Finance Digest for Week of August 16, 2004

DEBT AND DELUSION

Since the last serious outbreak of inflation in the 1970s, central banks have conquered this pestilence and have practiced a responsible stewardship over national monetary systems ever since. Due in no small part to the benign inflationary environment that has followed their victory, stocks and bonds have outperformed historical averages. This reflects a high degree of confidence in future monetary stability and prosperity. Or so we are constantly told.

That this consensus view is a twisted mirror of reality is the theme of an undeservedly obscure work of financial economics, Peter Warburton’s Debt and Delusion: Central Bank Follies that Threaten Economic Disaster. Warburton’s story begins in the aftermath of former Federal Reserve chairman Paul Volker’s triumph over inflation in the early 1980s. The conundrum facing governments at the time was how to enable governments to continue to live beyond their means, without suffering inflationary consequences? In this climate, a new outbreak of inflation would have contained the seeds of its own demise, as having recently been burned by inflation, bond buyers would have resisted any signs of rising prices by insisting on higher bond yields.

Central bankers offered a program to solve this dilemma, the centerpiece of which was a change in the method of financing government debt. Deficit finance bonds would be sold to private investors through existing financial markets. This would place the bonds in the hands of investment funds, rather than on the books of commercial banks as would have been the case had they returned to the old style of monetization. The subsequent explosion in the size and breadth of bond markets is illustrated by a few snapshots of gross issuances: less than $1 trillion in 1970; $23 trillion by 1997; and nearly $43 trillion by 2002.

A second part of the central bankers’ program was to reign in government deficits so as to reduce the need for borrowing. This advice has been mostly ignored. Borrowing to fund government deficits exploded under Reagan, continued to soar in spite of the phony “surpluses” of the Clinton years, and has reached stupefying levels under George W. Bush. It is the interaction between this explosion of debt and what Warburton calls “the capital markets revolution” that has produced a new and deceptive form of inflation. Warburton wryly notes that, “Periodic bouts of price inflation, the tell-tale signs of a long-standing debt addiction, have all but vanished. The central banks, as financial physicians, seem to have effected a cure. ... Few have bothered to ask how the central banks have accomplished this feat, one which has proved elusive for more than 20 years. As long as inflation is absent, who really cares exactly what the central banks have been up to.” The solution to this puzzling anomaly is to identify the source of demand for government bonds. For this, we must examine “what the central banks have been up to.”

HOW WILL RISING INTEREST RATES AFFECT HOUSING PRICES?

Home buyers and sellers have been bracing for higher interest rates - and the subsequent cooling off of the market -- for more than a year. Yet, real estate seems to keep going and going and going. In May, the median price for existing single-family homes reached $183,600, according to the National Association of Realtors (NAR), even as mortgage rates had begun ticking higher. In May 2001, by comparison, the national median was $145,000. Prices in some markets have more than doubled over the past few years. Between the first quarters of 2001 and 2004, median prices in Sacramento, Calif. went from $161,500 to $277,900. In and around West Palm Beach, Florida median prices went from $139,400 to $267,000. The average price of an apartment in Manhattan, meanwhile, is now more than $1 million.

That low interest rates have been the driving force behind real estate’s unprecedented rise is not a point of debate among economists. Quite simply, lower rates mean buyers can afford higher home prices. It stands to reason, then, that the opposite would be true. Yet, many economists have been arguing that higher rates will not hurt housing. “The reason interest rates are higher is that we are in a growing economy,” said NAR chief economist David Lereah in a recent release. The thinking, is that rising salaries and stock market returns can create enough wealth to offset the negative effects of rising mortgage rates.

“People are feeling much more financially secure,” said Freddie Mac chief economist Frank Nothaft. “Families who are more financially secure are much more likely to buy a big-ticket item, like a house.” Besides, mortgage rates are still near historic lows. “Even though we’ve seen [rates] rise since March, 6 percent is an incredibly cheap rate,” Nothaft added.

Others are not nearly so optimistic. “There has never been a run up in home prices like this,” said Dean Baker, co-director of the Center for Economic and Policy Research. Historically, rental prices and home prices have increased at about the same rate as inflation, he said. Over the past few years, though, home prices have been “hugely out of line with rental prices and the overall rate of inflation.” As with all bubbles, said Baker, buyers are ignoring fundamental values and buying simply because they think prices will continue to go up. The psychology is similar to that seen in the stock market in the late 1990s, he said, but that can change with higher rates.

Ultimately, home prices reflect the overall economic strength of a market, said David Stiff, director of economic research for Fiserv Case Shiller Weiss, though there many other factors that can affect home prices. “I’d be most concerned in places where housing affordability is an issue because the effects of rising interest rates are even more pronounced,” said Stiff. In other words, higher rates may not mean as much to buyers in South Bend, Indiana as they do to buyers in San Francisco. Median home prices in South Bend were recently $82,000 according to the NAR, while the median household income was about $40,500. Median home prices in the San Francisco Bay Area were recently $597,300, while median household income was about $68,000.

SPEED LIMIT? IN GERMANY?!

The world famous, bullet-fast, no-speed-limit German Autobahns may soon become just like every other highway -- boring. According to a recent poll, “the majority of German citizens would welcome the introduction of a sweeping speed limit on Germany’s notoriously fast highways.” The proposed new speed limit is 130 kmh (slightly greater than 80 mph). This may seem “fast enough” for most people, but come on... For every speed fanatic, or even for your average, law-abiding car enthusiast who has ever dreamed of someday “opening it up” on the German Autobahn, this is the end of an era.

Yet for those of us who understand Elliott waves, this news is hardly shocking. Germany has been leading the current bear market in Europe. Now, a vote to slow down the nation’s highways would be a logical consequence of a major social mood downturn that began in Germany back in 2000. This is the “right time” to cap the highway speed in Germany: Speed limits usually get introduced during bear markets and repealed when bullish times return.

AVOID PERSONAL DEBT AS GOVERNMENT SPENDS

This column is a bit out of the ordinary. It is not about your personal financial situation, but about all our financial situations on a combined basis. It affects all our futures, and the futures of our children and grandchildren. What overall financial condition will our country be in when we are ready to retire? What financial condition will our federal and state governments be in when we hand them over to our children?

