W.I.L. Finance Digest for Week of December 1, 2008

LEVERAGE AND PAIN

Consumers are replacing a 25-year borrowing and spending binge with a saving spree.

A. Gary Shilling has been pretty much correct in his forecasts for deflation and subdued economic activity. Seemingly rare among commentators who appear in mainstream publications, he incorporates obviously significant statistical trends into his thinking, such as that household debt rose from 45% of GDP in 1973 to 98% by the end of last year. Meanwhile, gadflies like Bob Prechtor and Peter Schiff have been pointing to such statistics for years, and have largely been ignored for their efforts -- until now.

Shilling believes the credit bubble unwinding and readjustment process is going to take years. Even after a recovery starts, he foresees slow economic and profits growth prevailing. Ergo, unlike David Dreman below, Shilling is in no rush to own stocks.

Painful financial deleveraging has given us an excruciating global recession. It may cause even deeper pain ahead. The slashing of borrowing comes after spectacular buildups in the financial and consumer sectors. The combined debt and equity of U.S. financial institutions went from 10% of GDP in 1973 to 118% at the end of 2007. Over the same period household debt, including mortgages, rose from 45% of GDP to 98%. Is it any surprise that this borrowing binge ended in a credit crisis?

The ending of a credit crisis entails deleveraging, which is to say, the liquidation, repayment or cancelation of debt. This process engenders pain.

Consumers dropped their saving rate from 12% in the early 1980s to zero 20 years later. They did this while persuading themselves that watching a rising stock portfolio or living in an appreciating house was a form of saving. The stock market crash at the turn of the century did not bring them to their senses, because by then the house price boom was under way. Now there is no asset left with which to play the savings fantasy game.

Stocks are not much higher than they were at the 2002 bottom. Houses are en route to what I forecast will be a 37% peak-to-trough falloff. Consumers are tapped out. Their credit cards are maxed out, and home equity lending is dead. Heavy borrowing pushed their equity in autos and other durables from 60% in the early 1990s to 40% today. Their $3 trillion in 401(k) plans at the end of 2007 has taken a beating as stocks have swooned.

So people are shrinking their discretionary outlays on everything from motorcycles to liquor. They are replacing a 25-year borrowing and spending binge with a saving spree. Over the last quarter-century consumer spending grew an average of one-half a percentage point per year faster than aftertax income, adding about a third of a percentage point to GDP growth. For the next decade spending is likely to rise a percentage point slower than income each year. Consumer spending constitutes 70% of GDP, and the effect of that restraint is multiplied as it ripples through the economy. As a result real GDP growth will drop by a full percentage point from its earlier 3% rate to 2%.

The saving spree will be reinforced by the fact that baby boomers desperately need to save for retirement, while those in their 20s and 30s, typically big spenders as they form households, are much fewer in number. The threat of deflation also depresses consumer spending. People are waiting for lower prices before buying houses, and they will wait to buy other things, too.

Capital spending will also be subdued, as slowing growth makes for excess capacity. Forget exports as a source of strength. American consumer restraint will slow imports, hurting foreign lands that depend on the U.S. for export growth and depressing their own demand for American products. Hence the clamor these days for government spending as a form of stimulus.

The BRICs will sink like bricks.

The BRIC quartet (Brazil, Russia, India and China) and other developing countries will sink like bricks as their exports drop and as commodity prices collapse, driven down by both enfeebled global demand and the end of the delusion that commodities are an asset class like stocks and bonds. China doesn't have a big enough middle class of free spenders to offset export weakness there (see my May 19 column,"Chinese Chance"), and the end of the oil boom will slash Middle East economic growth and hobble the petroleum-addled dictators of Venezuela and Russia.

Deleveraging threatens economic growth in many countries that have depended on Western bank generosity. Iceland is bust. Baltic nations, and eastern European ones like Hungary, are in for years of sluggish growth, with homeowners no longer able to borrow cheap money abroad. Argentina, already a pariah to international lenders, is setting an ugly precedent in grabbing its private pension funds to repay its debt.

The demise of securitization and other derivatives and the return to basic banking -- lending prudently at profitable interest rates -- will reduce credit availability for years and subdue economic growth. Big firms cannot float commercial paper; little ones cannot get bank loans to meet their payrolls. The accelerating consolidation of financial institutions will eliminate many risk-taking lenders, and entrepreneurs will be inhibited by the scarcity of venture capital money.

So even after the financial crisis and recession end, maybe by 2010, slow economic growth and poor profits are likely to drag on. Do not be in a rush to buy stocks.

LEAVING 2008’S WRECKAGE BEHIND, FORBES PANELISTS TAG 17 WINNERS AND LOSERS FOR 2009

A year ago Forbes asked 17 panelists for their long or short picks for the year ahead. In retrospect, of course, the choice was between being long and wrong or short and sweet. To their credit the bears' picks did far worse on average than the awful market as a whole. The longs' picks fell slightly less than the market, for whatever consolation that is. Here are the picks for the coming year.

Worthy of note among the bear picks are Parker Hannifin and Caterpillar -- not blue chips, but quality companies nevertheless. The bears apparently believe the ongoing economic slowdown is not fully reflected in the stock prices.

For the 12 months ended October 31, the S&P 500 lost 37%. Happily for the five bears in our annual equities contest, their picks did considerably worse. In October 2007 we challenged them each to name one stock that would trail the S&P over a one-year period. On average their stocks fell 61%. All five accepted our customary invitation to the winners to play again another year.

Our panel's 12 bulls scraped by. Only five of their picks beat the market, and only two of those showed gains. As a group they declined 37%, same as the S&P 500.

Richard Jandrain, head of growth investing at Fort Washington Investment Advisors, leads the bulls. A year ago he liked the look of Pharmion, a developer of cancer treatments. So did Celgene (NASDAQ: CELG), which acquired Pharmion last March and helped Jandrain to a 50% gain.

For 2009 Jandrain switches to the health services side with Eresearch Technology (NASDAQ: ERES), which specializes in computer systems used by drug and device companies to analyze data from electrocardiograms. "They have been a leader in [electrocardiographic] testing for the last 30 years," he says. The stock changes hands at eight times analysts' consensus forecast for 2009 profits.

At the head of last year's bear class: Barry James of James Investment Research. He warned in the fall of 2007 that a slowing economy would pose big problems for Circuit City Stores (NYSE: CC). He was not wrong. In its last four quarters the electronics retailer lost $607 million, while its shares fell below a buck, and the company recently filed for bankruptcy. James called the stock a loser at $8.

Barry James turns his attention now to casino operator Las Vegas Sands (NYSE: LVS), whose share price has crumpled over the last 12 months as the company began to lose money. James suspects a punk economy will keep the pressure on. "Do I continue to pay the mortgage and pay for health care or [take] the weekend trip to Vegas?" he asks. Another red flag, in his view: Las Vegas Sands's total debt stands at more than four times its shareholder's equity.

Harindra de Silva, president of Analytic Investors in Los Angeles, continues his remarkable run as a bear in our contest. He has been at this since 2003, and the 12-month performance of his yearly picks averages out to -19%. Fresh off his 59% dip on Yahoo! (NASDAQ: YHOO) last year, De Silva returns with a glum view of Caterpillar (NYSE: CAT), citing high levels of insider stock sales and downward revisions on earnings forecasts from equity analysts.

Honorable mention for the 2007-08 bulls goes to Robert Millen, chairman and portfolio manager at Jensen Investment Management. As subprime turmoil began to shake the financial sector in autumn 2007, he stuck with Wells Fargo (NYSE: WFC) and its "conservative credit philosophy." The stock ended the 12 months up 4 cents.

Millen now likes Waters Corp. (NYSE: WAT), a $1.6 billion (sales) manufacturer of lab equipment and supplies. Among the company's specialties: liquid chromatography, a technique for analyzing a substance's chemical components. Millen applauds Waters' strong market position and steady revenues from parts and service. Other positives: a 57% gross margin and relative resistance to economic turmoil.

Our 7 Love-Only-One newcomers are all bulls. Michael Balkin oversees small-cap growth investing for William Blair & Co., a Chicago investment firm tending to $35 billion in client assets. Balkin's choice: dg FastChannel (NASDAQ: DGIT), whose networks digitally transmit audio, images and video from 5,000 advertisers and ad agencies to 21,000 media outlets. Balkin expects the company to thrive from next year's conversion to high-definition television and growth in Web and mobile ads.

We get another growth pick, Omnicell (NASDAQ: OMCL), from Bernard Lirola, a portfolio manager with the asset management arm of investment bank Needham & Co. Omnicell develops medical systems such as dispensing cabinets, outfitted with bar code scanners and computer screens, to help nurses and pharmacists retrieve and review medication. Even in a tough economic stretch, he believes, Omnicell should enjoy earnings growth above 15% thanks to a robust backlog, an expanding market share and the fact that hospitals have a good history of eventually paying their bills.

J.B. Taylor comanages the $467 million Wasatch Core Growth Fund, which won one of 10 spots on our September mutual fund Honor Roll. He likes car auctioneer Copart (NASDAQ: CPRT), which over its past four quarters netted $157 million on sales of $785 million. Taylor foresees overseas expansion.

