Finance Digest for Week of July 26, 2004

FENDER BENDER

Ever since 9/11, U.S. auto sales have been relatively flat at a 16.9 million average annual rate. To maintain those sales levels, automakers have been forced to offer a steady and increasingly expensive array of inducements that may continue to be necessary, even after concerns about terrorism, high gas prices and other negatives have receded into the mists of history. The goodies started with the zero-interest rate financing deals initiated in October 2001. The idea, of course, was to tempt frightened Americans into dealer showrooms post-9/11. Sales that month shot up more than 30%. The auto companies originally planned those concessions as one-shot deals, but continued them because they worked so well and because they became necessary to sell cars at a time when the pockets of consumers had been stuffed with tax rebates and two rounds of tax cuts. Then incentives became bigger and better. Soon, triple-zero financing with no money down, no interest on the auto loan and no payments for six months or a year, hit the scene. The alternatives offered for cash purchases -- namely rebates -- have only grown over time.

In the face of all these incentives to buy, what does the flatness of vehicle sales in recent years tell us? For one thing, light trucks, mainly SUVs and minivans, have been sold in such great numbers that the average age of those trucks, already on the road, is falling. This works against new sales. More importantly, the key reason that vehicle age has been rising since the mid-1970s is that the quality of cars has been increasing. Cars do not rust out after only a few years any more. In addition, the number of vehicles per household has flattened in the past 25 years after doubling in the earlier postwar years. Now, with 2.14 vehicles per household and 2.62 people per household -- including children too young to drive -- further gains are unlikely and saturation is now a permanent feature in the auto industry.

The world has the capacity to make about 80 million cars a year, but global demand is only about 60 million. And the U.S. is the prime target for excess auto production just as it is for most of the world’s surplus goods and services. Furthermore, China and other developing countries expect to greatly increase their auto-capacity and auto-exports, and they have America in their sights. Since most of the materials that go into vehicles are internationally traded and priced, the biggest cost-disadvantage pressing Detroit is labor expenses. With global excess auto production capacity, limited growth in U.S. demand and Detroit’s oversized labor costs and lingering image problem, American producers will probably continue to lose market share. The days when GM had 50% of the U.S. market are long gone, and the current 27% share may soon slip to 25% or lower.

THE “NEW” PARADIGM?

Synopsis: As the deflation in stocks and lower grade bonds was reaching a climax late in 2002, policymakers were so distraught that one even threatened to dump currency out of a helicopter. Of course, this symbolized the plea of policymakers for speculations to re-engage so the Fed could, well, accommodate speculators again. This liberal credit policy has been seen to have worked essentially because, after 9/11, the consumer began to aggressively buy grand cars and the median home. This may be reaching saturation, as is the aggressive consumption of stocks and lower grade securities. Within the latter sectors, one of the salvations of the post-2000 crash was that it mainly involved tech stocks and telecom bonds. On the equity side, this left the rest of the stock market as a safe haven.

During the prolonged dismay of the tech bust, the remarkable rise in house prices provided a well of confidence that was critical for last summer’s launch to widespread speculation in the financial markets and aggressive consumption. Of course, the features of the run of very aggressive behaviour have been low interest rates and the weak dollar. Before taking this to what is next, it is essential to note that Treasury Bill rates plunged from 6.35% in 2000 to 0.86% in January of this year and that this was not a result of Fed policy but typical of the initial phase of a post-bubble contraction. To emphasize this, it is worth adding that such rapid collapses in interest rates have only occurred in the senior currency following a great financial bubble. The last two examples, which blew out in 1929 and 1873, show equally dramatic declines.

No matter whether the speculation has been in financial or tangible assets, the action has continued in the face of rising market rates of interest and these have soared beginning in January. The focus on changes in administered rates, such as Fed funds, is dangerous as the record over the past 200 years is that the senior central bank follows by many months the change in market rates -- either down or up. What is more important to today’s investment decisions is not how much further they rise (bill rates have been increasing for 6 months), but when they turn down, which in the past has signaled the end of speculation and the start of liquidation of no longer supportable positions. This will also be tied to a stronger dollar and the behaviour of the senior currency through previous post-bubble contractions is reviewed under Fundamentals below. This is followed by a technical analysis of the U.S. dollar index.

GOOGLING GOOGLE

The Google IPO is so mind blowing that the only way to even think about it is to google it. The company, along with existing shareholders, including executives, plans to sell 24.6 million shares for $108 to $135 a share. If successful, Google would, on paper, be worth between $29 billion and $36 billion. The IPO itself would generate between $2.7 billion and $3.3 billion. These numbers are unprecedented for a company of Google’s age, though mature companies, like United Parcel Service, and spinoffs have raised far more. Its market capitalization would immediately rival that of Yahoo!, which is $38 billion, which sounds plausible since Yahoo! and Google are both funny-named companies in the same business, Internet search, though at this point Yahoo! offers a lot more in the way of ancillary services, especially proprietary services. Yahoo!, by the way, took in about $33 million in its IPO in 1996 and had an initial market capitalization less than one-half billion dollars.

