Finance Digest for Week of December 27, 2004

WARREN BUFFETT’S VOTE OF NO CONFIDENCE IN U.S. FISCAL POLICIES IS UP TO $20 BILLION

The dollar has fallen savagely against the euro for the past three years, and the trade deficit is running $55 billion a month. Is the currency rout over? Can the trade deficit be fixed with a rise in interest rates or an upward revaluation of the Chinese currency? Warren Buffett, the world’s most visible dollar bear, says the answer to both these questions is no. His bet against the dollar, reported at $12 billion in his 2003 annual report, has gotten all the bigger. Now his Berkshire Hathaway has a $20 billion bet in favor of the euro, the pound and six other foreign currencies.

Buffett has for a long time been lecturing fellow Americans about their bad habit of borrowing from abroad to live well today. He made a big stink about his currency trades in his March 2004 letter to shareholders. Forbes phoned him recently for an update, hoping for the news that the Scold of Omaha had softened his views on the decline of the dollar. What we got was more doom and gloom, more than we have ever heard from the man. In other words, he is not about to cover his short position on the dollar.

Buffett said that he began buying foreign currency forward contracts when the euro was worth $0.86, and kept buying until the price reached $1.20. It is now worth $1.33. Buffett said he is not adding new positions now but has been rolling over contracts as they mature. Berkshire lost $205 million on currency speculations in the first half of 2004, but more than made that back with a $412 million gain in the third quarter. It is likely that the December quarter report will show another huge gain. Since January 2002 the dollar has fallen 33% against the euro. Buffett blames that on bad policy, coming from both the White House and Congress.

Says Buffett: “The rest of the world owns $10 trillion of us, or $3 trillion net.” That is, U.S. claims on foreign assets run to only $7 trillion. “If lots of people try to leave the market, we’ll have chaos because they won’t get through the door.” In a nutshell, the trade deficit is forcing foreign central banks to ingest U.S. currency at a rate approaching $2 billion a day. “If we have the same policies, the dollar will go down,” Buffett continues.

The $20 billion bet has to be put in context. Berkshire has a huge portfolio of investments that includes $40 billion of Treasury securities. Budget and trade deficits are likely to make dollars worth less and bonds worth less. So the currency play is a partial hedge of a large position that can be read as bullish on the U.S. Still, that Buffett is making a currency bet at all is striking given that this investor has, in his 74 years, rarely made macroeconomic bets. He built Berkshire to a $130 billion market value by acquiring parts or all of lots of businesses, primarily in the insurance sector and primarily in the U.S.

AMERICA’S BEST BIG COMPANIES

The Forbes Platinum 400 -- the Best Big Companies in America -- were created by running computer screens across 26 industries for companies with at least $1 billion in revenue and high rankings for corporate practices as well as long- and short-term sales and earnings growth and stock market performance. After additional scrutiny, writers and editors selected the best managed company in each industry.

BREAKING UP IS GOOD TO DO

Toys “R” Us, the inventor of chain-store toy discounting, is being run ragged by Wal-Mart. Tossing its hands up, in August 2004 Toys “R” Us announced plans to separate its toy business from its Babies “R” Us unit. Sales at the company’s U.S. toy business had declined in each of the past three years, and the profit margin had fallen to 2% in 2003. Babies “R” Us has increased sales 10% annually since 2000, and its EBIT margin (earnings before interest and taxes as a percentage of sales) has averaged 11%. Wall Street has applauded the proposed split, sending the stock up 27% since the announcement. Why jettison the business the company was founded on? The name of the game, says retail analyst Berke Bakay of Eqyty Research & Management, is “unlocking shareholder value”.

In a similar vein IBM will sell its personal computer business to China’s Lenovo Group because IBM can make more money on things like consulting than on PCs. Divestiture deals are on the rise. Thomson Financial forecasts over $200 billion worth of them in the U.S. in 2004, up 30% from 2002. This is typical of bear market recovery behavior, says David Katz, chief investment officer at Matrix Asset Advisors. Two holdovers from the hard times -- low interest rates and cash-flush corporate balance sheets -- give buyers of castoffs the wherewithal. Cash for companies in the S&P Industrials, an index of 383 companies that excludes financial firms, is $600 billion, more than twice what it was five years ago.

All that has to be overcome now is the natural disinclination of chief executives to dismantle their empires. Says Tony R. Boase, who tracks several conglomerates for A.G. Edwards, “It’s unfortunate the success of a General Electric or an IBM leads people to believe they shouldn’t divest businesses.” How to find the next Toys “R” Us? We searched through S.E.C. filings for large-cap companies that report results for multiple business segments. Our targets were companies where one segment has severely underperformed the others in profitability over the past three years.

ARE TEMPTING DIVIDENDS OFFERED BY CANADIAN OIL AND GAS ROYALTY TRUSTS SUSTAINABLE?

The Canadian Energy Field has become a happy hunting ground for higher yields than you can find outside the junkiest of junk bonds. And not simply because oil and natural gas prices are up. Or because Canada’s dollar is strengthening (now worth 82 American cents), giving Americans a nice bump from money earned north of the border. Canadian’s oil and gas trusts typically pay out most of their cash flow (net income plus noncash charges like depletion) to unit holders. Result: tempting payouts of 10% to 18% a year, paid in quarterly or monthly chunks and taxed lightly at 15%. That 15% is the same as the U.S. dividend tax rate. You pay the tax to Canada but can claim a foreign tax credit with the IRS.

Too good to be true? While some royalty trusts are solid investments, watch out: Those dividends are vulnerable to falling energy prices and higher interest rates. And it is not just volatility that is a problem. Some of these beasts pay out more cash than they are earning from pumping oil and gas. That means they must raise money from lenders and stock sales to keep the dividends flowing. If oil prices fall too far or interest rates rise too high, both cash sources could dry up.

Rolling 12-month returns for oil and gas trusts have fluctuated between 90% and negative 30% over the past 10 years. When oil’s price sank recently from $55 per barrel to $40, royalty trusts saw share prices dip around 10%. The price decline does not immediately jeopardize dividend-paying abilities since oil is still considerably higher than it was a year ago. The problem would come if oil prices slumped all the way into the teens, as they did in 1998. For some of the trusts, says Patrick Bryden, an analyst who covers the sector for RBC Capital Markets in Calgary, “sustainability is a big question mark”.

