Finance Digest for Week of May 31, 2004

DETOUR ON EASY STREET

Because of the American stock market boom, 1982–2000, tens of millions of Americans began to believe that they will be able to retire rich. This was always an illusion. They bought shares way too late in the cycle. The masses always do. But Greenspan’s asset bubble, 1995–2000, persuaded millions of Americans that Easy Street is wide and level. It never is. Thrift Lane and Discount Road are where the money is, but they are side streets, unpaved.

The middle class’s illusion of easy retirement is becoming more visible, year by year: the stagnant stock market. But no one who has adopted a pleasant fantasy ever wants to abandon it. Economic reality eventually forces itself on men’s consciousness, but usually only after the magnitude of the on-paper losses have become inescapably visible to their wives. Most Americans will retire into poverty: those who become dependent on Social Security/Medicare. But their poverty will be American-style poverty, meaning a lifestyle beyond most people’s dreams a century ago, or even a decade ago in China and India.

Maybe 20% of them will retire in comfort, if they retire before 2015. Most of these 20%, who live in the post-2015 world, will see their lifestyles decline as their pension fund income shrinks with the fall in the value of money. The best hedge against inflation, as Ludwig von Mises once said, is age. A few people will retire rich and remain well off, maybe 20% of 20%. But there are always big winners in every generation.

The performance of the stock market since 2000 points to the dead end of Easy Street. The stock market has gone nowhere. Stock brokers’ assurances to clients that “now is the time to buy” are common, but they are less and less believed. Stock brokers in Japan had the same message after 1989, but the Japanese stock market today is still only about 25% of what it was in late 1989. Few investors in Japan believe Japanese stock brokers any longer. Anyone who did believe them after 1989 is much, much poorer than if he had simply bought long-term Japanese government bonds and then gone fishing.

The steady, relentless decline of the Japanese stock market after 1989 was not random. Yet American economists, because they believe in random-walk investing theory, in 1990 would not have predicted what has happened. They would not have seen what would have been obvious to an Austrian School free market economist, namely, that the 1985–89 stock market boom had been a bubble created by central bank inflation, and the stock market would not soon recover. That it would decline as much as it has for as long as it has would not have been obvious, even to an Austrian School economist, but that it would not recover soon would have been.

HEDGE FUND BRIEFS

Pressure to open hedge funds directly to UK investors.

Those crying out to be able to offer hedge funds to retail investors have long said it is unfair, if not discriminatory, that only the UK’s richest investors should have access to such investment vehicles. Evidence of a surge in hedge fund investment among the UK’s wealthy will doubtless further fuel the call. With the direct route ruled out for the time being, the only exposure the majority of UK savers will have to hedge funds is via a company pension fund.

New way in for hedge fund investment for UK retail investors.

Hedge funds are about to be opened up to the UK retail market through a new product that will allow investment by people with net worth of as little as £50,000. This week IFX, a financial trading business, will sell contract-for-differences (CFDs) on a small number of hedge funds, giving retail investors access to the underlying fund through derivatives. Under current regulations, hedge fund investing for individuals is a cumbersome process, with investors often having to access hedge funds in offshore jurisdictions. The Financial Services Authority has strict rules on hedge funds being sold to investors because the products are unregulated. Hedge funds are not allowed to market themselves directly.

By using a CFD, an investor can buy into the performance of the fund without having to invest directly. IFX invests in the fund, and then sells the economic performance of the fund through a CFD. This process avoids regulatory hurdles. “If the fund goes up 5% a month, the CFD will do the same,” said Edmond Warner, chief executive of IFX. “And if it goes down 5% so will the CFD but it will also move intra-month and the investor can trade in and out.”

However, the IFX product is still small. The eight funds it has signed agreements with have just $2 billion under management, against an industry-wide figure of about $1,000 billion. Mr. Warner said IFX had a capacity of “several million”, which was enough for the time being.

Bermuda hedged out by Caymans?

Bermuda is losing out to the Caymans in attracting business from the rapidly growing hedge fund business, a leading accountant has claimed. Joel Press, a senior partner with Ernst & Young in New York and head of the top four accounting firm’s global hedge fund practice, told about 100 industry professionals attending a panel discussion on the future of the industry that the Cayman Islands -- not Bermuda -- was raking in new hedge fund business. As an example, he told the group that a number of start-up hedge funds -- with $7 billion collectively in assets under management -- had just recently chosen Caymans as their domicile.

SMARTER THAN THE CEO

American companies are suffering from a personality crisis. They talk about the virtues of flattened hierarchies and bottom-up organizations, and they laud the genius of the market. But when it comes to what they actually do, companies prefer authoritarianism to democracy. Success, most corporations assume, depends on the efforts of a few superlative individuals. As a result, they treat their CEOs as superheroes, look on most of their employees as interchangeable drones, and remain fond of command-and-control strategies that would not have been out of place in the Politburo. In doing so, firms are neglecting their most valuable resource: the collective intelligence of the organization as a whole.