Matthew Kaufler runs the Touchstone Value Opportunities Fund at Clover Capital Management, a Rochester, N.Y. outfit with $2.6 billion in assets. He picks Zale Corp. (NYSE: ZLC), which retails jewelry at 1,400 stores in North America. Zale has been trimming head count, inventory and shares outstanding. Kaufler thinks more such steps are likely. He also expects the company to post earnings of $1.25 per share for the fiscal year ending July 2009. The stock trades at 11 times that sum.

Another value manager entering the lineup is Jason Ronovech of Albany, New York's Paradigm Capital Management. Ronovech spies a bargain in Endo Pharmaceutical Holdings (NASDAQ: ENDP), which sells Percocet and other anodynes. Endo's stock, selling for two times sales, has suffered on worries that flagship products Lidoderm and Opana will lose patent protection. But Ronovech expects profits to hold up long enough for Chief Executive David Holveck, a Johnson & Johnson alum hired in March, to set the company on the right path.

Once Wachovia Securities' chief equity strategist, Douglas Sandler now helps set the direction for $200 million in client assets at Riverfront Investment Group in Richmond, Virginia. For 2009 he gives the nod to Cisco Systems (NASDAQ: CSCO) on the strength of its $26.7 billion in cash, versus $6.3 billion in long-term debt, and the inexorable growth in mobile computing and Internet video. The stock is priced at 2.5 times sales, against a historical average of 5 times.

Securities analyst Adrienne Tennant of fbr Capital Markets tracks 16 companies in the business of retailing clothing. Tennant, who came to equity analysis via finance stints at the Gap and Disney, tries her luck on Hot Topic (NASDAQ: HOTT). She argues that the $735 million (sales) retailer, which caters largely to teenagers, is showing signs of life in several categories. Its strong balance sheet will allow it to weather a period of weak mall traffic.

A table listing all of the picks is here. Last year's long/short picks are listed here.

IT IS TIME TO BUY

There is an endless choice of quality businesses trading at or near liquidation prices.

Veteran Forbes columnist, author, and value investing promoter and money manager David Dreman is sticking to his longtime message: Buy cheap stuff, and do not try to time the market because you are likely to miss out on the big market up-days which are so important to catch. He likes stocks because they hold their own against inflation over time, and he expects serious inflation from all the current money creation once we emerge from the current troubles.

Chastened -- we would guess -- by some disastrous financial stock recommendations earlier this year, and consistent with the return of inflation thesis, Dreman is recommending oil and other natural resource stocks.

We have plunged into the worst financial crisis since the 1930s. The leadership of Treasury Secretary Henry Paulson and Federal Reserve Chief Ben S. Bernanke in fighting it has been sluggish and inconsistent. Although we have just elected a new President and Congress, they will take time to develop policies to stimulate the economy and promote liquidity. What is an investor to do?

First, do not flee the market by selling your quality stocks. Yes, it is the worst bear market since 2000-02, and stocks are trading at valuations not seen in decades, but equities will come back. Second, because credit is subject to unpredictable crunches and it is impossible to guess when this bear will end, do not buy on margin. Third, do not hold shares of companies that will need cash to expand or refinance. There is a good chance they will not be able to borrow.

Fourth, keep your bond maturities very short. When governments face economic crisis, they print money. The magnitude of this crisis suggests that the printing presses will be running around the clock for some time. That means we will see serious inflation when we emerge from the recession. Long-term bond prices could then drop even more than equities already have dropped. Stocks, by contrast, hold their own over long stretches of inflation.

How patient do you have to be? Some economists argue that it will take years to recover from the worldwide collapse we are facing. I do not agree. The Fed and Treasury may have handled the crisis ineptly so far, but the U.S. and every other economic power know only too well the lessons of the Great Depression. Nobody will try to fight the recession by raising interest rates, or by closing the door to imports, as we did in 1930 with the Smoot-Hawley Tariff Act. We are already seeing real global cooperation to prevent true disaster, such as early October's coordinated rate cuts by the Federal Reserve, the European Central Bank, the Bank of England and the central banks of Sweden, Canada and Switzerland.

Panics invariably provoke investors to make the wrong moves. So resist the panicky calls from many of your friends (and some experts) to move to cash while you still have some savings left.

And if you have uninvested cash? There is almost an endless choice of quality businesses trading at or near liquidation prices. Start with oil companies and producers of raw materials. In a panic, people think growth is gone forever. These stocks reflect that misapprehension.

Oil exploration and production companies have fallen as sharply as has the price of oil. Three to look at: Encana (44, ECA), with a price/earnings ratio of 7 and a yield of 3.7%; Nobel Energy (47, NBL), P/E 6, yield 1.4%; and Parallel Petroleum (3, PLLL), P/E 4. Other oil stocks I would consider are Chevron (70, CVX), P/E 6, yield 3.7%; Occidental Petroleum (46, OXY), P/E 5, yield 2.8%; Valero Energy (18, VLO), P/E 4, yield 3%; and Transocean (70, RIG), P/E 5. Also look at these raw materials companies trading at a small fraction of their former highs: Rio Tinto (152, RTP), P/E 4, yield 4%; and Freeport- McMoran Copper & Gold (23, FCX), P/E 3, yield 8.7%.

BOND BUYER’S DILEMMA

The bond market is bracing for deflation, yet inflation looks like the greater threat. Our advice: Buy TIPS.

The inflation vs. deflation debate continues. Forbes talked to a few well-known, highly respected academics. Like many of us, they cannot quite believe their eyes that we are seeing an honest-to-goodness deflation. They too see the Fed money pump working in overdrive overtime and think the piper will eventually have to been paid. We are certainly sympathetic. Remember this, though: The market can stay irrational longer than you can stay solvent.

The economic numbers are scary. October car sales were off by a third. Retail revenues (before subtracting inflation) fell 4.1% from a year earlier. Housing starts are at their lowest level in at least a half-century. About the only things that seem in high demand are "For Sale" signs and that perennial recession staple: Spam. [Of the quasi-food sort, not email.]

At first blush it looks as if the “D” word is upon us. Not "depression" but "deflation" -- the vicious phenomenon in which falling spending begets wage and price cuts, which beget further spending cuts in a debilitating downward spiral. That, anyway, is what the bond market is suddenly signaling (see chart).

A year ago investors priced Treasury Inflation-Protected Securities based on the expectation that consumer prices would rise 2% a year over the next half-decade. These days 5-year TIPS are yielding 0.5 percentage points more than 5-year Treasurys, implying prices will fall 0.5% annually. The last time U.S. prices fell consistently was in the midst of the Great Depression.

If prices merely flatline for a few quarters they could ignite "waves of bankruptcies," says Joseph Stiglitz, the Nobel Prize-winning economist. That is because many firms went into debt counting on a whiff of inflation to bail them out. Commercial real estate investors, for example, made heavily leveraged investments assuming they could hike rents. Deflation would turn such plans into financial disasters.

Merrill Lynch chief economist David Rosenberg expects prices to fall at an annualized 1% or 2% a year from now, and lays 50-50 odds the drop will continue through the first half of 2010. "It's going to be a very steady and significant decline," Rosenberg says. "You have deflation in commodities, labor markets, assets and credit."

His advice: Buy zero-coupon 30-year Treasurys, which have been rising sharply as the economy slows. Rosenberg's is a cogent case in view of recent data. But the danger is that this bull market in Treasurys is about to end. Inflation might replace deflation. If that happens, those zeros will get clobbered.

That is something with a high probability of coming true, according to the majority of big thinkers Forbes contacted. As Milton Friedman famously said, "Inflation is always and everywhere a monetary phenomenon," and in the past two months the Federal Reserve has injected money into the economy as never before. One broad measure, the adjusted monetary base, has risen $11 billion a day to $1.3 trillion since early September. That is a jump of nearly 50%.

The federal government, meanwhile, is on track to run a $1 trillion deficit as it throws money at banks, insurers, carmakers and, possibly, cities, homeowners and taxpayers as well.

Carnegie Mellon University economist Allan Meltzer acknowledges that falling oil and food prices could lead to a quarter of general price declines. But he insists that is not really deflation: a sustained drop in prices that gets baked into expectations and stifles economic activity. He scoffs at the notion that, at a time when the money supply is on steroids, deflation could be a serious danger.

"People who say deflation is a threat are either rumormongers or ignorant," Meltzer says. "They need to take a refresher course in economics."

That may be so, but what about those TIPS spreads? William Poole, former president of the St. Louis Federal Reserve, says noise from the financial crisis is distorting TIPS's message. TIPS are priced for deflation, he says, not because people expect prices to fall but because investors have been eager to get the relatively high liquidity of straight Treasurys.

Nobel laureate Edmund Phelps also finds bond market predictions of falling prices screwy and says he "can't imagine" deflation is a serious risk, given the liquidity the Fed is pumping into the economy.

In contrast, he warns that money could become a lot more expensive. Phelps has been tracking real interest rates, which exclude inflation adjustments, and he does not like what he sees. On 5-year TIPS, the real rate jumped from 1% in March to a recent high of 3.13%, implying that the credit crunch is forcing even the U.S. Treasury to pay more for money.

Phelps is also fearful some European and Middle Eastern investors could grow weary of financing our government spending, causing prices to tank and yields to shoot up. With previous deficits, he says, "we had a superabundance of foreign savings save the day. But bailouts entail such a huge increase in the public debt they could raise rates for bondholders of all kinds."

Another concern is whether the Federal Reserve will have the intestinal fortitude to turn off the money spigot at what could be a politically perilous time. The moment of truth could come if the Fed senses early signs of inflation while the recovery is still weak, unemployment high and pressure intense from the Obama Administration to keep rates low.

