Finance Digest for Week of June 7, 2004

IGNORANCE IS BLISS

In a speech given by the author at the New York Institutional Gold Show last week, he reflects on how humility is probably the greatest of all virtues. It helps you in all of life. In investing, it is essential. After many years of humiliating attempts to understand the market and being humbled, he finally realizes that he knows almost nothing!

HOUSING: TOO GOOD TO BE TRUE

Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.” It is too good to be true. What the prophets of the new housing paradigm do not discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures.

The case of Japan’s real estate bubble is instructive. Japan had a stock market bubble in the 1980s that was very similar to the U.S. stock market bubble in the 1990s. As the Japanese stock market started to bust, the real estate market continued to bubble. One general index of Japanese real estate shows that prices rose for almost two years after the stock market crashed with prices staying above pre-crash levels for more than five years. The boom in home construction continued for nearly six years after the stock market crash. Prices for commercial, industrial, and residential real estate in Japan continue to fall and are now below the levels measured in 1985 when these statistics were first collected.

It has now been three years since the U.S. stock market crash. Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bailout the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.

Hot Vegas

It was reported last week that the M3 money supply has increased at a breathtaking 20% annual rate in the last 4 weeks, going up $155 billion. Coincidently (or not), the Bureau of Land Management (BLM) held another of its semi-annual land auctions in Las Vegas. With Alan Greenspan providing the juice and animal spirits aplenty in attendance, the BLM set new records both in terms of the total amount of land sold ($707,185,000 worth) and price per acre ($279,299). The total sales figure was more than double the $309,769,500 total appraised value of the parcels.

Australia’s housing bubble could be the first to burst. It won’t be the last.

Seeking to cut through the tangle of statistical measures of Britain’s housing market, the economics editor of The Economist turned to her hairdresser. Last year, he was convinced that “buy to let” was a sure way to make money. Today, finding it harder to cover his costs with rents, he has decided to sell. A sign that the residential-property boom could soon turn to bust? Maybe. Figures, not just anecdote, also suggest that in Britain and elsewhere, housing markets look ready to fall.

Two years ago, we launched a set of house-price indicators, backdated to 1975, for 13 developed economies. In our latest quarterly update we have added three more countries: New Zealand, Denmark and Switzerland. Our indicators, based on data from estate agents, lenders and official sources, show that house prices are slowing in several economies that had been looking frothy.

Australia’s housing market has weakened. According to official data, average house prices kept rising in the first quarter, leaving them 18% higher than a year before. However, figures collected by Australian Property Monitors, which are more timely because they are based on prices when contracts are signed rather than at settlement, suggest that home prices tumbled by an average of 8% in Sydney and by 13% in Melbourne in the first quarter. Anecdotal evidence suggests that the slide has continued since then. Last weekend in Sydney only one-third of properties put up for auction -- the most common method of sale in Australia -- were sold, signaling that prices have farther to fall.

The drop in house prices in Australian cities undermines a popular argument heard in Britain and America that even if house prices do look frothy, they are unlikely to fall unless there is a big rise in interest rates or a jump in unemployment. Neither has been needed in Australia. Instead, the main reason for the falls in Sydney and Melbourne seems to be that first-time buyers have been priced out of the market, while demand from buy-to-let investors has dried up as net rental yields have fallen below mortgage rates.

Through The Roof

“A record shortage of homes for sale in London has prompted a new property trend -- the sealed-bid auction,” read the opening line in an Evening Standard article. So, it has finally come to this -- auctions for houses. In London, there are now 10% more buyers than sellers of homes. For the privilege of home ownership, buyers are now willing to bid on houses at above their maximum asking price. No negotiations, no “let me think about it” -- take it or leave it. In fact, the number of house buyers in London has exceeded sellers every month since July 2003. Real estate agents attribute this to a low supply... but would it not be more accurate to blame high demand?

It is the demand for houses that is truly unprecedented. Halifax, Britain’s largest mortgage lender, reported today that houses in the UK are now appreciating at 20.4% a year. To an average person, that sure beats owning stocks: The FTSE 100 is at best flat for the year. Real estate became the investment dujour in the UK (and the U.S.) after the 2000 top in global stocks. But at least in the U.S., the housing craze can be “explained” by low mortgage rates, pegged to the Fed’s historically low 1% interest rate. In the UK, however, the Bank of England began raising rates in 2003, and is expected to do so again on June 10. Yet even the rising cost of borrowing is not able to cool the demand for homes.

