Finance Digest for Week of March 8, 2004

FREE ENTERPRISE THINKING IN KOREA, CHINA AND VIETNAM

I recently returned from two weeks in Korea, China and Vietnam. It was very invigorating to see great progress in both ideas and policy. Below is a pretty good description of the highlights that I thought you might find interesting. My main mission on the trip, which was sponsored and paid for by the Atlas Economic Research Foundation was to make contact with liberty-loving intellectuals and think tanks in all three countries.

The Center for Free Enterprise in Seoul is fighting an uphill battle to turn around a rising tide of socialist and anti-American sentiment in the country, especially among young people. Government schools in Korea are not exactly imparting the principles of a free society to the students, which underscores the importance of CFE’s work.

Economically, it is wildly apparent that China has made enormous progress since my last visit in 1988. Growth and construction are everywhere. Private businesses of all sizes are all over the place. Many Chinese told me that there is no turning back. Too many people are enjoying the fruits of economic liberties to allow any regime there to ever seriously turn back the clock to the days of Maoist central planning. The works of Hayek are well known and often cited among Chinese intellectuals, who are very aware and disturbed at the drift toward socialism in America. They told me more than once how laughable some of the academics from America are who come there and still extol some aspect of central planning, which no one “with any brains” believes in any more in China.

Vietnam was actually the highlight for me. Hanoi and Ho Chi Minh City (Saigon) are charming, with some of the best-dressed, well-groomed and good-looking people I have ever seen. Everyone is quick to smile and strike up a friendly conversation. I found no lingering hostilities left over from the war; quite the opposite, in fact. Americans are treated immediately with great respect and affection. Vietnam has also made enormous progress economically, as a result of a liberalization and abandonment of most central planning. Fully half of GDP is now generated by private businesses big and small; 90% of workers are employed in the private sector; and the government is selling off state-owned enterprises as fast as it can. I found it interesting that enough local autonomy is allowed that the policies in Ho Chi Minh City are noticeably more pro-enterprise than Hanoi’s, which is producing pressure on the city authorities in Hanoi to ease up on regulations and paperwork so as to stimulate business there even more.

REVALUING THE RENMINBI IS A RED HERRING

Treasury Secretary John Snow has urged China to adopt “a flexible, market-based exchange rate” for the Renminbi, which is currently fixed at 8.28 to the dollar. Flexible exchange rates can provide benefits to the countries that use them. In recommending that China float its currency, however, the Bush administration is wrapping a protectionist policy in free-market rhetoric. The administration’s real goal is to make Chinese exports less competitive against U.S. manufacturers -- and that is bad policy for everyone, especially consumers.

China’s controls on the movement of capital out of China (“capital controls”) are the source of whatever problem may exist with its nominal exchange rate. Getting rid of those controls would compel China’s monetary authority to deal with pressure to revalue its currency. Either a new peg or a free float would follow. If Chinese leaders were to abandon capital controls, U.S. protectionists would lose an argument against China. At the same time, China’s central bank would no longer need to subsidize America’s budget deficits and capital formation through its purchases of U.S. Treasury obligations.

At this time, China is in no position to eliminate capital controls. Such a policy move would compel the government to confront the problem of non-performing loans at its four large, state-owned banks. Cleaning up these loans, estimated at $300 billion-400 billion, will take years. The Bush administration does not want an unstable China, and so will not press on the real economic issue. Calling for China to float its currency is political rhetoric to salve U.S. domestic political wounds, not serious international economic policy. The citizens of both China and the United States will benefit when China moves closer to a market economy. In the meantime, the leaders of both countries need to avoid protectionism in all forms, including monetary.

China eyes lifting curbs on capital account.

Guo Shuqing, head of the body that manages China’s $416 billion foreign currency reserves, said the capital account -- the system for managing investment transactions -- may be mostly open within five to six years as long as reforms to China’s ailing state banks are completed.

China’s desire to ease upward pressure on the renminbi has spurred a more flexible attitude to the capital account. The People’s Bank of China, the central bank, and the State Administration of Foreign Exchange have moved to rebalance demand between the US dollar and the renminbi. Beijing’s argument that the renminbi did not have to be revalued had received a boost, Mr. Guo said, because the trade balance swung into a deficit of “several billion US dollars” in the first two months of this year. The surplus in 2003 was $25.5 billion.