WILL THE FED’S SLOW-MO APPROACH BACKFIRE?

Carefully orchestrated utterances from the Fed make it clear that when it starts raising interest rates in coming months, it will do so ever so gingerly. They are desperate to avoid a repeat of 1994, when aggressive rate increases of three percentage points over one year helped precipitate financial traumas of the sort that occurred in Mexico and in Orange County, California.

But James W. Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, said he thought that the Fed’s timid approach could backfire, creating just the sort of spike in rates that the central bank hopes to avoid. Given how indebted American consumers are, a sudden, sharp rise in rates could have broad and damaging implications across the economy. After all, one in three home mortgages has an adjustable rate today, exposing borrowers to considerably higher costs as rates rise.

“If I am a bondholder, I want a massively aggressive, inflation-fighting Fed,” Mr. Paulsen said. “The last thing I want is a Fed that is timid, touchy-feely, slow and communicative. The Fed has said we’re going to be slow in our response so we don’t scare anybody. But I think that approach is exactly what is going to scare everybody.” When bondholders are afraid, they do not wait for sweet talk from Alan Greenspan. They sell bonds, pushing up interest rates, whatever the Fed says or does.

Shouldn’t Greenspan quit while he’s ahead?

A year ago, when President Bush said he would nominate Alan Greenspan for a fifth term as the Federal Reserve chairman, I said that it was a bad idea. Recklessly disregarding my advice, the president went ahead this month and nominated Mr. Greenspan anyway. It is an even worse idea now.

PENSION UNDER-FUNDING IS THE EMERGING GLOBAL DRAGON

Pension plan funding across the world is much like a dragon that has just begun to emerge from its cave. Spurred by stock market declines, poor investment decisions,aging populations and underfunding of defined-benefit pension plans, the beast is beginning to inflame the political process. Politicians who admitted skipping pension payments are at the center of a major political scandal in Japan, for example. In the U.K., the government is considering a new pension insurance program called the Pension Protection Fund. In the U.S., intense political pressure created an opposite result: companies in financial distress were allowed an $80 billion break from plan funding over the next two years.

Global pension challenges will not be solved easily. Solutions will not be forthcoming, though, until all parties agree that the restive beast is more than a myth that is hidden in some dark, cavernous financial statement. Global disclosure is the first step in this epic battle.

ENERGY INDUSTRY GETS JOLT OF VENTURE CASH

With gas prices at record highs, venture capitalists who invest in the energy industry believe their prospects are looking up, particularly with investments in startups specializing in areas like conservation technology and alternative energy. Growing public demand for technologies to reduce power bills and fuel costs, they say, is helping their cause.

“When you have a trillion-dollar-a-year market in the U.S. that seems to grow at an inexorable 2 to 3 percent a year, it just begs for innovation,” said Tucker Twitmyer, a principal at EnerTech Capital, a venture capital firm that specializes in energy-technology companies. Even so, Twitmyer said, the energy business has historically attracted fewer venture investors and entrepreneurs than more established areas of investment like biotech and information technology. With a fund pool of about $300 million, EnerTech’s investments center on technologies for storing and conserving energy, adding monitoring capabilities to the power grid and reducing emissions. Investments run the gamut from fuel cells to diesel engine technology.

EnerTech is one of several venture capital firms focused predominantly on the energy industry, a purportedly growing niche for early-stage investors. In 2003, the industry represented a little more than 2 percent of total VC investments in the United States, according to Nth Power, an energy venture firm.

Biodiesel boom well-timed.

Biodiesel fueling stations are sprouting like weeds across America, where production of the alternative fuel rose 66% in 2003. Experts say the rapid growth of the renewable fuel will stretch the country’s tenuous petroleum supply while helping people breathe a little easier. According to the National Biodiesel Board, the number of consumer biodiesel fueling stations rose nearly 50% last year to 200. So far this year, 25 new stations have opened, including 10 in Colorado and five in New Hampshire.

Ron Heck, president of the American Soybean Association, said biodiesel can be blended with regular diesel in any ratio, or can be used as a fuel by itself. “It has almost the same amount of (energy) as petroleum diesel,” Heck said. Using biodiesel will clean an engine’s fuel injectors and cut down on the number of required oil changes, according to Heck. “I buy it because it’s better fuel.”

A NINE-FIGURE AMOUNT ... HANGING ON THE WALL?

