W.I.L. Finance Digest for Week of June 9, 2008

WHAT MR. CRUDE OIL SEES AHEAD

Gas may have to hit $5.75 a gallon before consumption cools enough to take the heat off fuel prices.

Goldman Sachs energy analyst Arjun Murti made a gutsy call four years ago that "a potentially large upward spike" in energy prices was in the offing "at some point this decade." Needless to say, events bore him out. Barron's finagled an interview with the publicity-shy Mr. Murti, and quizzed him on what he sees ahead now. In short:

• The current oil price runup is not just due to hedge funds and other speculators. There is insufficient supply to meet current demand, however unsustainable that demand level is in the longer run.

• The oil price per barrel could spike as high as $200, but it will not stay there because demand will eventually fall off, as in the 1970s.

• Integrated oil companies and exploration/production companies are attractively priced, because the market is too pessimistic about the sustainable level of energy prices. Pipelines are also attractive, but refiners face tougher times ahead.

• The biggest risk facing energy stocks is that emerging-market growth abruptly slows down.

"We don't think the world has run out of oil. We do think [many producers] aren't on track to grow their supply aggressively." ~~ Arjun Murti

In 2004, Arjun N. Murti, a top energy analyst at Goldman Sachs, published a report predicting "a potentially large upward spike in crude oil, natural gas and refining margins at some point this decade." It was a controversial call, with crude around $40 a barrel at the time. But it was right on the money. Four years later, crude is trading around $139.

Murti sees energy in the later stages of a "super spike," in which prices rise to a point where demand drops off. In a note last month, he wrote that "the possibility of $150-to-$200-per-barrel oil seems increasingly likely over the next six to 24 months."

With supply growth constrained and global demand staying strong, prices must rise further, in Murti's view. Barron's caught up with him last week in his New York office. The 39-year-old analyst does not give many interviews and keeps a low profile, preferring not to be photographed. But his strong views on energy have resonated across the financial markets.

Barron's: What do you make of Friday's big surge in oil prices?

Murti: There have been a number of bullish fundamental data points recently that contributed to the rally. These include further declines in U.S oil inventories announced June 4, the announcement of a decline in Russian oil production in May, and recent comments that Mexico expects further meaningful declines in oil production over the rest of this year.

Longer-term, what is driving crude to such high levels?

Spare capacity throughout the energy complex seems very limited, whether for OPEC crude oil, natural gas or refining. In all of those areas, capacity is limited. And it is getting very difficult for companies and countries to boost supply -- something that became increasingly apparent to us over the first half of this decade.

Our view started shifting, from one of "It is easy to grow supply," which was the perceived view of the 1990s, to "It is going to be more difficult to grow supply." That is partly because some oil-producing regions, like Mexico and the North Sea, are declining. The Lower 48 states in the U.S. are very mature.

There are growth areas, such as Brazil and Angola. But when we add up all those pluses and minuses, non-OPEC supply looks like it is not going to grow very much.

So, essentially, there is constrained supply, along with increasing demand?

Demand has been consistently growing. On the supply side, we do not subscribe to the peak-oil view. We do not think the world has run out of oil.

We do think that the places that have large quantities of recoverable oil, notably Saudi Arabia, Iraq, Iran, Venezuela and Russia, are not on track to grow their supply aggressively. It is growing at a very moderate rate, and so the remaining oil resources are concentrated. And, to some degree, high prices are disincentivizing some of these countries to either open up their industry or spend the money themselves.

What actually is keeping them from producing more?

These countries do not need the incremental revenue. They are getting the revenue through price; they do not need it through volume. It means they have sufficient capital to try and develop their oil industry on their own. With high prices, they do not need Western capital. Venezuela, where Western companies' assets have been expropriated, is a good example.

You have made the distinction in your research that while the world's oil supply is barely growing, if at all, there is a lot of oil that is not being taken out of the ground. Take Russia, for example. Why are not they producing more oil?

In a lot of the key oil-exporting countries, the government is the key driver of whether their oil fields get developed. Relative to 10 years ago, Russia is in a very healthy position.

So, logically, there is less incentive for Russia to massively grow their supply and bring down oil prices. Frankly, that is true for a lot of these countries.

In terms of your super-spike scenario, what phase are we in?

We are getting closer to the end game here, where despite eight years of rising energy prices, supply looks like it is going to barely grow this year. We have been bullish, but we did not expect such a slow growth rate of supply. And demand outside the U.S., Europe and Japan has been more resilient than we expected.

What markets are you referring to?

That would include China. The Middle East is a big demand driver, though it is often underappreciated. In aggregate, Middle East demand is about the same size as China's and it is growing at about the same rate. Demand from Latin America is also increasing.

Let us talk about the possibility of crude hitting $200 a barrel. If we get there, how does it play out?

Our view has been that the price will keep going up to the level where it meaningfully reduces demand. This is Economics 101. We need more supply or less demand. And because there are various political and geologic constraints on growing supply, we are left with looking for the price at which demand is reduced. We have never thought we knew what that exact number is. But we have tried to look at the 1970s, notably the economic impact of gasoline prices that ultimately led to a reduction in demand.

How does the current situation compare with the 1970s?

In the 1970s, you had a traditional supply shock. You took a bunch of oil off the market, and the price rose very quickly in a short period of time. That led to lower demand that proved sustainable, because the market worried that the supply would not come back. It has been, up until the last three or four months, a much more gradual increase -- and therefore, people have generally been able to get used to the price. And it has allowed demand to be more resilient than even we thought it would be.

But if crude does hit $200 a barrel, what kind of prices will we see at the pump?

Oil at $150 to $200 a barrel would imply between $4 and $5.75 a gallon.

At which point you probably see a falloff in demand, right?

We are already starting to see a drop in demand in the U.S., but they are still having demand growth in the non-OECD countries, including China, the Middle East and Asia. The OECD countries are mainly the U.S., Europe and Japan. The real question: At what point do the non-OECD economies slow down? The other thing about U.S. demand is, at what point do you have sustainable change in consumer behavior? So if the price temporarily goes to $4 [a gallon], but immediately falls back to $3, it is likely that people will keep driving cars with poor gasoline mileage. But if people believe the increase in oil prices is more sustainable, they might shift to taking mass transportation, if available, driving hybrids or taking the other kind of actions that are necessary to reduce demand on a sustained basis.

Do you see a sustained drop in demand at $200 a barrel?

That is the big question. We have always assumed that, at some point, you get a sustained drop in demand. Our long-term oil forecast looking out 20 years is [for crude] to fall back to $75 a barrel, or some lower number. The questions are: How long do prices stay high? How sharply do they rise? And do people truly change their behavior or are they just temporarily driving less? It is an unknown at this point.

There has been a lot of discussion about speculators driving up commodity prices.

Oil markets are driven by fundamentals. Our response to the notion that it is merely a bubble is that you are still seeing no supply growth. If the price is not real, where is the supply?

Where are natural-gas prices going?

Our thesis has been that LNG [liquefied natural gas] would not arrive in the U.S. in anywhere near the quantities people expected, because LNG prices are so much higher in the rest of the world. In a country like Japan or Korea, they are now paying $18 to $20 per million BTUs [British thermal units]. Our natural-gas prices have risen to around to $12 million per BTU. Europe is $13 to $14 [million], so we have amongst the lowest natural-gas prices in the world. Therefore, it makes less sense for companies to ship liquefied natural gas to the U.S. For LNG to come into the U.S., we would have to have much higher natural-gas prices than the rest of the world. So either prices would have to fall in the rest of the world or they would have to rise here. Also, natural-gas inventories in the U.S. are tightening, putting upward pressure on prices.

You are pretty bullish on energy. But you are Neutral on the refiners.

The challenge for the refiners right now is that we are starting to see the U.S. experience negative gasoline-demand growth and the U.S. refiners are very tied to gasoline margins, which are likely to be lackluster if gasoline demand growth is negative. There is also higher ethanol production. The bottom line is that U.S. refiners get squeezed.

One group you and your colleagues do like is the integrated oil companies. Why?

Right now, the market seems to be very pessimistic on the integrated oils. I think the market is worried that there may be windfall-profit taxes.

The market has also taken the view that if you are bullish on oil, you are better off owning E&P [exploration and production] companies or oil-services companies. And, again, the market has generally factored in lower oil prices than we think are likely. All this makes the major oils look very inexpensive.

As of last week, the major oils, including ExxonMobil [XOM], ConocoPhillips [COP] and Chevron [CVX] were trading at about eight times earnings, based on oil prices of $110 a barrel. They were trading at four times enterprise value [stock-market value plus net debt] to EBITDA [earnings before interest, taxes, depreciation and amortization]. That is fairly inexpensive by historical measures. [See table of Murti's recommendations.]

Do any of these companies stand out?

ConocoPhillips is our overall top pick among the major oils, partly because they have more oil in OECD countries. The tax rates tend to be a little bit lower in those countries than they are in some of the non-OECD countries. They have also got a large natural-gas position, which they got when they acquired Burlington Resources several years ago. In the two years after they bought it, natural-gas prices fell. So the market has taken a pessimistic view of the Burlington Resources acquisition. But now, with natural-gas prices rebounding to around $12 per million BTUs, those assets should be performing a lot better.

