Finance Digest for Week of November 1, 2004

BLACK TUESDAY REMEMBERED ON THE 75TH ANNIVERSARY OF THE GREAT CRASH OF 1929

“Black Tuesday”, October 29, 1929, wiped 10% off the value of U.S. common stocks and seared a place in America’s financial psyche. Even today, the popular image of “the panic” is of bankrupted fat-cat investors throwing themselves to their deaths from windows high above Wall Street. The bubble the Great Crash burst was ripe for the popping. The speculative run up in stock prices was the last hurrah for the heady years of Jazz Age America. Few on that day could have guessed what the global consequences would be thanks to a series of spectacular policy mistakes in its aftermath: the Great Depression of the 1930s. This special report looks at October 29, 1929, and the weeks immediately following through the eyes of contemporary reports. We reprint 11 articles from Forbes magazine’s three issues following the Great Crash.

The magazine’s founder, B.C. Forbes, wrote four. They are perceptive about what had led up to the crash and the way markets – and more precisely market participants – work. At the time, most serious observers thought the cause of the crash to be widespread abuse of securities markets by insiders and inadequate disclosure of financial data by companies, two themes that echo down the decades to today. Forbes’s pieces were also written before the Federal Reserve raised interest rates precipitously, triggering the recession that Congress helped turn into depression by passing the Smoot/Hawley trade bill that kicked off global tit-for-tat trade protectionism.

Could 1929 happen again?

Nobody seemed to pay much attention to the bad news that cropped up in the stock market throughout the year in 1929. Individual investors were buying stocks on margin, speculators drove up prices and the government had a hands-off policy on the economy. The resulting crash on October 28-29, 1929, drove the Dow Jones Industrial Average down 23.9%, sparking a widespread panic that helped sink the nation into the Great Depression. 75 years later, although Wall Street recovered not only from that crash but subsequent precipitous declines, the question lingers: Can 1929 happen again?

The crash was preceded by a series of sharp declines. But those drops during October created little fear among investors or the public at large. There had been one other major decline in stock prices – a 24.4% drop on Dec. 12, 1914, precipitated by the start of World War I. And while the war years were hard, the Roaring Twenties were an era of unprecedented economic growth, with the overall stock market increasing in price by 667%. Speculation of the 1920s was not just in stocks, but also in bonds, real estate and commodities such as oil and coal. So when investors finally woke up to what was happening on Wall Street, they rushed to pull their money out of those other investments to cover their stock losses, causing the value of all their holdings to tumble as well. The Dow, after peaking at 381 in September 1929, fell to just 41 by July 1932. It would take a quarter century, until 1954, until the Dow rose above 300 again.

The two days of the 1929 crash rank as the third- and fourth-largest one-day percentage losses for the Dow. The 1914 loss remains the largest, followed by the October 19, 1987, crash, when the Dow fell 508 points, or 22.6%. But those two crashes did not result in major economic depressions. Why?

The stock market crash that also hit Switzerland.

It all began on “Black Thursday”. On the morning of October 24, 1929, a sharp fall in prices sent shares tumbling. Shares continued to slump on the following days, which entered the history books as “Black Friday”, “Black Monday”, and “Black Tuesday”. It was the largest stock market collapse the world had experienced. The crash was the catalyst for the world economic crisis that in the following years pushed countries and millions of people to the edge of ruin.

Germany was the hardest hit country in Europe, with more than six million unemployed in 1932. The crisis created the right conditions for Adolf Hitler to seize power in 1933. Switzerland did not escape from the effects of the stock market crash and subsequent world economic crisis. The consequences were not as catastrophic but they lasted longer than anywhere else, said Swiss historian Bernard Degen, who lectures at Bern University’s Institute of History.

Degen said that it was only in 1931 that there was a collapse at the Swiss bourse. Shareholders in Switzerland at that time were mainly richer people and there were “certainly no small shareholders who had put all their savings into shares”. This was in contrast to the US, where owning shares was something like a “public movement”, in which many people with smaller incomes played along, he said. In pure figures, the crisis in Switzerland reached its peak in 1936 when there were 125,000 people without a job. But unlike the U.S., where there were masses of people on the streets locked out and unemployed, such scenes in Switzerland were few and far between.

WHEN THE CROWD IS WRONG, YOU CAN MAKE MONEY BETTING AGAINST IT

If you had a magic box that could accurately predict quarterly earnings, you could make good money. You would buy shares of companies that are destined to beat consensus earnings forecasts and sell shares in companies destined to disappoint. Since 1995 San Francisco research boutique StarMine has found that in the two weeks surrounding an earnings announcement stocks of firms that beat the consensus estimate for earnings, even if only by pennies, have risen 3% on average, while companies that missed saw a 2% drop in stock price.

The next best thing to magic is an analyst with a history of being right with earnings forecasts. Last spring StarMine identified a handful of individuals with exceptional records for forecast accuracy. We recently checked in with these analysts to find out where their 2005 earnings calls set them apart from the herd, not by pennies but by nickels and dimes.

Credit Suisse’s Ivy Zelman topped the list of analysts for accuracy. She thinks La-Z-Boy’s profits will be 18% below the consensus – avoid. She likes Sherwin-Williams, where her estimate is 6% above the consensus. If Robert Morris is correct, the energy industry is still a buy. Most of his earnings estimates for 2005 run 20% to 30% higher than the consensus among his peers. He notes that valuations among oil and gas stocks still seem to reflect assumptions of oil at $28 a barrel and natural gas at $4.75 per million BTU. Lloyd O’Carroll ranked just below Ivy Zelman on the list of smart earnings estimators. For 2005 he sees opportunity in aluminum.

Andrew Kligerman of the insurance sector for 2005. Valuations, he offers, are presently in line with or above their historic norms, and the outlook for industry fundamentals does not look all that tantalizing. Kligerman predicts sales of life insurance and annuities will creep up at a single-digit rate. Andrew Collins suggests bank revenues usually advance at a 3% to 5% annual rate; he is expecting 6% to 8% in 2005, largely on strengthening fee income. Do not expect companies with large wood-products operations to do as well in 2005 as they did in 2004, warns Richard Schneider. He thinks a slowing housing market and additional supply will hit wood prices. Schneider prefers companies whose main business is paper.

WHERE TO FIND A GOOD YIELD

The creditor class is starved for income. Your bank pays you nothing. Junk bonds pay a pittance. At 6% they yield what the ten-year Treasury did just four years ago. What to do? I have a deceptively simple solution, or, rather, a partial solution, to offer. Not before I declare an interest, though. I am a shareholder in the company I am about to name, and I am friends with some of its senior managers. That said, I crown this mortgage real estate investment trust “the Best of a Sorry Lot of Income-Producing Alternatives.” It pays a 50-cent quarterly dividend, for now. That is an annual yield of 11.8% a year – for now.

