Finance Digest for Week of June 21, 2004

DOUBLE BUBBLE WILL LEAD TO VENTURE CAPITAL RETURNS TOILING IN TROUBLE

Brace yourself. It is only a matter of time before someone pitches a concept for an online pet store. Just 20 months after the bottoming of NASDAQ, and with only a modest uptick in initial public offerings, bubble-era enthusiasm is back in the venture capital business. Pension funds in the U.S. and investors as far-flung as Dubai, Finland and Singapore are all but knocking one another down to get into the best Silicon Valley funds. Failing that, they may end up giving their money to anyone who will take it. And the valuations of the upstarts that get the money are starting to suggest mania.

New Enterprise Associates raised $1.1 billion in February for a venture pool. “We could have raised $3 billion if we wanted,” says NEA managing general partner Peter Barris. Dixon Doll, cofounder of DCM-Doll Capital Management, says the $375 million fund he closed in June was way oversubscribed. ComVentures’s last two funds, though mostly invested, have failed to deliver any substantial payouts to limited partners. Yet cofounder Clifford Higgerson says his recent $300 million fund was overbooked, too. Snipes Nancy Schoendorf, a managing partner at Mohr, Davidow Ventures: “Mickey Mouse and Donald Duck could raise a fund today.”

Playing the role of Goofy are the limited partners that put up the cash. If you believe the intended asset allocations of pension funds and other investors, they would like to put $1 trillion to work over the next five years in venture capital, on top of the $50 billion still unspent from the first bubble. This looks like a recipe for bad returns, given the inverse relation between the supply of investment capital and the resulting gains. The new mania is inspired by the excitement over Google and the average annual 8% return that existing venture funds claimed for the last three months of 2003, the first positive return in three years. Public pension funds are joining the gold rush.

WHY RATES WILL GO UP

Interest rates will be rising for the next quarter-century. You can look it up. Cycles in the bond market are famously long-trending. In the U.S. yields fell for the last 40 years of the 19th century. They rose for the first 20 years of the 20th century. They fell between 1920 and 1946, then started up again. They peaked in 1981 and fell for the next 22 years, i.e., until June 13, 2003, when the yield on the ten-year Treasury note slid to a meager 3.1%. Now the yield is back up to 4.7%. You would perhaps like to know where it will be next week, on Labor Day or at the close of business on New Year’s Eve. The truth is that I do not know. Nevertheless, I do believe I know where rates are going over the next generation: They are going up.

I base this forecast on precedent, and if for some reason the market has slipped its historical moorings, I will have to execute a predictive U-turn. But unless and until the yield makes a new low (and the market value of bonds, a new high), I will treat June 13 of last year as the day the sun started to shine on long-suffering American savers. The new money they put to work will be collecting better coupons. Why have interest rates done what they have done? What accounts for these long-ranging cycles? Science has produced no explanation.

Possibly, because longer-term yields are so sensitive to inflation, the answer lies with consumer prices. And these prices, too, are long-trending. And there is a closely related factor at work in prices and interest rates. Monetary systems, too, rise and fall. The late-19th-century decline in rates and prices coincided with the restoration of the full-strength gold standard after the Civil War. And the great post-World War II bear market in bonds happened to coincide with the decline and fall of the Bretton Woods monetary system, which was instituted in 1944. But the decline in interest rates from 1981 to 2003 occurred despite the transformation of the dollar, beginning Aug. 15, 1971, into nothing but a piece of paper. The bond market, although initially alarmed by this epochal development, at length warmed to it, finally deciding that the Federal Reserve was as good as gold, if not better. That was then. If past is prologue, the future will surprise. An era of rising prices and rising interest rates is at hand. Posterity will supply the reasons for the looming rise in interest rates. History says that it is coming.

DON’T WORRY ABOUT A 1973 REVISIT, AND BUY OIL STOCKS

Veterans of Wall Street grimace at the memory of 1973, the year of the Arab oil embargo. Back then drivers often waited an hour in line to fill their tanks at prices that had skyrocketed 150% to $3.80 a gallon (in 2004 dollars). Higher fuel prices plunged the economy into recession, as well as the worst stock market break of the post-World War II period. Now a number of prominent strategists say the sharp spike in oil prices makes today look eerily like 1973. Are they right? Absent a devastating terrorist action, no.

There are significant and reassuring differences between 1973 and 2004. Then the economy was weakening for cyclical reasons, and now it is strengthening. The market had hit a peak in early 1973 and had already begun to fall when the embargo arrived. Today you can argue that the market is a bit overpriced, yet nothing like in the past. The S&P 500 trades at 17 times estimated 2004 earnings.

I do not share the view that oil will return to mid-$20s per barrel prices; I expect the price to soon settle in the mid- to high 30s, a good $10 above what we had grown accustomed to. High oil prices are with us for a while. Oil is no longer in oversupply, and refineries are almost at capacity. The oil industry has not increased, and in some cases has reduced, exploration budgets, making a tight supply even tighter up ahead. What shines through the contrasting prognostications is that oil stocks are good buys. They still look cheap because of the mistaken Street consensus that per-barrel prices will dip. These stocks have low price/earnings ratios, with many showing strong cash flows, low debt-to-capital ratios, plus rich and increasing dividends.

ONE IN EVERY 125 U.S. RESIDENTS IS A MILLIONAIRE

The 2004 World Wealth Report, compiled by Merrill Lynch & Co. and consultancy Capgemini Group, says the number of U.S. millionaires was up 14% from last year. It also found the United States and Canada together added more new millionaires last year than Europe, Asia, Latin America and the Middle East, combined. Researchers said the number of wealthy people would have been higher had the study included the value of peoples’ homes.

China home to 236,000 millionaires.

There were 236,000 Chinese citizens with at least $1 million in financial assets, excluding their homes, says the 2004 World Wealth Report. Hong Kong had the greatest growth with a 30% increase during 2003, which Merrill Lynch attributed Hong Kong’s increase to the booming Chinese economy.

Hong Kong sees large growth in high-net-worth individual population.