Royalty trusts are like U.S. real estate investment trusts, which can avoid corporate taxes by channeling most of their earnings to investors. The U.S. version of a royalty trust also owns oil wells, coal deposits and pipelines. But American trusts cannot issue new debt or equity, so their reserves are a dwindling asset. Eventually the trust will peter out. In Canada the trusts can raise fresh capital to expand energy holdings and theoretically keep rolling into the big-dividend future. That is why Canadian trusts now are a craze. They even have moved beyond energy to own stuff ranging from fast-food chains to dog-food factories. By far the most money still flows into energy.

The trick for investors is to find trusts that have sufficient wells to generate the necessary cash to cover dividends, as well as interest and operating costs. To keep the dollars flowing, trusts have to keep finding more oil, a process Canadian energy types call “staying on the treadmill”. The best trusts find them; the lesser lights do not.

THE PAPER STANDARD

In the red-letter year of 1986 the U.S. became a net debtor: The value of foreign-owned assets in the U.S. topped (by a small margin) the value of American-owned assets outside the U.S. Thomas Gale Moore, a member of Ronald Reagan’s Council of Economic Advisers, said not to worry. “We can pay off anybody by running a printing press, frankly, so it’s not clear to me how bad [a net debtor status] is,” he declared. Maybe we are going to find out. Foreigners now own $2.4 trillion more of us than we do of them. The U.S. current account is in deficit in a sum equivalent to 5.7% of U.S. GDP. The dollar is in a bear market. The dollar printing press to which Moore so lightly alluded is working overtime.

Reading about the greenback, you have probably encountered the word “system”, as in “monetary system”. But your great-grandfather’s system was the gold standard, under which the money supply was regulated by movements in the quantity of monetary gold. Then came the ersatz gold standard, also known as Bretton Woods, under which the money supply was supposed to be regulated, or influenced, by movements in monetary gold (but really was not). President Richard Nixon put this fake gold standard out of its misery in 1971. Next up was the pure paper standard, under which the money stock is positively not regulated or influenced by anything on the periodic table of the elements. And it shows.

You do not have to be a goldbug to acknowledge the deficiencies of the post-gold-standard monetary arrangements. The hallmark of the classical gold standard was the prompt adjustment of international payments imbalances. The hallmark of the pure paper standard is the indefinite postponement of international payments imbalances. Under the gold standard, a deficit country, if it persisted in its deficit, would eventually run out of gold. Under the pure paper standard, a deficit country, if it is the U.S., can keep right on printing money. That is, it can keep on printing until its creditors cry “Uncle!”

Japanese and European authorities are deploring the unwanted appreciation of the yen and the euro. They are weighing joint intervention to stop it. Such talk underscores a vital fact. In 2005 a strong currency is the Old Maid of the monetary deck. Nobody wants it, not even George W. Bush. But the universal yearning for weak currencies is tantamount to a yearning for a strong gold price. I believe that these complementary longings will be fulfilled. Count me as bullish on gold -- still.

HOW TO PLAY COMPANY REBOUNDS

Investors live for rebounds, just as in the movies when the hero picks himself off the floor and vanquishes the villain. There are rebounds by the market as a whole or by industry sector. You capture the broad rebounds by owning an index or sector fund. At best these may log a double-digit advance for the year. On average, they rise in the high single digits. But it is the individual company rebounds that bring true riches. Say you had invested in scandal-plagued Tyco International two years ago. The conglomerate’s makeover, with the rascally old management gone, quadrupled your stock price.

With smaller companies the rebounds can be as profound, if less celebrated. Hartmarx has suffered from the business-casual trend that has diminished demand for men’s suits. The company responded by buying a woman’s clothing line, “Exclusively Misook”. Hartmarx stock is up 45% since then, far outstripping both the S&P 500 and the small-cap Russell 2000. And this is just the beginning for Hartmarx shareholders.

When is it too late to get in on a rebound? Do not be afraid if you conclude that a company has good underlying fundamentals and a wise strategy, even if a run-up has occurred. Two years ago Tyco stock hit bottom at $8 per share. You might have waited until September 2003 to be sure the company was on the right track, and the stock was $20. Getting in then still would have served you well, though not as well as the riskier, earlier bet. The stock is now at $34.

Although I do not necessarily count myself among the pure-value breed -- I am more of a growth-at-a-reasonable-price (GARP) guy -- I certainly appreciate the satisfaction of finding gems that have lost their luster, followed by the thrill of surging valuations as the rest of the market piles in. Three small companies jump out at me as smart rebound plays. All have seen their stock rise as investors caught wind of their comebacks. And I am convinced that all have much more to rise.

JUNK: NOT WORTH IT

The junk market is overstretched. All four Forbes Best Buys in junk bond mutuals yield less than 6%. That is a limbo-low return in the riskiest bonds. The story is the same for individual junk issues. The new-issue market tells the tale. There is just no “high” in high yield anymore. Junk yields are at the narrowest spread over Treasurys since 1998. According to Merrill Lynch, junk in October 2002 yielded an average 11 percentage points more than Treasurys; now we are at a mere 3.25-point differential. That, in my book, is far from adequate compensation for the risk of default.

The reason for the narrowing spreads: Everything that could go right in the junk bond market has. Fundamentals and balance sheets are greatly improved. With rates so low, institutional investors have scrambled to buy anything with a smidgen more yield than Treasurys and high-grade corporates. Hence new junk issues are oversubscribed, so the demand escalates prices and depresses yields. No wonder there are no bargains. This will all end badly. When the high-yield market swoons (and it eventually will), liquidity will dry up and getting out at good prices will be impossible.

My recommendation is, well before that dread day arrives, harvest some of your profits from your high-yield funds. Do it now. Take the money and upgrade your quality. Sure, you will give up yield. Better to be early than have to squeeze through the exit door with the masses, when you will get a whole lot less. Switch into issues rated BBB or better. These do not rely, for their repayment, on a bank to extend a credit line or an underwriter to unload a new issue.

STOCK BUYBACKS SEE GROWING SKEPTICISM

When it comes to stock buybacks, more investors are wondering what is in it for them. A buyback should be good for shareholders, because it means there will be fewer remaining shares, and each remaining share will be worth more when valued against the company’s earnings. But increasingly, stock buyback announcements are getting a skeptical reception, because many times, the number of shares does not fall or in some cases, even rises. “Buybacks are often hocus pocus, smoke and mirrors,” says Gordon Bell, fund manager at Citigroup Asset Management.

