Finance Digest for Week of July 5, 2004

RECORD-SETTING SKYSCRAPERS AND ECONOMIC DOWNTURNS

This 4th of July will mark the groundbreaking of the Freedom Tower at ground zero of the World Trade Center. The design of the building calls for a height of 1,776 symbolic feet, which will capture the title of world’s tallest building when it is completed in late 2008 or 2009. Groundbreakings, opening ceremonies, and certainly July 4th are all causes for celebration, but the Freedom Tower may be a signal that something much more sinister is afoot. For more than a century there has been a correlation between the building of the world’s tallest building and severe economic downturns.

The correlation is as follows. The announcement and groundbreaking for the world’s tallest building takes place at the end of a long boom or sustained bubble in the economy. The stocks go into a bear market; the economy goes into recession or worse. The building is completed. The economic turmoil that ensues is either severe, drawn out, or as in the case of the Great Depression, both. Since 1997 there have been several plans to set new records for the world’s tallest building.

At first glance the association of record-setting skyscrapers and economic crisis would seem to be a spurious correlation. However, there is good reason to believe that skyscrapers and crisis are linked via the business cycle. Long periods of easy credit create economic booms, particularly in investment, speculation becomes pronounced, and entrepreneurs lose their compass of economic rationality and make big mistakes. The biggest mistakes -- record-setting skyscrapers -- comes toward the end of the long boom and signal the bust. Obviously, this indicator is not foolproof, but if it is correct there is an economic crisis coming.

FED RAISES THE FEDERAL FUNDS RATE BY 0.25%. NOW FOR THE REALLY BIG NEWS

The most important economic news of the last six months has received little attention in the English-language financial press. China is now running a trade deficit. In the June 25 issue of the English language edition of People’s Daily Online, we read: China recently announced a trade deficit of 8.4 billion yuan for the first quarter of this year, the first quarterly unfavorable balance of trade registered by the country in 17 years.

In simple terms, economists explain that a country with a favorable balance of trade is lending money for others, while one with an unfavorable balance of trade is borrowing money. This means that China is no longer accumulating Western currencies, net. It is now dispersing Western currencies to purchase imports. Presumably, these imports are mainly raw materials: oil, cement, and steel. China is now the second-largest importer of oil in the world after the United States. It is consuming over half of the world’s cement and almost 40% of the world’s steel. An unprecedented construction boom is going on in China. If China is no longer accumulating Western currencies, then its central bank will cease buying T-bills, net. It may even begin selling T-bills in order to obtain dollars in order to buy oil. This means that demand for T-bills will fall, which means that T-bill interest rates will rise. The Treasury will have to offer a higher interest rate to lenders because of falling demand from China.

This leads me to my main point: the recent announcement by the FED regarding the increase of interest rates has the scent of pre-emptive strike about it. As I argue in this report, the FED has not adopted a monetary policy that is consistent with its public commitment to raising interest rates. Yet its announcement has sent a message to the financial community: interest rates will be rising from here on. Interest rates will indeed be rising. At this point, however, the FED has nothing to do with it, except as an English translator of Chinese central bank policy. This makes it appear as though the FED is setting interest rates. It isn’t.

Interest rates and the Federal Reserve.

Last week the Federal Reserve announced it was raising the targeted federal funds interest rate from 1 to 1.25 percent, to begin to prevent a possible future price inflation. The next day the European Central Bank (ECB) decided to leave its targeted interest rate unchanged at 2 percent, even though price inflation within the euro currency area is averaging above the target range set by the ECB. Practically all the commentaries that either preceded or followed the Fed’s and ECB’s announcements have focused on what impact these decisions will have on investment and consumer spending, and whether or not the decisions will fuel higher price inflation in the future. What has not been commented on is the more fundamental question of whether either the Fed or the ECB should be attempting to set or influence interest rates in the market. Clearly, the presumption is that it is both legitimate and desirable for central banks to manipulate a market price, in this case the price of borrowing and lending.

In the free market, interest rates perform the same functions as any other price: to provide information, to serve as an incentive, and to bring supply and demand into balance. Market rates of interest balance the actions and decisions of borrowers (investors) and lenders (savers) just as the prices of shoes, hats, or bananas balance the activities of the suppliers and demanders of those goods. There is one crucial difference, however, between the price of any other good that is pushed below that balancing point, and interest rates being set below that point. If the price of hats, for example, is below the balancing point, the result is a shortage; that is, fewer hats are offered by suppliers than the number consumers are willing to buy at that price. Some consumers, therefore, will have to leave the market disappointed, without a hat in hand.

In contrast, in the market for borrowing and lending the Federal Reserve pushes interest rates below the point at which the market would have set them by increasing the supply of money on the loan market. Even though savers are not willing to supply more of their income for investors to borrow, the central bank provides the required funds by creating them out of thin air and making them available to banks for loans to investors. Investment spending now exceeds the amount of savings available to support the projects undertaken. Investors who borrow the newly created money spend it to hire or purchase more resources, and their extra spending starts putting upward pressure on prices. At the same time, more resources and workers are attracted to these new investment projects and away from other market activities, due the extra money offered for their services.

The twin result of the Federal Reserve’s increase in the money supply, which pushes interest rates below that market balancing point, is an emerging price inflation and an initial investment boom, both of which are unsustainable in the long run. Thus the expansionary monetary policy that the Fed has been following for the last three years, and which has kept interest rates artificially low, is finally starting to bring about the price inflation that the authorities now say they must prevent. And they worry about dampening the investment and consumer spending booms that their own artificially low interest-rate policies have brought about.

Rather than continuing to manipulate interest rates, the Federal Reserve should simply stop creating money. It is really that simple. Unfortunately, neither the Federal Reserve nor the European Central Bank is willing to give up their monetary mischief. And commentators in the media seem to be obsessively focused on looking at the interest-rate symptoms rather than at the monetary disease.

GOOD AS GOLD

For 70 years, the American Institute for Economic Research has advocated a return to the classical gold standard, one in which gold coin actually circulates. What is surprising, however, is that a diverse group of academics, businessmen, and investors -- including at least our retired officials of the Federal Reserve System -- recently gathered at AIER’s campus to seriously discuss an issue with no apparent policy traction. Inflation has been benign for a decade. We have been on the Greenspan standard, which until recently has been viewed “as good as gold”. Chairman Greenspan’s recent suggestion to bankers that the Fed might need to move aggressively to combat inflation called that conviction into question.