Annaly Mortgage Management (NLY) is a thrift institution without walls and without deposits. It buys mortgage-backed securities. It finances those securities in the capital markets. When the cost of its borrowings is lower than the yield on its mortgage securities, that is a good thing. Balance-sheet leverage makes this good thing better. Given that the mortgage market is fairly efficient and given that leveraged interest-rate speculators are famously prone to blowups, how do they do how well they do? Can they keep on doing it?

“It is all very well in practice,” the skeptics may say, “but what is the theory?” Annaly is the low-cost provider in the mortgage REIT industry (at 0.13% of gross assets yearly, it charges one-third of the group’s average expenses). For the past two years, Annaly chief Michael A.J. Farrell says, the company has prepared for a flattening of the yield curve – i.e., for less daylight between short rates and long rates. Such preparations have necessarily penalized the bottom line. But to its credit, management knows what it does not know. And among the things it does not know is the future. “My experience in this regard,” he adds, “is that it is better to be early playing defense, rather than late, even if it means you leave a few dollars on the table, which, despite our success, we have.” Evidently, the management knows it is a mortgage REIT and not the world’s hottest hedge fund.

BENCHMARK-PRESSED

Benchmarks are a big part of how investors make decisions. Each quarter investors pore over the results from individual stocks, mutual funds and other types of portfolios – and then compare them to an index, a broad basket of stocks in their category. If a stock or fund trails the benchmark’s performance for only a quarter, a distressing number of investors sell. Bad idea. The most common benchmark for large-cap domestic stocks is the S&P 500. Small caps and midcaps are measured by other Standard & Poor’s yardsticks and ones from Russell, too. Foreign stocks have various Morgan Stanley Capital International indexes. For mutual funds Lipper produces several benchmarks to track different fund styles. Like professional athletes, we money managers live and die by the scores.

Benchmark comparisons can be useful, but only up to a point. Too often they prompt investors to prematurely sour on a good stock with temporary problems and to make an unwise, short-term decision. The road to investment riches is paved with patience and judiciousness. If a stock or a mutual fund falls short of its benchmark for the quarter, relax. You should be concerned only if it lags behind for a very long time, over different market cycles.

Also understand that benchmarks are hardly infallible tools. Benchmarks vary enormously within the same stock category because they are constructed differently by different organizations. A pro basketball court has identical dimensions no matter what the arena. If only the same were true for the stock market benchmarks that have proliferated in the last two decades.

WAR REFUGES

One of the very first lessons of macroeconomics is that economies cannot thrive while simultaneously overproducing both guns and butter. But that is what we are doing right now in the U.S. The Federal Reserve is stimulating consumer demand with low rates while the Administration is running enormous deficits fighting in Afghanistan and Iraq. A war and terrorism burden of $200 billion and counting will inevitably lower economic returns to domestic stockholders and crowd out more productive uses of capital.

The war-related economic drag will not be over soon. Since religion is involved, this struggle will last years and years, if not decades. The “war on terrorism” is a polite way of referring to a conflict between radical Muslims and mainstream followers of the Judeo-Christian tradition. Unlike rebels in places like Northern Ireland, Mideast radicals are not open to compromise.

A guns-and-butter imbroglio must inevitably shift assets away from the U.S. dollar and equity markets. We are getting double-whammied by a policy producing a trade deficit approaching $50 billion per month, or 6% to 7% of gross domestic product. We depend on foreign investors to bail us out by buying Treasurys and other domestic instruments. The day they no longer do will be dark indeed. With the U.S. embarked on such a self-defeating path, it is folly to keep the bulk of your portfolio in domestic issues.

Where should you put it? While addressing that question, first realize that you should never be distracted by economic influences that everyone focuses on – because you cannot predict how these will play out. In the late 1990s investors fixated on tech’s huge role in transforming the economy. Not many had the wisdom to see that tech investing would get too far ahead of itself and implode. Today energy prices have caught the world’s attention. ExxonMobil may know what will happen next with the price per barrel, but I do not.

Hence my basic advice has always been to invest according to what you know, not what you cannot know. What I can know is that the real global growth story is Asia, a trend likely to continue for a good while. Just as important, I also know that Asia (except for Indonesia, the world’s most populous Muslim nation) is relatively removed from the religious war. I have advocated investing in Korea, Japan and China. I now think it is time to add Taiwan to that list, despite signs of trouble that have kept investors at bay.

WHEN A BROKERAGE HOUSE BUYS YOUR NO-LOAD FUND, THINK ABOUT GETTING OUT

Since 1994 the percentage of mutual funds with sales loads has dropped to 49% of all equity funds from 60%, according to the Investment Company Institute. But not all the news is good for the do-it-yourself investor. Some of the best no-load, low-cost funds have been bought by brokerage houses, which have not only imposed loads on them but also raised annual expenses – even as assets grew.

At least 63 no-loads worth a collective $79 billion in assets have been bought by brokerages over the last decade. Of these, 19 were once Forbes Best Buys and/or Honor Roll funds. All are now saddled with sales charges – most of them a steep 5.75% upfront load – while 54 also increased expenses. The group, post-acquisition (including those few that implemented decreases), boosted expenses an average of 20%, even while assets grew 13%. Shouldn’t economies of scale from more assets bring down expenses in percentage terms rather than raise them?

Brokerages argue that it takes money to gather fund assets--after all, there are marketing, distribution and sales costs. Maybe so, but where is the good in it for shareholders? Asset gains bring a nicer income to brokers and money managers, but why should shareholders foot the bill? What can shareholders do? If you are grandfathered into a cheap share class and the portfolio managers you came for stick around, hang in there. If either condition is not met, depart.

PUT BONDS IN A TAX-DEFERRED ACCOUNT AND STOCKS IN A TAXABLE ONE

The latest Federal Reserve Survey of Consumer Finances shows that Americans invest their taxable accounts and their tax-deferred accounts – their 401(k)s and IRAs – almost identically, devoting just over two-thirds of each to stocks. Those who do this are stupid. They should put bonds into the sheltered accounts and stocks into the taxable accounts. Investors are bombarded with information about proper asset allocation: how they ought to split their money among stocks, bonds and other assets. Meanwhile asset location between taxable and tax-deferred portfolios gets short shrift.

Yet according to Carnegie Mellon finance professor Robert Dammon, putting securities into the wrong type of account can easily slice 20% off your ending nest egg. It is especially costly to young and middle-age investors, because their mistakes have longer to compound. Your basic goal is simple: to put your most highly taxed assets in tax-deferred accounts, while stashing more lightly taxed assets in your taxable account. Calculating taxes can get complicated, since they depend on how long you hold securities, whether they are exempt from federal or from state tax, and what bracket you are in. Fortunately, though, a recent study in the Journal of Finance sorts through all of this and comes up with some fairly simple rules of thumb.