Personally, I have an aversion to debt. Call it old fashioned, but I only charge to my credit cards what I can pay off next month and I look to pay off my home mortgage early. I do not borrow to buy or lease my automobiles. I learned my financial philosophy through hours of casual conversation with my Depression-era grandfather. But this philosophy seems to be at odds with the way many of my contemporaries think. Many of my peers seem more interested in living for the here and now, with the idea that the future will take care of itself. That also seems to be the way our federal and state governments are run. Does anyone worry about the impact of federal and state deficit spending on our future, or is it only me?

What can you do personally to protect yourself in the future? Try not to rely on Social Security as a major part of your retirement income. The system will survive, but who knows what form it will take. Specifically, increase your personal savings to have enough of a nest egg to retire on without relying on government programs. Build up equity in your residence and vacation home. Maximize contributions to your qualified plans. Remember, most financial planners suggest that you will need 80% of your current income after you retire to maintain your standard of living. Try putting numbers down on paper to project your retirement needs and the assets you must accumulate to accomplish them. This can be a sobering experience.

INVESTING CAN BE LIKENED TO SAILING AND POKER

A recent piece by John Hussman, of Hussman Funds, in which he drew an analogy that really hit home with me. He wrote, “Investing is a lot like sailing -- you can go anywhere you wish without forecasting the wind. What is essential is to measure the wind properly and often, and align yourself with prevailing conditions.” Hussman’s point is that a macro viewpoint (“the big picture”) is essential to getting where you want to go in investing. However, it is a macro viewpoint with a difference. This is not forecasting where the market is going to be at the end of the year, or making predictions about interest rates or oil prices. That sort of prediction is fruitless and is not likely to add to your profits. Worse, it may hurt your ability to make money in the market, as these sorts of macro predictions are often wrong.

There is a difference between recognizing dangers and making a prediction that something bad is going to happen. As Hussman writes, “An open quart of gasoline next to the barbecue is a recognizable danger, but need not resolve into any particular outcome. It’s just the outcome isn’t good on average.” In a similar way, when I take a bearish view of equities generally, I am not predicting that they will decline. I am noting that given the valuations of today and given what we know about financial history, the returns from stocks in such a climate has not been good. With this backdrop, we know to be careful and selective in this market, more so than usual. Investing in the 1990s when the markets were strongly rising was much easier. Even your mistakes generally still made money -- they just lagged the indexes. Not likely this time, when the overall market is more likely to stagnate or decline.

Peter Lynch, in an article appearing in Bloomberg several years ago, recommended that all investors take a course on poker to improve their thinking about investing, and specifically about how to think about risks. In poker, as in investing, you are dealing with uncertainty and with limited information. You do not know what cards are going to come up next. However, there is a rational way to deal with that problem. You deal with uncertainty by thinking in terms of probability. Great poker players think more about the process and experience of playing poker; they are not focused on their short-term results. In the short term, anything can happen. But over the long term, the better players get the money. Great investors stick to their knitting -- they stick to what they know and realize that sometimes it is not going to work out. What great investors do not do is change their approach just because it did not work in one instance.

A RECESSION IN PINK

On the intermediate term, we seem to be in a range-bound trading cycle. As Bill King noted: “Most everyone realizes that stocks have traded sideways for 2004. The DJIA’s 8% range for the past seven months is a historically tight range. The venerable Richard Russell recently noted that the 8% range equates to the 1972 market. Mr. Russell adds that the historic bear market of 1973-74 ensued. The Amex, which then housed the speculative issues and small caps, lost 89% of its value.”

There has never been a true long-term bull market that started from the valuation levels at which we find ourselves today. You can get substantial bear market rallies, as we did in 2003. As I have noted before, the market goes up 50% of the years within a secular bear market. We could, and probably will, see a range-bound market for some time. But the next major turn of the market will be down, pushed over the cliff by a slowing economy and/or a recession. On average, the stock market drops 43% in a recession. That means a Dow in the 6,000 range. The Nasdaq will be ugly, as it is the most overvalued of the indexes.

In the “for what its worth” department, my friend Gary Scott sends me his daily letter, full of interesting ideas on investing and the occasional odd tidbit. He likes looking for trends, so in yesterday’s letter, he reminded me of a very serious group called the Williams Inference Center, which sifts through mountains of reports and data looking for disparate anomalies that taken together may tell us of some new trend. They have a good track record of drawing attention to trends before they become mainstream.

All their thoughts seem reasonable enough. Then we come to the last one: “The rise in the popularity of the color pink may foretell a harsh stock market reaction -- pink (psychologically) symbolizes delusion and denial. Pink is the equivalent of rose-colored glasses.” Not remembering any pink shirts in my closet, I asked my daughter, who works across the hall, if pink was showing up any more than usual. “It’s really big now, especially overseas,” she reported. James Williams reports that, “People are buying pink clothes for their dogs. I even have a clipping where men are buying women’s shoes so they can wear pink shoes.” Williams then drew my attention to three areas of denial: debt, age and law. He has cabinets full of stories confirming the tsunami of denial breaking over our collective minds. We seek our reality in our entertainment and deny the reality in our lives.

But it will not be so amusing for those in denial come the next recession, whenever that takes place. It takes two, and sometimes three, bear markets to bring reality back to a bubble-intoxicated market. The next recession may bring the end of denial, at least for this cycle. It will also destroy a lot of paper wealth in the process.

THE REAL ESTATE BUBBLE THAT ATE THE STOCK MARKET

Real estate’s contribution to the over-inflation of the Dow may prove to be the greatest of all present economic dangers to the US economy. I contend that, on a forward basis, aggregate P/E ratios are back at historic highs. Current market P/E ratios are high by historic standards. But they are low according to media opinion, and this has led to complacency and misplaced optimism. Highly profitable financial companies have low current P/E ratios but their earnings have clearly peaked.

We know that demand for new mortgage originations is slowing. “Industry-wide, residential mortgage originations were approximately $800 billion during the second quarter of 2004, down from approximately $1,075 billion in the second quarter of 2003.” (Source: Inside Mortgage Finance.) The present danger resides in the point that most of the easy money in the mortgage industry is made through mortgage resale and loan origination activities. This is why there is no shortage of lending companies and salespeople. Low-hanging fruit tends to be the most profitable.