In May, the hot market for “things” extended from commodity futures to wall decorations, to wit: The $104.2 million paid for Picasso’s painting titled, “Boy With a Pipe”. This amount broke the previous all-time record of $82.5 million, paid in 1990 for a Van Gogh. Transactions like this almost never occur in a vacuum, and this one did not either, since this past month art collectors paid record-high prices for the works of 13 other contemporary artists. The timing is especially noteworthy, given what other price spikes in famous artwork did vis-à-vis the stock market in 1987 and 1990. Years ago, Bob Prechter discussed art prices as an “outlet” of an “investment mania”. He observed that once the stock market registers an important peak, “art prices won’t be far behind.”

Along with these moon-shot prices, financial publications like Barron’s are tracking the way “Young Buyers are Plunging Into the Market” for art. Coincidentally, the heavily emotional artistic style known as “abstract expressionism” is a growing favorite at art auctions. None of this is random. It is part of the same social mood driving the market for “things”, in general, and all the extremes that come with it.

GLOBAL BLOW-OFF?

Around the world, the authorities pulled out all stops in 2003 in playing the growth gambit. It worked, but at a cost -- a record state of global imbalance that has only gone further to excess. The reflationary efforts have created a growth spurt that could well be borrowing from future gains -- 10% growth in durables consumption by the American consumer over the year ending 1Q04 and a 43% surge in Chinese fixed investment over the same period. These are the signs of an overshoot that almost always elicits a payback, as the stock of durable goods and productive capacity returns to long-term sustainable equilibria. And, now, as US interest rates rise, oil prices move higher, and Chinese authorities up the ante on tightening, that payback could well be exaggerated to the downside. To the extent that this year is turning into a global blow-off, I worry about precisely the opposite for 2005. In my view, this is shaping up more and more as the boom that finally begets the bust.

CHINA: SOFT LANDING OR BUST?

China has experienced one of the great economic transformations in the history of the world, owing to economic reforms that unleashed astonishing productive capacity that had been bottled up for long period of state controls. And yet this transformation has been endangered by the bane of all booms under fiat money: money and credit creation. The question is whether China’s boom will settle softly or coming crashing down.

It seems that a bust is more likely than Chinese authorities are currently admitting. A possible bust of the Chinese economy is likely to be bad news for the US and other world economies. There are already indications that the rate of increase of China’s imports is slowing down. After rising to 76.7% in February the yearly rate of growth of imports fell to 42.7% in April.

To prepare for the possibility of a genuine bust, there is only course of action for China: it can and should be mitigated by further liberalizations of capital investment rules and even more privatization. This is the only “countercyclical” policy the government should consider, since all efforts to reflate are doomed to fail.

OUR FINANCIAL RECKONING

Unlike the mainstream financial media on CNBC, FNN, Fox and Bloomberg, Bill Bonner has not forgotten history. He remembers that only 25 years ago, the stock market’s price/earnings ratio and dividend yield were the same at 6. He remembers that at the same time, the Dow Jones Industrial Average and the price of gold per ounce were the same near 850. Government bonds yielded 15% in those days. The trade balance has been negative since the early 1980’s. The investment balance was positive in 1986 but now stands at a minus $3 trillion. Yet government bond yields today are in the 4% to 5% range. “Is it three times safer to lend money to the government now?” Bonner asked the crowd rhetorically.

Investors have forgotten the old adage “buy low and sell high”. Stocks and real estate are both expensively priced yet people are still buying, expecting a happy ending. But, we do not always get happy endings in real life, Bonner reminded the crowd. Investors expect that Alan Greenspan can control things and ensure eternal sunshine -- that central bankers know more than they used to. But as Bonner eloquently pointed out: “In science and technology knowledge is cumulative, but in central banking, finance and romance knowledge is cyclical.”

People used to have a deep distrust of paper money. This was learned over many generations. Governments will always print too much money, to the point of making it worthless. But, who today distrusts paper money, despite the fact that Greenspan has created more money than any central banker in history? The common wisdom used to be that a person should not go into debt. This view was based upon centuries of experience. But, now people follow the government’s lead, the government will never get out of debt and neither will the people. People have also forgotten what it means to save. The savings rate has dropped from 10% to nearly zero. Instead of distrusting Wall Street like their ancestors wisely did, the “lumpeninvestoriat” believes that they can “get rich in their sleep”.

Bonner believes that the U.S. will have a “slow motion slump” or as he describes in his best-selling book, Financial Reckoning Day, a soft depression. Near the end of Reckoning he provides what he believes to be the “trade of the decade”. In the 1970s it was to buy gold, in the 1980s it was to buy Japanese stocks, and in the 1990s it was to buy U.S. stocks. In 2000 the trade was to buy gold and sell the Dow, a trade that is looking good so far.

