Finance Digest for Week of August 9, 2004

HOW DID I MISS THAT 100-FOOT WAVE?

Statistical models have helped make the world a better place. For decades, these models have been the quiet heroes that helped engineers ease traffic congestion, doctors slow the spread of diseases, and meteorologists forecast the path of hurricanes. These successes have inspired mathematicians and scientists to apply statistical models to other complex problems, from thorny human behaviors like drug addiction to certain natural phenomenon -- for example, why it is not possible for 100-foot high waves to regularly swell up from the surface of a perfectly calm ocean.

ESA (Europe’s counterpart to America’s NASA) studied “rogue waves” as part of the “MaxWave” project, which was begun in December 2000 to either “prove the phenomenon or lay the rumours to rest.” The agency used two Earth-scanning satellites to record 30,000 pictures of the ocean’s surface over a three-week period. ESA reports that the data, after a mathematical analysis, “revealed 10 massive waves -- some nearly 30 meters (100 feet) high.” This result was, shall we say, unexpected. It does not fit into the standard statistical model, therefore it “shouldn’t exist at all.” Statistical models -- linear by nature, based on averages and probabilities -- can account for the “outliers”, i.e., lying outside the supposed statistical norm , but assigns them a probability of appearing only “once in ten thousand years”. But could 10 outliers appear within a three-week period? Sorry, the model says that is not possible.

The truth is that for all the good work models have helped accomplish, there are certain stupendously huge patterns that they miss. This is a column about finance, so perhaps you know where this is headed next. Conventional economists use these models to study “thorny human behavior” with their number-crunching stock market models. When they are done crunching they use phrases like “Efficient Market Hypothesis”, which assumes that markets -- and investors -- are “rational”. Sometimes they even get Nobel Prizes in economics, like the two prominent intellects employed by Long Term Capital Management did in October 1997, less than one year before the fund they helped to manage lost $4 billion. Oops. They did not see the 100-foot tall outlier headed their way; after all, its arrival could only come once in ten thousand years. When it all blew up, the scale of the losses threatened to collapse the U.S. banking system. But beforehand? A financial calamity that large was unthinkable.

But if your method of analysis is NON-linear, you can expect unexpected turns and trends in price. What is more, your search for patterns can begin and end with the market itself -- purported “outside influences” never have and never will change the dominant price trend. A radical approach? Yes, but no more “radical” than the size of the outliers you can train yourself to look for on the horizon.

PURCHASE OF US ASSETS BY ASIAN CENTRAL BANKS COMES UNDER SCRUTINY

Voracious purchases of US Treasury bills by Asian central banks are coming under scrutiny ahead of presidential elections amid concerns over national security and a ballooning current account deficit. Led by Japan and China, Asian economies have been gobbling up US dollar based assets, particularly US Treasuries running into hundreds of billions of dollars, over the last two years. By investing in US securities, the Asian economies stash away proceeds from selling their own currencies in an attempt to prevent them from rising against the dollar and so making their exports cheaper and more appealing to American consumers.

Some say that while the massive Asian holdings may keep US interest rates low and help bankroll America’s debts, they are propping up the US record $541.8 billion current account deficit -- the balance of goods and services between US and the rest of the world. Others fear that such immense US wealth in foreign hands could boomerang if, for example, the assets are unloaded abruptly in a deliberate attempt to destroy the American economy. Lawrence Summers, Harvard University President and US Treasury Secretary under ex-President Bill Clinton, likened the Asian purchases to hoarding of gold by European states centuries ago. “In a real sense, the countries that hold US currency and securities in their banks also hold US prosperity in their hands,” he said. “That prospect should make Americans uncomfortable.”

Foreigners already hold almost 40% of marketable US Treasury debt. The Asian central banks have increased their holdings of US assets to about $one trillion, according to market estimates.

PAYING DEBT BEATS MANY INVESTMENTS

Lenders are lined up at our mailboxes. They offer new credit cards, new mortgages and new home equity loans. They do this because it is very profitable. This is worth considering. Perhaps “un-borrowing” would be a profitable activity. Maybe interest saved by not borrowing will provide a higher return than what we can get by saving and investing. The after-inflation, after-tax returns on money market funds, typical bonds and average stocks is around minus 3.15%, minus 0.9% and a mere 2.4%, respectively. Well, let us see how those returns stack up against what we can save by not having to pay interest on debt. Paying off even low rate, tax-deductible mortgages could be a good idea.

WORLD OIL MARKET STANDS ON BRINK

Analysts have long doubted that oil prices could be sustained at today’s higher levels. But instability in Iraq and other countries, combined with surprising global economic growth, has surprised everyone. How high could oil and gasoline prices go? Traders are bracing for the prospect of $50-a-barrel crude oil in the coming weeks, with fears of terrorism and other supply disruptions plaguing the world oil market. The market is tighter than it was during the crushing 1973 oil crisis, one analyst said Monday. Other analysts are broaching the subject of $100-a-barrel oil if a major supply disruption -- from Saudi Arabia, Russia or other key exporters -- hits an already precarious supply situation.

Higher oil prices could cool the rapidly growing global economy and also spark a surge in U.S. gasoline prices as the summer driving season winds down this month. “There are just too many uncertainties” about supplies, said Tom Kloza, director of the Oil Price Information Service. Crude oil for September delivery closed Monday at a record $44.84 a barrel, up 89 cents, after oil exports were stalled from violence-plagued Iraq. Gasoline prices at the pump, however, have steadied since hitting a record average of $2.06 a gallon in late May amid worries about refinery output.