Their first finding is that you will do best if you put your bonds and real estate investment trusts, whose payouts are mostly taxed at ordinary (federal) income rates of up to 35%, into your tax-deferred accounts. Put your stocks, which pay long-term capital gains and dividends taxed at a top 15% rate, into your taxable account. That holds true, the professors show, even if you trade stocks a lot, generating highly taxed short-term gains, or hold a mutual fund that does the same.

The second, and more surprising, conclusion is that even well-off investors should favor taxable bonds in a tax-deferred account over tax-exempt bonds outside of one. Investors at all income levels, says the study, should fill their tax-deferred accounts with REITs or with taxable bonds (if they want to hold that many bonds) before they even consider buying municipal bonds, which are tax-exempt.

DIVIDEND WINNERS

Most folks who are Thomas Cameron’s age pay close attention to dividends, thinking only of their current income. But Cameron, 77, has an entirely different motivation for being in love with dividends. Consistent dividend payers, he says, have a higher total return than other stocks. “Stocks go up when dividends go up; it’s just that simple,” says Cameron, former chairman of the Philadelphia Stock Exchange. He says you should buy stocks that have had handsome and regular dividend increases over the past decade. Out of 12,000 stocks traded in the U.S., a mere 156 have raised dividends in every year of the last ten and have raised them at an average annual rate of at least 10%. Let us call these “Dividend Dazzlers”.

There is a case to be made for Dividend Dazzlers, but it is not quite as simple as it looks. If unexpected prosperity descended upon a small subset of corporations, it stands to reason that they would both beat the market and have the wherewithal to boost dividends at a high rate. This cause-and-effect connection would be useful to you only if you could somehow get your hands right now on the Dazzler list of 2014. Alas, it is not available. A better acid test of the Cameron thesis: Go back to 1994 and create a list of all the Dazzlers that were to be found then. There were 173. How have they done since? Well. This group, which includes such companies as Johnson & Johnson and General Electric, has averaged a 14.4% total annual return, three points better than the S&P 500. This is not proof that Cameron’s approach will work over the next decade, but it suggests that he is onto something. Dazzlers lagged during the late-1990s bull market in technology stocks. They have done fairly well in the value-driven market of the past five years.

The current Dazzler list includes the likes of 3M, Caterpillar and PPG Industries. If you want to go after dividend payers, now is a good time to play the game in a taxable brokerage account. Under present law, the 15% tax rate enacted last year lasts through 2009. The average yield in the stock market is a mere 1.7%, but historically dividends have been a much larger component of total return. The real total return on stocks since 1926 has been 7% or so, and dividends account for 4 percentage points of that total. The 2003 tax cut has brought dividends back into style. The dividend-raising trend is gaining strength.

Apart from warming the hearts of retirees who make an old-fashioned distinction between principal and income, dividends serve a beneficial function in braking executives’ penchant to squander corporate resources. So argues Michael Jensen, a Harvard professor emeritus who believes that payouts make managers think twice about overspending on iffy projects that might endanger the dividend. Not all dividend increases foretell upcoming glorious days. Some struggling companies try to buy investors’ love with fat payouts. Getting the most out of a dividend-driven investment strategy requires that you look beyond stocks with the highest yields, which can lead you astray.

One of the drawbacks to a company with fast-growing dividends is that it is likely to be much sought after. Some of these stocks trade at multiples of 15 or more of their future earnings. For a cheaper portfolio, consider companies that are merely good payers rather than growing payers. The table on this page lists companies with above-average yields and payout ratios below 50%.

IF YOU THINK THE TECH BUBBLE POPPED IN 2000, TAKE ANOTHER LOOK

America’s love affair with racy concepts, phony values and paper pseudo-wealth continues unabated. The flair for risk-taking is still alive and well. Investors are still smitten with New Economy thinking. Reading a little of veteran tech watcher Fred Hickey’s analysis a few days before Halloween was like reliving a horror show. I kept thinking, “Not again! Didn’t we just go through this not too long ago? Didn’t pie-in-the-sky tech investing get smacked once already?”

“One would have thought that such a shellacking would have ended the irrational love affair for tech and Internet stocks,” Hickey writes. “But here we are, almost four and-a-half years from the bubble’s bursting in March 2000, and we are still waiting for a return to a sane investing environment.” Consider Travelzoo, valued at 50 times its sales, and Google, selling for about 186 times earnings, and up about 60% from its IPO. Better yet, just look at the whole NASDAQ itself. Hickey notes that the NASDAQ as a whole is trading for 57 times earnings and nine times sales.

Have investors forgotten the devastating losses that such craziness can lead to? Have they forgotten about the 95% losses on stocks like CMGI, JDS Uniphase, and Sycamore Networks. Have they forgotten that the NASDAQ lost 2/3 of its value in two and-a-half years after starting with such nosebleed valuations? “Often I sit in my office and I cannot believe what I’m seeing,” writes Hickey with exasperation. “The lunacy does not seem to end.”

What we are witnessing may be like some sort of Indian summer, a little warmth in the midst of a bearish winter. It is like a weigh station to a new, more normal value. What that normal value might be, is anybody’s guess. Believe it or not, bubbles such as these often create opportunities in other neglected areas of the market. The excessive valuations in tech-land are also self-correcting as new competitors start to come in looking for a piece of that money. During the next leg down, the intangibles of technology – the supposed “story stocks” and their great promise – will be outdone, once again, by solid tangible assets that actually deliver real cash flows.

What is technology anyhow?

Somehow in the financial press and Wall Street circles, the word “technology” became short hand for any industry that makes an electronic component or facilitates electronic information exchange. The NASDAQ 100 is frequently referred to as “tech heavy”. Not that long ago, chemistry, biology, and engineering were associated with technology. I always associated “technology companies” as those with large R&D budgets who hired scientists and engineers. In the 1990’s companies that were tied to the Internet were all the rage and considered on the leading edge of “technology”. Whether they were selling pet supplies over a web site, or slapping computer parts together and selling them, they were the elite, “high tech”, new economy.

I raise this issue in the context of investing for some important reasons. If you think you are investing in a high growth company because someone slaps a label on it as a technology company, you had better take a closer look. For starters, take a look at the R&D expenditures and the growth rate. I would be suspicious of a company who spends little on R&D, does not grow, but had a rich valuation because of public perception. For example, a railroad or chemical company may have better growth prospects than a semiconductor company despite public perception of semiconductors as a “hot growth area”. One of the larger applications for semiconductors is a computer, which is in my opinion a commodity.

We must be diligent as investors in distinguishing mundane companies masquerading as innovative high growth “technology” companies with inflated price to earnings multiples. The companies engaged in technology industries are subject to fierce competition and their products and services may be subject to rapid obsolescence.

Google and the Boston Red Sox both long ball hitters?