Another sector you favor is exploration and production.

The E&P companies tend to be more leveraged to natural gas, where we also have a fairly bullish outlook. Gas prices have been very inexpensive over the past couple of years, and they are just starting to recover in the U.S. So some of these natural-gas E&P companies are big beneficiaries of that. Also, many of these E&Ps are now in some of the newer natural-gas shale plays, like the Barnett Shale in Texas, the Fayetteville Shale in Arkansas and the Horn River Basin in British Columbia.

Our top pick is Cabot Oil & Gas [COG], one of the smaller companies, with a market capitalization of about $6 billion.

We like their exposures to some of these specific shale plays, including the Marcellus Shale in Appalachia. Because they are a smaller company, some of these new areas can have a disproportionate impact on the size of their reserves and production. Another company in this group that we like is Apache [APA], which is larger, with a market capitalization of about $45 billion. They have a nice balance between crude and natural gas and domestic and international exposure. We think international natural-gas prices are likely to start rallying, and Apache has got a good position in Egypt and Australia. And they have a number of key assets domestically.

All of these companies look very inexpensive because the market has not factored in anything near the current oil and natural-gas prices. Based on our numbers, Apache's enterprise value was recently at four times EBITDA and Cabot's was a little bit more expensive at 6.5 times EBITDA.

What other sectors look attractive?

Pipelines. The pipeline companies do not directly benefit from higher commodity prices, as would integrated oil or E&P companies, but there is a great need to expand our pipeline infrastructure in this country, and a lot of the companies we favor are positioned to do just that. Oneok [OKE] and El Paso [EP] are two we like. El Paso has a very large natural-gas pipeline network, and it looks undervalued to us. As for Oneok, they are well-positioned to benefit from a lot of natural gas in the Rockies and some of these mid-continent shale plays.

Are there any calls you wish you could have back?

We stayed too bullish on the U.S. refiners for too long, and that has been a mistake.

What most concerns you about energy stocks, going forward?

The biggest risk is that emerging-market growth abruptly changes for some reason. It is hard to predict that reason, but if it changes, it will probably change suddenly. That is what we worry about.

As for the possibility of $200 oil, that is not sustainable in your view, right?

No, we call it a spike, which implies an upside and a downside. So we do not talk about a sustainable price of $200. We call it a peak price, but we do not know what that is. We have got a range of $150 to $200.

Thanks very much, Arjun.

AN ELUSIVE OCEAN OF CRUDE

Two miles below North American wheat fields is an area that could rival Saudi Arabia.

Stories about huge oil fields underneath the farms of North Dakota and Montana have been making the rounds the last several years. Here is a background piece on the situation. The Bakken Formation of the Williston Basin has huge amounts of light, sweet oil. But it is trapped in tight limestone formations. Current extraction technology will recover only a small fraction of the oil in place. Obviously the incentive to improve on that is substantial.

John Bartelson, who smokes Marlboro Lights through fingers blackened with tractor grease, may look like an average wheat farmer. He isn't. He is one of North Dakota's new oil barons.

Every month, he gets a check for tens of thousands of dollars from Houston company EOG Resources, which drilled two oil wells on his land last year. He says the day his first royalty check arrived was one to remember. "I smiled to beat hell, and I went to town and had a beer," Bartelson, 65, says.

His new wealth springs from the Bakken formation, a sprawling deposit of high-quality crude beneath the durum wheat fields of North Dakota, Montana and southern Saskatchewan and Manitoba. The Bakken may give the U.S. -- the world's biggest importer of oil -- a new domestic energy source.

Unlike the tar from Canada's oil sands, Bakken crude needs little refining. Swirl some of it in a Mason jar and it leaves a thin, honey-colored film along the sides. It is light -- almost like gasoline -- and sweet, meaning it is low in sulfur.

Best of all, the Bakken could be huge. The U.S. Geological Survey's Leigh Price, a Denver geochemist who died in 2000, estimated that the Bakken might hold 413 billion barrels. If so, it would dwarf Saudi Arabia's Ghawar, the world's biggest field, which has produced about 55 billion barrels.

The challenge is getting the oil out. Bakken crude is locked two miles underground in a layer of dolomite, a dense mineral that does not surrender oil the way more porous limestone does. The dolomite band is narrow, too, averaging just 22 feet in North Dakota.

The USGS said in April that the Bakken holds as much as 4.3 billion barrels that can be recovered using today's engineering techniques. That is a fraction of the oil that Price said should be there, but it is still the largest accumulation of crude in the 48 contiguous U.S. states. North Dakota, where Bakken exploration is most intense now, will not become Saudi Arabia unless technology improves.

For decades, the Bakken was the fool's gold of the oil industry. The name describes a geological formation that looks like an Oreo cookie: two layers of black shale that bleed oil into the middle layer of dolomite. It is named after Henry O. Bakken, the North Dakota farmer who owned the land where the first drilling rig revealed the shale layers in the 1950s. All of the layers are thin — about 150 feet altogether -- and none of them give up oil easily. In older, vertical wells, oil would often flow for a month and then fizzle.

Now, companies like EOG are drilling horizontally. They go straight down 10,000 feet and then put a slight angle in the mud motor, a 30-foot piece of tubing that drives the bit, so they hit the Bakken sideways, making a horizontal tunnel as much as 4,500 feet long through the dolomite. Then they pump pressurized water and sand into the hole to fracture the dolomite, making cracks for oil to seep through. It eventually winds up in a pipeline that runs east to Clearbrook, Minnesota, and then south to Chicago.

Several billionaires are at work in the Bakken. Harold Hamm's Enid, Oklahoma-based Continental Resources has leases on 487,000 acres in Montana and North Dakota. Hamm, who started out driving a truck, owns 73% of Continental, worth $7.9 billion.

The big winner so far has been EOG, formerly a subsidiary of bankrupt energy trader Enron Corp. It drilled a horizontal well in western North Dakota just north of Parshall -- population 1,028 -- in April 2006. The well came online a month later and kicked out 1,883 barrels in the first seven days. Unlike the older vertical wells, it is still going.

Northern Oil & Gas, a 5-person company near Minneapolis, makes money without actually drilling or operating wells. It leases in promising areas like the Bakken and gets paid when someone else uses the land to drill.

The other people doing well in the Bakken are the mineral owners under the oil wells — folks like John Bartelson. Oil drillers have paid them millions for right of access to the oil deposits. "It'll crash again," Bartelson says, sipping on a late-afternoon cup of coffee beside his tractor.

Maybe so. But with crude trading above $130 a barrel, it will be a long time before the rigs leave again, and John Bartelson is likely to be a wealthy man before they do.

EXPLODING INNOVATIONS

Martin Hutchinson analyzes the causes of the exploding derivatives market, and offers reasonable steps to avoid "too big to fail" institutions accumulating huge portfolios of amorphous and risky assets in the future. As he concludes: "Free markets are economically optimal, but partially free markets, with endless creation of fiat money and implicit government guarantees of the big boys, can produce perverse and dangerous results."

In the absence of deep-sixing the Fed, which would in turn mercifully eliminate the "immense pools of leveraged speculative capital that have disfigured the global economy in the last decade," Hutchinson's semi-regulatory recommendations are so reasonable it will be a wonder if it is adopted. In short, if a institution is too big to fail, it should be confined to conservative investments and its compensation schemes should not incent management to bet the ranch on risky gambles. All such bets/compensation schemes should be in smaller institutions where it the investors' capital that is at risk, not the taypayors'.

Eleven of the world's largest investment banks have announced the creation of a clearing house, to open in September, for the $62.3 trillion credit derivatives market. Since it has been patently obvious for several years that such an innovation was essential for the stability of the market, the news is welcome, if a little belated. However $62.3 trillion is real money, so the question arises: How did something so dangerous grow so big before efforts were made to control its risks?

Credit default swaps and other credit derivatives were invented in the late 1980s, shortly after the interest rate and currency swap markets became substantial. Under a CDS, one bank promises to pay another bank money if a particular debt obligation of a third party borrower defaults. The precise definition of "default", the mechanism for calculating the amount of money payable and the extent to which the deal relates to general debts of the third party or to one particular obligation all vary between CDS, as do the maturity and amount. There is thus no easy mechanism whereby a liquid securities market could be created in CDS, since the differing terms of each transaction tend to make them un-substitutable.

The $62.3 trillion figure for the total principal amount of credit derivatives outstanding is to some extent a "scare" number. Nevertheless, the soothing explanations from market participants that suggest they are simply a mechanism to transfer credit risk to more capable hands come up against an awkward fact: The volume of credit derivatives outstanding is now a substantial multiple of the total volume of loans and bonds to which they relate, and that multiple shows every sign of increasing rather than diminishing. In this as in other derivatives markets, it is obvious that something more than mere "hedging" and risk transfer is occurring.

Comparisons with other markets are telling. The total volume of home mortgages outstanding in 2007 was about $12 trillion, while the total of life insurance in force was $20 trillion. Thus the entire insured population of the United States could be wiped out, and its entire housing stock fall down (a not unlikely contingency for the McMansion portion thereof) and still the losses to mortgage lenders and the insurance industry would be only about half the overall losses from a credit derivatives meltdown.

