.S. taxpayer? Some $180 billion, or 3% of annual economic output.
2. Europe's Bad Banks: Staff at the European Central Bank might like to recall the Greek and Italian bailouts of the early 1990s ... or the $10 billion failure of France's Credit Lyonnais in 1995 ... or Germany's Girobank crisis in the mid-1970s?
3. Japan's Lost Decade: The 1996 rescue of Japan's zombie banks cost more than $100 billion in public funds. Two years later, the Obuchi Plan spent another $500 billion of taxpayers' money -- some 12 percent of Japan's GDP -- on loan losses, bank recapitalizations, and depositor protection.
4. The U.K.'s Repeat Failures: From the "second line" crisis of the mid-1970s to the collapse of Johnson Matthey in 1984, BCCI in 1991, Barings in 1995, and now Northern Rock in 2007, the U.K. authorities have repeatedly failed to spot trouble before wading in with taxpayers' cash.
5. Canada, 1985: The Bank of Canada itself notes how the failure of 15 members of the Deposit Insurance Corporation -- including two banks -- accounted for less than 1% of the total banking system. Yet it led to long-term liquidity loans, funded by the public, plus 15 years of expensive court wrangling.
6. Sweden's Systemic Crisis: In the early 1990s, two banks accounting for 1/5 of all Swedish banking assets were declared insolvent. By 1994, five of the six largest banks faced serious problems, costing taxpayers 4% of GDP in government support.

Don't the current heads of the world's biggest central banks ever flick through World Bank research reports while waiting to get their teeth straightened or beards trimmed?

But given the current collapse of real estate markets, banking models, hedge fund credit lines, and short-term liquidity the world over since last August -- back when gold bullion traded 1/3 below today's current price -- who in their right mind would bother to read a study of 113 truly system-wide banking crises in 93 countries between 1970-2000? No one running monetary or fiscal policy in the G-7 group of top economies, that is for sure!

"If the countries in our sample had not pursued any such [supportive or bailout] policies, fiscal costs [borne in the end by the taxpayer] would have averaged about one percent of GDP -- little more than one-tenth of what was actually spent," write Patrick Honohan and Daniela Klingebiel in their report, published in January 2002.

What is more, trying to bail out or support failing banks did nothing to reduce the economic drag that followed, according to Honohan and Klingebiel's analysis. The so-called "output dip" never responded to government meddling -- not unless the central bank stepped in to ease liquidity problems at crisis-hit banks with unlimited cheap loans.

That kind of support -- exactly the support given to Northern Rock as it went belly up in September last year -- is only one step removed from the marketwide support now being offered to New York brokers today. Yet it "actually appears to have prolonged crises," write the two World Bank bean counters, "because recovery took longer" following liquidity loans to effectively insolvent banks.

In other words, the only sure way of prolonging a financial crisis is to try to delay it. Say, by putting taxpayers "on risk" with $200 billion in mortgage-backed loans. ...

Nasty rumors keep whacking "living dead" bank stocks in London, Tokyo, Frankfurt, La Defense, and Wall Street right now. And so far, taxpayers aren't on the hook for recapitalizations; UBS and Citigroup have gone to Asian and petro-wealth funds for that. Ben Bernanke has so far only demanded that subprime lenders write off the value of outstanding loans, rather than calling on Congress to issue the checks directly.

But if the authorities sat on their hands during this crisis, the fiscal cost might equal one percent of GDP, the World Bank report suggests. Donning a cape, tights, and mask, instead -- and pretending they can unwind the mal-investments caused by record low-interest rates from the Fed after the tech stock bubble burst -- the cost may rise 60 times over. That is more than a 98% saving, if only the G-7 authorities would sit back and let the failed banks fail.

Put these findings to one side, however. Because what is most remarkable about the World Bank study -- other than the fact central bankers are so clearly ignoring it -- is that anyone could ever imagine things differently. Throwing "good money after bad" is a moral hazard that everyone's grandma knows to avoid. And just like the truly historic bubble in credit that created it, the endgame for today's official response to this historic banking crisis looks as inevitable as it is sure to prove painful. ...

High inflation and a currency collapse, you say? As a rule, smarter investors spotting this trouble in good time can switch into hard currency to hedge their domestic inflation risk.

But today's systemic banking crisis crosses all developed economies ... from North America to Japan and Australia onto Europe and the United Kingdom. So unlike the Asian crisis of 1997, you cannot flee the Thai baht by hedging with dollars today. Nor can you flee the Hungarian forint for the safety of French francs or Deutsche marks, as you could when 25% of Budapest's banking assets were caught in a mass bank failure in 1993. Where to go? What to use as a hedge against all currency risk?

BLACKSTONE AND THE GREAT BUYOUT BUST

“No one saw this kind of outcome.”

No one can say that Robert Prechtor and his crew over at Elliott Wave International did not see today's mess coming. One could argue that he was way to early in his forecast of when it would come, but that is another matter. Thus the dazed looks of today's hand-wringers who claim that everything happening is a complete surprise can be interpreted any number of ways, starting with greed-induced blindness.

Certainly it is human nature to not want to think about tomorrow while the party is still going strong. It does take a certain willful disregard of reality to claim that the party will never end. However, that is exactly what a multitude of professionals were doing while the bubble was in full swing. As John Kenneth Galbraith, who was right about some things, said: "In a rising market, the tendency to look beyond the simple fact of increasing value to the reasons on which it depends greatly diminishes."

Another day, another titan of the financial industry gets a first-hand idea of what it feels like to go bungee jumping off a cliff ... without a bungee cord. On March 10, the leading U.S. private equity firm Blackstone Group was transferred to I.C.U. -- Imploding Credit Unit. The company's stats: Fourth quarter 2007 earnings plunged 89%, alongside two failed buyout completions, soft results from its two biggest divisions, and a 60% slide in its public stock price.

According to a same-day New York Times report: The celebrated buyout firms of 2007 "are seeing the handwriting on the wall. They're staring into the jaws of hell ... No one saw this kind of outcome."

If by "no one," they mean the mob of mainstream-goers racing to get on board the bullish buyout bandwagon back in 2007. At the time, private equity takeovers soared to a historic high of $3.66 trillion, topping the previous record set in 2000. And, Blackstone Group's very own chairman, a man who once openly dismissed the I.P.O. market as "overrated," was actively pursuing going public.

"All Aboard the M&A Express," cheered a January 2007 news source. "If you were a betting man, you would see the boom times continuing as far as you can see out. It's hard to [imagine] a catastrophe happening or even one or two things that could take the wind out of the sails of the market." (Times Online)

And, this June 1, 2007 Bloomberg: "The private equity world is in its golden era right now. The stars are aligned. There's no end in sight to the frenzy."

For our analysts, however, the prospect of "one or two" things taking the wind out of private equity's sails was not a matter of imagination. It was reality. On this, our April 2007 Elliott Wave Financial Forecast kicked off a series of discussions regarding the dramatic fall from grace in store for the high-risk world of venture capitalism. Below is a thumbnail view of these observations ...

WHICH BANK IS GOING TO FOLLOW THE BEAR?

The subprime mortgage crisis/fiasco continues to escalate. Old time Wall Street house Bear Stearns has traditionally had a reputation of sorts as a firm with a scrappy, savvy trading culture that compensated for their smaller size. So much for the savvy part, anyway. Now their equity would be negative if their assets were marked to market. A firm can continue under this condition if their lenders keep extending them credit, but in today's conditions no one is in the mood to do this. So the Bear is scrambling to stay alive.

The natural question then is, who is next? There are the direct lenders to Bear Stearns, whose asset values and therefore equity are compromised. And there are those with similar, e.g., subprime mortgage-backed assets featured heavily in their balance sheets.

Update: Bear Stearns was trading at over 60 early in the week of March 10-14, and still traded at a price greater than 30 on Friday, March 14. JPMorgan Chase announced a deal Sunday to acquire Bear Stearns for just $2 a share, or $236.2 million -- with a $30 billion boost from the Federal Reserve.

This could happen to any financial firm. With miniscule equity/asset ratios it does not take a big fall in asset values to wipe out the equity, and then some. This is why we are so leary of financial stocks. Leverage and a bear market is not a good combination.

So who is next? As advisers to Bear Stearns struggle to find a buyer or funding in the next 28 days, Wall Street, the City and the financial district in Tokyo were scrabbling to find out who is the most exposed to Bear Stearns, either through loans or trading positions. Traders in all three centres were panicking even for those banks not directly exposed to Bear. They feared that the problems experienced at the stricken bank signaled that the credit crisis has deteriorated to a new level.