Last week, the only sound more thunderous than the roar of Red Sox fans in Boston was the round of applause coming from Google investors on Wall Street. Talk about hitting one out of the stadium like David Ortiz: On October 29, Google shares rocketed 15% in a one-day gain that sent prices beyond the Green Monster and out to the galactic region of $200. That pushed Google’s market cap to $52 billion – more than Ford and General Motors combined. But what is even more phenomenal than the “stupendous” or (our personal favorite) “Hindenburg-esque” increase in the Google I.P.O. price is this: the lack of fear among investors that the stock is overvalued.

Let us see what that means: When Google’s stock soared to $200 a share, its price-to-earnings ratio was 76:1. (A “healthy” average P/E ratio is 15:1.) But that fact did nothing to dampen the speculative fire. You could roast marshmallows on the bullish Google forecasts. Nobody is denying the similarities between Google’s long-ball ride and the late 90s “dotcom froth”. But according to the experts, this time around, “froth” will not lead to fizz, because Google is not taking over old, shriveled businesses like Encyclopedia Britannica.

An October 30 New York Times piece brings us up to date: Google is the leader of a hot, “new” industry that continues to include “services with the potential for robust growth. These recent innovations deserve recognition as a kind of golden age of product development.” We repeat: “the potential for robust growth.” So basically, investors are pinning their Google star on future technology and innovations that have not even proved themselves yet. We have a phrase for this kind of psychology: blind optimism.

“HEAD & SHOULDERS” TECHNICAL FORMATIONS, THEN AND NOW?

If there is a “bible” of technical analysis, it is Edwards & Magee’s Technical Analysis of Stock Trends. Serious technicians and traders have learned from it for more than 50 years. Bob Prechter has said that, “There is no better place to begin your education in market behavior than this pioneering book.” A memorable passage in Edwards & Magee describes what is “by all odds, the most reliable of the major reversal patterns,” namely a head-and-shoulders formation.

On August 30, 2002, The Elliott Wave Financial Forecast identified this very formation in the S&P 500, and said this to subscribers: “The market’s precise action to and from these ... levels suggests that the move at hand is every bit the [selling] opportunity that EWFF forecast in March and September 2000, January 2001 and March 2002.” From there the S&P 500 fell 15% in five weeks, to the bear market lows in October 2002.

A head & shoulders pattern is again clear to see. It suggests the sort of opportunity that, as usual, you are not likely to discover anyplace else.

SMART MONEY SELLING IN ART MARKET?

More than half a billion dollars worth of paintings and sculptures, led by a $40 million Gauguin, will be up for bids in Sotheby’s and Christie’s annual fall sales as owners try to capitalize on a bullish art market. Charles Moffett, co-chair of Impressionist and modern art at Sotheby’s, contrasted the sustained art market boom, which has defied the sluggish U.S. economy, with that of the late 1980s when speculative bidders set record prices.

“That was almost a commodity market,” he said of the 1980s run. “Now it’s more characterized by educated, driven, well-informed people who are consciously assembling collections. They want the best Monet, or the best (Jackson) Pollock, and that’s what’s causing a lot of these extraordinary prices.”

Sotheby’s art auction rakes in $194 million.

New records were set for works by Gauguin, Modigliani and Mondrian at Sotheby’s auction of Impressionist and modern art, which achieved the biggest total since 1990. The sale of 48 paintings and sculptures, among 61 lots, took in $194,289,600, including Sotheby’s commission. Sotheby’s officials said they were thrilled with the result, despite its falling short of the low pre-sale estimate of $203.5 million. Sotheby’s had estimated that the total could go as high as $275.6 million. The highlight, as expected, was Gauguin’s vibrant 1899 oil-on-canvas “Maternite (II), which fetched $39,208,000, setting a new record for a Gauguin but short of the low estimate of $40 million. Still, it smashed the old mark of $24.2 million.

The sale’s major casualty was Kandinsky’s “Sketch for deluge II”, also estimated at $20 million to $30 million. It failed to sell when no bids beyond $16.5 million could be elicited from the packed salesroom. David Norman, Sotheby’s co-chairman of Impressionist and modern art, said the auction house was quite happy to own the work. “We knew full well when we guaranteed it that we might own it,” he told Reuters after the sale. Guarantees are confidential minimum payments promised to the consignor regardless of whether a work sells, and they have become an increasingly common practice in recent seasons. “We can be patient,” Norman added, noting that the Modigliani that went for $31 million earlier could not even get $600,000 when it was on offer in 1979-1980.

As in recent sales at both Sotheby’s and arch rival Christie’s, sculpture did especially well, with Henry Moore’s large-scale work “Three-Piece Reclining Figure: Draped”, breaking the artist’s record and selling for $8,408,000, well above the high estimate of $6 million. And Brancus’qs famous piece “The Kiss” went for $8,968,000, making it the evening’s fourth-highest priced work.

The annual fall art auctions continue next week as Sotheby’s and Christie’s hold their contemporary and post-war auctions. A Warhol from the pop artist’s “Death and Disaster” series is among the highlights and could be poised to set a new record.

HEDGE FUND BAROMETER SEES SHIFT IN SENTIMENT TOWARDS COMMODITIES

Geneva-based hedge fund advisory firm Tara Capital released its quarterly hedge fund strategy barometer, which has shown investors tending to shy away from convertible arbitrage funds in favor of managed futures and commodity trading funds. According to the barometer, sentiment has consistently shifted against convertible arbitrage strategies in recent times, due largely to a dip in implied volatility on longer term convertibles, which has resulted in “relatively significant losses” for many funds in this sector.

Noting a drop in the CBOE Volatility Index (which measures volatility in the equity markets) to the lowest level since 1997, John Lowry, CEO of Tara Capital, commented, “This reflects a complacency amongst investors, which is somewhat curious given the backdrop of concerns over growth rates and higher energy prices.” Meanwhile, the barometer has recorded a noted shift in sentiment back towards Managed Futures funds and CTA (Commodity Trading Advisor) funds, with 44% of respondents stating that they plan to increase asset allocations in these sectors, contrasting sharply with the 6% who said the same in the last survey.

VOTERS MAKE BIG DECISIONS OCCASIONALLY, TRADERS EVERY DAY

Like voters in the United States who were making momentous decisions Tuesday, traders make momentous decisions, too. It is just that they make them every day, sometimes many times a day. Wouldn’t it be great if they could take a poll to find out which way the markets are headed? Sure, have pollsters call 100 investors to find out what they bought and sold today in the markets. It turns out that is not such a crazy idea. In a recent interview with Futures Magazine’s editors (in the November issue), Bob Prechter talked about this very subject:

“When I started at Merrill Lynch back in the ‘70s, there was a long-time technician there who used to be a broker. He said his dream indicator would be a direct line to 50 brokers who would report to him every move their clients made. When he saw a consensus action – not just an opinion but an action – he would just do the opposite.”