EVENT HORIZON, BLEAK

US investors and those investing in the US have long been led by positive events on the horizon. True, many of these impending certainties proved as illusory as that new era of ever rising indexes, profits and equity returns. Let us set that sad intrusion of reality aside-as millions of investors have. My point is that the market’s broad measures have been led by faith and expectation regarding future positive events that muted the occasional rational fear and banished the prudent arguments you have been reading on the pages of this fine site for years. High P/E ratios, unsustainable growth forecasts, weak dollars, twin deficits and macroeconomic problems were cast into the darkness of under-consideration by an endless succession of just around the corner positive developments. The Bull crystal ball ever refocuses attention on looming windfalls, recoveries and equity price surges. Honestly, can you afford to be left out of the latest just around the bend, next quarter recovery? No!

As serious as the many once and future ignored threats that face investors is the shattering new fact that the event horizon offers nothing positive! Over the past several months and likely over many months to come, there is nothing positive on the horizon to stare at as you ignore the rising flood waters of softening corporate guidance, tightening interest rate policy, weakening consumer spending, lackluster GDP growth, terror attack risks, rising crude oil, inflation risk, housing market weakness and the Presidential election. Without a distant fuzzy blob on the horizon to stare at, markets are left to technical analysis and the occasional acknowledgment of nasty fundamentals. Needless to say, this does not bode well for returns over the remainder of this disappointing year.

THE COSTLY CLEANUP OF STOCK OPTIONS

The stock option war is heating up, and Silicon Valley thus far is winning the day. Under pressure from high-tech executives the U.S. House of Representatives in late July voted to defang a proposed accounting rule that would compel companies to count the value of employee stock options as compensation cost. The tech crowd, in particular, is addicted to paying workers with options because options get a free ride on the profit-and-loss statement. They are not counted as a cost, either when they are awarded or when they are cashed in.

Too bad for the rule-making Financial Accounting Standards Board, which has been struggling for a decade to end this charade. The FASB wants option issuers to estimate the theoretical value of an option when it is granted and count that as a cost. Under present rules companies have to disclose these costs only in footnotes. The House vote was on a bill to limit options-expensing to a company’s leading five executives. In the calculation of the expense figure, moreover, the company issuing the option could assume zero price volatility, which is absurd. If the House bill passes the Senate, the FASB would have to retreat.

A surface logic attaches to the argument of the anti-FASB lobbyists: A company does not lay out a single penny when granting options, and besides no accurate way exists to value them. But the anti-FASB rationale falls apart if and when the options-granting does indeed trigger a cash outlay -- to mop up the dilution from the employees’ new shares. Companies pay huge sums to buy back stock and reverse the watering-down of earnings per share caused by employee options exercises. Eight of the heaviest options users on the Nasdaq spent $50 billion, or 24% of their cumulative $210 billion in cash flow from operations from fiscal 1999 through fiscal 2003, mopping up dilution from employee options, according to the analysis of Georgia Institute of Technology’s Charles Mulford.

That $50 billion was in hard cash. When the tech execs argue options do not cost a thing, says Lynn Turner, former chief accountant at the Securities & Exchange Commission, “they’re out in la-la land.”

THE LAND OF THE RISING CURRENCY

The financial press speaks of “the dollar” as though it had a single price. But actually it is priced against every other currency according to how traders feel about the United States and its economic condition, as well as the conditions in the other country. The euro-dollar exchange rate gets the most publicity, but the movements in this currency pair do not necessarily reflect movements in other currencies, such as the Japanese yen-dollar pair. Indeed, I am projecting a sharp drop in the dollar against the yen in the months ahead.

But before I elaborate, I need to address some common misconceptions about the relative value of currencies. I think this will help you understand why the U.S. dollar refuses to fall against the euro, as some of the “fundamentals” say it should. It will also help you understand my yen recommendation. The value of a currency is closely related to the strength of its underlying economy. In the case of the United States, despite staggering budget and current account (trade) deficits, a deteriorating geopolitical situation and many other imponderables, it still has the world’s biggest and strongest economy. Europe’s GDP growth this year will be 1.6% this year at best, compared to 4.5% or so in the United States. Even if the Middle East explodes and oil prices spike higher, the euro is unlikely to gain against the dollar and might even fall, as the United States is much further away from the trouble, geographically, and less dependent on imported oil than Europe.

An economy perceived as “strong” attracts inbound investment. Each month, the United States needs an influx of $40-45 billion to fund its current account deficit, but a great deal more money than that actually flows in -- on the order of $70-90 billion per month. In contrast, while Europe is running a current account surplus of around $15 billion per month it is losing almost twice as much in combined direct investment and portfolio outflows. The folks who decide how to allocate capital on a global basis do not miss information like this, and it makes them wary of investing in Europe, or more specifically, the euro.

So now they are turning their attention to another strengthening economy -- Japan. While the capital inflow into Japan is miniscule in comparison to the United States and Europe, it is rapidly increasing. And that bodes well for both the Japanese equity markets and the Japanese yen. Japan is the world’s second-largest economy, after the United States, but for the last 15 years, investment inflows into Japan have been tiny. Big reasons are that the Japanese economy is only now pulling out of a tailspin that began in 1989, and because of structural problems in the financial sector and excessive government debt, which caused ratings agencies to rank Japan in the same class as Botswana(!).