THE TAPESTRY OF MONETARY COLLAPSE

The view here is that the patterns of economic boom and bust emerge from an unstable loam, too saturated with the oils of monetary intervention. Interest rates and money no longer manifest the natural underlying demand of consumers, nor do they provide accurate signals regarding the core supply of capital. What emerges is a distorted pattern of production, a mishmash of mis-priced capital, too soft to harden into a sound and sturdy foundation. The beacon, which the market uses to allocate capital, has become errant and is leading the market onto the rocks.

The threads of this story form a grand tapestry that will one day tell a sorry tale of monetary collapse. For the time being, we can explore the tapestry in bits and pieces, as one might examine the shards left in the trail of a twister, wondering how it came to be and where it will strike next. Today, we start at the very beginning...

The Granddaddy of central banks was probably the Swedish Riksbank. Originally chartered as a private bank in 1656, it would collapse eight years later due to bad loans, at least some of which were due from the government. The Riksbank was an early creaky prototype for what would become, in countries all over the world, “the modern central banke. It resembles the Federal Reserve in that it was created by an act of the legislature and that it enjoyed legal tender status on all its notes.

Monopoly and privilege would define central banks from the very beginning, as various steely-eyed historians and clear-seeing economists have pointed out. Central banking has always been tied to, enmeshed with, and a part of, the exigencies of state finance. Its power emanates from its status as a legal and protected monopoly issuer of legal tender notes, which was a very welcome weapon in the armory of the state. It was for later generations to adorn it with the tinsel of necessity, and adorn it they did. The modern sheathing of central banking in fine-spun theoretical regalia occurred after the fact by self-important bureaucrats and ambitious courtesans.

Today the Fed Chairman enjoys fame near the level of the President of the United States, with his every whisper subject to endless interpretation by pundits and others. And yet, despite its position of power, prestige and privilege, the economy lies still beyond the grasp of the central bank. The bank can influence, but it cannot control. It can turn on the hose, but it cannot aim it. The real danger arises when it thinks it can.

DEBT BUBBLE STRETCHES TO BREAKING POINT

Should we stop worrying that the debt bubble created by the Federal Reserve since the 2000 market crash could still burst? No. Just the opposite, in fact. My three rules of bubbles, identified and explained here, say we are approaching the most dangerous period in the life of any bubble: the time when it is most in danger of breaking.

I know that it is tempting to stop worrying. The parts of the U.S. economy most sensitive to interest rates are showing few signs of crumbling in the face of the huge increase in 10-year Treasury yields since March. Sales of existing homes are running near a record pace. Consumer spending keeps chugging along. Even car sales are holding up. But the “Three Rules of Bubbles” tell me that it is too soon to stop worrying. We have hardly begun to correct the distortions that cheap money has created. So what are these three rules?

1. A bubble expands far longer than anyone expects. Let us look at home sales. Counterintuitively, instead of cooling the housing market higher rates actually have created a flood of new buyers who fear getting shut out of the market if rates rise too high.
2. A bubble expands faster as the cycle nears its end. This tendency for bubbles to become more excessive as they mature is built into modern financial systems.
3. It is tough to admit the cycle is over. The impulse is to keep inflating the bubble. That is why they finally pop.

These three rules for bubbles do not pinpoint when the bubble will burst. They do suggest what to look for: Institutions that have the money to lend are so pressed by their own need to grow that they will make loans without much regard for the ability of borrowers to repay them.

Let’s look at one more issue. The business of lending to hedge funds is incredibly lucrative for banks on and off Wall Street at a time when banks are facing profit pressure. I do not believe for a moment that all of those hedge fund loans went only to the most creditworthy funds. And I know for sure that leverage, which produces outsized profits in good markets, increases the risk that, in a bad market, a moderate loss will turn into a huge one.

One of the most frustrating things about this market and about the interlocking relationships so characteristic of our financial system is that it is so hard to figure out who will get left holding the bag. I am certain, however, that this is not the time for investors to let their guard down. This bubble is unlikely to break with the kind of pop that took down the entire stock market in 2000. But it is even less likely to deflate gently and painlessly.

HOW DID THE FED’S CREDIT EXPANSION EFFORT GO?

A largely overlooked truth about the Federal Reserve is that controlling the money supply is only part of the central bank’s job: the Fed’s bigger task is to expand credit. And for 90 years, the Fed has indeed expanded credit to staggering levels. With the central bank supposedly about to begin raising rates, let’s look at how it “succeeded” in the rate cutting campaign that began in 2001.

If you look at individual households -- revolving home equity loans, for example -- the debt has grown rapidly, from $128.3 billion in January 2001, to an all-time record $326.4 billion as of May 19, 2004. Of course, home equity loans turn assets into debts; this debt will produce no income, only the burden of repayments. If, on the other hand, you look at commercial and industrial loans, the lending has been progressively shrinking. It reached a record $1.1 trillion in January 2001, and from there has steadily fallen to a near six-year low of $871 billion (5/12/2004). Commercial and industrial loans also must be repaid, yet the debt often produces growth and income (via new equipment, facilities, etc.).