Announcing a buyback has never been a guarantee a company would actually do it. Even when a company does buy back stock, the benefit is often mitigated by other things it does. An analysis of data from The Buyback Letter found that during the fourth quarter of 2003, 94 companies announced stock buybacks. But as of the third quarter this year, on average, the number of shares outstanding remained almost exactly the same. It has been the same story among companies in the Standard & Poor’s 500 this year. So far, 205 have announced buybacks and released updated share counts. But among these companies, the share counts rose 0.5%, according to S&P.

SIGNIFICANT CHARACTERISTICS OF BULL MARKETS AND GOLD AND SILVER

A lot of views are expressed about the recent fall in the prices of gold and silver. Linking the arrest in the fall of the US$ to the fall in the price of gold and silver is a popular view. The arrest in the fall of the US$ is apparently considered more of a “technical” necessity than a fundamental move. Similarly the fall in the prices of gold and silver are considered “technical” necessities to relieve the overbought conditions. Some market commentators look to the 2-year correction in the 1970’s gold bull market and are now calling for a similar correction! History rhymes but does not necessarily repeat!

Since I found this reasoning to be quite inadequate, and studying the charts not as helpful, I went over the fundamentals once again. The monetary and fiscal policies of the global governments are expansionary and unsustainable. The value of the currencies in terms of purchasing power has been shrinking and the people are being lied to shamelessly about the extent of price “inflation”. The stock bull of the last twenty years has changed the perception of the masses towards equities (and now real estate) and the concept of wealth. Debt-based consumption is being promoted as economic nirvana!

Is there a simpler view to the gold and silver story? In bull markets, the markets stay overbought much longer than we can imagine. In bear markets, they stay oversold far longer than we can imagine (US$ please note). The bull market in gold and silver has begun and the safer thing is to let the fundamentals of various asset classes dictate our asset allocation, rather than getting clever in attempting to maximize returns by micro-managing our holdings. Hence, maintaining my core precious metals position is the most logical thing for me to do. As has truly been said, sitting quietly after making our investments is the hardest part of investing, requiring the courage of conviction in our assessment.

INVESTMENT FOLIO FOR AVERAGE JOE

An old saying claims that the rich get richer. But recent advances in online investing now allow people of modest means to tap into investment options traditionally reserved for the wealthy. Separately managed accounts -- customized portfolios based on models by one or more managers -- are hot investment vehicles with a Rolls Royce connotation. Their minimum investment runs from a hundred grand to half a million, with hefty fees paid to the investment adviser and managers. Less affluent investors have watched this luxury ride wistfully, from a distance. Now they can bum a ride. Foliofn, a company that sped the automation of portfolio management, is forming alliances to offer consumer products with the benefits of separately managed accounts. Unlike mutual funds, the underlying assets allocated in SMA models are owned by the individual investor. The investor can decide to refuse a manager’s buys and sells, adjusting as desired for personal tax strategies or feelings about particular companies.

Foliofn began as an online service empowering individuals to, for all practical purposes, run their own private mutual fund by filling a “basket” with up to 50 stocks or other securities. Investors can go online to rebalance the basket, buying and selling stocks without paying commissions, only a monthly or annual membership fee. Current annual fees are $200 for one basket, $100 for additional ones. Folio has no account minimums and allows fractional share ownership, so investors can trade in exact dollar amounts. Prices are kept low in part because Folio’s technology allows it to first try to match up buys and sells in-house, between member investors, reducing the share price bid-ask spread.

Investors can make up to 200 no-commission trades per month per basket; trades are executed at the close of two daily windows. Trades executed at other times, or exceeding the 200 maximum, cost extra. Entire baskets can be rebalanced or traded in entirety with a click. Those wanting to try their hand running their own fund can create folios from scratch or can begin with one of Folio’s 75 “ready-to-go” baskets. They include the conventional, like the best or worst 30 stocks of the prior year, and sectors such as technology, software, internet, biotech or aerospace companies with the largest market capitalizations. One basket picks companies that manufacture golf equipment and manage golf courses. Social issues, such as tobacco-free, environmentally responsible or labor-friendly criteria, underpin some baskets.

Among available research features is market information compiled by Zacks Investment Research. All dividends and short- and long-term capital gains and losses are tracked and can be downloaded into tax software. The company sees SMAs as the next logical move, and recently allied with TheStreet.com’s Jim Cramer, a former hedge fund manager. For an additional $30 a month, investors get online “action alerts” allowing them to follow any stock and cash allocation changes Cramer is making on his “Plus” investments portfolio, which usually carries around 20 stocks. But Folio is careful to offer no recommendations on tax strategies or securities selections.

DARK CLOUDS GATHER FOR THE PERFECT STORM

The stage is getting set for the enactment of The Perfect Storm. Over the last 50 years, whenever the Fed tightened by 200 basis points or more, we had a recession 75% of the time. Previous spikes in oil prices have also, without fail, led to recessions. Conditions in the rest of the world are not encouraging either. In Europe and Japan we have slowing growth. Interest rates are rising everywhere as higher energy costs stoke inflation fears -- causing central banks to tighten. With large government budget deficits (3%+ of GDP) in the world’s major developed economies, there is not much room for further fiscal stimulus either. In the U.S., amidst slowing auto sales, GM and Ford are cutting production. The specter of higher long-term interest rates haunts the huge housing-related industries. In a recent consumer survey, intentions to buy a car over the next six months dropped to the lowest level in 40 years. Home buying intentions tied with the low in 1994 and was lowest over the past 20 years.

In Japan growth has petered out again. Consumers are reluctant to spend because of a lack of “confidence” … no doubt fueled by the huge rise in “temporary” jobs as a proportion of total jobs. With public debt at 160% of GDP and rising at the rate of 7% a year, there is not much additional government stimulus likely. In Germany, unemployment continues to rise into the low double digits. The rapidly strengthening euro will no doubt hit exports and the export dependent German economy. In countries like UK and Australia, after a spectacular boom in house prices, a decline has already begun as their central banks are well into their tightening cycles. China is trying to slow down unhealthy growth by clamping down on credit. So yes, it is clear that it is going to rain. But the key question is what kind of rainstorm?

For the U.S., five factors loom large in the economic calculus. One, never before in the past 40 years has the Fed had fewer bullets in its interest rate gun. Two, never before has the U.S. government been in a worse position to stimulate the economy with deficit spending. Three, never before has the dollar been so weak … a consequence of it being the currency of the world’s largest debtor nation. Fourth, the stock and housing markets are in bubble territory. House prices -- both as a ratio to incomes as well as replacement costs -- are at record levels. Reversion to the mean is inevitable. Fifth, and most important in my analysis, never before have we “owed so much to so many”. The record debt burdens of all three sectors -- Government, Business, and Household -- cumulatively 300%+ of GDP, are truly the stuff of legends.