Just over a year ago, the most widely followed Japanese stock market index, the Nikkei 225, fell to 7,600 -- down from nearly 40,000 at its 1989 peak. However, experienced traders sensed a historic low and money has been pouring into Japan ever since. It may be too soon to say Japan is back, but the probability is high. Money follows growth -- fortune favors the yen right now. Until very recently, the Japanese government did not want a stronger yen -- they feared it could choke the recovery and bought dollars heavily to stop the yen from rising. But now, whatever the official explanation, the Japanese have, at least temporarily, sworn off intervention. Were the dollar to fall against the yen from today’s 110 to 80, as it did in 1995, the Bank of Japan would hardly be silent. But a more modest fall, say to 100, would probably be acceptable.

From the dollar’s peak against the yen at 135 in February 2002, it has fallen to 110. If the yen continues to move to the same extent and at the same pace, it will reach 100 by year-end 2004. Currently, the dollar has been rallying and has pushed the yen up beyond 111. It is my assertion, therefore, that this represents an excellent buying opportunity in anticipation of a yen blast upward.

WORK “MAY WARD OFF ALZHEIMER’S”

People who have mentally demanding jobs may be less likely to develop Alzheimer’s disease later in life, a study suggests. The researchers said further studies are needed to find out if there really is a link. However, previous studies have indicated that keeping the brain active can protect against Alzheimer’s. Research published last year suggested that dancing, playing musical instruments, reading and playing board games can all reduce the risks of developing the disease.

TRYING TO KEEP THE USS GREENSPAN ON AN EVEN KEEL

As everyone will know by now, last Friday’s eagerly-awaited US employment report further shook confidence in the solidity of the recovery process. With a total estimated gain of only 32,000 jobs -- the weakest such number so far this year -- the upset meant that financial markets were immediately engulfed in yet another nasty burst of turbulence. Incidentally, in this same report, the Bureau of Labour Statistics itself revised almost twice as many poor unfortunates (61,000 in all) back on to the welfare rolls in an admission that they themselves had overstated May and June’s combined job gains by more than a fifth. Given that slippage, we might just begin to suspect that the whole charade of mainstream economic prognosis makes Madame Wanda’s palm reading business look the height of scientific respectability by comparison.

In fact, it is not the actual number that matters to the trading-desk Top Guns or to the hedge fund hot-shots -- much less the revisions -- but rather the divergence from the finger-in-the-air consensus, for that -- supposedly -- is the number the “efficient” market has come to “discount” in advance. Thus, one of the reasons for the size of last week’s “shock” to the Street was that, of the 72 firms polled by Bloomberg, the lowest “forecast” for the data was for a gain of 180,000 (an error of a mere 462%) and the average call was for a 240,000 addition (650% too high, it transpired), while the wild optimists at ING Bank and at an outfit called -- with an irony no script editor would allow -- “Insight Economics” were out by a mere factor of 10 or so with their 325–350,000 high bids!

This laughable failure of the whole, expensive, rent-a-comment panoply of bank, brokerage, and third-party research talking-heads to point their rules in the right direction on the graph from the last known data point duly had several effects, including Nasdaq falling to its lowest level since October and gold bursting, temporarily, through $400/oz. again. At this point cooler heads and those who make a living out in the real world, rather than in the casino-crammed, concrete canyons of Lower Manhattan, will be asking themselves: could just one, highly-erratic, frequently-revised, heavily-massaged datum really be so filled with so much significance that all those billions of dollars of flows and trillions of dollars of notional values be so sizeably altered? A dispassionate analysis clearly leads us to doubt this.

But what all this violence once more underlines is how far divorced from the production of physical wealth and the generation of real income have become the hot money speculations of high finance. Imagine a scene where every time someone spots a ripple in the water, every last fisherman -- each complete with his multi-billion dollar rod-and-line -- goes rushing from one side of the boat to the other. The skipper will have a very hard time of it keeping things on an even keel. One day, the old sea dog at the helm is going to misjudge his response, or the throng will move a little too quickly for him to correct in time. On that day, an awful lot of folks will get very wet, indeed, and, sadly, a good many will find they cannot swim, laden down, as they are, with all that fancy tackle they have accumulated.

STEFAN ZWEIG MEETS MR. MARKET

If we are on the cusp of a deep decline, what happens next? There is no syllabus for such a study. The approach taken was to look at precedents, identify the common social and financial characteristics, and observe how they unfold. My point of embarkation, like the average investors’ response to the Federal Reserve chairman’s latest pronouncement, is to take the statement as fact.

If all the inflationists and deflationists sat down to dinner, they would probably come to at least one majority opinion: prices will fluctuate to a degree most have never known. The financial cause and effect is there for anyone with eyes to see: the world’s integration is rising on a vast expansion of unsecured credit, tightly bound in carry trades, hedge funds, derivative swaps and multi-billion dollar institutional portfolios solely positioned for this quarter’s relative performance. Part-and-parcel to the world’s trading position is the worldwide bubble in every market: US and UK houses, copper and soybeans, Euro bonds.

Where will it burst first? What is next? Can some of the minor bubbles deflate rather than burst? It would be silly to predict the markets in which to hide and chase and avoid when the trillions of dollars start to unwind, or how quickly or slowly it will unravel. In times past, prices moved very quickly, once they got going. Leo Tolstoy described such a situation when Napoleon reached the outskirts of Moscow: “Prices that day indicated the state of affairs. The price of weapons, of gold, of carts and horses kept rising, but the value of paper money kept falling... peasant horses were fetching five hundred rubbles each [a life’s savings] and furniture, mirrors, and bronzes were being given away for nothing.”