"We know how to control inflation, but will we have the willpower to do it?" asks Carnegie Mellon's Meltzer.

Former St. Louis Fed chief Poole says the odds are one in three that core inflation (which excludes oil and food prices) will average 4% annually within a few years. That might not sound apocalyptic, given price rises of the past few years. But it would be 1.7 percentage points more than the yield on 5-year Treasurys bought today. Poole suggests buying 5-year TIPS. They pay a 2.8% yield on a redemption value that goes up and down with the cost of living but cannot sink below the original issue price.

Shopping for Junk

Risk-averse investors have been fleeing the high-yield market. Sabur Moini says that has made for some great buys.

Junk bond debt may be risky, but it has been a better shield against losses lately than stocks. The Merrill Lynch High Yield Master Index is down only, so to speak, 25%. To point out the obvious, simple mathematics says that something down 25% only has to rise 33% to break even, whereas something down 50%, such as the average stock, has to double.

The Payden High Income Fund, managed by Sabur Moini, is down 20% -- less than the benchmark Merrill junk index. Moini likes higher quality junk, and it shows up in lower yields. The fund's current yield is around 10%, versus many credits in the sector which yield well into the teens. The 10% is still a huge spread over equivalent duration U.S. Treasuries -- whose yields look absurdly low, we should interject. The big question in our mind is how much this 10% yield can fall, thereby adding potential capital gains to the non-skimpy current return. The spread on junk vs. T-notes definitely has some downside, but the absolute yield on the later has some real upside.

Asking a junk bond manager if high-yield debt is a buy is like asking a barber whether you need a haircut. Even so, Sabur Moini, who runs the Payden High Income Fund, makes a persuasive case that junk is too cheap today.

The gist of Moini's thinking: Investors have fled junk bonds for safe Treasurys, forcing mutual funds and hedge funds to dump holdings to meet redemptions. That has left some respectable credits in a market yielding 16 percentage points over 5-year Treasurys. That is the widest spread ever, and it implies that defaults will rise from an annualized 3% recently all the way to 15% -- higher even than the 13% during the 1990-91 recession, when Drexel Burnham Lambert blew up.

"We see an incredibly compelling market right now," says Moini. "Yields have never been anything like this."

Another positive of a depressed market: You have generally got excellent protection against the issuer calling in your bonds. HCA's bonds, for instance, are trading at 87 cents on the dollar with a 9.125% coupon. If the hospital chain wants to call in those bonds, and deprive you of your high yield, it will have to wait until 2010, three years after the initial issuance, and it will have to pay you 105 cents on the dollar for the luxury. Investment grade bonds, by contrast, tend to give issuers greater flexibility in calling in bonds and the ability to do so on less favorable terms for investors.

Moini concedes what is cheap sometimes gets cheaper, and we do have an evidently nasty recession under way. Forbes columnist Marilyn Cohen conservatively recommends staying out of the junk market for now.

Moini, 46, agrees things could get ugly for many junk issuers but insists careful shoppers can avoid most blowups. He has a decent record of doing so. A Pakistan native, he grew up in Washington, D.C., listening to his father, a World Bank economist, discuss the risks of lending money to shaky governments, like the Shah of Iran's. Moini earned an M.B.A. from UCLA and went to work in 1995 investing in high-yield bank loans for SunAmerica. He moved to Payden & Rygel eight years ago.

It has been instructive, Moini says, to run a junk portfolio in Los Angeles, which he calls "ground zero" of the subprime crisis. "I saw it all. People flipping houses. Gardeners and maids living in half-million-dollar homes," he says. He avoided bonds issued by housing-sensitive companies Residential Capital (subprime lender) and Realogy (real estate agents). Payden High Income is down 19.6% over the past 12 months versus the Merrill Lynch High Yield Master Index's 25% loss.

As manager of a fund with a mere $187 million in assets, Moini focuses on sub-$300 million issues that big junk shops like Pimco tend to skip. These days he is aiming at upper-end bonds rated B or BB. He seeks out firms whose debt is no more than five times their operating income (in the sense of EBITDA).

Moini owns B+ rated debt from Davita 6.625%, due February 2013, trading at 92 cents and yielding 8.9%; the dialysis provider derives 70% of revenue from government reimbursements. American Achievement sells yearbooks and class rings to graduating high schoolers; its B rated 8.25% bonds mature in April 2012, and at a recent 92 cents are yielding 11%. Iron Mountain stores corporate files; its 7.25% B+ rated issue is due January 2015 and, at a recent 90 cents, is yielding 9.9%.

Unless you are putting millions into the market, you are probably better off in a fund than in individual bonds. An expanded version of the table below can be found here.

Eeny, Meeni, Muni, Moe

Yields on municipal bonds are luscious these days. Here are a few things to think about before plunging in.

Those investors who are looking seriously at fixed income instruments should consider alternatives to U.S. government issues, which have absurdly low yields (see "The New Asset Bubble Is Treasury Bonds and T-Bills"). Corporates, both investment grade and junk, are one option. Preferred stocks and closed-end fixed income funds are another.

Municipals, covered here, are yet another. These days one gets historically high yields vs. Treasuries, and those yields are largely tax exempt (with some exceptions, noted below) to boot. Offsetting risks include the possibility of default and of early call if yields fall subsequent to purchase.

In early October California was so short on cash that Governor Arnold Schwarzenegger wrote U.S. Treasury Secretary Henry Paulson warning of yet another entity in need of a federal bailout. Dramatic, even for a Hollywood actor. Within two weeks California had raised $5 billion by issuing notes backed by tax revenue the state will collect in spring 2009. The state had to pay a usurious 4.25% yield on the 8-month paper, triple what the U.S. Treasury pays. This despite the fact that the California paper, but not the T-Bill, is exempt from federal income tax.

The municipal bond market, in case you had not noticed, is in a state of turmoil. In normal times tax-exempt general obligation bonds from creditworthy states and cities pay somewhat less than U.S. Treasury bonds of like maturity. Investors are willing to accept a lower yield on the muni (and put up with a risk of an early call, a risk almost absent from the Treasury market) in return for the tax exemption. These are not normal times.

The average AA-rated state bond due in 20 years yields 5.3%. That is 120% of the yield on a 20-year Treasury. For most of the past 15 years the 20-year aa muni average yield has been 88% or less of the corresponding Treasury yield (see chart).

What is depressing the prices of municipal bonds, and thus forcing up their yields? One big thing is that some banks and insurance companies with mortgage-related losses have been unloading muni bond holdings. But there are four good reasons wealthy individuals, the mainstay of the muni market, have been hesitating to buy.

The first and biggest risk with a municipal bond is inflation, which would soon entail higher interest rates, which would in turn make a low-coupon bond worth less. That is a risk with Treasurys of long maturity, too, so it does not explain the inverted yield relationship with Treasurys. It is simply a reason for you not to go whole hog into long-term muni bonds.

To mitigate the risk of rising rates, go short with some of your money. John Miller, chief investment officer at Nuveen, who runs munis for the company, suggests splitting a muni bond fund portfolio 60% to 40% between short or intermediate funds and long-term ones.

Next, early call. If we get deflation instead of inflation, bondholders will want to cling to their 5% coupons, but muni issuers will snatch them away by redeeming the bonds early and refinancing at lower rates (just as homeowners do with their mortgages). Most munis are callable. Most Treasurys are not.

Third is default. This is a distinct risk on so-called revenue bonds -- those backed by a project or a private company rather than a government's taxing authority. It is a rare but not impossible occurrence on government-backed bonds. In 1994 Orange County, California defaulted, although savers who waited patiently eventually got the cash they were promised.

The fourth hazard is taxes. The federal government counts "tax-exempt" interest in figuring how much of your Social Security benefits are taxable and how much you have to pay for Medicare benefits. Also, the regular income tax hits you up for the portion of your yield that comes from any discount in the price you pay. Finally, the alternative minimum tax nails interest on some revenue bonds. If you are likely to be subject to the AMT, inquire before buying a bond or a bond fund.

Should you buy bonds or a bond fund? A no-load bond fund is a very liquid investment and makes sense unless (a) your portfolio runs to several million dollars or (b) you know you will hold all your bonds to maturity. For a table of some of the best available muni bond funds, go here.

Should you go out of your way to buy a fund containing only bonds from your home state, so as to avoid both federal and state income tax? That is a moot question in eight states that do not tax any muni interest: Alaska, Florida, Indiana, Nevada, South Dakota, Texas, Washington and Wyoming. If you live in a tax-happy populous state with a lot of choice in bond funds (California or New York, for example), a double-tax-free muni fund can make sense.

Watch those overhead costs. Residents of low-issue states such as Arizona do not have any cheap single-state muni funds to buy. With the Franklin Arizona Tax-Free Income Fund an in-state investor earning $150,000 a year avoids a 4.5% state income tax. Applied to the 4.75% yield on a national muni fund, that tax costs you 0.21% of your assets annually, or 21 basis points. But you can deduct Arizona taxes on your federal return (unless you pay the AMT). So the tax cost of an out-of-state muni bond shrinks to 14 basis points. Vanguard has national muni funds with expense ratios of only 0.15%. The Franklin Arizona fund runs 48 basis points more, and carries a 4.25% front load. It does not begin to cover this added burden with the tax benefit.