If significantly higher interest rates coincide with lower employment and incomes during a recession, the debt bomb will explode. Declining “wealth” -- due to deflating bubbles in the housing and stock markets will add fuel to the fire. Rising defaults -- mainly on the consumer side, will ignite a major banking system crisis requiring a government bailout. A financial crisis is what turns a recession into a depression. Over the last 75 years, the probability of a “perfect storm” has never been higher.

CHARGED TODAY, TAPPED OUT TOMORROW?

Retailers probably celebrated the news that shoppers used their charge cards for a record number of transactions over the holidays. Industry observers, however, were divided about whether there really is a reason to cheer. Visa, the No. 1 payment card issuer, said spending on its Visa branded cards last week spiked about 32%, while MasterCard boasted the highest number of transactions ever recorded in its history for the crucial November-December holiday shopping season.

Retail consultant Howard Davidowitz said he’s concerned the strong numbers belie troubling times for retailers in the months to come. “The big picture is that we’re a debtor nation but remain the most profligate spenders,” said Davidowitz. For instance, the average U.S. household currently carries about $14,000 in credit card debt, according to Cambridge Credit Counseling Corp., a non-profit consumer debt counselor that also says consumers owe a record $750 billion in total credit card debt. “We had moderate growth in income but we’re borrowing our brains out. The most concerning thing is that the level of savings is at less than one percent of personal income,” said Davidowitz.

But some analysts said even though household debt has risen, it will not constrain consumer spending -- at least not yet. Conference Board director of research Lynn Franco, citing this week’s bullish report on consumer confidence, said spending could stay at current levels at least for the early part of 2005.

EVEN DRUG DEALERS ARE GIVING UP ON THE DOLLAR

The dollar’s decline against the euro shows no sign of ending. Clearly, currency traders have made a long-term judgment about the relative value of the currencies of the Old and New Worlds. That sounds bad enough. But now there are signs that we are losing some of the most devoted fans of the greenback: drug dealers, Russian oligarchs, and black-market traffickers of all kinds. James Grant, of Grant’s Interest Rate Observer, whose harsh commentaries on the dollar and other subjects are as droll as they are pricey, highlighted the latest indignities to befall the once-mighty dollar in his Dec. 17 issue.

People the world over -- central banks, companies, and individuals -- like to hold the dollar. It is stable, liquid, easily convertible, and never goes out of style. The dollar is popular in the official global economy -- the money that changes hands through computer terminals, checks, and wire transfers. But it has also been extremely popular in the world’s vast cash economy. For American tourists, Chinese smugglers, Ukrainian arms dealers, and African dictators, the dollar has long been the currency of choice. The fearful and shady, those who subsist on tourism, and residents of countries with unstable domestic currencies love the greenback. Citing Federal Reserve estimates, Grant writes that “between 55% and 70% of the $703 billion of U.S. currency outstanding circulates outside the 50 states.”

The Un.S. benefits greatly from the fact that the dollar is the worl’qs reserve currency. Many of the $100 bills circulating throughout the globe are essentially loans that we never have to pay back. Americans use them to buy goods, services, or other currencies. But many of those bills never return to our shores to be redeemed for anything we make or produce. Instead, they stay under mattresses in Bogotá, circulate in Iraq, and are stashed in bank accounts around the world.

But among a subset of global cash connoisseurs, the dollar is losing ground to the euro -- and it has nothing to do with concerns over U.S. multilateralism. First, the euro zone has been expanding with the addition of new countries and the continued integration between Eastern and Western Europe. So there are simply more people who accept and use euros now. Since 2002, the growth rate of euros in circulation has far outpaced that of dollars. Add in the euro’s recent strength against the dollar, and the case for Eastern Europeans and euro-neighbors to use euros becomes more compelling. In the 1990s, the dollar was remarkably popular in Russia, where residents had long been deprived of coveted Western imports. But between January 2002 and August 2004, Grant notes, the percentage of private Russian currency transactions employing the dollar fell from 94.1% to 84% while the euro’s share rose from nothing to about 15%.

Finally, in the past two years, euros have also become easier to carry, store, and hide than dollars. Generally, the largest denomination of U.S. currency readily available is the $100 bill. But in the past two years, the European Central Bank has started to print €200 and €500 bills. At today’s rates, a 500-euro note is worth $682. So if you wanted to, say, hide cash by swallowing it temporarily, euros would the obvious (and more comfortable) way to go. For most products, losing international drug cartels and corrupt Third World dictators as customers would seem to be a desirable outcome. But these guys represent part of our long-standing and faithful base. If you think pundits are fretting about the slumping dollar now, just imagine what might happen if we start to lose the arms dealers.

A STUNNING PRICE -- AND THIS TIME, FOR AN OLD PIECE OF ART

It is said that people buy contemporary art when they are confident about the future and old art when they are not. Maybe a few worries are setting in. On December 9th, a piece of furniture known as the Badminton Cabinet -- made, in pietra dura, ebony and ormolu, in 1720-32 by the Medici workshops for the third Duke of Beaufort -- was sold at Christie’s in London for £19 million ($36.7 million), a record for a non-pictorial work. The auctioneers had hoped to match the £8.6 million paid by the previous owner in 1990.

The cabinet is the latest of a number of older works going for record prices. However, in recent years, contemporary art has made all the running. Last month saw record auction sales of contemporary art in New York. Research by the Art Sales Index shows that over the past four years the shares of contemporary and modern art in auction-market turnover have risen, while those of Old Masters and 19th-century works have declined. That said, Daniele Liberanome of Gabrius, a company that tracks art prices, considers Old Masters undervalued based on their performance since 1990.

Conventional wisdom has it that older art holds its value, while contemporary stuff is for risk-lovers. William Goetzmann, a professor at Yale, estimates that during the last art-market slump, which set in after 1990, Impressionist and contemporary works fell by most (51% and 40% respectively), while Old Masters suffered least (down by 16%). Yet despite the bumps, contemporary works have been rewarding for those who are prepared to hang on: according to two professors at New York University, since 1970 the returns on contemporary art have far outstripped those on Old Masters and 19th-century paintings.

Contemporary art has served rich investors particularly well in the past few years. Prices stayed buoyant when stockmarkets slumped. Nevertheless, one recent academic study has found a correlation with another asset class: during the last world art boom, in the late 1980s, prices were closely tied to property values, specifically Japanese land prices. After 1990, art and property slumped together. Now property prices in several countries are once again at giddy heights.