Of the 68 countries and territories reviews in the World Wealth Report 2004, Hong Kong recorded the biggest leap in its high-net-worth individual population. Buoyed by the recent economic recovery and profiting from increasing levels of investment in mainland China, the combined wealth of Hong Kong’s HNWIs (people worth US$1 million or more excluding residential real estate) grew to US$437 billion in 2003, up from US$337 billion the previous year. The findings are also in stark contrast to what happened between 2001 and 2002, when the number of HNWI in the territory shrank by 8,000 to 35,000.

BOMBAY MIX

After meeting with the Indian managing director of McKinsey & Co., the CFO of a major Indian telecom company, and Kakesh Jhunjhunwala -- one of India’s successful proprietary investors -- I have confirmed many of my original thoughts. India is a place worth investing in for the long haul. I will explain by taking you through each of my three meetings.

The Buffett of Bombay

Amid the squalor in Mumbai lies a golden gem. And for the uninitiated small-cap investor stateside, it is -- quite possibly -- a buried treasure. I have to say that meeting Mr. Bharat Shah, CEO and Managing Partner at ASK Raymond James, here in Bombay, was the highlight of my trip to India. The “Buffett of Bombay”, Mr. Shah makes his living by scouring the market for true value stocks -- companies with both a margin of safety and a growing business model. He has a history of being right. From the interior of Mr. Shah’s office, anyone could tell that Mr. Shah was a very successful investor.

There is no doubt that this man knows what he is doing. And he knows how to spot value in the market. With that in mind, my first question was: “Do you think the Indian market is overvalued, undervalued or properly priced?” He told me that, as a whole, he felt the Indian market was slightly undervalued - not much, mind you. But with stocks trading for around 11-times earnings, Indian businesses certainly are not expensive.

Mr. Shah is not concerned with the price of a company. He determines value by looking at how well a company manages its capital, how well the managers run the business and how the company is valued based on EBITDA and cash flow. “If you really want to find value in India right now,” he told me, “you shouldn’t look to the large blue chip companies -- those trading on the Sensex and Nifty (the equivalent of the Dow and the S&P in the States). Rather, the real gems are hiding in the mid and small-cap markets.” There are many smaller Indian companies with cash, growing businesses and competent managers, which are flying under the radar screen. These are the companies you should be looking at. And then he made a point that really resonated with me... “Value without growth isn’t value.”

WHEN FIGHTING HMOS, SHOOT FIRST (AND ASK QUESTIONS LATER)

Are health maintenance organizations in the business of practicing medicine? No, the Supreme Court says: They are in the business of denying medicine. The court has weighed in on one aspect of so-called patients’ rights laws and held that patients could not sue HMOs for the results of their refusal to pay for certain doctor-approved remedies. The best they can do under the federal law that governs such matters is sue under the insurance policy for reimbursement of the cost of the benefits the HMOs denied. In a unanimous decision written by Justice Clarence Thomas, the court held that coverage-denial suits against HMOs cannot be filed under state malpractice laws but must proceed in federal court under the Employee Retirement Income Security Act of 1974.

HEWLETT-PACKARD UNDER THE MICROSCOPE

It is not surprising that the analysts are not recommending HP. The increase in revenue in Q1 is largely the result of the fall of the US dollar and the increase in profit is mainly due to cost-cutting exercises which cannot go on forever. What does that leave us with? Not a lot.

The world has moved on since Walter Hewlett opposed HP’s 2001 proposal for a merger with Compaq. There is no way of estimating where HP might be if the merger had not taken place and the likely consequence of that, Carly Fiorina not being HP’s CEO. It has to be said though that Walter was quite correct on a number of points. He saw the larger PC exposure as being a cash drain with increased risk and the economics of the situation being unattractive. Certainly spending over $6 billion to return about $55 million profit per quarter does not seem a wise move when Printing generates about 16 times the profit and does it on lower costs.

Walter also claimed that the average selling price of PCs was falling and that has certainly been proven. He also said that the profits from PCs go to the “owners” such as Microsoft and Intel, and you cannot argue with that statement. He emphasised that Dell’s direct distribution model allowed it higher profit margins than HP even at lower selling prices and this continues to be a sore point for HP. The growth in the Services segment has been one of few areas where Walter just may have got it wrong, but the merger came at a high price if Services turns out to be the only major benefit.

Some commentators have wondered why Carly Fiorina has not received more credit for the way HP is performing but that is the problem; it’s not. The company is almost stagnant when the effects of the declining dollar are taken out of revenue and cost-cutting is all very good but cannot continue for ever. Just watch those profits decline when the dollar regains ground against other currencies.

Whither Gateway?

Gateway certainly has a lot going for it -- its brand name is recognized world-wide, it is renowned for its customer service, and those that buy its products are generally happy with their purchase. But Gateway is still losing money. It really has to do things fundamentally differently if it is going to survive as a viable business. By putting its consumer and business customers truly first -- by building a relationship of trust with them -- could wwll give Gateway the differentiation that it needs that could propel it to prosperity and safety. With about a billion in cash and marketable securities, Gateway’s future is in its own hands. Gateway’s restructuring and its purchase of eMachines shows that the IT vendor has seen the light. But as it travels down its own Damascus road, has it seen the vision?

How to benchmark semiconductor stocks.

Investing in IT stocks of all kinds is not a business for the feint of heart. This holds especially true in the semiconductor stock world. Risks can be great, but so can the financial rewards. Melanie Hollands has been following this stock sector for more than a decade, and herein offers some valuable insights on this topic.

Techs gone wild!

It has not been a fantastic year for tech stocks... but speculation is alive and well. Investors have fallen head over heels in love with stocks of Internet search and handheld-computer companies (what is this, 1999?) as well as a couple of companies that traders are billing as homeland security technology plays. By way of comparison, the NASDAQ is down about 1 percent for the year, and several large cap tech bellwethers, including Intel, Texas Instruments and EMC, are sporting double-digit percentage losses.