We live in the midst of the largest financial bubble the world has ever known. The past patterns are what I hope will steer the reader to recognize any similarities to conditions today, where we are likely headed, and what to do about it. World bubble-isation is courtesy of a monetary phenomenon that lacks antecedents. Never before has any country printed as much money or extended as much credit without melting down the printing presses. The US dollar remains the world’s reserve currency, and our dollars are absorbed by any and all. Thus the 25% inflation rate shows up in speculative finance, the traditional cubbyhole for excessive credit.

The credit madness is difficult to comprehend. It is hard to understand in relation to past economic imbalances, because none exist. The relationship, though, between money printing and credit expansion is as old as the hills. (In the end, it is the overextension of credit to vagabond borrowers and speculators that crashes.) It is best to open with a scenario and we will look at the future as seen through the eyes of Sir John Templeton. His fortune was earned with the guiding policy of “buy at the time of maximum pessimism and sell at the time of maximum optimism.” He left little ambiguity as to his state of mind in an interview last year with Equities magazine, in which he informed investors to expect a 1929-style stock market crash.

Again, I am not predicting, but instead, expounding on the initial premise. One other common feature is the bedazzlement of smart and knowledgeable people, whistling past the graveyard, while the hangman adjusts the scaffold. This is usually the case and worth remembering since it is difficult to hold convictions, and only human to harbour doubt, when all around live on Fantasy Island. A central problem within the investment industries is of narrow concentrations. Someone may be expertly versed in the monetary aggregates, flow of funds, historical market ratios and the hidden debt shifted off-balance sheet, but a person who anticipates the calamity discussed must be equally attuned to how people behave. An eloquent witness to his own myopia was Stefan Zweig. It is for this reason I include a rather prolonged quotation from his autobiography, The World of Yesterday, about late 19th century Vienna during the Habsburg monarchy.

FAUST’S METROPOLIS

The post-World War I German hyperinflation is well known to readers of The Daily Reckoning. (In November 1918, it cost 100 reichsmarks to buy one U.S. dollar; by November 1921, 276 marks per dollar; a year later, 4,456 marks; in August 1923, five million marks; and then the mark shot straight up -- or is it down? -- and soon passed a billion, then a trillion per dollar by November 1923.) The concentration of this essay is on the social consequences of inflation, starting with Austria. Ludwig von Mises recalled hearing “the heavy drone of the Austro-Hungarian Bankundefineds printing presses, which were running incessantly, day and night, to produce new bank notes.” Manufacturing machinery sat idle other than “the printing presses stamping out notes... were operating at full speed.”

“The government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many dollars as it wishes at essentially no cost,” said Fed Governor Ben S. Bernanke.

The Austrian inflation ran greater than 50% a month. By the way, in 1923, the Reichsbank, in concert with a long line of propagandists from Mirabeau to Greenspan, was miffed at public opinion and denied that the central bank was “responsible for the enormous new burdens of increasing inflation and acute payments difficulties.” Whatever the government response, it mattered little to the people who were so malignantly served by both institutions. For those looking for a money-making opportunity in all this gloom and doom, I transcribe the advice of Alexandra Ritchie, from Faust’s Metropolis: “One could buy a row of elegant houses, or hire the Berlin Philharmonic for the night for a mere $100.” If Fannie Mae had been a German invention, instead of our own Faustian horror, what would that collapse in real estate prices do to its hedge position? Ritchie also identifies all of the common maladies we have seen in the French hyperinflation: “Hard work now seemed to mean nothing; one could only get ahead through crime, black marketing or prostitution.”

As things grew increasingly dire, Berlin threw itself into an orgy... the higher prices rose, the greater the abandon, the madder the nightclubs, the faster the dance steps, the louder the jazz bands, the more plentiful the cocaine... Alan Bullock in his book Hitler: A Study in Tyranny said that the foundations of German society were not destroyed so much by the war, but by the inflation.

The printing press is not always an enemy of sound money. This technology has proved a most satisfactory incubator for conservative finance -- when those overzealous machines are destroyed. Most recently, the Kurds in Northern Iraq have used the “Swiss dinar” (called such, after the country where they were printed), of which the last was issued in 1988. The money supply could only grow dirtier and unreadable. In Hussein’s Iraq, the dinar supply grew by 25 times over a decade’s period. The “Swiss dinar” was worth 300 Iraqi government dinars. And this, in the Kurdish territory with “no government, no central bank, no legal tender and no cash.”

Impoverishment: Then and Now

The methodical impoverishment of the American people, particularly those who are living on the edge, has been one of the few U.S. government success stories. Flooding the world with dollar bills to support a moribund economy has performed as all such operations begin. The flows have not been channeled towards productive enterprise, but towards speculation, and the speculation is not always by choice. Statistics may show that 80-year-olds are buying and speculating like the baby boomers, but they are caught in the pitiable condition of not being able to live on 1% interest; the disincentive to save has been energetically promoted with a short-term yield of microscopic content.

A previous 1% rate era was ripe for the leadership of a madman; the 1930s could have been far worse in America. With 6 million jobless one year after the crash and 1 million unemployed walking the streets of New York by 1932, it is surprising that no fascist or communist uprising took root. Franklin Roosevelt deserves credit, but at the cost of some highhanded populist measures. Whether his means were necessary is not a matter to debate here; it is the precedent we can study and the sort of nonsense that goes mainstream when in extremis.