A YEAR FOR ASIA TO REMEMBER -- AND FORGET

Even without the recent and ongoing earthquake/tsunamis tragedy, 2004 has been a year to remember for many reasons. It has also been one many would just as soon forget. Be it the increasingly bizarre events in North Korea, China’s boom, war in Iraq or Japan’s recovery, 2004 is a year worth talking about. As a memorable year draws to a close, some awards seem in order for the Asian countries, companies and people that, for better or worse, mattered most in 2004. Drum roll, please.

THE MISSING LINK

The badly flawed consensus thinking about the implications of sustained large U.S. capital inflow starts with the error that U.S. assets are uniquely attractive to foreign investors. The reality is that U.S. investors are earning far higher returns on their assets in Europe and Asia than foreign investors do on their U.S. assets. European firms and investors who invested heavily in the United States during the “new paradigm” years in the late 1990s are still smarting from horrendous losses. The DaimlerChrysler disaster is by no means an isolated case.

As to U.S. bond yields, they are just marginally above euro yields, but considerably below the yields obtainable in emerging countries. What is more, after inflation, they are the lowest in the world. A falling dollar is, of course, a virtually prohibitive deterrent to foreign bond purchases. In fact, it might induce selling. This leaves the central banks of Asian surplus countries as the potential buyers of last resort for the dollar, unwanted by private investors. They did heavy dollar buying in 2003 and in early 2004, but never forget, the dollar purchases by the central banks have a heavy price in turning healthy economies into sickly bubble economies.

The sustainability of the U.S. capital inflows is, actually, the totally wrong question to ask from the American point-of-view. Far more important is another question, concerning the effects of the trade deficit on the U.S. economy, in particular on employment and income creation. We find that the dogmatic belief in the mutual benefit of foreign trade has stifled any reasonable discussion in this respect. Frankly speaking, we do not see any true benefit of a trade deficit. Yet there is a widespread view that the flood of cheap imports, by keeping a lid on U.S. inflation and wage pressures, fosters lower interest rates, which tend to spur economic growth. For us, both effects are not beneficial at all, because the imports implicitly distort both inflation rates and interest rates to the downside. In essence, the lower inflation rates allow a looser monetary policy than domestic conditions justify.

The job losses from the soaring trade deficit have always been there. But they did not show up in the aggregate for many years because the booming economy -- driven by extremely loose monetary policy -- created sufficient alternative jobs. But this alternative job creation has drastically abated since 2000, and the soaring trade deficit’s damage to manufacturing is now surfacing in full force. Having said this, we hasten to add that the U.S. trade deficit must be seen as one imbalance among several others, whether zero or even negative national savings, a soaring budget deficit, record-low net capital investment or sky-high consumer debt. They all derive from the same underlying key cause: Unprecedented credit excesses that have boosted consumption for years at the expense of capital formation.

What governs the U.S. trade deficit is not the law of “comparative advantages”, but the careless depletion of domestic saving and investment resources though policies that have recklessly bolstered consumption. Essentially, employment creation through capital investment is out. Putting it bluntly, the U.S. trade deficit, like all other imbalances, reflects a grossly skewed resource allocation toward consumption. F.A. von Hayek explained in great detail that an increase in consumer demand at the expense of saving will inevitably lead to a scarcity of capital, which forces a “shortening in the process of production”, and so causes depression. Putting it in simpler parlance: Excessive consumption inevitably crowds out business investment. As a share of GDP, consumption in the U.S. is presently excessive as never before. And it keeps worsening.

Assessing the U.S. economy’s prospects, it also has to be realized that the bubble-driven consumer-spending boom represents artificial, unsustainable demand. Apocalypse will follow when the housing bubble bursts -- which is sure to happen in the near future. Our particular nightmare is that the huge carry trade bubble in bonds will inevitably burst. A fire sale of bonds in unimaginable proportions would begin, with bond prices crashing and yields soaring. With the prices of housing, stocks and bonds crashing, the entire U.S. financial system would be at risk.

It is typically argued that the U.S. economy is importing too much in comparison to exports. Superficially, that is true. Yet on closer look, it is a mistaken perception. Compared to other industrialized countries, U.S. imports are very low as a ratio of GDP. The true key problem is abysmally low goods exports, accounting lately for barely 7% of nominal GDP. This compares, by the way, with a German goods export ratio of 35% of GDP. The cause is precisely the same one that chokes productive capital investment -- the progressive shift in the allocation of available domestic resources away from capital formation through saving and investment in plants and equipment, and toward immediate consumption. That is the supply-side problem. Then lacking domestic output capacity to meet the soaring domestic demand, an increasing share of the demand creation from monetary excess has exited to foreign producers, resulting in the huge U.S. trade deficit. It is a flagrant policy failure that has created a monstrous, unsustainable imbalance, both domestically in the United States and globally. The day of reckoning is rapidly approaching.

MARKET-TIMING INDICATOR WITH GOOD LONG-TERM RECORD IS VERY BEARISH ON THE STOCK MARKET

Ford Equity Research Investment Review is published by Ford Equity Research of San Diego. The newsletter’s record has been good, especially in recent years. Over the past five years, for example, this newsletter’s top stock picks have produced a 13.1% annualized return, in contrast to a 0.7% annualized loss for the Wilshire 5000. Because the firm does not recommend a particular division of a subscriber’s portfolio between stocks and cash, we do not calculate a market-timing record for it. However, each month the firm reports in its newsletter an indicator that purports to show how much the market is over- or under-valued. This indicator is a composite based on a ratio that Ford calculates for several thousand individual stocks.

This ratio, which is referred to as a price-to-value ratio, or PVA for short, “is computed by dividing the price of a company’s stock by the value derived from a proprietary intrinsic value model.” As Ford describes it, “A PVA greater than 1.00 indicates that a company is overpriced while a PVA less than 1.00 implies that a stock is trading below the level justified by its earnings, quality rating, dividends, projected growth rate, and prevailing interest rates.” Ford uses the price-to-value ratios it has calculated in deciding which stocks to recommend. But, in addition, it also averages these PVA ratios across all stocks in its universe to come up with a composite indicator of the market’s overall valuation. And it has been doing that since 1970, more than 30 years.

This composite currently stands at 1.44, indicating that -- at least according to Ford’s analysis -- the average stock is 44% overvalued. Furthermore, the current level is higher than all but 6% of the readings since December 1970. How much weight should you place on this indicator? To help answer this question, I first segregated the monthly readings since 1970 into quintiles and then measured the average return of the Wilshire 5000 over the subsequent 1, 6, and 12 months for all readings within each quintile. The results appear in the accompanying table.