Sounds awfully contrarian. Why would that work? Because it means that you could beat the herd of investors rather than follow them. But to be really successful, it is also important to understand your own personal psychology and how the urge to herd affects you as an individual. In the interview, Bob goes into some detail on this concept:

“Because of the herding impulse, most people’s emotions fluctuate as if it were true that rising prices increase the chances for rising prices and vice versa. But the opposite is true. You need to act in accordance with reality. [W]hen you start out, recognize when you get bullish in a rally or bearish in a decline. That’s the signal to think about doing the opposite of what your emotions are telling you to do. But it’s hard. It’s like forcing yourself not to duck when a rock is hurtling toward your head.”

CLARITY, FUZZINESS & PRESIDENTS: WHAT WERE YOU THINKING?

The same psychology that drives the long-term trend in stocks also drives trends in the economy, pop culture, and, yes, politics. That psychology is either positive or negative – and once you know what to look for, it is easy to tell the difference. Let us take politics, specifically the way voters think about elections and candidates for office: Periods of positive psychology are marked by “clarity”, while “fuzziness” becomes conspicuous once the psychological trend turns negative.

The 2004 presidential election included astronomical amounts of spending, record turnout, unprecedented “get out the vote” efforts, and transparently vulgar emotional appeals from both sides. All this (and more) fed the notion that this election was “the most important in decades”, and that “the differences between the candidates could not be more obvious”. Well, what is obvious to me is that both candidates had – “A plan” to create more jobs, to make health care more affordable, to cut taxes, to reduce the deficit, to spend more for education, to win in Iraq, to defeat the terrorists, ... you get the idea.

On any of the points above, could you have explained the meaningful differences between the respective plans of President Bush or Senator Kerry? Do you think most voters could have? If not... what characterized the way voters were thinking about this election and these candidates? Bob Prechter just posted a special Interim Report (available to one and all through 5:00 p.m., November 10 to Club EWI members) during with his observations and commentary on the election, and what to expect from the stock market. One thing I can say is, his thinking is more clear than anything else you'll read.

DOES THE FED “CONTROL” INTEREST RATES?

Most of what you hear from Wall Street and the financial press suggests that the Fed “controls” the trend in interest rates. In turn, Treasuries are supposed to be the investment market where that trend will show itself. And as 2004 began, all the establishment economists told us to expect inflation, as part of a “rising interest rate environment”. Treasury yields, they said, should follow upward. Curious thing was, you did not hear them talking much about the trend in Treasury yields in the first 10 weeks of this year – that is because those yields were going against the conventional wisdom, namely down.

So mid-March was the perfect time for us to step in with market analysis that ignores “inflation” and “the Fed”, and instead show authentic indicators like cycles, Elliott wave patterns, and sentiment. On March 10, 2004, we informed subscribers that, “With the pattern near completion, odds are rising that a turn up in yields and down in prices is drawing close.... The combination of this cycle, the nearly complete Elliott wave pattern and the extreme in bullish sentiment, suggest that the bond rally is on its final legs.” You can see the timing of this forecast on this chart. The rapid turn in the trend speaks for itself.

You will see a second arrow that points to May 14, some two months later. By then, Treasury prices had been falling for nine consecutive weeks (yields and prices move inversely). A decline that persistent had not happened for 24 years. Sentiment indicators were off the chart. At last, everyone “knew” that Treasury yields were “anticipating” the coming rise in rates; therefore, Treasury prices should keep going down.

Our May 14 analysis: “There’s a solid chance that today’s high in yields and low in price marks the end [of the trend]”, and that “The evidence is very strong that a multi-week bond market rally has arrived at our doorstep.” Once again, the chart tells the story: Treasury yields went DOWN and prices went UP, as we forecast – and completely contrary to the conventional wisdom at the time. The Federal Reserve has raised the discount rate THREE times, but the trend in Treasury yields has NOT followed – in fact it has been headed mostly in the opposite direction. The Treasury market pattern we followed then is the same one we see now.

MR. PRESIDENT, HAVE AN ECONOMIC REALITY CHECK

Memo to the president-elect:

Congratulations. Take some time off, relax, clear your mind, because when you come back, you will face a number of big challenges. Putting together a new team. Managing a victorious withdrawal from Iraq. And, oh yes, dealing with an economy headed back into the ditch.

Yes, I know that is not the consensus forecast. After all, the economy looks to be in pretty good shape right now. Economic growth will probably come in at a respectable 4 percent for 2004, while the global economy will have its best year in decades. Core inflation is around 1.5%. Corporate profits are up about 20% for the second year running, providing the cash for a respectable, double-digit increase in capital spending. Unemployment is drifting downward.

Unfortunately, this is probably the best year we are going to have for some time, the result of some lucky breaks, a modest decline in the value of the overpriced dollar, continued high productivity and an enormous amount of fiscal and monetary stimulus. The heavy dose of stimulus is unsustainable, and wearing off in any case. Our luck ran out with $50-a-barrel oil and the escalating cost of the Iraq war. The benefit from all those productivity gains just is not translating into more jobs or higher incomes, except maybe in India. And the structure of the U.S. and global economies is such that a falling dollar has not spurred exports or dampened our appetite for imports as much as expected.

At this point, the most likely scenario is that growth will fall to 3 percent next year and below 2 percent in 2006, with few gains in employment and gradually rising inflation – a mild form of stagflation that carries with it a good chance of recession. The underlying reason is pretty simple: For 13 years, the United States has been living beyond its means. ...

THE U.S. ECONOMY IS AN ACCIDENT WAITING TO HAPPEN

In the financial markets, we endlessly debate the prognosis for next quarter’s numbers – GDP, earnings, inflation, and the like. Our fixation on the here and now reflects both the difficulties of longer-term forecasting as well as the short-termism of the investment community. Each quarter that we escape a problem, the greater the comfort level as to what lies ahead. Such myopic risk assessment misses the forest for the trees. In my view, the U.S. economy is an accident waiting to happen. That is the message to be taken from a record shortfall in national saving, a record current-account deficit, record levels of household indebtedness, a record deficiency of personal saving, and outsize government budget deficits. The emphasis is on the word “record”. Never before has the U.S. pushed the envelope to this degree on such a wide array of economic imbalances.

The politicians have not touched these issues in Campaign 2004. That is hardly surprising. After all, the resolution of imbalances may actually imply some personal economic sacrifice – not exactly the approach that attracts votes. Just ask Jimmy Carter or Walter Mondale. But the campaign is now over. The rhetorical flourishes hopefully will subside. With the most daunting economic agenda America has faced in a generation, the real debate can begin.

I continue to believe that the national saving construct offers the most comprehensive framework to understand many of America’s toughest economic challenges. America’s net national saving rate is in the 1-2% range over the 2003-04 period – all-time lows by any standard. Such anemic saving speaks of a nation that is living well beyond its means, as those means are defined by America’s domestic income generating capacity. A record-low saving rate also ties together many of America’s other economic problems: the current-account gap and budget deficit, the asset inflation-based economy, household debt, etc.