Real estate investment on both sides of the ocean seems to have entered the mania stage. Houses today are the tech stocks of the late 1990’s. Was the 80% drop in the NASDAQ not a hard enough lesson for investors? Or did it happen so long ago that people already forgot how quickly the market can “regulate itself”? In the face of a mania, these questions become meaningless.

INVESTING OFFSHORE NOT JUST FOR THE RICH

There are over 100,000 offshore funds, some with investment minimums as low as US$5,000. A great example is GAM Diversity, a low-risk hedge fund that has gained an average of 13% per annum since 1989, with 50% less standard deviation, or risk, than its benchmark index (MSCI World Index). While GAM Diversity is now closed to new investment, GAM Diversity III), managed in the same manner, is still available.

Because many offshore funds want to avoid burdensome US regulation, many of them will not sell shares directly to U.S. citizens or residents. However, you can legally buy them through an offshore bank. Another hurdle for US residents investing in offshore funds is U.S. tax laws. These laws can require you to pay taxes on unrealized gains on your funds on a yearly basis. Yet you can easily overcome this obstacle by purchasing these funds through a tax-deferred vehicle such as a retirement plan.

STOCKS: THE BIG PICTURE (FROM ONE PERSPECTIVE, ANYWAY)

Over the last two decades, Ross Clark, who heads up the technical research published under the ChartWorks banner, has discovered some important relationships and/or recurring patterns. The one laid out in the following chart was first observed in 2001 when, in internal discussions, it was referred to as the “expanding pattern”. The discovery was that the distinctive pattern set at the top for the S&P in March, 2000 was being replicated at subsequent highs although the time span for each top was expanding. While expecting the phenomenon to continue, it has been important to present the research in a clear format and at an opportune time.

Since the chart pattern that is the subject of this essay was first observed in 2001, the term “constrained randomness” could definitely be used to describe the powerful and, so far, measurable forces at work in the stock market. Should it continue to work out, the ultimate low for the S&P would be around 400 in August 2008 (vs. around 1140 today). Will the S&P continue to follow the “model”? As on any observed recurring patterns, our conclusions have been that there is no guarantee that the phenomenon will continue to work out. Then again, there is no guarantee that it will not.

MILTON FRIEDMAN: AHEAD OF HIS TIME THEN ... AHEAD OF HIS TIME NOW?

If you majored in economics or are well read on the subject, you almost certainly know who Milton Friedman is. He has been plausibly called “the most consequential public intellectual of the post-war era,” for two good reasons: 1) His powerful advocacy of free markets & smaller government, and 2) His Nobel-prize winning arguments on behalf of monetarism, namely that government can restrain inflation and promote economic growth by controlling the money supply. I long ago lost faith in monetarism as an economic policy, yet my personal admiration of him never waned. The two points above are widely embraced these days, but I assure you that it has not always been so. Milton Friedman was reviled as a contrarian and reactionary in the late 1970s. He was ahead of his time.

All that said, the recent chatter about “what” the Fed will do and “when” it will do it reminds me of an essay I read around this time last year. Morgan Stanley’s Stephen Roach was the author, and he quoted a Financial Times article (also from June 2003), which attributed these words to Dr. Friedman: “The use of money as a target has not been a success. I’m not sure I would as of today push it as hard as I once did.” I could hardly believe it, to the point that I tracked down the Financial Times article. It was true. Mr. Roach rightly observed that “the world’s most well-known monetarist” had “just recanted the central premise of monetarism.”

The irony speaks for itself, but I will say it anyway: As the central bank still tries to use monetary policy to manipulate the economy, monetarism’s greatest champion has run up the white flag. Apparently Dr. Friedman’s mind -- now in its 91st year -- is still sharp. I wish I could ask him why he changed that potent mind; it is possible that he agrees with Stephen Roach that “macro policy has had a truly terrible track record in dealing with inflation.” What I DO know is that the monetary and fiscal policy “solution”q are running low, claims of “unlimited ammunition” notwithstanding.

