Finance Digest for Week of November 15, 2004

THE CLASSIC APPROACH TO PICKING STOCKS

Money manager Robert P. Morgenthau, scion of an old New York family, has an appreciation for things of the past. And one of them is key to how he assesses stocks: return on equity, a concept swathed in faded elegance. Its many detractors say this classic metric, which divides net income by shareholders’ equity, had more relevance when U.S. companies were all about hard assets like factories and stock-in-trade. Today, they say, accounting distortions make the ratio useless. The number can be artificially inflated by writedowns or share buybacks that reduce the denominator. The ratio shifts downward in a takeover, when intangibles like brand names and patents get thrown onto the acquirer’s balance sheet as “goodwill” and thereby expand the acquirer’s equity.

But to Morgenthau, 47, old-fashioned ROE is a better investment tool than betas, style boxes or any of the mumbo jumbo that fellow managers throw around. It is the first metric his firm, NorthRoad Capital Management, uses when picking large-company stocks (minimum market capitalization $10 billion) for its $1.2 billion of individual and institutional money. NorthRoad screens for companies with an average annual ROE of 10% for the last five years and a high degree of consistency in the number. Recognizing the limits of ROE, Morgenthau inspects the metric’s constituent parts to ensure he is not getting a fake reading.

Another caution: ROE mixes balance sheet and income statement items, so two radically different companies can have the same number. That is why a company with low profit margins can easily goose ROE by loading up on debt or buying back stock. Conversely, a company with no leverage can look mediocre on an ROE basis even if it has fat margins and a ton of cash. Once Morgenthau has screened out the ROE clunkers, he turns to a good cross-check: a look at the gross profit margin (sales minus cost of goods sold, divided by sales) and EBIT margin (earnings before interest and taxes, as a percent of sales).

By Morgenthau’s reckoning, the utility of ROE is that it measures the skill of a business in deploying capital. “A dollar of capital doesn’t know what business it’s being invested in, and it doesn’t care,” he says. “We don’t want to own a stock just because it’s a member of a certain industry or in a certain index.” Consistency is also important in Morgenthau’s book. Companies that have consistently high return on equity tend to be clustered in less cyclical industries such as pharmaceuticals, consumer products and financial services.

THE COMING MELT-UP IN STOCKS

The postelection rally of November is just a down payment on what should be a terrific market for stocks in 2005. Next year will be a lot like 2003, when the S&P 500 index was up 28.7%, dividends included. I have to confess that in my columns last spring I was expecting a strong second half of 2004 and was wrong. But that makes me more optimistic for 2005. We get part of what should have been the 2004 rally added to 2005.

Nowadays everyone has heard that the first year of the term of a President, even a returning one, is typically weakest of the four. This oft-quoted statistical fact is misleading. It is true that the average of all first years is low (from 1929 to 2001, the 19 first years have averaged a total return of 7.5%), and in 10 of these the number was negative. But look more closely. In the 9 first years with gains, the gains have been big, averaging 28.4%. I think next year will fall into the gain column and that it will fit the pattern by being big -- up 30% or more.

What is the significance of Bush’s victory? The last century demonstrates exceptional variability of returns in the year after Presidents have been reelected. The negative years span from negative 35 to negative 10.8% in 1957. The lowest positive year was 12.5% in 1965. There was no middle ground between. You get the uglier numbers like negative 35% after Roosevelt’s 1936 victory and 25% down after Wilson’s 1916 reelection. And the 30-plus-percent up years after Coolidge, Reagan and Clinton. Ugly or awesome? I bet the latter.

GOVERNMENT INVENTORY ADDTIONS HAVE ADDED AT LEAST $10 TO THE PRICE OF OIL

Oil prices have more than doubled since 2001, hitting $55 per barrel in mid-October. This price surge has produced a great deal of handwringing and gloomy predictions. Doomsters claim that output simply cannot keep up with demand -- that we have entered a new era of permanently high oil prices.

Before we jump on this bandwagon, let’s take a look at the price behavior of WestTexas intermediate crude oil. If we adjust prices to today’s dollars, the average oil price from 1988 through October was just under $28, and 95% of the time the price fell within a range of $14 to $41. During the past 15 years oil prices were outside this range on only three occasions. During the Asian financial crisis of 1998 prices briefly slipped below the low end of the range, and on two other occasions they pierced the upper end. The first occurred in the run-up to the first Gulf war. Thanks to George H. W. Bush’s order to sell crude from the government’s Strategic Petroleum Reserve, prices did not stay high for long. The second unusual price upsurge began in late 2001 and has left current prices well above their ordinary range. Will they stay there or once again fall back toward the average?

To answer this question we must understand what pushed prices so far this time around. There is no doubt that robust demand growth (the China-India factor) and capacity problems (most recently, those inflicted by Hurricane Ivan) have played a role. But that well-worn story is incomplete. What is missing is the inventory story. The government’s weight in the market for storage has been significant in pushing prices to such extraordinary levels. I estimate that the government’s buildup of oil stocks has added at least $10 to the price of a barrel. The good news is that the government’s reserve is scheduled to be at full capacity in May 2005.

It turns out that this inventory story is already in the market. Quotes for oil futures contracts are lower than today’s spot price. Traders expect the price of oil to decline and return to its ordinary range. These traders, playing for real money -- rather than for quotation in the newspaper -- do not buy the notion that we have entered a new era of permanently high oil prices.

Analysts say wide oil price swings could become the norm.

As crude oil shortages caused by a string of September hurricanes have begun to ease over the last month, oil consumers have gotten a break. In just a few weeks, prices have fallen $9 from record highs above $55 a barrel. But the latest supply numbers include some ominous signs that prices could soon be headed higher again -- especially for heating oil and diesel fuel. And with global demand for oil pushing the limits of world production capacity, these large, sudden price swings may become much more common, analysts say.

DOWN AT THE DOG POUND

There are good reasons why junk bonds should have become more expensive than they were in, say, the autumn of 2002, when the interest-rate “spread” on junk over Treasuries reached ten percentage points or thereabouts (the number is pretty meaningless because there was not any trading to speak of). Since then, the nightmares about the financial health of corporate America have disappeared as the economy has been bathed in sunlight, profits have risen and companies have apparently become sharply less indebted. Junk-bond defaults have fallen from a peak of 10.5% of all issuers in the year to March 2002, to 2.3%. These are the respectable reasons for bidding up the price of junk. The bad reason is that it offers a sniff of yield in a world where returns are hard to come by. It is a bad reason because thhose snapping up the bonds at their current derisory yield are not being rewarded for the risks they are taking.

The highest-flying markets in recent weeks have been for bonds issued by the least creditworthy companies: those rated B and lower. (For comparison, the highest is AAA and D stands for default.) The Merrill Lynch index of B-rated corporate bonds now yields 7.4% -- a quarter of a point less than a month ago, even though Treasury-bond yields are higher. Just how unlikely investors are to get their money back can be gauged by the default statistics that the rating agencies produce. According to Standard & Poor’s, a bit more than 13% of issuers with a rating of B- or less will default within a year, and 39% of them within five years. For those with a rating of CCC the figures are 30% and 53%. According to S&P, 85% of junk bonds issued so far this year have a maturity of more than seven years. Chances are, in other words, that anyone hanging on to such bonds until maturity will not get their money back.

Some investors might think they have a better chance of being repaid than those numbers suggest, because of the decline in defaults. But S&P points out that when issuance of bonds with a rating of B- or lower exceeds 30% of total junk-bond issuance for any length of time, defaults pick up within a couple of years. So far this year, the figure is about 40%. Issuance of CCC bonds accounts for some 12% of junk issuance. That should surprise no one: supply has risen to meet demand. What self-respecting finance director would shun an opportunity to issue extraordinarily cheap debt to eager punters? At some point, however, the cycle will turn, the economy will slow, defaults will rise, appetite for risky bonds at suicidally thin spreads will evaporate, and investors will wish they had not visited the local dog pound.