Financial markets have been fretting for some time about inflation. In a nation at war, the federal budget is bloated by a “guns and butter” policy of a president with an ambitious domestic agenda coupled with a forward defense posture. Monetary policy has been expansionary. Oil prices are setting records, at least in nominal terms, and there is a serious threat of further supply disruptions. In short, many of the problems confronting Ronald Reagan when he took office as the nation’s 40th president in 1981 are now present or anticipated. The Reagan administration is the last time a gold standard was seriously considered.

There was consensus among the participants at the AIER gold conference on two points. First, monetary reform comes only as a consequence of economic and financial crisis. No one wished for such a crisis, but some feared we may be on the cusp of one. Second, the price at which gold and the dollar were pegged would be critical for the success or failure of any return to gold. On the second point, there was no agreement on a figure for the peg.

A MOST SAVAGE CREDIT CRUNCH

While the Fed hiked its rate by a paltry 25 basis points, the bond market used a hammer, raising 10-year Treasury yields by 100 basis points within just two weeks -- that is, by nearly a full percentage point. If the Fed truly and urgently wanted credit restraint, the action in the bond market should have pleased them. We suspect the abrupt surge of long-term rates has shocked them, because the resulting higher mortgage rates have effectually choked the mortgage refinancing bubble, presenting policymakers in the Fed with far more credit tightening than they really want.

According to the Mortgage Bankers Association (MBA), mortgage-financing activity in the United States in the week ending June 4 was down 68% compared to a year ago. The MBA’s Refinancing Index had plunged by 85% year over year. Yet the impact of the higher interest rates seems to have been cushioned by a surge in the demand for adjustable rate mortgages (ARMs). What exactly could or would the Fed accomplish with a quarter-point rate hike? What would that do to the economy and the financial system? In short, it would not be likely to change much, if anything at all. Even the carry trade would still be profitable at this higher rate.

In fact, the existing short-term rate of 1% is ridiculously low for a supposedly booming economy to begin with. In hindsight, it seems reasonable to say that by maintaining the consumer borrowing and spending binge in the face of plummeting income growth, the mortgage refinancing bubble has been the U.S. economy’s lifeline. But as explained, this lifeline has been badly damaged. There is no spectacular collapse like that in the stock market of 2000-01. Yet a drastically deflating refinancing bubble is sure to have a much greater effect on the economy. What is unfolding there is not just gradual credit restraint. It is a most savage credit crunch. It stuns us how little attention this fact is finding. In our view, the fate of the mortgage refinancing bubble and its further impact on the economy is presently the single most important issue facing the U.S. economy. All other major GDP components are much too weak to take over as the new locomotive.

The other bubble that gives us the greatest headache is the highly leveraged carry trade in longer-term bonds. We ask ourselves how this monstrous bubble, having certainly run into several trillion dollars, can ever be unwound without pushing market interest rates substantially upward. Well, prices of longer-term bonds crashed in April-May -- for 10-year bonds, the loss was close to 10%. For the time being, U.S. bonds have stabilized at their lowered level, as unwinding, i.e., selling, has drastically abated or stopped. But it is a deceptive stability. Such a huge bubble that has been built up over two or three years is not liquidated within weeks. Certainly the bulk of the carry trade still hangs over the markets. The decisive point to note is that huge purchases of bonds with borrowed money essentially result in artificially low longer-term interest rates.

While the U.S. economy has near-zero domestic savings, it possesses a financial system that, thanks to its central bank, knows no limit in credit and debt creation. However, this extraordinary financial elasticity overwhelmingly works its way into two major areas: personal consumption and financial speculation. From year-end 2000 to the first quarter of 2004, private household debt has soared by $2.52 trillion, or 36%, and financial sector debt by $2.9 trillion, or 35%. From 1980 to the first quarter of 2004, the debt of the financial sector in the United States has skyrocketed from 21% of GDP to 98.4%.

Mr. Greenspan keeps hailing this extraordinary ability of the U.S. financial system for expansion as a sign of superior efficiency. We increasingly wonder about its elasticity in the opposite direction. Considering the huge amounts involved in the U.S. carry trade, we think that this bubble has, actually, become far too big to allow for orderly unwinding, by which we mean unwinding with moderate interest effects. The fact to see is that the Greenspan Fed has lured the U.S. financial system into a horrible liquidity trap.

SHILLING FOR A NEW WORLD ORDER

Yale Professor of Economics Robert J. Shiller rocketed into the public’s consciousness with the spectacularly well-timed release of Irrational Exuberance in early 2000, just months before the NASDAQ bubble popped. The book, a psychological examination of Clinton-era bubblemania, is mostly old wine in new bottles in that the madness of crowds engaged in fevered speculation is hardly a new phenomenon. Irrational Exuberance proved prescient, and even cathartic to those observers whose years-long warnings of a liquidity-driven asset inflation had gone unheeded. Yet the connection between asset inflation and irresponsible, even exuberant, central banking was not a part of Shiller’s discussion of contemporary matters any more than it was a part of his shaved history lesson. Out of a 233-page romp through media, market theory and psychology, a mere one page and four lines are devoted to an inconclusive discussion of monetary policy and speculation, which is rather like having written a book on pyromania in which the word “match” does not appear.

But why would a discussion of monetary excess -- the very tool by which elites create the bubbles that target the masses for an old-fashioned soaking -- be a part of Shiller’s analysis? As a quintessential figure of the establishment, who publishes frequently in prestigious journals and top shelf newspapers, regularly testifies before Congress, runs a gaggle of ambitious, cost-free (to him) graduate students, and who was careful to thank the U.S. National Science Foundation for 20 years of financial support in Irrational Exuberance’s acknowledgments, the author is a man obliged. Ambitious too, as his newest book, the extraordinarily-titled The New Financial Order, testifies. It is easy money that first puts scent to wind, and only then does an entirely predictable human psychology take hold among a population. The masking of this age-old reality from the cyclically swindled public is but one of the principal aims of the academic mouthpiece brigade.