A short table of "top performers with cheap expense ratios and relatively affordable buy-ins" is given here.

BARGAINS ABOUND AMONG PREFERREDS AND CLOSED-END FUNDS

Unlike David Dreman above, fellow Forbes columnist Richard Lehmann favors fixed income securities over stocks. He believes that as a modicum of confidence returns to the credit markets their prices will recover, while stocks face an undetermined period of declining earnings. The special situations he recommends look interesting enough.

The financial crisis has eased back from panic, but recession is still upon us. Common stocks and income securities both suffered mightily as investors were driven to worry not just about companies' earnings but also about their very solvency. We are all feeling better about solvency now, thanks to the government's interventions, but no one is optimistic yet about future earnings.

We are at a stage, though, where the fixed-income market has been reassured and can be expected to gradually recover as a deepening recession drives down interest rates. The stock market, on the other hand, faces declining earnings for an as yet unpredictable time. Therefore the place to be for the immediate future is in fixed income.

Some parts of the income market have been beaten down more severely than others for reasons that have little to do with risk. They are where the best opportunities will be found. One of the hardest-hit areas is preferreds -- not preferred stocks but bond issues packaged as interest-paying and exchange-traded preferred securities that usually have a $25 par value. They are designed primarily for small investors who do not have the multimillion-dollar portfolios that would justify $100,000 round-lot trades.

In the past these preferreds enjoyed higher yields and less volatility than bonds, mainly because large institutions do not bother to deal in such small issues. In the current financial crisis this advantage turned into a disadvantage when small investors, panicked by the meltdown, rushed to sell. The market in the preferreds was not deep enough to handle the resulting volume, so prices plummeted. Yields for many of these issues are still out of line with those of the bond market, with many yielding one to three percentage points more than the bonds that underlie them. This is partly because their limited, little-known market can make them harder to unload; partly because investors are staying away from any kind of securitization right now; and possibly also because of a false fear that they could be vulnerable to the fates of some of the firms -- Bear Stearns, Lehman Brothers, Merrill Lynch -- that created them.

A good example is the Goldman Sachs 6% PPlus (15, PJI), which yields 10.2% to maturity versus 8.9% for the underlying bond. This $80 million issue, which is to be redeemed in 2033, represents claims on Goldman bonds due that year. The share price's 40% discount from redemption value almost entirely insulates you from call risk. The S&P credit rating on Goldman debt is aa--. With issues like this you get a nice income and the prospect of a capital gain.

Another buy is the Credit Suisse 6.25% PPlus (17, DKY), with a 10.1% yield, versus 7.2% for the AA-- bond, due in 2032. Also, Motorola's 8.2% corporate-backed trust certificates (12.65, XFH), yielding 17% while the bond yields only 13.2%; it matures in 2097 and gets a BBB credit rating. Acquiring one of these is like buying a closed-end fund for less than its net asset value. If you insist on only the very highest quality, consider two General Electric 6% preferreds, GEC and GEJ. They both trade at 21 and yield 7.1% to maturity in 2032 and 2037. GE still enjoys an AAA rating, although the pricing of default insurance on GE debt suggests that Wall Street thinks the rating agencies are being a little too kind to the company.

A second fixed-income area that has been beaten down is closed-end income funds. They rely on leverage of up to 30% to enhance their returns. When that leverage drove down their NAVs, investors unloaded them, depressing their prices. But just as leverage hurt them on the way down, it should speed up their recovery. My favorite among these is Cohen & Steers Select Utility Fund (12, UTF), which sells at a 17% discount to net asset value, yields 21.5% and bears an annual expense burden of 1.5%. Also look at Flaherty & Crumrine Preferred Income Fund (6, PFD), with a 13.8% yield and a 1.9% expense ratio. This fund sank to a 13.5% discount to net asset value because it had to push back payment dates of its monthly dividend for short-term technical reasons. I detail many more candidates for recovery in my Forbes/Lehmann Income Securities Investor newsletter.

Resist reaching for yield by buying B-- and CCC rated issues. They are too vulnerable to default, which becomes common during a recession. Also avoid foreign financial preferreds. They are noncumulative -- their dividends do not accrue and have to be paid before distributions to common shareholders -- and that is a real concern at a time when some of their issuers are being propped up by capital injections from their host governments.

WALL STREET ROULETTE

October’s market drop has left lots of stocks looking cheap relative to earnings projections, if those earning pan out. Big “if.”

Wall Street analysts almost always overestimate earnings. And when a recession hits they are almost always way high, by an average of 30 to 35%. Yet everyone is supposed to credulously value stocks and make buy and sell decisions based on these estimates.

One can always apply some sort of standard haircut to the estimates for one's own purposes, yet one might think Wall Street itself would take account of its own biases and poor results and do the adjusting itself. But no. Certain what are euphemistically called "institutional biases" persist. Just as an alchoholic is "biased" towards taking another drink, Wall Street earnings estimates are biased high.

So before buying stocks based on their allegedly cheap P/E ratios, make sure you are not relying on a bogus "E". Better yet, figure out what the company is actually worth. This will depend on a company's earnings power over a whole economic cycle, not just one year. The whole emphasis on single-year earnings is misguided.

By historical standards stocks look cheap these days. The S&P 500 is trading for ten times the $91 Wall Street analysts say it will earn next year. That is a 43% discount to its average price/earnings ratio over the past half-century.

Does that mean it is time to tame your demons, cash in your bank CDs and dive into equities? Only with extreme caution.

At what is one of the most volatile periods in market history, the only certainty is that the numerator in price/earnings calculations -- stock prices -- is a lot lower than it was a few months ago. Since September 30 stocks have fallen 22%. That leaves the S&P 500, as of November 13, down 42% from its high 13 months earlier.

The wild card in calculating whether stocks are cheap is the denominator -- earnings. Historically analysts have gone into recessions, like the one that probably started early this year, with wildly optimistic earnings forecasts. In the past three recessions, analysts have overestimated earnings by an average of 30% to 35%, figures MKM Partners economist Michael Darda. Once the downturn begins to bite, analysts have been slow to pare estimates back, leaving anyone who is paying attention with the impression that stocks are far cheaper relative to future earnings potential than is actually the case.

True to form, industry analysts are now scrambling to slash their 2009 outlooks. In November, more than a year into a market downturn that has threatened Morgan Stanley's survival, the 17 analysts who cover the company cut their 2009 mean earnings estimate by 36% to $3.63 per share.

Only days before Macy's November 12 announcement that it swung into the red in the third quarter, the 17 analysts who follow it cut their 2009 outlook 44%, to $1.11 per share (see table). The 24 analysts who cover home goods retailer Williams-Sonoma have pared their estimates 80% in the past three months, to 31 cents a share.

Despite such drastic revisions, analysts have trimmed their 2009 earnings estimates by a modest 7.5% so far for the S&P 500 as a whole, according to Thomson IBES. For their current projections to prove accurate, earnings will have to grow 15% next year to $91. That is down from the 24% gain analysts were expecting two months ago. It is before nonrecurring items, which knocked $12 off the net in the first nine months of 2008.

Jeremy Grantham, chairman of Boston's GMO, which manages $100 billion, says 2009 projections are vastly overstated. Grantham says S&P 500 earnings could easily drop 30% to $65. Even if the S&P 500's forward P/E ratio remains flat at 10 times estimated 2009 earnings, that would bring it down 29% to 650. Grantham, by the way, thinks the index is close to fairly priced at its November 13 close of 911. But he notes that bear markets overshoot as often as bull ones do. So he guesses that the index will bottom out between 600 and 800.

Why do analysts tend to be so wrong? At least in part because of the biases baked into the system, innocent or otherwise.

Robert Arnott, chairman of Research Affiliates in Pasadena, California, oversees $30 billion, most of it in passive index funds (stocks and bonds). He says analysts are tacitly encouraged to put out bullish forecasts to support firms that their investment banking colleagues have underwritten and to encourage investors to "pull the trigger" and buy.

"Sell decisions are much more difficult," says Arnott. "People tend to put them off."

Another problem is that Wall Street's "bottom-up" industry analysts generally focus in on the sectors they cover. An auto analyst will watch model changes, ad campaigns, industry sales trends and guidance from company management -- which tends to steer them toward operating earnings and away from one-time items, which can be both substantial and unrelenting.

Such baggage aside, bottom-up analysis can work fine when the economy is chugging along. But it leaves a big blind spot when, say, a subprime lending crisis cascades into a financial crisis that morphs into a broad recession.

In times like that "top-down" earnings estimates, put out by economists, strategists and the like, and focused on macroeconomic trends, tend to be more conservative -- and more accurate. Here is a telling statistic: Standard & Poor's industry analysts expect S&P 500 earnings to come in at $94 next year. Its economists are calling for $62, or 1/3 less.

"The macroeconomic environment is deteriorating much faster than guidance from management, which is what bottom-up analysts use to derive their estimates," says Michael Pento, senior market strategist at Delta Global Advisors. "I would expect operating earnings to be much lower in 2009 than analysts' projections."

As disconcerting as analysts' excessive optimism are the massive discrepancies in the conclusions they draw from digging through what is mostly the same data.

The 17 analysts covering paper products giant Weyerhaeuser expect it to earn as much as 75 cents or to lose as much as $1.50, per share. At their recent $33 the shares are going for a P/E of between 44 and a number best characterized as "not meaningful."