Junk Alert

Bond market history teaches us that the mighty can be brought low. As recently as 1980 Standard & Poor’s gave AAA ratings to both General Motors and Ford Motor. Right now the two are BBB-, one notch above junk. The way things are trending lately, I believe that at least one rating agency will downgrade the auto giants to junk by this time next year. But do not let that stop you from buying Ford’s and GM’s bonds, with their nice yields.

What is gone wrong with the big two car companies? Just about everything: loss of market share, humongous retiree costs, union difficulties, restructuring, rising raw materials prices, excessive inventory, lackluster new products. And what is right with them? They are big car companies, and they will not disappear. These guys may be sick, but they are far from dead. They still have strengths, particularly tremendous liquidity -- huge amounts of cash, marketable securities and bank lines. Plus, their finance units are profitable; indeed, they carry the parent companies.

At a time when decent bond income without scary risk is scarce, the automakers’ yields look enticing. If you hold the bonds, do not panic and sell them, since the prices likely will recover after a few months when people see the auto firms are not doomed. Not every GM or Ford issue is a buy. Avoid creatures called Smart notes or Direct notes. These are usually loaded with fees and trade at significantly lower yields than the larger issues. And there is poor liquidity.

THE TRADE WILDCARD

The politicization of trade frictions and the heightened risks of protectionism could well be a major wildcard for the global economy in 2005 and for years to come. In large part, today’s U.S. trade deficits are made in Washington -- not Beijing. Lacking in private saving, outsize U.S. budget deficits are leading to ever-widening current-account and trade deficits. Try telling that to your favorite politician! Unfortunately, with the Bush Administration likely to exacerbate the long-term budget deficit problem with its penchant for permanent tax cuts, the current account and trade problem is undoubtedly here to stay. Unwilling to accept responsibility for the role it plays in creating this problem, Washington has opted to pin the blame on the politically expedient scapegoat -- China. This, of course, borrows a page right out of the script of the late 1980s, when Japan was the scapegoat of America’s last episode of twin deficits. Unfortunately, the risks today are far greater than they were back then. Not only are global imbalances on a much greater scale, but job-related angst is a far more potent political force. Now that the US presidential election is over and the “free-traders” have won, there is great temptation to breathe a sigh of relief. Don’t take too deep a breath.

THANKS TO ARMS, MORTGAGE HOLDERS ARE IN DOUBLE TROUBLE

Double. That is basically what interest rates were in November 1994 vs. today. That was also the last time Americans were taking out adjustable-rate mortgages at today’s record pace. Back then, when the 10-year Treasury yield was about 8%, ARMs made sense. At today’s 4% level, such a choice is plain disturbing. The Mortgage Bankers Association reported last week that the percentage of new loans being written with adjustable rates hit 35.3% in the week ended Nov. 5, matching the 1994 record.

I am just thinking out loud here, but this may not be one of those records we would want to cheer about. Try as I might, I cannot grasp the concept of consciously taking on a payment you know is going to rise. Maybe I just do not get it. Maybe I am behind the times.

SMR Research in New Jersey specializes in consumer finance research. George Yacik, vice president of SMR, cites ingenuity in the mortgage industry as the reason ARM volume is perversely rising in the face of rising rates. “A lot of the reason is lenders are trying to keep up their loan volumes,” he said. “That means getting as many people qualified to buy as much home as they possibly can.”

Problem is, many of these new-fangled loans have yet to be tested outside some number cruncher’s office. In fact, no study can correctly predict the Armageddon scenario I fear. And why is that? Inflation-adjusted home price appreciation the likes of which we are experiencing in the current real estate cycle has never been documented. Not in the 1980s. Not in the 1920s. Not ever.

INVESTORS MUST STAY VIGILANT FOR BOOKKEEPING PRACTICES THAT MASK A COMPANY’S TRUE CONDITION

Such is the advice of 37-year market veteran Robert A. Olstein, astute stockpicker and overseer of the Olstein Financial Alert fund. As Mr. Olstein explains, accounting rules require a lot of estimates, and that gives considerable wiggle room to company managers. “All corporations use some aggressive assumptions in the application of generally accepted accounting principles as management is heavily incentivized to make the numbers,” he said. “When the numbers deviate from economic reality, you have to adjust them before reaching conclusions about future estimates and valuations.”

While not every investor can pick apart financial statements the way Mr. Olstein can, they still have to be on guard. To illustrate how managers’ assumptions can lead investors astray, Mr. Olstein cited two examples. In one case, the deviations from economic reality translate to an overpriced stock; in the other, an underpriced stock.

THE BUSH BOUNCE

The American stockmarket’s verdict on the election was plain: hooray for George Bush. When early exit polls on November 2nd suggested that John Kerry would become president, equity prices dropped. They changed course abruptly once the true result emerged: according to a survey of 40 hedge funds by International Strategy & Investment, a research firm, these investors went from net short to net long as soon as the election results became clear.

A week later, the market had not given up its gains. A surprisingly good jobs report on November 5th, indicating that non-farm employment had risen by 337,000 in the previous month, did the market no harm at all. And share prices were never likely to be perturbed by the Federal Reserve’s decision, on November 10th, to increase the federal funds rate by a quarter-point, to 2%. The Fed’s plans had been clear long before, and the rise had been priced in. Indeed, several further increases are generally expected.

By and large, Mr. Bush’s re-election has been good news for companies that benefit from increased public and private spending, friendly government and low taxes -- most companies, in other words. The gainers include department stores, health care and defence (see chart), along with heavy machinery, air freight and industrial metals. Stocks with large dividends also rose strongly, reflecting a belief that under Mr. Bush taxes on capital will be lower than they might have been under Mr. Kerry. Only two sectors have slipped. One is energy, perhaps because Mr. Bush would allow more drilling in America and thus boost supply. The other is textiles, possibly because Mr. Bush seems keener on free trade than Mr. Kerry.

Furthermore, it could be that investors were quite happy with continuity. The American economy is not in noticeably poor shape. Growth is pretty strong. Inflation is low, though showing some signs of rising. Unemployment, at 5.5%, is a little lower than when Bill Clinton was re-elected in 1996. Corporate profits have risen by 75% over the past three years and profit margins are approaching their highest in three decades. Interest payments as a percentage of GDP have fallen back to the levels of the early 1980s, before junk bonds and highly leveraged acquisitions became popular and made it easy for companies to pile up debts.

There is more. Although the Bush administration is not perceived to be especially close to Wall Street, it is seen as a friend of business. Thus the election relieved the market’s concerns that new taxes would be imposed. Looking ahead, the sinking dollar should be a fillip to American exporters, but it will also add to inflationary pressures. Household savings are low: if these have to rise, then consumers will spend less. Corporate earnings are still growing strongly, but the pace is fading. America has a huge government budget deficit that can only be reduced by extraordinary economic growth, higher taxes or spending cuts. Worse still, Mr. Bush shows little inclination to plug it. And after the markets’ brief burst of post-election euphoria, they will have to look ahead to what he might do in his second term.

DOLLAR’S DECLINE IS 2004’S DEFINING MARKET MOVE

It is time to dust off a remark John Connally made about the dollar when he was Richard Nixon’s U.S. Treasury secretary. “It’s our currency, but it’s your problem.” Three decades later, the problem is back. After years of ignoring U.S. deficits, the currency market is using the trade and current-account figures as a reason (excuse?) to whack the dollar to a record low against the euro and a seven-month low versus the yen. The biggest worry for European and Japanese officials is not just the extent of the dollar’s slide. It is the conspiracy theory doing the rounds that says the U.S. would like nothing more than to see a sustained slide in its currency.