China has said for months that it plans to introduce greater flexibility into its exchange rate regime, under which the renminbi is pegged to the US dollar at Rmb8.28. Most analysts believe this means Beijing will at some stage allow the renminbi to fluctuate within a wider band. But it is far from certain now that such a widening of the band would result in a renminbi appreciation, analysts said. The steps China is taking to increase demand for the dollar and decrease it for the renminbi are expected to sap the upward pressure on the Chinese currency.

WEALTHY INVESTORS TURN HEDGE FUNDS INTO GROWTH INDUSTRY

During and since the bear market, managers of these high-risk, largely unregulated investment vehicles have attracted billions of dollars from deep-pocketed investors. The minimum entry fee into a hedge fund can be as much as $1 million or more. Fueling this expansion are pension funds, foundations and university endowments. After losing tons of money in stock-related investments between 2000 and 2002, they are shifting money into hedge funds for added security. “Institutions are making this change because they realize that diversification within the stock market is not adequate protection,” said C. Scott Akers Jr., managing director of the Hedge Fund dataBank LLC. “They needed diversification that is not corrrelated to stocks.”

Typically hedge funds engage in nontraditional techniques such as arbitrage, options, derivatives and especially shorting. They do not have to register with the SEC. Fund managers do not have to register either, although many do. A key advantage of a hedge fund is that it does not depend on the vagaries of the stock market to produce a positive return. From 1990 through 2002 hedge funds posted an average annual return of almost 15%, vs. 9.1% for the S&P 500, according to an index of 3,500 funds maintained by Hedge Fund Research Inc.

ANOTHER REVIEW OF FINANCIAL RECKONING DAY

I would recommend the book to everyone whether you are interested in the philosophical, theoretical, historical, financial, or just worried about saving your own financial hide. It would be great for home high schoolers or college students. Ladies and gentlemen, we Americans are in hot water and if you want to know what the temperature is, this book is a good place to start. Needless to say, this is not a hopeful book. It presents no obvious solutions. It does however tell the reader that the water is indeed hot and that it might not be a bad idea to jump out before it is too late.

Disclaimer: While water boils at a certain temperature, no one knows how hot or cold an economy will get before moving in the other direction. The peaks of manias and the depths of depressions are impossible to predict, so for now I am keeping one foot in the pot and one foot in the frying pan. I am diversified between cash, gold, natural resource stocks, and safe stocks in consumer goods, health care, telecoms (a.k.a. telephones). Out of sympathy for Martha Stewart, I think I am going to buy a little MSO.

DR. FRANKENSTEIN’S MORTGAGE MONSTERS

On February 24, Alan Greenspan issued a warning that Fannie Mae and Freddie Mac have grown so large that they pose a threat to the entire financial system. To reduce this threat the Fed chairman recommends that Congress cap their size. In this regard, in Q4 the assets of Fannie Mae stood at over $1 trillion. According to Greenspan, because of their size both Fannie Mae and Freddie Mac know that the government will not allow them to go belly up. It is this that makes them less prudent in accumulating massive amount of debts and assets: the moral hazard at work.

But this is not only applicable to Fannie and Freddie, it is also applicable to most large U.S. banks. In fact the entire banking system is built around the ongoing support provided by the Fed’s monetary pumping. So why single out Fannie and Freddie? Now, even if we did not have such institutions as Fannie and Freddie, due to the Fed’s loose monetary policies we would still have undesired symptoms regarding the housing market.

Can a stricter regulation of Fannie and Freddie, as suggested by Greenspan, eliminate the risk of a plunge in the real estate market? As long as the Fed continues with its loose monetary policies, it will not be possible to eliminate this risk. Once loose monetary policy is activated it immediately sets in motion the process of a false economic boom, or financial bubble, which sooner or later must be liquidated because it is unsustainable.

It seems to us however, that Greenspan is already preparing the public for the likely bust of the housing market. There is a strong likelihood that the U.S. housing market bubble has already reached dangerous dimensions. The trend adjusted house price index has been following an explosive growth path.