To retain forward earnings, financial companies must continually write more and more business. At the current point of saturated demand, this cannot occur. Some companies are already laying off in order to retain bottom-line earnings. Other mortgage lenders are trying to hire mortgage originators as fast as they can. This too may be a sign of failure. The managements of these companies do not yet realize they cannot market pencils to paupers. Some companies are bloating their balance sheets with assets (loans) so they retain earnings in a downturn. We know these assets are increasingly risky because the companies themselves report that they are selling sub-prime and exotic products -- the danger can be seen lurking in the footnotes of financial statements everywhere.

A contraction in new loan originations will have a dramatic effect, and not just on the health of mortgage companies. Lower earnings for this important sector will raise the consolidated PE ratios of the major stock indexes. In a real estate contraction, the stock market and employment will adjust long before the main event, which is the collapse of real estate properties and valuations.

WHY EUROLAND COULD FALL APART IN 2005

It seems that there is currently not a single subject on which the investment community agrees to the same extent, than the likelihood of a further fall of the US Dollar. My personal take on the dollar situation is that the exact opposite of what everyone thinks is going to happen.

It has so far been ignored and overlooked by most commentators, but 7 July 2004 may go down into history as the day the Eurozone started to fall apart. Italy’s national debt was downgraded by the rating agency, Standard & Poor’s. It does not take an economics degree to figure out that other mainland European countries are facing a similar downgrade. With several European governments having reached a state, where you could say that they are fighting for financial survival, it may soon become every man for himself. This in turn would prepare the center-stage for talks about a return to national currencies. Most Europeans are still unwilling to support tough economic reforms. Thus the only way to prop up the Euroland economies will lie in devaluing the currency. Individual Euro countries will not be able to devalue the Euro, which is why talks of a re-introduction of national currencies are bound to happen.

Surprisingly, the hurdles for such a move will be lower than one would expect. And politicians will always do everything it takes to win the next election. They peddled the Euro with the promise that a united European economy would create growth and prosperity. But the promises never materialized, and the voters are growing restless. New ideas are needed to win votes. Reintroducing national currencies could prove the No.1 promise that virtually guarantees election victory. Yet most of the media lacks the perspective to report this event in advance. Mark my words: In a year’s time, talk about the demise of a currency will be focused on the Euro, not the US Dollar.

ANATOMY OF THE TECH WRECK

If you are thinking of studying computer science in college, don’t waste your time. The great tech boom of 1965-2004 is coming to an end, and it is not going to return. On a 40-year view, or the average length of a professional career, there will be better opportunities elsewhere.

In the short term, tech shares have been declining more or less throughout 2004. Various Initial Public Offerings have been postponed, for example that for Lindows, a Linux software vendor now surviving on a $20 million legal settlement from Microsoft (under which it promised to change its name) thus demonstrating that it is no longer possible to raise large amounts of money for companies whose direct costs consistently exceed their revenues. Reality may -- at long last -- be returning.

Nevertheless, in the week when Google approaches the market for an IPO expected to capitalize the company somewhere north of $30 billion, it may seem eccentric to call for the end of the tech boom, as distinct from just another fluctuation in its expansion. After all, the opportunities for enrichment in the tech sector over the last decade have been legendary. According to press reports, the average stock option profit to be received by Google employees, including the janitors, will be well in excess of $1 million each.

This sounds wonderfully benign, until you pause to think about who the money for the overpriced Google IPO is coming from -- mostly retail investors, generally pretty unsophisticated, many with a net worth well below that to be gained by the average Google janitor. The Google founders proudly proclaimed in their registration document that their central business principle was “Do no evil”. They seem by so egregiously overpricing their IPO to have failed in this endeavor pretty well as conclusively as did Bonnie and Clyde in robbing banks.

The unfolding Google IPO fiasco strikes to the core of what is wrong with the tech sector: the excessive sense of entitlement among its youthful and fabulously rich elite, who seem to think that simply because we do not understand the arcane jargon of their cult, we are mere “little people” to be fleeced through overpriced IPOs and moved aside for their luxury housing developments and yacht marinas. But since the Industrial Revolution began around 1780, there have always been new technologies, invented by geniuses, that changed our lives, but the job of understanding the details of their design was for engineers, not for the public at large. These engineers were skilled people, and rewarded as such, but they were not the original inventors, and were not entitled to become fabulously wealthy through working out the detailed design implications of the inventors’ inspiration. (By and large the geniuses themselves did not get rich, either.)

The reality is that tech today has become a mature industry, and both the opportunities and justification for creating new tech billionaires have become outdated. The business has been commoditized, and is in the process of moving entirely to China and the like. Techies at this point will respond that the next generation of chips, soon to appear, will be twice as powerful, or a thousand times as powerful -- I can never remember which -- as anything we have yet seen. To which I respond, so what?

All high level scams peopled by boring socially-challenged overpaid engineers come to an end, which should be a relief for the rest of us. The tech sector will shortly migrate to the low cost manufacturing sectors of Asia, where quality will be excellent and overpaid “entrepreneurs” almost non-existent. The next great industry, still several years away from its full flowering into a financial cornucopia, is pretty clearly that of genetic manipulation. Of course, in the current political climate, the United States, home of the stem cell research ban, will not be part of this bonanza. Neither perpetual tech sector dominance, nor perpetual U.S. economic dominance, are in any way pre-ordained in the long run.

GOOGLE FORCED TO SLASH IPO PRICE TO $85

Google’s IPO was poised to raise barely half the amount originally hoped for after it was forced late on Wednesday to slash the price for its shares well below its earlier targets. The company priced its shares late in the day at $85, far lower than the its earlier indicated price range of between $108 and $135. The price was also at the bottom of a new indicated range of $85-95 that Google issued early on Wednesday, the final day of bidding. Google’s decision to cut its price range indicates its potential value has fallen by more than $10 billion, to up to $25.8 billion. Rival Yahoo’s market value is $38.3 billion. Shares sold in the IPO were set to raise barely half the $3.5 billion that would have been raised if the stock had been priced at the top of its previous range and the number of shares for sale had not been cut back.

Investors have been wary of IPOs in recent weeks. Twenty-four have been pulled in the US since the beginning of August, traditionally a bad month for IPOs.

A dream scenario for Google buyers.

This is rapidly becoming a dream scenario for Google IPO buyers. The online search company’s hiccups and heartaches on the way to going public make it increasingly likely the (relatively) few brave folks who bid for the company’s stock will make out like bandits. Why, then, are we being bombarded with negative stories about the offering? People call it expensive, point to the search company’s dual-class share structure and generally carp about how dear Google’s newly public shares will be.