Proponents of credit derivatives will indignantly point out that the aggregate exposure in the credit derivatives market adds to zero, so that for every contract there is a winner and a loser. Either the debt pays when due, in which case the seller of credit protection gains, or it defaults, in which case the buyer gains. However that is also true of life insurance. Either the assured party lives through the term of the insurance, in which case the insurance company wins, or he dies, in which case the assured party wins, or rather his heirs do.

In the insurance case, mass slaughter would wipe out the insurance industry, because the gainers would be individuals not insurance companies. However that is also true for credit derivatives. The gains and losses are not confined to the "banking system" however that amorphous entity is defined, but are spread among insurance companies, hedge funds, investment institutions and well connected riff-raff. Even financial institutions may fail, as did Bear Stearns, for whom the network of credit derivatives obligations was so threatening that the Fed was compelled to step in and arrange a bailout. If the financial institutions do not initially fail, their counterparties may fail in large numbers, plunging the system into disaster.

At first sight, the contingent nature of credit derivative exposure appears to offer protection, but in practice it offers little. Although losses on credit derivatives only occur when an underlying loan defaults, and the modest hiccups of normal years can thus easily be absorbed, in a credit crunch such losses will be bunched. In such a situation the credit system is already under strain. If several underlying companies fail, financial institutions will be placed in a precarious position at a time when funding is hard to come by. Then a cascade effect would take place, with each default making other defaults more likely.

Thus in a severe credit crisis, the potential losses on credit derivatives may indeed approach the same fraction of total exposure that the $1.0-1.5 trillion of potential home mortgage losses bears to the $12 trillion of home mortgages outstanding. The ultimate loss would then be not 10% of $12 trillion, but 10% of $62.3 trillion or $6.23 trillion, several times the capital base of the entire U.S. banking system, more than the current total of Federal government debt outstanding and about 40% of a year's U.S. GDP. That would make a credit derivatives crash far larger in monetary terms and somewhat larger in terms of the economy than the Japanese banking problems of the 1990s, which caused 13 years of recession in that country.

The new clearing house will help this situation, but only if most currently outstanding credit derivatives are transferred to it. The credit derivatives market is not something that might become a problem going forward. It is already a gigantic problem that needs to be addressed in terms of the business already done. In any case, the clearing house is not a panacea. In a truly deep credit disruption it would go under along with most market participants. If a company with $10 billion of debts fails, there may well be credit derivatives outstanding relating to its debt of $100 billion. Thus while a clearing house will solve the problem of the bankruptcy of an individual participant such as a hedge fund, it is only too likely to be overwhelmed by a systemic problem.

In the Bear Stearns case, the existence of a credit derivatives clearing house would have allowed Bear Stearns to be pushed into bankruptcy, and its counterparties would have been able to continue dealing with the clearing house instead of being subject to severe uncertainty. If credit conditions among Bear Stearns' clientele remained satisfactory, that would have been the end of the matter. The clearing house would have borne any modest losses involved, less what it could recover from the corpse of Bear Stearns. However if after a clearing house-assisted Bear Stearns bankruptcy a substantial portion of credits underlying Bear Stearns' credit derivatives fell into default, the clearing house would very probably follow Bear Stearns into collapse, precipitating an implosion of the entire $62.3 trillion market.

It is clear what has led to the tottering and bloated nature of the credit derivatives market: The perverse incentives of Wall Street. Senior traders are rewarded with "drop dead money" -- amounts that enable them to leave the business at any time, financially secure for life, with only the distant threat of long-term imprisonment to deter them. Since the financial services industry also works excessive hours, allowing little time for reflection and intellectual stimulation, a high proportion of its inmates become possessed with a monomaniacal urge to accumulate the cherished "drop dead money."

The obvious way to do this is to find some product area in which profits can be accumulated with great rapidity in the short term albeit with the risk of enormous losses in the long term. Complex and poorly understood products, for which the accounting can be rigged to maximize current profits and push losses into the future, are particularly attractive. Credit derivatives, for which the appropriate accrual of reserves against loss is little if at all understood, have provided an ideally attractive field of endeavor for such machinations.

Once the credit derivatives problem is defined in this way, there is an obvious historical analogy: the life insurance market. Like credit derivatives, life insurance provides cash flow in the form of premiums in its early years, while losses in the form of deaths occur only later, often decades later. Like credit derivatives, the proper reserving for such losses was initially poorly understood, so life insurance companies with aggressive salesmen and low premiums could record excellent profits, and raise additional capital on the basis of those profits. The tsunami of new business and apparent surge in profitability enabled rewards to be paid to such companies' proprietors, who were thus acting economically rationally in the same way as today's credit derivatives traders.

The first large insurance bubble occurred over the generation leading up to the South Sea crash of 1720, after which almost all existing insurance companies went under. Similar bubbles occurred in New York and other U.S. jurisdictions throughout the 19th century. Gradually it became obvious that life insurance companies should not be allowed to scam investors and policyholders in this way, and regulations were introduced -- the first by the Life Assurance Act of 1774 -- to ensure the actuarial soundness of insurance companies, and prevent their looting by proprietors.

The analogy between the credit derivatives market and pre-1720 life insurance is a close one, even if it is difficult to imagine credit derivatives traders taking to periwigs and snuff and decamping to Antwerp rather than Brazil when things go wrong. It also suggests a solution to the problem: The Fed can make itself useful by regulating the market tightly, in particular by requiring the establishment of large reserves against each credit derivatives transaction, to be held in escrow and not paid out until the credit concerned has been repaid. Naturally, this will cramp the future growth of the credit derivatives market, but on balance that can only be a blessing.

Preventing future such casinos from growing to a size that endangers the entire financial system is more difficult. Part of the solution will come from much tighter money, reducing the immense pools of leveraged speculative capital that have disfigured the global economy in the last decade. Part of it could probably be achieved by tighter regulation of Wall Street's compensation schemes. While government regulation of earnings is in principle unattractive, it would certainly make sense for both overall caps and limitations on short term profit-related payouts to be introduced for institutions that were deemed "too big to fail" and thus ultimately risks on the taxpayer.

Such restrictions would have the salutary effect of driving the best talent away from very large institutions and towards medium sized ones, whether hedge funds or "merchant banks." That in turn would ensue that new innovations remained of moderate size while their long term viability remained untested, since counterparties would not risk gigantic potential liabilities against houses of only moderate size. If the new houses could be constructed as partnerships, so managers had primarily their own money at risk, so much the better.

Even in the financial services industry, innovation is welcome. Nevertheless, the perverse incentives of today's Wall Street and the implicit state guarantee of the largest houses have together combine to produce in the credit derivatives market a nexus of liabilities that serves little comprehensible economic purpose and would wreck the global economy if it collapsed. Free markets are economically optimal, but partially free markets, with endless creation of fiat money and implicit government guarantees of the big boys, can produce perverse and dangerous results.

THE GAMES WILL BE CHANGED TO PROTECT THE INNOCENT

Keeping the thread of what post-bubble regulation of financial institutions might look like going, PruduentBear.com's Rob Peebles, editor of the monthly Random Walk column, helpfully translates a speech Treasury Secretary Paulson gave back in March. It is not clear how closely Martin Hutchinson's suggestions above will be followed, but there is a whole lotta risk takin' that won't be going on going forward. Or so Paulson implies. Who knows what happens once the crisis passes and palms are greased?

Back in the old neighborhood we played baseball in Tommy's backyard because he had the highest fence. We used real bats but pitched a tennis ball to keep the collateral damage in check. Eventually we decided our field was too cramped so we moved around to the front. Sure, the risk that we would destroy something was greater, but the game was more fun. With the pitcher throwing from the middle of the street, we even had a full-sized infield.

But the outfield was not so big. In fact, Ed's house was the outfield. So, balls bouncing off the roof were playable, but anything that cleared the house was a home run. It sure beat the back yard.

One day a kid replaced our tennis ball with a rubber ball because it felt more like a baseball when you hit it. The new ball made things riskier, but what the heck, the game was more fun too. Until that line drive to right center.

With the house serving as the outfield fence, it just so happened that the living room windows took up much of right center field. When the ball hit one of them, it sounded like a shotgun. At first we all lurched in different directions. But who were we kidding? We were all identifiable. So we hung our heads and waited. Finally, Ed's dad, probably the biggest Dad in the neighborhood, walked out of the front door tossing the ball in the air and looking at us kids. It was a game changing event.

These days, those hitting it big in the financial stocks probably deserve six atta-boys for trading prowess. But if long term investors calling a bottom in financials are right, they will be lucky instead of shrewd. That is because how the financial game will be played going forward is still under review.

It is probably no coincidence that as financial markets became increasingly deregulated the financial sector's share of profits increased as well, reaching all-time records before the recent implosion(s). Post implosion (PI) not only do we not know how things will shake out, we do not even know much about what has been shaking in the past.

If Bear Stearns boasts a book value of $86 one day and gets taken out at $10 on another, what kind of earning power do investment banks really possess? If Citigroup sold at X times book five years ago, can investors expect Citi to regain that valuation in a PI world?