What is harder to fathom is that Google would, to investors, be worth more than Ford Motor, Vivendi Universal, or Schering-Plough, and perhaps as much as Boeing. Those four companies report, on average, annual sales of $64 billion. Google’s annual sales: about $1.5 billion, but growing fast.

THAT CAME FROM BARRON’S?!

“The point of this brief review of sentiment then and now is not novel but very much worth repeating: The bear market of 2000-2002, despite the devastation it wrought, did not fully dissipate those giddy dreams of avarice that were so much part and parcel of the market mania of the ‘Nineties. Which is why we’ve been so stubbornly insistent that the big move up from the lows, for all its power and pizazz, was a bear-market rally, not a new bull market.”

You might be surprised at the source of the quote above -- this week’s Barron’s magazine -- unless you have been a regular reader of the gentleman who penned it, namely Mr. Alan Abelson, now nearing his 50th year of service with that publication. From day one, he has been “in” the establishment but not “of” it. He toes no one’s line but his own. He continues:

“Beginning in the first quarter of 1994 ... there were 46 straight weeks of more bears than bulls. That extended streak, he contends, provided ‘a long foundation of bearish psychology that acted as the springboard for the market's next six years of advance.’

“Compare that with the past couple of years: Bullish advisers have had the upper hand over their bearish counterparts for something like 92 weeks in a row ... the 26-week average of bulls minus bears, is higher than it was at any time in the great bubble markets of the 1990s.

“We’ve been a faithful follower of the Investors Intelligence stuff forever (or since we became a professional spectator of Wall Street, whichever is longer). It’s not infallible -- nothing is. But if you can’t put your trust in investment advisers as a contrary indicator, then, for gosh sakes, what can you put your trust in?”

ARE YOU IRRATIONALLY EXUBERANT OVER REAL ESTATE?

In hindsight, it was not the high P/E ratios or absurd IPOs that marked the height of the stock market in the late 1990s. It was the dimwitted brother-in-law bragging about what a killing he'd made on Pets.com (on paper of course), the college kid hanging on Maria Bartiromo’s every word, and the soccer mom explaining how you could not lose in “the new economy”. Fortunes were lost. Attitudes changed. But not for long.

Now that dimwitted brother-in-law is bragging about the killing he has made on rental houses in Las Vegas (on paper of course), the college kid has dumped Bartiromo for Rich Dad, Poor Dad author Robert Kiyosaki, and the soccer mom is quick to point out that you simply cannot lose with real estate. Does all this enthusiasm spell trouble? “I would say a bubble is happening,” said Robert Shiller, whose book Irrational Exuberance warned in 2000, correctly, that the stock market was grossly overvalued by investors’ unfounded optimism. “When it’s going to burst is the real question,” he said. “It’s difficult [to know].”

The Yale economist is now working on the book’s second edition, which will among other things look at whether America's obsession with the stock market has been displaced by exuberance for real estate. During a housing bubble, he said, buyers who would otherwise consider a house too expensive go ahead and buy anyway because they overestimate future price appreciation and underestimate risk. The bubble bursts, or deflates, when buyers are no longer so sure that prices will continue to increase. “The essence of a bubble is investor enthusiasm,” said Shiller. If the CNN/Money inbox is any indication of investor sentiment, confidence in real estate has been quite high. Some might say too high.

While you cannot time the housing market, you can make sure your decision to buy does not defy reason. You know you are exuberant if ...

Rate race drives home sales through the roof.

Sales of pre-owned houses in June soared by 17.4% from last June, while the median sales price of an existing home hit a record $191,800 nationally. In New York City, prices of existing homes are about double the national median. Realtors say home buyers are taking advantage of lower mortgage rates -- now about 6.29% for a fixed 30-year mortgage -- as well as the urgency of home sellers to make deals so they can close on newer homes or other living arrangements. About 85% of residential sales are for occupied homes. Some economists expressed surprise at the momentum of the sales rise. Despite the jump in home values -- sharply pronounced in New York and California areas -- economists do not see any danger of a housing bubble emerging.

ARMs appeal most to poor, minorities.

Lower-income and minority consumers are most likely to choose adjustable-rate home mortgages over fixed-rate loans -- making those borrowers especially likely to be hurt by rising interest rates, a study released by the Consumer Federation of America found. By contrast, about two-thirds of those surveyed in the poll said they preferred fixed-rate mortgages and appeared to be aware of the risk of ARMs.

THE ECONOMICS OF DOOM

The leading environmentalist Lester Brown, at the New America Foundation Thursday, provided a new take on our environmental dangers that is worth careful consideration for one reason: uniquely from an environmentalist in my experience, the short term danger is more salient than the long term one. Brown began by expounding the danger the world is currently undergoing of exhausting its water tables, the underground sources of water that have been key to modern agriculture since exploitation of underground water resources began in 1950-70. The Ogalalla aquifer in the western United States is already reaching exhaustion in the southern part, although the northern part, which is deeper, has several generations of water left yet. India and China, more dependent on underground water than the United States, are showing signs of depletion; in particular the aquifers of northern China are a worry.