The newest twist of the old dog’s tail is the emerging field of behavioral finance. Shiller, a recognized pioneer in such, explains that behavioral finance “takes into account the details of human behavior, including human psychology and sociology.” What behaviorists propose is the use of those details to manipulate a largely clueless retail investor class and to justify a further, draconian reduction of human liberty and free markets as a panacea for man’s flawed psychology and allegedly baffling (to behaviorists) sometime propensity for dicey speculation over the rewards of patient investment. Shiller is an index man too, and given the explosion of new technology and the rise of the Surveillance State on the shoulders of the 50-year old National Security State, he is a pretty excited index man at that. According to the author’s The New Financial Order, redemption lies in the cornucopia of personal and financial data on human beings worldwide now being amassed and delivered to U.S. authorities.

Though Shiller deploys the now routine rhetoric of free markets, his early reference to John Rawls, the Harvard guru of “distributive justice” and icon of central planning, as his moral lodestar is a tip-off that what lies ahead is a blueprint for a new-fangled, high-tech socialism. Socialist central planning failed because no collection of human beings could ever calculate and match the accuracy and speed of the free market’s spontaneous price signals. Resources, consequently, can not be allocated effectively, and the result is ruinous waste in a world of scarcity. It is the author’s conceit and unstated premise that surveillance data married to 21st century technology will do the work of the free market’s price signals.

It is the poisonous capstone of the Ivy League professor’s Big Idea scheme that demands our attention: Shiller advocates the end of money. He condemns “money” for having failed to serve “as a stable and sensible unit of measurement for financial transactions,” which has therefore, through inflation and deflation, caused “innumerable financial dislocations”. He coyly “wonders, then, why we do not have units of measurement, for our financial and other contracts, that remain stable and meaningful through time?”

Rubbish. It is not money, but fiat scrip that has failed, dramatically so. Money has served man for millennia; its invention, acceptance, and usage is what allowed for the division of labor and therefore economic development. It is Federal Reserve Notes (FRNs), unsigned and undated promissory notes issued by a private banking cartel whose operations have never been audited, that have failed as both a store of value and a unit of account. The only thing to wonder about is the phenomenon of an economics professor at one of the nation’s most prestigious universities playing the cherry so shamelessly. There is nothing random or unpredictable about the process that eroded the value of the dollar, yet Shiller avoids any discussion of the Fed, referencing the institution only once in the entire text and then only on page 12 in a long list of financial “innovators”.

The author is invigorated at the thought that “evading taxes by paying in cash and keeping no records will be harder and harder.” He is all for ongoing criminalization of the “inappropriate” use of both cash and encryption, which he assures us will destroy the underground economy. In reality, the way to explode the underground economy is to make government approval of all transactions a legal requirement, a situation that is rapidly being realized due to the requirements of the Patriot Act. Here is the money quote: “The inability of citizens to evade and cheat offers opportunities for social planners. We will be able to achieve a more equitable income distribution because we will be observing it more accurately.”

Funny, but I do not remember crowds of middle class taxpayers, who heretofore have been kept peacefully on the federal plantation by virtue of having the opportunity of becoming more unequal than they are at birth, demanding a mandate for the Ivy League to redistribute their income equitably, or otherwise. But, as a matter of fact and history, Ivy League social planners did get a congressional mandate to restructure and reform an entire nation in 1992 when Harvard’s agents in the Clinton Administration successfully privatized on Harvard’s behalf the USAID contract for Russia. How did that go? The Harvard-designed reform process worked marvelously to squander billions of US taxpayers’ dollars while relieving the Russian people of their national legacy in favor of Westerners and their selected Russian allies, a catastrophe with which Shiller had more than a passing acquaintance.

The New Financial Order’s single grace note is the front piece’s quote of a particularly lyrical passage from Ecclesiastes, which cautions mankind that “time and chance happeneth to them all.” Indeed -- but why increase the odds of certain calamity, a diligent Bible student might well respond, by failing to honor God’s command in Deuteronomy that “Yea shall have honest weights and measures.”

IS THERE A “BEST” MEASURE OF INFLATION?

Indeed there is. It is a time tested, even ancient standard; it is not perfect, but neither is it subject to mistaken calculations, quarterly “revisions”, or political manipulation (from the Fed, the CBO, the GAO, or whomever occupies the White House). It is the commodity known as gold. In other words, it is the market’s measure of inflation. What is more, gold’s price unfolds in Elliott wave patterns: Many of our most exceptional forecasts over the past 25 years came when the pattern in gold was suggesting a move that virtually no one else expected. Once again, we believe a move of this kind is just ahead.

GUNSHIPS AND OPIUM

If anyone steals the election in 2004, it is going to be the Chinese. China may be very close to picking a time to go after Taiwan while the U.S is preoccupied in Iraq. That might seem rash. But think about it in terms of winning without fighting. When could the Chinese attack Taiwan without provoking a U.S. response? At a time when political pressure constrains the U.S. from responding. Bush sending carrier groups into the straits of Taiwan weeks before a general election? Is the American media mature enough to see that as a legitimate response to honor our agreements with Taiwan?

Or would critics be right in calling it election year brinkmanship? Either way, it would be a bold challenge and the last thing the President needed at such a time. It could also happen early in the next term of either President. The same logic applies. Challenge early and get your opponent on his strategic heels. Do governments really think this way about one another? Yes, apparently, they do, thus operation Summer Pulse. You would be hard pressed to find two more paranoid defense establishments in the world than the American and the Chinese.

It is hard to imagine, with $124 billion in trade between them and their economic futures now intimately intertwined, that America and China would go to war over Taiwan. But both appear determined to do just that if they feel they have to. Let us hope they do not have to. Even if the Americans succeed in staring down the Chinese this summer, they will not have won any points with Chinese policymakers. China has seen this kind of thing before. And it is still bitter about it.

In the 1830s Britain’s East India Company was exporting tons of opium to China, trading the opium for tea and manufactured goods. As you might expect, all that opium created a lot of addicts. The imperial government (Qing Empire) made opium illegal in 1836 and began closing down the dens. The British spent two years running their gunships up and down the coast, bombarding the Chinese into submission. And in 1942 the Treaty of Nanking reopened the opium trade and exempted British citizens from Chinese law. Two years later France and the U.S. also signed similar treaties with China. The war planted historic seeds of resentment that still flower today. China is just now nursing a national sense of growing power. Trying to subdue it by reenacting the kind of diplomacy that is recalled as a national shame at the hands of the West is likely to fire up even more Chinese nationalism.