Are the conspiracy theorists correct? Is a unilateral policy of benign dollar neglect by the U.S. administration set to inflict shock and awe on the financial markets? A look at the motivations of the four most interested groups should help determine how willing the U.S. might be to let the dollar extend its slide.

The dollar is down, but should anyone care.?

It sounds eerily like the worst economic nightmare for President Bush’s second term. Bogged down in a costly war that shows no sign of ending, the United States faces a gaping budget deficit and ballooning foreign indebtedness. The dollar plunges against other major currencies, while turmoil in the Middle East sends oil prices soaring. The rest of the decade is plagued by rising inflation, increased joblessness and sky-high interest rates. But the president under fire was Richard M. Nixon -- not George W. Bush. The war was in Vietnam, not Iraq. And the dollar crash was in 1973 rather than 2005.

Could it happen again? With the dollar down more than 40% against the euro since 2002, and hitting new lows since Mr. Bush’s re-election, economists are debating whether America’s foreign indebtedness could lead to a collapse in the dollar and a global financial crisis.

The U.S. is spending nearly $600 billion more a year than it produces, almost 6 percent of its annual gross domestic product. Much of that spending has been financed by Asian governments, which bought more than $1 trillion in Treasury securities and other dollar assets in the last two years to help keep the dollar strong against Asian currencies. Many analysts expect the financing gap to widen and the dollar to decline further. But there are at least three schools of thought on whether a dollar collapse is likely and, if it happens, what it would mean.

The U.S. never had a “strong dollar” policy.

When Treasury Secretary John Snow once again indicated the U.S. would not attempt to stem the dollar’s slide against the euro, the U.S. currency fell another notch. Analysts and European politicians complained about U.S. indifference to its responsibilities. Who is kidding whom here? What is it the Europeans would like to see the U.S. do?

A quick glance at the trade statistics shows that the dollar’s decline actually has not hurt Europe very much so far. The inevitable pain associated with capping and shrinking the huge U.S. current account deficit really is yet to come, and there is nothing the U.S. can or should do to try to prevent it. Such endless fixation of foreign-exchange markets on whether the U.S. will continue to hew to a “strong dollar” policy is bizarre and always has been bizarre, because there has never been such a policy.

Typically, the value of a currency is determined primarily by a nation’s monetary policy. However, only on rare occasions -- and none of them recently -- has the Federal Reserve given significant weight to the dollar’s value in making its interest rate decisions. Certainly it is not doing so today, and neither Snow nor any of his recent predecessors have pressed the Fed to act to support the currency. As for fiscal policy, which can affect national savings and has an indirect impact on the dollar’s value, you can be sure that the dollar’s value has not had any effect on the tax and spending choices made by President Bush or Congress.

In some ways, the puzzle has been why the dollar has not fallen faster and further, given the rapid expansion of the U.S. current account deficit to almost 6 percent of GDP and the need to shrink it. That process unavoidably will involve a big drop for the dollar.

LAWRENCE SUMMERS COMES CLEAN ON THE U.S. CURRENT ACCOUNT

Suppose they had a bond auction and everybody stayed home? We had a variant on that theme a few months ago. During a routine sale of U.S. Treasury bonds in early September, one of the essential pillars holding up the economy suddenly disappeared. Foreigners, who had hitherto been regularly buying nearly half of all debt issued by the U.S. government stayed home on September 9th. To be sure, the foreigners returned in force at the next Treasury auction, and the 9th was quickly dismissed as an aberration, but the episode demonstrated something we have repeated on these pages ad nauseum: the extent to which the U.S. remains dependent on the kindness of strangers in terms of sustaining its very way of life. We have posited the notion that a buyers’ strike, a foreign creditors’ revulsion, could arrive as a sudden thunderclap of financial crisis -- spiking interest rates, swooning stock market and crashing home prices, a scenario which will not seem so absurd if we have a few more days like September 9th.

A few wise heads in finance, like billionaire investor Warren Buffett, have sounded the alarm -- Buffett refers to the U.S. as “Squanderville” and has openly acknowledged shifting billions offshore into foreign currencies for safety. But for the most part, political leaders, monetary officials, and leading businessmen and financiers have remained silent on these dangers. ... Which is why we found former U.S. Treasury Secretary Lawrence Summers’s recent discussion of the issue so germane. At the 2004 Per Jacobbsson Lecture this past October 3rd, The US Current Account Deficit and the Global Economy, Summers addressed the question of global imbalances and the US current account deficit. Liberated from the constraints of active political life, he forthrightly addressed all of the relevant controversies surrounding this area.

Amongst Americans, Summers, now President of Harvard, is probably uniquely positioned to comment on the issues raised, given his earlier role in diagnosing the disease of debt trap dynamics in the emerging world when he was chief economist at the World Bank and his later contribution to the very same symptoms in the U.S. through the continued embrace of Robert Rubin’s strong dollar policy when he succeeded the latter as Treasury Secretary in 1998.

Implicit within Summers’s analysis is that the status quo between Asia and the U.S. will therefore go on until either Beijing or Tokyo conclude that the pain associated with ending it are outweighed by the costs of continuing it. Unfortunately for the U.S., creditor nations, such as China or Japan, naturally have the upper hand, like any banker who can call the loan when he sees the borrower is hopelessly mired. Such is the inevitable state of a country now subject to the vagaries of what Summers terms “international vendor financing”, which has steadfastly refused to pull back from profligate consumption and resign its role as “buyer of last resort” for the global economy. With foreign central bankers showing increasing signs of “buyers’ fatigue” in the U.S. Treasury market, the day of reckoning for the U.S. economy approaches ever nearer.

The Armageddon Foil

Spinning a tale of global imbalances does not exactly make me the most popular person in the investment community. There are, in fact, three possible endgames that can spin out of the global rebalancing framework: For starters, I could be dead wrong in worrying about global imbalances. After all, many believe that a “new symbiosis” has emerged between American consumers and Asian producers and financiers. All it takes is the vision of an expanded dollar bloc, and imbalances quickly vanish into thin air. The crisis is at the other end of the spectrum -- probably triggered by a foreign buyer’s strike of US Treasuries that would then spark a dollar crash and a spike in U.S. interest rates. But there is a third alternative -- the in-between outcome of a measured venting of global imbalances that need not be associated with a wrenching crisis. In my view, the measured venting outcome is the most likely of the three possibilities. That would entail a managed but sustained decline in the dollar, a gradual increase in real U.S. interest rates, a moderation of growth in interest-rate sensitive components of US domestic demand, and a related rebuilding of private saving. It would also require a regeneration of domestic demand elsewhere in the world -- gradually transforming Asia and Europe from savers to spenders.

The Armageddon foil -- focusing on but ultimately dismissing the low-probability crisis alternative -- effectively sweeps all of the above concerns under the proverbial rug. My own view is that the odds are now shifting in favor of the measured-venting strain of global rebalancing -- a more optimistic stance than I have previously held. Three factors recently have come into play that have encouraged me -- moderating oil prices, a lower likelihood of a China bust, and the dollar decline. For a lopsided, U.S.-centric global economy, a weaker dollar is the most important relative price shift that needs to occur. While I am encouraged that such a shift now appears to be under way, there is still a long way to go in defusing the tensions of a severely unbalanced global economy.

THE SOUND ECONOMY OF 1929

Sunday, October 24, was the 75th anniversary of Black Thursday, the worst day of the 1929 Wall Street crash. Looking back from 2004, one is struck by how reasonable was 1929’s stock market valuation, how sound was 1929’s U.S. and world economy. At the peak of the 1929 bubble the market’s P/E ratio was 13.5 times. Radio Corporation of America, that era’s premier glamour stock -- its Cisco or Google -- sold for a princely P/E ratio of 28 times. The entire stock market had a total valuation of around 85% of GDP, compared with 180% of GDP at the peak of the 2000 bubble and about 95% of GDP today.