So: During the most aggressive interest rate-cutting campaign in its history, the Federal Reserve has helped millions of households convert their assets into burdensome liabilities. Yet the Fed did not help increase overall borrowing by businesses (despite the lowest lending rates since the 1950s), which could use the loans to create growth. The facts show that the Fed’s attempt to expand credit has increased “bad” debt, even as “good” debt shrinks. This (among other things) is what the media somehow overlooked in the recent frenzy of “Fed rate hike” stories.

WHY THE CALIFORNIA REAL ESTATE MARKET IS A BUBBLE

I have been a Southern California resident my entire life and let me tell you, the price of real estate here is INSANE right now. We live in Orange County and right across the street from us, in a non-fancy area, with no clear extras, the price of a three-bedroom townhouse is $735,000. I am not making this up, we went open house shopping last weekend. A townhouse/condo with no yard in a new but cramped and crowded development is going for $735K. My wife and I laughed at the idea of putting down nearly $150,000 of our hard-earned saved-up money for a 20% down payment on a piece of property that would have sold for less than $200,000 five or ten years ago. How can this be possible?

My wife and I are savers. We don’t waste money, we pay our credit card bills in full every month. We do not live an extravagant lifestyle. We have excellent jobs with good salaries. Yet we cannot afford to buy a house in California. What is wrong with this picture? After laughing at the price of houses here in Orange County for awhile, I realized that people are actually paying these prices. And I do not understand how. So I sat down and did exhaustive research on the real estate market in California. I read about the history of earlier California real estate crashes.

I finally figured it out. California real estate is overpriced for one of two reasons: 1) first time buyers are getting 1 to 3 year Adjustable Rate Mortgages at 4% or less; and/or 2) people are selling their homes to first time buyers and “trading up” to more expensive houses using BIG down payments from the inflated equity they squeezed out of their house. I can cite references, but you know it is true. So I realized that my wife and I can afford an average, standard, forgettable single family residence in the middle of So. California suburbia. All we have to do is get an ARM.

Are the lenders in this country on crack (or just repackaging their loans and passing them off to blind investors)?! This can only lead to heartbreak and pain. See, anybody who has done their homework knows the rates are going up. Just from a statistical point of view, it is clear the rates are not staying this low, and when they do go up, they will likely stabilize at a significantly higher rate. I firmly believe that when the initial fixed rate on 1 year ARMs is back up to 5.5 to 6% we are going to see a clear shift in the dynamics of the California real estate market. The last time the cheapest mortgages had 6% rates, the price of real estate in California was 40-50% cheaper than it is now. And incomes have not risen appreciably since that time. I do not know anybody whose wages have risen more than a few percentage points in the last several years. Think about that for a minute.

To express it in near mathematical terms: my argument is that the price of real estate in California is inversely proportional (on a parabolic curve) to the interest rate on the cheapest mortgage product available to the least qualified borrower. In other words, as the monthly payment for the least qualified buyer goes up or down, the overall price of real estate goes up or down in some proportionate fashion. Only time will prove if my theory is correct.

The California real estate market is going to go down in flames. With a rock-solid, high earning, excellent credit, two-income, no children, minimal expense, saver household, my wife and I cannot afford to buy a single family residence in our community for the price of the monthly payment on an 80% 30 year fixed rate loan. Something is wrong in the world.

In ARMS’ Way

Contrary to popular rhetoric, given today’s interest rate environment there are no circumstances for which homebuyers should choose adjustable rate mortgages (ARMs). That so many people are currently opting for ARMs reflects a level of real estate speculation unparalleled in American history. Homebuyers have been lured into this foolish choice by real estate and mortgage brokers eager to earn commissions, their own avarice in pursuit of easy riches, and by a fed chairman desperate to keep the real estate bubble inflating. Unfortunately, the longer the Fed remains “patient” with regard to raising short-term interest rates, the more homeowners will be lured into the ARM time-bomb.

One argument is that, by using ARMs, “savvy” homeowners save money because the months of lower payments will more than offset higher payments in the months following the interest-rate hikes. This ignores the fact that when those higher payments ultimately arrive most borrowers may not be able to afford them. After all, it is not as if they are saving the money that otherwise would have been spent on higher fixed-rate mortgage payments. The typical borrower is already maxxed out with the current low payment, and hopes to meet any higher future payments by extracting appreciated equity.

The most popular justification for choosing an ARM (other then the fact that many borrowers simply do not qualify for a fixed rate) is the buyer’s intention to sell the house in a short period of time, say 2-3 years, so why pay the higher interest costs of a 30-year fixed-rate mortgage? The fact that people buy houses with the intention of selling them on again in only 3 years, is itself one of the best signs of the speculative nature of the current real estate market. Those doing so are speculating on price appreciation, plain and simple. Such individuals would be far better off renting, especially given today’s high housing prices, transaction costs, and relatively low rents.