The first opium war forcibly opened up China for free trade (especially for opium). A new war broke out in the period from 1856 to 1860. This time, the British and French united under one command and pressed for even more advantage. They were joined by Russia and the United States. In the second opium war the Western powers succeeded in driving the emperor from his palace in Peking and occupying the city. The West is still trying to get China to open up, but on Western terms. And we are still using guns to do it. The Chinese, for their part, are rolling back political freedoms in Hong Kong and rattling sabers at Taiwan. Who is going to win this time? And will it take more than an economic war to find out?

THE STOCK MARKETS ARE COMPLETELY UNDERESTIMATING THE EFFECTS OF HIGHER RATES

Higher rates will not just be bad for stocks, they will be disastrous. The commentary from professionals and amateurs are the same: we will have more of the same of what we have had recently. However, a look at the charts of the 2 year, 10 year and 30 year treasury securities should make investors consider more sobering views. Each of these securities is sporting yields that are 1% more than they were last year. Yet, most equity portfolio managers are chanting the mantra of the 90s bull market: low interest rates, low inflation and double digit profit growth = bull market. Interest rates are already higher without the Federal Reserve and Greenspan doing a thing. The impact of these rates will be felt more significantly by September.

In addition, while higher yields make bonds look appetizing at current prices, I suggest that interest rates will perhaps be even higher by year end. Perhaps as high as 2% higher. Bonds are being spoken of as a contrarian trade. It is a sucker’s trade. Investor sentiment for bonds is low but likely to go even lower. Most bond portfolio managers are still fully invested despite knowing that they are a poor investment. It is the same mistake that equity portfolio managers made in late 1999 and early 2000. They stayed invested despite knowing full well that the stocks were trading at ludicrous levels.

The equity markets are in as much trouble. The 1990s mantra makes some sense, although the trend on interest rates, inflation and profit growth make it a very different environment than that of the 90s. Low interest rates. Yes, interest rates are low, the lowest they have been for decades. While that is positive, it is offset by the reality that increasing rates will have disproportionate impact as they go up as a result of how low rates are. For instance, if interest rates go up from 1% to 2%, that is a 100% increase. While seeming minor, it is actually substantial increase. The impact of rising rates is being significantly underestimated.

Inflation is low but rising. This is quite different from the 1990s when inflation was low and kept going lower. As long as the dollar continues to decline, inflation will continue to trend higher. Profits are growing nicely, perhaps by as much as 20% in 2004. The stock market with a P/E ratio of 20+ has taken nearly all of this into account. Unless, profit growth is significantly greater, the majority of the increases in the market are in current prices. But despite a history of big accidents occurring when the Federal Reserve starts raising rates, most markets are “cautiously optimistic”.

HEDGE FUND HELL

Alex Brown likes to steep itself in its two centuries of history, proud to have financed the nation’s first water utilities and railroads. But two new lawsuits paint a disturbingly different picture of America’s oldest investment bank, alleging fraud, mismanagement, inept options trading and conflicts of interest. Even more surprising is the source of the suits: several dozen executives at Yahoo, Ask Jeeves and other big-name firms. “Even the biggest fish in the pond can get screwed,” says plaintiff Philip McKee, the former chief executive of TurboChef Technologies. “If they can do it to us, they can do it to anyone.”

In 1997 and 1998 some 170 highly sophisticated investors, many of them techies flush with soaring stock options, put $286 million in stock into two so-called exchange funds. The funds are designed to let execs diversify beyond their own company stock -- and dump insider shares without full disclosure or having to pay taxes on any gains. But the clients lost hundreds of millions of dollars, the suits claim, when the two funds bet wrong as tech stocks rocketed up in 1999, then bet wrong again when the market fell.

In the chaos the funds borrowed massive sums to keep afloat and abandoned the strategies that had backfired so badly -- yet they issued opaque, generally sanguine updates to their investors, the suits allege. Alex. Brown is accused of failing to step in because it savored the rich fees: $25 million shared with the two managers for one of the funds, plus millions more for providing them with margin loans and stakes in mutual funds and private equity funds. From their peak to their trough in early 2003, the two funds declined $500 million. By some reckoning, they are down 50% even after the tech recovery.

OFFSHORE CENTRAL BANKS TREASURIES HOLDINGS EXCEED $1.0 TRILLION FOR FIRST TIME EVER

Treasury debt prices drifted lower on Wednesday as traders sought to cheapen the market to attract demand for a $15 billion auction of U.S. government debt. The benchmark 10-year Treasury note’s yield inched up to 4.49% -- well below the 4.76% peak seen last week reflecting speculation the Federal Reserve will not have to hike interest rates as high as first thought this year.

Key, as usual, will be the interest of indirect bidders, which include customers of primary dealers and foreign central banks among others. Traders doubted they would see a repeat of June’s sale, when indirect bidders took a record 56% of the issue. Others were more hopeful that foreign central banks would be active buyers at the sale given they had shown little inclination to stop investing in Treasuries so far. Figures out from the Federal Reserve last week showed offshore central banks snapped up $18 billion of Treasuries to take their total holdings above $1.0 trillion for the first time ever. That equates to around 27% of the entire U.S. Treasury market.

THE USE AND MISUSE OF CREDIT CARDS

College students today are confronted with ads to get a credit card. They may run up bills that they cannot handle. Parents will then be called in to bail them out. No one in high school taught them the uses and misuses of debt. If I were teaching high school, I would buy a pile of Texas Instruments BA-35 Plus Solar calculators for student use in a class on consumer economics. I would teach students how to use the I, N, PV, and FV keys. A student who does not understand the use of this $20 tool is opening himself up for a lifetime of servitude.

This threat did not seem great in 1959, when I took such a class. Credit cards were then unknown to my generation. The credit card had been introduced in 1950 by Diners’ Club. The initial client base was a total of 200 people, who used their cards in a total of 27 New York City restaurants. American Express introduced a card in 1958. Its target audience was traveling salesmen. In that same year, Bank of America also introduced a card, later called VISA. I can remember receiving my first credit card in the mail in the mid-1960s. I am not talking about an application form. I was sent an actual card. I tore it up. That was one of my better decisions.

A credit card loan is a legally unsecured loan. Thus, the likelihood of default is higher. So, rates are high. Anyway, it was higher until the new bankruptcy law was passed, making it illegal to stiff the credit card issuer. The strongest chains of debt are made of plastic. The public became used to paying rates of interest above 15%. People seldom seek to change what they are used to. A credit card lowers the cost of making a debt obligation to practically zero. It may actually be zero, net, because the risk of carrying a credit card is less than the risk of carrying a lot of currency, at least for legal transactions with after-tax money. When the price of something falls, more of it is demanded. So, a lot of people use credit cards. Most of them do not understand the erosive effects on capital of a 15% interest payment. Ignorance is not bliss. It is expensive.