As can be seen, this indicator has an impressive record, especially in identifying overvalued markets. To give anecdotal evidence in further support of this, consider that the record high reading of 1.81 for the indicator came on Sept. 30, 1987, three weeks before the 1987 Crash. The next highest reading of 1.79 was registered at the end of February 2000, less than a month before the top of the Internet bubble.

Though the message of this indicator is not good news for the overall stock market, it is worth noting that Ford’s message is not equally bad for all segments of the stock market. The highest PVA readings, the ones representing greatest overvalue, are currently concentrated among the smallest-cap stocks. To the extent you are inclined to pay attention to Ford’s market-timing indicator, therefore, you either should be reducing your equity exposure or, failing that, shifting out of small-cap stocks into the large-caps.

OIL PRICES FALL, BUT UP 30% IN 2004

In the last trading day of 2004 for U.S. oil, prices were down 74 cents at $42.90 a barrel -- around $10 higher than the beginning of the year, but nearly $13 below the contract’s all-time high of $55.67 on October 25. Oil prices have fallen hard over the last two months on signs that high fuel costs were beginning to weigh on economic growth. A mild U.S. winter and year-on-year surplus in U.S. crude stocks have also prompted speculative funds to take money out of energy and pursue equity or money markets.

In Saudi Arabia, suicide bombers tried to storm the kingdom’s Interior Ministry and a security unit in the capital Riyadh on Wednesday, but were blocked and detonated their cars outside the gates, wounding at least 18 people. It was the second major militant strike this month amid a surge of Islamic militant violence in which about 170 people have been killed, including Westerners, since May 2003. Oil facilities and exports have not been affected, but traders remain anxious over the kingdom’s 9.6 million barrels per day of production -- more than a tenth of world supply. Osama bin Laden urged fighters loyal to his network to attack Gulf and Iraqi oil infrastructure earlier this month.

Oil rallied steadily this year as a surge in demand forced OPEC producers to pump at their highest level in 25 years, leaving little spare capacity to deal with unexpected outages and sharpening concern over oil supply security. Falling prices after the October highs spurred OPEC to trim 1 million bpd of excess supply starting January 1, hoping to prevent a rapid build in stocks they fear could drag prices lower when demand wanes after the northern winter. Sustained falls in the value of the dollar -- reducing producers’ purchasing power from oil sales denominated in the U.S. currency -- has strengthened OPEC’s resolve to stop further price falls.

The battle for Saudi Arabia.

Every time something goes kaboom in the Kingdom of Saudi Arabia, I thank God that I am no longer working there. It is cold comfort, though, given how many friends and acquaintances I left behind, and I always worry that someone I know is going to be in the wrong place at the wrong time, when the shooting starts. The attack Wednesday in Riyadh is the latest in a series of attacks dating back several years. Despite the litany of bombings and shootouts in Riyadh and Makka, the Saudi militants do not seem to be able to sustain a continuous pace of operations. But the Anglo-American Invasion and Occupation of Iraq could change everything. Traditionally, Saudi militants smuggled their weapons from Yemen, but that long, bleak desert frontier with Iraq is now an open sieve.Who knows how many young Saudi men have wandered into Iraq to make jihad, to kill and be killed, and then wandered back, their skills, bravado and experience intact. What is the Royal Saudi Arabian National Guard or the Interior Ministry when you have fought the United States Marine Corps and lived to see the next day?

So far, the militants have not been able to hit anything oil related, and aside from shooting of foreign oil workers in Yanbu, it is not clear that they have tried. But the Nymex light, sweet crude contract jumped $2 per barrel on this news, and there is no telling where it would go if they hit a pipeline or an oil terminal or set an oil well on fire. Saudi Aramco, the state oil company, regularly assures the world that everything is fine, and I suspect that aside from the Al Sauds themselves, oil facilities are the most heavily guarded things in the country.

For anyone out there entertaining happy visions of an end to Saudi rule, you need to be reminded -- the entire industrialized world’s economy runs through Riyadh. Saudi Arabia produces slightly more than 10 percent of the 80 million barrels of crude the world consumes every day. If that crude disappears, for whatever reason, there is no way to make it up. The global poverty and misery that would accompany that loss as economies grind to a halt or even collapse in the struggle to secure their share of the world’s remaining crude oil would be staggering.

I suppose the U.S. could occupy the oil fields and facilities of the Arabian Gulf and Red Sea (the plans have been around for ages), but with what army? The U.S. military cannot even secure Iraq, and the Iraqi resistance has shown how to fight and beat the U.S. Any attempt to use the military to secure oil fields would be met with the same kind of resistance (and a likely popular one at that) aimed at destroying the very infrastructure we had come to save. I have not given myself over to pessimism. A few thousand Saudi police could still beat a few hundred committed militants. I will not lose sleep over this -- yet. But I will keep my bicycle in good repair. Just in case.

PROTECTING YOURSELF FROM A HOUSING SLUMP

In many U.S. cities, the housing market looks as extravagant and top-heavy as a Dr. Seuss castle. In metro New York, the median price of a single-family house is up 78% since 1999, according to the Office of Federal Housing Enterprise Oversight. The gains are even bigger in Miami (87%), Los Angeles (97%), and San Diego (115%). For years house prices in these markets have risen faster than family incomes. The trend made sense when mortgage interest rates were falling, but rates hit bottom in mid-2003 and they are likely to rise. Put it all together, says Yale University economist Robert J. Shiller and “it seems like house prices are within a year or so of a cyclical peak.” Even if the worries of a nationwide housing bubble are overblown, it is prudent for people living in the hottest markets to prepare for the possibility that prices will flatten out or fall in 2005.

So, what should you do? In a nutshell: Pull in your horns by paying off debt and reining in spending. Also, think defensively about the housing market. It is fine to take financial risks when you know you can raise cash quickly by selling your house for a big profit or taking out a home-equity loan. But you need to behave differently if there is a chance that you will not be able to sell or borrow against your house on reasonable terms. Preparing for a downturn is a bit like boarding up your windows ahead of a hurricane that never strikes, if you are lucky. If you keep your leverage modest and prepare yourself to sit tight, even a steep drop in prices should be manageable.

COMMODITIES LURE FUNDS INVESTORS

Pension and mutual funds are increasing their exposure to commodities markets as they seek to diversify their portfolios, attracted by the strong returns provided by energy and metals markets over the past few years. Heather Shemilt, managing director of commodity marketing at Goldman Sachs, said that the amount tracking commodity indices had risen from about $15 billion in mid-2003 to about $40 billion at the end of 2004. 90% of this injection of cash came from pension funds.