The task ahead is not to bemoan the past but to address what needs to be done to face a very challenging and risky future. The national saving framework provides some obvious and important answers. First, fix the budget deficit. The heavy lifting of deficit reduction is an urgent imperative – especially in the early months of any political cycle. Second, let the dollar go. A weaker dollar will also put long overdue pressure on the rest of the world to stimulate its own domestic demand – both by embracing structural reforms and by backing away from the increasingly reckless and destabilizing recycling of foreign exchange reserves into dollar-denominated assets.

There are no quick fixes for America. Yet political campaigns are designed to give voters just such an impression. This charade should now come to an end. And just in time, I might add. In my view, 2005 could well be a year when many of America’s imbalances reach their tipping point. A failure to act would be the greatest tragedy of all.

UNITED STATES: CAPEX CAUTION OR CAPEX DISCIPLINE?

Despite many challenges, the capital-spending (capex) revival that began nearly two years ago continues at a hearty pace. Yet many, including Fed officials, believe that pervasive caution is restraining Corporate America from spending even more aggressively. Rather than capex caution, however, I think that capex discipline has returned to the executive suite, and this nuance matters hugely for investors and for the Fed. Capex caution could turn into exuberance again if circumstances turned favorable. In contrast, capex discipline would increase the chance that companies will sustain high returns on invested capital (ROICs). And it will likely boost operating rates, adding to the incentive to expand and yielding a further improvement in pricing power. All three are good news for investors. For their part, the Fed should also welcome a less-steamy expansion that may last longer and might thus provide a favorable backdrop for resolving some of our economy’s long-term imbalances.

INSURERS SUFFER RECORD CATASTROPHE LOSSES IN Q3

The property insurance industry sustained record third-quarter losses this year according to an actuarial firm’s preliminary estimate. Eight catastrophes, including hurricanes Charley, Frances, Ivan and Jeanne, contributed to $21.3 billion in insured property loss claims, according to New Jersey-based ISO. That figure compares to $19.15 billion in the third-quarter 2001 – the previous record, which included $18.8 billion in insured property losses from the September 11 terrorist attacks.

For the first nine months of 2004, insured losses stand at $24.7 billion, second only to the $26.1 billion from the first nine months in 2001. Last year, insurers lost $10.2 billion in the first nine months. This year’s four major hurricanes together accounted for an estimated $20.5 billion – just over the $20.3 billion loss caused by Hurricane Andrew in 1992, in inflation-adjusted terms, an ISO spokesman said.

THE ACQUISTION THAT JUST KEEPS ON TAKING: TIME WARNER SETS ASIDE $500 MILLION FOR AOL PROBE SETTLEMENT

The federal investigation into accounting problems at AOL had been disclosed long ago. Many of the problems involve AOL when it was an independent company, before the Internet service provider purchased Time Warner in a deal that closed in 2001. The company said it expected to restate its 2000 and 2001 revenue and income lower due to a change in accounting for its interests in AOL Europe prior to 2002. While it did not formally restate those earlier results with this statement, it said it expected revenue in 2001 would drop $810 million and it could be left with a net loss of $5.1 billion rather than the $4.2 billion net loss previously reported. It said 2000 revenue would likely drop by $640 million and net income could decline by about $300 million to reach $813 million. It said the $500 million reserve is its best estimate of the cost to settle those probes and various shareholder suits pending against the company.

HOW COAL CAN HELP REDUCE SOARING NATURAL GAS PRICES, AND SATISFY ENVIRONMENTALISTS

Prices at the pump have gotten a lot of attention lately, but it is time to focus on another gas price crunch. The price of natural gas has more than doubled in the last four years. This presents a prime opportunity to make widespread use of a long-overlooked technology: producing gas from coal. The U.S. is the Saudi Arabia of coal: While we have only 3% of the world’s natural gas reserves, we have a quarter of the world’s coal. In the late 1980s, however, investments in coal fell as cheaper and cleaner gas plant technology came on line; over the last ten years power companies have invested $100 billion in natural-gas-powered plants but very little in coal-powered ones. The expectation was that gas would remain inexpensive and U.S. and Canadian supplies would meet demand. But today gas that was supposed to cost $2.50 per million Btu costs $5 or more. Higher prices have caused chemical and fertilizer companies to cut back production and lay off workers. And home-heating costs will rise this winter.

The natural gas price squeeze gives us the opportunity to usher in the return of coal power – not power from conventional high-polluting plants but from a new generation of much cleaner technology. Processes that first gasify coal – adding steam and oxygen under pressure to produce hydrogen, carbon monoxide and other gases, turning it into fuel that can be burned like natural gas – remove more than 90% of toxic mercury emissions as well as impurities such as sulfur, nitrogen and particulates.

Moreover, technology makes it possible to separate out carbon dioxide, the chief culprit in global warming, before it is released into the atmosphere. Instead, the separated CO2 could be piped underground. This process has yet to be developed for use commercially, but the science is promising. Gasified coal costs 20% more to build coal-gasification plants than traditional coal plants. In a report, my colleagues Dwight Alpern and Michael Walker and I spell out how the new coal technology might be made commercially viable if utilities, state public utility commissions and the Department of Energy join together to finance an initial fleet of plants.

THE DOLLAR’S LONG-TERM DIRECTION: DOWN

The election drove the dollar all over – down when it looked like President Bush would lose, up briefly when Senator Kerry conceded defeat. But ultimately, the dollar’s fate never hinged on the outcome of the presidential election. Now that the dust has settled, the currency is back on its long-term path: downward. According to most economists, it is likely to stay there over the next four years. “There is a certain inevitability to the decline,” said Alan Blinder, an economist at Princeton University who served as vice chairman of the Federal Reserve and was an adviser to President Bill Clinton. “I think the Treasury understands this. It would be nice if they would say so.”

Managing this potentially painful move will be a pressing challenge for Mr. Bush’s economic team. The nation’s current account – the broad gap between the nation’s exports and imports of goods and services – has reached a deficit of nearly $600 billion, almost 6 percent of the nation’s overall economic activity. And it shows no signs of diminishing on its own. Closing this gaping hole will overshadow the administration’s trade policy, coloring its push for better access to foreign markets for American products, and adding urgency to its attempts to make China and other Asian nations revalue their currencies against the dollar so that American industry can be more competitive.

An influential group of economists has argued that there is no reason that this imbalance cannot go on relatively undisturbed – if not forever, at least for a very long time. But most mainstream economists argue that, at a minimum, the unraveling of this web would send the dollar lower and squeeze American consumption. Kenneth Rogoff, a professor of economics at Harvard, said that to smoothly and significantly narrow the current account deficit requires a depreciation of at least 20% in the dollar, making it much more costly for Americans to buy imported goods and travel abroad.