People who study financial manias will tell you that the favorites during the bubble phase never lead after the bubble bursts. They will tell you lots of other stuff too, especially if you are next to them on a ski lift or in an airplane seat, but the point is, financials may have just turned in their best years for years.

Sure, Citi shareholders might argue that they did not see any bubble in that stock's price as it peaked right around the old 2000 highs. Bank America's shareholders did better, but they never saw anything like the dot-com rocket charts of 1999.

But there were plenty of big winners in the financial firmament, including Bear Stearns, Countrywide, other mortgage makers, mortgage lenders, mortgage insurers, bond insurers-turned-exotic financial instrument insurers, and private equity owners wishing to cash in pre-PI. There were also bubbles in private equity generally, hedge fund assets, hedge fund manager salaries, trading desk profits, investment banking bonuses, interior decorating businesses in the Hamptons, and confidence in a New Financial Era.

Even if we can determine how much capital financial companies really have, and how much will still be around a year from now, the rules of the game are about to change. And it is hard to believe they will change in a way that allows for more risk taking, more leverage, more aggressive prime broker relationships, more pedaling of complex financial products to school districts, fewer disclosures, record earnings growth and higher multiples.

Congress is already pitching more regulation of investment banks, particularly those taking advantage of the Fed's helping hand. Just last week [in March] Rep. Barney Frank mentioned the two words non-bank banks hate the most: reserve requirements and transparency. Ok, three words. And if investment banks are the Great Enablers, constraints on the big banks will crimp "financial innovation" across the board.

[Then] Treasury Secretary Paulson essentially announced that the pendulum that has been swinging toward crazier and crazier risk taking was about to reverse. Even though he was talking to the U.S. Chamber of Commerce, a group that thinks the cock fighting industry can regulate itself, Hank spelled out some game changing plans for investment banks, at least for those who could decode what he was saying. Here are some excerpts:

Thank you for inviting me to address your Capital Markets Competitiveness Conference. We share a commitment to competitive markets, and Treasury will soon release a Blueprint for Regulatory Reform that proposes a financial regulatory framework which we believe will more effectively promote orderly markets and foster financial sector innovation and competitiveness.

Translation: There are so many regulations coming that we have not even finished compiling them.

Taking this step in a period of stress recognizes the changed nature of our financial system and the role played by investment banks in the post Glass-Steagall world.

Look, we gave you guys a chance to do whatever you wanted and you embarrassed us. Now we are changing the rules. We think the utility industry serves as a good model.

Such direct lending from the central bank to non-depository institutions has not occurred since the 1930s. Recent market turmoil has required the Federal Reserve to adjust some of the mechanisms by which it provides liquidity to the financial system. Their creativity in the face of new challenges deserves praise, but the circumstances that led the Fed to modify its lending facilities raises significant policy considerations that need to be addressed.

And boy will we address them.

These changes require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability. Now that the Fed is granting primary dealers temporary access to liquidity facilities, we must consider the policy implications associated with such access.

You know, like capital requirements. Collateral requirements. Disclosure requirements. Counterparty disclosures. And I am just getting started.

Historically, commercial banks have had regular access to the discount window. Access to the Federal Reserve's liquidity facilities traditionally has been accompanied by strong prudential oversight of depository institutions, which also has included consolidated supervision where appropriate. Certainly any regular access to the discount window should involve the same type of regulation and supervision.

Have you noticed how often I am using the word "supervision"?

A properly designed program of deposit insurance greatly reduces the likelihood of liquidity pressures on depository institutions and as a corollary, makes the funding base of these institutions more stable. The trade-off for this subsidized funding is regulation tailored to protect the taxpayers from moral hazard this insurance creates.

So we save your skins, you settle for earnings growth similar to Con Ed's.

For the non-depository institutions that now have temporary access to the discount window, I believe a few constructive steps would enable the Federal Reserve to protect its balance sheet, and ultimately protect U.S. taxpayers.

You think implementing the Patriot Act gave you headaches?

Second, and perhaps most importantly, the Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions.

If it is off balance sheet, bring it on.

Despite the fundamental changes in our financial system, it would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed's liquidity facility. Recent market conditions are an exception from the norm. At this time, the Federal Reserve's recent action should be viewed as a precedent only for unusual periods of turmoil.

If we ever get of this mess, this will NEVER happen again. Bank on it.

EMERGING MARKETS FACE INFLATION MELTDOWN

The latest round of infatuation with emerging markets appears to have cooled off, as stock markets tumble and central banks belatedly scramble to contain inflationary fires. The talk of "decoupling" from the U.S. economy -- the latest example of markets making opinions -- has proved to be predictably premature, if not fatuous. The emerging markets' will truly emerge in time, at which point they will not longer be called "emerging." But that day will have to wait for a while.

Which is not to say that any of these countries' markets will not be good buys, sooner or later, at a price. But that will be after the worldwide credit bubble fluff is removed from valuations. With China down 50% from its peak we are clearly heading in the right direction if we are interested in buying in. Equating the emerging markets to the dot-coms of a decade ago: Think of the BRIC countries and other quality emerging markets as being like Cisco, Yahoo, and Amazon -- companies that actually made money which had valid business models and good growth prospects ... which fell 80% or more from 2000 to 2002.

Central banks across much of Asia, Latin America, and Eastern Europe will soon have to jam on the breaks or risk a serious crisis as inflation spirals into the danger zone. As the stark reality becomes ever clearer, this year's correction in emerging market bourses and bond markets has now accelerted into a full-fledged rout.

Shanghai's composite index touched a 14-month low of 2,900 [on June 12]. It follows moves this week by the central bank raised reserve requirement yet again, draining a further $60 billion from the banking system. Chinese stocks have now slumped by almost 50% since peaking in October.

In India, Mumbai's BSE index has lost 27% of its value as the exodus of foreign funds accelerates. The central bank has raised rates to 8% to curb inflation and halt a run on the rupee, but critics still say the country waited too long to tackle overheating. The current account deficit has shot up to near 3.5% of GDP. A plethora of subsidies has pushed the budget deficit to 9% of GDP.

Russia, Brazil, India, Vietnam, South Africa, Indonesia, Nigeria, and Chile -- among others -- have all had to raise interest rates or tighten monetary policy in recent days. Most are still behind the curve.

"The inflation genie is out of the bottle: easy money is the culprit," said Joachim Fels, chief economist at Morgan Stanley. "Weighted global interest rates are 4.3%, while global inflation is above 5%. The real policy rate in the world is negative."

The currencies of Korea, Thailand, the Phillipines, and Malaysia have come under pressure this week as investors scramble for dollars in moves that echo the East Asia crisis in 1997-1998. Several countries have had to intervene to slow the currency slide.

The sudden shift in sentiment appears to follow comments by Ben Bernanke and Tim Geithner, the heads of the U.S. Federal Reserve and the New York Fed, leaving no doubt that Washington has lost patience with the crumbling dollar.

The "sudden shift" would not have happened had the market not been ripe for a reversal already. No market goes to zero or infinity without corrections along the way, and the anti-dollar sentiment had reached an extreme. Good timing, Ben and Tim.

It is almost unprecedented for Fed officials to take a public stand on the Greenback. The orchestrated move is clearly aimed at halting the vicious circle in the oil markets, where crude prices are feeding off dollar weakness -- with multiples of leverage.

The "strong dollar" campaign has switched into high gear. U.S. Treasury Secretary Hank Paulson has conducted an aggressive lobbying drive behind the scenes in the Middle East and Asia. America's friends and foes have been left in no doubt that the enormous strategic might of the United States is now firmly behind the currency. From now on, they cross Washington at their peril.

The markets are now pricing in two rate rises by the Fed this year. Investors no longer doubt that the U.S. -- and Europe -- will do what is needed to restore credibility. This display of resolve has suddenly switched the focus to the very different universe of emerging markets, where a host of countries have repeated the errors of the 1970s.

Richard Cookson, a strategist at HSBC, advises clients to slash their holdings in these regions. "Inflation looks like a very real problem in Asia, and the risk is that investors will lose faith in the region's currencies. Although markets have fallen savagely from their peaks, they are still looking pricey. We are lopping exposure even further, to zero," he said.

"Where to put the money? We think corporate debt is stunningly cheap compared with equities. Seven-year to 10-year 'BBB' [rated] corporate bonds in the U.S. have not been this cheap since the Autumn of 2002," Cookson said. "Until and unless policy makers in the emerging world -- especially those in China -- tighten policy dramatically, the inflation rates are unlikely to fall much. Our guess is that most don't have much will to tighten pre-emptively."

Russia's inflation is 15.1%, yet interest rates are 10.75%. Vietnam's inflation is 25%; rates are 12%. Fitch Ratings has put the country on negative watch and warns of brewing trouble in the Ukraine, Kazakhstan, the Balkans, and the Baltic states. The long-held assumption that emerging markets are strong enough to shrug off U.S. troubles is now facing a serious test. The World Bank has slashed its global growth forecast to 2.7% this year. The IMF and the World Bank define growth below 3% a "global recession".