The effect of this may be seen quite quickly in a world shortage of grain and consequent rise in its price. World grain consumption has exceeded production since 2000; in 2002 by as much as 100 million tons, 5 percent of world consumption. Chinese grain production, which grew extraordinarily from 90 million tons to 392 million in 1950-1998, has dropped back quite sharply to 322 million tons in 2003. Hence grain stocks have been drawn down, both in China and worldwide, to the lowest levels since immediately after the Soviet grain purchases of 1972, which caused a food crisis and high grain prices for several years thereafter. In 2004, current estimates in the world’s grain producing areas are for a relatively good harvest, perhaps as good as comes along once a decade; if this were to happen the drawdown in world grain stocks in 2004-05 might be only around 20 million tons. However, according to Brown, this would still leave stocks below the levels of 1972-3, at the lowest levels in modern history. In any case, unless the 2004 harvest is unexpectedly good, a world grain inventory problem seems bound to occur in 2005 or 2006, particularly if China enters the world grain purchase market in a big way (it has already purchased 9 million tons in 2004.)

If and when we get a sharp rise in world grain prices due to inventory shortages, this will cause a sharp rise in prices generally, particularly if it occurs in late 2004, at a time when the effects of the recent rise in oil prices are still working their way through the system. This in turn will cause a sharp rise in bond yields, a collapse of confidence in the Federal Reserve (which will be seen to have erred yet again on the side of over-optimism) and a sharp decline in world stock markets. Brown, who for some reason believes the free market currently “isn’t working” is expecting a “wakeup call” from the water depletion and grain shortage; this would certainly provide one. The next question arises: a wakeup call to what?

THE JULY JOLT: WHAT TRIPPED THE STOCK MARKET?

After plodding along peacefully for the first six months of the year, the U.S. stock market is suddenly on the ropes. The Standard & Poor’s 500 Index has fallen 4.9% from June 30 through July 26. If the month had ended then, July would be the 23rd-worst month in the past 20 years. On the Nasdaq Stock Market, the damage has been worse. The Nasdaq Composite Index has dropped 10.2%, making July the Nasdaq’s 14th-worst month in the past two decades. The July jolt erased all the gains of the first six months. Now the S&P 500 is down 2.8%, the Nasdaq 8.6% and the Dow Jones Industrial Average 5% since the year began. What tripped the stock market? And what is likely to happen in the next few months?

SEC RELEASES DETAILS OF HEDGE FUND REGULATION PROPOSALS

The U.S. Securities and Exchange Commission has released more details on the proposed hedge fund regulation initiatives. This follows the highly discussed 3-2 split vote a few weeks ago by the commissioners authorizing the proposals. However, many questions remain to be answered, amidst resistance to the plans. Critics of the new proposals argue that the SEC could achieve all of the stated objectives through already existing laws.

There is also the possibility that such laws may actually force many more hedge funds to relocate to offshore tax havens, which have been home for a significant number of US mutual fund companies as well. According to SEC staff estimates, nearly 50% of the US hedge funds have already registered with the SEC.

THE LAW OF PERVERSE OUTCOMES... PEOPLE GET NOT WHAT THEY EXPECT, BUT WHAT THEY DESERVE

According to Greenspan and others, the derivatives market allows for more sophisticated risk intermediation. It turns liabilities (debts) into assets by packaging them up and parceling them out, often with a snazzy credit rating, to investors looking for a higher yield than say, the money market or a U.S. Treasury bond. “It’s not the GSEs you have to worry about, although there is certainly a problem there in its own right. It’s the CDO and CBO market,” said Kevin, a derivatives trader. He was talking about the securitization of debts and bonds.

The jargon of trading debt decoded... A CDO is a collateralised debt obligation... a CBO... collateralised bond obligation. The CDO/CBO market, according to the British Bankers’ Association, has a notional value of just under $5 trillion. The business of trading debt is big. In the great hunt for a few points on a trade... and investment instruments to sell investors... CBOs and CDOs represent a strange new devilry. Packaging up debts in and of itself is not so wicked. But it IS an occasion for financial sin... and there are three cardinal ones.

First, you can be a hedge fund and make a wrong directional bet in the derivatives market. This is what happened to Long Term Capital Management. They expected global interest rates to converge. They had a position in Russian bonds. Russia defaulted. LTCM was leveraged to the hilt. Once their Russian position fell apart, they were forced to liquidate everything else, which brings me to the second sin, default. Default is always a risk when you buy debt.

There are not a lot of firms that guarantee CDOs and CBOs. And that is exactly the problem. Some insurance firms found a good business in guaranteeing the quality of otherwise non-triple-A rated CDOs and CBOs. That is, some institutions are barred from buying emerging market sovereign, corporate, or municipal debt on the open market because ratings agencies like Fitch, S&P, and Moody’s have rated the debt less than triple-A. But if an insurance company comes in and slaps a guarantee on the packaged up debt, it is effectively given the junk a triple-A rating, making it safe for the big money to come in and play.