[Friday, March 14], traders began to look anxiously at the robustness of Lehman Brothers, which, although bigger than Bear, is small compared with JPMorgan Chase, Morgan Stanley and Citigroup. Shares in Lehman dropped 11% [Friday], a far bigger fall than its other rivals, which saw their stock decline by about 3%.

Although Lehman is more diversified than Bear, it has a similar investment profile, with huge holdings in mortgage-backed debt. Lehman sought to reassure the market when it said yesterday [Friday] that it had secured a $2 billion credit line with Paolo Tonucci, the bank's global treasurer, calling it "a strong signal from the market and our key bank relationships."

However, Chris Whalen, of the Wall Street consultancy Institutional Risk Analytics, said: "This is going to go all the way up the chain. There is a risk that all broker dealers are going to become an endangered species if the credit crisis is not sorted out. If they cannot fund themselves, they will have to shrink. All the other firms are in danger, too."

He said that should the U.S. Federal Reserve, the U.S. Treasury and the Securities and Exchange Commission not devise a broad rescue plan to address the credit turmoil on Wall Street this weekend, "I would not be surprised to see an emergency bank holiday announced. That hasn't happened since Roosevelt." During the Depression, 75 years ago almost to the day, Franklin Roosevelt declared a four-day bank holiday, which stemmed a frantic run on banks. Mr Whalen added that should banks such as Lehman continue to be unable to sell the billions of dollars of mortgage-backed securities held, they were doomed. He said: "Broker dealers have to be able to get rid of assets. If they are illiquid, they die."

Over the past 10 years, global banks increased their issuance of mortgage-backed securities to feed a growing appetite for what investors believed were high yet stable yields. In 1998, banks issued $16.4 billion of the securities, according to calculations by Thomson Financial. By last year, the issuance figure had ballooned to $366 billion. Issuance so far this year is $4 billion.

The Royal Bank of Scotland was the world's biggest underwriter of mortgage-backed securities last year. An underwriting bank takes responsibility for selling the securities into the market. RBS underwrote $44.7 billion of securities, taking a 12% share of the market. Bear Stearns was the 18th-largest underwriter in 2007, underwriting $6.3 billion of the investments.

Fears of a UK financial casualty were also alive in the Square Mile, with banking stocks among the biggest losers on the stock market yesterday. ... Their shares fell even though British banks have tiny exposures to the American mortgage market in comparison with the big U.S. and European investment banks.

Their direct exposure to the American mortgage market may be "tiny", but their exposure to the equally bubbly British mortgage market is undoubtedly large.

THE FED’S “INFLUENCE” IS “NONEXISTENT”

For those still under the delusion the Fed can prop up the U.S. stock market, here are a few words of discouragement.

Amidst all the happy words and noises that followed yesterday's [March 11] story that "Fed Offers $200 Billion Lifeline for Spurned Debt," most news accounts either failed to include or buried the truly relevant details ...

Looked at closely, the Fed's "Offer" of a "Lifeline" comes attached with the kind of terms you would expect from a benevolent loan shark. Banks can "borrow" Treasury securities from the Fed, but those Treasuries must be "repaid" in 28 days. And, the "borrowing" must be more than fully collateralized -- meaning, the Fed will not even recognize the face value of AAA-rated mortgage backed securities. Banks must put up more than $200 billion in collateral, in case that collateral loses value in the next 28 days.

These terms make the whole thing a bad joke. What is more, the butt of this particular bad joke is anyone who believes the Fed has delivered "a shot in the arm to stressed financial markets."

As columnist Floyd Norris points out, yesterday was the 9th time since August 16 that the Fed has "done something." The S&P 500 is up a net 81 points on those days, but down a net 173 points on the other days (and 6.5% lower overall since August 16).

The story is even worse for the S&P Financials index -- slightly net higher on Fed "announcement" days, far more net lower other days, down 24% overall since August 16.

None of this is a surprise. I would say that the Fed's influence is quantifiable, except that the quantification process itself shows the Fed's influence is nonexistent. The only real surprise is that anyone still imagines it exists at all.

WHY THE DOLLAR IS SO CHEAP

Rise of the Euro and Gold

Peter Morici, business professor and former Chief Economist at the U.S. International Trade Commission, gives a fairly conventional explanation of the whys behind the cheap dollar. Like most conventional anaylyses, he blames things like Chinese mercantilism for the U.S. trade deficit while being seemingly oblivious to the basic accounting identity that unless the U.S. is running deficits in financial flows there cannot be a trade deficit.

The dollar is trading at all time lows against the euro and gold for good reasons. The Bush Administration has flooded the world with greenbacks, and global investors have little confidence in the management of the U.S. economy.

During the Bush years, the U.S. trade deficit has doubled. Thanks to dysfunctional energy policies and tolerance for Chinese mercantilism, the deficit has exceeded $700 billion each of the last three years and is more than 5% of GDP.

The Bush energy policy emphasizes incentives for domestic oil production and letting rising prices instigate conservation but those have failed. Domestic crude oil production is falling, the price of gas has risen from $1.51 to $3.21, automakers have populated U.S. roads with fuel guzzling SUVs, and petroleum now accounts for about $380 billion of the trade deficit.

Cheap imports from China have chased millions of Americans from manufacturing jobs, as the U.S. purchases from the Middle Kingdom exceed sales there by nearly five to one. The trade deficit with China is about $250 billion. China has engineered this competitive triumph by keeping its yuan even cheaper than the dollar, euro and gold. Annually, it sells at deep discount about $460 billion worth yuan for dollars, euros and other currencies in foreign exchange markets. That provides a 33% subsidy on Chinese exports and keeps Chinese goods cheap on the shelves at Wal-Mart. ... The remainder of the trade deficit is largely autos and parts from Japan and Korea, who through various means have kept the yen and won cheap too.

The huge trade deficit must be financed either by attracting foreign investment in new productive assets in the United States or by printing IOUs. Investment has only provided about 10% of necessary cash, so each year the U.S. sells currency, bank deposits, Treasury securities, bonds, and the like to foreigners. Those claims on the U.S. economy now total about $6.5 trillion. That floods world financial markets with U.S. dollars and paper assets that function much like U.S. dollars-what economists call liquidity. And, it evokes an iron law of the universe. If you print too much money, it will not have any value.

Until recently, most of that borrowed purchasing power was put into the hands of U.S. consumers by the large Wall Street banks. Essentially, through mortgage brokers and regional banks, those Wall Street banks loaned Americans money to buy homes and refinance their mortgages. In turn, the banks got the cash needed by bundling mortgages, as well as auto loans and credit card debt, into collateralized-debt-obligations-bonds backed by consumer promises to pay-for sale to fixed income investors, hedge funds and others.

The bankers could get reasonably rich on this scheme but got greedy. Last summer, we learned that the banks were not creating legitimate bonds. Instead they sliced, diced and pureed loans into incomprehensibly arcane securities, and then sold, bought, resold, and insured those contraptions to generated fat fees, big profits and generous bonuses for bank executives.

Now investors ranging from U.S. insurance companies to the Saudi Royals are not much interested in buying bonds created by large U.S. banks, and the banks can no longer make loans to many credit-worthy consumers and businesses. Without credit, the U.S. economy cannot grow and prosper.

The Federal Reserve has direct regulatory responsibility for the large U.S. banks, and it is Ben Bernanke's job to require them to fix their business practices and resurrect the market for bonds backed by bank loans. Yet, Federal Reserve Chairman Bernanke has offered no plan to address these problems, or even acknowledged the urgency of the situation. And, without a well functioning banking system, the U.S. economy heads into recession of uncertain depth and duration.

International investors, recognizing the U.S. economy lacks competent helmsmen at Treasury and the Federal Reserve, are fleeing the dollar for the best available substitute -- the euro and gold. When George Bush was inaugurated, the euro was trading at 94 cents and gold cost $266 an ounce. Now they are trading at $1.52 and $985 an ounce. That is a plain vote of no confidence in the Bush­Bernanke economic model.

So it is mostly Bernanke's fault for failing to make the banks "fix" their business practices and otherwise come up with a good plan to get the U.S. of the mess it finds itself in. This is simplistic, to say the very least. No mention is make of, e.g., the over-indebted situation across multiple major sectors of the U.S. economy and financial players. But at least Morici acknowledges that the falling dollar and rising price of a gold is a symptom of an underlying problem. For a former government inside that is something.