There is a dawning realization that China is facing a major storm as inflation (7.7%), the rising yuan (up 5% this year), soaring oil prices, and an economic downturn in the key export markets of North America and Europe all combine to crush profit margins. China uses five times as much energy as the U.S. to produce a unit of GDP. It is acutely vulnerable to the energy crisis.

A quarter of the 800 shoe factories in the Guangdong region have shut down in recent months, and several thousand textile workshops are battling to stay afloat. Hong Kong's industry federation has warned that 10,000 firms operating in the South of China may soon go out of business.

PREPARING FOR A BIG PAYDAY AT AUTOMATIC DATA PROCESSING

ADP was a classic growth company, the kind that used to warm the cockles of the late Philip Fisher's heart. Look at its long-term chart, here. From 1984 to 2000 the stock went from a little over $2 (split-adjusted) to the mid-60s. Moreover, it was already a quality company in 1984, not some speculative startup. But look at what has happened since 2000: Over the ensuing 8 years it has irregularly declined to the mid-40s.

In 2000 ADP was, as the euphemism for overpriced goes, “ahead of itself” -- riding the coattails of the dot-com mania. As often happens, its earnings growth faltered after it reached peak valuation levels, providing the vicious combination known so well by owners of busted growth stories: contracting multiple and earnings. The fundamentals weakness was exacerbated when it diversified away from its core competency of payroll processing, and ended up with a portfolio of inferior ancillary businesses.

Lesson apparently learned, ADP has sold or spun off its peripheral business segments and reconcentrated on its core area -- which it figures has a lot of room for growth still. (As it did not when ADP was acquiring the stuff it later discarded??) Now you can buy it at around 20 times earnings, which is not expensive but not cheap for a quality growth company in our book. Assuming ADP has indeed reinvigorated itself, it is certainly worth tracking.

ADP figures there is a $70 billion market for outsourced payroll services, which it plans to dominate. A bet on the stock at these depressed levels will pay off -- once the skeptics realize what they are missing.

It is one of a handful companies in America with a credit rating of triple-A. It has delivered double-digit revenue and earnings growth for the past two years and is expected to do so again this fiscal year. Its dividend yields better than 2.5% and it has been buying back shares using the formidable flow of cash it generates each year. Margins are expanding. 90% of its revenues are recurring, and it boasts extremely high customer-retention rates.

In short, it is a nice business.

Yet for all that, Automatic Data Processing (ticker: ADP), the dominant provider of employee payroll services, finds itself in the unlikely position of being out of favor with investors. There are concerns that the weak economy will hinder growth as layoffs mount and companies become hesitant to spend money on outsourcing. There are worries, too, about the effect of lower interest rates on its investment portfolio, essentially the float from the funds that companies pay in advance to ADP before the employee checks are cut.

Through its car-dealer operation, which provides an array of back-office services for dealerships, ADP is exposed to the struggling U.S. auto market. And memories linger about how badly ADP fared during the last economic slowdown, in 2002, when its share price plummeted from a high around 57 at the peak of the tech bubble in 2001 to 25 by March 2003.

But ADP is not the same company it was then -- and its stock could rise almost as dramatically as it fell then.

Just look at what the company has done. It has sold or spun off sluggish business segments, including an insurance-claims management business and a securities transaction processor. Now, the ... company is focused on its core business of providing employee services to companies, which accounts for about 90% of its revenue. Even though ADP already pays one in every six U.S. employees -- and 33 million workers in 30 countries -- its market still looks under-penetrated. ADP figures that there is a $70 billion global market for outsourced payroll services, yet in the most-penetrated part of the market, mid-size companies, roughly 45%-50% outsource the function. That leaves ample opportunity for growth in that segment, to say nothing of the under-served market in small and large companies.

At the same time, ADP is managing its investment portfolio better to limit its exposure to short-term rates. It is adding to its sales force and bolstering services, a lesson learned from the last downturn, when belt-tightening and retrenchment hindered its recovery. It is moving aggressively to offer high-margin "beyond payroll" products and services such as 401(k) and benefit administration. And it is expanding its overseas presence in employee services.

Management is forecasting another strong year, with revenue growth of 12%-to-13% for fiscal 2008, which ends on June 30. At a number of technology conferences last month, it repeated the forecast and said it is "confident" of achieving the high end of its earnings growth forecast of 18%-21%, or $2.12-to-$2.18 a share.

The differences between now and then, however, appear to be lost on the market, meaning that investors are missing a nice opportunity to pick up shares at a discount to ADP's normally fat premium. Changing hands at about $44 a share puts ADP's multiple at about 20 times this fiscal year's estimated earnings and less than 18 times fiscal 2009 expected earnings. That is a bargain compared with the 24 times earnings they have traded at historically.

Our rule of thumb is that if you can get a company that can grow at double digit rates organically at a mid-high teens multiple you are leaving yourself some good upside while protecting yourself against faltering growth. 20 is about the most we would pay, but we are cheapskates.

This is not to say the company has not experienced some softness. Growth in new sales has moderated, as have "pays per control," the number of employees its clients pay and for which it receives a fee. It is also taking longer to sign contracts with larger businesses, although bookings for small and mid-sized companies remain solid and are growing at double-digit rates. When it reported third-quarter results last month, it noted the interest earned on client "float" remained flat with year-ago levels.

"That does not bother me, as long as their customer retention is strong and they continue to see growth in their payroll and 'beyond' payroll services," says Quoc Tran, portfolio manager at Lateef Investment Management in Greenbrae, California, who is a fan. Tran notes that payroll services gained by 8% in the most recent quarter, and "beyond" services rose 13% from the earlier period.

Perhaps most impressive, ADP's return on equity rose to 24% in 2007, up from 17% in 2006 and 14% in 2005. Return on equity should continue to move higher as ADP continues to see growth in its higher-margin businesses. That, in turn, should result in multiple expansion, says Tran. Using a 24 multiple on his estimate of calendar-year earnings of $2.58 for 2009, Tran derives a price target of $62 for ADP, a 41% jump.

Another thing to consider is that multiple expansion of the sort described pretty much requires a benign interest rate environment. One of the factors that devastated the "Nifty 50" in the mid-1970s, besides their performance revealing that the faith in those companies' earnings resilience was unjustified, was the multiple collapse the followed the higher inflation and interest rates of the era. Another reason to set your P/E buy point conservatively.

At some point, too, he expects ADP to spin off the car-dealer unit to focus further on its core business. Buying into ADP at these levels seems to us, well, automatic.

THE LONG AND SHORT OF BANK STOCKS

This market commentary from Barron's adds yet another opinion to two areas of interest that we have covered no small amount: (1) oil prices, and (2) bank stocks.

On the rare occasions when the market clearly shows its hand, it typically does so with a smack to the face. In one of those exceptions to the market's rule of keeping its wishes and fears obscure, stocks became suddenly scrutable Friday. [Referring to the 400 or so point drop in the Dow Industrials on June 6.]

In deflating by 395 Dow points, stocks hinted strongly that their recent firmness and Thursday's 200-point Dow gain were based on the following collective, hopeful notion: "Maybe the recession calls were premature, maybe oil has finally topped, perhaps the dollar can really rally and, you know what, the Fed may even be able to tighten before long."

The half-percentage-point pop in the May unemployment rate, coming hours after the top European central banker hinted that he would be boosting Continental interest rates, handily undercut that scenario. Promptly, the dollar heaved lower, oil prices screamed moonward, and the Dow rushed to price in consumer distress.

In general, the whole oil-up/stocks-down dynamic way oversimplifies the reality. But, for the moment, that conventional wisdom seems at work, which has set Wall Street observers to devising novel means of showing oil prices have gotten out of whack with other assets.

Oil prices are at a historic high relative to the Goldman Sachs non-energy commodity index, implying that crude has decoupled from other scarce and consumable necessities with listed futures. Then there is the oil/gold ratio, which has not been this high since the summer of 2005. That was an excellent moment to buy gold, incidentally, and one when oil prices stalled for a time.

If the oil/gold ratio maintains its high ground for an extended period, in our book that would be valid evidence that something in the supply/demand equation is justifying historically high real oil prices.

And a decent reason one might care to consider how oil trades in relation to gold is that, to a significant degree, both commodities trade like a currency called "the anti-dollar." Despite the cries of "it is all supply/demand" from the peak oil-believers, the negative correlation between oil and the dollar has never been steeper in 15 years than in recent months.

The fact that oil had never before been up the daily limit of $10 a barrel -- and did so Friday accompanied by an analyst's call that the price would hit $150 in a month -- is not exactly a bell-ringer, but it does give some pause. I would never like to shout "Qualcomm $1,000 price target" in a crowded futures pit [Qalcomm went from under $3 in the fall of 1998 to $88 in late 1999 at the peak of the dot-com mania, the later after a 4-for-1 stock split. So presumably at $350 or so pre-split the bulls were calling for $1000, right at the never-exceeded-since top.], but the echoes are there.

---

The oracle otherwise known as my e-mail inbox evidences an outsized focus on financial stocks. As a rule, trading-oriented folks are playing for bank shares to crack to new lows. Longer-term types are warming to financials as cheap on a two-year horizon. Goldman Sachs strategist David Kostin quantifies exactly this split, showing hedge funds still short and long-only money overweight the group.