To the extent that such investors are telling the truth about their intentions, they are wrong. Sure, Google’s stock is expensive, but so is the stock of Google’s peers -- Yahoo, AskJeeves and the like -- and so has been almost every newly public high-profile company in the last decade. You do not get to be Google’s size and prominence and then somehow tiptoe public. The latest twist in the tale, of course, is the change in the proposed price and number of shares in the Google offering.

It is not pretty, but Google and its eventual shareholders are trying to do something different here, to use a Dutch auction in taking a large, high-profile company public. The very newness will scare some people away, of course, but that is fine. In the perverse world of financial markets, it just increases the likelihood that Google shares close higher on the first day of trading.

THE PLUG FACTOR

At first look, the May consumer income and outlays numbers -- which we were eagerly awaiting last month -- appear excellent: Incomes are up 0.6%, and spending is up even a full percentage point. At second look, after adjustment for inflation, the reality is pretty ugly. The increase in disposable income melts to less than 0.1% in real terms, and that of spending to 0.4%, of which well over half came from the burst in motor vehicle promotion. Spending on nondurable goods has been flat for two months. The whole of the extra increase accrued from a blip in spending on services.

Amazingly, this sharp slowdown in consumer spending, though lasting for half a year, has been met with flat denial all around. During the five months to May, it was up in real terms by $78 billion, or $186 billion annualized. This is less than half of the consumer spending growth in the second half of last year -- $376 billion annualized. Meanwhile, we know that June was another horrible month for consumer spending.

One important reason for the general indifference to this drastic reversal in consumer spending was apparently the fabulous job figures for the three months March-May that the Bureau of Labor Statistics (BLS) miraculously pulled out of the hat, reporting almost 1 million new jobs during these three months. It shocked us to see how readily and uncritically research institutions, economists and media around the world accepted these numbers at face value, even though they came like a bolt from the blue in the face of otherwise rather mixed economic data. For the few who wanted to see, these numbers were bluntly suspect. It turned out that virtually two-thirds of the new jobs had come not from the survey, but from a new computer model.

What all this means for the U.S. economy’s prospects should be clear: The suddenly strong support from job and income growth looks very much like a mirage. To the contrary, sharply slower consumer spending is essentially exerting the opposite effect of depressing income growth. Glancing over the figures for real personal consumption expenditures, it strikes the eye that the sudden spending weakness has gripped all sectors of consumption, services and non-durable goods, as well as durable goods. Lesser consumer spending essentially means lesser income growth, and if allowed to develop, it implicitly turns into a vicious circle where lower and lower spending leads to lower and lower incomes.

Our view on this has always been clear and unambiguous. Ultra-cheap and loose money together with fiscal priming of unprecedented scale have provided a tremendous stimulus to consumer spending in the United States. For the bullish consensus, this policy stance has been most successful, as measured by recent real GDP growth of 4% and higher at annual rates. For us, this is a much too simplistic and superficial a view. Lost in the celebrations are the long-term costs of this recovery as manifested in the form of ever-mounting structural imbalances -- namely record trade gaps, record levels of financial leveraging, record levels of personal indebtedness, a record-high budget deficit and rock-bottom national savings. For any reasonable person, it ought to be clear that this cannot be the road to healthy economic growth.

NOT ENOUGH GRID, TOO MUCH LOCK IN CHINA

China is facing an electricity shortfall of 30 million kilowatts. Shanghai, which was lit up like Times Square in May, has darkened its neon in August. The Chinese government has scrambled to transfer coal to where it is needed most to keep factories humming and the lights from going out. But what you are seeing here is the very beginnings of China’s own era of energy dependence. China needs a lot more energy than it has. In the meantime, the coal-fired plants are cranking. And this, by the way, is what makes the air quality all over China so lousy. The air quality problem is real. It will have an affect on public health care costs, if it already does not. It is also a great gauge of China’s voracious demand for energy. But it shows why Australia is such a desired trading partner for the Chinese.

This is great news for Australian resource firms like BHP Billiton. BHP reported a 78% increase in annual profits on the back of surging commodity prices and boffo demand from China. BHP produces iron ore, coking coal, and manganese ore, among other products. BHP is exactly the kind of company that will deliver you profits from the China and commodities boom -- without requiring that you own risky Chinese stocks. Just compare BHP to any foreign carmaker that thinks it is going to get rich selling cars to the Chinese.

You can do all the market share calculations you want, but there is one compelling reason why you should not buy carmakers doing business in China -- there is not enough room in Chinese cities for more cars. China needs more superhighways before it needs more cars. What is more, at high oil prices, where are Chinese drivers going to find the discretionary income to pay high fuel prices?

Do not count on an car sales boom any time soon in China. More importantly, do not bother taking the investment risk when you do not have to. There are plenty of strong China-related investment themes -- energy foremost among them -- that promise higher profits with less risk.

HERE IS WHAT NOBODY WILL WANT TO DISCUSS TOMORROW

If you want to know today the thing that no one will want to talk about tomorrow, I think I have figured out a nearly foolproof method -- if “tomorrow” means around 6 to 12 months from now. It is simple, really, especially when it comes to finance and the economy. The next time some talking head says, “What we know for certain in the coming year is that...” -- or words to that effect -- grab a pen and jot down whatever he is “certain” about. What you will have is today’s conventional wisdom, namely the thing nobody will want to discuss not too many months from now.

What was the major piece of conventional wisdom as 2004 began? In the words of a talking head who frequently appears on financial TV, “The Federal Reserve is holding interest rates steady.... Overall, we’re in economic nirvana. Since this is an election year, there will be continued stimulus to promote economic growth and create new jobs. The velocity of money is accelerating, and prosperity is rising.... I strongly recommend that all investors remain fully invested and enjoy the stock market’s ride back to new highs.” His opinion was anything but unique. He was mouthing the conventional wisdom about the Fed holding up the stock market in an election year.

But now, some seven months later, walk into the first roomful of investors you can find and strike up a conversation about the “marke’qs ride back to new highs” and being “in economic nirvana”. The response you face may be worse than an unwillingness to continue the conversation; a pair of shin guards and a mouthpiece may come in handy. Is there a relationship between the markets, the economy, and presidential politics? Indeed there is, yet you cannot grasp it by applying the silly logic at work in the quote above. Social mood is the common denominator, and that mood unfolds in recognizable patterns.