WEAK DOLLAR GAINS NOTICE OF BUFFETT

Warren E. Buffett, the billionaire investor, has a $12 billion bet against the United States. Mr. Buffett said over the weekend in an annual letter to shareholders of Berkshire Hathaway, his holding company, that he began investing in foreign currency for the first time in 2002 and expanded his positions in 2003. By the end of 2003, Berkshire Hathaway held foreign-exchange contracts valued at $12 billion that were spread among five unspecified currencies, he said in the letter, which was released on his company’s Web site.

He said Berkshire also owned $1 billion of euro-denominated junk bonds. Mr. Buffett, who still has the bulk of his assets in the United States, bought into the foreign currency as the United States trade deficit swelled and enjoyed large investment gains as the dollar continued to weaken. “As an American, I hope there is a benign ending to this problem,” Mr. Buffett wrote, referring to the trade deficit and the weaker dollar. He said, however, that the impact could reach “well beyond currency markets.”

One Berkshire shareholder said the move was an about-face for Mr. Buffett. “I’ve attended the annual meeting for well over the past 15 years, and every year until this year when asked about the dollar or foreign currency, Berkshire’s basically said, ‘You don’t make money betting against the United States of America,’” said Tom Russo, a partner at Gardner, Russo & Gardner, which owns about 1,000 Berkshire shares. “Something must have really scared him.”

Buffett says corporate America should pay more tax.

Buffett told the shareholders of the Berkshire Hathaway annual meeting that the company’s tax bill rose eleven-fold to $3.3 billion between 1995 and 2003, while the firm’s profits rose ten-fold to $8.25 billion. However, he also highlighted the fact that the federal income taxes paid by all US firms in the same period fell by 16% to $132 billion.

“Tax breaks for corporations -- and their investors, particularly large ones -- were a major part of the administration’s 2002 and 2003 initiatives,” Buffett noted, adding that: “If class warfare is being waged in America, my class is clearly winning.” He continued: “We hope our taxes continue to rise in the future -- it will mean we are prospering -- but we also hope that the rest of corporate America antes up along with us.” Buffett also pointed out that corporate tax revenues accounted for 7.4% of the country’s tax receipts in 2003 -- the lowest level in 70 years, with the exception of 1983.

A PERENNIAL GIFT FROM GREENSPAN

For years, the central planners at the Federal Reserve have assured us that inflation is dormant, if not dead. Federal Reserve Governor Ben Bernanke, during a recent speech in Washington, took pains to emphasize that inflation is “Under very good control”. But considering the relentless increase in the money supply engineered by the Fed over the last decade, one wonders whether Mr. Bernanke, Chairman Greenspan, and company protest too much.

Austrian-school economists demonstrate that true inflation is monetary inflation. True inflation therefore can be measured by an increase in the money supply. Mr. Greenspan and Fed policy makers have more than doubled the M3 money supply in less than ten years. While Treasury printing presses can print unlimited dollars, there are natural limits to economic growth. This flood of newly minted US currency can only increase consumer prices in the long term, as more and more dollars chase available goods and services. Lew Rockwell, president of the Ludwig von Mises Institute, explains that Federal Reserve governors are incapable of telling us the truth about inflation for a very simple reason -- they are the ones causing it.

The Treasury department parrots the Fed line that consumer prices, as measured by the consumer price index (CPI), are under control. But even some Keynesian economists admit that CPI grossly understates true inflation. The most glaring problem is that CPI excludes housing prices, instead tracking rents. Everyone knows the cost of purchasing a home has increased dramatically in the last ten years. Home prices in many regions have more than doubled in just five years. So price inflation certainly is alive and well when to comes to the largest purchase most Americans make.

THE ALL REAL ESTATE, ALL THE TIME ECONOMY

As the baby boomers have remade the economy in their own image, they have increasingly relied on their homes as a source of “wealth”. Soon the entire economy will hinge on the rising price of the single family home. Satire? Or reality. You decide.

A KURT RICHEBÄCHER TWOFER

Do not believe the talk about the “exceptionally mild” recession.