Many of the hot companies have extremely robust growth outlooks. But what is worrisome is that investors seem to be cavalierly dismissing valuations to blindly chase momentum. And there is no greater friend to a momentum investor than a press release. News, regardless of how innocuous it may be, is like manna from heaven to people buying and selling stocks with small floats. But that is trading, not investing. For longer-term investors trying to figure out how to play the tech sector for the remainder of the year and beyond, a good place to start is by avoiding most of this year’s big gainers.

UPDATE ON “THE TRADE OF THE DECADE” (SELL STOCKS, BUY GOLD)

Our “trade of the decade” was announced in the year 2000. “Sell stocks, buy gold”, we said. At the time, stocks were higher, especially NASDAQ stocks, and gold was lower. So, we are ahead. But we are not rich. The Dow lost about 2,000 points. Gold rose about $100. Big deal. You can still get 26 ounces of gold for one Dow (the combined value of the Dow stocks). A quarter of a century ago, it was one-for-one. The real payoff, we suspect, still lies ahead. We do not know what is coming, but we greatly doubt it will include higher stocks and lower gold. It is one of those rare times when people have never been more sure that nothing will happen... thus greatly increasing the odds that if something does happen -- it will pay off big for those who take a chance on it.

A gold bull market regardless.

Bill Murphy heads up GATA, which has been the focus of a movement to bring transparency to gold dealings by the anti-gold cabal. Lately the Blanchard case against J.P. Morgan and Barrick seems to be making headway. Despite stalling tactics, the judge is resolute that requirements of full discovery be met. This will be very interesting as this case will be a proxy against central bank manipulations as well.

Since the 1980s, our view has been that gold’s bear market would run until the bubble ended and that the officialdom’s bear raid would only seem to be successful. At various times, we described this as likely the only negative metal cartel in history and concluded that the real test of their abilities would come with the natural rise in gold that has been one of the distinguishing features of the post-bubble condition. More specifically, once the bubble had blown out in the first part of 2000, it became automatic that gold’s real price would begin a secular recovery in November of that fateful year. Relative to commodities, the low was in October.

Even if the Blanchard case is settled out of court, it would signify a success for free markets over intervention. Although involving two corporations, it would indirectly censure central banks and their agenda of currency depreciation without the impartial and continuous adjudication that would be provided by a free market for gold. The cartel only seemed to be successful during gold’s natural decline with the bubble. The real test has always been its putative ability to drive the price down during the post-bubble contraction when gold’s real price has been expected to recover. Clearly, the cartel has not been successful, as gold has recorded a modest recovery over the past 4 years. Like other grand schemes, this is likely to end with considerable financial dislocation. Gold’s next extended recovery will trigger this off and it seems that the key players have been too big or too stupid to cover. A judgement in favor of the Blanchard case or even an out of court settlement would be extremely embarrassing to the establishment.

“RETIREMENT HOME” TAKES ON A NEW MEANING IN THE U.K.

According to a report last week by the UK’s Trades Union Congress, “young people face poverty in their retirement because fewer are saving for pensions.” Apparently, nowadays, fewer than half of Britons under the age of 30 are saving for their retirement. In the 1950s and 1960s, says the report, the UK citizens of the same age group were much more thrifty. Huge education loans, low-wage graduate jobs, record credit card debts and high real estate prices have all been cited as “reasons why” young professionals simply have no money left to set aside for retirement. On the surface these reasons may add up to a valid argument, yet there may be a broader explanation for their lack of frugality: Young Brits stretch their budgets thin with record personal debts and mortgages because, having grown up during the “easy time”q of the past two decades, they are optimistic about the future -- more so than their parents’ and grandparents’ generations.

So optimistic, in fact, that they increasingly rely on rising home values to somehow provide them with retirement income. Perhaps the fact that many younger British homeowners now see their properties as a sort of “pension plan” helps explain their cavalier attitude towards retirement? This sentiment seems to increase at the same pace as UK home prices, which are now rising at 20.4% a year. How thrilling and comforting it must be to see your “pension capital” grow at such a rate.

But “people relying on property to provide them with a retirement income could be left high and dry,” continues TUCs report. To boot, this week the governor of the Bank of England warned the public that house prices were now “well above what most people would regard as sustainable in the longer term.” What is more worrisome for first-time homebuyers expecting to retire off their home’s value is how many of them are choosing adjustable-rate mortgages. They disregard the risk of further interest rate hikes by the BOE that may very well push their mortgage payments to unmanageable levels, forcing them to lose their homes. Already this year personal bankruptcies in the UK are running at 26.8% higher than in 2003.

WE ARE AWASH IN DEBT

Household debt levels in Canada and the United States are at record highs, and are continuing to grow rapidly. Is that a dangerous sign of financial instability and underlying economic weakness? U.S. Federal Reserve Board chairman Alan Greenspan says it is not -- but others disagree. They say the impact of rising interest rates on that mountain of consumer debt could well have severe repercussions for the economy. A look at debt in Canada and the United States reveals some eye-popping numbers: In both countries, the level of debt to disposable income is at about 115%, meaning residents owe more than their entire available annual income. A decade ago, that ratio was closer to 85%, and even as recently as three years ago it was less than 100%.

Rather than scale back consumption during the recent economic downturn, consumers took on debt at an unprecedented rate -- and that has continued, despite the promise of higher interest rates. In the first quarter of 2004, U.S. household debt rose at an annual rate of 10.9%, the second fastest in 15 years. It has risen by 30% since 2000 to $9.4 trillion (U.S.). The primary engine for this has been record-low mortgage rates, which have driven a refinancing boom in the United States and to a lesser extent in Canada. That, in turn, has poured billions of dollars into consumption of all kinds, including house buying. And the main driver behind low mortgage rates, of course, has been the lowest interest rates in half a century.

Not surprisingly, considering the Fed has been the central architect of this “easy money” policy, Mr. Greenspan says he is not concerned about high levels of household debt. He and others argue that it is not a problem because most of it is mortgage-related (about 70% in the United States and about 60% in Canada). In other words, it is backed by a hard asset, and one that has been increasing in value.