This is a fraction of the money that pension and mutual funds allocate to fixed interest and equity markets. But Ms Shemilt said it pointed to growing awareness among long-term investors that commodity prices could provide strong returns. The Goldman Sachs Commodity Index has risen by 25% this year although it has dropped by more than 12% points from its peak in October. In comparison, the S&P 500 index, has risen by about 10% this year. Goldman Sachs estimates that the returns on the GSCI have averaged about 12% a year since 1970, while returns from key equity and bond indices are between 8.5 and 11% over the same period. Ms. Shemilt said the GSCI had attracted close to $30 billion in funds tracking the index. Other commodity indices including the Reuters Commodity Research Bureau and the Deutsche Bank Liquid Commodity Index have attracted about $10 billion between them.

“That is an incredible increase in funds flowing into commodity indices, considering it took eight years for the GSCI to get its first $3 billion,” said Ms Shemilt. The GSCI was first open for investment in 1991. The increased interest from pension funds over the past 18 months has coincided with a period in which oil prices were on a record-breaking run in nominal terms, culminating in a peak of more than $55 a barrel.

The higher exposure by pension funds to commodity indices has also meant that they have become more involved in the underlying commodities through the purchase of crude oil and precious and base metal futures. Analysts said this trend of higher pension and mutual fund participation was reflected in the higher number of futures contracts bought on commodity exchanges in Europe and North America, which have had record trading volumes this year. Nevertheless, pension funds represent a fraction of the trade in commodity futures, which are the domain of hedge funds and industry participants.

HEDGE FUNDS MAY FALTER AND LLOYDS MAY BE SOLD

It is appropriate at this time of the year to recall one of Sir Winston Churchill’s remarks: “I always avoid prophesying beforehand, because it is much better to prophesy after the event has already taken place.” That said, this column can claim modest success in 2004: five hits and three misses. Here are the ones that were on target: Lazard LLC went for an initial public offering; hedge funds started listing/selling themselves; commodity prices boomed; the Greek economy, helped by the Olympics, was one of the fastest growing in Europe; and plasma screen TV’s moved into the mass market. Still, I would rather forget saying: Volkswagen AG might merge with France’s PSA Peugeot Citroen, new media would make a comeback, and Spain would join the G-8, making it the G-9. Nevertheless, here are eight predictions for Europe in 2005.

SWIMMING WITH LOAN SHARKS?

Earlier this year, five leading financial experts from across the country collaborated to publish a booklet of “utmost importance” to the future of the U.S. economy. On December 14, the final version was publicly released at a National Press Club conference in Washington, D.C. As a December 29 Newswire reports: The booklet is “the first of its kind”, and even more extraordinary is the subject matter. Five leading economists and not one word on the typical hot topics such as the Federal Reserve, the housing market, the nosedive of the dollar, or crude oil prices. Check this out. The title of their study is “Payday Lending: A Practical Overview of a Growing Component of America’s Economy”.

And by “growing”, they ain’t kidding. In the last four years, the number of payday lending retail outlets has more than doubled from 10,000 in 2000 to 22,000 in 2004. In 2004, payday-lending stores distributed about $40 billion in loans and collected $6 million in finance charges. In 2003, more than 13% of all U.S. households used a payday loan. In 2003, an estimated 70 million people used Web-based payday lending sources.

Lest we forget, payday lenders did not earn the pet name “loan sharks” for nothing. Truth be told, the risk factor for this particular debt can be quite deadly. A December 11 USA Today article notes that the annualized percentage rates for most payday loans are in the triple digits; many run as high as 780% (vs. 18% APR for credit cards). That does not include a $10 to $30 fee per $100 borrowed. Not to mention the fact that on-line payday lenders are not required to list their contact information, are “difficult to reach”, are free from the eye of state and federal regulators, and have access to the bank account and social security numbers of each borrower. These facts alone are why 15 states classify payday lending as a crime punishable by 20 years in prison or fines of up to $25,000 per transaction -- a barrier the internet has made virtually null.

But the point is, the number of people willing to swim with these loan sharks is soaring, and it is the captains of the ship that are urging them to jump in. “This used to be called loan sharking,” says one consumer advocate. “Now it is a segment of the market that is being hotly pursued by four of the ten largest U.S. banks.” Heck, the five leading economists who authored the “Payday Lending” booklet urged “consumers who may otherwise be denied credit from other lending institutions” to take advantage of this “practical solution” to short-term debt.

So, are they right? Will swimming with these loan sharks bring borrowers to a debt-free shore? The December Elliott Wave Financial Forecast has the answer, plus we reveal how the recent popularity of payday loans is an “integral part of the process” taking place in the U.S. economy, one that will change the face of the financial marketplace as we know it.

INFLATION DISINFORMATION

The Federal Reserve has done a masterful job of distributing disinformation. Last year, they were scaring Americans by announcing that deflation was a threat. This year, they continue to announce “inflation is contained” so interest rates can be raised at a “measured pace”. The Federal Funds Rate has moved up from 1% to 2.25% while the CPI has risen from 2% to 3.5%! The real interest rate -- the Federal Funds Rate less inflation -- remains clearly negative. “Loose as a goose” as in continuing to “goose the money supply” might be a good analogy. Meanwhile, everyone is fighting deflation and totally focused on the core inflation rate, which is running at about 2%. The reason the core rate goes up so slowly is because it is carefully designed to leave out the key expenses that really affect our lives and go up in price such as energy costs, food, and housing. The essence of disinformation is basically to get everyone to look the other way when something like inflation is really big and in your face constantly.

Critically, the mainstream press has been a big help to the Fed in this endeavor. For the most part, they simply print what they are told without doing any factual digging or additional research, or actually examining the “real” inflation numbers. When the Fed claims that all that matters is the core rate, you really need to go to the BLS and find out what the year-over-year rate is. Price increases are downright ugly and the last thing the government wants you to do is take a closer look.

A peek at some of the government’s recent numbers on prices surely indicate there is a whole lot of inflation going on now and in the “price pipeline”. The magnitude of real inflation is around us everywhere. An example of this could be seen in New York where taxi cab prices increased by 25%, while nationwide college tuition, health care, insurance, drug prices and property taxes are, in most cases, running near or above double digit annual rates of price increase.