In the economy as a whole, GDP had increased by 15.3% in the 4 years to 1929, almost 4% annually, while inflation had hovered around zero. The U.S. ran a persistent trade surplus, but had a healthy savings rate, and a substantial Federal budget surplus, even after tax cuts, throughout the late 1920s. In the corporate sector, balance sheets were strong. Brokers’ loans, so frequently cited as an immediate cause of the collapse, totaled less than 10% of the value of outstanding stocks; 86% of the increase in bank credit in the 4 years to 1929 went to this dubious purpose, but that was still less than 8% of GDP.

Domestically, therefore, the U.S. economy of 1929 was less overvalued and far better balanced than that of today, with President Calvin Coolidge and Treasury Secretary Andrew Mellon’s fiscal and economic policies having been enormously superior to those of either President Bill Clinton or President George W. Bush. Internationally, the picture was less serene. Nevertheless, internationally as well as domestically, economies in 1929 seemed to be in decent shape, and there was no obvious reason why recovery should not continue. The U.S. stock market was only modestly overvalued, and any crash, being smaller in terms of GDP, should have had a much less deflationary effect than the relatively larger drops we have seen in 1987, 2000-02 or 1990s Japan. So what went so terribly wrong, and what can we learn from the disaster that followed? That, ladies and gentlemen, there is not the slightest reason why it cannot happen again.

MONEY MANAGERS TAKE TOO MANY CHANCES TO SATISFY THE PUBLIC’S UNREALISTIC EXPECTATIONS

When I started out in the investment business in 1982, most money was run by banks and investment-counseling firms. I was part of the latter community. Back then, I believe that the investment world tried to act pretty responsibly. They really did worry about risk, viewing the money entrusted to them as though it were their own. One reason I left the investment-counseling business in late 1995 (in addition to my concerns about what Fed chief Alan Greenspan was doing) was that I could see the more reckless contingent was going to get the upper hand. As the public started to take charge of their money and turned it over to mutual funds, I realized that this development would create an environment where my concept of the best way to run money would not be particularly successful. In other words, there was no way I was going to be at the top of the performance sweepstakes, which is what folks demand.

I believe that the behavior of the public helped drive the mutual-fund industry to the sort of gunslinger mentality that prevailed in the late 1990s and early 2000, where all the money flowed to the zaniest money managers who put up the biggest numbers. That mentality is similar in the hedge-fund community, where money has moved over the last few years. (It can be argued, however, that some of these people have actually put some of their own money at risk. So, they behave in a somewhat saner fashion.) The bottom line is that we have bred a much more speculative, trading-oriented investment community. Instead of worrying about losing money, the overwhelming majority worries that they will not perform well enough on the upside. The fear of getting fired for not having made enough is the driving factor.

Respected investment strategist Jeremy Grantham, chairman of Grantham, Mayo, Van Otterloo & Co., described this brilliantly: “In markets where investors hand over their money to professionals, the major inefficiency becomes career risk. Everyone’s ultimate job description becomes ‘keep your job’. Career risk-reduction takes precedence over maximizing the client’s return. Efficient career-risk management means never being wrong on your own, so herding, perhaps for different reasons, also characterizes professional investing. Herding produces momentum in prices, pushing them further away from fair value as people buy because others are buying.” That, ladies and gentlemen, is a perfect description of what the professional money-management business has become.

I fully believe that we will eventually revert to a more conservative environment. But I think the only way that can happen is through some sort of a market dislocation, as I have been discussing for at least the last six months. Though it has not yet occurred, I still think it will at some point. I just do not see how the structure presently in place can unwind in anything but a violent manner that involves some dislocation.

ADVICE FROM A BEAR: PANIC

Jeremy Grantham, Boston’s most famous investing bear, exudes a kind of reassuring calm when he tells you that he has seen the stock market’s future, and it is a train wreck. The chairman of Grantham, Mayo, Van Otterloo, warned institutional clients in the late 1990s that the stock market was headed for a dangerous fall. He was early, which cost his firm big business, but ultimately right. His current warning is a different kind of bitter pill.

“We’re faced with the most broadly overpriced asset class mix of my career, 35 years, and if I had a 50-year career, I think it would still apply,” Grantham says. Grantham saw the market top of 2000 as perilous because investors could lose huge sums of money betting on growth stocks, but there were plenty of other types of assets that traded at bargain prices. Today, he believes the potential fall is not so steep, but there is hardly anyplace to hide. The hiding holes of 2000: bonds, real estate investment trusts, and value stocks. Try to find similar opportunities today.

In its most recent quarterly letter to clients, Grantham’s firm outlined a strategy for superior relative performance, faring better than the rest of the pack or an index. But what if the objective was actually to make money? “Our summary advice on an absolute basis is much more painful to deliver though shorter: PANIC,” the letter said. “Now is the time to lower risk and survive to fight another day with your assets as intact as you can manage.” Where to go? Grantham suggests emerging-market stocks and timber for institutional clients. He tells them to hold bonds with shorter durations and conservative stocks with a tilt away from US securities.

The firm paid a price for its dire stock-market warnings and conservative asset allocation beginning at the end of 1997. “We never lost any business for 18 years, and then we lost 45% of our book of business in 2 years,” Grantham says. The firm shrank to about $20 billion dollars in assets under management by early 2000, losing big in one of history’s great bull markets, but has since climbed back to manage $70 billion. But the comeback has been built on a similarly gloomy message. Grantham says the Standard & Poor’s 500 stock index should logically bottom out at 725, from its current level of 1,183, though he will not venture a guess about when.

Grantham has been right before, but he has also been wrong on other market calls. And getting it right at the wrong time can be expensive, too. Many of Boston’s best money managers disagree with Grantham’s warnings today, but they take the messenger very seriously.

POKING HOLES IN THE 2005 PROFIT PICTURE

If past is prologue, corporate profits could show little or no growth in 2005. While few analysts have espoused this view, history shows that it could happen if economic growth decelerates as expected and profit margins decline from peak levels. Official forecasts put earnings growth at 10.6% next year, down from about 19% growth in 2004, according to Thomson First Call. But the conditions for a much softer number could be in place.

Economists surveyed in the Blue Chip Economic Indicators newsletter recently predicted that GDP would slow to around 3.5% next year from 4.4% this year, as consumer spending moderates amid higher interest rates. Meanwhile, many analysts say very strong profit margins are unsustainable. Pretax profits as a percentage of GDP, adjusted for inventories and capital consumption, were sitting at 10.1% in the second quarter, up from a low of 7% in the third quarter of 2001 and above the 35-year average of 8.4%.

“The level is very high by historical standards and the run-up over the past three years is rare,” said Ron Wexler, an economist at Merrill Lynch. If a deceleration in profit margins and a slowdown in the economy were to coalesce next year, the implications for earnings could be profound. Whenever these two events have coincided in the past, profit growth tended to flatten out or even decline.

KPMG WILL NOT SIGN OFF ON FANNIE MAE’S FINANCIAL STATEMENTS

Mortgage giant Fannie Mae, which is currently embroiled in an accounting scandal, missed its second deadline for filing its quarterly financials after its outside auditor, KPMG LLP, would not sign off on the report. The nation’s largest mortgage company also stated that if it does not qualify for hedge accounting for all quarters going back to January 1, 2001, it would report a $9 billion loss on its derivative transactions. In addition, Fannie Mae revealed -- for the first time, according to the Associated Press -- that its methodology for performing certain calculations for 2001 and 2002 “was not consistent with GAAP”.

U.K. HOUSING CRASH FEAR DRIVES DOWN PRICES

The housing market is suffering its worst downturn since the tail-end of the 1990s property crash, a leading industry body has warned. The Royal Institution of Chartered Surveyors (Rics) says the market is in the grip of a vicious cycle as mounting speculation of a property crash conspires to drive down prices. It says the number of surveyors reporting a fall in prices outnumbered those seeing a rise by 41% in October -- the lowest reading since December 1992. Although the figure does not directly equate with a fall in property values, it is the latest in a run of industry reports to highlight a fall in prices last month.