Now that rates are rising, it is time to do whatever you can to get a locked-in rate on your credit card. If you have procrastinated, it is time to make a call to renegotiate your credit card rate. Before signing up with a new card company, there are a series of questions you should get answered. Read the fine print. If you are tempted to re-finance your home to pay off a credit card, don’t. The loan-creation fees will eat you up.

Banks do not like debit cards and the skinflints who use them. I am told that people who pay off their monthly credit card bills on time are referred to in the credit card industry as “deadbeats”. For items I purchase that I do not care who knows about, I use a credit card. This is usually limited to gasoline, an occasional bag of dog food, and books. A credit card is a tool. Like any tool it can make your life easier if you know how to use it. But it can mess things up terribly if you do not. Use it properly. If you have any doubts, get a debit card instead.

HAS MICROSOFT PEAKED?

Microsoft’s business ambitions have never wavered. Microsoft was founded in 1978, went public in 1987, and has since grown to become the world’s largest technology company and one of the world’s largest publicly traded companies. It has as an enormous cash balance of around $55 billion on its balance sheet and 93% share of the consumer software market. Investors typically regard MSFT stock as a no-risk investment with a stock price that will keep going up. However, that is not the case. Yes, Microsoft has a ton of cash on the balance sheet. But it is not balance sheet cash or market share that propels a stock price upward. It’s growth. And growth leveled off at Microsoft about 18 months ago, when the company went ex-growth and ex-cash.

Currently, MSFT stock is roughly at the same levels as it was in October 2002, while the S&P 500 is still up around 30% since that time. This result contradicts the prevailing conventional wisdom about MSFT stock continuing to be a growth stock. I have long-term concerns about Microsoft and its growth outlook. If I were to 1) balance out the potential for the areas where Microsoft can grow, 2) handicap the stock for the company’s (relative) inability to sell, 3) add in the amount of potential loss of existing business to Linux (a high probability there), and 4) handicap it for the risk of being declared a monopoly, then there seems to be little chance of much growth at Microsoft for the next couple of years. On this basis and over the long term, I believe that MSFT stock trading at 9 times sales is a stock that is priced too high for this low-growth scenario. I would consider a stock price of somewhere around five to six times sales ($17 to $19) to be a more appropriate reflection of its growth outlook, but I do not believe the stock will fall that low, since a cushion of higher expectations should keep a floor under the stock at around $24 or so.

Long term, the basic problem with Microsoft is that IT budgets are not going to grow very fast over the next several years, and they already own large chunks of the market. There is limited ability to increase revenues from the Office business, because the company risks ticking people off and driving more people off license. Growth in new PCs, and therefore operating system sales, is likely to be constrained to three-to-four-year upgrade cycles for laptops and four-to-six-year cycles for desktops. Creation of new markets for other sorts of operating systems will probably be constrained by the reluctance of many potential partners to get “in bed” with Microsoft.

A QUICKSAND OF DEBT

The world monetary order consists of a large assortment of national currencies all of which are fiat money. They are made legal tender by the decree, or fiat, of their governments. The U.S. dollars we know are money because the courts say they are legal tender and we accept them. Internationally, they have no legal status but are readily used because of their relative prominence and good repute. As the world’s most popular money, they have become “standard” money. Unfortunately, it is a precarious standard that may soon sink in the quicksand of debt.

The Federal Reserve manages the standard in utter disregard of basic principles and laws of economics. It blithely and routinely ignores market rates of interest that limit the demand for loan funds to the supply of savings. It prints money and creates credit at will, allowing member banks to borrow new funds at one percent and then relend them happily at 4, 5 or even 6 percent. Its bargain rate induces financial institutions to extend new credits not only to the federal government itself but also to business and consumers. Guided by popular notions of the benefits of money creation and driven by political concerns, Federal Reserve governors take pleasure in keeping their interest rates far below market rates in order to stimulate and activate the economy, thereby creating bubbles of debt.

During the great stock market bubble of the 1990s, growing current-account trade deficits signaled a rapid flow of American funds abroad. Between 1992 and the first quarter of 2002 the annual excess of imports over exports of goods and services actually rose to some $500 billion, or five percent of GNP. Other countries obviously run trade surpluses that cover these deficits, acquiring masses of U.S. dollars or U.S. Treasury obligations. A world economy that labors under such chronic imbalances with goods and services flowing to the biggest and richest economy and its fiat money drifting to poorer countries is highly unstable.

According to an optimistic view of global readjustment, a gradual fall of the U.S. dollar relative to the Euro and other currencies would facilitate a smooth correction. There are other noteworthy scenarios. One is a sudden rather than smooth decline of the dollar. It would not take much to upset an international configuration in such imbalance. An abrupt fall of the dollar would trigger sharp rises in long-term interest rates and steep falls in American asset prices. They in turn would reduce household spending, which would aggravate the economic slowdown. In reaction, the Fed may accelerate its debt-monetization and dollar depreciation.

A mountain of debt casts a shadow on the brightest place. American current-account trade deficits and foreign debts are casting a dark shadow on the U.S. dollar.

DECLARING YOUR INDEPENDENCE FROM THE FATE OF THE DOLLAR

I came to Asia looking for a path out of a dollar-based U.S. centric world and into a something-else-based non-U.S. centric world. If possible, I wanted to find Asian stocks that provide direct exposure to the growth story taking place here, without taking on too much risk. Easier said than done. Asia has all the tools to get out of the dollar... high savings rates, domestic demand, raw materials, and cheap labor. Yet it is still wedded at the head to the greenback. And Asian stock markets are dominated by foreign money -- which as we have seen in the past few weeks, is skittish.

But one of the other reasons I came to Asia, and specifically to Australia, is that I am looking to become Sovereign. What do I mean by that? Let me put it in the form of a question: What can you do today to make sure that your financial future is not dependent on things beyond your control? I am asking because most people’s eyes glaze over when you tell them the dollar could lose all of its purchasing power in the next 10 years. Most people, and maybe you are one of them, find it unrealistic that the world’s entire financial system is so over-leveraged that it threatens to topple and radically affect living standards.