Eleven analysts cover Overseas Shipholding Group (market cap: $1.1 billion), whose 112 tankers ferry petroleum and gasoline. The highest forecast, by Stephen Williams at Simmons & Co., pegs earnings next year at $10.08 per share, Bloomberg says. The lowest, by Rikard Vabo at Fearnley Fonds ASA, calls for $3.36. At a recent $39, the stock is either a screaming buy at 4 times earnings, or a so-so one at 12. Fidelity Investments seems to like OSG; four of its funds are among the shipping firm's 10 biggest owners, with a combined $208 million stake.

The oil and gas business is just as inscrutable. (And we cannot blame the analysts. Who knew that oil would go from $146 to $55 in the space of a few months?) Earnings estimates among the 28 analysts covering Devon Energy (market cap: $34 billion) range from $3.85 (by an analyst Bloomberg does not name) to $12.95 (Philip Weiss at Argus Research). At a recent $78 Devon trades at a rich 20 times earnings, or a bargain-basement 6 times. Vanguard owns a $835 million stake in Devon. Unlike Fidelity, it has no choice; Devon is an S&P 500 member and therefore a mandatory holding in Vanguard's index funds.

Then there is the baffling case of AIG, the insurer with the revamped $150 billion government bailout. Estimates from 17 analysts for next year range from a $5.15 per share profit to an 11-cent loss. Most startling, perhaps, is the mean, or consensus, estimate of $1.57 (down 66% in three months). Is AIG really going to earn over a buck and a half next year after losing $1.82 per share so far this year?

CATCHING THE HOG CYCLE

Cereal and cookie companies are for wimps. If you want excitement, buy shares in a butcher or fruit packer.

Commodity food stocks are about as volatile as commodities themselves, i.e., very. This leaves a lot opportunities for gains and losses. Money manager Colin Symons has had a fair amount of success trading the stocks, and many of them look quite cheap now. Join the crowd.

These stocks have return characteristics similar to infinite-lived options. The trick is make sure you buy into companies which will survive, and ideally are at least mediocre enough to benefit from the inevitable up-cycle when it comes along. As usual this means paying close attention to the ability to service debt in the worst part of the cycle. In these stocks' favor is that managements know that a down-cycle will be coming. The rest of the world could have used some of that knowing.

In a recession, food manufacturers like Kraft are a traditional safe haven. But to Colin Symons, chief investment officer at Symons Capital Management in Pittsburgh, the riskier, commodity-tied food companies are more compelling.

Symons has 20% of his $187 million in assets under management in food stocks. Not that it's done him much good lately. Some of his purchases have been reeling. Dairy company Dean Foods (NYSE: DF) is down 43% since he started buying it, Fresh Del Monte Produce (NYSE: FDP) is down 24% and meat processor Smithfield Foods (NYSE: SFD) is down 57%. So what makes Symons sure he is on the right track?

"People have to eat," he says.

Symons, 34, did not have to work too hard to get into the money management business but has performed quite respectably. His dad opened Symons Capital Management in 1983, which Colin joined in 1997. In January 2000 he was handed the job of managing a portfolio of separate accounts focused on value stocks.

The group was up 11% annually through 2007, versus a 3% annual gain for the S&P 500. In December 2006 the family launched the Symons Alpha Value Institutional mutual fund, and Colin got that job, too. The $6 million fund has lost an average of 8.4% a year, which is considerably better than the S&P 500's 17% annual loss.

Symons owes his relative success to going a bit against the grain. Giant foodmakers sell branded foods like cereals and turn out dependable earnings regardless of swings in commodities prices. But investors know that and have already climbed into these stocks.

Other food companies that sell commodities more than brands -- eggs, chicken and pork, for example -- offer bigger cyclical swings. That provides Symons a chance to buy low and sell high, if he can time it right, even without catching the bottom.

"We have a good history of buying stocks awfully cheap and watching them go down 20%," he says. "But then they go up 100%."

Symons first makes sure his target can survive. When he bought meatpacker Smithfield in July, it was at $17, down from a high of $35. He looked back to see how stressed it could get. He looked especially, although not exclusively, at margins, considering them a good indicator of where a company is in its boom-bust commodity cycle.

In its April 2003 fiscal year Smithfield's profit dwindled to $26 million on $7.1 billion in sales. Symons assumed this time Smithfield could even see a loss. But it will survive, he figures, because it sold its beef processing and cattle feeding business for $565 million in October. That leaves Smithfield, which is headquartered in the Virginia town of the same name, closer to its origins as a processor of premium hams. It butchers 85,000 hogs a day.

Since he bought it, the stock has fallen to $7.41. Symons says he may buy more. The trick, he says, is "having patience to wait for a happier future. In the meantime, you can lose half your money." If this one does not end in complete disaster, Symons will be thinking about selling when the ratio of Smithfield's market value to annual sales, now 7%, gets close to its 10-year average of 40%.

Another patience-testing stock is Fresh Del Monte. Symons bought in June at $25. It is now at $19, giving it an enterprise value (debt plus market value of common, less cash on hand) of $1.6 billion. That compares with operating income (EBITDA) that Value Line forecasts at $300 million.

Fresh Del Monte had some lean years in the 1990s and a loss in 2006. Still, Symons thinks the company is a survivor, despite its $439 million in debt. It is having some success streamlining its commodity pineapples and salad greens business.

The article concludes with a table of food companies that "lean toward commodities and have margins that Symons would savor."

MONEY IN THE BANK

Not all financials deserve a bad rap. Accounting sleuth Donn Vickrey says he has stumbled on some gems.

Financial stocks were in a bubble through 2007. The bubble has most definitely popped. When is it time to wade back in the financial stock waters? Usually surviving members of former bubble stock groups can be expected to take a good half-decade to start recovering. Exhibits A, B, and C: energy service stocks after the 1980 top, small technology stocks after the 1983 craze, and dot-com stocks post-2000.

Reiterate the "surviving" criterion. Bubbles are characterized by excessive capital investment in the annointed economic sector. Even the quality companies in the sector have to suffer with depressed margins while the excess investment is obsoleted, destroyed, or run down as the sands of time grind away and competitors leave the business. Here financial companies have what might be ironically characterized as an advantage. Industry capital consists mostly of financial assets, minus financial liabilities, and only very secondarily of dedicated bricks and mortar. The vicious financial markets have given a major haircut to the assets, while most of the industry's customer/debtors -- bank depositors, insurance policy holders, annuity owners, etc. -- expect to be paid in full, thank you very much. Result: The excess capital in the industry is already gone. The pressing issue is resolving how much, if any, capital is left at all.

So enough capital withdrawl/destruction has occurred to warrant looking at financial stocks again, we will posit. Now the question becomes price.

Gradient Analytics provides quantitative analytical services for money managers. Founder Donn Vickrey was dragged into a court case with Overstock.com chief Patrick Byrne a couple of years ago when Byrne accused Vickrey of colluding with short-seller to drive his company into the ground. (Overstock.com has survived so far.) Vickrey's most basic issue was with the accounting. He later fingered Washington Mutual and AIG, based on questionable accounting, before they collapsed.

Now Vickrey has buy recommendations out on select financial stocks whose accounting is good -- companies with solid asset portfolios and plenty of reserves for future losses. So far, so good. And prices? Here we must counsel caution. Banks as a whole are trading at 2.1 times book value. Those of us with long memories recall the average quality regional bank was selling at around book value in 1982. Vickrey recommendation National Penn Bancshares might be a great little bank with impeccable accounting, but at 2.6 times book we wonder what the upside is. National Penn and the other recommended banks are all selling at P/E's or 12 or more -- not terrible, and not back-up-the-truck cheap. Insurance company UNUM at 7 times earnings and less than book at least gets our attention.

Donn Vickrey sticks to his guns when making tough stock calls. The former accounting professor landed in court a few years ago after Patrick Byrne, the fiery founder of Overstock.com (NASDAQ: OSTK), accused him of conspiring with short-sellers to trash his stock. (The case was settled in October for undisclosed terms.)

A year ago Vickrey's firm, Gradient Analytics, began warning its mutual and hedge fund clients that Washington Mutual was failing to take adequate charges for shaky loans. In February it gave AIG an “F” for earnings quality.

Now that the market has spiraled downward, Vickrey is dispensing more contrarian advice: Buy financials. Not the industry as a whole, which he says could fall further, but a handful of gems he says he unearthed while digging for land mines. "What we have tried to do recently is find pretty boring stocks that happen to have solid fundamentals," he says.

By boring and solid Vickrey means banks with conservative accounting, diverse loan portfolios and hefty reserves. That has drawn him to regional banks, like National Penn Bancshares (NASDAQ: NPBC). This Boyertown, Pennsyvania, outfit, with 127 branches across three states, saw nonperforming loans drop 8.5% in the second quarter to 0.36% of total loans. Vickrey does not expect much deterioration as the economy sours, given National Penn's dowdy book of commercial, consumer and student loans. If loans do turn sickly, the bank has a comfy reserve cushion of $3.75 for each dollar of nonperforming loans. "That is almost unheard of these days," he says.

That is indeed extraordinary nonperforming loans coverage. In fact, it is surprising that the IRS or their accountants let National Penn get away with it. Feeding the financial stocks frenzy of this decade was inflated earnings due to clearly inadequate reserves taken against future loan losses. In its anxiety to grab maximum tax revenues today -- without given a thought to the morrow even though those losses would inevitably grow without toiling or spinning -- the IRS virtually demanded a "just in time" accounting for losses. Now they will not be getting receiving many tax payments from the banking industry as a whole for a good long time, thanks to the loose credit standards encouraged by such accounting.