SHOPPING ‘TIL THE (U.K.) MARKET DROPS

“Shoppers spend-spend-spend despite rate rise threats,” reads a recent BBC headline. In the UK, retail sales are now the strongest since April 2002. During that previous peak in UK consumer spending, the FTSE 100 stood at around 5,200. By June 2002, it started sliding and finished the year 27% lower. Today, after a one-year rally, the FTSE is up big. Could the current “strength” in UK retail sales be a warning sign in disguise for the FTSE, as it was back in April 2002?

Quite possibly. And here is another “positive sign”. Analysts say that the surging UK consumer spending is bound to make the Bank of England raise interest rates again -- and soon. That could prove to be an ill-timed decision: Central bankers’ timing has been off on more than one occasion. For example: The U.S. Federal Reserve raised the rates near the great market peaks of 1929, 1966 and 2000. Japan’s central bank did the same thing right after the markets hit an all-time high in December 1989, raising the discount rate a full point in March 1990 “to let the air out of the bubble slowly.” We all know what happened to the NIKKEI next.

The spike in UK consumer sentiment is only one sign, and not even the strongest one, of a break in market trend across Europe. The just-released June European Financial Forecast shows you six other strong economic and technical indicators that may bring you to surprising conclusions about the current condition of stocks in Europe. In fact, over the past few weeks, European bourses have already validated all but one of those indicators. There is just one last piece of the puzzle remaining ...

NO MORE “BUY” AND “SELL” ... JUST “BUY AND HOLD”

Recently, the British bank HSBC adopted an unprecedented new policy to “scrap their analysts’ buy and sell recommendations”q The decision came after the bank’s clients expressed a lack of interest in the “traditional equity research”, according to an HSBC spokesperson.

In the past four years, many investors lost faith in “traditional” research. Mainly because all through the 1990’s bubble, it seemed that “traditional” analysts would never put a “sell” recommendation on a stock. Most brokerage firms continue to keep their average recommended asset allocations near 70% in stocks. And so far, no other major financial institution has followed HSBC’s lead. Indeed, why even bother with “buy” and “sell” when you can just “buy and hold”? The “traditional equity researcher”, in their almost unanimous bullish consensus, still say that right now, “the biggest risk... is not being in stocks.” That is despite the fact that through legal insider trading, U.S. executives continue to unload billions of dollars worth of their own companies’ stock every month. In February, they sold $4.9 billion worth of shares, the highest level since May 2001. Don’t take Wall Street or the City at their word. Weigh the bullish and bearish evidence yourself.

GOLD’S ACHILLES’ HEEL

Oil prices recently hit all-time nominal highs in excess of $43 per barrel. The Middle East remains a tinderbox. Washington has warned us anew that it fears a major terrorist attack against U.S. interests -- perhaps even again on U.S. soil. Even absent oil price pressures, inflationary expectations in the United States have been steadily on the rise. Yet in spite of all of this and more, gold has been unable to get out of its own way. The uncertainty and volatility that have bedeviled virtually all markets over the last few months certainly has not helped gold, with traders unsure whether they should zig or zag. But there is a far bigger factor that currently has gold acting tentatively; and one unlikely to go away any time soon.

To recap first, after plunging precipitously in April down to near $370 per ounce the yellow metal has since managed to bounce a time or two, courtesy of the recent softening in the dollar. However, as you see here, gold remains in a descending channel, and has noticeably been unable to break both out of it, as well as back above its 50 and 200-day moving averages, which have just converged.

Fundamentally, the news for gold recently has not been all that bad. However, the “killer” has been the always fickle investment demand for gold, which since late last Summer has been the main driver of the gold price. A recent World Gold Council report revealed that net institutional investment demand for the metal stagnated during the first quarter; a situation that “may in fact have intensified,” it added, in the second due to speculative funds unwinding their previous positions, as well as being uninterested in establishing new ones to any great degree. Sentiment -- which currently is lousy -- may not change any time soon.