James P. Warburg (son of Paul Warburg), wrote of the immediate pressure FDR confronted from the Committee for the Nation. This mix of industrial leaders and college professors wanted -- demanded -- that the dollar-gold exchange rate be recklessly devalued. They held rallies in Madison Square Garden and allied themselves with the arch-propagandist Father Charles Coughlin, the “Radio Priest”, who, in rebutting the Sound Money Committee, “in less than half an hour of blazing oratory... undid months of hard work by the opposition.” All we know is the outcome that occurred; there are many other routes the Great Depression may have followed.

Looking ahead, words of our wise board of governors and those of the Bush (or Kerry) administration will boomerang on the promoters. I predict that the Federal Reserve Board will be lynched, figuratively speaking. There will be no getting around the fact that the Fed promoted overconsumption on credit that the homeowner could never repay. You might argue that it was the consumer who decided to borrow and spend, but just as safe banks were nationalized along with bad banks in the 1930s, I am afraid that those who have acted responsibly will win no good citizen awards.

But let’s forget about truth, since the inversion of the truth already predominates. Evidence of encouragement “by those guys” to commit financial suicide is ubiquitous. My favorite call to arms was the workmanship of Federal Reserve Governor Bob McTeer, who urged all Americans to “join hands and buy a new SUV.” And so they did, and continue to spend more than they earn. Inflating assets are the artificial stimulant to an artificial boom. The chairman knew the score. Mr. Greenspan’s view is that the household balance sheets are “in good shape”, and perhaps stronger than ever, because “the value of people’s houses and stock portfolios have risen faster than their debts.” And people believe this stuff.

The masses will need the explicit crash to illuminate their world. Then, we must consider the possibility of the capstone to inflationary destruction: the Napoleon precedent. Is the moment of the iconoclasts at hand? Will everyone look elsewhere for leadership, far afield from those whom they so innocently, indolently and irresponsibly trusted?

“WHO REALLY CONTROLS THE MONEY?” A LAYMAN’S GUIDE

There has been much written about how the world money supply is being run by secret societies of the occult; strange people hidden in the shadows from the pubic eye only to appear once every few decades in clandestine encampments to decide the fate of empires; to discuss the fortunes of money and to roast marshmallows and weenies. One of these well-documented groups is the Bilderberg group; another is The Knights Templar. Today you may hear much about the Carlyle group. If you know little or nothing about these groups and their grubby little meetings -- deciding the fates and destinies of entire nations -- then this article is for you.

THE WALL STREET SELF-DEFENSE MANUAL

Part 1: What You Won’t Learn from Your Broker

Sadly, I can no longer work on Wall Street, so I get to experience it only the way most people do: as a customer. Slate has asked me to write about this. Specifically, they have asked me to create what might be described as a Wall Street User’s Guide -- aka a “Self-Defense Manual”. The ironies and concerns of my writing about this subject are many -- I have addressed them in this detailed disclosure statement.

This User’s Guide starts the same way many people’s investing begins, with a visit to a financial adviser. A few weeks ago, I met with an adviser at a full-service brokerage firm, a chipper New Yorker ensconced in a midtown office tower. At the adviser’s suggestion, I had previously submitted financial details -- assets, risk tolerance, time horizon, objectives, etc. -- and the adviser had developed a “proposed investment program”. The adviser handed me a presentation book and skipped to the punch line: With careful asset allocation, manager selection, and portfolio rebalancing, my proposed investment program should generate average returns of about 10% per year. How?

The good news: Most of the advice inside was responsible and sane. The program emphasized asset allocation (instead of stock-picking), diversification (instead of swinging for fences), and patience (instead of trying to predict near-term market performance). The program was also personalized (if yours is not, head for the elevators). It did not tout the adviser as a stock-picking wizard (if yours does, sprint for the elevators). It illustrated that the projected return was only a median. It disclosed all fees, in both percentage and dollar terms. Overall, I was impressed. If I were to follow the proposed program (and I will follow some of it), I believe that, over time, I would make a little money without taking much risk. I would pay a lot of fees, but such is the cost of using a full-service brokerage firm. What I would not do, in my opinion, is generate anything like a 10% average return.

When gazing at a presentation book filled with beautiful pie charts, graphs, and tables created just for you, it is easy to forget that projected returns are just black marks on a page. Far more important are the assumptions and logic underlying them. The projected returns were before fees and transactions costs -- just like that, the 9% median return dropped to about 7% -- and also before taxes and inflation. I eventually found some “Assumptions”: I was going to generate about 10% per year with limited downside by getting 11.81% a year from stocks, 7.15% from muni bonds, and 4.47% from T- bills.

The numbers were so precise, so reassuring (even expressed to two decimal places!). Alas, they, too, were simply black marks on a page. In my opinion the firm’s assumptions are probably aggressive, and, therefore, unlikely to be achieved.

Part 2: How Long is “The Long Run”?

The method the brokerage firm used to generate projected returns for my hypothetical portfolio -- extrapolating past performance -- is common. It is logical, and, in some cases, defensible. It is also, unfortunately, dangerous. As the fine print suggests, past performance does not guarantee future results. What it usually does guarantee is that we will expect more of the same going forward. Unfortunately, in the market realm, most of what we can easily observe -- periods of three, five, 10 years -- are often too limited to be useful as a forecasting tool. Why? Because market cycles usually last 30-40 years, not three to 10 years.