The dollar has not crashed, yet. The bond market has not imploded, yet. And the stock market has not set a new standard for wealth destruction, yet. There is still time to reduce your risk. Part of reducing your exposure to the biggest financial risk of your lifetime is to think about more than just your stock portfolio. You have to think about all your assets. If you take seriously the proposition that no currency regimes last longer than seventy five years, than you have to put some real thought into what changes you are going to make to your personal balance sheet to adjust for a radical decline in the dollar.

It is not simply a matter of reducing your equity allocation from 75% to 50% and adding cash and bullion. You can start with simple, principled goals. Stay debt free. Make sure your assets are liquid. Have enough cash to survive in a crunch. Live in a place that is not going to go up in a ball of flame if there is a great deal of social “disruption” in an American financial crisis. That is why I like Western Australia so much. It is not densely populated. The climate, from what I hear, is a lot like San Diego. And it is in close proximity to the major investment story of the next one hundred years.

It would be even sweeter, I thought, if it turned out you could get some real Indian Ocean real estate on top of all the other benefits, and get a cheap, with a currency upside. But there is a slight problem. Australia, like the U.S. and the U.K. is in the grip of a housing hysteria. The central bank here has already started hiking rates. And just a modest hike has been enough to put a crunch on new housing demand in the hot markets of Sydney and Melbourne. But you are hard pressed to find bargains anywhere, especially here in Perth. The market favors renters.

But the hard asset/real asset strategy is still very much alive. And Western Australia is going to play a big part in it. Which brings me to Independence Day. You have probably heard about the death of the dollar in a dozen articles by now. Maybe you believe it. Maybe you don’t. For my part, I believe the Federal Reserve and the Federal Government have betrayed the American people. The so-called guardians of our money have destroyed it. But when, you might ask, will the whole thing end? And why? The “when” is anyone’s guess; the whole world is bound to the dollar’s fate. No one is eager to abandon the devil they know for the devil they don’t. So foreigners keep on selling their own currency and buying the American one. Asia lacks the self-confidence to get off the dollar standard. But just what is the limit? Well... I suppose it is possible you could see a current account deficit that is 10% of GDP before the imbalances become so radical that an involuntary adjustment (crash) occurs. 10% is just a number out of a hat though.

You still have time to make the big decisions about where you want your money invested and what mix of assets you want in your personal balance sheet. As I said, I am leaning ever more to fewer equities, more bullion, and when you are in the equities market, being in with leveraged options bets that hedge your risk on your open long positions. The question for you is, when are YOU going to declare your monetary independence from the fate of the currency your government has done so much to endanger? It is not too late.

THANK YOU, “BUBBLES” GREENSPAN

I want to personally thank Mr. Alan Greenspan for all the good he has done me. This is not a sarcastic statement (above title notwithstanding), nor a poor humor one. Too many attack the poor man’s policies. Most of the criticisms have been misguided. He has bailed me out of financial disaster by giving the most precious gift I can think of: time. The “secular bear market”, what I call the “Great Recession”, began in 2000 and could easily last 15 years. Many of us criticize him for too low interest rates/too high money supply growth that helped cause, in order, the mid-90s emerging Asian equity bubble, late 90s tech stock bubble, the early 2000s global bond bubble, and the mid-2000s US real estate and global commodity bubbles. So vociferous are some of those critics, that they have called him “Bubbles” Greenspan. Their arguments, while having logical cause and effect, miss the point. They miss the point because these serial market bubbles are at the exact center of the reason he has helped me.

My balances plummeted like everyone else’s in 2000, 01, and especially 02. I added to my moderate growth stock mutual fund holdings in 01 and early 02. Recession over, so take the plunge, right? I got clobbered by the across the board declines in 2002 to the point where I did not open my quarterly statements. I did not want to unload the pie piece I had allocated to high quality bond funds. I had no idea how low the global market indexes could go. It was not until the middle of 2002 that I began to realize that not only had the boom in stocks starting in 1982 ended in March 2000, but also a long-term bust had begun. The previous boom years, after all, spanned 24 years from 1942 to 1966. In other words, a “secular bull market” in global equity indexes had ended. A “secular bear market” had begun two years earlier. I heard the timeout buzzer late and also earlier than expected.

As Mr. Greenspan dropped short term interest rates to 1%, a “cyclical bull market” in US equities began in October 2002. There was a cause and effect, not a coincidence. While the Great Recession overpowers any one institution or man, one man can (and did) tweak the timeline. And timing is everything. Whether a misguided attempt at reflation, an “echo bubble”, or a cyclical bull market given steroids, a label on the current stock market run is irrelevant to me. After a cyclical bear market that lasted two and a half years to October 2002, my retirement portfolio recovered nicely into 2003 and 2004. I have used this opportunity to sell mutual funds: technology, growth, index, international, and selected industry sectors. My 70/30 stock/fixed income asset allocation of early 2000 has reversed. The cash portion has soared. I will sell more on rallies. Now being aware about the current secular bear, I can bide my time and pick my spots to buy treasury bond funds, inflation protected securities, oil funds, international bond funds, gold funds, or just sit on cash. I plan to reduce my principal risk in this way for another 5 to 15 years. After all, the previous two secular bear markets lasted 16 and 13 years.

It has been two years since I have come to the realization (along with others scattered around the country) that we are in a secular bear market. Besides readjusting my retirement portfolio, I have also been paying down mortgage debt, not taking on credit card debt or auto financing, and hanging on to my old car. I use savings to add to cash and cash equivalents like treasury money market funds, savings bonds, and savings accounts. I plan to buy gold bullion coins on upcoming dips. All these actions amount to personal fiscal prudence in case the Great Recession sends the economy from shaky to ugly. What about my house? Where I live in suburban Houston there is no housing bubble -- I guess we missed that financial storm. To Mr. Greenspan’s gift of time, I respond with thanks and praise.

FREDDIE MAC’S IMPENDING FIASCO

The long-awaited financial update for Freddie Mac was held June 30 and proved to be less than expected. The revised numbers show that Freddie broke even for the second half of 2003, after a profitable first half. Losses from its derivatives trading -- the source of the accounting problems and of some $4.3 billion in losses in the second half of 2003 -- were the cause of the poor second-half showing. To refresh your memory, interest rates fell in the first half of 2003, and they rose in the second half. Perhaps you need not be reminded where they have gone since April of this year.