But investors such as Bill Gross of Pacific Investment Management Co. of California -- whose bond fund is the largest in the world, with $400 billion in assets -- say they are worried that Mr. Greenspan is being a little too sanguine about the risks posed by household debt levels. One problem is that the rise in asset values that justifies all that mortgage debt is in part a byproduct of that debt. In other words, house prices have been rising in part because consumers are taking on more debt to pay those higher prices. The risk is that as interest rates rise, that cycle gets unwound, something that could cause severe pain to consumers who are overexposed. While most mortgages are at long-term fixed rates (80% in the United States), the number of adjustable-rate loans has been growing at a rapid pace, to the point where they now account for close to 30% of new mortgages in the United States.

Cashing in on debt collection.

Consumers’ busted budgets have created boom times for collection firms. As Americans struggle to pay off a mountain of non-mortgage debt that now exceeds $2 trillion, more independent companies are buying up portfolios of unpaid auto, credit card and other loans, then hiring armies of phone reps to collect what they can.

The trend has meant attractive livelihoods for people like John Yacoub, 22, a former airline baggage handler from Chicago who joined Cavalry Portfolio Services’ Phoenix office less than three years ago. He places 150 to 200 calls to debtors in a typical day, juggling about 100 accounts at a time. Yacoub, who earns a base salary and commissions on accounts on which he collects money, expects to earn close to six figures this year. Before joining Cavalry, he had never worked as a collector.

U.S. INVESTORS TURN TO CASH AS STOCKS STAGNATE, BONDS AND TRADING DROP

Bill Miller, whose U.S. stock mutual fund has outpaced the Standard & Poor’s 500 Index for a record 13 years, said he is struggling to find much to buy these days. “Most stocks are trading at about where they should be,” said Miller, 54, who has run the $14 billion Legg Mason Value Trust since 1982. He said that with bargain stocks hard to find, he is turning to analyzing how companies’ strategies place them in their industries. Twice as many money managers are closing their mutual funds to new investors as they did last year. Hedge funds have told clients they are short of investment ideas.

Investors put $30.7 billion into money market funds in the first week of June, the fastest pace in almost a year, according to Money Fund Report. Stocks are stagnant, with U.S. indexes almost unchanged this year and price volatility for the Standard & Poor’s 500 the lowest in 50 years; U.S. bonds are suffering the worst quarter in 24 years as the Federal Reserve prepares to raise base lending rates.

At the beginning of 2003, Robert Rodriguez, chief executive of Los Angeles-based First Pacific Advisors, which manages $6.8 billion, uncovered 200 stocks out of 10,000 that could have met his investment criteria from a price-to-earnings, price-to-cash flow, market value-to-revenue and debt perspective. This month, he found 90.

Robert Arnott, who manages the $2.3 billion Pimco All Asset Fund, can buy everything from real estate and commodities to emerging market bonds and U.S. stocks. He is keeping 25% of his portfolio in cash and short-term debt securities. The fund has just 17% of its assets in U.S. stocks and no investments in long-term U.S. Treasury and investment-grade corporate bonds. “The next three to five years are likely to be disappointing for stocks and bonds,” he said.

Why is volatility so low in financial markets?

“Implied volatility”, very roughly, is the amount of price movement which sellers of options (which grant the buyer the right but not the obligation to buy or sell something) expect to see in the underlying asset on which the option is based. This expected movement is the single most important piece of information in setting the price of options. For the buyers of options, it can be seen as the price of insurance against bad outcomes in financial markets. And this price has been falling sharply almost everywhere, making financial markets much more attractive than they would otherwise have been.

Implied volatility in equity markets is now extraordinarily low. The closely watched VIX, an index of the implied volatility of options on America’s S&P 500 stockmarket index, is close to its lowest in seven years. The VIX recently peaked in August 2002, when it climbed to 45, and its lowest in April this year, when it fell to 14. It is now trading at a sniff over 15, and has squeaked above 20 on only a handful of occasions this year. As go equities, so go interest rates. The price of an option to pay or receive a fixed rate of interest in dollars for ten years has been falling sharply of late. Indeed, the boffins at Goldman Sachs now reckon it is at its lowest for more than three years.

Of course, there are good reasons why the markets’ fears of price swings in general might be smaller now than in late 2002, when, among other things, fears about the fragility of corporate America were at their height. However, there is -- or should be -- a lot more uncertainty than the markets seem to be allowing over the direction of the global economy in general and the path of interest rates in particular. So why then is volatility so low? Jim Bianco, who runs an eponymous research firm, suggests an answer of beguiling simplicity. Many people -- at hedge funds and banks in particular -- are selling options to earn money from the fees for doing so. Selling options is a splendid way of making money when markets behave themselves -- and indeed such a strategy has made huge profits for those that have done so over the past couple of years. The problem comes when markets misbehave, which happens far more frequently than the sellers of options allow for.

Who controls Account 990N?

The entire S&P price action in the Futures is being controlled by one counter party. All the guys strongly hate them: their CME clearing number is 990N and they clear through Gelber trading. That one account is solely responsible for the current level of the S&P. They are the ones that are throwing the S&P up overnight. Then they are the ones that are sitting on the bid all day long, supporting the market action. The S&P pits have been decimated, absolutely ruined. There is no volatility, so all the traders have left. All the traders I have talked to view the market as being rigged. They keep waiting for the price action to break loose, but it never does.

They are stunned by the lack of volatility. And furious. Time after time after time 990 just sits there on the bid. Don’t they ever go away? They just absorb the entire market and then push the price wherever they want it to go. “Gee, I wonder who that counter party is.” They are all terrified of shorting, because every time they do, they get drilled. I thought it was just my systems that were not working that well, but they are far more dispirited than I. Intervention at its finest, your tax dollars at work, providing the ultimate tax to us all.