Vickrey values financials by comparing share prices to tangible book value adjusted for his own estimate of how well an institution is provisioned for likely losses. If reserves seem paltry, he pares back book value. Despite its solid standing, National Penn is trading for 2.6 times Vickrey's adjusted tangible book value, versus 2.1 times for all banks.

StellarOne (NASDAQ: STEL) is a $3 billion (assets) bank located in Charlottesville, Virginia, trading for 1.2 times adjusted tangible book value. Nonperforming loans will likely decrease in the third quarter. Vickrey likes StellarOne's 12% ratio of equity to risk-weighted assets. That is double the required level.

A few other fuddy-duddy regionals that pass muster: $10.7 billion (assets) FirstMerit (NASDAQ: FMER) of Akron, Ohio, with $2.70 of reserves for each dollar of nonperforming loans and with a skimpy charge-off of bad loans, equal to 0.16% of assets per quarter in the first nine months; and $13.3 billion (assets) BancorpSouth (NYSE: BXS) of Tupelo, Mississippi, with an 11% ratio of equity to adjusted assets.

The article concludes with a listing of financial stocks which Donn Vickrey found to be "conservative, and cheap."

CRUISING FOR BARGAINS

Take a plunge. Buy leisure stocks in a recession.

In our long-departed youth we were regular readers of Mad Magazine, whose inspired lunacy, and subtle and not-so-subtle subversion, stands the test of time -- in our humble but objective opinion. One piece we recall from way back was titled something like "Advertising slogans that will never be used," and one of the slogans therein was "Sink Your Lifesavings in a Boat!" That slogan came to mind when reading this article that offers up the idea of buying leisure stocks in spite of the recession, an association which says more about our mind than the merits of the article.

The leisure stocks are to the health of the consumer sector of the economy as white is to rice. If people are feeling confident, their discretionary dollars quickly find their way into the coffers of the industry. If not, people stay close to home and the industry suffers. No surprise, then, that the industry is hurting right now.

As always, price is the great equalizer. The stocks are way down. The strong companies will survive. Humans are emotionally wired to extrapolate the long run from their experience of the last three months, if that long. Right now it feels like the consumer sector will not recover in our lifetimes. This is par for the course. If you can ride out the volatility there are some pretty good companies here, e.g., Carnival Cruise Lines and Harley-Davidson.

Two weeks ago Carnival Corp. [stock symbol: CCL] tried to gin up publicity by breaking the world's largest piñata. But just as a wrecking ball was about to send 8,000 pounds of candy raining down from the 60-foot-tall papier-mâché horse, Philadelphia officials halted the stunt over fears it would imperil public safety.

The move is emblematic of how badly things have gone lately for the Miami cruise ship firm and the leisure business as a whole. With the economy in recession, quite possibly a long, nasty one, perhaps the last places many investors want to be is in stocks that depend on free-spending consumers. As if that were not enough, Carnival gave shareholders a Halloween scare by suspending its dividend indefinitely, sending its stock down 12% in a day.

Does all that make Carnival and the rest of the leisure business an industry to shun? Only if you think this storm will never clear out. For long-term investors, leisure stocks offer bargain prices, as well as a way to profit from an eventual recovery. That is because historically, leisure stocks, especially those of cruise lines, are among the first to snap back.

"They track the economy without significant lags," explains analyst Robert LaFleur of Susquehanna Financial in Stamford, Connecticut. "It is not like cars or washing machines. When the summer comes, if people are pretty confident they are going to have jobs, they go on vacation."

The industry's recent troubles have knocked down Carnival 50% from its 52-week high to $22. It now trades at 8 times LaFleur's 12-month forward earnings estimate. Rival Royal Caribbean [RCL] is down 65% and trades at 5 times forward earnings. That puts the companies at about half their respective historical price-to-earnings ratios and well below the S&P 500's ratio of 10 times forward earnings. Both are also trading for less than book value.

Even in the near term there is room for optimism, argues Susquehanna's LaFleur. Crude oil is down 62% from its $147 peak this summer. It accounted for 22% of Royal Caribbean's $923 million operating costs in the latest quarter. Each $10 drop in crude translates into a 28-cent rise in quarterly earnings per share. So far the fuel price decline has offset about half the earnings impact of a drop in Royal Caribbean's 3rd-quarter bookings from the year-earlier level. Carnival does not hedge fuel costs and stands to benefit even more from price drops.

Brunswick [BC], the world's largest recreational-boat maker, is down 90% since January, thanks to a 45% drop in retail sales and a loss of $6.70 per share ($591 million) in the 3rd quarter. Investors can now pick up shares of Brunswick for about 1/4 of their tangible book value of $10.50. Brunswick's bowling and fitness divisions, which throw in 1/5 of sales, should hold up until boats begin selling again, figures T. Rowe Price analyst Ira Carnahan. He also likes Harley-Davidson and Polaris. Unlike Brunswick, both are making money.

Given the unknown depth, and length, of the recession, none of these stocks is a place to park money short term. But they are the sort of early recovery winners that it often pays to get into too soon rather than too late, Carnahan says.

SEVEN SIGNS IT MAY BE TIME TO FIRE YOUR FINANCIAL ADVISER

Better late than never ...

Standard human tendency is to not question one's financial advisor while the market is doing well, even if he/she is doing a terrible job, and to question him/her severely when the market is doing poorly, even if the advisor is doing a great job. With the market is a severe bear market there is currently a massive bull market in advisor dissatisfaction. A September poll found that 57% of investors surveyed planned to dump their then-current advisor. One readily imagines the percentage is still higher now.

Since the market has got your attention anyway you may as well go about your inquiries rationally. You may find satisfactory answers to your questions after all -- or not. We have plenty of direct and indirect experience with good and poor financial advisors. Those whose first priority is serving you rather than feathering their own nest are usually obvious enough, but it is good to include be rigorous in your followup analysis. Good intentions alone are never enough.

This helpful set of guidelines from Forbes is a good stepping-off point for all would-be inquisitors.

In September, when hundreds of investors with more than $1 million in financial assets were surveyed, 57% said they planned to dump their current financial advisers and only 6% said they would recommend him or her to a friend. "I've never seen this level of discontent, not even after the dot-com bust," says Russ Alan Prince, whose Redding, Connecticut firm conducted the survey. "People are running from their financial advisers."

With stocks sinking and big brokers and banks brought low by their own bad investments, the rich folks Prince studies -- and the less wealthy ones, too -- are wondering whether the fat advisory fees they have been paying are worth it.

"They still get paid no matter how much money we lose," laments Scott Stevens, a Bend, Oregon ophthalmologist who just fired the firm to which he had been paying 1% of assets to manage his practice's pension fund. Stevens, 47, insists he told the partner handling the account that his main goal was preservation of capital, but that, as the stock market rose through last year, the adviser did not rebalance to reduce his equity exposure. In September, Stevens says, with the account down 10% from its January 1 balance of $650,000, he called the adviser and was told to sit tight because his stock allocation was already as conservative as the adviser would recommend (at a bit below 60%). Finally, in early November the disaffected doc moved the $440,000 left to another firm.

Is your adviser earning his keep? Here are some factors to consider in deciding whether to fire (or hire) a financial pro.

Underperformance

"Investors have always given financial advisers too much credit for results in bull markets and too much blame for losses in bear markets," says Jack B. Waymire, cofounder of PaladinRegistry.com, which matches investors with advisers. His service screens advisers for education, professional accreditation and a clean regulatory record, but not performance, since it has not found a practical way to compare or verify their claims. Still, you as the individual client do have a way: Your money manager should be ready to set benchmarks against which you can judge the performance of various segments of your portfolio. For example, your blue-chip value holdings might be benchmarked against the Russell 1000 Value Index. Make sure to measure performance net of the adviser's fees. And settle on the comparison index in advance.

If your pro has consistently underperformed, get a satisfactory explanation why, find another one or move your money into low-cost index funds. While you are discussing benchmarks, make sure your adviser has paid attention to your individual needs and risk tolerance, rather than giving you a cookie-cutter asset allocation.

Undisclosed or excessive fees

You might prefer a financial adviser who works on a "fee-only" basis, taking compensation only from you -- for example, 1% of assets under management each year. (Fee-only advisers are listed here.) But most advisers, whether they work for a big financial firm or on their own, take commissions on the sale of stocks, funds and/or insurance and annuities. You might not object -- if your adviser discloses all commissions and (even better) credits at least some of them against any fees he charges you. Ask your pro to go over with you how he makes his money, and get it in writing. If the written version has something you did not know, or that makes you uncomfortable, it could be a warning sign.

Conflicts of interest with duty

Advisers affiliated with a big firm often earn larger commissions from selling their own firm's funds and products, placing their interests at odds with yours. "These large firms are mostly sales mills," asserts Michael Edesess, author of The Big Investment Lie: What Your Financial Advisor Doesn’t Want You to Know. "There is constant pressure on advisers to sell products and maximize revenues," he adds. At the least, such conflicts should be fully disclosed and discussed. Waymire's service lists only advisers it considers independent of any product vendor.