ROBERT MURPHY BATTLES ANTI-MARKET ECONOMICS AND ETHICS

The Politically Incorrect Guide to Capitalism reviewed.

We have found the Politically Incorrect Guide series of books to

Robert Murphy's admirable book is much more than a conventional defense of capitalism. Murphy includes standard material, e.g., why price controls, minimum wage legislation, and rent control do not work. Though it was once controversial to point to the inadequacies of these measures, now even mainstream textbooks hasten to condemn them. Murphy goes far beyond this. He takes on the most difficult and controversial challenges to the free market, and offers convincing responses to them.

Few matters excite critics of the market to rage as the high salaries of corporate CEOs; Paul Krugman, e.g., in his Conscience of a Liberal, makes little effort to conceal his envy at those who dare to earn more than he does. The response by defenders of the market is obvious: If the market pays the CEOs high salaries, this indicates that those who pay the salaries expect the executives to generate sufficient profits to justify their high compensation. Critics are often invited to found their own corporations.

But is not this defense of the high salaries open to objection? The claim is that financial success justifies the high salaries: how, then, can one justify enormous severance packages to CEOs who fail? Surely one cannot here appeal to market efficiency. Murphy accepts the challenge:

Unlike routine managerial work, the task of a CEO often involves bold innovation. If the steps necessary to turn a particular company around and earn millions were "obvious," the company would not be in trouble in the first place. When a new CEO comes in with ambitious plans, he knows that failure is entirely possible. If the shareholders said, "We'll pay you $20 million if you succeed, but nothing if you fail," it would not be a very attractive offer at all. This is because the type of person who gets picked to head a major corporation could easily make hundreds of thousands, if not millions, for certain by consulting or offering other services less glamorous than being CEOs. (p. 21)

We do not find this line of argument entirely convincing. While fully cognizant that the market rewards scarcity rather than virtue, it strikes us that a lot of high priced managers are no more that somewhat above averagely competent. When you hear of CEOs such as Exxon's Rex Tillerson taking home $18+ million in a year, are we supposed to believe the board of directors could not have found someone to do the job for $15 million? No, we smell some kind of "market imperfection", as the economists like to call everyday life, at play here.

In reality, unless you have the capital to make a takeover run at a company, it is about as hard to effect a policy change in a large corporation as it is to in a -- well, large city -- government. A line that made the rounds in the 1980s was that it was easier to change a Soviet Politburo member than a corporation management. Why? Other than shear size when a company gets big enough (what is too big varies with the amount of easy credit floating around), the government set-up and enforced rules of the game weigh in favor of managerial incumbants. What a surprise. The upper echelons of the American (and worldwide) managerial class are a club that is substantially insulated from challenge, thanks in large part to government. Of course, we do not expect Krugman to ever finger that source of the problem.

Murphy continues the same pattern with another issue. The free market cannot be blamed, an often-repeated argument tells us, for racial discrimination. Quite the contrary, those who discriminate pay a penalty. If an employer refuses to hire people of a certain race or religion, he will pay a penalty. ... What if the consumers themselves hold discriminatory views? Will it not be to the interest of businessmen to satisfy them? ... "But in cases like this the free market ... still punishes discrimination -- only this time the customer pays the 'racist fee': the customer pays extra (in the form of inferior service) to be served by a white waitress who is worse at her job than a better-qualified black candidate. (p. 32)" ...

Murphy is at his best in his magnificent defense of free trade against a variety of specious objections. Many who should know better complain that free trade takes away the jobs of American workers. Are not supporters of the free market willing to sacrifice the interests of Americans to their single-minded pursuit of profit? The view here sketched is a common fallacy, many times refuted; but Murphy, displaying a remarkable ability for apt illustration, responds exceptionally well. Tariffs, he notes, may help particular groups of workers, but they hurt the whole population:

To see this, suppose the government fined Americans $10 every time they ate dinner at home. Such a measure would certainly boost sales and wages in the restaurant industry. Yet does anyone think it would be a good idea for America as a whole? Would such a tax on home cooking make us all richer? (p. 148) ...

But what about the trade deficit? Can America continue indefinitely to increase its deficit, already at an unprecedented height? A standard response, which Murphy makes, is to point out that a trade deficit is nothing to be feared: "If foreigners really are stupid enough to send us goodies year after year without buying as many US goods in exchange, why does this constitute a problem for Americans?" (p. 156). But Murphy also has another answer.

What the mercantilists overlook is that the trade balance must always balance. This is not an economic theory but an accounting truism. If Americans buy $1 trillion of merchandise from Japan while Japanese consumers purchase only $850 billion in merchandise from the U.S., what happens to the missing $150 billion? ... Except for foreigners who literally stockpile hoards of U.S. dollar bills, the money flowing out of the country (because of trade deficits) must somehow find its way back in. (p. 157)

One way this can happen is for the foreigners to invest in America. Ironically, often the same people who complain about the deficit also complain about foreign investment: apparently it is bad both when money leaves America and when it comes back.

Which was our point about the Peter Morici article discussed above. This begs the question of what happens when the "missing $150 billion" comes home, or the (in)advisability of policies which create distortions which create such results. Needless to say, the governments' fingerprints are so thick on the window of international trade as to render it opaque. The best we can hope for is a piecemeal debunking of the meddlers' cases as they come up, one at a time. This Murphy does, cuts through many flawed arguments about how the trade deficit can or should be "fixed" -- including those made by well-meaning people such as Paul Craig Roberts.

UPSIDE-DOWN MORTGAGES AND SINKING HOME PRICES

Gary North takes a closer look at the role of Fannie Mae and Freddie Mac in the U.S. mortgage market, and does not like what he sees. Similar in their essentials to many institutions who were intimately involved in the now-unwinding credit bubble, the amount of capital on their balance sheets versus the value of their outstanding mortgage guarantees is miniscule. It is the outcome of yet another instance of writing flood insurance as if it were going out of style based on the assumption that recent drought conditions would continue to prevail indefinitely, even as storm clouds were gathering.

Due to their former status as federally owned entities and their political importance, the two "government-sponsored enterprises" (GSE's) have gotten a free pass for the most part. It is assumed that in the event of real trouble that the feds will -- wink, wink, nudge, nudge -- "stand behind" them. (See entry immediately below.) The GSE's may be to big to fail, but they are too big to bail too. Even the U.S. government cannot credibly engineer a $1 trillion bailout. North explains what happens when the full implications of this fact are taken to their logical conclusion. The title of the article is no small clue.

An upside-down mortgage is a mortgage for which the home owner owes more on the mortgage than the home is worth. According to a report on the CBS TV Early Morning Show on March 10, if house prices fall another 10% nationally, 20 million households will be in an upside-down condition.

As of the year 2000, at the last census, there were 83 million residential properties. Almost 68 million were owner-occupied. Of these 68 million properties, 67% had a first mortgage. So, about 45 million homes had mortgages. If the 20 million figure is correct, then about 43% of all mortgage-owing households would be stuck with underwater mortgages. But this assumes conditions of 2000, before the really maniacal phase of the bubble took place.

The source of this estimate was not identified on the broadcast. It may be wildly pessimistic, but I doubt it. Millions of home owners have borrowed on their home equity since 2000. When people have sold their homes at a profit, they have moved up -- more expensive homes, more debt. ...

There are three other factors to consider. First, the actual sale prices of these homes will be lower than the listed prices -- maybe substantially lower. It already takes almost a year to sell a home nationally. This delay period is going to get longer. Those who need to sell will take lower prices.

Second, the appraisal agencies are in panic mode, fearful of lawsuits for overinflated prices. They are cutting appraised values. This is possible for them because, with liquidity gone, homes are staying on the market far longer. Appraisers are assuming the worst regarding market value. The appraised value is the "sold today" value. That is a discounted value.

Third, it costs $50,000 to foreclose on a house. Incredible, isn't it? The lenders made loans on the assumption that they would not have to foreclose to get the properties back. Now that assumption is seen as naive. Owners can live rent-free simply by paying property taxes.

The recession has only just begun. The number of abandoned homes is rising. The holders of these now-dead mortgages cannot get renters in fast enough. Weather and vandalism and crackheads are now threatening the collateral of the loans even before foreclosure.

Will home prices nationally fall by 10%? There are no signs today that they will not fall this year through 2009 because of ARM mortgage interest rate re-sets. At the margin, home prices will fall, which will force appraisers to lower appraised value, which will lower what lenders are willing to lend. I think 10% is a low-ball estimate.