In a recent speech, Alan Greenspan applauded himself once more for his successful policy with the following words: “There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble’s consequences rather than the bubble itself has been successful. Despite the stock market plunge, terrorist attacks, corporate scandals, and wars in Afghanistan and Iraq, we experienced an exceptionally mild recession -- even milder than that of a decade earlier.” He offered mainly two explanations: “notably improved structural flexibility” and “highly aggressive monetary ease.”

We are tempted to say that we disagree with every single word. GDP numbers are an abstract statistical aggregate. What truly counts for people is what happens to their employment and their income. By these two measures, the U.S. economy is experiencing its longest and deepest recession since the Great Depression of the 1930s. There is one obvious statistical source for the GDP numbers: artificially low inflation rates.

Plunging dollar will pull the rug out from under the bond and the stock markets.

Considering all the imbalances impairing U.S. economic growth, we are unable to see the sustained, strong recovery. A closer look at the recent economic data [and last Friday’s jobs report] confirms this skepticism. Possibly, if not probably, economic growth has already peaked. For us, the question rather is when general disappointment will gain the upper hand. That would be sure to soothe the bond market, allowing moreover the Fed to maintain low interest rates. But it will conjure up another, even greater risk at the currency front. It will pull the rug out from under the dollar.

In our view, the U.S. trade deficit is big enough to cause a true tailspin of the dollar against all currencies. So far, two things have prevented this threatening dollar collapse: the gargantuan dollar purchases by Asian central banks and the still rather positive perception around the world of the U.S. economy. In our view, few people realize its true weakness and vulnerability.

There is widespread hope that the falling dollar will go a long way to lower the U.S. trade deficit. It takes a lot of wishful thinking to believe that. Its persistent growth has various reasons. One of them is that the gap between exports and imports has simply become too big to be reversible. Empirical experience suggests that exchange rate changes by themselves have very little effect on trade flows. One obvious reason is that Asian as well as European exporters readily adjust their prices to maintain their market shares.

The U.S. trade deficit reflects gross overspending on consumption on the demand side and a grossly unbalanced investment structure on the supply side. There was gross underinvestment in manufacturing versus gross overinvestment in retail, finance and high-tech. Our assumption is that there is no intention or will on the American side to correct any of these maladjustments. American policymakers and economists take only two economic problems seriously: high rates of inflation; and, in particular, slow growth and rising unemployment. They could not care less about the dollar. The low inflation rate is the excuse for more of the same extreme monetary looseness.

There is quite a variety of accidents waiting to happen in the markets, but the most predictable and biggest risk is a dollar crisis. In addition to the gargantuan trade deficit, looming in the background are existing foreign holdings of dollar assets in the amount of $9 trillion. The U.S. bond market, due to its underlying heavy leveraging, prohibits any defense of the dollar through tightening.

INEFFICIENT MARKET: KEYNES’S BEAUTY CONTEST

In an efficient market all relevant information is said to be reflected in the current share price. Competition ensures that rational expectations among market participants prevail. If this were not the case, it is claimed, then investors with better foresight would be able to garner superior returns. Yet there is no evidence that such superior investors exist, say the market efficientists (turning a blind eye to Warren Buffett and many others). Another school of thought, however, suggests that investors do not, in fact, discount information in the rational manner suggested by theory. As a result, it is possible for the stock market to remain for long periods at levels far removed from intrinsic value.

In The General Theory, John Maynard Keynes went on to liken the activity of professional investment to a newspaper competition in which “competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole.” He believed that such a speculative mentality -- one concerned with anticipating changes in market psychology rather than the long-term yield of investments -- dominated the stock market, creating instability and leading to the misallocation of resources.

Bull markets are myopic. They do not peer too far into the future, but tend to focus on more immediate information, such as quarterly earnings-per-share. Such information often has little relevance to intrinsic value (i.e., the discounted cash flow generated by a company over its entire lifespan). Bears, on the other hand, think much further out than the rest of the market. Often they are spooked by what they see and feel frustrated that others do not share their concerns. Although Keynes never actually said that “markets can remain irrational longer than you can remain solvent,” this sentiment faithfully reflects his ideas.

The irrational exuberance of investors has certain economic consequences. It leads to the misallocation of capital, an excessive build-up of debt and a corresponding lack of savings. Reason in the real world cannot be suspended indefinitely. Boom gives way to bust. And when this happens, those who have retained the capacity to think not just one but several steps ahead of the market, end up having the last laugh.