On the "buy the banks" side, a piece by Tom Brown of Second Curve Capital and BankStocks.com was in heavy rotation last week. It argued, to summarize radically, that extrapolating the horrid 2007 mortgage-loss experience far overstates the likely ongoing level of pain.

The S&P Financial Sector exchange-traded fund (XLF) is right back to the mid-March Bear Stearns low. And yet, the salient indicators of credit-market stresses are all far more benign today, from the corporate swap spread to Fannie Mae spreads. And the yield curve is steeper, thus more favorable.

Michael Darda of MKM Partners notes that while bank stocks have fallen about as much as they did before bottoming in the 1989-90 recession, the yield curve, federal-funds policy and other capital-markets conditions are far more favorable now.

This does not mean financials will be a leadership group, even if they are forming a sloppy, halting bottom, as seems plausible. And, if financials lag, it is not doomsday for the broad market, contrary to common claims.

At the risk of sounding like the proverbial broken record: Financials led the market for such a long time that it would be astounding it they reasserted leadership after a mere one-year relative correction. The extent of the credit mania would call for a multiple year correction. Given that fixed physical assets like oil rigs or fiber optic lines do not have to be absorbed, the correction might be shorter than average, but one year seems too short.

On the second point however, not only would lagging financials not be doomsday for the broad market; it would be expected and healthy. It the market depends on an overvalued sector getting more overvalued it is hardly healthy.

RETAILERS LEADING THE WAY? NOT REALLY

This straightforward little piece of analysis concludes that high food and energy prices are obscuring meaningfully poor results in other areas of consumer spending -- which investors are apparently overlooking. "By the time investors figure this out, the whole retail sector will be hitting record lows." Ergo: "I think clothing retail in particular is ripe for short-selling."

For months now, investors have been looking to the retail sector for insights on the U.S. economy. After all, 70% of U.S. GDP comes from consumer spending. So the retail sector is often thought of as a bellwether for the U.S. economy as a whole.

Things are not looking good, though retailers have been doing their best to mask this. Take the April same-store sales numbers, for instance. That month, same-store sales declined for most major retailers. However, instead of admitting that things were slowing down, they blamed an early Easter and rainy weather for their poor results.

Not much of a cover-up. First of all, retailers knew that Easter came early this year. It was already factored into their forecasts -- forecasts that they subsequently missed. As for the weather excuse, it is pure nonsense. Yes, I suppose if there were a typhoon people would shop less. But even a second-grader knows it rains in the spring. How come retail executives and Wall Street types cannot discount this fact into their forecasts?

These excuses look even more absurd when you take in some of the more glaring items in April's results. Most notably:

• A record 80% of retailers missed estimates.
• The UBS-International Council of Shopping Centers' sales tally posted a decline of 2.3%, the biggest drop since the index started tracking data.
• Wal-Mart posted its biggest monthly decline in 28 years.

Thus far, the Goldilocks crowd has managed to overlook these items. They believe that the U.S. consumer is going strong thanks to Bush's $600 rebate checks.

At first glance, May's same-store sales results seem to support this view. Except for one small problem -- these results do not distinguish food and energy sales from clothing and other discretionary items.

With gas at $4 and food prices expected to rise 5% this year -- the largest increase since 1990 -- I am willing to wager that most of the retail growth is coming from these segments, not merchandise.

Greg Weldon, of Weldon Financial, agrees with me. According to Greg's analysis, 77% of the increase in retail sales for the first three months of 2008 came from food and gas. Greg states that if you remove these two sectors, retail sales actually fell 2% in Q1 08.

Most major retailers are doing everything they can to keep this fact from seeing the light of day. Consider the May sales numbers for Wal-Mart, Costco, and BJ's Wholesale Club. Last week, Wal-Mart and Costco reported May same-store sales growth of 3.9% and 7%, respectively. Seeing this, the Goldilocks crowd rejoiced, claiming that growth of this caliber negates the view that we are in a recession.

Then BJ's crashed the party. BJ's Wholesale Club actually broke its sales figures down by sector. Total same-store sales growth was a fantastic 13%. By segment, gasoline sales jumped 6% while food sales jumped 11%. Merchandise was flat.

I guarantee you that most of the sales growth coming from Wal-Mart and Costco is the result of high food and energy prices. And this illusion is the only thing keeping consumer discretionary stocks from collapsing. Should Wal-Mart or Costco come clean that merchandise has fallen off a cliff ... the clothing retailers and other sellers of discretionary items would really plunge.

Simply put, the U.S. consumer has shifted from buying things he does not need and cannot afford to buying things he DOES need and can BARELY afford. By the time investors figure this out, the whole retail sector will be hitting record lows.

And while the Federal Reserve may do everything it can to postpone financials' collapse, it is not going to bail out Nordstrom or the Gap. I think clothing retail in particular is ripe for short-selling.

ETFs or ETF-like instruments that are relevant here are Retail HOLDRs (RTH), PowerShares Dynamic Retail Portfolio (PMR), Consumer Discretionary SPDR (XLY), and Vanguard Consumer Discretionary Vipers (VCR).

BY THE NUMBERS, MINING STOCKS ARE UNDERVALUED

This article attempts to make a statistical case that gold is somewhat undervalued, and that gold mining stocks are somewhat undervalued relative to gold, thus giving mining stocks a potential double-barreled boost down the line when the market discovers the error of its ways. The case made is far from ironclad, but the attempt is nevertheless useful and credible. Objective analyis that helps ground pie-in-the-sky (or "the bottom is falling out") projections cannot but help one keep one's head during times when many are losing theirs. In the land of the blind, the one-eyed man is king.

How can I say mining stocks are over- or undervalued? I would have to do the math for all the listed companies, which is more or less impossible. But there is a more convenient and possibly even more accurate way to argue that a market sector is trading with a significant discount.

In mining, the most important value driver is the value of the underlying asset, e.g. gold. If gold rises should gold stocks not rise too? In the recent months, particularly junior mining stocks did not rise even though gold saw a spectacular performance. On the other hand, big cap mining stocks did benefit from the rising gold price but nevertheless were underperforming.

There are many reasons behind this divergence. But the most important was, that investors were explicitly not willing to take risk. But once risk appetite returns, investors will find out that many mining stocks are trading at considerable discounts to their implied value. In the next paragraphs I will show you my considerations and give you some investment ideas to participate.

So why do I believe that mining stocks are undervalued? I calculated the theoretical value of the AMEX Gold Miners Index (GDM, which is composed mainly of big cap mining stocks) by using a linear regression model. ... A linear regression analyzes the relationship between two variables, x and y (in this case between the AMEX Gold Miners Index and gold). For each variable you know both x and y values and you want to find the best straight line through the data. ... I calculated the correlation over a 5 year period with weekly closing data. The AMEX Gold Miners Index has a correlation of approx. +0.96 to gold (and R² +0.922 which is very significant). The correlation got weaker during the last couple of months ... This created the current discount in mining stocks. The following graph shows the various number of observations between gold and the AMEX Gold Miners Index at specific dates.

By using the formula provided by this model, I came up with a potential value, based on the current gold price and historical correlations, of around 1,357 points for the AMEX Gold Miners Index. Currently, the AMEX Gold Miners Index is trading at around 1,187 points which means more or less a discount to its calculated value of 14%. If you believe that gold will hold its current price level or rise even more -- as I do, than the mining stocks will eventually catch up.

If you are happy to buy gold at the current price, then that the miners are a good buy inside this statistical model is a valid conclusion.

The correlation coefficient between the TSX Venture Index (TSX-V, which is composed mainly of junior mining stocks) and gold is also significant with +0.78 (5 year, weekly closing data). Taking the recent sell-off in the junior mining sector (represented in the TSX Venture Index) into consideration, it is not very surprising that small caps are trading with an even bigger discount to their applied value. The TSX Venture Index is trading with an approximately 18% discount to its applied value. Even though the TSX Venture Index is not only composed of mining stocks and many of the mining stocks do not even have gold resources (e.g., early stage exploration companies), the statistical analysis is still significant and clearly points to a causality.

In summary, investors can currently buy big cap mining stocks and junior mining stocks with fairly attractive discounts which I believe will eventually be balanced.

A more comprehensive statistical analysis would look at the variance of the predictions falling out of the regression model. The confidence interval, e.g., around the predicted value of 1,357 for the AMEX Gold Miners Index might be very tight -- in which case the 14% discount would be signficant (if not exactly breathtaking) -- or it could be wide -- in which case the 14% discount is just random statistical noise. (If you flip a coin and get 6 heads, the deviation from 50/50 randomness is not worth thinking about. If you flip it a million times and get 600,000 heads, you know with virtual certainty that the coin is rigged.)

I will show you now the case for approx. $1,000/oz gold at the end of 2008: I found that the highest correlation to gold occurs with the following input variables -- which also makes sense from an macro-economical approach:

• EUR/USD to Gold +0.86
• USD/CNY to Gold -0.97
• WTI Oil to Gold +0.89
• U.S. Dollar Index to Gold -0.85

These correlations are all significant and allow to build up a model to forecast the price of gold. In the following matrix you can see where the price of gold should be at the end of 2008. There are single targets based on each input variable and an equally weighted forecast. I therefore predict a year-end target of gold at $972/oz or approx. +12% from current levels.