But is housing really a bubble? Why do I think it is a bubble? Because it has these characteristics:

1. Funded by extensive leverage (debt)
2. Carry-trade: borrowed short and lent long
3. Widespread belief that it is not a bubble
4. A huge percentage of borrowers
5. Faith that the government can protect debtors
6. Economists deny it is a bubble

The Federal government and its licensed agency, the Federal Reserve System, have combined to create the ultimate economic bubble: the residential housing market. Other national governments have done the same thing. The housing bubble is now international, but especially in English-speaking nations.

The U.S. government has created an economic illusion, namely, that the two government-sponsored enterprises (GSE's), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), are agencies of the U.S. government. They are not. One piece of evidence for a bubble that I take seriously is provided in the 2007 annual report of Freddie Mac. The Chairman began his lengthy message with this admission, signed on February 28, 2008:

In 2007, our sector suffered the most severe housing correction since the Great Depression. In my 35 years as an economist, central banker, regulator and businessman, I have never witnessed a situation quite like this one -- in which a housing bubble has played such a central role in bringing the world's largest economy to the brink of recession.

But this is a concealed bubble. This makes it unique. How is it concealed?

1. No market index for housing in general
2. Extensive reservation demand: owners will not sell
3. Illusion that GSE's are legally protected by the Federal government

The Federal government created both organizations, then let them become private, profit-seeking corporations. They both can borrow at below-market rates because of their special relationship with the Federal government. The question is this: To what extent will Congress be pressured by constituents to bail out these forms in a true freeze-up in the mortgage credit markets?

This is a crucial question. These firms together own 40% of all mortgages in the U.S. The total value of these mortgages is equal to the total annual production, including government, of the United States -- over $11 trillion. ... That Congress would add to [the GSEs'] credit line[s] in a national crisis is politically obvious. That Congress could and would pony up an extra trillion dollars is something else again.

What if the GSE's lock up? The GSE's primary role is to provide liquidity in the secondary mortgage markets. Loan originators sell the mortgages to the GSE's. What happens if investors in these agencies decide that these two behemoths are too illiquid to continue to make purchases of mortgages? That will end the mortgage market's liquidity overnight.

In the first week of March, the interest rate spread between agency-backed mortgage bonds and T-bonds reached the highest level in 20 years. Twenty years ago, the U.S. was in the middle of the S&L crisis. Meanwhile, non-GSE lenders have ceased to lend. In 2000, the GSE's accounted for 40% of mortgages. According to the Housing Wire site,

Both Fannie Mae and Freddie Mac accounted for a record 76.1% of new mortgage-backed securities issued in the 4th quarter, a number than industry sources say is likely to reach well above 80% to start 2008. Some have even suggested that the GSEs may end up owning as much as 90% of the lending market before this year is out.

The American housing market is now almost completely dependent on two non-government agencies that are widely regarded as government agencies. These two agencies are facing the most risky market in their history. William Poole, president of the Federal Reserve Bank of St. Louis, offered this assessment on February 29: "I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector."

But can the Federal Reserve not intervene and bail out these agencies? [Poole] does not think so. "As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues."

Solvency issues are at the heart of this recession: the solvency of home borrowers and, by implication, the solvency of Fannie Mae and Freddie Mac. The Fed can always monetize both organizations' inventory of mortgages. This would solve the solvency problem of both organizations, if such insolvency ever threatens their survival. Poole has not yet discussed in public this fall-back position of the Federal Reserve. ...

In his 13-page message to Freddie Mac shareholders, the chairman tried to make the best of a $3 billion loss, compared with $3 billion profit in 2006. He ended with a note of optimism: rising long-term demand for homes. ... There is demand. People want to buy homes. The question is: Who is going to lend money to them at rates that have prevailed under the Greenspan era? Where are the GSE's going to get lenders to forfeit access to their money for 30 years at 6%? ... [W]hen will [a housing recovery] recovery take place? After what percentage of decline in housing prices? Are they headed back to where they were in 1995? If not, why not? He ended with these words:

So thank you for your fortitude and confidence in Freddie Mac. During this difficult time for housing and the economy, rarely have they been as needed or as beneficial for our nation. Yet also, from my perspective, rarely as well justified.

Fortitude and confidence are indeed great things, as General Custer no doubt remarked to his troops. From my perspective, I see a lot of Indians.

We are now facing the previously unthinkable: a real lock-up of the mortgage market, followed by a sharp decline in housing prices. This would produce dramatic capital losses. It would reverse the wealth effect. The wealth effect is the emotional effect of a person's equity any party of his portfolio. He feels richer. He spends more. He saves less. The poverty effect reverses this mentality. He spends less. He saves more.

The transition period is what we call a recession. Capital values in formerly booming markets fall rapidly. There is a rush for liquidity and safety. We are seeing this in T-bill rates, which have been under 1.5% this month. This does not compensate investors for losses to inflation and income taxes. When people move to T-bills below the FedFunds rate, they are scared. This includes bankers who are borrowing from the FED at 3% and lending to the Treasury at 1.5%. They are taking a beating on their profit and loss statements, but not so great a beating as their balance sheets will take if they hang onto the mortgages that they are unloading on the Fed at the TAF (term auction facility) window.

The housing bubble has burst where it was most prominent. There is no sign that housing prices have begun to rise there. When they do, and when this lasts a year, the rest of the country will be able to breathe more easily. That is not now.

A NON-GUARANTEE PUT TO THE TEST

The Ballad of Fannie and Freddie

The folks over at Elliott Wave International share the touching story of how Freddie and Fannie got their start in life, and then what happened when they reached adolescence and things got a little out of control.

Part 1

Once upon a time, the U.S. government created the secondary mortgage market. (During FDR's New Deal, if you are dying to know). With help from the agency known as Fannie Mae, this government creation grew tall and strong. What is more, the government held a virtual monopoly over its creation for several decades -- and after all, the market was its creation.

And this was a prosperous market indeed! Fannie perfected the practice of "securitization," whereby it bundled mortgage loans into tradeable securities. Everybody was happy. The getting was so good that, with a wink and a nod, the government made a partner for Fannie, and called him Freddie Mac -- eventually, the time came when they were even allowed to call themselves Private Corporations! The handsome couple was a model of stability.

Now, going private meant Fan and Fred lost their monopoly over the secondary mortgage market, and securitization was loosed upon the world. Yet the couple was more than clever enough to meet this challenge. Big Brother government's wink and nod meant Fan and Fred could get away with a slightly naughty ploy -- namely, paying just a wee bit less in yields than the competition. This discount was the value that investors placed upon Big Brother's wink and nod.

Alas, a suitably potent mix of time, monetary policy, and mania psychology can turn even the happiest couple ... well, into something it did not used to be. The 1980s arrived and Fan and Fred stopped behaving like "government sponsored entities" and started acting like hedge funds. They created ever-more elaborate ways to transfer large interest rate risks. Derivatives and interest-rate options found their way into the mix. But Fan and Fred's competitors were no less creative. More time passed, and fewer and fewer mortgage lenders held on to the debt. Securitization became the norm.

The secondary mortgage market was a financial party, and Fan and Fred got a little crazy. They held more than a trillion in mortgages, and saw fit to pay millions to dozens of their executives. They got into some trouble with Big Brother in 2003, but their "time out" in the corner did not last long. Interest rates had fallen to 50-year lows, and an even bigger mortgage market party -- the "Subprime Bash" -- was about to begin. They intended to be the stars of the show.

Part 2

Part 1 of this story left off yesterday in the early 2000s, when Fan and Fred were about to attend history's biggest mortgage market party -- "The Subprime Bash." And make no mistake, it truly was history's biggest, one for the ages in every way. In fact, the size of this party was a product of arrangements that had been tried and tested on a smaller scale.

Homeownership rates in the U.S. had been remarkably constant for 40 years, always in a range between 63% and 66% (Census Bureau data). But a change in that data began to unfold in the late 1990s. Homeownership reached 67% for the first time ever in Q3 of 1999, then 68% in 2001, then 69% in 2004. Yes, Fan and Fred took (and received) lots and lots and lots of credit for these record levels of homeownership. After all, can you imagine anyone being against it?

But credit of a veeerrryyy different kind was the real reason for the unprecedented levels of homeownership. This different kind of credit took those levels where they had never been before by making "homeowners" of folks who had never owned homes before. Which is to say, folks who were often unable to qualify for a conventional loan. Fan and Fred was not motivated to bother with those types, given how easy their lives were via the benefit of Brother Government's wink and nod -- you know, the non-guarantee guarantee implicitly behind all "government sponsored entities," even when they act like hedge funds.