Canadian dollar touches 12-year high.

The Canadian dollar soared to its highest level in 12 years Wednesday as its U.S. counterpart defied market expectations by losing ground against major world currencies after an apparent win by incumbent U.S. president George W. Bush. The Canadian dollar – which closed Tuesday at 81.68 cents (U.S.) had surged to 82.79 cents, its best showing since 1992. It closed even higher at 82.71 cents. The latest gains came as the U.S. dollar lost ground against most world currencies, including the euro.

DEFICITS AND TAX SYSTEM CHANGES IN BUSH’S SECOND-TERM ECONOMY

Even as President Bush was celebrating his election victory, his Treasury Department provided an ominous reminder about the economic challenges ahead. After four years of rapidly rising budget deficits, the Treasury announced on Wednesday morning that the government will borrow $147 billion in the first three months of 2005 – a new quarterly record, but one that is likely to be eclipsed before that year is out. Empowered by his own victory and stronger Republican majorities in Congress, Mr. Bush has pledged to push an economic agenda that could be more ambitious than the $1.9 trillion worth of tax cuts over 10 years that he signed in his first term.

The new economic agenda will focus on two big goals. One is expected to aim for a fundamental overhaul of the income tax, very likely in the direction of a system that lessens even further the taxation of investment income; the other to push for a partial privatization of Social Security that could eventually reduce costs but require borrowing more than $2 trillion over the next two decades.

The challenge ahead can be seen in the fiscal decline that took place between Mr. Bush's first inauguration in 2001 and his second one on Jan. 20, 2005. Federal tax revenue was $100 billion lower this year than when Mr. Bush took office, but spending is $400 billion higher. The ballooning budget deficits, which could total $5 trillion over the next 10 years if Mr. Bush succeeds in making his tax cuts permanent, could constrain the president’s choices far more than they have in the first term.

Foreign investors have thus far been willing to finance the United States’ borrowing, but most of that has come from central banks of Asian nations rather than private investors. If foreign appetite for Treasury securities wanes, interest rates would have to rise to make such investments attractive enough to keep money flowing into this country. Making the job more difficult, politically as well as economically, is that higher oil prices have slowed American growth even as job creation continues to languish. Slower growth would aggravate Mr. Bush’s budget problems.

U.K. HOUSE PRICES FALL IN OCTOBER

House prices fell 1.1% from the previous month after a revised 1.3% monthly increase in September. The year-over-year growth rate fell to 18.5% from 20% a month earlier. Higher borrowing costs are slowing consumer spending, which accounts for two-thirds of GDP, and reining in a five-year housing boom that doubled property prices and underpinned the longest economic expansion in 200 years. The U.K. economy, Europe’s second-biggest, grew at the slowest pace in 18 months in the third quarter.

“What we are witnessing is the start of a prolonged period of falling house prices,” said Ed Stansfield, property economist at Capital Economics in London. “The speed of the slowdown will reinforce financial markets’ growing belief that interest rates have peaked.”

Lennar delays delivery of homes, citing soft market, hurricanes.

A recent softness in the housing market in Southern California and Las Vegas led home-building giant Lennar Corp. to delay the projected delivery of 600 homes it had hoped to sell this year into the first quarter of 2005. The company, which has several projects under way in San Diego County, added that the hurricanes in Florida also contributed to the delay in the delivery of the homes. “Southern California has presented to us a little bit of a softer face more recently,” Lennar chief executive Stuart Miller said in a conference call yesterday. “Whether that’s a trend, I’ve consistently said one month in a row does not define a trend yet. We’ll have to see.”

While Southern California’s housing market has experienced a rise in the number of homes for sale in the past few months, the number of home sales overall has remained solid, industry experts say. So Lennar’s announcement came as a surprise to some Southern California housing experts. Miller said he believes the investment community is preoccupied with a “bubble mentality” and is overreacting every time the industry sees fluctuations in individual markets.

Still, Raymond James analyst Paul Puryear expressed concerns about the softness in Las Vegas and Southern California. “Slowdowns in Southern California and Las Vegas will hit home builders extremely hard, as many rely on these markets for a large portion of their total earnings, given the much-higher-than-average margins being generated in these markets,” Puryear said in a research note. He worries that the Las Vegas softness may indicate that problems that recently hit rival builder Pulte Homes Inc. recently may not have been “company-specific”.

MERCK SHOULD HAVE PULLED VIOXX IN 2000, STUDY SAYS

Merck’s Vioxx painkiller showed heart risk in studies four years before the drug was recalled, and it should have been pulled from the market then, according to a study published in the medical journal Lancet. Vioxx was the world’s second most-prescribed pain medicine when it was withdrawn from the market Sept. 30 after a study found it doubled the risk of heart attacks and strokes after 18 months. Researchers at the University of Berne in Switzerland found the same level of heart risk was apparent by the end of 2000 and was present even earlier than 18 months.

Vioxx, with $2.5 billion in sales last year, was the biggest-selling drug ever withdrawn from the market. New Jersey-based Merck faces several hundred Vioxx lawsuits in state and federal courts in California, Texas, Florida, New Jersey, Alabama, Mississippi, Georgia and Arkansas, court docket records show. The Lancet study may help those plaintiffs, Prudential Financial analyst Timothy Anderson said. When Merck announced the recall, it said the findings of heart attacks and strokes were unexpected.

A WORLD OF RANDOMNESS

When I was in the employment of the New York office of a large investment house, I was subjected on occasions to the harrying weekly “discussion meeting”, which gathered most professionals of the New York trading room. While the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street “economists” or “strategists”, who make pronouncements on the fate of the markets, but do not engage in any form of risk taking; thus having their success dependent on rhetoric, rather than actually testable facts. During the discussion, people were supposed to present their opinions on the state of the world.

To me, the meetings were pure intellectual pollution. Everyone had a story, a theory, and insights that they wanted others to share. I have to confess that my optimal strategy was to speak as much as I could, while totally avoiding listening to other people’s replies by trying to solve equations in my head. Speaking too much would help me clarify my mind, and, with a little bit of luck, I would not be “invited” back (i.e, forced to attend) the following week.

I was once asked in one of those meetings to express my views on the stock market. I stated, not without a modicum of pomp that I believed that the market would go slightly up over the next week with a high probability. How high? “About 70%.” But then someone interjected, “But, Nassim, you just boasted being short a very large quantity of S&P 500 futures, making a bet that the market would go down. What made you change your mind?” I answered, “I did not change my mind! I have a lot of faith in my bet! As a matter of fact, I now feel like selling even more!” The other employees in the room seemed utterly confused. “Are you bullish, or are you bearish?” the strategist asked me. My opinion was that the market was more likely to go up (“I would be bullish”), but that it was preferable to short it (“I would be bearish”), because, in the event of its going down, it could go down a lot.