An adviser can be biased by his professional background. "Everyone calls themselves a financial planner these days. Most of them are just stockbrokers who want to put your money in stocks or insurance agents who want to sell you insurance," complains Karl Amstadt, 53. When Amstadt, who runs a Cleveland Internet marketing company, and his wife, a dentist, went shopping for a retirement planner recently, one they interviewed recommended they put most of their $30,000 a year of savings into a whole-life insurance policy. No mystery what that fellow gets commissions to sell.

"We found a fee-based adviser who took the time to create a financial road map for us," Amstadt says.

Excessive trades or funds

If your adviser takes commissions, look at the turnover in your portfolio. Too much trading can generate extra income for him, but unnecessary fees and taxes for you. (Some extra shuffling of your holdings this year may make sense as a way to harvest tax losses.)

Check whether you hold a large number of mutual funds with similar objectives. "Sometimes advisers do this to increase their fees," says Edesess. Problem is, many funds have tiered pricing; the more you invest, the lower your cost. Moreover, if you hold a large selection of actively managed equity mutual funds with the same objective, Edesess says, the net result might look a lot like owning a far cheaper index fund. (Managed U.S. equity funds charge an average of 1.4% of assets a year, while the Vanguard Total Stock Market Index fund costs only 0.15%.)

Neglect or administrative lapses

"Did you have to call them twice about anything?" asks Carol Fabbri, a financial planner who left Merrill Lynch in April to start her own Denver firm, Fair Advisors. This is not just a matter of dodging your calls when the market is down. Presumably, you are paying for more than just stock- and fund-picking advice. You are paying for help dealing with essential investment chores. For example, if your pro neglects to tell you about a required minimum distribution from a retirement account or bungles a rollover from one retirement account to another, you could get hit with a tax penalty.

Buzzwords or bluster

When you ask questions, does your pro lapse into buzzwords or suggest it is all too complicated for you to understand? "Remember the Wizard of Oz? Look behind the curtain," says Fabbri. Leslie Jeanne Kelly, cofounder of American Financial Advisors in Orlando, Florida, worked for years at a big Wall Street firm with a colleague who fancied himself just such a wizard. When clients questioned him, "he would pound the table and say, ‘I'm a vice president. What do you know? You should listen to me,’" she recalls. If you feel intimidated or your adviser does not listen, or cannot explain his ideas, it is time for a divorce.

Inappropriate investments

This includes an asset allocation that is simply too conservative or too risky for your age, wealth and personal-risk tolerance. Are you a 60-year-old with 80% of the money you need for retirement in equities? Maybe that is where you personally want to be, but be wary of an adviser who has not discussed with you the outsize risks you are taking and how your allocation differs from what is considered prudent at your age.

A continuing problem is with the sale of complicated variable annuities to investors who do not understand what they are buying and probably should not be buying annuities. (For one new variation, read "The High Cost of Security".)

Steven Trager, now 62, owns a pizza shop in Santa Monica. In 2006, on the advice of an insurance agent who billed himself as a "Senior Financial Advisor", Trager sank $1.4 million from the sale of real estate into 5 equity-indexed annuities from Sun Life of Canada and Midland National. Trager says the agent told him he was guaranteed a minimum 3% annual return and that the policies, which track the S&P, had earned 12%. "Music to my ears," he says.

What Trager says he did not understand was that the potential gain was just a fraction of that from the S&P; that he would not receive dividends, as he would from stocks; that he faced surrender penalties for as long as 14 years; and that any gains would eventually be taxed as ordinary income, not lower-taxed capital gains. Steven E.M. Roth, whose fee-only firm, Wealth Management International, was hired by Trager to analyze the annuities he had already bought, figures if the S&P 500 returned 12% (including dividends), Trager's annuities would earn 4%. He estimates the adviser earned $125,000 in commissions.

The insurance agent, for his part, says Trager, was a "sophisticated investor" who knew what he was buying and was never promised a minimum 3% return -- the guarantees are actually for less. Trager is asking the companies to refund his investment without penalties. Sun Life has refused, saying provisions of the annuities were adequately disclosed. Midland says it is waiting to receive Trager's response to the agent's denials.

DESPERATE HOUSEWARES

Observing the Christmas carnage at FAO Schwarz, Bottega Veneta, and Bergdorf Goodman.

Regular Slate financial columnist Daniel Gross has been thrown for a loop. Bergdorf Goodman, whose salesmen in normal times will not give him the time of day, is cold calling his house, asking him to come take a look at the bargains. That Bergdorf Goodman would even be price discounting, never mind cold calling the hoi polloi, indicates that these are not normal times. The upper income strata members are actually hurting this downturn. The primary beneficiaries of the great credit inflation have been hit by the only force that would reverse their fortunes: the inflation turning into a deflation.

This is shaping up to be a dismal Christmas. The International Council of Shopping Centers, which is supposed to help promote the industry, last Thursday trumpeted an "awful beginning to the holiday season." Excluding Wal-Mart, retailers reported that same-store sales last month fell 7.7 percent, the worst November in recent history. The big crowds that stampeded (literally, sometimes) through the doors of big-box retailers on Black Friday have dispersed. Shoppers seem inured to the relentless Christmas spirit. The Boston Consulting Group says that half the households it surveyed are planning to reduce their Christmas spending, while only 10% plan to boost it. ICSC projects that holiday sales could actually decline in 2008, "which would be the weakest holiday-sales performance on record," says Michael Niemira, chief economist and director of research at ICSC.

But no indicator was quite so telling as the plaintive message left on my home answering machine over Thanksgiving weekend. A kindly Bergdorf Goodman salesperson invited members of our humble household to stop by and check out the bargains. Now, if you are not a habitué of the his-and-hers luxury department stores on Manhattan's Fifth Avenue, there are a few things you should know about Bergdorf Goodman. This place puts the haute in haute couture. It is about as welcoming to the public as North Korea. It is the kind of store where the salespeople take one look at your shoes and judge whether you are a big spender. Bergdorf Goodman cold-calling suburban shoppers? It is like college kids canvassing for Obama votes at a National Review conference.

But these are desperate times. During the late economic expansion, the well-off -- and, in particular, the really well-off -- thrived while the middle and working classes struggled. But in 2008, the stalwart customers of New York's luxury retailers have been falling along with the hedge funds. The investment bankers and their significant others? See ya. Rich tourists from points south and west? Not this year, y'all. Europeans and Brits fueled by their powerful domestic currencies? Adios, au revoir, cheers! Russian oligarchs? Da svedanya. In November, according to ICSC, luxury stores saw sales fall 10.5%. Neiman Marcus, which owns Bergdorf, reported sales were off 11.8%.

Strolling the half-mile of Fifth Avenue from Rockefeller Center to Central Park -- the white-hot heart of the high-end American Christmas experience -- you encounter the businesses that manage to separate more people from their hard-earned money more than any others. But crowds in these thrift-killing fields were relatively sparse last week (aside from the clutch of Citigroup bankers trying to present toxic mortgage-backed securities as collateral for loans from Salvation Army kettles). The Rockefeller Center tree, like everything else in New York this year, has been down­sized. The 2008 Norway spruce is 72 feet, down from 84 in 2007. In Bottega Veneta, not a creature was stirring, not even a Vogue assistant editor. The Apple Store earlier this fall was so mobbed that hipsters had to take a number to enter the Shrine of Jobs. This time, I swept right in and did not have to wait to pay. Across the plaza from Apple stands FAO Schwarz. In normal times, it is an anxiety-inducing miasma of kids, tourists, and flying plastic toys. Last Tuesday, it was an oasis of calm. I could have done yoga safely in the Lego section.

Why should we care where and how the well-off are spending? Well, the top 20% of households account for about 40% of discretionary spending, and the top 40% account for 74% of all discretionary spending, according to BCG. As go the rich and wannabe rich, so goes the nation. And while the residents of Richistan are not moving to Pooristan just yet, they are cutting back. "Consumers who have money have decided they want to hold it in their pocket," says BCG partner Michael Silverstein. Luxury retailers have responded by acting like discounters. "In a better economy, customer service, quality, selection are the key selling points," says Ellen Davis, vice president at the National Retail Federation. "But this year it is really all about price." Saks, which specializes in imported finery, is taking a cue from domestic automakers and offering zero percent financing. A/X is advertising all sorts of merchandise as half-off.

But not all luxury retailers seem to have gotten into the 2008 Christmas-shopping spirit. At Bergdorf Goodman's men's store, tasteful signs advertised 40% off marked prices. Which meant, for example, that a lovely Brunello Cucinelli gray wool sweater was marked down from an astronomical $1,075 to a merely absurd $649. As I looked at a rack of dark blazers, I was flattered that a salesman actually spoke to me. "How much?" I asked. "Fortysomething hundred dollars," came the reply. I laughed. "That's Brioni," he said, "if it means anything to you." Why, yes it does, I thought. It means an insanely expensive product that probably will not sell much this year and, as a result, will fail to deliver fat commissions to nasty salespeople.

It has been fun. But next time, Bergdorf, don't call me. I'll call you.

WHO IS THE WORLD’S WORST BANKER?

Needless to say there are plenty of candidates. Daniel Gross comes up with a good pick for the winner.

In the past couple of years, the entire global lending industry has covered itself in shame. Virtually every banker was suckered by the credit and housing bubble. But who made the sorriest choices? Who forced shareholders and the public to bear the highest financial cost? Who, in short, is the Worst Banker in the World?