So, Fan and Fred's competitors found a competitive edge of their own -- and it was called "Subprime." That is when you make loans without worrying about whether the borrower can pay back the money. You simply sell it on the secondary mortgage market.

And then, when interest rates fell to levels not seen since Eisenhower was president ... the Subprime Bash was on. "Interest-only", "sub-prime", "no-doc", "hybrid", "negative amortization", "balloon", and "exotic" mortgages were all part of the festivities. At this party the mortgage lenders put up a Limbo Pole, and raised it high enough for borrowers as tall as Shaquille O'Neill to walk beneath.

Fan and Fred couldn't resist -- they got in on the Subprime Bash too.

We know how the story -- and the party -- ended. Well, we do not really know the FULL ending to the story, only where it stands today. Fan and Fred recently announced a quarterly loss of $3.6 b-b-billion. Investors who hold Fan and Fred's paper were getting lower yields all along anyway, now the situation speaks for itself. As for investors who hold stock shares, this chart of Freddie also speaks for itself.

Bear Stearns, one of Wall Street's "Big Five" investment banks, announced today that it is out of money. It is not too far fetched to imagine Fannie and Freddie's non-guarantee guarantee being put to the test in the foreseeable future.

The government cannot help you, and, apparently, government sponsored entities ain't doing so hot either. Think for yourself.

BOOMING TRADE ALONG THE NEW SILK ROAD

Greg Mayer explains how the growing trade between Asia and Europe is like 1325 all over again.

Call it globalization, if you want. It is the long and ongoing process whereby the world seems to shrink a bit every day. Its hallmarks are increasing trade between countries and a steady flow of people and ideas across blurred national borders.

This process of integration has been going on, in fits and starts, for centuries. Perhaps the most famous and influential trade routes in history were those of the old Silk Road. Now unfolding before our eyes is a sort of new Silk Road. Trade surges across the lands of Eurasia and the Middle East. This flow of trade creates important new opportunities for investors.

But before I get into how this is happening today and how you can take advantage of it, let us look over our shoulders into the slipstream of markets past. Certainly, it is not usual practice among investors to look to learn something from a man who has been dead for over 600 years. But as Charlie Munger, the witty vice chairman at Berkshire Hathaway, likes to point out, there are billion-dollar answers buried in history books.

In this case, the story of Ibn Battuta is one that informs. He led a truly amazing life. His tale is wonderfully retold in Ross Dunn's book The Adventures of Ibn Battuta: A Muslim Traveler of the 14th Century.

Battuta's story begins in 1325, when at the age of 21, he left his home in Tangier, Morocco. Battuta was off to make the pilgrimage to Mecca. But his journey would prove unlike any other. Battuta did not see Tangier again until he was 45 years old. Until then, he chose to wander the globe. Battuta crossed over 40 modern countries and covered over 70,000 miles. He became one of the greatest travelers the world has ever seen. He left behind a travelogue of his life's journeys filled with details on the places, people and politics of medieval Eurasia and North Africa.

His adventures reveal, as Dunn writes, "the formation of dense networks of communication and exchange." These networks "linked in one way or another nearly everyone in the hemisphere with nearly everyone else. "From Ibn Battuta," Dunn continues, "we discover webs of interconnection that stretched from Spain to China, and from Kazakhstan to Tanzania." Even in the 14th century, an event in one part of Eurasia or Africa might affect places thousands of miles away.

In reading the book, this multinational aspect of Battuta's world really fascinated me. The Mongol states allowed merchants to travel freely in their realms, regardless of religion or origin. This led to the creation of a worldly, prosperous and traveling elite, transmitting ideas as well as goods across countries. For these traders, the focal point was not countries, but cities. They were also, in Dunn's words, "free from the grosser varieties of parochial bigotry." It is one reason why some historians say that during the medieval period, the Islamic cultures came closer than anyone else in creating a common social order.

Needless to say, it was a time of great growth and trade. Households enjoyed porcelain from China, pottery from South Arabia, gold and ivory from Africa, animal skins from India, rice from the Ganges Delta and much more. Ships sailed the Volga, their holds filled with grain from the steppes, timber from the mountains of Crimea and furs from Russia and Siberia, along with salt, wax and honey -- all carried by a hodgepodge of peoples: Egyptian traders, Turkish nomads, Greeks, Circassians, Alans ... even Florentines and Venetians.

China, too, played an important role. The huge Chinese junks, the ocean liners of the day, expanded trade across the Chinese seas to the Bay of Bengal. Populations soared. Cities multiplied, along with a vast network of canals and roads. That, to me, is a beautiful portrait. I think the new Silk Road is a revival of that kind of period. It is a kind of integrated economic bloc that stretches from the Mediterranean to the Sea of Japan.

Just look at the booming trade between China and the Middle East. It was a trickle of only $6 billion in 1995. By 2006, that number swelled to $69 billion. ... [M]y guess is we are approaching $100 billion by now. ...

The possibilities of today's new Silk Road are sometimes mind-boggling. Consider this: There is huge demand for an overland route from Europe to Asia. Imagine it: A steady stream of trucks leaving the river towns of the Yangtze Delta, bound for the trading cities of Eastern Europe. It is not far-fetched. China is constructing 12 highways to link its western Xinjiang province with Central Asia, which could eventually link up with Europe. China plans to nearly double its highway system, from 28,000 miles to 53,000 miles by 2010 -- that is only two years away!

The ports, too, are busy along the new Silk Road. Global Insight says container-shipping volumes between Asia and Europe grew 17% in 2007. Total volume was double the 2003 level. And the ships used today are, on average, two times the size of the largest ship a decade ago. Many ports can barely handle the volume. ...

Shipping companies are actively pursuing new routes. Perhaps through the ice-free Arctic passages ... Right now, Singapore is still king. It is the world's largest container port hub. Singapore, sitting in the Strait of Malacca, is the hinge that links Asia's shipping lanes with Europe. Some of the excess may bleed into airfreight. China alone plans 48 new airports over the next decade, to add to its current total of 130. ...

It is not all peaches and cream, of course. There is all of that pollution and environmental destruction, for one thing. It is a concealed debt, to borrow author James Kynge's expression. The region will have to deal with that eventually. Even in the cleanup, there will be opportunities for investors. Of greater concern are rising social tensions and political minefields. Mankind has often proved adept at getting in its own way.

Still, as an investor, I want to be a part of this new Silk Road. Companies that own the commodities the new Silk Road needs should prosper. It will need lots of copper, iron ore, nickel ... as well as oil, coal, natural gas and much more, including clean water.

CRUNCH MYTHOLOGY

Crisis, what crisis? asks Ken Fisher (and Supertramp).

In so-called credit crunches of times past, credit was not available to anyone, even true AAA-rated credits. Ken Fisher claims that this is not the case now -- that only crummy credits are being denied additional credit. For example, interest rates on "superprime" debt have gone down the past year. Even BBB bond rates are down a little. Concomitantly, takeovers and stock buybacks by firms with investment-grade credit rates continues apace, according to Fisher.

The upshot of all this? Fisher thinks the stocks of big companies will outperform going forward, after a long period of small stock outperformance. Even more bottom line is, says Fisher, to keep your head. The world is not ending.

If you believe the popular economic myths of the day, you think there is a credit squeeze -- less total credit available. This is nonsense. There is indeed less credit available to poor risks, individual and corporate. But that just means there is more for the good borrowers. Blue-chip companies are flush with capital and borrowing power. This is bullish, both for the economy and for stocks, especially stocks of big companies.

Fact: The largest firms have much more credit access in all forms than they did 12 months ago. These are the very firms that can spend it the most and the fastest. Fact: Total corporate borrowing -- that is, total U.S. corporate debt issuance -- was higher in 2007 than in 2006. In January 2008 U.S. corporate borrowing was $101 billion, up slightly from the same month a year ago. The majority of this debt was of investment grade, meaning that it was rated BBB or better; within this segment the borrowings were up 12% from a year ago. Some credit crunch!

If there were a squeeze, interest rates would be shooting up. They are not. Over the past year the yield on investment grade corporate bonds has gone down. At the superprime end, debt rated AAA, the yield is down from 5.18% to 4.63%. Globally, there are only 14 corporate borrowers with that rating (among them ExxonMobil and Novartis). But there are more than 350 A-rated or higher. Recently rates are down, a little, on AA, A and BBB bonds, too.