Assuming today’s short-term buyers put their houses on the market, who will buy them, especially if interest rates have risen? If the current crop of buyers has relied on low-interest ARMs and lax lending standards to qualify for their mortgages, how will future, similarly situated, buyers qualify when interest rates are higher and lending standards are stricter? Short-term buyers may very well end up living in their houses for much longer periods then they initially imagined -- unless, of course, they lose their homes in foreclosure.

Those who argue that real estate is not in the grips of a bubble, typically have a vested interest in seeing the bubble continue. Those arguing that rising interest rates will not affect home prices are living in some self-serving, delusional, alternate reality. The real losers in this whole fiasco are likely to be those who did not even participate in the mania. As over-leveraged borrowers walk away from properties in which they have no equity, the Fed will most likely attempt to bail out both debtors and bank depositors (and the government sponsored enterprises that insured the loans) with the most inflationary monetary policy ever undertaken in the history of central banking.

THE DIVORCE BETWEEN GOLD AND FIAT NEEDS TO BE FINALIZED

The age-old “marriage” between gold and fiat is in the process of being dissolved. But didn’t Nixon do that in 1971? He did not really file for a “divorce” between the dollar and gold as much as force a sort of “de facto separation” while holding gold hostage to the dollar’s fortunes, locking it away in chains in the Treasury’s legislative value-prison: Although Nixon refused to ship gold to foreign nations upon their demand, he did not totally rescind the legislatively fixed, official dollar-gold price. That means the US Treasury continued to value the public’s gold stock at the now effectively useless legislatively fixed price ratio (then $35.00 per ounce, today at $41.222 per ounce). One could argue that it does not matter one whit why he did this because the official dollar price of gold is obviously not being observed by anyone in the world other than the US Treasury’s bean counters. That would be partially correct.

The dollar has in fact functioned as a gold-substitute ever since. Maybe not that well, but it has, nevertheless. Nations used it as their currency reserve. Nations, corporations, and individuals used it in international trade settlement. People in third-world and communist countries saved it to hedge against their own currencies’ decline. Oil was bought and sold in dollars. The entire world learned to revolve around the dollar, and the dollar alone.

If old-time hard money thought was correct, the world would have figured out that fiat cannot last and would have been reluctant to use it, but this did not happen. Demand for fiat remained high even after the market last vestige of gold-convertibility was severed. Now the financial leaders of at least part of the world appear to have recognized that fiat money is here to stay, but that gold cannot be “suppressed” forever without bringing the entire wold financial structure to an untimely demise.

In essence, the world’s nations and their citizens want to be able to save something other than the dollar, something that has great value and that does not lose that value -- like gold. At the same time, however, they want to be able to use fiat in order to trade their worldly things, because it is so convenient and so easily manipulated. Naturally, the US has the most to lose in such an arrangement. What it stands to lose is its current privilege to simply loan into existence whatever currency requirements there are for the goods it wants from the world. That explains why the US is fighting this trend tooth and nail.

What the world (outside the US) appears to be moving towards is an arrangement where cash will be used for spending, while gold will be used for saving. What needs to happen for this to occur is that gold needs to petition the court of high finance and the jury of the public for a divorce from fiat. In other words, gold needs to be totally disentangled from all officially decreed and controlled national currency involvement in terms of any fixed fiat to gold price relationship. Nothing else will do the trick. Why not? Because we have already seen what happens to a gold standard when the government that decreed it gets into trouble: it gets suspended.

A plan to make the euro a brand-new super-currency that could compete with the dollar in terms of the size of the underlying market it services, and in terms of international desirability as a trade medium and currency reserve, can be seen by the steadfastness with which the European Central Bank pursues its stability-oriented interest rate policy. Despite all the pressure coming from the euro member countries to drop rates so they can goose their stagnant socialist economies like the Fed does here, the ECB has held fast so far -- and continues to do so. Even though oil is threatening to fire up price inflation and further strangle those members’ economies, the ECB has announced it is not changing its policy. That is quite a feat for a central bank -- and is a clear sign that the ECB is marching to a different beat than the US Fed, altogether. The plan is to convince the world that the euro is at least as good, if not better, than the dollar as an international trade medium and as a currency reserve.