If I summarize the following considerations and apply the same approach to forecast the AMEX Gold Miners Index [GDM] year-end target with the forecasted gold year-end target of $ 972/oz, the GDM target will be 1,510 (currently at 1,187) or approximately +27%. The year-end target for the TSX Venture Index is even approximately +30% from the current level.

Now, let us put these forecasts into investment ideas. From an investor's point of view, it is very important to diversify and therefore have some exposure to physical gold, big/mid caps and small caps. A very liquid way to gain exposure to gold is to buy the SPDR Gold Shares (GLD). The objective of this ETF is for the shares to reflect the performance of the gold bullion. Buying big/mid caps can also been done in a cost efficient way. The Market Vectors Gold Miners ETF (GDX) does reflect the performance of publicly traded equity securities of gold and silver mining companies, as represented by the AMEX Gold Miners Index [GDM]. The advantage of buying the SPDR Gold Shares and the Market Vectors Gold Miners ETF is to have one product which reflects a basket of stocks or gold instead of buying a bunch of single shares. If you do not like the idea of buying an ETF than you might want to buy BHP Billiton (BHP) to gain exposure to base metals and Barrick Gold (ABX) to gain exposure to precious metals. These two big cap companies are rather representative of their sector.

The much more challenging undertaking is to gain exposure to small cap companies. There are no ETFs around that reflect junior mining companies. I would therefore recommend to investors to buy a selection of junior mining stocks or a mining fund with exposure to small cap companies. For a nonprofessional investor the choices are pretty big and the risk is considerable. Consecutively, I will give you a selection of junior mining stocks, which I like and which offer excellent entry points for long term orientated investors. In the current market it is very important to only invest into junior mining stocks which have NI 43-101 compliant resources/reserves, established production or near term production prospect, management with a proven track record and located in politically stable countries. Therefore, I like the following companies ...

The author makes cases for Central Sun Mining (AMEX: SMC), Largo Resources (Nasdaq OTC: LGORF.PK), Excellon Resources (Nasdaq OTC: EXLLF.PK), U.S. Silver Corporation (Nasdaq OTC: CYLPF.PK), and Petaquilla Mineral (Nasdaq OTC: PTQMF.OB).

In summary, I am still very bullish on gold based on strong fundamentals. I also believe mining stocks in general are trading at attractive levels. But the biggest potential for long term orientated and risk aware investors definitely lies in selected junior mining companies.

BROKER FAILURES BECOME REALITY

Whenever overall credit is contracting, areas you never gave much thought to before can suddenly show up as trouble spots. Most people are aware that banks go under due to bad loans. A broker that, e.g., takes too many risks with its own capital -- e.g., Bear Stearns -- or the customers' capital, or ends up having to absorb losses on a customer's margin trade gone wrong, or any number of other loss-producing operations, could also go under. Small accounts can take some comfort in the insurance provided by FDIC and SIPC.

"Counterparty risk" has commanded a lot of attention vis a vis derivatives markets. Many derivatives trades involve transactions between two parties, one of whom might have to make good on a sizeable promise if certain events occur. A futures or options trader relies on the exchange's clearing house to vet, and ultimately make good on the promise of, the counterparty at the other end of a trade, whether that be another trader or a trader's broker. (We recall worrying whether the stock futures exchange clearing house might have problems after the 1987 stock market crash. These days the Fed would probably just lend the clearing house the money.) The essential fact is that participants in financial asset markets, including something as simple as having an account at a local bank, rely on a chain of parties making good on their promises. When anyone in the chain has problems, everyone has problems.

When trading stocks, a clearing service is one of the links between buyer and seller. Normally they just take care of the paperwork, confirmations, settlement and delivery (imagine all that was required to complete a transaction in the days of physical stock certificates). A clearing firm is also where your assets may actually be held, i.e., they are custodians for your securities. Normally they do not take market risks in their capacity as clearer, but clearly there is some opportunity for mischief.

North American Clearing was helping itself to customer funds to cover operating losses, possibly due to fraud. Customers of brokers who used the clearing services of NACI suddenly had no access to their account. The account existed on paper, but that was it. This Barron's article takes it from there ...

Customers of Just2Trade and other small brokerage firms recently got the nasty surprise many have feared: They logged on to their accounts to discover that they could not trade or withdraw funds.

It turned out that North American Clearing, which provided clearing services for several dozen small to midsize broker-dealers, had been shut down for lack of capital. A few days later, the Securities and Exchange Commission charged several top NACI officers with fraud, including misuse of client funds to hide severe financial problems, and other securities violations, and froze all of the funds at the Longwood, Florida, firm. The SEC appointed a receiver to see if he can make good on money owed customers without resorting to more time-consuming measures.

Failures of clearing firms -- which work with exchanges to confirm each trade, deliver securities and ensure that paperwork is in order -- are unusual because these companies generally do not take much market risk. NACI, however, was not taking market risk. It was using customer funds to cover daily operations, the SEC charges. Investors have grown more worried about potential disruptions as credit problems have hit brokers hard, the markets have wobbled and Bear Stearns had to be bailed out. On December 17 and 31, we wrote a two-part series on the topic, "Are You Covered if Your Broker Fails?" [See posting immediately below.]

In the case of NACI, account holders were allowed to place closing trades, but could not withdraw funds or open new positions. Just2Trade President Fuad Ahmed says he offered to buy out NACI, but without success. Ahmed says that he and co-workers worked through the Memorial Day holiday to transfer manually his most active customers to another brokerage owned by Just2Trade's parent firm, LowTrades, which clears through a separate firm. By late last week, Ahmed said that he had struck a deal with a clearing outfit, Legent, and that Just2Trade's other clients should be able to trade again by Monday, June 9. [Apparently this is the case.]

"I did not imagine this could happen to a clearing firm," Ahmed says. He emphasizes that his clients' assets are secure, but the legal restrictions thanks to NACI's alleged crimes make it impossible for these investors to access their holdings.

The SEC-appointed receiver, Atlanta-based attorney Peter Anderson, had this to say: "I have empathy for these clients and have to protect them, but there has to be a process. We have to do something that protects everyone, not just the big accounts or the frequent traders." Anderson estimates that more than 13,000 accounts are affected, mostly with what he describes as 3rd- and 4th-tier broker-dealers that allow customers to trade actively.

A notice on NACI's Website says Anderson is trying to figure out whether customers' funds and securities are adequately protected and whether NACI is a going concern. Anderson says that, if an orderly transfer of accounts to a new clearing firm cannot happen in a reasonable time, "The alternative is to pick up the phone and call SIPC [the Securities Investment Protection Corp.] and hand them the keys." SIPC is a federally mandated entity funded by broker-dealers that covers up to $500,000 of stocks, options and bonds per account.

All of the affected accounts are insured by SIPC for the $500,000, including a $100,000 claim for cash. In addition, NACI has excess SIPC insurance up to $30 million in aggregate, with a per-customer limit of $7.5 million. Obviously, the excess SIPC coverage will not go far if a lot of $7.5 million accounts are affected.

SIPC President Stephen Harbeck says his group is willing to wait until other avenues are explored because they might give customers control of their accounts sooner than if they had to follow a complex statutory regime.

"I know that the people who are looking at the possible ways to solve this problem have the customers' best interest at heart," says Harbeck. "If they cannot solve the problem, it may well end up in our laps, but it would be better if it got settled." Harbeck says that SIPC prefers a solution that does not get it involved; it can take 30 days -- or more -- if the receiver is unable to find a clearing firm that is ready, willing and able to take these accounts.

Without a clearing firm, SIPC would have to clear the affected accounts one by one -- a tedious process. "That is the last resort we have, and it is not a procedure anyone looks forward to," Harbeck says.

What can you do if you are one of the 13,000 accounts affected by this action? Unfortunately, just wait till the SEC and receiver allow a transfer to a different -- and they hope stronger -- clearing firm.

Are You Covered if Your Broker Fails?

What is at risk -- and what is protected -- if your online brokerage goes broke.

The time to be asking this question is now, not after the fact.

A couple weeks ago, we asked Barron's readers what would prompt them to switch online brokers or open an account with a new one. The overwhelming response -- over 3/4 of those who took the time to write -- was that the primary motivation would be to protect assets. "What would happen to my account if my broker goes under?" howled a respondent. "I just don't want to deal with that."

Brokerages are required to carry insurance backed by the Securities Investor Protection Corp., a federally mandated entity funded by broker-dealers that covers up to $500,000 of stocks, options and bonds per account. Futures contracts, commodities and currencies are among the asset classes ineligible for SIPC coverage.

Note that well.