All of this is fine, although difficult to do. The real risk comes from having so few derivatives insurance firms. Insurance firms like MBIA carry enormous risk should any of the derivatives they have guaranteed default. The obvious risk, and the reason Warren Buffett has called derivatives “financial weapons of mass destruction” is that a major derivatives insurer goes under... wiping out all the guarantees that the firm has extended to CDO and CBO bond buyers. It is the vaunted “daisy chain of risk default”. This is the modern financial era we live in.

Bondholders of the world beware. Those that have guaranteed your debt -- the U.S. government, British government, Washington-backed mortgage lenders Fannie Mae and Freddie Mac, derivatives insurers -- are running tremendous risks. I say “those” but what I really mean are individual traders now responsible for managing complicated positions AND making a profit. There is a long history of traders in risk making faulty calculations, and I am not just talking Orange County and LTCM. It is a common occurrence in financial markets. But you do not have to sit idly by as the major institutions to which you have entrusted you financial future run enormous risks. With the right attitude, approach and advice, you can develop an exit strategy that keeps you out of harm’s way, and liquid in times of crisis. More to follow...

POST-ENRON, STRUCTURED FINANCE ADDICTION HAS NOT EBBED

Three years after Enron’s off-balance-sheet shenanigans gave structured finance a black eye, the market for mind-numbingly complex financial deals with a habit of closing at the end of the quarter is sizzling. This week, the parent companies of Standard & Poor’s and Moody’s Investors Service both reported higher second-quarter earnings and revenue, in large part due to their ratings work on structured-finance transactions.

Among the fastest-growing areas of the structured finance market are asset-backed securities, sophisticated financing arrangements that companies and investors use to hedge risk, avoid paying taxes or convert an illiquid investment into cash. Asset-backed securities include a wide range of risk-shifting deals such as credit derivatives, credit default swaps and collateralized debt obligations. Generally, they involve the future cash flow of some asset being bought or sold at a discount in the present. So far this year, Thomson Financial reports, the dollar value of asset-backed securities sold by U.S. companies is up 41% over the same time last year to $444 billion. The number of deals is up 35% to 878.

But the growing demand for structured finance is at odds with the public outcry that followed the collapse of Enron, a company that took the shady art of earnings management to an illegal apotheosis. Andy Fastow, Enron’s former CFO, was a master at conjuring sham earnings from asset-backed transactions that could smooth out Enron’s earnings and help the company meet Wall Street growth targets.

TRUST, COMPLEMENTARY CURRENCIES, AND THE HOUSING MARKET

Right now, the entire housing market rests on that oh-so precarious of assets, trust. And whether it is a housing market, a currency, or an investment phenomenon, once the trust is gone, it is amazing how quickly the asset values follow. Let me explain...

On my recent travels, I was introduced to a man called Stephen Belgin. Belgin is one of the most insightful and brilliant financial minds I have come across. Currently, he is working in partnership with a man named Bernard Lietaer on a book called Of Human Wealth: Beyond Greed and Scarcity. Litaer was one of the architects of the Euro currency and a well-known thinker on the future of money. The problem with the current monetary order, Stephen explained, is that it does not help meet development needs in the many poor places of the world. Most of the world’s communities cannot raise money for infrastructure through a bond offering and there is not enough wealth to use as collateral for borrowing capital.

So how do you create wealth and opportunity in places that are not plentiful in capital or natural resources? Stephen is working on an idea called “complimentary currencies” -- complimentary, not alternative. He has in mind mediums of exchange that work alongside fiat money and are backed, not by the full faith and credit of a government or future tax revenues, or gold, or land, but human capital. How can any economic transaction be based on anything other than a medium of exchange whose value is agreed upon by both parties? Granted, that medium could be arbitrary... a seashell, oxen, or an ounce of gold. But does it not have to be a real thing that has the attributes of a good medium of exchange?

Stephen asked me to imagine a world where the basis of the currency is the faith we have in each other as human beings, as wealth producers. What kind of great societies could we produce if we abandoned the mental trap of scarcity thinking and unleashed human capital on the world? It is a provocative question. And Stephen and his colleagues are trying to solve a real problem... how to create currencies that work at the local level. He said he believes in currencies that work alongside fiat money.

But someday, and perhaps soon, it will not be an academic question but a practical one with some urgency. How do communities create a medium of exchange when government paper becomes worthless? The skeptic in me says you cannot have a currency based on belief in basic human potential. Some human beings are bad loan risks, whether you look at it in banking terms or moral terms. It is prudent not to trust all people because not all people are trustworthy. A man’s word may be his bond in some places, but in other places, I would much rather have his land as collateral than his handshake. It is a matter of trust. And it is also a matter of memory. You can get burned in a deal, at the micro level. And the macro level, crashes can happen. They happen all the time, in fact.