There is no dearth of candidates. Richard Fuld of Lehman Brothers and James Cayne of Bear Stearns presided over the remarkably disruptive failures of their respective firms. But Bear and Lehman were not banks, properly speaking: They were hedge funds lashed to investment banks. And their demises did not require much of a public bailout. The failures of AIG, Fannie Mae, and Freddie Mac necessitated massive bailouts, but they were not exactly banks, either. Iceland's bankers have effectively brought their entire country to ruin. But since Iceland's population is a mere 300,000, they are off the hook. In an interview Monday, Nobel laureate Paul Krugman nominated the gang that ran Citigroup into the ground. But Citi was so big it took three CEOs -- Sandy Weill, Chuck Prince, and Vikram Pandit -- to bring it to the brink of disaster.

No, my nominee is someone whose name may not be familiar to American audiences. He is Fred Goodwin, who until October served as CEO of the Royal Bank of Scotland. Goodwin (here is the Wikipedia entry about him) took the helm of RBS in 2000 and proceeded to turn it into an international powerhouse. Known as "Fred the Shred" for his willingness to cut costs -- and jobs -- he emerged as Britain's leading banker. He was even knighted in 2004 for services to banking. But the bank, which this summer was Britain's largest, is now neither Royal nor Scottish nor much of a bank. RBS's slogan is "Make it happen." A review of the record shows that Goodwin indeed made it happen. He aced every requirement for a hubristic CEO.

Let us review the record.

Carrying off mergers and acquisitions and calling them growth? Yes. After buying British bank Natwest for about £26.4 billion in 2000, Goodwin used RBS's cash and high-flying stock as a currency for more deals. Among the biggest was the $10.3 billion purchase of Charter One Financial, a Cleveland-based bank, in 2004, thus expanding the bank's footprint in the Rust Belt.

Ill-advised, history-making, massive merger precisely at the top? Yep. In November 2007, RBS and its partners, Fortis and Banco Santander, completed their acquisition of Dutch bank ABN Amro. As proud adviser Merrill Lynch noted, the $101 billion deal was "the world's largest bank takeover and one of the most complex M&A transactions ever." And it closed almost precisely when the air started to come out of the global lending bubble.

Massive commitment of capital to investment banking, trading in funky securities, and poor credit controls? Yes, yes, and yes. As this excellent Bloomberg postmortem notes, by June 2008, RBS had become Europe's largest lender. "Under Goodwin's tutelage, RBS also became Europe's biggest backer of leveraged buyouts," reporter Simon Clark notes. Goodwin also jacked up the bank's trading, "boosting derivatives assets 44 percent to £483 billion in the first half of 2008," which was greater than the bank's net deposits. "Meanwhile, its reserves of Tier 1 capital, a measure of financial strength and the vital reserve set aside to cover losses, was the lowest among its U.K. rivals at the start of 2008." In other words, Goodwin designed a house that would teeter when the slightest ill wind began to blow.

Building an expensive, self-indulgent new headquarters building just in time for the collapse? Right-o. In 2006, RBS started construction on a huge new headquarters in Stamford, Connecticut, which would house its expanding U.S. investment banking and trading operations. The centerpiece of the 12-story, $500 million building is one of the largest trading floors in the world. It should be ready for occupancy (or, given recent job cuts, partial occupancy) next year.

Telling shareholders you do not need more capital, and then raising it -- and then having that capital lose value rapidly? Yep. In February 2008, Goodwin said, "There are no plans for any inorganic capital raisings or anything of the sort." But in June, RBS sold £12.3 billion (about $20 billion) in shares at 200 pence per share, which was a significant discount to the then-market price. By October, as this chart shows, the stock was slumping.

And finally: Dump problems on fellow citizens by messing things up so badly the bank has to be nationalized? Bingo. With the stock continuing to slip, RBS staged another rights offering, giving brutalized shareholders an opportunity to add to their sharply discounted holdings at a sharp discount -- in this case at 65.5 pence per share. But shareholders passed, and the government last Friday had to step in as buyer of last resort, ponying up £20 billion pounds and assuming an ownership stake of about 60%. (The Guardian tells the grim tale.)

The result? RBS's stock (here is a two-year chart) has lost 91% of its value since March 2007 and retains value thanks only to massive government intervention. A job well-done, Sir Fred!

Chief Dunces of Wealth Destruction, Inc.

There are not enough dunce caps to go around for all of the egregious performance in finance, but here is a try.

Forbes has its own nominations for Masters of the Wealth Detruction Universe.

At $10 billion a month, the cost of fighting in Iraq for 5 1/2 years has added up to some $660 billion. By comparison, the wealth destruction just in financial stocks has been a great deal more.

The market capitalization of Citi has been reduced by more than $200 billion -- and that is despite an injection by Uncle Sam of $25 billion. Bank of America, once with a market cap larger than Citigroup's at over $240 billion, has sunk by $180 billion to only $60 billion -- again despite a $25 billion investment by the Treasury. AIG, the largest insurance company in the world, is running a close 3rd in loss of value -- some $160 billion and is even more in the debt of the regulators.

Add in the decimation in the stock prices of Wachovia, Wells Fargo, JPMorgan Chase, Goldman Sachs, Morgan Stanley, Lehman Brothers, UBS and Merrill Lynch -- even Warren Buffett's Berkshire Hathaway, where shareholders have paper losses of some $60 billion -- and you can easily see how the Masters of the Universe have taken out close to a trillion dollars of the public's savings and household net worth.

I am talking about financial institutions which, until two years ago, were looked upon as relatively safe repositories of other people's money. Supposedly safe dividend streams added billions to investors looking for income. Nobody gave a second thought to leverage. The only complaints involved the obscene bonuses being paid out that accented the growing inequality of compensation in the U.S.

Another irritant was the even more flabbergasting take-home pay of the Shadow Banking System -- the hedge fund managers and private equity bigwigs getting 2% for sitting on pension fund money and 20% of the profits, if there were any. Few besides John Paulson did their homework and examined the mortgages behind the mortgage-backed securities and found that they were based on 100%-borrowed principal without any equity or the income to service them. But they were rated AAA by the rating agencies. To go short, he thought, would be shooting ducks in a barrel. Paulson saw they were worthless and made his bundle, as he explained to Congress recently.

In light of the mismanagement that borders on malfeasance, Croesus wishes to award Dunce Caps to the stewards of this immense wealth loss and single them out for their negative contributions to ordinary investors.

Here are just a few:

• The directors and officers of Citigroup for spending $800 million to buy a hedge fund that had to be liquidated. And for adding off-balance sheet financing vehicles that are partly to blame for sinking the ship.
• The directors and officers of AIG who allowed its balance sheet to be endangered by $500 billion of derivatives that were in no way protected by any hedging and so sank the largest insurance company in the world -- a stock, by the way, held by just about every self-respecting investment manager. None of them could have read the footnotes to the consolidated financial statements, because it was all there.
• Alan Greenspan, former chairman of the Federal Reserve, for not adequately overseeing the major money center banks -- his main responsibility -- and for blocking all attempts to oversee and regulate those weapons of mass destruction, derivatives.
• Bear Stearns chairman Jimmy Cayne for not leaving his bridge tournament in Detroit to minister to his sinking investment bank that threatened the livelihoods of 14,000 individuals.
• Kerry Killinger, former CEO of Washington Mutual, who made idiotic acquisitions of risky mortgage companies at the peak of the bubble and destroyed 100% of shareholders' value.
• Return to the back row of economy class. Rick Wagoner, CEO of General Motors, flew to D.C. to plead for a $25 billion bailout on a private jet that cost GM $20,000, or almost 300 hours of labor on a GM car. And he should be denied credit for miles traveled.

In the past, we have risen to the task.

We would add former Wachovia CEO Ken Thompson, would bought mortgage orginator Golden West Financial for three times book value at the peak of a credit bubble. Now that actually takes talent.

SHORT TAKES

Property tycoon forced to sell £20 million home after going bust.

A sign of the times, and surely not the last instance we will see.

Cevdet Caner bought the 5-story house in Mayfair for £16 million in May last year, and spent a reported £6 million refurbishing it.

But administrators who were called in after the Austrian businessman's companies went under have invited sealed bids for the property, with a closing date of December 11. The guide price for the property is £15 million, making the house the most expensive to be sold off as a result of the financial crisis, but still £7 million less than Mr Caner has spent on it.

Despite its narrow frontage, the 7-bedroomed house has total floorspace of 11,250 square feet and has a 45 foot swimming pool and an attached mews house.

Mr. Caner, 36, is the chief executive of Caner Capital and the founder of Level One, a Monaco-based property investment firm. At one point he had a portfolio of 28,000 residential properties in Germany, worth around £1 billion.

He fell victim to the worldwide slump in property prices and his real estate companies filed for insolvency in September.

Unsaid, but it cannot be otherwise, is that there must have been a lot of debt behind Mr. Caner's properties. And the debt service must have become greater than the net rental revenues.

Easy Come, Easy Go: Asian Fortunes Fall

How quickly things can change, especially when a bubble pops.

A rotten stock market and, in India's case, a weak currency have imploded Asian fortunes. The 40 richest citizens of both India and China are worth less than half of what they were a year ago. China's top 40 tumbled $68 billion while India's sank $212 billion. India's top 5 -- 4 of whom ranked among the 10 richest people on the planet earlier this year -- accounted for more than half that drop.

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