A STUDENT OF THE MARKET WARNS OF A RESUMPTION OF THE SECULAR BEAR MARKET

The behaviour of equities, the yield curve, credit spreads, and metal prices have followed a similar pattern through the climax of each boom in history. From this, we assembled seven of the most reliable series into our Boom Indicators, which reached their most positive reading in December, 1999. By the end of January, 2000, enough had reversed for us to issue a warning on the longevity of the boom. The rest, as the saying goes, is history. And that history says that a lengthy contraction has followed every bubble as it occurred in the senior economy. In some cases, the initial phase was intense and completed in a minimum of 3 years. We thought this would make the first three years following 2000 rather straightforward, which it was for stocks, the yield curve and credit spreads.

As things turned out, almost 3 years was the count by October, 2002. However, manias often enjoy a restoration of the Good Stuff in the third year out. Such was the case for the extravagances of the Nikkei 1989, Gold 1980, the Dow 1929, and stocks following the 1873 bubble. Our view is that the senior indexes are as “overbought” now as they were “oversold” in October, 2002. With that background, our outlook follows:

1.) The secular bear market in equities will resume; 2.) With consumers approaching exhaustion from their aggressive buying of grand cars and median homes, the economy will begin a severe recession; 3.) The cyclical bull market in industrial commodities is close to culminating; 4.) Junk credit spreads, which have enjoyed an outstanding run since the 2002 panic, have reversed towards adversity (wider spreads of junk vs. sound credit instruments); 5.) Once the high was in for the stock mania in the first half of 2000, it became automatic that gold shares would end their secular bear and begin a secular bull market, which continues; 6.) Any increase in the gold/silver ratio -- recently at 62 -- will signal a pending liquidity crisis.

Before the 1970s, there were only two widely known financial extravaganzas. One was the “South Sea Bubble” of 1720 and “The Crash” of 1929. By the mid-1970s, enough research was completed to conclude that financial manias were a regular phenomenon and the “missing” ones could be found by thorough research and the next in the future would be set up by the end of the “old” era of inflation. As things turned out, there were 3 “missing”, which made 1929 #5 and 2000 became #6. Participants in the 1720 mania were remarkable as on the first go they designed, with the action in metals, credit spreads, and the yield curve, all of the component patterns that have been so faithfully replicated each time around.

By way of wrapping up, it is appropriate to review the items common to the post-bubble condition. The “big picture” has evolved to the pending resumption of the post-bubble contraction and the “close-up” concludes that selling the stock market now is technically equivalent to buying gold the week after the low at 103 in 1976. As we noted at the top in 2000, “The karma of the marketplace is about to overwhelm the dogma of policymaking.”

ROYAL DUTCH/SHELLSHOCKED

Royal Dutch/Shell has long been a byword for boringness in corporate Britain. With its two-company structure -- Royal Dutch and Shell retain separate boards despite merging almost a century ago -- and its monolithic Thames-side headquarters, it is considered to be more inward-looking and bureaucratic than the civil service. It is exactly because of this dull image that so many investors are now so shocked. For the world’s third-biggest energy company has not only been caught out overstating its proven oil and gas reserves, but it now transpires that some of its top managers may have known about the problem two years ago.

Shell sent tremors through world energy markets on January 9th when it cut its estimates of its proven reserves by a fifth. Reserves are a crucial asset for oil and gas companies, indicating the level of future production and revenues. Deciding when such reserves may be classified as “proven” is as much art as science, but there are guidelines laid down by the SEC. Shell apparently did not follow these. Certainly, Shell’s shifting of reserves (from “proven” to “probable”) cannot be compared to the phantom profits and bogus assets booked by Enron. That is because the oil and gas actually still exists. Experts say that “probable” assets are also very likely to get to market -- just not as quickly as proven ones.

Shareholders lost little time after the reserves revision in filing class-action suits -- one is seeking some $5 billion from Shell and nine former and current senior officials, including ousted former chairman Sir Philip Watts. The latest reports will no doubt lead to further writs. After all, Shell, for all its reserves-related problems, has very deep pockets.