The other day a colleague sent me a note saying that a crash in the U.S. housing market was impossible because there was no such thing as the U.S. housing market. Real estate prices are affected by interest rates. But they are also affected by local factors as well. Regardless of what is happened in the housing market, in some parts of the country real estate is still cheap. But that does not meant there will not be a housing crash. Mortgage bond buyers beware!

Real estate bubble -- yes or no?

Unless you have been living in a rent-controlled cave carved into the side of a mountain for the past year, you know that the U.S. housing market is apparently as “red hot” as they come. On July 25, in fact, the National Association of Realtors reported that home sales for June set an all-time record high. And, according to most economic experts, the only “bubble” new homebuyers need to be aware of is all the bubble wrap they will have to deal with when unloading their moving boxes.

Recent news items, such as this one, drive the point ... well ... home: “With prices moving up, you don’t have to be a genius to make money in real estate. Back in 2000, you didn’t have to be a genius to make money in stocks -- you threw a dart at a stock table, and you made money.” (New York Times)

Especially noteworthy is this little piece from the July 23 Pittsburgh Post-Gazette: “The Center for Economic Policy and Research sponsored a $1,000 essay contest to solicit the most convincing argument that a real estate bubble is NOT here. The winner was a researcher for the Federal Reserve.” OK. This is not Joe Average anymore. Folks working for the Fed are putting this bubble business to bed.

So, do we agree? Well, the July Elliott Wave Financial Forecast devotes an entire section to answering the question: “Housing Bubble Or Not?” In our words: “The housing market is the asset class that most investors trust the most.” In our commentary, you will find out if that “trust” is deserved.

UK house prices “30% overvalued”.

UK house prices are 30% above their long-term sustainable level, according to the National Institute of Economic and Social Research (NIESR). Price growth will slow to single digits rather than suffering an early 1990s-style crash, the NIESR report said.

WHAT IS THE REAL REASON MCDONALD’S WILL TAKE YOUR PLASTIC?

For many years, the credit-card industry wanted you to be able to use your plastic to buy your burger and fries at the drive-through. But the fast-food industry always politely said “no way,” since its business depends on how quickly their servers get you in and out. Making cashiers punch card numbers and hand you slips of paper to sign is no way to shave seconds off the average wait time per customer. Yet the card industry was willing to bargain. It offered to waive the signature requirement and even to reduce the transaction fees for fast-food merchants. That is enticing, but if you are wondering why McDonald’s Corp. really agreed this past March to accept cards throughout its restaurant chain, you need not wonder any more:

“McDonald’s found the average transaction jumped from $4.50 to $7 when customers used debit and credit cards instead of cash,” according to a recent piece in The Wall Street Journal. So from this anecdote, let us just paint the big picture. The ever-widening acceptance and use of plastic explains why 2003 was the first year ever that “Americans used cards -- credit, debit, and others -- to buy retail goods and services more often than they used cash or check.”

What is more, consumer debt should reach nearly $840 billion this year, which will be a 6.8% increase over 2003, and twice the amount it was a decade ago. American consumers use credit and debt in ways which range from inefficient to bizarre, although I will be the first to agree that the story has two sides. The average U.S. household had 7.8 cards in 2003, but the credit card industry will send out -- are you ready -- 4.9 billion card solicitations in 2004. Will a “saturation” point arrive in the market for cards, and in runaway consumer debt? Yes. It will come when the psychology of spending succumbs to the same psychology that overtook the stock market, along with the inevitable deflationary effect of unmanageable amounts of debt.

IRS DATA SHOWS FIRST-EVER CONSECUTIVE-YEAR DROP; LOSS OF JOBS BLAMED

Americans’ overall income shrank for two consecutive years after stocks plunged in 2000, the first time that has effectively happened since the current tax system was put in place during World War II, according to a published report. The New York Times, reporting data from the IRS, said gross income reported to the agency fell 5.1% to $6.0 trillion in 2002, the most recent year for which data is available, down from $6.35 trillion in 2000. Because of population growth, average income fell even more, by 5.7%, and adjusted for inflation the decline was 9.2%.

The paper said the decline was due to a combination of the big fall in the stock market and the loss of jobs and wages in well-paying industries as the recession started in 2001. The paper said before the recent drop the last decline posted for even one year was 1953. The drop in income has hit government tax collections -- the paper said individual income taxes declined 18.8% between 2000 and 2002. Part of that was due to tax cuts passed in 2001.

While the recession that hit the economy in 2001 in the wake of the market plunge was considered relatively mild, the new information shows that its effect on Americans’ incomes, particularly those at the upper end of the spectrum, was much more severe. Earlier government economic statistics provided general evidence that incomes suffered in the first years of the decade, but the full impact of the blow and what groups it fell hardest on were not known until the IRS made available on its Web site the detailed information from tax returns.

BRAZIL’S CENTRAL BANK PRESIDENT INVESTIGATED ON ALLEGATIONS OF TAX EVASION

Brazilian federal prosecutors have been investigating central bank President Henrique Meirelles since June on allegations of tax evasion, the prosecutor general’s office said. The probe also focuses on allegations of non-declared deposits in offshore accounts.