Let us assume that the reader shared my opinion, that the market over the next week had a 70% probability of going up and 30% probability of going down. However, let us say that it would go up by 1% on average, while it could go down by an average of 10%. What would the reader do? Is the reader bullish or bearish? Bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no experience in handling risk. Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration.

The best description of my lifelong business in the market is “skewed bets” that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage. Why are these events poorly valued? Because of a psychological bias. One such rare event is the stock market crash of 1987, which made me as a trader.

Many traders aim to get out of harm’s way by avoiding exposure to rare events – a mostly defensive approach. I am far more aggressive than those traders and go one step further; I have organized my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets.

THE ERA OF FICTITIOUS CAPITALISM

What could possibly interest us about a Chinese bureaucrat’s white paper on impending global war? First of all, his conclusion: “In the last century”, writes Wang Jian, “American people were pioneers of system and technology innovation. However, the interests of a few American financial monopolies now lead this country to war. This is such a tragedy for the American people.

“Clouds of war are gathering. Right now, the most important things to do for China are: 1.) Remain neutral between two military groups while insisting on an anti-war attitude. 2.) Stock up in strategic reserves 3.) Get ready for a short supply of oil 4.) Strengthen armament power 5.) Speed up economic integration with Japan, Hong Kong, Korea and Taiwan...” It is a rather unsettling idea. China as the neutral power in a war between the United States and a united Europe. How did Wang get there?

Wang’s argument in a nutshell: By the mid 1970s, the United States, the United Kingdom, France, Germany, Italy, Japan and other major capitalist countries had completed the industrialization process now underway in China. In 1971, when Nixon closed the gold window, the Bretton Woods system collapsed, and the dollar – the last major currency to be tethered to gold – came unstuck. Economic growth as measured by GDP was no longer restricted by the growth of material goods production. Toss in a few financial innovations, like derivatives, and the “fictitious” economy assumed the central role in the global monetary system.

From 1985-2000, production of material goods in the United States has increased only 50%, while the money supply has grown by a factor 3. Money has been growing more than six times as fast as the rate of goods production. The results? Wang’s research reveals that in 1997, before the blow-off in the U.S. stock market, mind you, global “money” transactions totaled $600 trillion. Goods production was a mere 1% of that.

Back to Wang: “In the era of fictitious capitalism, a fictitious capital transaction itself can increase the ‘book value’ of monetary capital; therefore monetary capital no longer has to go through material goods production before it returns to more monetary capital. Capitalists no longer need to do the ‘painful’ thing – material goods production.” Derivative instruments, themselves a form of fictitious capital, help investors bet on the direction of capital prices. And central banks, unfettered by the tedious foundation set by the gold standard, can print as much money as is required by the demands of the fictitious economy. You can, of course, trade the marginal values of these fictitious instruments and do quite well for yourself.

Wang sees a darker side to the equation. “Fictitious capital is no more than a piece of paper, or an electric signal in a computer disk. Theoretically, such capital cannot feed anyone no matter how much its value increases in the marketplace. So why is it so enthusiastically pursued by the major capitalist countries?” The reason, at least until recently, is that the “major capitalist countries” have been using their fictitious capital to finance consumption of “other countries’” material goods.

Here we arrive at the crux of Wang’s argument that a war is brewing: “While [fictitious capital] has been bringing to America economic prosperity and hegemonic power over money, it has its own inborn weakness. In order to sustain such prosperity and hegemonic power, America has to keep unilateral inflow of international capital to the American market... If America loses its hegemonic power over money, its domestic consumption level will plunge 30-40%. Such an outcome would be devastating for the US economy. It could be more harmful to the economy than the Great Depression of 1929 to 1933.”

In the era of fictitious capital, Wang surmises, America must keep its hegemonic power over money in order to keep feeding the enormous yaw in its consumerist belly. Hegemonic power over money requires that international capital keep flowing into the market from all participating economies. Should the financial market collapse, the economy would sink into depression. America’s reigning financial monopolies, he believes, (whoever they may be), would not stand for it.

JEREMY GRANTHAM, BILL GROSS GLOOMY OVER TROUBLES AND BUBBLES

Here is a handy way for optimistic investors to test the strength of their convictions: Spend an hour or two perusing the latest comments of two widely respected money managers, Jeremy Grantham and Bill Gross. Gross’s views are so glum he himself speaks of them as “the economics of despair”. Grantham says the history of investment “bubbles” argues for a drop of about 35% in the Standard & Poor’s 500 Index, on top of the 40% slide already endured in 2000-02.

“Asia has hollowed out our manufacturing base and is now making inroads into services,” says Gross, chief investment officer at Pacific Investment Management Co. in Newport Beach, California, where he oversees $415 billion including the biggest bond mutual fund. “We can’t really educate or innovate our way out of this.” In the circumstances, Gross says, the Federal Reserve will have to hold interest rates very low. “While that keeps the patient/economy breathing, it leads to asset bubbles, potential inflation, and a declining currency over time,” he says.

Grantham, chairman of Grantham, Mayo, Van Otterloo & Co., a Boston-based manager of $66 billion in mostly institutional money, says “the current U.S. equity bubble” is the 28th he found combing through the history of currency, commodity and stock markets. All the other 27 bubbles, he says, “broke and went back to the pre-existing trend”. For the S&P 500 to do the same now, he calculates, it would have to hit 720, compared with a recent level above 1100. “Everything important about markets is mean-reverting or, if you prefer, wanders about a trend,” he says. “Prices are pushed away from fair price by a series of ‘inefficiencies’, and eventually dragged back by the logic of value.”

One of those inefficiencies, says Grantham, is a phenomenon called herding, which occurs among both individual and institutional investors. In a highly specialized institutional world where managers are measured almost microscopically against benchmarks, Grantham says, “refusing on value principles to buy in a bubble will look dangerously eccentric. This has guaranteed increasingly larger and longer market distortions.”

Gross gives us an external reason – Fed policy – to figure on bubbles as a continuing part of the investment scene. Grantham gives us an internal reason, forces in modern financial life that reinforce the human tendency to “buy because others are buying”. If bubbles are so readily apparent, and so dangerous, why are more investors not fleeing them? “The problem with bubbles breaking and going back to trend is that some do it quickly and some slowly,” Grantham writes. He says the time spans of past bubbles he examined ranged from three minutes to 18 years. A simple strategy of staying away when bubbles threaten poses problems for many people who need to invest within a limited period of years – before the children are ready for college or it is time to retire.

So what to do? Investors can heed Grantham’s advice to “lower risk and survive to fight another day”. Those who do not agree with his assessment of the situation can still take his view into account by submitting their investments to a Grantham-style crash-test. How would the investment plan look, and how would the investor feel, if the stock holdings were marked down by 35 or 40%? Given one’s age and circumstances, how much time would the plan have to try to recoup the losses?