In the financial markets, the “long term” is long. Over the past 200 years, U.S. stocks have, on average, returned approximately 10% a year (about 7%, after adjusting for inflation). For many of those 200 years, however, stocks have returned nothing -- or worse. The fallow periods, moreover, have not just lasted months or years. They have lasted decades. In a 2001 Fortune article (the wisest, pithiest snapshot of market history I have ever read), Buffett observed that the 20th century encompassed three major bull markets in which the Dow jumped more than 11,000 points and three major stagnant markets in which the Dow lost 292 points. The three bull markets, in aggregate, lasted 44 years; the three bear markets 56 years. For more than half of the century, in other words, stock performance stank.

The most recent market cycle spanned 34 years, from 1966-2000. The bull phase, the one we all remember, lasted 18 years (1982-2000), and it took the Dow from just over 800 to just under 12,000. The bear phase lasted 16 years (1966-1982 -- 16 years!), and it took the Dow down nearly 20%. Lest this tempt you to rush out and buy bonds, average bond returns from 1966-1981 were worse than those on stocks. Because market cycles are so long, assumptions based on 10-year averages can lead to unfortunate expectations. The problem with most projections based on past performance is that they do not fully account for the length of market cycles and the tendency toward mean-regression. It is likely that we are in the early years of a 10- to 20-year “regression” in which the returns on financial assets will disappoint.

So what might alternative assumptions look like? After consulting the work of a few of the gurus of mean-regression I came up with my own subjective and imprecise guess for a median annual return: 4% -- a far cry from 9%, but the brokerage firm is still going to make me money, right? Yes, probably, but in all likelihood less than that suggested by either of the median estimates. Once again, the wisdom lies in the fine print: “Returns are shown before the deduction of fees … and assume reinvestment of income and no transaction costs or taxes”. The returns are also shown before the impact of inflation.

Part 3: Your Real Projected Returns …

Because the projected returns we have examined so far are, for the most part, before costs, fees, taxes, and inflation. When the stock market goes up 20%- plus per year, as it did in the late 1990s, costs do not matter much (or, rather, do not seem to matter much). When the market rises only a few percent a year -- or drops -- they matter a lot.

Let’s start with transaction costs. Most of our projected returns are market returns, not fund returns. Unfortunately, you cannot buy “markets”. All you can buy are securities and funds. All funds generate transaction costs, even “passively managed” index funds. An S&P 500 index fund, for example, acquires the stocks in the index and then continually buys or sells shares to maintain the appropriate balance. When the fund trades, it pays brokerage fees, just like the rest of us. John Bogle, the founder of Vanguard and author of Common Sense on Mutual Funds, estimates that, on average, transaction costs eat at least half a percentage point of annual return.

Next come fees -- fees charged, in this case, by the brokerage firm and the outside managers who actually run the money. Asset management fees often seem immaterial: “One or two percent a year? Who cares?” In fact, they are often outrageous. The fees on my proposed program ranged from 0 percent on cash to an astronomical 3%+ on funds-of-funds. In aggregate, this amounted to about 1% of assets, which is painful but (relatively) reasonable. The fees on low-cost funds like Vanguard’s run from 0.2% to 1% -- some of the best deals in town. The fees on generic “full-service” mutual funds can run as high as an absurd 2.2% or more.

Then we come to the biggest expenses: taxes and inflation. Most investment gains, interest, and dividends are taxed. Because taxes can take an eye-popping bite out of performance, investment advisers usually are not in a hurry to show you projected after-tax returns. This is unfortunate, because, in most cases, the only returns that matter are after-tax. After-tax returns depend on the asset class and the investor’s circumstances (tax bracket, state of residence, etc.), but they also depend on the manager’s tax efficiency. All in, taxes can chew off 40% or more of pretax returns.

Lastly, inflation. Inflation is not an explicit “cost”, but it might as well be. Depending on the era, inflation usually bleeds away 2% to 6% of your purchasing power every year. With inflation, you are helpless. You can’t run, you can’t hide. You can’t blame your financial adviser; you can only sob on his or her shoulder as your money drains away.

Bearing in mind that costs, fees, taxes, and inflation vary, let us assume that, on average, each year, transaction costs consume 0.5% of assets; fees 1.0% of assets; taxes 20% of gains, income, dividends, etc.; and inflation 3.0% of assets. On the brokerage firm’s assumed median return of 9%, this would result in a pre-inflation net return of about 6% per year and a net increase in purchasing power of about 3% per year -- nothing to sniff at. On my assumed median return of 4%, however, the pre-inflation return would only be about 2% per year, with a net loss of purchasing power of 1% a year. Lest this sound depressing, it is worth noting that if I just buried my money in my back yard then, thanks to inflation I would do even worse.

Part 4: What financial advisers are good for … and what they probably are not

I have now written three articles about financial advisers without once mentioning what many people assume is their raison d’etre: stock-picking. But the last reason you should hire a financial adviser is to learn which stocks to buy or sell. As numerous studies have shown, the vast majority of professional investors cannot beat the market -- because beating the market over a sustained period is extraordinarily difficult. As hard as it is for professional investors, moreover, financial advisers (and, thereby, you) face even longer odds.