Given the incessant “intervention” by 990N, there is very little liquidity beneath these markets to provide real support. This is all to alert you to this complete market manipulation and to see if you had any pull to get the word out to different traders and the media. I am one of the biggest S&P traders in the world as far as volume per day in that I average over 40,000 round turns per day on the screen in the e-mini. I tell you this because that is how I know one house is completely manipulating the market everyday because of all the trades I do with this guy. I know it sounds hard to believe that one person can control a world market but trust me: this is occurring. He works for the firm Gelber, which is house 990.

My firm and I have contacted the Merc on three different occasions with video proof that I recorded of my trading. It shows blatantly this guy crossing his orders thousands of times a day. The first person we talked to in compliance admitted that he saw something there when they reviewed the video of the trades I taped of him. He was mysteriously fired the next day. We then came up with more examples for them to review and in the beginning claimed he was not doing it. We called them a third time, this time talking to the head of compliance and he finally admitted that they had the guy under investigation because they saw something, but in the meantime he is still allowed to trade and make millions until their “investigation” is concluded.

They obviously love the volume the guy is putting up and how it makes the emini S&P look from a standpoint of a liquid market. But if the public had knowledge of what this guy was doing I do not think they would be too impressed with the liquidity.

COMPANIES EMBRACING FLOATING-RATE NOTES

With the economy recovering and the Federal Reserve poised to hike interest rates for the first time in several years, investors are bailing out of the bond market, forcing corporations to seek alternative funding sources or become more creative in the public markets. Indeed, last month investors yanked out a net $17.5 billion from bond mutual funds, the largest monthly outflow ever according to data from Lipper Inc. This includes $4.8 billion that was redeemed from junk-bond funds, the largest amount since Lipper started tracking this data in 1997.

So, what is an issuer to do? Companies that want to remain in the public markets are embracing floating-rate notes. In fact, companies have sold more floating-rate paper than fixed-rate bonds in recent months as investors have been seeking protection from the expected rise in interest rates.

NO SIGN OF U.S. HOUSING BUBBLE -- NY FED STUDY

There is no bubble in U.S. home prices despite the price surge in recent years, a New York Federal Reserve Bank study said, and even if regional prices do fall, that will not pose a threat to the overall economy. The recent increase in house prices has been in line with declining mortgage rates, a factor that many arguments about a housing bubble ignore, the New York Fed said. “Our analysis of the U.S. housing market in recent years finds little evidence to support the existence of a national home price bubble,” senior economist Jonathan McCarthy and vice president Richard Peach said. The Fed said that although house prices have risen strongly, increases in family income and low mortgage rates have meant that homes remained affordable, while demographic forces have also supported demand. The study has important implications for Federal Reserve policy because evidence of housing bubbles in both Britain and Australia has influenced their central banks to raise interest rates in the past year to cool the market.

The ever more graspable, and risky, American Dream.

In the new, ever-optimistic economics of home buying, a kaleidoscopic array of mortgages for people with little cash or overstretched budgets has enabled families of modest income to take on debt that once would have been beyond their reach. As long as new home buyers could count on rock-bottom interest rates and housing values were going nowhere but up, this seemed to be a virtuous circle. But now, with the Federal Reserve expected to embark on a series of interest rate increases starting with its meeting on June 30, some experts worry that recent first-time buyers could find easy home ownership a lot harder on their wallets, possibly causing housing prices to wobble in some high-price markets.

With the Daneshis of Anaheim, California, for example, rising interest rates on the two adjustable-rate mortgages they took out to buy their house would mean that their monthly payment of $2,500 -- already more half their monthly income -- could go up substantially in two years. Mr. Daneshi realizes that, but is unconcerned. “Why worry?” he said, adding that he believes rising home prices will help him obtain a better loan deal by then.

With interest rates going up, that may be wishful thinking. Most analysts agree that there is no nationwide housing bubble because housing prices have climbed only slowly in the Midwest and the South, even as they have soared on the East and West Coasts. Still, if rising interest rates cause housing prices to drop, even slightly, industry officials warn that some new buyers will have no equity in their homes and could choose to walk away from their loans if they run into trouble with payments.

Lenders have aggressively encouraged home buyers to stretch in ways that would have been unimaginable a decade ago. In the new world of flexible mortgage lending, it is possible to buy a $600,000 house with no down payment, and to pay only interest and nothing on the principal for years. “The financing has changed everything,” said Humid Karat, a manager of Tarbell Realty’s office in Anaheim. “Ten years ago, if I offered to buy your house with a 100% loan, you would have called it ‘creative financing’ and thought I was crooked. Today, everybody wants a 100% loan.” “Underwriting standards have loosened to almost historic levels,” said Bill Dallas, a pioneer in no-money-down loans and a board member of the California Mortgage Bankers Association. “Nobody is heeding the yield signs.”

The Coming Housing Crash

There are a lot of thing I do not know, but one thing I do know are houses. My father was a general contractor all his life, his father was a carpenter, all my relatives are contractors, and I built many a house starting when I was 12, and ending in my 20s when I finished college. I know houses, and because I know them, I know there is a boom right now, one that will be followed by a bust. I would not be surprised if houses in some areas dropped by 90% in value. I just do not know when.

Thirty-five years ago, when I was a kid, a nice middle-class house cost $25,000. Now they can cost up to $250,000, depending, of course, where you live. People have tried to tell me this increase in price is due to supply-and- demand. No, it’s not. Under the free market, as demand goes up, so does the supply. As supply goes up, the price drops. Under a truly free market, you would have stable prices that would last a century. If prices did anything, they'd drop slightly over several decades. Those brand-new $25,000 houses of 35 years ago should still cost $25,000 today, not $250,000. What caused this increase?

Overwhelmingly, it is inflation-the Federal Reserve pumping billions of paper dollars into the economy. That extra money in people’s hands has bid up the prices of houses. That causes a bubble. Bubbles, of course, are always followed by busts. All the money flowing into the housing market has turned housing into a gamble. People are buying houses and hoping the value continues to go up, so they can sell and make a huge profit. This works just fine except for the last people to buy the house, when the bubble bursts and they are left with a house that is worth $200,000 less than what they paid for it.