Brazil monetary policy chief quits over tax affair.

The monetary policy director of Brazil’s central bank resigned over allegations of tax fraud and other illegal financial transactions. Luiz Augusto de Oliveira Candiota denied any wrongdoing but said he would step down to protect the image of the central bank. “Continuing in the job would harm the central bank, the financial market, and the country,” he said. Mr. Candiota took office in March 2003 and was one of the key figures behind the monetary policy that controlled inflation and helped stabilize the economy after Luiz Inácio Lula da Silva became president in January 2003.

Istoé, a weekly news magazine, said in its latest issue that the authorities were investigating the tax situation not only of Mr. Candiota but also of Henrique Meirelles, the central bank president. Two public prosecutors from Braslia are investigating Mr. Meirelles in an “administrative process”, the prosecutor general’s office confirmed. It had no information on alleged investigations regarding Mr. Candiota.

Both central bankers issued statements responding to the Istoé report. Mr. Meirelles said apparent discrepancies between income statements he made in 2002 were because he was considered a foreign resident for tax purposes and a Brazilian resident for electoral purposes in 2001. Mr. Meirelles, who won a seat in Congress in 2002, insisted both were consistent with Brazilian law. Mr. Meirelles reiterated he did not intend to step down. He said he was taking “appropriate action” against Istoé for breaking bank secrecy laws by revealing his personal finances.

STONES AND GOLD

Stones and gold... that is practically all I ever invest in. I buy stone structures in Europe and I stash away a few gold coins here and there... no matter what happens, the stones will still be there. I have reflected on the apparent nuttiness of this and assured myself that it is less nutty than it seems. “Why would I buy stocks,” I asked myself. “In order to buy the things I want,” came the answer. “What things do I want,” we continued the questioning. “Old stones and gold coins!” Some people have a weakness for old, stone houses. Others cannot resist a pretty face. Still others are prey to good liqueur or bad whiskey. But put a pretty girl in front of a stone château, with a glass of Armagnac in one hand and a Krugerrand in the other, and I practically fall apart. I drop down to my knees in delicious agony and reach for my wallet. I offer neither excuses nor apologies for this behavior. Nor do I recommend it to others. Still, it has its advantages.

U.S. ECONOMIC SIGNALS VARY WIDELY IN LATEST FED REPORT

U.S. railroads scrambled to add workers, a Midwest trucking company turned down new business for lack of drivers and manufacturers say they cannot buy enough cement, scrap steel and other materials to fill their orders. Yet retailers complain of sagging sales, and car dealers struggle to trim bloated inventories. San Francisco reports a labor shortage. South Dakota reports layoffs.

As analysts wonder whether the nation is entering a lull or a period of sustained growth, the latest report from the Federal Reserve presented a mixed picture of an economy that continued to expand, but in uneven ways, with scattered production and transportation bottlenecks in areas where growth was strongest, and pockets of weakness elsewhere. The “Beige Book” compiles anecdotes from businesses around the country, and was put together to help Fed officials get a more vivid sense of the economy as they prepare for their next policymaking meeting.

Overall, the regional vignettes supported Fed Chairman Alan Greenspan’s recent public comments that economic activity appears to have rebounded somewhat this month, even though businesses continued to be cautious in its hiring and investment plans. With overall retail price increases “moderate”, the report supports analysts’ widespread expectations that the Fed will raise its benchmark overnight interest rate to 1.50% from 1.25% at the next meeting, scheduled for August 10.

The overall employment picture continued to improve, though it varied greatly by occupation and region, and wage gains remained modest. Most districts reported strengthening labor markets, with some of the best conditions found in the New York, Atlanta, Chicago, Minneapolis and Richmond districts. Richmond includes the Baltimore-Washington area. The weakest job reports came from the Boston, Cleveland and Dallas districts.

Although many companies complained about having to pay more for energy, metals, food, transportation and other goods and services, competition continued to generally constrain their power to raise the prices on their products and services, the report said. Residential real estate continued to boom as many buyers appeared to be acting in anticipation of rising interest rates, even as mortgage refinancing has dropped off steeply. Commercial real estate remained generally weak, the report said. One continuing bright spot since the spring has been travel and tourism, particularly in New York City, Florida, California and Hawaii.

GLOBAL OIL PRODUCTION NOW FLAT OUT

By the time this is being read, currently available oil production capacity all around the world will be producing flat out. How sustainable this proves to be remains to be seen. For many years now non-OPEC production has been operated at capacity, leaving OPEC to fine tune production in order to achieve its price objectives. In economic terms, because no company or country had the capacity to challenge OPEC, they had no choice but to be “price takers”, maximizing earnings by maximizing production.

OPEC’s record production of 31.7 million barrels per day (mbd) in 1977 was not exceeded until November 2003. Since then it has never been under that level. It reached 32.2 mbd in March, dropped back a little in April and May, and then in June reached 32.65 mbd. The utilization of the final bits of readily available capacity in Saudi Arabia -- in line with the 0.5 mbd expansion in OPEC quotas from August -- means that early August production will exceed 33 mbd. After that, the only incremental capacity is the, definitionally unsustainable, surge capacity and any new capacity that comes onstream. The August issue of Petroleum Review has tabulated the most up-to-date version of its megaprojects database. Although one or two projects have been added since it was last published. Most of the changes are project delays, most notably the Nigerian offshore Bonga, Erha and Agbami projects.