What is especially disturbing is that little guidance was given for any quarter of 2004 and, despite promises of greater transparency, management stated there would be no reporting of 2004 results until March 2005! The reason given is that the accounting is still not up to snuff. In fact, detailed financials for 2003 will not be published until September, so analysts will have to wait another three months to find out what was not said on June 30. One analyst quizzed Freddie’s CFO on what the effect of rising interest rates would have on its trillion-dollar-plus portfolio of derivatives. His astounding reply: “I don’t know.”

As I have said previously, the concern has always been that rising rates could cause Freddie to implode, much like the Long Term Capital Management hedge fund or the Orange County investment fund. Only, this time, the fallout could cause a systemwide financial panic. In any case, it is fair to say that Freddie’s stockholders are in for some sleepless nights, and Alan Greenspan and the U.S. Congress might be, too. Freddie could be just one car in the slow-motion train wreck that may be coming due to the artificially low interest rates engineered by the Federal Reserve in 2001.

AFTER A BUOYANT START TO THE YEAR, THE DOLLAR SEEMS HEADED FOR A TUMBLE

There was a time, not long ago, when economists and those who dabble in the foreign-exchange market could find scarcely a good thing to say about the dollar. In early January, the dollar was worth a quarter less, in trade-weighted terms, than it had been two years before. But when everyone is betting that a market will go one way, it often goes the other. By mid-May, the dollar had risen by 8%, bucked up, as it were, by the Bank of Japan, which bought ¥14.8 trillion ($138 billion) of foreign exchange in the first quarter, almost all of it dollars, in by far the largest-ever act of intervention by a central bank. Then, quietly, the dollar started to drop. By July 6th, it had fallen by 4.3% from its high. Not surprisingly, perhaps: the dollar’s prospects look even worse now than they did last year.

Most economists believe that at some point the dollar will need to get cheaper, maybe much cheaper, to encourage foreigners to finance America’s current account deficit. That point may be at hand. There are two weighty pieces of evidence to support this view.

EMERGING MARKETS, EMERGING RISKS

I had another of those I-can’t-believe-what-I’m-seeing moments when idly perusing a piece of research by Credit Suisse First Boston (CSFB). Bonds issued by Bulgaria and Romania, according to a chart in the report, have rallied so fast in recent months that they now yield scarcely a percentage point over the rate at which the healthiest western banks lend to one another, also known as the swap rate. After wobbling in April, along with just about every other emerging market, Bulgarian bonds have soared to dizzy heights, and the folk at CSFB expect more of the same. Investors, it seems, are convinced that the prospect of both countries joining the European Union in 2007, remote though it is, makes them as rock-solid a credit as you could wish for.

Clearly, emerging markets are once again in vogue, and investors’ appetite for risk is back -- and about as selective as it was before, which is to say not very. Emerging-market debt has now recouped about half the losses it suffered in recent months. But do not expect it to recoup the rest; if anything, the outlook has worsened even as the price of emerging bonds has risen.

Emerging economies that depend heavily on the whims of foreign investors to keep themselves afloat will find it very tough to compete with the rich countries’ need to finance current-account deficits, which is why emerging debt underperforms when rates rise -- however expected that might be. Turkey has a huge current-account deficit, $147 billion of foreign debt, an external-debt-to-GDP ratio of 65%, and lots of borrowing to do this year. It looks anything but a solid credit. But at least its foreign debt pays about three-and-a-half percentage points more in yield than Romania’s.

INVESTORS TRYING TO HEDGE THEIR BETS

It is estimated that there are now more than 8,000 hedge funds worldwide with AUM (assets under management) of more than $800 billion. According to a hedge-fund industry group, Hedge Fund Research, the industry pulled in the remarkable figure of $22.2 billion in the first quarter of 2004 alone. However, even as the industry attracts more interest and is growing in size, there are still some concerns among major market players in Asia.

In an interview with China Daily, Christopher Lee, chief executive officer of SHK Fund Management Limited -- Alternative Investments Division, which sources hedge funds based in the US and Europe for investors in Asia, says that while demand is not an issue, finding the right manager can be an onerous job. “It’s getting tougher to find good managers and also hard to negotiate the capacity you want,” says Lee. With more hedge funds mushrooming, this means increased competition. Lee concedes that one of the team’s biggest challenges would be to find the right manager to suit its clients’ needs in Asia. “Good funds are hard to find, the best funds are often closed.”

In most cases, investors in Asia are not fully aware of the well-known and well-respected hedge funds based abroad and, more importantly, the various ways to monitor them. Nevertheless, the division’s research team has tried to provide additional value and comfort to their investors by making the “extra” checks on hedge funds and their managers. According to him, the selection process of finding the right manager is quite exhaustive and can take anywhere from six to nine months. A majority of the hedge funds which investors in Asia are interested in are based in the US and Europe, and the team often engages private detectives to do background and security checks on the managers, as part of their due diligence, especially in the final vetting process.

SEC to examine hedge fund pricing methods.

SEC Chairman William Donaldson has continued to defend his plans to subject US hedge funds under his regulatory oversight. This time he takes issue with hedge fund pricing methods. According to Donaldson, this matter will be a key focus area for the SEC to look into. Part of the problem involved with hedge fund pricing, deals with the issue that many securities have thin trading volumes, and often illiquid. Many other securities are often traded over the counter, while some may also fall in the category of asset-backed issues. These complexities tend to make the pricing of such securities problematic.

VALUE MADE EASY

It is fashionable but wrong to think cheap stocks are now effectively nonexistent. Cheap stocks are plentiful. Now there are a lot of ways to define cheapness, but here is a simple formula: A stock is cheap if its earnings yield -- earnings divided by the share price -- is better than the yield on medium-grade corporate bonds. Lots of companies meet that definition. What about the prospect of rising interest rates? That would raise the hurdle for the earnings yield and put some companies out of the running as potentially cheap buys. Except for one thing: Earnings may rise just as fast as interest rates.

The Baa bond rate, the rate for companies at the low end of the investment-grade spectrum, is 6.75%. Any stock with a price/earnings ratio of 14.8 or less has an earnings yield better than 6.75% and is cheap by our definition. What happens if the Baa bond rate climbs a point to 7.75%? The stock is still a buy if by then its earnings have also climbed by 14.8% or more. I am less worried than most people about rising interest rates. But even if rates go up more than I expect, I think that many of today’s bargains will in hindsight still look like bargains, because their earnings will climb faster than interest rates. Here are five cheap stocks. Three of them are in the oil business, but my bullish case does not rest on any assumption about sharply rising oil prices -- despite what you may think, oil stocks mostly move with the market anyway. And if I am right that rate increases will be modest, midsize banks will be conspicuous beneficiaries.