In short, gold will for a while longer remain hostage exclusively to currency movements, chiefly that of the dollar against the euro. Until that situation clears up and the greenback more forcefully reasserts (or is made to reassert) its secular bearish trend, precious metals will languish. Gold’s Achilles’ heel -- investment demand -- which over the last several months of 2003 and early on in 2004 gave us soaring prices as short-term players piled on to what was already a two-year bull market, is now working against us. Don’t be a bit surprised if gold first trades at or below $350 per ounce, before we see $450 (or higher) somewhere down the road.

WHY ALL THIS POLITICAL STUFF ON A FINANCIAL PAGE?

If you have followed political discourse in the past couple of years, you do not need me to inform you that there is more “politicking” than “discoursing” going on. TV scream fests, the titles of best-selling books, columnists, even some moviemakers have gravitated to one political pole or the other. The dwindling handful in the middle is left to complain about ... well, “polarization”. New York Times columnist David Brooks is one of the “dwindlers”. He is not easy to categorize (he used to write for The Wall Street Journal). In a June 5 Times column, he says that in coming months he wants to write about “the dominant feature of our political life: polarization.”

His conclusion? “The overall impression one gets from these political scientists is that politics is a tribal business.” Sheesh, Mr. Brooks, didn’t we go there and do that more than 200 years ago? The Founding Fathers and their Federalist Papers got it all on the record -- you know, “power corrupts”, “checks & balances”, “enumerated powers”, the 10th Amendment and the like? “This theory doesn’t explain how the country moves through cycles of greater and lesser polarization” is his next-to-last sentence, which brings the reader full circle to the “confused” beginning. It is not my purpose to pick on Mr. Brooks, and you may be wondering what all this political stuff is doing on a page devoted to financial topics. Well, Mr. Brooks is on to something regarding “cycles of greater and lesser”q and the extreme degree of “polarization”. But by his own admission what he lacks is an “explanation”.

We have what he lacks, namely an understanding of the patterns of mass psychology. As for the reason I bring it up on this page, consider this 1989 comment from Bob Prechter, discussing “a polarization of opinion in all kinds of areas. It’s not just that the left takes over or the right takes over. During bull markets such as in the 1950s and the 1980s, most people are centrists. In bear markets, you see extreme polarization.” The psychology of a bear market reflects an even greater psychology. Once you understand it, you understand a great deal more than just the financial markets.

Anti-isms

The fear and hatred of strangers or anything foreign has a long history, stretching at least back to the ancient Greeks from whom the word “xenophobi”q originates. Name any nation around the globe -- Japan, Germany, the United States -- and it is easy to think of examples of xenophobic behavior, whether those within the country feared opening their shores to foreigners or hated certain people within their own borders based on their religion or the color of their skin. With the progress of the bear market in Europe, xenophobia and exclusionism are becoming more pronounced. Here is what The Elliott Wave Theorist back in 1992 had to say about social manifestations of a bear market mood:

“Major bear markets are accompanied by a reduction in the size of people’s unit of allegiance, the group that they consider to be like themselves. At the peak, it’s all ‘we’; everyone is a potential friend. At a bottom it’s all ‘they’; everyone is a potential enemy. When times are good, tolerance is greater and boundaries weaker. When times are bad, intolerance for differences grows, and people build walls and fences to shut out those perceived to be different. Ultimately, persecution and war result.”

Let us look at four examples of xenophobia and exclusionism going on in Europe now: 1.) Anti-immigration behavior is rampant; 2.) Extreme right-wing political victories; 3.) Anti-Americanism is on the rise; and 4.) Anti-Semitism is on the loose again.

Conclusion: All these “anti-isms” spring from the same source -- the emerging bear market in social mood. As Europe heads lower, the urge to close ranks and close out others will metamorphose into open conflict and escapist activities. The decline has a long way to go, so the likelihood is that the national boundaries separating EU members will regain much of their historic significance. And at least some of these emerging bear market impulses will serve as the basis for successful political movements.