On page 42 is Petroleum Review’s annual representation of global oil production from the latest BP Statistical Review (June 2004. This shows that 18 major oil producers are now in decline, handsomely offset by rapidly expanding production from the 15 countries growing at over 5%/year and the eight growing at over 10%/year. A straw in the wind, however, is that decline is now running at over 1.1 mbd and there is evidence of decline rates increasing. On page 26 Dr. Salameh tackles the thorny question of how accurate are Middle East reserve estimates. His conclusion that these may be overstated by up to 300 billion barrels, or roughly five North Seas, will certainly give pause for thought. If his assessments are right, the world faces very major challenges in developing and securing the oil supplies it will require.

However, the most minimal concern must be the latest developments in Russia. The nerve twisting drama of Yukos and the tax demands has now taken a dramatic and deeply disturbing twist. It now appears that the tax authorities wish to remove the bulk of Yukos’ production assets and so, we are told, sell them for a fraction of their worth. If this proves true, the hopes that Russia could be safely invested in, with law and regulation being fairly applied, are undermined. Investors with liquid assets will leave, those left will not be sure if they have paid good money for assets or liabilities. If the situation is not regularized very quickly then the outlook is very bleak indeed.

Why are oil prices so high?

Crude oil prices have risen by about 30% this year to levels not seen since the early 1980s. BBC News Online tried to explain why.

NANOTECHNOLOGY: TINY BUBBLES?

Google generated more than $1.4 billion in sales last year, so at a market cap of $36 billion, it would be valued at about 25 times trailing revenues. Frothy? Sure. But for a truly eye-popping IPO valuation, take a look at Nanosys, a nanotech firm that had just $3 million in sales last year. If Nanosys, which is scheduled to go public next week, prices at the high end of its $15 to $17 a share range, it would debut with a market value of about $372 million. So it would be trading at nearly 125 times last year’s sales!

Is a company that warns in its prospectus that it has yet to develop any products and may not do so for several years, if ever, really worth buying now? Nanosys simply says that it is developing technology for use in multiple industries, including energy, defense, electronics and life sciences. If investors vote yes next week, then that could usher in a tsunami of companies with Nano in their names going public. The Nanosys offering is a pivotal one for the history of this young sector.

Nanotechnology, the science of manipulating matter at the molecular level, has generated a lot of buzz during the past few years. But so far, most of it has been of the science fiction variety -- microscopic robots in the bloodstream fighting diseases, clothing that automatically changes styles, and flying cars. Wall Street, however, has taken notice of nanotech. Late last year, many nanotech related stocks surged after President Bush signed a bill calling for $3.7 billion in funding for nanotech research over the next four years. In April, Merrill Lynch created a nanotech index, consisting of stocks that the investment bank believes will have a significant portion of future profits coming from nanotech.

If Nanosys does well, it will be increasingly difficult for investors to avoid all the breathless coverage in the financial press that will likely follow about the Nanosys wannabes. That is only natural. Hopefully though, investors have learned from history. They do not have to look that far back either to find other examples of Wall Street fads at work.

MOODY’S CUTS AT&T’S DEBT TO JUNK STATUS

Moody’s cited concerns that relentless competition will cause a more protracted slump in revenue than expected. AT&T reported an 80% decline in second-quarter profits last week and a 13% fall in revenues. Earnings by some measures have declined for 13 consecutive quarters, thanks to brutal competition from cellular and local phone companies. But even though AT&T’s operating business has run into trouble, its balance sheet is still strong: The company had about $2.5 billion of cash on its balance sheet as of the end of June and has reduced debt by about 80% over the last three years to $11.2 billion.

The company’s shares dropped soon after the widely expected downgrade but quickly recovered. AT&T bonds fell relative to Treasuries, in part because many investors are not authorized to hold junk-rated bonds. AT&T’s Chief Financial Officer, Tom Horton, said in a statement that the company has a strong balance sheet and continues to generate significant cash flow. The downgrade to junk will not impair the company’s ability to operate, he added. But the downgrade will raise the company’s borrowing costs. AT&T shares closed essentially unchanged on the day.

“BEHAVIORAL FINANCE”, MENTAL HEALTH, AND YOUR PORTFOLIO

It is sad but amazing to see a promising and good idea get twisted beyond recognition by a set of beliefs that are old and disproved. Case in point: A “Health” column in the nation’s top financial newspaper today tried to explain why “behavioral finance” can help the average investor. As its name suggests, behavioral finance understands the importance of psychology in financial markets, and most scholars of this school reject the notions that markets are “efficient” and investors “rational”. It is one of the very few worthwhile fields of study to come out of the economics profession in decades.