SIPC insurance has been mentioned many times in the midst of the recent credit crisis, but the details of its coverage still puzzle many. As a reader noted, "Not to pick on E*Trade, but if they go into bankruptcy, what happens to the money in people's individual trading accounts? Are their stocks protected by SIPC but not their money-market funds? What happens if the account is $1 million? SIPC insurance does not cover amounts that high, or does it? That concern and uncertainty is causing people to move their accounts out of E*Trade and into other firms." (E*Trade's sizable mortgage exposure prompted speculation about its financial health. The firm has since received an investment from hedge fund Citadel Investment Group.

According to SIPC, customers of a failed brokerage firm get back all securities (such as stocks and bonds) that are registered in their name. The firm's remaining customer assets (including cash or assets not covered by SIPC) are then divided, with the funds shared in proportion to the size of claims. If that still does not cover the losses, then SIPC reserve funds are used, up to the $500,000 per-customer ceiling, which includes as much as $100,000 for claims of cash that were held in the client's account.

For this reason, it is often recommended that people ask that stocks be registered in their own name, as opposed to "street" name. It is less convenient for the brokerage, but more protection for the client -- especially one with assets of total value greater than $500,000.

The majority of the brokers we cover in Barron's have a relationship with a clearing firm, which is where your assets are actually held. These firms work with the securities exchanges to confirm, deliver and settle trades. They are also responsible for seeing that transactions are settled correctly in a reasonable amount of time.

Most brokerage executives we spoke with said that it would be difficult for a clearing firm to go bankrupt. If one of their member firms did something crazy, such as overextending margin or allowing a customer to trade a product he or she did not understand, it could affect the clearing corporation. But there would have to be a huge drop in the market, combined with a lot of trading on margin. In other words, a perfect storm is about the only thing that could cause a bankruptcy at a clearing firm.

A perfect storm, or, as we now see, hanky panky.

Here is how some electronic brokers arrange their coverage.

Mickie Siebert, CEO and founder of Siebertnet, says National Financial Services handles clearing at her firm and is ultimately responsible for customer assets. If Siebert's firm went out of business, the customer's assets would be kept segregated and safe at the clearer, she says. NFS has SIPC coverage in place and also provides, through an industry conglomerate called Capco, additional coverage with no cap.

A bankruptcy of OptionsHouse would have no direct financial impact on the assets of clients, says John Hass, the firm's CEO. Options House clears through Penson Financial Services, which holds excess SIPC insurance of $200 million in aggregate for all customer accounts, subject to a maximum limit of $900,000 per customer for cash. Of course, Hass makes clear that his firm has another form of protection: "Options House has never had and does not currently have funds invested in subprime or other low-grade securities."

Ultimately, the quality of assets and operations are a better place to look for protection than government-sponsored insurance.

Another Penson client, MB Trading, has access to SIPC coverage as well as insurance for $34.5 million in securities and $900,000 in cash through Lloyd's of London, says MB's executive vice president, David Lipsett.

ChoiceTrade also clears through Penson, and its coverage is similar to that of Options House: $200 million in aggregate, subject to a maximum cash limit of $900,000 per customer, in excess of the base SIPC insurance, according to President Neville Golvala.

"Firstrade Securities has unlimited excess SIPC insurance, which covers all accounts up to the total equity in the account, including all cash balances," says Vice President Peter Gschweng. Firstrade clears through Ridge Clearing & Outsourcing Solutions, which carries all its customer assets, so if something negative were to happen to Firstrade, these assets are protected, he says.

Siebert, a former banking regulator in New York State, is concerned about claims of excess SIPC coverage as provided by the insurer Lloyd's. That insurance is subject to a cap that does not cover all the assets held by the clearer. A large firm, she says, could have a cap of $600 million for its excess coverage, but its total account assets might be more than 20 times that figure.

Fuad Ahmed, president of Just2Trade [victim of NACI failure] and LowTrades, says that firms must have real-time systems to analyze customers' exposure. "It comes down to risk management and how the individual broker-dealer manages its potential risk exposure both through its own portfolio and through each client's trades," Ahmed says.

Adds Siebert, "Someone might think, 'Gee, I only have $2 million in my account and it says each account is covered to $25 million, so I'm safe.' But that is subject to the cap for the whole firm. The big firms would go through that kind of money so fast they wouldn't know what hit them. ... If my customers are going to lose their money, they want to lose it themselves. They don't want to lose it on something they thought was safe."

FRONTIER MARKETS

Emerging markets too dull for you? Try frontier markets.

Pakistan, Middle East countries, former Communist Block European countries, Africa -- these are all areas with stock markets worthy of the name so new that they constitute an investing "frontier." Is there real potential there? Chris Mayer thinks so. How do you get in on the action? Not so easy, yet ...

When the stock market turns ugly, the quest for "non-correlated assets" intensifies. A non-correlated asset is fancy Wall Street talk for something that does not move lock-step with the overall market. When the market falls, a non-correlated asset might actually rise, or at least hold its own better than the market.

Gold is a classic example. Its price tends to rise during times of stock market distress. But very few investments can rival gold's long history of non-correlation. Imposters abound. The imposters might move independently of the overall market for months or years at a time, thereby creating the impression that they are non-correlated. But when the markets really turn nasty, investors often learn that their "non-correlated" asset tumbles just as sharply as an S&P 500 Index fund.

However, some investors think they have found a reliable new non-correlated asset: "frontier markets." Merrill Lynch recently created an index not only to track them, but for investors to buy and sell them.

Frontier markets include Pakistan, Kuwait, the United Arab Emirates (UAE) and other markets throughout Africa and the Middle East. They also include Vietnam, Kazakhstan, Cyprus and others. They are individually too small for institutions to invest in, but cobble them together in a new index that allows you to buy and sell the basket and ... well, then you have something.

Merrill Lynch's new Frontier Index tracks the 50 largest companies in 17 frontier markets. Even so, the market value of all these companies combined is only about $330 billion -- or about that of General Electric. Right now, the index heavily tilts toward the Middle East, with 50% of the index in the region. Asia is the second largest component, with 23%, followed by Europe at 14% and Africa at 13%.

As for industry groups, banks usually are among the biggest companies in any emerging market. So banks and financial service companies represent about 65% of the index. Oil and gas is the next largest sector, weighing in at 13%. As far as countries go, the top three are the UAE (23%), Kuwait (18%) and Pakistan (14%).

So far, these frontier markets have lived up to their advance billing of not following the broader markets. Since September 30, for example, the frontier markets actually gained 31% while the broader market lost ground. Merrill Lynch backtested the index several years and found that between February 2000-December 2007, the index return's correlation with the S&P 500 was only 32%. Basically, that means that about two-thirds of the time, the frontier markets zigged while the S&P 500 zagged.

I love the idea of frontier investing, because I am an optimist when it comes to global trade and booming overseas markets. Maybe it is my globe-trotting that has skewed my view. But when I travel overseas, I see great opportunity. I see people building businesses. I see the impact of global market forces on local energy, food and resource markets. I see the world getting smaller.

I am long-term bullish on markets such as the UAE, Kuwait, Vietnam and others. But I also realize that the ride in some of these markets will be absolutely gut-wrenching. Just look at Vietnam. The Vietnamese economy is growing somewhere between 7-9% per year. It is a cheaper place to do business than many other parts of Asia. Hence, Vietnam continues to attract a strong flow of investment.

While I liked what I saw going on there, I found no direct investment ideas for us. The market is just too small and illiquid. Heck, before March 2002, the market traded only on alternate days. Moreover, as with most of these frontier markets, Vietnam suffers from poor disclosures and low transparency. When you invest here, you are really not sure what you are getting.

I remember listening to Carlo Cannell, a very good investor at Cannell Capital, talk about his trip to Vietnam and his investments there. This was back in May 2007. The theme was investing in the dark. In Vietnam, he basically made many blind bets on lots of companies, figuring enough of them would work out. But the market has tanked since then.

Perspective, though, is everything in markets. [The] chart looks nasty, with a near 50% drop from the high in less than a year. But as recently as July 2005, the index was only 250. You would still have more than doubled your money in less than three years. In 2000, it was only 100. Investors are still up 6-fold from 2000, which is a lot better than an investment in the S&P 500 Index. And that is really the key to the whole frontier market idea. As an investor, what is most important is what happens over the years.

I am skeptical of the idea of frontier markets as an "non-correlated asset" for all seasons. Links between these small markets and their bigger brothers are probably stronger now than in the past. Vietnam, for example, depends heavily on foreign investment. Vietnam's currency, the dong, is still linked with the dollar. So we have to be careful in taking the past and saying the future will work the same way.

On their own merits, as growing economies, I like frontier markets for the long haul. Unfortunately, only institutions can buy Merrill's index for now. But individual investors can still invest in frontier markets through mutual funds. The recently launched T. Rowe Africa & Middle East Fund (TRAMX) is one. Just be sure you can stomach the major gyrations that come with working the frontier of investing.

I am also watching the activities of individual companies in these markets. This may be a safer way to go -- a back door into the frontier markets, you might say. Many of our companies are in these markets one way or another. Take Hutchison Telecom (HTX), for example. It has got businesses in Vietnam, Ghana, Sri Lanka and Indonesia.

In any case, I think frontier markets will have a bigger role to play in portfolios in the years ahead, whether they are truly non-correlated or not. Worst case, you will lose money in many different languages, not just English.

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