Rics says that, “Additional uncertainty has been injected into the market by continued speculation over the potential for more serious declines in prices.” Individual surveyors across the country highlighted growing media speculation as a driving force behind the slowdown. Quentin Jackson-Stops, of Jackson Stops & Staff in Northampton, said buyers had been “spooked” by adverse media comment.

BULGE UNDER THE RUG?

The last several weeks have witnessed declining crude prices, rapidly rising equity markets and one good jobs report. It is off to the races for sentiment and index valuation. Trends picked up steam after the shocking achievement of electing a president within 24 hours of an election. The anticipated Fed rate hike and a horrible trade number spun as positive have heaped fuel on this dreamy brush fire of delusion.

I am fundamentally unconvinced. What follows are my attempts to add company to those yet to be sold on post-election Nirvana. The health of the consumer sector -- roughly 70% of US GDP -- is poor, perhaps some policy Vioxx will dull the pain? Today’s debt weary, and income challenged masses are looking scary as a basis for growth and ever less likely to be able to sustain recent consumption -- let alone increase debt fueled spending. Debt carry costs are on the rise and many face an uphill battle to pay for heat, gas and rising local property taxes. The obvious housing bubble looks to be reaching a terminal swell. Rising rates and falling incomes are mixing with double digit price hikes and foreign stirrings about the wisdom of buying ever more bundled home loans.

Much of today’s bullishness is based on confidence in a consumer dominated economy and the ability of corporate America to make up any shortfalls. While I concur that profits have been stellar, revenues have been less impressive, and the catalysts for rising profits appear temporary. The weakening dollar alongside unpopular foreign policy and massive trade and budget deficits is calling into question the practice of bottomless credit extension to the U.S. state and consumer. There is little room for further corporate tax cuts in these budgets, and precious little justification for loans to consumers. These loans would almost certainly have to involve channeling foreign savings, as we are in short supply here at home.

These are the fundamentals that markets and policy makers have ignored over the past few months and recent rally. There is a large object under the rug. How long before people notice it? Will you notice it crashing down to earth when it snags your foot as momentum and desire propel you head long toward a stumble?

PRIVATIZING SOCIAL SECURITY

According to a recent poll, those young Americans who believe in flying saucers outnumber those who think Social Security will be there for them in their old age, by about two to one. While they may or may not be right about UFOs, the kids’ skepticism about Social Security is completely warranted. Worse, not only will their own money not be there, but during their working years they will be subject to the intolerable burden of having to support the huge demographic bulge that is about to enter its retirement years.

Though everyone in Washington acknowledges the looming crisis, help is decidedly not on the way. Kerry liked the system just as it is, while Bush has proposed only a small tinkering with it. Neither is viable. Unless Social Security is completely overhauled, we will be forced to accept one or more of the following: higher taxes, reduced benefits, transfer of money from other programs, more and more debt. Fortunately, for a true and workable alternative, all we need do is consult one of our neighbors to the south. Meet José Piñera, former Chilean Minister of Labor and Social Security and author of the book, Empowering Workers: The Privatization of Social Security in Chile.

Piñera knows what he is talking about. He was Minister in 1980, at which time Chile’s pay-as-you-go, government-administered system went bankrupt. This system, similar to ours, had been in place since 1925, and was a disaster. Chileans paid up to 25% of their incomes into Social Security, receiving meager benefits upon retirement while providing a good life for politicians. (For example, factory workers could not retire until 65, while members of Congress needed to work for only 15 years before they could collect.) Piñera presided over the transition to something better. The answer was pension savings accounts. These are private property, fully portable, inheritable, and protected from government expropriation (even during wartime) by the Constitution.

Chilean workers contribute between 10 and 20% of their earnings -- based on the first $25,000 of income -- to their tax-deferred pension savings accounts. The contributions are invested in capital markets through private managers, working with guidelines that prohibit highly risky investments. Thus, every Chilean has a direct stake in the national economy. They are an entire nation of business owners. Who decides when to retire? The individual. He or she can decide when to convert the account into an annuity paying 50% of his or her final wages. Work ‘til 80, go fishing at 50, it does not matter. What about poor people? If, by the time they reach retirement age, they do not have not enough capital to buy the annuity, the government will supplement their account so that they can. This is the only place where the government intervenes, and the cost to taxpayers is small.

The transition, of course, was not problem-free, but this was not a short-term project. It required the long view. Most notably, the government had to pay those who were currently retired and collecting. That was not cheap, about 3% of GNP. But the government tightened its belt and used debt financing as needed. There was no increase in taxes, inflation or interest rates. Now, a generation later, the problem has naturally eased, and for the past six years there has been a government surplus of 1-2% of GNP. Soon, there will be no one left collecting under the old system.

MIA: THE “MANLY” MAN

According to a November 9 New York Times column, the gorilla and the “guys’ guy” do have one thing in common: they both are endangered species. Where are all the “Save the Males” t-shirts, you ask? Two words: Maxim Magazine. Known worldwide as the premier periodical in “male” sensibility -- behind the usual bikini-clad cover model, its content ranges from sex to sports to big-screen television sets -- the magazine has experienced its first serious “drop in success” in its 7-year long history.

“We’re the natural habitat for successful American men,” explains Maxim executive. The problem is, that habitat is quickly disappearing due to a disorder called “Mantropy: a spiritual degeneration among men that is indicated by manicures, excessive smoothie consumption, and frequent seaweed wraps.” As a result, the magazine is launching a $1 million ad campaign including “mock petitions” aimed at rescuing the “manly” man from “rollerblading into extinction” in an “effeminate world gone mad.”

Good luck, because this “world gone mad” is actually a world undergoing a major downshift in mass social mood, as reflected in the wave count unfolding in stocks. And no amount of moolah OR manly muscle can tweak the trend in collective psychology once it has turned. If 1960s cowboy icon Clint Eastwood were working now, he would not say, “Go ahead, make my day” to the crew of Queer Eye for the Straight Guy. He would say: “Go ahead, make me over.”

ODDBALL INVESTING

Forrest Berwind “Bill” Tweedy was a strange fellow. No one really knows where he came from or when he was born. And if you saw him today, you would probably laugh. The man wore suspenders, had a bushy mustache and a good-sized potbelly. He never married or had kids. He ate lunch at the same place at the same time every day. He was an oddball, to put it bluntly. And if you happened to walk past 52 Wall Street, chances are, you would see Tweedy working at his cluttered desk -- busy writing letters and looking through company reports. Tweedy’s business was his life. And it was a successful one at that.

He owned a small niche brokerage house that specialized in trading tiny illiquid securities. Day after day, Tweedy scoured the market for publicly traded companies that had between 50 and 150 shareholders on the record. He attended their annual meetings, wrote down all the shareholders’ names and sent them personalized letters. His goal was to find out who wanted to sell their shares and who wanted to buy more. From there, Tweedy paired the buyers with the sellers and brokered the deals himself. It was a brilliant idea.

Bill Tweedy quickly became one of the only small- or micro-cap brokers in New York -- the “broker of last resort”, as he was called by the many shareholders who could not trade their shares anywhere else. Tweedy’s business was successful throughout the 1920s and into the 1930s. Then he got his big break... In the early 1930s, Tweedy developed a client relationship with Benjamin Graham, the father of value investing, and author of now-famous books Security Analysis and The Intelligent Investor -- two of the best primers you will ever find on investing.