FEAR FACTOR

“I will tell you the secret of getting rich on Wall Street. You try to be greedy when others are fearful, and you try to be very fearful when others are greedy.” -- Warren Buffett

Every week on the hit TV show Fear Factor, young people commit risky and repulsive acts on national TV in order to compete for a $50,000 cash prize. There is a much easier way to make $50,000 that is neither difficult, dangerous nor disgusting, and which requires very little time, talent or energy undefined but which most investors are less likely to do than eat a raw pig’s rectum or lie in an open glass casket with live rats crawling all over you. Uncomfortable as it is for most people, this simple strategy is without a doubt one of the single greatest secrets to getting rich in stocks. Rather than telling you the secret outright, it is much more effective to show you a pristine example...

Amazon.com’s IPO was 3 million shares at a price of $18 each (presplit). Bill Miller, manager of the Legg Mason Value Trust, bought Amazon’s stock at the IPO, back in May 1997. Miller sold that first position, later saying it was, “the dumbest thing we ever did.” Miller bought Amazon again at $80 a share in 1999. Amazon’s stock price fell apart, just like every other Internet stock. Miller responded by doing the only sensible thing he could do. He bought more. A lot more. As he recounted to Fortune magazine, he started buying again in mid-2000 when the stock was in the $40s, and then we bought it all the way down -- the stock was $35, he would buy 50,000 shares, at $25, he would buy 150,000 shares, and at $14 we would buy 300,000 to 400,000 shares. Miller says he finished buying “between $7 and $8.”

Miller’s buying strategy goes by a name you might be familiar with, dollar cost averaging. Dollar cost averaging is when you spend the same dollar amount no matter what the stock price is. Today, Amazon is around $37 a share. Miller’s average cost for the stock is around $19.69 per share. He paid as much as $82 for some of his shares, and he is still up 88% with the stock 55% below his initial entry price. From his highest price to his lowest price, the stock fell 91%! And he is still up 88%!

Brilliant as Miller’s strategy is, the “trend is your friend” crowd reacts to Bill Miller’s behavior like an ape in front of an obelisk. Buying stocks that are falling in price? Throwing good money after bad? It’s sacrilege! William O’Neill, editor of Investor’s Business Daily, advises investors to sell stocks of perfectly fine companies if they commit the apparently unforgivable sin of falling by as little as 8%. This is known as the use of a “stop loss”. I have yet to find a wealthy value investor with a successful long-term track record who advocates any such thing. Better to heed the advice of Warren Buffett, who once said that you should not be in the stock market if you are not ready to watch your stocks fall by 50% without selling in a panic.

Bill Miller is the one and only investor who has outperformed the S&P 500 every single year for the last 13 years. Miller manages the Legg Mason Value Trust, and he has got $20 billion in assets under management. And now you know how he makes more money in stocks year after year than any other mutual fund manager. Miller’s strategy, his secret, is so utterly simple. It boils down to a single phrase, one that he repeats to anyone who will listen: The long-term investor wins.

OVERPRODUCTION WHEN PRODUCTIVE CAPACITY IS DECLINING?

Stores like Big Lots scoop up excess goods and sell them to consumers at deep markdowns. If you have never visited one, I commend the experience to you. You will see first-hand that our economy -- and the economies that export to the U.S. -- together produce way beyond the point of overproduction, so that dollar stores are now “the fastest growing retailers in America”, according to Business Week. There is even a chain called “Little Bucks” that has recently come to greater Atlanta, which is a dollar superstore -- groceries to clothing to tools, all priced at $1. During the week when school started they had an immense box of ink pens at the entrance: 50 pens for 99 cents.

Consumerism run amuck? Perhaps. Yet in a time when the powers-that-be chatter about “inflation worries”, because the economy is supposedly in “expansion mode”, it is interesting indeed that a glut of goods in so many cases actually means lower prices. And should you decide to stroll through a nearby Big Lots (or a similar “liquidator”), remember that the excess all around you has come during a period when the economy’s productive capacity has largely declined.

Yet, when reports come out like this week’s anemic increase in the leading economic indicators, and a similarly feeble trend in GDP, the news stories cannot seem to repeat the phrase “soft patch” often enough. Is “inflation on the rise”, or did the economists and “experts” see what they wanted to see in a few months of rising prices?

MEDIAN CALIFORNIA HOME PRICE SETS RECORD

The median price of a single-family home in California set a new record during the second quarter of 2004, rising 25.3% from a year ago to $461,730, the California Association of Realtors reported. Sales of existing homes in California rose 10.4% to 635,580 units for the second quarter of 2004. Southern California communities with the greatest median home price increases in the second quarter include: Malibu (50.5% -- to $1.4 million) and Beverly Hills (49.7% -- to $1,410,000).

Fannie Mae subpoenaed by its regulator.

Fannie Mae (FNM) was subpoenaed by its U.S. regulator as part of an examination of the largest U.S. mortgage financier’s accounting practices, the Wall Street Journal said on Friday, citing an unnamed person familiar with the situation. The subpoenas come amid signs that the regulator, the Office of Federal Housing Enterprise Oversight, wants to report its findings in the next month or so, earlier than expected, the newspaper said, citing no sources. The newspaper did not say what specific information is being sought.

Any new finding of flaws might strengthen the hand of politicians hoping to more tightly regulate Fannie Mae and smaller rival Freddie Mac (FRE). It might also add to pressure on Fannie Mae executives, whose compensation has been questioned by some members of the U.S. Congress, the newspaper said. Chief Executive Franklin Raines received about $20 million last year, it said.

BONDS OR GOLD -- WHICH MARKET IS WRONG?

One of the most curious anomalies of the last few weeks has been the fact that both U.S. Treasury securities and gold have been rallying. While not unprecedented, this is a situation that is inherently contradictory, and is unlikely to last. To be sure, some are arguing that the rallies in each are due, in part, to terrorism fears and the inevitable flight of some capital to traditional safe havens; on this score, both bonds and gold qualify. At the end of the day, however, both markets will be supported or shunned based on their underlying fundamentals.

Let us start with the bond market. Virtually everyone at the beginning of the year believed that long-term interest rates had nowhere to go but up from their lowest levels in half a century. But after topping out twice around the 4.9% area the yield on the government’s current bellwether 10-year note has plunged lately -- it now stand at around 4.25%. Bond traders appear to be betting that we have already seen what rise we are going to in long-term market rates, and that, before much longer, we will be fretting over recession/deflation anew.