A parallel myth is that corporations have stopped doing takeovers and stock buybacks. Tell that to Microsoft. It is just that we have changed from a lot of small deals to fewer bigger ones. By the fourth quarter "credit crunch" headlines were ubiquitous, yet fourth-quarter 2007 announced takeovers were $478 billion, the fourth-largest quarter ever. The volume was a $116 billion gain from the third quarter. Share repurchase announcements in January totaled $59 billion, up 16% from a year ago. That is a $700 billion annual rate. The prior four months were also up -- collectively, by 63.5%, to $276 billion ($828 billion annualized). Where do we get all these myths about crises and collapses? From pontificators. The sort of folks who frequent Davos.

Yahoo will cost Microsoft $40 billion or more if it goes through -- essentially half cash. It will issue long-term debt for the first time in its existence. Surprise, it will be AAA-rated. In one bite, IBM announces a $15 billion stock buyback. Some credit crunch. Think big.

As I detailed last month, the market has shifted, as it did in the mid-1990s, into a period where the biggest stocks do best. We are in the first full correction of the new leg of the bull market. The Asian debt contagion then is the American debt contagion today. This debt crisis is, like the last one, a false alarm. By midyear we will awaken to an ever shrinking supply of equity and a growing economy. The market will be led by big companies.

If you think we are moving toward recession, you might expect steel prices to weaken. So many expect this to happen that recession is already built into the prices of steel shares. Since I see no recession, I expect steel to do well. Hence I like Arcelor Mittal (MT), domiciled in Luxembourg but spread across the globe. It operates in 60 nations. Its 115 million tons of annual capacity give it 15% of the world total and three times as much as its largest competitor. Arcelor mines coal and iron, makes coke, has both integrated mills and minimills and has top-notch distribution. In an industry selling at two times annual revenue Arcelor is at just one times. It goes for ten times likely 2008 earnings and two times book value. A little price increase from here could go a long way for this $115 billion market-cap producer.

Still worried about a recession? Then buy Wal-Mart (WMT), which retails affordable consumer staples in good times and bad. The world's dominant retailer at a market multiple of earnings is not a bad way to go when the biggest stocks are doing best. Market capitalization, $204 billion.

It is going to take years for the financial sector to recover from its excesses, just as it took years for energy to recover from the 1980 collapse and for technology to recover from 2000. Still, I like Citigroup (C). The stock costs less than half of what it did last year. The market value of $129 billion looks high against earnings of $3 billion. But those earnings reflect the subprime writeoffs. These writeoffs have simply nothing to do with the underlying business. Take them out of the equation and you find Citi going for four times operating earnings. I think this is a $40 stock by mid-2009.

A courageous man indeed. Wading into the financial sector waters using Citigroup as a preferred vehicle now is equivalent to going back into a burning building to save the wedding china, or something like that. If his prediction that the market will be in recovery mode by midyear is correct, it will undoubtedly work out fine. In his favor is that whenever "the world is ending" predictions have started to proliferate in the last 70-80 years, it has been a good buying opportunity.

THE PREFERRED WAY

Forbes financial columnist and fixed-income money manager Marilyn Cohen thinks that preferred stocks being issued willy-nilly by staggered financial firms are sporting attractive risk-adjusted yields. Maybe so. We do not pretend to have the level of expertise to evaluate these recommendations. On the other hand, the lyrics of Irving Berlin's song "Doin' What Comes Natur'lly", from Annie Get Your Gun, come to mind:

"You don't have to go a private school
Not to pick up a penny near a stubborn mule,
You don't have to have a professor's dome
Not to go for the honey when the bee's not home.
That comes naturally ..."

Let us leave it that Ms. Cohen's suggestions strike us as speculations rather than investments. Whether the speculation should be granted the adjective "intelligent" is another matter.

When the market hands you lemons, make lemon chiffon. That is what I am doing for my clients. In my last column I cautioned investors to wait until later in the first quarter to buy either preferred shares or exchange-traded funds that track preferreds. I predicted that by then financial firms would come clean regarding their losses. Sure enough, this winter's red ink and writedowns proved to be momentous. Tin cups in hand, several of their chief executives had to beg for alms from the Asian and Mideastern sovereign wealth funds to shore up eroding capital.

Foreign bailouts have not been enough, though, and these financial giants have also had to issue bonds and preferreds. The equation is simple: More writedowns equal additional capital needed. For you individual investors, let their pain be your gain. It seems every week another needy bank or broker floats new preferreds, which are easier to trade and more transparent than bonds. The issuers are household names: Citigroup, Bank of America, Lehman Brothers, Deutsche Bank and Wachovia.

Fortunately for the needy firms, a huge appetite exists for the new preferreds. Citi may have its troubles, yet no one believes it will default on payouts. Do not bother buying regional banks or brokers. Go for big, liquid issues. Many of the latest preferreds are listed on the New York Stock Exchange.

The bad news is that the securities offerings have attracted crowds of institutional investors, leaving just small portions for individual buyers. To give yourself a fighting chance, make sure your broker has you on a priority list for all the newly issued preferreds, which automatically puts you in the bidding. All you have to do is ask; anyone with an account is eligible. Then you can bid a specific yield. Another way to lay your hands on the shares is to place a "when-issued order," the equivalent of a market order for common. This means you bid within a range of yields -- say from 8% to 8.25% -- and accept what the market gives you. This boosts your chances of getting an order filled.

Even if your order is unfilled, you will at least see the market yields of the winning bids. That will help if you try to find the shares in the secondary market. Thus far many of these new preferreds' dividends qualify for the 15% maximum tax rate. (The favorable rate disappears in 2010.) Bond interest is taxable at regular rates up to 35%.

The financial firms' preferred yields nowadays are superior to those of their bonds, which are higher in the credit pecking order and hence less risky. Example: In January Citigroup issued 148.6 million preferred shares at $25 to raise a quick $3.7 billion. The Citigroup (c 8.125% Series AA Pfd) shares now trade on the NYSE at a slight premium ($25.40) and still offer a decent yield, 7.99%. They are callable Feb. 15, 2018 at $25 for a 7.95% yield to call. Compare the Citigroup preferred with its closest bond equivalent: the 10-year $1 billion Citigroup bond issue, 6.95% due Nov. 1, 2018. The bond yields 6% to maturity.

Even the firms that have not been slammed in the credit crunch are joining the preferred party. Perhaps they are figuring that today's yields, while generous, are still lower than they will be amid the likely higher rates of an economic recovery. Lehman Brothers and Deutsche Bank had less exposure to the subprime-fueled deals of now suffering rivals. They have recently issued preferreds that are worth looking at.

Their yields are slightly lower than the likes of Citi, because these firms are not as desperate to raise extra capital. Yet the payouts are still pretty decent. ... My suggestion is to buy a variety of preferreds with different dividend payment dates and varying call features. ...

Please do not think you have missed out on these preferred opportunities. Writedowns and losses in the financial realm, already around $150 billion, are far from over. Some analysts calculate that additional writedowns may total another $200 billion amid subprime and collateralized debt obligation carnage. UBS just reported an $11 billion 4th-quarter loss and warned of more to come. Watch it for a preferred issue.

ROBERT FROST INVESTING (TAKING “THE ROAD LESS TRAVELED”)

Jim Lowell, editor of Forbes ETF Advisor, has some ways to invest -- via ETFs, naturally -- in the energy, agricultural, and transportation sectors. "Less traveled" than the most popular thoroughfares of the day they may be, but we are not talking bushwhacking through jungles here. Nevertheless, his suggestions seem sensible enough. And the basic idea of looking where others are not is more sensible still.

Investors should take inspiration from the poet Robert Frost that taking the road less traveled is often the better choice. To be sure, popular stocks that are riding a seeming long-term trend likely will continue to perform well for some time. But what if you could capitalize on the big economic trends without paying too much for trendy stocks? This seems to be a better choice.

For example, I remain bullish on the global economy, and hence on energy. Lately energy issues have done very well -- witness the 25% run-up in the past year of the U.S. Oil Fund, an exchange-traded fund that invests in oil futures contracts (it is up 8.3% since my December 2007 recommendation).

With China still hell-bent on growth, oil is not likely to go back to $40 or $50 a barrel. But a recession would probably freeze its upward march. So maybe this ETF has enjoyed its best days for a while. You should move on to oilfield service companies, which will probably be kept quite busy even if oil prices plateau.

Oil prices fluctuate with the vagaries of hedge fund monkeyshines, economic reports, political tensions and oil refinery explosions. But drilling continues at a brisk pace and will continue to do so as long as oil is comfortably above $30. The SPDR Oil & Gas Equipment and Services ETF (XES) sells drillers the tools of their trade, whether they strike black gold or not. The fund's two largest holdings are Patterson-UTI Energy, trading at 9 times trailing earnings, and Helmerich & Payne (HP), trading at 12 times.