Graham (who, among other things, is famous for teaching Warren Buffett the ropes of value investing) proved you could make a fortune investing in companies that were selling for a huge discount to their intrinsic value. Graham looked for bargains -- companies selling for 60% to 70% LESS than they were worth. And it just so happened that many of the small, illiquid companies Tweedy tracked fit Graham’s “value” model simply because they received no coverage on Wall Street and were undervalued. Thanks to their shared investment strategy, Tweedy quickly became Graham’s “go-to” broker. And Graham became Tweedy’s largest customer.

Over the years, Tweedy’s business grew. Howard Browne became Tweedy’s partner in 1945. And the company slowly grew from a simple brokerage house to a full-fledged investment advisory business, which currently manages over $10 billion in assets. Although Tweedy, Browne is now a large money manager, one thing has NOT changed in its 84-year history. The company still looks to buy stocks that are trading for huge discounts to their real worth. Here is how it’s done...

IS SEARS A BLUE LIGHT SPECIAL?

Retailers have been in the spotlight this week. Several large retailers reported earnings this week, but it was the announcement that K-Mart will purchase Sears that captured everyone’s attention. Besides being ailing retailers, both companies share Ed Lampert as their largest shareholder. There has been speculation that Lampert would turn K-Mart into the next Berkshire Hathaway and use the excess cash to purchase other companies. Analysts are mixed on almost every aspect of the merger. By some, it is being viewed as a way to compete with Wal-Mart by becoming a larger force in retailing by allowing it to ask for more price concessions from suppliers. Others view it as a real estate transaction, arguing that by putting together two bad retailers, you do not get one good one. The truth probably lies somewhere in between.

Companies that supply Sears and K-Mart also jumped on the assumption that this would increase the market they sell into. Whirlpool jumped 4.5% and Martha Stewart rose 6.2%. It might not be that easy. If this was put together to rival Wal-Mart, it is likely that the company will demand price concessions from its suppliers. Whirlpool might find it more difficult to implement its price increase planed for the beginning of the year. For those looking at the real estate angle, the company planes to convert several of the existing K-Mart locations to Sears and plans on vacating several of its mall-based locations. Investors were quick to assume that these mall-based stores were worth more than previously thought. If Sears anticipates moving out of malls, this will result in an increase of the supply of mall anchor space. In a recent research note, UBS reminds investors that recent real estate divestitures at May, Saks, and JC Penney have resulted in substantial charges as opposed to hidden upside.

Personal consumption grew faster than overall GDP in 17 of the 23 quarters from September 1997 until March 2003. This was fueled by a constantly diminishing savings rate along with rapid personal debt growth. Retailers reacted by aggressively expanding. Does the K-Mart / Sears merger mark the end of this expansion? Will other retailers start consolidating as growth opportunities diminish? Time will tell, but it seems improbable that the current trend can be sustained for another five years.

WHAT GIVES WITH GOLD -- LONG TERM?

The Bush Bounce continues in the stock market, but gold goes up, too. What gives? Wednesday night, Dow Theory Letters’s veteran editor Richard Russell seemed almost on the point of abandoning his long-held bearishness on stocks. His (grudging) conclusion: “Is the stock market bubble back? Feels to me as though it is. Wild prices going for stocks that offer nothing in the way of dividends, but with all this liquidity, what’s a body to do but buy, buy, and well -- buy.”

But Russell has also been relentlessly, if patiently, bullish on gold. And it has paid off for him. He said, “Gold and gold shares continue higher -- early in their second phase bull market rise. You’ve ridden the bull so far -- stay on his back even though he’ll try his best to shake you off.” Russell’s explanation for the two rallies: “Liquidity, liquidity, liquidity.”

Recently, we looked at the long-run stock market. We concluded that the market was still quite high by historical standards -- the excesses of the 1990s had not been worked off. They are even less worked off now! But we will see. Now we look at gold over the long term.

The remarkable thing about gold is that really has been a store of value. Adjusted for inflation, a dollar invested in gold in 1801 has fluctuated around about a dollar ever since. It has been as low as 59 cents (1970). And it has been as high as $4.26 (1980). Recently, it has rebounded to about $1.45. What drove the gold price down in the mid-20th century, of course, was that Washington fixed its price in U.S. dollar terms. Arguably, the 1980 rebound to $4.26 (over $800 in nominal terms) was an overshoot reaction. What now? Gold is getting into the range that it has occupied for much of its history. In current terms, $500 an ounce would seem a reasonable upper limit. But gold is still far below its 1980 recent peak. On the evidence of these charts, gold is hardly overvalued.

ENERGY FUELS AN INFLATION SURPRISE

So that is where the impact from the oil-price spike was hiding: The overall Producer Price Index (PPI) -- a measure of inflation at the wholesale level -- surged 1.7% in October, according to a November 16 report from the Commerce Dept. The monthly gain was the largest since January, 1990, and well above the economists’ median forecast of a 0.5% gain. Meanwhile, the core index, which excludes food and energy prices, jumped 0.3%, vs. the 0.1% median forecast of economists. The October surge in the overall index explains the mystery of the lack of “follow-through” impact from wholesale energy prices to government inflation indexes. And the size of this number suggests additional upside risk for the month’s CPI report, scheduled for release Nov. 17.

How will the Fed react to this October surprise? The jump in prices will certainly draw the attention of Alan Greenspan & Co. and should keep the central bank on track for another quarter-percentage-point tightening at the December FOMC meeting.

FAITH IN THE TRADING SYSTEM

Born and raised on a New England dirt farm, this young man went on to become the greatest stock trader ever -- and one of the most despised men of his time. He lived through two of America’s most horrible stock crashes -- making millions in a single day, as others jumped from windows to escape financial ruin. At times, he controlled the entire American economy from his posh New York office. He was blamed for the great crash of 1929. He survived death threats and kidnapping plots -- on several occasions. His name was Jesse Livermore. And in 1940, he killed himself with a .32 caliber pistol in a New York City hotel.

Immersed in the wild action of trading stocks at age 14, Livermore gradually began to realize that the market had a life of its own. And he was bent on trying to figure it out. During those lonely years, two realizations formed his entire trading philosophy ... and would make him one of world’s richest men. The first realization was that he had to become a student of the market. He had to commit himself to an ongoing education ... not only of the market dynamics, but also of the personality flaws that caused people to make fatal trading errors. The other realization was that he needed a system -- a set of self-imposed rules that would govern his life as a trader. His belief in a system arose from his detailed observations that the stock market had an inherent logic ... and that it was only through logic that a trader could beat it -- and make a real killing.

Two years into his self-education, Livermore felt confident enough to test his trading theories. He headed straight for the notorious bucket shops of Boston. He won so often he was banned by the bucket shops in Boston. Shut out, he decided to put his skills to the ultimate test. He went to Wall Street. In New York, he quickly made a fortune... but lost it when he strayed from his system. Since he was banned in Boston, he went to St. Louis and then New Haven to rebuild his stake. Finally, he was ready to return to Wall Street to make another killing.

In the summer of 1929, Livermore’s extensive analysis of the market pointed to a disastrous downturn. He just did not know exactly when it would happen. He started shorting the market, his positions growing increasingly larger as Wall Street collapsed around him. The results were amazing. While millions of people waited in soup-kitchen lines, he made a staggering $100 million during the Great Crash of 1929. The millions of investors who had lost everything complained about Livermore. Even The New York Times blamed him directly for the tragic crash. Death threats came directly to his phone line -- and he took them head on, talking his way out of them.

After his $100 million windfall, Livermore lost his passion for trading -- and with it his fortune. No one could understand why -- not even himself. It was not until his legacy had been chronicled that experts understood he had been suffering from clinical depression. But at the time there was only way out for him... a .32 caliber slug to the brain.

Like most great concepts, Livermore’s incredible system was simplicity itself. It involved market timing, quickly cutting losses, anticipating trends and optimizing the market’s momentum (up or down). Livermore was the first trader to actually demonstrate that both a commitment to market understanding, and a bona fide trading system were the keys to making millions in the stock market. And although Livermore is dead, his ideas live on to form the cornerstone of modern stock trading principles.