Houses are what are called “durable consumer goods”. Strictly speaking, they are not investments. You generally are not supposed to make a profit off of them, no more than you would make a profit of off an old car, unless it became the kind people wanted and bid the price up. The main reason houses become profitable investments is when inflated money pours into the market. And then it is not so much “investing” as it is gambling. And gambling is a heck of a lousy thing to base an economy on. It is certainly never the basis for a solid, long-lasting economy that provides good, high-paying jobs for people. What would I do if I owned a home in an area where the prices kept skyrocketing every year? I would sell and get the heck out, and go someplace where prices are a lot more stable. An inflationary boom-bust cycle is something you can bet on. It is such a sure thing it is not even gambling.

HSBC, unlike Fed, sees housing bubble.

Economists at HSBC waded into the debate over whether the U.S. housing market is over-inflated, declaring a bubble exists, something the Federal Reserve has been reluctant to do. Just a few days after the Federal Reserve Bank of New York said there was little evidence of a nationwide housing bubble, HSBC said a bubble exists and prices are likely to deflate gradually over a few years, triggered by Federal Reserve interest rate rises. “This bubble-psychology has manifested itself in very rich valuations,” HSBC chief U.S. economist Ian Morris wrote. House prices relative to income, rent, replacement-cost and home-equity have all set new highs, Morris said in a report entitled The U.S. Housing Bubble -- The case for a home-brewed hangover. “Expectations of future house price appreciation are spectacularly, and unrealistically, high,” he said.

Over the four years to the first quarter of 2004, official figures show house prices rose 33% nationally. Over the same period, prices in Washington, D.C., were up 70%, in California 60% and in New York and Florida 50%. The New York Fed said the decline in interest rates in recent years justified the price increases. The 47-page HSBC report said a “hard landing” is typical after a housing bust because the wealth effects -- which can affect consumer spending -- from real estate are more powerful than from stocks. “Prices are 10 to 20 percent too high and can overshoot on the way down,” HSBC’s Morris said, most likely deflating gradually over a few years rather than crashing like stocks.

THE LAND BOOMERS

Extracts from the book The Land Boomers by Michael Cannon, published in 1966...

Victoria (Australia) was made rich by gold, and populous by the immigrants who sought it. Two great economic booms and depressions had already shaken nineteenth century Victoria. The first occurred shortly after the early Melbourne land sales of 1837, reaching its peak about three years later. The discovery of gold sparked off the second great boom, which reached its peak in the 1850s. People had money to burn, and either dissipated it in wild extravagance or bought property at inflated prices. But because of the continuous rich flow of gold, there was comparatively little suffering when the inevitable crash followed. Then came the land boom of the 1880s. This time every type and degree of man was involved. Clergymen, labourers, widows, schoolmasters all grasped at the chance of quick wealth and invested their savings.

The land mania of the 1880s took two main forms. The first was based on a plethora of building societies, whose optimistic officials were relieved that every family in the colony could simultaneously build their own house, keep up the payments through good times and bad, and support an army of investors who were being paid high rates of interest for the use of their money. The second form of mania was the deeply held belief that it was impossible to lose money by investing in land a belief that persists to the present day. The boom continued to gather strength. In 1886 it appeared to some of the associated banks that the land boom had reached its zenith and would now plunge downwards. Then in 1887 there began a new wave of speculation, the land boom proper, so forceful that it over-rode all considerations of interest rates. Land selling in Surrey Hills for 15 shillings a foot in 1884 rose to 15 Pounds in 1887.

Once again the banks, dismayed by wildly fluctuating values, began calling in overdrafts. Unfortunately, some of the leading banks had encouraged speculation when money was plentiful, and ruthlessly suppressed it when the inevitable reaction set in. This traditional banking policy, aimed primarily at safeguarding the banks’ own interests, proved utterly ruinous to the general community. The land promotors began looking elsewhere for easy finance. Thus the years 1888, 1889 and even 1890 saw the formation of most of the disastrous land and finance companies, and so-called land banks. Under the loose banking and company laws of the time, they were able to take savings deposits, issue shares, float loans, discount promissory notes and other commercial paper, and in general perform all the functions of an established bank. The boom soared upwards to dizzy new heights. How could such values last? The maximum rentals which tenants were willing to pay often amounted to only 2.5% return on the money spent on sites and buildings. As the boom petered out, many tenants could not pay even that. A few experienced speculators realised what would happen, and quietly began to sell off their shares and land while there was yet time.

For a few months, many investors still appeared to be hypnotized by the boom. By the time they realised that the crash was indeed final, practically every land company was in liquidation and calls on their shares had gone forth. The same pressure was felt by the land banks, many of which owned shares in associated speculative companies. Some were able to use the public’s cash deposits to stay open a little longer. But one after another they toppled, the pressure multiplying each day as their depositors took fright and withdrew their cash. Every day brought news and rumours of fresh disasters, of another land company folding up. And when they folded, there came the inevitable calls of capital on their partly paid shares to help pay the creditors.

By the end of 1891 the bottom had completely dropped out of the land market. The year 1892 may have been sombre, but the disasters to come in 1893 were quite unprecedented. The collapse of the boom economy was sudden and dramatic. As each company closed its doors, it dragged others down with it. Clerks, surveyors, accountants, builders, and every other kind of employee was thrown out of work, and onto a labour market which was harsh enough in good times, but almost non-existent in bad times. In the absence of trustworthy statistics, it is difficult for us today to form a complete picture of the extent of unemployment and the human suffering it produced. All we can say for certain is that this was the worst depression in Australian history, before or since.

BANK OF JAPAN IN FOR ANOTHER FIGHT, THIS TIME NOT DEFLATION

Any change to the Bank of Japan’s ultra-easy monetary policy might mean it has won the war on deflation, but may also get the central bank into another fight -- this time with a government that has come to take cheap credit for granted. The BoJ has repeatedly denied it has an exit policy is in the works, and no change is expected from last week’s policy board meeting. But a strong economic recovery is forcing markets to price in the possibility of an early end to deflation and with it an end to zero interest rates. Higher rates mean the government faces a bigger bill to service its ballooning debt.