Financial advisers have dozens of things to worry about before they can help you pick stocks: recruiting new clients, schmoozing, hand-holding, monitoring positions, executing trades, paperwork, attending “compliance” seminars, etc. If not for technology, most advisers would barely have time to follow the market, let alone analyze stocks. At a big firm, an adviser’s views on a stock may be improved by the work of research analysts, but even this often is not enough (and not because of “conflicts of interest”). Big brokerage firms will have several hundred stocks or bonds rated “buy” at any given time. Your adviser would have to sift through hundreds of buys to find the ones appropriate for you.

And this is not even the real problem. The real problem is that, in any stock-picking effort, you and your adviser will be competing with thousands upon thousands of full-time professionals engaged in nothing but trying to find and exploit tiny information advantages that other full-time professionals miss. To beat the market, you have to capitalize on other investors’ mistakes, and, in this effort, no matter how alert and dedicated your adviser is, the two of you will be at a major disadvantage. Weekend warriors rarely imagine that they could hop on a bike and win the Tour de France. For a variety of reasons, however, many casual investors imagine that, with a modicum of effort, they can ride wheel-to-wheel with the Lance Armstrongs of investing (a delusion, it must be said, that is actively encouraged by much of the financial press). And the time it will take you to determine whether your adviser is a member of the elite group that can consistently beat the market will probably render the effort irrelevant.

So what are financial advisers good for? The best ones, in my opinion, will do less, not more. They will be decent, trustworthy people you feel comfortable with. They will help you allocate your assets appropriately and keep your costs low. They will warn you not to expect to beat the market (and explain why) and encourage you not to trade actively or change your strategy every year (unless, again, your primary goal is to have fun playing the game). They may offer expertise on estate planning, insurance, mortgages, or banking services. Above all, the best advisers will dissuade you from being stupid -- an invaluable service, one we can all benefit from.

This is why the advice the brokerage firm gave me was sound, even if, as I suspect, their projected returns prove too optimistic. If you are comfortable making your own asset allocation decisions, you should probably forgo an adviser and use a low-cost firm like Vanguard. If you are uncomfortable or if you want someone to help you keep your financial house in order, then find an honest, straightforward adviser at an independent financial planning or brokerage firm. But if the adviser ever calls with a foolproof plan to beat the market, scram.

HOW SHARPLY WILL THE AMERICAN ECONOMY SLOW DOWN, AND WHAT WILL IT MEAN FOR FINANCIAL MARKETS?

Economists can broadly be divided into those (most of them) who laud Alan Greenspan, the chairman of the Federal Reserve, as a latter-day Solomon, and think that America is experiencing a normal recovery with a few problems; and those (like your columnist) who think that those problems are symptomatic of the fact that this recovery is different from all previous recoveries since the second world war. The front-line in this battle has been the jobs market. When the “jobless recovery” started to produce jobs in the late spring, bears went into hibernation. Now they are back, frisky and growling, egged on by weak numbers and jittery stockmarkets. After recent falls, the S&P 500 is now below where it started the year.

American consumers, of course, hold the key to growth. Betting against their spendthrift habits has generally been a loser’s game in recent years, but only a fool could think that Americans can rely on the stockmarket or the housing market to save on their behalf for ever. Saving is close to record lows and the recovery has been built on a huge rise in household debt, the cost of servicing which is close to record highs even though interest rates are still so meager. Straws in the wind, perhaps, but there are signs that Americans are starting to tighten their belts. Consumption fell by 0.7% in June.

Intriguingly, despite all the inflationary scares, bond yields are not far above where they started the year -- or, indeed, last year. Whether that is good news for buyers of financial assets that are not Treasuries is a moot point. It could well mean that the economy is about to slow down sharply, which is unlikely to be favourable to risky assets. The question is: how sharply? To a walk? A halt? In dressage, going backwards is called reining back; in economics, it is called a recession.

FED SAID AGGRESSIVE POLICY MAY BE NEEDED

The U.S. Federal Reserve’s policy panel in June saw a series of gradual interest rate rises ahead but acknowledged more aggressive steps may be needed, meeting minutes released on Thursday showed. “Depending on the rate at which resource utilization increased and the level and trend of inflation, a more aggressive pace toward reaching a neutral policy stance might be called for so as to provide assurance of containing emerging inflationary pressures and averting the potential need for greater overall tightening,” the minutes said.

The Federal Open Market Committee raised the key federal funds rate target by a quarter-percentage point to 1.25% at the end of its June 29-30 meeting, and increased it by the same amount at its most recent meeting on Tuesday. June’s move was the first rate increase since May 2000. Minutes from the June meeting show the FOMC was confident the U.S. economy was growing at a solid pace, and expected strong expansion to continue through 2005. The committee cited strong output and job gains, as well as signs of inflation, as reasons for the rate hike.

WHY ASIA IGNORES GREENSPAN’S RATE INCREASES

A funny thing happened here in Taiwan right after the Federal Reserve raised U.S. interest rates: nothing. Normally, Taiwan’s central bank moves with the Fed, the most powerful monetary authority. It did not even bother to meet this week and review the Fed’s second rate increase in two months. Nor does it seem worried local inflation is rising at its fastest pace since late 1998. Moreover, none of Asia’s central banks came through with the usual copycat rate moves after the Fed acts. In fact, one -- South Korea’s -- even cut interest rates. Asia’s go-slow approach to boosting rates says much about the risks facing the region. People here worry trouble is afoot in the global economy.