The plan is NOT, however, to convince the world that the euro is as good as or better than gold. Rather, the plan is to free gold from all governmental price controls and let it literally run free. The euro has nothing to lose by letting gold rise. One clear sign that this is so lies in the fact that the euro system values its collective gold reserves at market price -- whatever that may be. This shows more than just their concept that an ounce of gold is worth more to them than $41.22. It shows a definite philosophical, psychological, and especially political break from the American notion that, in order for their fiat currency to prosper, gold must be “controlled”. The euro is not competing with gold in its function as a savings-medium, as the dollar is. The euro is not even competing with gold as a currency. History since 1971 has already proven beyond a doubt that there is virtually endless demand for fiat. There is simply no conflict -- as long as each is allowed to operate in its best-use arena.

Even if gold and fiat have reached their natural “equilibrium price” -- whatever that may be -- gold will always remain the favorite value-safe, and that is why the entire notion of fiat having to “compete” with gold in that arena is really misplaced. It was a giant international monetary policy snafu. Gold has its perfect sphere and primary function -- and fiat has its, even though either one may make temporary inroads into the other’s “territory”.

The fiat powers will be assured of a more stable, self-supporting world financial system once such an equilibrium has been reached (a system they can still manipulate to their hearts’ content) because gold-suppression efforts no longer drains their resources. The gold hogs (savers) will be assured of the value of their accumulated wealth. And all will live happily ever after... except those who do not have any gold and must buy it. Some day in the not-so-distant future, even hedge funds will figure out that holding physical is way better for their bottom line than trading its paper-derivatives for depreciating fiat profits. Because of the sheer volume these outfits are able to move, that will be the day when the real gold price-hike begins. Unfortunately, a lot of water will run down all the rivers before that day comes. It is not a two or three-month proposition. Gold will “crash” and almost instantly recover many times before then, but those who can hold their gold until then will live like Kings -- or better.

But first, there must be a divorce.

OVER BOUGHT -- UNDER THE SWORD OF DAMOCLES

Markets stumble from the sudden realization that we are at war in Iraq -- and it is not going well. Likewise, rising crude and gas prices have suddenly starting showing up on the radar along with strains in the Sino-US trade structure. Grotesque pension under funding, ballooning debt, twin deficits, lackluster employment growth, slowing Chinese economic growth, and global hatred for the Stars and Bars have yet to be considered.

I propose an over-under analysis to make sense of investors’ recent (and likely short-lived) return to their concern with global political and economic events. I believe that markets have been caught in a classic case of rotation of attention. Not traditional sector rotation, but an all together different breed. Despite the end of the 1990s, cheers and expectations that equities always defy gravity remain. Yet, conviction is thin. Periodically reality intrudes and indices tumble. I believe this has been true over varying intervals and with a wide fluctuation of intensity since 1998.

A brief look at NASDAQ, S&P 500 and DJIA charts of the past year show the emergence of new volatility and strains in the faith. Months of “under-concern” -- often open disregard -- for flows of macroeconomic and current events information, have given way to brief and furious rounds of fear and selling. These dips are driven by overdue epiphanies regarding the seriousness of threats -- economic and geo-political. Yet, the market has proven unable to stay focused on, and adequately downward adjust, for the bad news that hovers over buyers’ heads like the Sword of Damocles. Like the poisoned and temporary wealth of Damocles, delusion-fueled gains prove seductive until the correction sword is noticed hovering overhead. The Sword has been intermittently glimpsed over the last few months. Unlike Damocles, buyers have refused to trade their tenuous and imperiled gains for safety and sanity. There is “over concern” with gains and “under concern” for the hovering blade.

Under concern with context drives flights of fancy, followed by over the top fixation on serious problems, driving averages lower. If the recent past is a guide, this can only last so long before hotter heads and the need to believe again trump rationality -- the handmaiden of selloffs. Under concern will then combine with over interest in cashing in. An irrational surge will temporarily vanquish wise doubt. This will set the stage for a real, sharp and prolonged correction. This has been the pattern for at least six years and will continue to be until, and unless, massive trauma or a reversion to sanity occurs. I would tend to think the former far more likely than the latter.

CORPORATE CRONYISM CONTINUES

Despite all the furor about bad governance, despite the bad name that miscreants at Tyco and Enron gave to capitalism, some executives are still practicing old-fashioned corporate cronyism. Some 75% of companies still engage in related-party deals, says the Corporate Library, a research group in Portland, Maine. that studied 2,000 publicly held firms. That means the companies have to make embarrassing disclosures in their proxy statements about nepotism, property leased from the boss, corporate-owned apartments and other forms of insiderism that ought to be passé. What is the matter with these guys?

With help from the Corporate Library and a review of 520 company reports, we went trolling for mischief in the executive suite. What follows is a summary of the more outlandish moves. Please note that none of them is illegal.

WHY IS THERE A RECORD NUMBER OF NEW SUPER-JUNKY BONDS OUT THERE?

“The financing of today will be the bankruptcies of tomorrow,” Carl Icahn warned debt investors at a recent Bear Stearns conference. Spoken like a vulture who knows where his next meal is coming from.