WHY THE WORLD NEEDS A WEAKER DOLLAR

A $40 trillion world economy is dangerously out of balance and seriously in need of a fix. A decline in the dollar is not a cure-all for all that ails the world, but it should go a long way in sparking a sorely needed rebalancing. That adjustment may now be under way. Global imbalances are a shared responsibility that requires a joint resolution. America is guilty of excess consumption, whereas the rest of the world suffers from under-consumption. Growth in U.S. consumer demand averaged 4% annually (in real terms) over the 1995 to 2003 period, nearly double the 2.2% gains elsewhere in the industrial world.

America’s consumption binge has not been supported by internally-generated income growth. Instead, U.S. consumers have borrowed against the future by squeezing saving to rock-bottom levels. The personal saving rate stood at just 0.2% of disposable personal income in September 2004 -- down from 7.7% as recently as 1992. Moreover, large federal budget deficits have taken the government’s saving rate sharply into negative territory -- pushing the overall national saving rate of consumers, businesses, and the government sector to historical lows.

America’s saving shortfall has major consequences for the rest of the world. Lacking in domestic saving, the US imports saving from abroad in order to fund the ongoing growth of its economy. And it must run massive current-account and trade deficits to attract such capital from overseas. The United States balance-of-payments deficit hit an annualized $665 billion in mid-2004, or a record 5.7% of GDP. The flip-side of America’s consumption binge is an overhang of excess saving elsewhere in the world. Not only has the United States turned increasingly to offshore production platforms and labor markets in recent years, it is now outsourcing its saving, as well.

This is a highly unstable arrangement. The day will come when foreign investors simply say “no” to this arrangement -- refusing to fund America’s consumption binge without getting a meaningful concession on the terms of financing. That is when the dollar collapses, U.S. interest rates soar, and the stock market plunges. The only way to avoid this wrenching endgame is for the world’s major central banks to move preemptively on the dollar, carefully managing a gradual but significant depreciation over the next several years. There are several advantages of such an approach.

In the end, a lopsided world needs a jolt to find this healthier state of balance. A weaker dollar is the functional equivalent of a major shift in the world’s relative price structure that could well lead to greater balance. Provided the currency shift does not get out of hand, a sustained but managed weakening of the dollar is good news for the global economy and world financial markets.

As economists fret, U.S. manufacturers enjoy rising exports.

Let the worry-warts fret about the risks of a plummeting U.S. dollar. At Al-jon Inc., a company in Ottumwa, Iowa, that makes heavy machines for the steel and solid waste industries, the descent of the U.S. currency has business humming. A weaker dollar means that Al-jon’s machines, which weigh as much as 90,000 pounds and cost hundreds of thousands of dollars each, can sell more cheaply in overseas markets. It also forces the company’s main German competitor to increase prices on its machines in the U.S. market.

“It has made a staggering difference,” said Kendig Kneen, Al-jon’s owner and president. The dollar’s 24% drop against the British pound since January 2002, from $1.40 per pound to $1.85 yesterday, has been a particular boon. In the British and Irish markets, where Al-jon concentrates much of its export effort, the 110-employee company saw its annual sales shrivel to two machines early in the decade when the dollar was strong; this year, it will sell 17 machines, Kneen said.

The benefits of a cheaper dollar for U.S. manufacturers are one major reason why the Bush administration has taken a relaxed attitude toward the slide in the U.S. currency, which has fallen 20% since early 2002 against several currencies, including a 3.4% drop in the past month.

What’s black and blue and read all over?

The financial news stories detailing the relentless beating of the U.S. dollar index, that’s what. And just when you thought it could not get any worse, on November 12, the greenback plunged to a seven-month low against the Japanese Yen, a seven-year low against the Korean Won, and an all-time record low against the Euro. Ouch. Now, according to Wall Street, the “yawning” U.S. deficits are to blame for the dollar slaughter.

But you could not sell us the idea that the trade deficit is behind the dollar doldrums if you paid us to buy it. From the fall of 1995 to the fall of 2000, the account deficit was ballooning (we are talking Hindenburg, here). Yet, during this same period, the U.S. dollar RALLIED 42%. We ask: “Did the massive current account deficit cause the dollar to decline then?” That is a rhetorical question, by the way. If a relationship is causal, then “a” must equal “b” all the time. Otherwise, it is called a loose affiliation.

Can mere words can move a trillion-dollar market?

The question was: Do central bank interventions have a lasting effect on currency exchange rates? The answer came back: “We do know that the very large interventions (such as in the case of the Bank of Japan) ... do not create very large increases in exchange rates of a protracted nature.” Anyone who thinks otherwise can take it up with Federal Reserve Chairman Greenspan, who today made the remark quoted above.

Why do interventions not work? Well, because “the degree of sophistication of the international financial markets has reached the point where you can see the fund-flows in the order of magnitudes that we’re seeing with remarkably little change in either interest rates or exchange rates as a consequence.” In other words, central banks may try to “prop up” a currency, but the exchange markets are too large and complex to change the trend. The daily dollar volume of the currency markets is around $1.4 trillion; for comparison’s sake, the New York Stock Exchange trades around $40 billion to $50 billion per day. Currencies dwarf all other markets, which Mr. Greenspan understands full well. Therefore, a central bank trying to change a currency’s price trend amounts to ankle biting.

Now, you would think that the import of the Chairman’s remarks would sink in for anyone whose I.Q. reaches room temperature, most of all among the people who REPORT those remarks. But alas... “Dollar Plunges on Greenspan Comments” declared one headline, while another proclaimed that “Greenspan Sends Dollar Reeling”. So... central banks cannot move currency rates, but a central banker saying so sure can!! In truth, of course, the U.S. dollar’s price trend has been southward for several months. Is there more to come, or is a major change in that trend just ahead?

CALIFORNIANS FEAR HIGH HOME PRICES MAY DRIVE YOUNG PEOPLE AWAY

More than 50% of California residents said in a survey being released today that they are very concerned that fast-rising home prices will lock out younger generations from the housing market. That trend already appears under way for those ages 18 to 34, with 31% saying high housing costs are forcing them to ponder a move from their region or out of the state, according to the study by San Francisco’s Public Policy Institute of California. Researchers at the nonpartisan think tank say an exodus of young workers could undermine state’s economy, especially in the Bay Area, which relies on a skilled, mobile labor pool to drive its dominant technology industry.

Lance Uyeda, a code enforcement manager for San Jose, sees the problem firsthand. Uyeda first bought in the Los Altos area nearly 30 years ago. Since then, two of his four children have bought homes in the Bay Area, but one daughter lives with Uyeda and his wife, Susie, while his oldest son rents an apartment. “We’re the remnants of a generation that could afford a big family and a big home and three cars,” said Uyeda, 61, noting his property is worth well over $1 million. Unless his 34-year-old son, who works in retail sales, “wins the lottery, he’s not going to have a home to call his own.”

The report, based on a telephone survey of 2,502 state residents, underscores the polarizing effect of skyrocketing home prices. While homeowners enjoy the higher quality of life and economic health associated with rising home values, a growing number of renters face a less certain future. That is not news to Bay Area tenants, who for years have struggled to get a toehold in the market. But some recent statistics paint an increasingly bleak picture.

“WHAT, ME WORRY?” WITH DEFAULTS DOWN, BANKS AND BOND MARKETS FIND NOTHING TO FEAR

Call it the “What, me worry?” market. The dollar may be quivering and economic recoveries in Europe and Japan may look shaky. But this is a time of confidence for those who lend money to corporations. That confidence is shown by an increasing willingness to lend money at low rates to even those with dubious credit. The fear of default seems to have almost vanished.