Longer-term, that is certainly where we are heading to some extent (though whether everything goes down in price or, in the alternative, at least some items such as commodities buck the coming unwinding is yet to be determined.) For the time being, however, gold is begging to differ with some of this hypothesis. Gold traders also see soaring energy costs; they realize to some extent, however, that such an event has always meant higher eventual inflation. In addition, those tiptoeing back into the yellow metal with increasing conviction seem to recognize something stock traders and the cheerleaders on financial television incredibly continue to dismiss; and that is -- terrorist premium or not -- high (and rising) energy costs are here to stay. If and when oil does settle down for a while, it will later be looked back on as nothing but an interlude in what is otherwise a long trend to substantially higher U.S. dollar prices for crude.

I stress U.S. dollar prices because that is another thing seemingly understood by those re-entering gold that is utterly lost on those again willing to loan money to Uncle Sam for 10 years at 4.22%, as of today’s close. Though the greenback has spent most of 2004 successfully holding its own against most other currencies, it is inevitable that its secular bear market will soon resume. Our nation’s external debts continue to mount. Eventually, a trade deficit now running in excess of $600 billion annually and a combined current account deficit of even more means that the currency with which that “nut” must be serviced has to go down in value. The disconnect between bonds and gold was especially stark when it was announced a few days ago, in fact, that the U.S. trade deficit for June had surged to a new record of $55.8 billion, smashing the old mark. The dollar sank, gold rose -- and bonds yawned.

For our present purposes, in addition to betting that bond traders are wrong in the near term, I am increasingly willing to bet that gold traders are correct. Gold has managed to move above $400.00 per ounce again and, in the last couple days, has additionally moved above a down trending resistance line in place since its peak around April 1. Unlike the false starts of late May and late June/early July, this last few days has seen volume increase smartly as well. In the end, I have to take sides with either the bond bulls or the gold bugs; and for the time being, I am choosing the latter.

Gold futures, indexes close week at 4-month high.

Gold futures prices closed above $432 in April -- that was their highest close since late 1998. Gold for December delivery rose to a high of $416.80 an ounce Friday on the New York Mercantile Exchange, a level not seen since April 13. It closed at $415.50, up $6.20 for the session, and up a hefty $14.30 for the week.

Tracking the sector as a whole, the Philadelphia Gold and Silver Index ($XAU: chart) rose 1.9% to close at 95.82, led by a nearly 3% climb in shares of Agnico-Eagle Mines (AEM) and Harmony Gold Mining (HMY). For the week, the index was up 9.1%. The CBOE Gold Index ($GOX: chart) closed at 84.87, up 1.7T for the day, and up 7.8T for the week. The Amex Gold Bugs Index (HUI: chart) ended at 209.49, up 2.1T for the session, and up 10.3T from the week-ago close.

“OIL SHOCK” HAS SOME ECONOMISTS WORRIED

Crude oil prices soared Thursday to nearly $49 a barrel, heightening concerns that sustained high energy costs could drag the slowing U.S. and world economies into a more serious downturn. With growth slowing in China, Europe and Japan, some economists worry that rapidly escalating oil prices will trigger a self-reinforcing spiral of falling demand in the U.S. economy and among its trading partners.

“The economy is near its tipping point,” said Stephen S. Roach, chief economist for Morgan Stanley. He said the nation would likely fall back into recession if oil prices hover near $50 a barrel for three to six months. “This is an oil shock, absolutely,” Roach said, noting that Thursday’s closing price was 68% higher than the roughly $29 per barrel average that had prevailed since early 2000. “The oil price is high enough to make a real difference to a vulnerable U.S and global economy.” Roach and other economists also agree that oil prices could reverse and fall suddenly if the market psychology changes, which would give a boost to the U.S. economy, and in turn the rest of the world.

The pace of the oil price rise has quickened in recent weeks as events that would command little notice in a calmer environment fed expectations of rising prices. They were then fanned higher by feverish speculation among traders in the oil markets. Benchmark U.S. crude oil for September delivery closed at $48.70 on the New York Mercantile Exchange Thursday -- a record since trading began in 1983 -- after surpassing $47 per barrel the day before and exceeding $46 per barrel for the first time last Friday. “The speculators have totally, totally run away with this market,” said Fadel Gheit, senior energy analyst with Oppenheimer & Co. “It is no longer driven by any resemblance to sanity or fundamentals.”

Oil’s new high may persist, says ChevronTexaco CEO.

While energy analysts debate whether this is really just a short-term spike or the beginning of the end of cheap oil, one thing is clear: Energy prices will face continued pressure. Demand is only going to increase, supplies are getting harder to reach, and tight refining capacity could make getting oil to market more problematic.

“This may not be a short-term aberration,” said ChevronTexaco CEO David O’Reilly, in a recent speech before the US Chamber of Commerce. “I believe energy prices are going to face continued pressure -- reflecting fundamental changes in demand, supply, and geopolitics. We are, in fact, witnessing a change in the basic energy equation.”

Contrary bet on oil is costly to year-old hedge funds.

Hedge funds started a year ago by a leading investment strategist, Barton M. Biggs, have been stung by losses this year, partly because of a bearish bet on the price of oil at a time when the commodity’s prices are setting records. Mr. Biggs, for nearly three decades a strategist at Morgan Stanley, set up his investment firm, Traxis Partners, in June 2003 with two other longtime Morgan employees. He now manages around $2 billion in assets. Mr. Biggs, 71, joined an exodus of scores of prominent Wall Street executives over the last few years who started hedge funds -- portfolios managed on behalf of wealthy investors and institutions like pension funds. Mr. Biggs’s funds were down more than 7% this year through July, net of fees, according to a letter to Traxis investors.

In his letter to investors, Mr. Biggs said he thought the price of oil should be closer to $30 to $34 a barrel. So convinced is Mr. Biggs of his investment thesis that he increased the size of his bet in July, even as prices were rising. Mr. Biggs said he considered oil overpriced because supplies were surging even as he anticipated a slowdown in the global economy. He also cited a “terrorism premium of at least $12 a barrel in the current price.”