OIL-AHOLIC AGRESSION

A hawkish leadership in the US, the war in Iraq, terrorism, soaring commodity prices, the economic rise of China and its thirst for resources (oil in particular), several recent articles concerning the growing tensions between Japan and China, and instability in Saudi Arabia all suggest that global geopolitical tensions are on the rise and could, at some point in the future, have a very negative impact on the global economy and financial markets. Today we focus on China. Last year, China replaced Japan as the world’s second largest importer of crude oil. Soon after taking over power, a year ago, President Hu Jiantao and Premier Wen Jiabao decided that, “securing reliable supplies of petroleum and other scarce resources was not only crucial to sustained economic development, but integral to China’s national security.” It is a thirst that threatens to pit China against its neighbors, despite Beijing’s avowed policy of “peaceful emergence” in the global community.

It may initially seem far-fetched, but with all these threats, it is not hard to see why China might want to invade Taiwan. To anyone who looks at a map of the region, the reasons are obvious. Taiwan’s strategic location makes it extremely valuable. The Taiwan Strait is a critical sea lane, and taking Taiwan would allow China to choke off international commercial shipping, especially oil, to Japan and South Korea, should it ever decide to do so.

Wendell Minnick, Jane’s Taiwan correspondent, published a disturbing article recently. Under the title “The year to fear for Taiwan: 2006.” (Most analysts believe that China’s military strength will exceed Taiwan’s defense capabilities by 2005, hence 2006 is the year to fear.) Minnick postulates that should China decide to take this route, it would be unlikely to be a large-scale, Normandy-type of amphibious assault, but involve something more akin to a “decapitation strategy”. Minnick explains that “decapitation strategies short circuit command and control systems, wipe out nationwide nerve centers, and leave the opponent hopelessly lost. As the old saying goes, ‘Kill the head and the body dies.’ All China needs to do is seize the center of power, the capital and its leaders.” There would be too many pro-China people in the US State Department -- privately relieved the Taiwan issue was finally settled -- to say anything in Taiwan’s defense. With pro-China sentiments running high in the Taiwan military, it is likely that most would grudgingly accept a new mainland president.

Taiwan is strategically important for the US and Japan, but from the Chinese perspective it is vital. Rest assured that the administration will consider every option to ensure China’s continued growth, including military operations.

WEALTHY US INVESTORS’ OPTIMISM AND BEHAVIOUR MISMATCHED

Wealthy US investors are “optimistic” about the outlook for the stock market but are holding off because of worries over terrorism and other geopolitical factors, according to a survey sponsored by United States Trust Co. The survey polled a sample of 150 people from all regions of the U.S. considered to be among the wealthiest 1% of the population based on adjusted gross income of more than $325,000 per year, or a net worth greater than $5.9 million.

The respondents said they expect annualized stock market returns of 10% over the next three years and over the next 10 years. Their expectation over a one-year period was 8%. But that optimism did not match their behavior, said Paul Napoli, executive vice president and head of personal wealth management for US Trust. “They have taken a very defensive, very conservative posture,” Mr. Napoli said. The wealthy investors have about 40% of their portfolios in cash and bonds. About 33% is allocated to domestic equities.

BOMBAY DREAMS

For nine days, I am going to be meeting with some of the most powerful businessmen in all of India. I want to confirm my suspicion that, over the next 15 years, India will emerge as the next Asian Superpower. On paper it seems like a no-brainer. With a population over 1 billion, a huge growing, well-educated middle class, a stronger stock market, an improving education system and a democratic government, the foundation is set for some serious growth. Now I want to see it for myself.

For the first time ever, India is no longer a debtor country. It has foreign exchange reserves in excess of $116 billion. It expects to double its college graduates in the next six years. Its currency has been upgraded to “investment grade” by Moody’s, for the first time ever. Major Western companies like Microsoft, IBM and GE are all opening offices in India’s main cities. And technology (phones, computers and Internet access) is starting to make its way into India’s towns. This is an exciting time for India -- and for long-term investors willing to put money in Indian stocks. And when India does emerge into a legitimate superpower (eventually growing into the third-largest economy in the world), I expect a surge in one industry in particular.

When a country emerges from Third World to superpower, one of the first industries to rise is telecom. And the boom is already taking place in India. Couple that with the fact that India has now opened the telecom industry up to competition, and the stage is set for explosive growth in the future. Anytime you own stock in an emerging country like India, you have to be prepared to lose. But the rewards if you are right can be huge.