IS WiMAX A PROMISING NEW WIRELESS TECHNOLOGY, OR JUST A LOAD OF HOT AIR?

If you find it difficult to get excited by the details of a new wireless-data protocol, you are not alone. So what explains the current buzz in the telecoms and computer industries surrounding WiMax, a high-speed, long-range wireless standard? This week investors pumped $20 million into Aperto Networks of Milpitas, California, one of several firms planning to launch WiMax products this year. Heavyweights such as Intel, Nokia and AT&T are lining up behind the standard. Sean Maloney, the head of Intel’s telecoms division, says it will put “the next 5 billion users” on the internet. But whereas WiMax has promise, says John Yunker, an analyst at Pyramid Research, it is currently surrounded by much confusion and “a ton of hype”.

Indeed, all this is strongly reminiscent of the fuss over Wi-Fi, a popular technology that uses a small base-station plugged into a high-speed (broadband) connection to link laptops within 50 meters or so to the internet. Wi-Fi is undoubtedly useful -- in 9% of American households, for example -- but it is used mainly to provide wireless internet coverage inside homes, offices and schools. Few people seem to be prepared to pay for fee-based Wi-Fi access in “hotspots” in airports and railway stations, and schemes to cover whole cities with Wi-Fi and make expensive third-generation (3G) mobile-phone networks redundant have gone nowhere. But whereas Wi-Fi provides coverage within a small hotspot, WiMax, which has a maximum range of 30 miles, could provide blanket coverage. It could, as a result, prove to be a far more useful, and disruptive, technology.

One promising area for WiMax is for use as a wireless “last mile” in the developing world, since it can carry voice calls using voice-over-internet protocol (VoIP). Instead of laying copper cables, network operators would set up far less expensive WiMax towers, and then install WiMax telephones in subscribers’ homes. Internet access could also be provided. Mr. Maloney says 20 or 30 operators in developing countries have expressed interest. But the cause of the excitement is what might happen next. At the moment, WiMax is a fixed technology. But if the technology can be scaled down to fit inside mobile devices, says Mr. Yunker, “that changes everything.” Not everyone is convinced, but amid the hype and the confusion WiMax is evidently worth keeping an eye on.

ARUN SHOURIE, INDIA’S PRIVATIZATION MINISTER, BEATS THE DRUM FOR MARKET REFORM

As the public face of the Indian government’s privatization program, Arun Shourie is basking in the success of the Indian stockmarket’s largest-ever public share issue. Its offer of 10% of the shares in ONGC, an oil exploration and production company, was the last of a hectic spate of six privatization issues. The offering was fully sold within minutes, and when it closes on March 13th will raise some 100 billion rupees ($2.2 billion). This is a godsend for a government struggling to meet its fiscal-deficit target ahead of a general election on April 20th. Just as important for Mr. Shourie is to see another lurch forward in India’s erratic economic liberalization.

The success of the sales will encourage boldness in other areas, “like drum-beaters bringing out the tiger,” as he puts it. It will also burnish Mr. Shourie’s reputation. Like reform itself, the minister has suffered his share of setbacks. One came last September, when the Supreme Court ruled that the privatization of two state oil companies required a vote in parliament. This had the effect of stalling his favoured method of disposing of the government’s assets -- selling control to strategic investors, rather than minority chunks to the market. At the time, Mr Shourie vented his frustration by saying the ruling showed the difference between India and China: “In India, everybody has a veto.”

Mr. Shourie hopes that the next government will continue reforming -- even if Congress, the main opposition party, wins. Congress launched the reforms in government, but now often seems opposed to them. Everybody opposes reform in opposition, argues Mr. Shourie, but in office, finds it the only option.

WARREN BUFFET SEES WEEDS BEING PRICED AS FLOWERS

“Yesterday’s weeds”, Buffet opined in his latest letter to shareholders, “are today being priced as flowers.” The Sage of Omaha has not, as far as we know, turned his attentions from investing to gardening. No, he was merely using an appropriate horticultural metaphor for a market about which this column has had some harsh words in recent months: the market for junk bonds. The year before last, it turns out, Berkshire Hathaway bought some $8 billion of junk bonds because they were very cheap. “The pendulum swung quickly though, and this sector now looks decidedly unattractive to us,” said Mr. Buffett.