Yet of all things, this health column suggests that behavioral finance offers investors “help in making sense of things such as corporate profits and outlooks during the earnings season now under way, rising interest rates, the coming election and fear of terrorism.” It does no such thing. Instead, it equips you to understand the sort of consistently irrational beliefs that other investors hold, so that you will not do likewise -- such as believing you need “help in making sense of” external news events that have nothing to do with the market’s internal trends.

One irrational notion leads to another, and by the column’s end behavioral finance has been morphed into an endorsement of Wall Street’s most tattered clichés: “Keep a long-term perspective, remain adequately diversified... and rebalance your portfolio.” Follow advice like that, and the losses in your mental health will be surpassed only by what happens to your portfolio.

THE REAL ESTATE BUBBLE GROWS BIGGER AND BIGGER AND BIGGER

The mysteries of real estate investing in the current hysteria deepen. Six months ago, the most you could hope to get, renting an apartment in Baltimore’s poor sections, was about $600 or $700 a month. This was not because poor people were too cheap to pay more; it was neither a reflection of want nor need, but of means. They could not afford more rent. Now, developers expect poor people to pay more than twice as much rent for a much nicer apartment. Where will these new renters come from? Where will they get the money? We do not have any idea.

But the math is no different in middle class suburbs. A few years ago, an average family might have bought an average house in Howard County for $250,000 or so. Now, prices look as though they have doubled, even though they are still the same people in the area, earning only fractionally more money than they did before.

Even in the best markets in the country, prices do not always go up. A recent piece in the New York Times described a one-bedroom apartment on Riverside Drive in Manhattan. “Sold for $180,000 in 1985... ten years later, at the bottom of the region’s most recent real estate slump, it sold for $167,000.” But nearly everywhere we go, we hear telltale comments: “You just can’t go wrong with real estate.” ... “Better buy now, because it will just be more expensive later on.” ... “Buy as much house as you can afford... you won’t regret it.” Is this a bubble, or what?

INSURANCE COMPANIES KEEP THOSE BAD MEMORIES ALIVE

According to my record, I have filed two water claims with an insurance company. It is not as bad as it sounds. It happened a few years ago. After almost eight years, a gasket on my dishwasher finally gave out and began leaking water under the appliance, seeping into cabinets and drywall. We filed a claim and repaired the damage. A few months later, a nasty winter storm blew through and caused a leak in our roof. Turns out it was not a bad one. No claim was paid, but because I let my insurance company know about it, it was another strike. In the homeowners insurance game, you only get one strike. After that, your premiums go up and most big-name companies treat you with an affection typically reserved for bloated roadkill in August. My offenses were two houses ago, but I am still a pariah among most underwriters.

I could have avoided the second water claim if I had known that calling my agent would count as a claim, or that two claims had pushed me over the hidden limit. But I did not know. Few people do. In the insurance game, policy owners often do not know the rules until they have been broken. If insurers are going to fabricate ludicrous criteria for raising premiums and denying coverage, they should have to at least tell us upfront. Something that says “filing this claim will result in a doubling of your rates.”

The basis for the water-claim blacklisting is a report from the Comprehensive Loss Underwriting Exchange, a claims clearinghouse for insurance agents operated by Choice Point, a credit bureau in Georgia. CLUE reports basically track claims history on individuals and properties. One of the problems with the CLUE reports is that a simple call to your agent can get logged as a claim, even if no money is paid. When CLUE's claims-tracking capability is combined with insurance companies’ fear of mold, the results are devastating. Insurers seem to believe all water is bad. They treat any water claims as a potential multimillion-dollar loss.

WHEN WILL THE “MOOD” CATCH UP TO THE “MARKET”?

How can one tell when a bear market in stocks has reached a long-term low? When the psychology of market participants has plunged as far down as the stock prices themselves. In other words, the low is in when the mood catches up with the market. Yet this has not happened in the four-plus years since the major U.S. stock indexes turned down from their all-time highs. The facts clearly show that market participants have remained in a bullish mood all along.

The evidence accumulates to this day. During this month (July), as the NASDAQ steadily lost as much as 10%, our Sentiment Composite Indicator showed that optimism was on the rise during the same time. Mutual fund cash levels have recently told the same story. Low cash levels mean a fund is heavily invested in the market, which of course means fund managers and investors are bullish. Well, fund cash levels fell to 4.2% this past June. The only lower reading came in March 2000, when the NASDAQ and S&P 500 stood at their all-time highs.

These near-term figures line up with what the bigger picture has shown all along. The consensus among investment advisors has now tilted toward the bullish side for 93 consecutive weeks (according to Investor’s Intelligence). If that sounds like a long time then consider this: If you go back five-and-a-half years -- some 306 weeks in all -- the bears have outnumbered the bulls in this survey during only nine weeks.

This clearly IS a psychological extreme, but it is clearly NOT one that is “catching up” with the market. This mood can only be described as standing in stark contrast with what the stock market has actually done. What to make of this contrast? If a bear market has not produced a bearish mood, when will that mood indeed catch up?