The bond market has been exuding confidence for much of 2004, evidently assured that world growth would keep profits pouring in. But the trend has accelerated this month, as oil prices slipped and investors expect that business conditions will improve with President Bush and the Republicans in firm control in Washington. This week, the Federal Reserve released its quarterly survey of bank lending officers and found that banks said they were easing credit terms and getting less for their loans to corporate customers. And when they were asked if they were concerned that conditions might worsen over the next year, few saw this as likely while a larger number thought that things would continue getting better.

The confidence is also reflected in the stock market. There, the underlying strength is obscured by the fact that some large stocks have not done as well as the overall market. This month’s rally has left the Standard & Poor’s 500-stock index up 6% for 2004, but more than 20% below the 2000 peak. Still, most stocks in the index are well above where they were when the market peaked. The S.& P. reflects that by measuring the index in an alternative way -- one that assumes that an investor put an equal amount of money into each stock, rather than buying more shares in larger companies. On that equal-weighted basis, the index is up 11% this year -- and is more than 20% above the 2000 peak.

Is the lack of worry reasonable, or a sign of dangerous complacency? The margin for error is obviously greater when there is little in the way of extra compensation for taking on risk. At the moment, the yield premium on speculative bonds -- whether denominated in dollars, pounds sterling or euros -- is a third or less of what it was just two years ago, according to Lehman Brothers data. “We are reaching levels that are clearly unsustainable,” said Guillaume Menuet, an economist at Moody’s in London, speaking of the small yield premiums. “The question is how fast they will go up.” It may be that within a year or two it will appear that the biggest risk that investors took was the decision to act as if there were no risks.

RATING AGENCIES GET A CREDIT CHECK

Credit-rating agencies wield enormous power as gatekeepers to the financial markets for companies and even governments. For more than a decade, the Securities & Exchange Commission has wrestled over whether -- and how -- it should act as a watchdog over rating agencies, which operate largely beyond the reach of regulators. Even the barrage of criticism from Congress and bondholders that raters should have uncovered problems sooner at Enron, WorldCom, and other corporate disasters has not jolted the SEC into action.

Turns out that what the SEC needed was a push from overseas. European financial authorities are debating their own regulatory scheme for the American-dominated industry, and now the SEC is kicking into high gear. BusinessWeek has learned that the SEC is pursuing two measures to expand its limited role.

CONVICTION IN NEW ORLEANS AS “BROAD AND DEEP” AS BOB PRECHTER HAS SEEN IN 30 YEARS...

The annual New Orleans Investment Conference was this past weekend, and, as in other years, Bob Prechter was there to give a talk. Several of his thoughts are well worth sharing. “If there was one theme of the conference, it was the inevitability of soaring oil prices. ... People were clamoring to sign up for oil and gas deals, drilling operations, etc. ... “The consensus that oil prices can only go upward for the rest of human existence is as broad and deep a conviction as I have ever witnessed toward any market in 30 years in the financial analysis profession.

When oil was selling for $12 a barrel a few years ago, no one was interested. There were no booths at conferences touting higher oil. But isn’t that exactly when investors should have been buying it? ... The point is this: If almost everyone is betting on higher oil prices, then all bets are in.”

Conviction as “broad and deep” as he has ever seen in 30 years -- that covers lots of ground and lots of conviction. The key issue is clear: If all bets are in, where does the market go from here?

THE MONETARY COLD WAR (WITH GOLD IN PLACE OF ICBM’S)

Who is Oleg Mozhaiskov? A Russian spy? A defecting nuclear scientist? A gold-medal winning weightlifter? A gold-metal loving central banker? Mr. Mozhaiskov is, in fact, a central banker -- that rarest breed of central bankers that favors buying gold instead of selling it. Since this particular banker’s affinity for gold is not a fleeting fancy, but the studied result of a thoughtful macro-economic analysis, this particular banker may urge his comrades at the Russian central bank to buy more of the stuff. Meanwhile, central bankers in China and India have begun musing publicly about diversifying out of dollars. Presumably, any diversification out of dollars would include a diversification into gold. Is the ancient monetary metal, therefore, becoming the modern monetary metal? Oleg Mozhaiskov suspects so.

“Gold is predominantly a financial asset,” he says, “not merely a precious metal ... the time has come to admit that investment demand was, and still is, the main driving force behind price fluctuations on the gold market. The changing character of demand heavily depends on what is going on in the international foreign currency and financial markets.”

“The modern monetary system, although undoubtedly robust and long-standing, in fact has a number of flaws and weaknesses,” Mozhaikov asserts, as he issues a scathing indictment of American monetary and fiscal profligacy. “Although there are several reserve currencies, the blatant lack of discipline is demonstrated by the U.S. dollar. I am leaving aside the main aspects of this problem, such as the social and economic injustice of a world order that allows the richest country in the world to live in debt, undermining the vital interests of other countries and peoples. What is important for us today is another aspect, which is connected with the responsibility of the state issuing the reserve currency and for the international community preserving that currency’s buying power.”

“The world has come to a paradoxical situation in which the creditor countries are more concerned with the fate of the dollar than the U.S. authorities themselves are. Thus,” says Mozhaikov,“qthe evolution of the U.S. dollar’s reserve role in recent years has given ground to some quite pessimistic forecasts, based on rational economic theory. No wonder that the number of people who have held assets in dollars and now wish to diversify them partly into gold -- the traditional shelter from inflation and political adversity -- is steadily growing.”

Russia’s $113 billion of foreign exchange reserves would rank it 7th on the list of the world’s largest central bank reserves. Yet its gold reserves total a mere 500 tonnes, or $7.8 billion worth -- i.e., gold represents less than 7% of its total reserves. Meanwhile, the People’s Bank of China holds about the same amount of gold as its Cold War ally, despite holding four times the foreign exchange reserves -- China’s gold reserve represents less than 2% of its massive $474 billion foreign exchange reserve. By comparison, many European central banks hold more than 30% of their reserves in gold, even after unloading much of it in recent years.

These data suggest a very provocative “what if?” for the gold market. What if the countries that are amassing sizeable stacks of dollar bills were to swap some of those stacks for gold? A mere flinch in the direction of adding gold reserves by China or Russia or India -- or all three at once -- would place a sizeable bid under the gold market. “The internal imperfections of the international monetary system,” Mozhaikov concludes, “have already led to a number of regional financial crises and still carry the danger of larger upheavals. Under these conditions, the growing interest of investors in real assets, gold in particular, is more than justified.” Comrade Greenspan ... any rebuttal?

THE “WORLD’S MOST PESSIMISTIC PEOPLE”

If you had to guess which nation or region of the world was the “world’s most pessimistic”, what would you say? No, it’s not the poorest African countries. Or Japan, despite its 15-year bear market. Or Cuba, despite its totalitarian government. It is Western Europe. Yes, according to a survey by the World Economic Forum, the most depressed people on the planet currently reside in the core nations of the European Union. And among them, Germans are the most pessimistic of all about their future.

Now, you have heard us say time and again that the main engine of any market is the mood of investors. So with the mood of Western Europeans this gloomy, can there be any hope for European stocks? Ah, but this is where things get interesting. Elliott wave enthusiasts among our readers know that in bear markets, there are two instances when social mood turns particularly dark. The first one is the middle of a third wave down in social mood (as reflected by the stock market). That is the so-called “point of recognition”, when “bad news” in the headlines intensifies and stocks fall hard and fast.

But European stocks have been climbing since the early 2003, so despite this survey’s results, the mood of European investors has clearly been on the rebound. That is further evidenced by the fact that the number of pessimistic Europeans “has declined since 2003.” So it is unlikely that the current extreme in pessimism is the “point of recognition”.

That only leaves the second choice. Collective psychology also reaches a dark extreme -- near a bottom. Which means that this extreme of being the world’s most pessimistic people actually gives Europeans an opportunity to rebound. Does this also mean that there is hope for European stocks, after all?