Just how quickly the pendulum has swung can be judged by the $1.1 billion in pre-tax profits that Berkshire Hathaway recorded on its junk-bond portfolio last year. Perhaps Mr. Buffett, who chastises himself for not selling more stocks in the “Great Bubble”, should sell more of the junk-bond portfolio than he has. Many of those bonds that you could barely give away a couple of years ago now fetch prices that would seem more appropriate for an altogether more exotic bloom, such as -- to take one example at random -- Semper Augustus, a much-sought-after tulip in 17th-century Holland.

The heady prices that investors are willing to pay for less-than-fragrant credits can be seen in the weediest of the lot: those awarded a rating of CCC by the rating agencies (the lowest rating is D, which does not stand for durable). Michael Lewitt, who runs Harch Capital, a hedge fund, neatly sums up the risks investors run by buying these bonds: “It’s like playing Russian roulette with all the chambers loaded.” Some 34% of CCC issues will default within their first year, according to historic studies by Standard & Poor’s. But so great is demand from investors for yield, whatever the risks, that fully a third of all new junk issues so far this year have been from companies with a CCC rating. Many of these have a coupon of less than 9%, even though in all probability they will die before they mature.

Mr. Buffett, for one, is well aware of the lack of rewards in riskier assets, which is why Berkshire Hathaway is invested so heavily in government debt. This may pay “pathetically low interest”, but the pain of doing something stupid in riskier markets is potentially worse. “Charlie [Munger] and I detest taking even small risks unless we feel that we are being adequately compensated for doing so. About as far as we will go down that path is to occasionally eat cottage cheese a day after the expiration date on the carton.”

THE REAL TRUTH ABOUT SOCIAL SECURITY

The impending “crisis” in the Social Security system is surprisingly simple to explain and to understand, as are the solutions, once the distortion, mythologies, and outright lies about the system are punctured. The best place to start is with the lie about the actual Social Security tax rate on the individual. This lie sets the tone for the total misrepresentation throughout the system.

THE VALUE OF GARBAGE

The S&P 500 index includes some of the greatest business enterprises ever created: Microsoft, ExxonMobil, Wal-Mart. All the big names are there. Those 500 big names earned investors an average of 28.7% in 2003, an excellent one-year return. Many 401(k) plans invest in the S&P 500 index. So a vast number of investors did well investing in those companies that most people agree are the safest places for your money... but you could have made twice as much money last year simply by focusing on those companies that failed miserably. Some of them actually turned out to be staffed by criminals!

The stocks I am talking about are the components of an index called the Feds Index. The equity investment department at Guardian Life Insurance Company created the Feds Index. It is a list of several companies that are under investigation by the federal government and/or the Securities Exchange Commission for possible wrongdoing. The Feds Index contains stocks like Tyco, formerly headed by the now infamous Dennis Kozlowski. Also in the Fed Index are El Paso, HealthSouth, Qwest, Symbol Technologies and Computer Associates.

HealthSouth, for example, was down 98% while under investigation for accounting fraud. But it staged a miraculous 5,365% comeback. It is still rising, even though the size of its fraud has been raised from $2.7 billion to as high as $4.6 billion. The reason why lousy companies bring you great returns is simple. Since nobody wants to own them, their share prices get far cheaper than those of the popular, successful companies most investors want to buy. Right now is an especially good time to focus on the losers. A year-long rally has pushed many stocks up so that they are either overvalued or simply no longer cheap. There is not much worth buying today, except the failures and criminals.

To find the next Gateway, HealthSouth or Williams Cos., set your favorite stock screener to find “meltdowns”. Look for companies trading at huge discounts to book value. There are a several insurance companies out there that fit this bill. Also look for those that have fallen at least 50% in the previous 52 weeks. Remember, you want the worst, not the best. One caveat: Ignore the bankruptcies -- they have a letter “Q” on the end of their trading symbol.