For all the reforms implemented since the 1997-1998 Asian crisis, this region still relies heavily on growth in the U.S. and China. The U.S. has long been a key growth engine; China morphed into one in recent years. Now, both growth engines may be on the verge of marked slowdowns at a time when oil prices are surging. All this explains why central bankers are taking a wait-and-see approach toward matching the Fed.

The triple whammy of U.S. and Chinese slowdowns and rising oil prices bodes poorly for Asia. That is especially true of Japan, which is crawling out of 14 years of negligible growth largely thanks to China’s boom. Similar concerns can be raised about Korea, which even with a 5% growth. Asia’s economies are in far better shape than in 1997, when currency devaluation in Thailand touched off a region-wide crisis. Yet rapid growth rates at the moment mask a stubborn reality: Asia’s post-crisis reform efforts are still a work in progress.

Among the lingering vulnerabilities is debt. While the region has done considerable heavily lifting since 1997, the weakness of public balance sheets remains a constraint on future growth. Here in Taiwan, for example, government officials are accumulating record budget deficits to support growth at a time when tax revenue is falling. Asia’s biggest vulnerability is its over-reliance on exports, leaving the region susceptible to events in the U.S. and China. Yes, small, export-oriented economies will always be at the whim of the economic giants, but Asia badly needs to do more to stimulate domestic growth.

That Asia is not dutifully following the Fed and boosting rates may be a sign of maturity. The inactivity seen at Asia’s central banks also speaks to concerns about the outlook. Governments have propped up growth with traditional fiscal pump-priming methods and central banks have helped with lower rates. Yet only when authorities do more to stand on their own, separate from U.S. and Chinese demand, will investors have deeper confidence in Asian markets.

JUST DREAMING!

Some interesting and funny fantasies on what might follow if financial actors, regulators, the government, et al actually told it like it is. It is fun to dream, anyway.

MINING SHARES TRAILING THE METALS

This week’s disappointing jobs report highlights what I and some others have been saying: the “strong” economic numbers we saw in the first quarter were a mirage. Bonds will rally on this economic weakness and gold, too, will rally as investors come to realize that even if the Fed does hike rates next week, this tightening cycle will be an aborted one; our debt-dependent economy only survives on the back of monetary inflation and cannot take meaningfully higher rates. So, if my past thesis is correct and the maintenance of generally low interest rates on the part of the Federal Reserve is mandatory with ongoing dollar weakness as the likely result, as seems so plainly obvious, what is the best way to gain investment exposure to gold?

Of the two most common ways to gain precious metals investment exposure, through the purchase of physical metal or buying mining company shares, most analysts I read agree on one thing: “The mining shares lead the metals.” I believe the opposite to be true.

The $XAU index of mining company shares is nowhere near the levels where it stood when gold was last at $400/ounce. Now, on the surface, this may seem a bit simplistic; components of the index have changed, the environment is different, etc. At the same time, consider: few industries have been forced to learn how to operate “lean” like the mining companies had to when gold was wallowing near $250/ounce. These companies were forced to learn how to get the most out of their efforts. Such periods of pain, regardless of industry, set the table for fat years when conditions turn for the better, which they of course have for the miners. In other words: $400 gold is a lot more meaningful to mining companies today than it was 10 years ago, but the share prices of these companies do not reflect it. Even more than any fundamental argument of what mining companies are worth/should be trading for, however, this essay is about sentiment.

The stubborn bullishness we have been seeing on the part of U.S. stock market investors since the bubble popped in 2000 makes perfect sense; after an 18-year bull market, investors have learned to “buy the dips”, “get in and stay in”, and to “be bullish on America”. Undying faith is the natural residue of history’s greatest bull market. Conversely, gold experienced the opposite over the same time period -- a crushing bear market. After nearly 20 years of pain, is it reasonable to believe investors will jump right back on the gold bandwagon at the first sign of strength? Hardly. At any sign of weakness in the metal, investors abandon mining shares; again, this seems to me the natural state of investor sentiment in the aftermath of such a long and torturous bear market. No one believes.

For those of us who read and write alternative newsletters and follow the various gold websites regularly, we tend to think that precious metals are very early in what will be a long-term bull market. We are also in the minority by a large margin. The vast majority of the investing public has no understanding of, let alone faith in, gold as an investment. The still-tentative action of the mining shares, which is the way most investors will gain exposure to this sector, provides evidence for this point. I estimate that the worst case is a consolidation that lasts longer than investors expect. Investors siding with my thesis can decide on the amount of patience they wish to exercise while accumulating the still-unloved shares of the precious metals miners.

Note: Some Elliott Wave types believe that gold actually remains in a major wave 5 to the downside which will culminate with the metal’s final bottom back near or below $250. I do not subscribe to this theory since I think this outcome would require another deep recession (or worse) in which global economies ran off a cliff together and demand for commodities dried up across the board. I have faith that such a scenario would be met with predictable action from the world’s central banks -- stepping on the monetary gas peddle, which is of course bullish for gold.

DOLLAR SLUMPS AFTER US TRADE DEFICIT REACHES RECORD HIGH

The dollar fell sharply against major currencies after official data showed the US trade deficit widened to a massive $55 billion, way above expectations for a deficit of about $46.9 billion. “The numbers took everyone by surprise and put huge strain on the dollar,” said Gary Noone, currency analyst at MMS International, adding that the shock was even greater because of speculation beforehand that the deficit could be narrower than earlier predictions.