His bearish bet on oil is the latest in a string of contrarian bets Mr. Biggs has made. He had a negative view on stock prices, for example, during much of the bull market of the 1990’s, although he turned bullish in late 2002 just before the market hit its lows. Not all of Mr. Biggs’s prior contrary bets fared well.

Too much money to blame for rising price of oil, economists claim.

As oil prices continue to set new records, markets, manufacturers and motorists alike seek to apportion blame. Sometimes it is violence in the Middle East, sometimes it is Venezuela’s political troubles, or surging Asian demand, or Russia’s crackdown on oil company Yukos. But while few would dispute the role of supply disruptions in pumping up the price of crude this year, a small but influential group of economists thinks that a price fluctuation of this magnitude is determined less by supply and demand for oil, and more by that for money.

They think interest rates have much greater influence on commodity prices than is widely assumed, and blame loose monetary policy in particular for the current high level of oil prices. If true, their contention underscores the unpredictable consequences of monetary policy and provides a powerful argument in favour of tightening monetary control.

Mervyn King, the Bank of England’s governor, has defended central banks from the charge that their lax policies have fuelled the oil price rise. But he conceded that aggressive rate cutting may have contributed to the rise in commodity prices, including oil. Eric Barthalon, chief economist at Allianz Dresdner Asset Management, has tracked a correlation between US public debt held by central banks -- a measure of overall global liquidity -- and the oil price. Meanwhile, the ratio of global reserves to world trade, another measure of global liquidity, has risen for two years at the fastest rate since the 1970s the last era of oil shocks according to data collated by the International Monetary Fund.

Stephen Roach, chief economist at Morgan Stanley, thinks the world is now seeing a commodities bubble. “Central banks have been biased towards excess accommodation in the last four years, and that has left the environment ripe for bubbles,” Mr. Roach said. Although Mr. Roach thinks exuberant Chinese demand was driving up commodities prices, he lays some of the blame on the monetary authorities. “A key proponent of rising commodity prices has been investors and speculators and hedge funds in particular, searching for a return in a low return environment.” Mr. Roach says there would be a “sharp reversal” in commodity prices as China’s economy slowed, but Mr. Barthalon says foreign exchange reserves growth means the annual average price of oil could rise by 15-20% over the next two years.

Natural gas seems headed the way of oil: more demand, less supply, higher cost.

At a time when the nation is chafing at its persistent dependence on foreign oil, it is becoming clear that the United States may be headed for the same situation with natural gas. Demand is growing far faster than supply from domestic sources or from friendly neighbors like Canada. Soon, probably within the next decade, the United States will become a significant importer of gas from regions like North Africa, the Middle East, the former Soviet Union and the Caribbean, transported in liquefied form by giant tanker ships.

Faced with that prospect, policy makers and industry executives are pondering whether that means natural gas will become another vulnerable front in American diplomacy and energy security, posing the same quandaries and threats that crude oil does now. The U.S. will probably be able to meet most of its gas needs with domestic production for another 20 years. But some analysts worry that, as with oil, gas supplies around the world will not expand fast enough to meet rising global demand, driving prices higher even as the U.S. turns increasingly to imports.

BOGUS PHONE MESSAGE USED TO PUMP UP STOCKS

The SEC issued a warning, explaining the set-up. A woman leaves an intimate sounding message for “Tracy”, her girlfriend, saying the price of a certain small, thinly traded stock is about to take off. She indicates she got the tip from “Evan, that hot stock exchange guy I’m dating.” The called adds that, "This new company [will be] making some big news announcement this week. It’s 50 cents now and it’s going up to, like, 5 or 6 bucks this week, so get as much as you can.” The woman leaves a cell phone number and ends breezily with, “Anyway, I miss you, give me a call.”

According to the SEC, the scam is likely a pump-and-dump scheme, whereby the caller hopes the individuals hearing the message will buy the penny stock, driving up the price, at which point the heist-meisters dump their own shares for a tidy profit. As soon as the hucksters stop pumping the stock, the price plummets, leaving those who bought the stock at artificially inflated prices holding an empty bag.

OLYMPICS: WHERE IS THE FEVER?

By now, everybody’s heard that the Olympics’ triumphant return home after 108 years is turning out to be not so triumphant at all. Today was the third day of the competition, but barely half of the 5.3 million tickets have been sold, despite heavy discounts. All the explanations -- some plausible, others not very -- do not go to the root of the problem. To find out what is really going on, we plotted a chart showing the number of nations and athletes that competed in the Olympics since 1896. And -- what emerged was a five-wave structure, a classic Elliott wave pattern. Like any activity where collective psychology is present, the chart of the Olympics clearly shows that the Games, after their 100-plus year run, were due for a corrective decline.

Indeed, at the 2000 Sydney Olympics, the president of the International Olympics Committee stated, “We realize the size is getting too big and getting to the limits of what a city can deliver.” He later added that IOC wanted to “halt the expansion of the Games.” As the old saying goes, be careful what you wish for. The fascinating feature of Elliott waves is that you can see them at work in any entity governed by collective psychology.

YEN DEFIES BANK OF JAPAN’S POLICY SCRIPT

If the yen left egg noodles on your face during the past year and a half, you are not alone. It did the same to the Bank of Japan (BOJ). Between April 2003 and March 2004, the BOJ dumped a record 32.8 trillion yen, hoping to depress the currency and make Japanese exports more attractive. Instead, exactly the opposite occurred -- the yen steadily dug down to its strongest position against the dollar in three years.

So, when the Japanese yen market bottomed on March 31, was the BOJ dropping yen as patiently as ever, determined to win the day and hear praise for the upside swing we are seeing now? Nope. On the contrary, officials were going out of their way to explain that they had abandoned their aggressive monetary policy by mid-March.

Global Market Perspective currency analyst Peter Rehmer probably said it best: “When can we believe central bankers? When their opinions are in synch with the wave patterns; otherwise, it’s best to turn a deaf ear.”

WHERE US INTEREST RATES AND INFLATION ARE HEADING

“Super Money” is a measure of global money supply. It is the sum of the US monetary base plus dollars held by foreign central banks. It is a good measure of the world’s supply of dollars. It is important to measure foreign dollar holdings as well as the US monetary base because many of those foreign dollars are invested in the US bond and stock markets. Specifically, foreigners now own 40% of all US Treasury debt. Over the last 12 months, foreign central banks bought $198 billion of US Treasury securities, financing 49% of the US deficit last year (the largest annual deficit on record). Federal credit creation (deficit spending) and foreign investment increases the money supply in the United States, which leads to faster rates of economic growth and inflation. It is worthy to note that the “Super Money” is now growing at a faster rate than at anytime in the last 30 years.