THE MOVE IN SMALL CAP STOCKS AIN’T OVER YET

I keep hearing about how the day of small-cap stocks is almost done. Conventional wisdom, backed up by history, holds that small stocks do best at a recovery’s start and then yield the dominant position to big names. Since the bear-market nadir on Oct. 9, 2002, the small-cap Russell 2000 has gained 80%, and this April it eclipsed its bull-market high point set in March 2000. The large-cap S&P 500, though, is up 46% from the low and has a ways to go to attain its former glory. But assuming the overall market breaks out of a current narrow trading range and moves higher, should we assume that small caps will be investment laggards? No.

At a recent investment round table, money manager David Bellet of Crown Advisors gave me renewed confidence that the stars are in alignment for the next big leg-up in small caps -- and that conventional patterns are not foreordained to be repeated. Bellet, who has had a long and successful career assessing small companies both as an analyst and a portfolio manager, maintains a contrarian viewpoint about small caps that is worth heeding.

In summary, Bellet believes that small caps are in a solid position now because their balance sheets are far stronger than they were in early 2000. This gives them the ability to fund higher growth. Plus, past shifts of investor capital into large caps, whether to ride out huge takeover plays or because the big stocks had greater cachet, did not always bring the best result. Hence small caps have a greater allure now than before. Sure, some small issues were Internet flameouts, but they are gone. While large caps may well go on to romp, that does not necessarily mean that small stocks cannot continue to appreciate handily. When big stocks soar, many have a symbiotic relationship with small caps that benefits both. I am talking about small suppliers. Fatter orders from the big boys can only help these little guys.

LEARNED BEHAVIOR, LOST HISTORIES

The Great Bull Market of the 1980s and 1990s trained the investing public to behave in certain ways. These behaviors affected their financial decisions in everything from retirement planning to home equity refinancing to saving for their children’s college. In countless ways, their behavior presumed that stocks always go up. Some people even learned classic “contrarian” techniques like dollar-cost averaging, namely to buy more shares when stocks appeared cheap. The bull market rewarded and reinforced this apparently sophisticated method for a long time, to the point that eventually it was not sophisticated at all; it devolved into vulgar notions like “buy the dip”. Alas, as Pavlov observed, learned behaviors can continue long after the reward stops.

Yet some folks seem to think that ringing the bell loudly can make the food appear again. In a much-remarked upon, 4900-word memorandum to employees this week, Microsoft Chief Executive Steve Ballmer said he expects the worldwide base of PC users to grow from 600 million to 1 billion by 2010; the tone of the memo suggests that Mr. Ballmer believes that technology is still a “growth” sector, in the “New Economy” sense that generated so much hot air in the 1990s. “Key for Microsoft,” he writes, “is delivering secure, groundbreaking software and compelling scenarios that captures the imagination of end users.” Never mind that Microsoft has never produced a single line of “groundbreaking” code, much less software that captures anyone’s imagination. The truth is, Mr. Ballmer confuses corporate sales with sector growth. Chrysler and GM may push a lot of units in the next several years, but will that convince you that automobile production is a “growth” sector?

Mr. Ballmer’s confusion even extends to growth in equity share prices: “Obviously, we all want to increase the value of our stock, and we have the best opportunity to do that since the end of FY98. Our stock was around $25 then, as it is now, and we have more than doubled our operating profits since.” Yet his lack of understanding is understandable, since he seems to have forgotten history itself regarding Microsoft’s share price: From the end of 1998 until the start of 2000, the price nearly doubled to a high near 60. But from there it fell to lows that erased two-thirds of its value, and has not traded above 30 for more than two years. The stock market will punish learned behaviors as few other activities can, especially when the “learning” includes mistaken assumptions and forgotten histories. It can be otherwise for you.

OUR GLOBAL PYRAMID SCHEME

Recently in Ireland there has been a sad news story which has interesting parallels with the global economy. It concerned that very old confidence trick or financial scam of a “pyramid scheme” or a “pyramid selling scheme”. It is believed that this particular scam, which was euphemistically called “Women Empowering Women”, was begun in the U.S. in the late 1990s and spread to the U.K. and subsequently to Ireland. Everywhere it has collapsed leaving the few who are first in and first out very wealthy. Meanwhile, the majority of those beguiled by stories of easy, no risk returns have been left a lot poorer.

In reading about and listening to various current affairs radio programs discussions about this modern day morality tale, I was reminded of the many parallels between this bogus pyramid scheme and our new and increasingly bogus “asset based” global economy where earnings and savings are disrespected in favor of the blind pursuit of capital gains in the property market.

It does not require a BA from Yale and an MBA in Business from Harvard to realize that such schemes are doomed to collapse and the majority of those who have been entangled are going end up out of pocket. The pyramid scheme “Women Empowering Women” was based on what all pyramid schemes are based on -- maintaining confidence among those already in the pyramid and there being a growing number of new recruits to replenish the base, feed the peak of the pyramid and prop up the proverbial “house of cards”. A drop in new recruits is akin to taking one card out from the bottom of the house of cards. It is a fraud because the promoters know the sums do not add up and it is bound to collapse. They know the implied promises will not materialize, and all but a few will be left with nothing from their involvement. The confidence trick only works as long as confidence in the scheme remains. Note the yin and yang-like relationship between the investor suckers and the cunning enablers: there would not be suckers without enablers and there would not be enablers engaged in such schemes without a supply of suckers.

On hearing the tale I was immediately struck with the thought that if one was to substitute the word “Investors” for “Women” in the title “Women Empowering Women” the parallels between this scheme and our current asset based global economy would become evident. Wall Street and the financial press’s continual spin is that “we are all investors now” and that we can all get rich by getting involved in “investing”, especially in that one way street to riches -- the property market. The property markets of the western world are very similar to a massive Pyramid Scheme. Rich and poor, blue collar and white collar, moms and pops are all property “investors” now. They are forming the base of the pyramid and their money will go to the “smart” money at the top of the pyramid who have had the sense to get out of the property markets in recent months and take their capital gains, or are in the process of doing so. The smart money knows it is better to have money or gold stored in a secure location rather than owe a lot of money to the bank.