CASH MIGHT NOT BE SUCH TRASH AFTER ALL

The dollar has unmistakably broken out of its downtrend. This happened when, late last month, the U.S. Dollar Index moved above its 50-day moving average, and was confirmed last week when it managed to push above additional overhead resistance in the 87.5-88 area of the USD Index. I have little doubt that the long-term trend for the U.S. dollar is still down. However -- just as fundamentals have mattered little where the stock market has been concerned in the recent past -- neither do they presently matter much where the dollar is concerned (see latest U.S. trade balance chart here). It is technical factors that now argue for a further appreciation for the buck, which likely has considerably further to run before this counter-trend rally becomes history.

The stock market has been bending for this and other reasons; but in the last few trading sessions is showing increasing signs that it also is about to break. For the last few weeks now, the NASDAQ has been trading below its 50-day moving average. Even more ominously -- especially if the weakness of the last few days takes the Index below the 1990 level -- it will have added to a recent pattern of lower highs and lower lows, as it grinds back down. The Dow Jones Industrial Average has this week joined the NASDAQ South of its 50-day moving average. The Standard and Poor’s 500 is about to join them. With increasing signs that the cyclical bull market that began a year ago is now over -- or, at the least, is entering its most serious corrective phase thus far -- we cannot be far from a point where those betting against the market begin to regain their fortitude.

Those still believing that gold will prove a refuge amid all this do so at their peril. As where the U.S. dollar is concerned, I do not believe the recent (and expected) behavior of the yellow metal is changing its long-term attractiveness. However, were you to take a look at gold’s chart of late, you will find it just as ugly as that of the NASDAQ; a well-defined downward trend punctuated by lower highs and lower lows. I do not think much will be immune from at least some damage as Wall Street completes its topping process, and breaks into a correction. The one asset class that has come into the most disrepute over the last couple years, may regain some respect: CASH!

GOLD’S PERFORMANCE DURING INFLATIONS AND DEFLATIONS

One often hears that gold does better in deflation than inflation. This is a half-truth. By definition, under the gold standard that existed throughout most of the 1800’s, gold must do well in a price deflationary environment. After all, if prices are dropping, and gold remains pegged to the dollar, and one dollar remains one dollar, logically what else can happen? However, once gold was un-pegged to the dollar and became increasingly demonetized in the 20th century, its price behavior relative to inflation, deflation, and commodities became increasingly erratic. The situation becomes even more complicated given that the terms “inflation” and “deflation” have very different meanings and imply different policies for different economists.

(After a long treatise he concludes...) Today, even though the M3 growth charts look scary, the government, central bank, national media, and public at large are still in denial. Let us call this stage the Phase I denial stage. We still have at least two more phases to go. Phase Two entails general acceptance of a serious inflation problem. Phase Three entails taking decisive steps to stop the problem, as Fed Chairman Volcker did in the early 1980’s. One might simply buy gold and silver stocks now and hold until America shows credible evidence of achieving Phase III. This will probably be many years from now.

In his article “To the Moon, Alice!” James Puplava wrote about how in the first phase of a long term bull market, the smart money gets in. Then in the second phase the institutional investors get in. Finally, in the third and last phase, the little guy gets in. Puplava thinks we are in the tail end of phase I. Mass media publications are often a contrarian indicator for when the little guy is finally catching on. If Puplava is correct, one might still consider accumulating gold and other precious metals stocks now and then wait until someone like Pierre Lassonde, President of Newmont Mining, makes the cover of Time magazine before inserting stop loss orders.

DEFICITS DO MATTER

Politicians and officials in high places are telling us that government debt does not matter; after all, we owe it to ourselves. As long as government borrows Funds internally and expenditures are financed from internal sources, so the notion goes, no real cost is incurred. Interest payment on debt merely represents transfers from taxpayers to bondholders. Debt to foreigners, by contrast, is seen as a wholly different matter because it necessitates interest payments to outsiders. It is analogous to private debt.

The federal government debt now exceeds $2 trillion and is expected to reach the $3 trillion mark by the end of the decade. We do not owe these sums to “ourselves”, the U.S. government owes them to individual savers and investors. Deficit spending is the mother of debt, which is the prolific mother of folly and despair. A small debt may be cleared off in a little time, whereas a large debt may never be repaid. A debtor who owes a great deal may despair of ever being able to pay and, therefore, may be tempted to default. As the U.S. government debt soars past the $2 trillion mark, the possibility of default looms ever larger.