“If rates keep rising, it is quite possible that the government will ask the BoJ to help, to prolong easy monetary policy and keep long-term rates under control,” said Mamoru Yamazaki, chief economist at Barclays Capital. “The BOJ isn’t going to give in to such a request so easily if it believes the economy is doing well and bond yields are in line with fundamentals. There could be a bit of a tussle.” Japan has a record amount of public debt, with its debt-to-GDP ratio among the highest of industrial nations at around 140%. The government is issuing about 36.6 trillion yen in new government bonds (JGBs) in this fiscal year alone. Comments by officials suggest tension is already building between the BOJ and the government.

YOUR RIGHT TO DEFLATION

In addition to big government, debt, and war, let us add one more item to the list of wicked legacies that the Bush administration has given to this country: inflation. The newest price data raise serious concerns that we are being robbed (that is what inflation is) by this government more than we know. It some ways, the return of constant upward price pressures on a level exceeding economic growth is a telling act of destruction, and a testament to the power of government to create messes where none need exist.

We have all been stunned at the price increases in tuition, medical care, housing, and energy. And yet not all prices are rising and no prices rise in tandem. In fact, we can all think of recent times when we have experienced reverse sticker shock. “Only $35 for a CD player?” “This huge jar of olives for only $4?” “This set of screwdrivers and sockets for only $10?” Those of us with access to Wal-Mart, Sams, Big Lots, or any number of other large discounters experience this sense every time we shop. Low prices impart optimism about the future, and somehow provide a glimmer of the prelapsarian might-have-been, with all goods and services priced at zero: a world in which scarcity imposes no barriers to all-round prosperity.

Our intuition tells us that falling prices are great for our pocketbooks because they leave more left over for savings or other forms of consumption. It is just as good for society at large. Our money becomes worth more and more, and hence our remunerative labors grow in value too. If inflation works as a stealth tax, deflation works as a tax refund. Falling prices are a gift that the free market grants to all people, provided that the market’s natural benevolence is not thwarted by central bankers and government officials. The market does this through technological innovations that make production more efficient, and a widening division of labor due to the much-derided phenomenon of globalization.

Sadly, in our times, we are being robbed of our right to deflation by a massive countervailing force: the central bank. Thanks to the Federal Reserve and its monetary spigot, the value of our money continues to decline overall rather than increase as it should. Inflation robs us of our savings, redistributes wealth from savers to debtors, reshuffles property from consumers to those connected to the government, makes conducting business more difficult, and subsidizes short-term thinking at the expense of long-term planning.

DO INVESTORS BUY A P/E RATIO ... OR A PRICE?

I expect silly things from the financial press and they seldom let me down -- like the Tuesday story on a top financial Web site that claimed stocks were down because, “Investors have been reluctant to make any big plays as inflation, earnings, interest rates, Iraq, terrorism and the November election remain question marks.” This “reluctance” apparently did not last long, because the indexes soon began climbing and were up at the bell. Those sure were a lot of answers that investors came up with in a few hours ... especially the one about the November election.

The real letdown comes when you read silliness from a source that should know better. That is what I felt when an analyst I respect recently posted an essay about P/E ratios. He claimed that while the current stock market looks overvalued, it really is not; because there “have now been three straight quarters of over 20% growth” in earnings, this “strong earnings momentum ... is likely to continue into 2005.” This argument is a simple projection of the past into the future: the logic could not be more linear.

Investors do not buy a stock’s P/E ratio: They buy its price, a fact that was all-too-clear in the rally last year. Even over the past three months, the stocks with the strongest gains were mostly in sectors that do not even pay dividends, like Internet services. No one has been buying stocks because earnings are growing; they are buying because they do not want to miss the next rally.

A PEER REVIEW FOR THE STOCK MARKET

When scholars or researchers make a significant discovery, they typically submit their findings to some type of “peer review”. This allows other experts in that field to confirm the results or find flaws in the methods leading to the discovery. The process is tedious but necessary. This process is supposed to prevail in economics research, but things get muddy when it comes to the study of financial markets. Here the work is built on “paradigms”, “models”, and formulas that often include more assumptions than evidence. Still, several Nobel Prizes in Economics over the past 30 years have been given to researchers of financial markets. In most cases, the economists shared two basic assumptions: 1) The stock market is efficient and 2) Investors are rational.

But recent years have made a mockery of them. For the S&P 500 to lose half its value from 2000-2002 -- and the Nasdaq to lose even more -- is inefficient and irrational in the extreme. We do not submit our findings to peer review for a simple reason: The market itself is faster and far more ruthless than any “peer review” could be.

MANY SECOND EARNERS ARE GETTING A BAD DEAL

Q: My husband and I need assistance figuring out the tax benefit, if any, if I stay home with our son. ... We would like to know how to figure how much I am bringing home after subtracting any additional taxes my working is causing, as well as day care. We itemize deductions on our tax return. ...

A: Your real take-home pay probably does not amount to much. And over your lifetime, the deal you are getting is even worse. ... Laurence Kotlikoff, the economist who co-authored The Coming Generational Storm: What You Need to Know about America’s Economic Future (MIT Press, $28) with me, examined this question in a generational accounting context last year. He found that the second worker in a couple faces a true lifetime tax rate that is devastatingly high. One of the main reasons your lifetime tax rate is higher than your current out-of-pocket tax rate is [that] the second worker pays full employment taxes but gains little or nothing in retirement benefits. ...

NEW RULE ON SHORT SELLING

Shorting the stocks of some of the largest companies in the United States is about to become easier. But shorting the stocks that some investors view as the most overvalued will become more difficult. The S.E.C. approved a new rule on short selling that for the first time in decades will allow some stocks to be sold short even though the price is falling. The original rule, which let investors sell most stocks short only when share prices were rising, was adopted during the Depression at a time when short sellers were blamed by some for the 1929 crash. The short selling rule was adopted unanimously at the same meeting at which the S.E.C., as expected, voted to require that chairmen of mutual fund boards be independent directors, rather than the head of the management company, as is now often the case.