Another off-the-beaten-trail strategy is to invest in an uncelebrated energy source, coal. Headlines are always proclaiming the most recent zig or zag of oil prices, while those of coal are largely ignored. Over the past five years coal's price is up 675% versus 233% for oil. China consumes nearly three times as much coal as oil and uses more coal than the E.U., Japan and the U.S. do together. In China a new coal-fired power plant is brought on line every 10 days. Energy-hungry India, whose population is projected to overtake China's by 2030, is also busy building coal plants.

Enter the two-month-old Van Eck Market Vectors Coal ETF (KOL), which tracks the price and yield performance of the Stowe Coal Index. This index is made up of 60 coal-oriented companies from 12 different countries, everything from coal miners to coal shippers.

At the same time, we have to worry about that possible recession in the U.S. and Europe. Consumer staples are the classic refuge in tough times, when people will give up on everything except food, drugs and beverages. The obvious choice here is the iShares S&P Global Consumer Staples Index ETF (KXI), whose biggest holdings are household names: Procter & Gamble, Nestle, Coca-Cola, Diageo and Kraft Foods.

A still smarter way to play the trend is to own the necessary ingredients for the goods found in that iShare's basket. Agricultural commodities are seeing big price gains, what with appetites for grain-fed beef in emerging nations and the corn-supplied ethanol boondoggle. That situation means there's plenty of momentum behind these commodities. You can participate by buying the PowerShares DB Agriculture ETF (DBA). This fund is the sole soft commodity play in the ETF field. Its benchmark is the Deutsche Bank Liquid Commodity Index, made up of the most liquid and widely traded agriculture products: corn, wheat, soybeans and sugar.

Finally, I would look to a sector that is a longtime proxy for the U.S. economy: transportation. Amid dire prognostications for the domestic economy, the iShares Dow Jones Transportation (IYT) is slightly down from its year-ago price ($90). Nonetheless, many in this ETF's collection of companies are expanding considerably in emerging countries. Railroads like Burlington Northern Santa Fe, Union Pacific and Norfolk Southern are not expanding abroad, of course, but ups, FedEx and Overseas Shipholding Group (oil tankers) are. Should that much-anticipated recession arrive, this ETF will suffer to some degree. Yet the fund will also be up and running ahead of most other sectors' when recovery inevitably steams over the horizon.

To quote Frost: "And that has made all the difference."

MR. COOL SURFS THE WEB

Ryan Jacob, the champ Internet stock picker, has seen boom and bust. With Net stocks back in the drink, he shows where to find tomorrow's winners.

For those with fond memories of the late 1990s dot-com bubble, now eight short years in the rearview mirror, and anxious to catch a ride on any revivals of the sector, Ryan Jacob's Internet fund may be as good a slot machine handle as there is out there. Forbes notes that you can be fairly sure Jacob will outperform up markets in internet stocks, but it sure would be nice to know just when these up markets are going to show up. Just so.

Ryan Jacob is a study in cool. He has unflappably dared much for Web investing and has borne up when it has disappointed. ... Jacob gets excited by gadgets and world-changing technologies. He is an iPhone addict but only recently an Apple shareholder. ...

In the late 1990s the mutual fund he ran, Kinetics Internet, posted triple-digit returns. "The world doesn't operate by the old rules anymore," he grandly pronounced back then. In December 1999 he opened his Jacob Internet fund, only to watch it tumble. In 2003 came a euphoric recovery of Web stocks, just in time to save both these funds. Jacob Internet is having a rough go so far this year, with a loss of 11.8%. Bear with me, he says: The Web this time is not, as it was in 2000-02, the cause of the market malaise.

With a gambler like this, you can be fairly confident of outperforming in an up market. If only you knew just when that would be.

Of the 11 Web funds that Lipper researchers list, the $55 million Jacob Internet has the best 5-year record, clocking a 22.8% total return (appreciation plus dividends), versus a sector average of 14.8%. But it ranked near the bottom as of the end of February. Jacob Internet charges a punishingly high 2.26% in annual expenses and runs up a 91% annual turnover, which can add a tax burden, though Jacob's investors are shielded for now by the fund's past losses. But you do not have to think about that if you buy only some of his picks.

Jacob has a long-standing preference for Internet portals and for years has valiantly owned Yahoo, which he considered a kind of value version of the larger and faster-growing Google. After weathering some bad days with Yahoo, Jacob has seen his patience pay off with Microsoft's buyout offer of $31 per share. Although Yahoo is resisting, Jacob believes the deal will eventually go through in the mid-30s.

Jacob expects more Web stock declines in the next six to nine months. Still, he is beginning to see a lot of value and is buying battered shares. The tactic is not easy because some Web issues could be irreparably hammered this time, almost the way they were in 2000-02. Even the venerated Google is off 35% from its high.

Jacob says that small Web companies will suffer the worst in an economic downturn, as small companies tend to do. An example: Newly public NetSuite ($281 million market value), which provides Web-based business software, could suffer if the economy forces its larger customers to pull back. Smaller companies drove performance for a while, especially in 2003, when Jacob had a 101% return. No more.

The second thing Jacob is sure about is that larger Web firms with a strong consumer focus will ride out the economy's problems and emerge better than ever. In other words, they are catching a wave: Internet service providers, Chinese portals, photo-sharing sites and Google (see table).

The six stocks listed here are still trading at pretty high price/earnings multiples (except for EarthLink, which does not have a P/E since it is in the red). Yet look at them through the lens of growth prospects and they become much more affordable. Their PEG ratios -- that is, price/earnings multiples divided by the percentage points in growth projections over the next three years -- are almost all under 1.0. By contrast, the S&P 500 index is trading at 18 times 2007 estimated earnings but enjoys expected growth of 15%, for a PEG of 1.2.

Among Jacob's largest holdings is Sohu.com (SOHU), the Chinese portal. Because Sohu has the exclusive Web rights to the Beijing Olympics, Jacob thinks it is still worth buying at $44 and 50 times trailing earnings. Olympic sponsors wanting to reach Chinese consumers on the Web will have to advertise with Sohu, which in 2005 won a fierce bidding war for the honors. The risk here is that the Chinese government is unpredictable about what it will and will not allow its citizens to see on the Web.

Google was recently his second-biggest stock, but he has pulled back as the company suffered from revelations that ad clicks were flat in January. Of course, that may be a function of the company's push to reduce "poor quality" clicks by ending contracts with ad-only sites. Thus, the thinking goes, Google would be able to charge advertisers more.

Jacob was too skittish to buy Google during its 2004 IPO at $85. He bought the stock two years later, at $460, and added more during price dips afterward. While he is concerned by the growth slowdown, he remains impressed by Google's protean innovative spirit. Initiatives like Gmail and Google Docs, an online competitor of Microsoft Office, might even make a profit someday.

While Jacob is mainly into pure Web plays, he does dabble in some backbone companies -- especially those that design gear for cable and phone companies rushing into broadband. Broadcom (BRCM), for example, makes chips that deliver triple-play Internet, cable and phone service. Sigma Designs (SIGM) develops chips for Blu-ray DVD players, the winner in the high-definition format sweepstakes. "Sigma will have a hammerlock," Jacob says.

With Shutterfly (nasdaq: SFLY), an online photo service, you go on vacation with a digital camera and upload your photos to the site, which stores and organizes them for free. Then the company sells you prints and overpriced mousepads. There is a tie-down effect that keeps Shutterfly from having to lower prices when competitors do. Once people send over all their pictures, they are unlikely to go through the hassle of switching to a competitor.

Jacob occasionally takes a flier on a company in need of restructuring. Such a one is EarthLink, the Net service provider whose forays into other areas proved disastrous. The firm has booked six consecutive quarterly losses. Under a new chief executive since last year, it is retreating from an ambitious plan to roll out free or low-cost Wi-Fi networks, which were to give wireless citywide Web access to anyone in places ranging from Philadelphia to Anaheim. The Web wants to be free, but it does have limits.

GETTING SOUTH AFRICAN ASSETS VIRTUALLY FREE

An alternative to holding gold in direct form is to invest in gold shares. This is a riskier alternative for a variety of reasons, but can also provide greater rewards. Precious metals trader Ed Bugos describes these risks and rewards, and points out that South African-based gold mining stocks have actually underperformed the metal itself -- giving share holders no reward for the risk incurred. He believes the market may be overdoing things here, particularly vis a vis Gold Fields (NYSE: GFI).