There has never been so much new junk on the table. Virtually anyone can raise money in the debt markets this year; all they have to do is show up, even if they limp on one leg to get there. Through April, companies issued $44 billion of speculative-grade debt -- rated BB or lower by Standard & Poor’s -- compared with $28 billion over the same period in 2003, which was the second-biggest year ever for high-yield issuance. Worse yet, a record high of 12% of this year’s new junk is rated by S&P as CCC. In the ratings inflation of the bond-rating world, that is not a gentleman’s passing grade. It is just two full notches up from bankruptcy. Some of junk buyers have obviously forgotten the telecom blowup.

Don’t look for the sky to fall right away. With interest rates still low, companies are refinancing to get longer maturities and lower coupons. Nicholas Riccio, a managing director at S&P, said that “the caliber of new credit is telling you that two or three years down the road you are going to see a surge in defaults.” Here is a sampler of the junkiest debt securities.

PROFIT ILLUSIONS

The spotlight is on corporate earnings. They have got to be robust to substantiate the bulls’ enthusiasm for stocks. The recent jump in bond yields, anticipating a Federal Reserve tightening and renewed inflation, makes you wonder how robust earnings will be -- and how high stock prices can stay. In fact, at 22 times the last 12 months’ earnings, the S&P 500 is already unsustainably high. Furthermore, the average dividend yield (now 1.7%) is far too low to provide meaningful support for equities.

Unlike some of Wall Street’s bears, I do not predicate my disdain for stocks on an inflation threat. I continue to forecast mild deflation in future years, with 30-year Treasury bonds yielding 3% compared with 5.4% today. My case against stocks rests, in contrast, on the weak outlook for corporate profits. I also believe the recent yield spike more than accounts for all the likely Fed tightening this year. And the U.S. economy may be soft enough by year’s end to revive deflation concerns and to lower Treasury yields. But this still does not make me like stocks. The main problem with equities is going to be weak profit gains.

FEAR OF RISING INTEREST RATES UNJUSTIFIED?

Today the investment community is convinced that once the Federal Reserve shifts from sly hints to bona fide interest rate hikes, stocks will get clobbered. Maybe even more than Iraq and oil prices, Fed fear is what has held back the market this year. And this in the face of good earnings news, which should be a tonic: 76% of S&P 500 stocks beat earnings estimates in the first quarter. History, though, teaches that these naysayers are probably going to be wrong. As noted by fellow columnist David Dreman and several others with a sense of the past, any negative impact on stocks from rate hikes is short-lived. Then the market tends to rise anew.

Everyone remembers how bonds got creamed in 1994, when the Fed pumped short-term rates from 3% to 6%. Long Treasurys lost 25% in value. What everyone does not remember is that stocks survived the rate hike. They treaded water in 1994 before moving up again. My firm has measured what happens to stocks when the ten-year Treasury is in a 20% rally or decline. There have been 11 such bear markets in the ten-year since 1962. In 6 of them the market went higher during the bond market decline (that is, as rates increased). The average length of these bond market declines has been 8.5 quarters, and the S&P 500 has gained an average 5.5% taking in all 11 periods. When rates go up, price/earnings ratios usually do contract: They did so in 7 of those 11 episodes. Bonds, of course, were massacred during those times of rising rates, losing an average 34% in value.

Many market optimists also suffer from a lack of historical sense. These bulls want to shun gold, with its reputation as a safe haven in tough times. That cliché about gold is dead wrong. When stock markets turn up, gold is right there as well.

Wall Street expects an opening tightening move at the Fed Open Market Committee’s next meeting, June 29-30, with a quarter-point move that may be a prelude to more. One rule of thumb is that short-term rates should be two points over inflation. With the Consumer Price Index gaining 2% over the past year, that means the overnight rate must go from 1% now to 4%. While the market reels during that exercise, treat the malaise as a selective buying opportunity. Note the caveat. Some stocks are down and likely will stay down because they were the creatures of excess.

KEN FISHER’S ROAD MAP FOR THE REST OF 2004

While 2004’s stock market has started off bleakly, abundant reason exists for optimism here and now. Stand your ground. Buy stocks. Historical patterns strongly lean toward the likelihood that 2004 will end with a gain for the stock market. As my March column detailed, presidential election years are almost never down years for the broad U.S. stock market. Since 1899 there have been 26 quadrennial elections; in only 4 of these years did the market fall.

To refine history a bit more: In 18 of these elections an incumbent was running, and the index showed a yearly decline in only 2 of those cases. Now, to press the statistics to their limit: You could further look at the 13 election years in which an incumbent was reelected, and you would find that the market was up for all but one of the years and that the average total return for all 13 was 15.8%. So, better if Bush is reelected, but either way I am expecting an up move for U.S. stocks between now and December.