Foreign central banks will not be able to continue to be such large holders of US currency, especially considering that China is now the world’s largest buyer of US government paper (debts). The most likely trigger for a reversal in foreign investment is the falling purchasing power of the dollar, especially in the market for oil. These facts, combined with the skyrocketing, over 20% annual growth in “Super Money”, mean investors must be on the lookout for rising commodity prices and higher interest rates.

Inflation is moving higher. But interest rates are still at near record lows. Prices for financial assets, real estate, stocks, and now commodities are at record levels. Returns on fixed income investments are not attractive, given the rate of inflation and the likelihood of it increasing. There is almost nothing safe to do with your money... or anything to buy that is likely to give a good return. Warren Buffett is now holding $34 billion in cash -- with most of it in foreign currencies. In his previous 50 years as an investor, he had never bought foreign stocks or currencies. Now he owns billions of both.

Other notable money managers -- the best in the business -- have allocated heavily into cash and foreign securities too. Ironically, as the world’s best investors get out of stocks, move out of US bonds, and move heavily into cash and foreign securities, Mr. and Mrs. Mutual Fund are still piling in. But that is par for the course. Mutual fund buyers tend to have all their money in stocks and bonds at the market top and all their money in cash at the market bottom. They are right on track once again. In their own ways, the world’s best investors (in cash) and the world’s patsies (in stocks & bonds) are telling us it is time to be cautious in stocks and bonds. Expensive stocks and inflation don't mix.

AMERICA’S REVOLT AGAINST FATE

Our speech topic -- America’s Revolt Against Fate -- requires a little introduction. Because Americans no longer believe in Fate. They believe in themselves -- at least they have since the Reagan revolution helped them out of their Carter-era funk. They believe that they are the captains of their own fates. “Everything is getting better,” wrote Michael A. Ledeen, a neo-conservative dreamer at the American Enterprise Institute. “And if not, we’ll fix it.”

All the great epochs of the Planet Earth knew no fixing. There were no votes taken. No opinions asked. They just happened. As do major events of history, largely beyond anyone's comprehension, let alone anyone’s control. Who wanted World War I? Who gained from it? Whose fault was it? Looking back, the answer is no one. And yet, it was the most costly war in human history. After a couple of years, it was plain to everyone that nothing would be gained...that it was a lose-lose proposition. Newspapers spoke of peace. Soldiers on all sides threatened to take matters into their own hands and lay down their arms. And then, Woodrow Wilson stepped into the breach to “fix” it. He managed to prolong the war... add millions of names to the casualty list... practically destroy Western civilization. Every major government of Europe fell in the aftermath. In their place came the ugly “isms” of the 20th century -- communism, Bolshevism, fascism, syndicalism, modernism, abstract expressionism -- and the world was a different place.

Who wanted the Great Depression? Who made it? Who gained from it? Whose fault was it? We do not know the answer. But we know it got worse after Franklin Roosevelt stepped in to “fix” it. Not only are events largely beyond your control, but Fate has a way of bringing you what you least want, least expect and most deserve. There are patterns to life, some of them inescapable... some of them inexorable. Fate decrees that acts have consequences. Invite the wrath of the gods... and you will regret it. Sow the wind, says the Bible, and you will reap the whirlwind. Give and ye shall receive. There seem to be certain natural laws that govern life. What goes up must come down. What goes wrong must be set right.

Natural law used to be something people believed in. The old English common law had no lobbyists’ fingerprints on it... no congressional sponsors... no pork-barrel amendments. Instead, judges and juries merely tried to “find” the law. They assisted Fate, rather than trying to straighten it out. People ought to get what’s coming to them; a common-law jury of 12 men “good and stout” helped make sure they did. But now a congress of men -- neither good nor stout, but conniving and willowy, grasping -- make all the laws. And a whole nation is convinced that there is no gravity. We can get not what we have coming -- they say -- but what we want. Fate...?

“The best news about our future,” says the neo-con scholar, “is that it’s still in our own strong hands.” The U.S. economy is thought to be in the strong, bony grasp of Alan Greenspan and the Federal Reserve. This too is a departure from former times, before the central bank of the United States was formed -- under the selfsame President Woodrow Wilson who almost single-handedly derailed Western civilization... and even before there was a United States of America -- the two Adams... Smith and Ferguson... began what was to become the study of modern macroeconomics. But the two men were hardly economists of the modern stripe. They called themselves “moral philosophers”. They believed that their mission was to study economies as naturalists studied birds and bees -- and to discover the laws by which they operated. The two ur-economists believed in fate... that an “invisible hand” -- which they took to be the extended hand of God himself - made sure that things worked as they should. But in this new world, it is the hand of Alan Greenspan that is supposed to make sure things work out -- not as they should, but as they wish.

Markets make opinions, as they say. Markets, for the last quarter of a century, have been so delightful that they have encouraged in Americans a delightful opinion of themselves. They believe themselves capable of just about anything -- including controlling their own fates. The “new dawn” that the Reagan era began, they believe, will last forever. As markets make opinions, it should not surprise us that opinions are as cyclical as markets themselves. Technological progress is cumulative and universal. But in other things -- love, war, markets and central banking, for example -- there is little real progress. Instead, we merely repeat the same mistakes, over and over again, in patterns that are cyclical and local.

The internal combustion engine works as well as in Paris, France, as it does in Paris, Texas. But war is far more popular in the hollows of West Virginia and the plains of West Texas than it is in France. This was not always so. Napoleon Bonaparte had led the most expansionist, action- oriented, pre-emptive-attacking foreign policy in history. After Napoleon was defeated, followed by a defeat at the hands of the Prussians, then World Wars I and II, and being booted out of Vietnam... and then Algeria, it is hardly surprising that they were not eager to follow the Americans into Iraq. Meanwhile, Americans have a taste for expansion... for war... for debt. We are “conquerors”, says Ledeen. We cannot imagine that the wheel still turns, that Fate still waits for us as it has for so many before us. Ledeen was unable to imagine history would continue grinding down the ambitions and pretenses of the world’s success stories... and that Americans would be next on the list of those brought low by Fate.