The South African gold and platinum deposits are among the vastest and richest in the world. Even after a persistent drop in annual production since the 1970s that has driven output down to an 85-year low, the country is still the 2nd-largest gold producer in the world. With gold and platinum prices breaching record levels every other day now, especially in terms of the struggling South African currency, you would think that investing in South African miners would prove to be a winning formula.

Yet many of the South African gold shares have all but sat out the bull market in gold so far. Smaller producers are trading near their worst levels since 2000. Harmony is up only 100% since 2001. Same with Anglogold, which has been diluting their South African investments by investing overseas. Gold Fields is up a little better (200%t) since 2001.

Still, these gains pale in comparison to the HUI (AMEX Gold Bugs Index), which is up some 600%, let alone some of the leaders of that group, such as Goldcorp or Agnico Eagle, which are up 800 and 1,300% respectively, since 2001. Or even compared to the gold price, which has more than tripled, and hence outperformed all of the South African producers.

South Africa started experiencing "rolling blackouts" in late 2007 -- due to an overloaded grid. The power shortage prompted the South African government utility, Eskom, which provides 95% of South Africa's electricity supply, to halt all exports on January 20. It did not help. ... The problem of course is underinvestment, thanks to government planning. ... The move to rectify the situation has only begun, and 2012 is when additional power is expected to come on stream. In the meantime, businesses have begun to factor this into their long-term plans.

On February 25, after prepping the market for months, Gold Fields (GFI) announced the impact of this crisis on its South African operations, which make up 2/3 of its group production profile. It expects production declines of as much as 25% this quarter, then 10-15% on a "steady state" basis thereafter. After considering its international operations, this translates into a 15% production shortfall this quarter, and afterwards management expects growth in its international assets to offset the decline and fill the void altogether. The company expects operating costs to increase by up to 25% this fiscal year, but gold prices are already up 50% on GFI averaged realized FY2007 prices.

Gold Fields is mothballing some capital expenditures, and shutting down six of 21 shafts at three of four mines in South Africa -- and plans on shedding 6,900 jobs (10-15% of their work force). In a teleconference, management said power has been tight for three years already, but Eskom's latest announcements have acted like a catalyst, forcing the company to deal with their problems more or less immediately. However, this news is not likely to have a significantly bearish impact on share values from current levels. In fact these expectations have already been baked into the share price -- and from here early investors could stand to see a 200% gain in the next two to five years. This is just the latest in a series of short straws that the South African miners have drawn, and that have worked to depress valuations in the segment. ...

Technically, the climax in bearish sentiment occurred in 2005. The current crisis is anticlimactic. Some pure South African players climbed right through the news. That is where I see a potential buying opportunity in Gold Fields ... The market is paying $110 dollars for each proven and probable ounce of gold in the ground owned by Gold Fields (GFI). That is less than half of what the market is paying for Newmont's reserves -- which boast lower grades and less potential to convert resources into reserves.

In terms of its overall "measured and indicated resource," Gold Fields is trading at 1/5 of Newmont's value. At a $10 billion market capitalization the market values Gold Fields roughly equal to the intermediate producer Agnico Eagle, a Canadian company with about 1/5 of the reserves, 1/10 of the resource, and which will be producing at 1/4 of the annual output that Gold Fields is producing, even after Agnico's expansion program. In fact, Agnico Eagle is roughly the size of Gold Fields' international assets. At these prices, that is like getting Gold Field's South African operations free!

On the one hand, this situation demonstrates the difference between investing in gold and investing in gold shares. Buying gold possesses no risk other than the possibility that the government might take it away from you, or that the central banks might abandon their inflation policies. It is the ultimate risk-free investment, particularly in today's ideological climate -- with respect to monetary/banking policy.

Investors in gold shares are investing in a business, not a commodity. There are added risks. So, if your gold shares are not outperforming gold, you are taking too much unnecessary risk. On the other hand, this situation may well represent a small window of opportunity to buy some of the best quality mining assets in the world on the cheap.

Now, here is a secret. The gold shares that have outperformed gold to date are unlikely to outperform it from here on. You can mark my words. The operating environment in South Africa may not be conducive to growth until 2012, when the new power generation plants are expected to be up and running. But given how tight supplies are already, it is likely that the price of gold will rise fast enough to make up for the lower level of output.

Moreover, the circumstances may finally provoke Gold Fields into an acquisition spree, as it has abandoned its focus and capital expenditure plans on some of its mines in South Africa. I could think of two companies instantly that would make a good fit for their international portfolio. Then again, its shares are so cheap it may represent a takeover target itself ...

STOCKS: RUNNING SCARED, BUT OPPORTUNITIES STILL PRESENT

Does your contrarian streak tell you that now is the time to step up and buy something. Well if you do, try to be a little smart. The Elliott Wave International folks drop a few helpful hints in one of their freebie sample articles.

Most people talk about the economy like it is something that exists separately from them. Like it is a hot-air balloon floating up in the sky. That is us, here on earth, feet on the ground, and there is the economy -- up there, see it?

Economy expands, economy contracts; economy enjoys cheap labor and dislikes high interest rates. And lately, "Economy is not responding to the Fed’s economic stimulus." But just what IS economy?

Economy is people. Us -- you, me and that guy over there. "Economy" is all of us getting up in the morning and going to work. Without us, there is no economy. If we feel like working, and earning, and borrowing, and spending, the economy hums along and maybe even grows a little. If we do not feel like doing any of those things, the economy stalls.

Same goes for "the markets:" They are also made of people -- traders and investors. That is what came to mind this morning as I was sipping my coffee and watching CNBC. Right now, the people sitting around the table were saying, "markets" are not feeling like taking on any more risk.

Translation: Traders and investors are feeling scared. Have you noticed that market sell-offs are usually faster and stronger than rallies? That is because fear is stronger than greed, markets' other engine. And they are wondering why the Fed's interventions are not working?

Just what, exactly, "markets" are so scared of is another subject. Fear aside, for stocks traders the question always is -- are there any potential trades right now?

Of course. There are always opportunities -- as long as you feel like putting money on the line. Understandably, most of those have been on the short side lately. Just today (March 13), for example, Elliott Wave International's Prime Stocks Flash service issued an update for GDX, Market Vectors Gold Miners ETF, and supplemented it with this chart (some labels have been erased for this publication).

Right now, says Prime Stocks Flash, the top Elliott wave count for GDX strongly hints that the recent price action "can be an ending diagonal." If you are familiar with Elliott, you understand exactly what this implies for the trend.

Far be it for us to make any claims to being a chartist, technical analyst, or other such ne'er-do-well, but the chart looks like one of those compressing triangles that either blows out to the upside ... or it doesn't.

STOCKS, REAL ESTATE, FORECASTS: THE LONG AND SHORT

More wisdom from Elliott Wave International:

Several times on this page recently I have talked about housing and stock market forecasts that Bob Prechter (and other Elliott Wave International analysts) made several years ago. We have heard from a great many subscribers who were helped by these forecasts.

Yet I have also heard from folks who correctly point out that, from the 2002 to the 2007 high, the Dow Jones Industrials virtually doubled. Their basic question is, didn't we miss a big opportunity to be "long" or make the even bigger mistake of being "short"?

Fair question, I offer two points of reply. First, the Dow Jones Industrials (or any stock index) do not reflect in any way the actual gains of equity investors themselves. ... The well-known Dalbar Study looked at investors' returns for the 20 years 1986-2005, and found that while the S&P 500 earned 11.9% annually, the average equity investor earned a 3.9% annual return. The annual inflation rate for period was 3.14%.

What is more, Vanguard Group founder John Bogle, published research in The New York Times (October 15, 2006) which analyzed the 200 equity mutual funds with the largest money flows from 1996 through 2005. Bogle found that those funds had average annual returns of 8.9%, while the average investor in those funds earned 2.4%.

Second, please consider a couple of charts. [This chart] goes a long way to explain the facts above -- in truth people do not buy and hold, they chase performance.

This table gives another perspective even on buying and holding a stock index fund. It speaks for itself. As for being "long" or "short", individuals who fit the "buy and hold" profile typically have a low tolerance for risk, which means they prefer "safe" instead of "aggressive".

I will quote Bob Prechter's words from Conquer the Crash to folks who fit that profile: "If you do not know by experience what the terms 'short selling' and 'leaps' mean, I recommend that you avoid engaging in these activities."

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