Short selling is the practice of borrowing shares and then selling them. It is usually done to bet that the stock price will decline, which allows the seller to buy the shares back at a lower price and pocket the difference after returning them. But it can also be done as part of hedging strategies. To many economists, short selling helps create efficient markets for stocks by allowing prices to be influenced by everyone who has an opinion on a stock, and restrictions on the practice, therefore, impede market efficiency. But many companies bitterly complain that traders use it to drive down prices in what are called bear raids. They are especially angry about so-called naked shorting, in which stocks are sold short even though the seller has not borrowed shares.

The S.E.C. agreed that for a year, beginning on Jan. 3, one-third of the stocks in the Russell 3000 (basically the 3,000 largest companies traded on American markets) would have the basic limitation on short selling -- that they only can be executed at a price higher than the last different price -- removed. Naked shorting is now against the rules of all exchanges, but the rules vary. The S.E.C. decided to adopt its own rule, requiring that brokers may not execute a short sale until they have determined that shares are available to borrow.

Why the rule change now?

During the Depression, short-sellers took some of the blame for the 1929 crash. So in the 1930s, regulators created the short-sale rule, which allowed investors to sell stocks short only on an uptick or when their prices were rising. Unfair, you protest? Of course it is. Whoever heard of the opposite -- being able to buy a stock only when its value is declining?

But back to the bigger point. It appears that regulators now think that they do not need to guard against prices being driven down by short-selling. The SEC announcement suspends the short-sale rule for a year on one-third of the Russell 3000 -- basically, the largest companies traded on U.S. exchanges. What that shows us is a level of complacency not seen since the 1920s.

BIG PAYDAYS FOR BAD CHIEF EXECUTIVES

Leo Tolstoy once wrote that all happy families resemble one another, while each unhappy family is unhappy in its own way. In the business world you could flip that around, for it seems that many unhappy companies resemble one another: According to mail from more than 1,000 readers of this column on the subject of the nation’s worst chief executives, a great number of dysfunctional companies are run by tyrants who gouge gross compensation packages for themselves and their cronies out of the hides of their workers and customers.

What makes a terrible CEO in the minds of so many investors and employees is not merely poor decision-making on the allocation of capital and other resources. Almost everyone can tolerate well-intentioned plans that go awry. It is the ugly way that some CEOs have normalized the behavior of compensating themselves at increasingly more obscene levels -- often on the basis of self-set relative performance targets that fail to account for the absolute performance that matters most to all stakeholders: long-term corporate value as reflected in a higher stock price.

A CRUDE AWAKENING

The only shock about the surging price of oil these days is that Wall Street is shocked by it. If professional investors did not see this one coming, they must have either been locked up in an Iraqi prison or in a coma. We certainly saw it coming. For as much as we have talked about the impact of growing demand for petroleum from China, India and a cavalcade of SUV drivers in North America, the biggest reason for the bull market in oil is a shortage of supplies. From bottlenecks caused by aging refineries and a supertanker shortage to depleted production from non-OPEC producers, the price of crude is being pushed higher because of one simple fact: There is not enough of it.

What is so bullish for oil is that, while world discovery rates peaked in the 1960s, global oil reserves have not increased since 1990. In fact, over the past four decades, exploration efforts have yielded a diminishing return. In the 1960s the industry discovered 375 billion barrels... in the 1980s, 150 billion barrels were discovered. Even fewer barrels were discovered during the 1990s. Perhaps this year, and certainly by no later than 2005, world production will hit its apex. That means that over the second half of this decade world oil output will begin to decline... just as global oil demand is surging. Not even Saudi Arabia has the oil capacity to ease the world’s supply problems. The conventional thinking is that oil prices will fall, but I am certain they will go just the opposite way.

Energy disinformation

A National Geographic cover story for June, “The End of Cheap Oil”, suggested the price of oil is high because the world is using it up faster than it can be replaced. But if high oil prices today prove the world is running out of oil, what was proven by $11 oil in late 1998?

ALL ABOUT THINLY TRADED STOCKS

Thinly traded stocks are quite common in the technology sector. Know how and when to trade them, and you can ride a stock that triples, quadruples or more in a relatively short period of time. However, these stocks are deceptively difficult to trade and the downside of a mis-traded position can be considerable.

A thin market is a slang term for a lack of liquidity for a stock (or other security). In effect, there are few buyers and sellers at current price levels. A thin market is one with few bid (to buy) and ask (to sell) offers. Also called a narrow market or an illiquid market, a thin market is characterized by low liquidity, high spreads (between the bid and ask prices), and high volatility. Small changes in supply and/or demand can have a dramatic impact on market price -- the price moves easily and can swing around. The price is also vulnerable to manipulation. I define a thinly traded stock by whether you get in and out of a position easily. I find myself involved with thin stocks predominantly on the short side, because they tend to look expensive and are generally seeped in fraud. On the long side, if you find a technology that is innovative -- at a company that is unknown -- then it is worth a shot. But you have to size it in a way that 5-15% daily swings to the downside do not hurt you.

EMERGING-MARKET BONDS HEAD FOR FIRST QUARTERLY LOSS SINCE 2002

Emerging-market bonds are headed for their first quarterly loss since 2002 as yields on 10-year U.S. Treasury notes surged more than 1 percentage point to 4.9%. Demand for developing- nation debt declined as the extra yield on the securities was deemed insufficient for the risk of default. About 60% of J.P. Morgan Chase & Co.’s EMBI Global Diversified Index was rated below investment grade at the end of May. U.S. Treasuries have top AAA credit ratings. Emerging-market bonds fell 5.5% in the quarter, more than any other fixed-income securities, ending seven quarters of positive returns, according to the EMBI Global Diversified Index. The bonds surged every year since 1999 as sliding U.S. Treasury yields prompted investors to seek higher-yielding assets elsewhere.