So, why does the CPI rate of increase look so low? Ah, the genius of disinformation. First, many of the items going into the CPI are adjusted for quality changes, referred to as hedonic adjustment. However, our favorite disinformation trick in the CPI is the grand assumption that everyone in America rents their house. As you can imagine, rents have not been moving up as fast as housing prices. What is the “real” CPI? If we assume that housing prices are only increasing at three times the rate of the cost of renting, and the hedonic adjustment is only 0.5%, I think we can safely assume that real consumer inflation was 6%, as opposed to the reported number of 3.5%.

In looking at these numerical facts and the actual world around us, we can truly appreciate the magnitude of disinformation on the inflation front. The Fed needs inflation, wants inflation, and is getting inflation. Without inflation to inflate away a massive amount of personal, corporate, and government debt, our financial system could collapse. A lower dollar and higher inflation will ease the federal deficit while the foreign central banks, that have purchased U.S. Treasuries, will end up paying for the war in the Middle East as America’s debt is inflated away. To make the disinformation plan work, it is critical that even if inflation is not contained, the knowledge and perception that inflation is kicking up, is contained. The average American is so busy trying to make ends meet that when it comes to inflation, they do not even know what is happening.

SHINING THE LIGHT ON GOLD

On December 29, gold prices took a long walk off a short pier, plunging 2% and more than $8 in the worst one-day decline in three weeks. But the real injury was inflicted on the intelligence of anyone reading the fundamental explanations for the fall. The first reason offered by the mainstream press was -- to put it simply -- about as true a nugget of fool’s gold. A December 29 CBS MarketWatch column has the story: “Those who purchased gold due to the (South Asian) tsunami have reconsidered the value of that investment as there is not much of a disaster hedge as far as economic losses are concerned.” As far as whose economic losses? According to a December 28 ABC News article, the tsunami tragedy is both the “deadliest disaster of our century” AND “will require the most expensive relief effort in history ever.”

Now the second reason just sounds funny: “Gold dropped because the dollar has sort of recovered a little bit from yesterday’s levels.” (CBS MarketWatch Dec. 29) I kinda, sort of have a little bit of a problem with this statement (for many reasons) but mainly because the U.S. dollar still ended the day at a record low against the euro.

And here is what we had to say on that particular day: “Closing beneath [a certain price level] would break the up trend support line that has formed connecting the lows of December 10, 16, and 22, and would be the initial signal that the rally is complete and a new wave down has started.” 48 hours later, gold prices topped and tumbled south.

MARKET MISCONCEPTIONS

Investors and strategists will tend to argue that the recent weakness in the U.S. economy represents a typical mid-cycle slowdown and that a pickup in economic activity is just around the corner. The consensus also holds that stocks will be higher in a year’s time and that the market is reasonably priced. Concerning the Chinese economy, the consensus believes that a moderation in China’s growth rate has taken place. Restrictive credit policies are expected to be relaxed shortly. Therefore, by early next year, growth will once again surprise on the upside. Based on these assumptions, the popular view is that commodity prices will -- following their recent sharp break -- continue their bull market. However, I see a scenario that could upset this optimistic view of the global economy and asset markets.

Turning first to the U.S. economy, several recent developments raise the possibility of a more pronounced slowdown in economic activity. A decline in home prices -- which I expect -- will negatively affect consumption, since it is asset inflation that has driven consumer spending since 2000 (and, to some extent, the tax cuts) and not rising personal pretax incomes. The ever-optimistic homebuilders will, of course, tell you that the housing market is fundamentally healthy. But investors will not have to wait long to find out about the true condition of the housing industry. Recently, I wrote that a breakdown of financial stocks would be a warning for the credit-driven economy and the stock market, which would have to be taken seriously. In fact, investors should pay close attention to the rebound in financial stocks. A failure of the group to make new highs in the near future, at a time when the bond market has been rallying strongly, would have negative implications for the entire market as well as the housing sector.

On its own, weakness in the U.S. housing sector would not overly concern me. However, if it were simultaneously accompanied by weakness in the Chinese economy then I would take a dimmer view of the world. In the U.S. strong credit growth did not lead to rising net capital formation and industrial production. But in China the credit bubble (inherited from the expansive U.S. monetary policies through the fixed exchange rate) led to an unprecedented capital spending boom designed to boost manufacturing capacity in order to satisfy domestic and overseas consumer demand growth, which was expected to never end. In addition, rising commodity prices led to significant inventory accumulation. However, there are suddenly signs that not all is well in the Middle Kingdom and that the likelihood of a very hard landing has increased meaningfully.

The consensus holds that the slowdown in economic activity in China is solely caused by the government’s administrative measures implemented at the end of last year in order to cool down the “overheated” economy. But this is not my take of China’s recent economic slowdown. I believe that, in the same way that all interventions by governments and central banks are implemented, they came at the wrong time. In the case of China, the restrictive economic policies came at precisely the time the economy was about to cool down for cyclical reasons anyway. With or without the Chinese government’s measures to cool the economy, I would have expected capital spending to slow down, because of the over-capacities and bloated inventories!

My view is that capital formation will decline significantly in 2005 and that foreign direct investments will decline far more than is expected, as vast production over-capacities will result in widespread losses on foreign companies’ investments. In my experience as an emerging market investor, and also from what I have read about previous capital investment rushes over the last 200 years, it would be most unusual if the recent great China investment boom ended any differently than the various canal or railroad booms of the 19th century, or the great European investment rush into Russia at the beginning of the 20th century!

This is not to say that China will not become an even more important economic and political force in future. However, in the context of the present investment markets it is a warning that a Chinese economic slowdown -- or, as I would expect, some form of a cyclical hard landing -- could badly backfire on investors who simply base their investment strategies on a continuous economic boom in China.

DOLLAR POISED FOR THIRD ANNUAL DECLINE

The dollar fell to a e-week low against the yen, heading for a third consecutive annual drop, on expectations Japan will let its currency strengthen next year. The Bank of Japan refrained from selling currency for a 9th month, even as the yen rose to the strongest in almost five years, government figures showed. The dollar is set for a 3rd annual loss versus the euro as demand for U.S. assets wanes and on speculation U.S. officials favor a weaker currency. Japan “can’t help the dollar falling further against the yen,” said Toshi Honda, a currency strategist in London at Mizuho Corporate Bank Ltd., a unit of Japan’s largest lender by assets. “Dollar-yen could pierce 100 next year, and we expect it to go to 98 in three months.”

The Federal Reserve’s Trade-Weighted Major Currency Dollar Index is on course for its longest losing streak since Ronald Reagan was president. The index lost 5.8% this year after weakening the previous two years. Speculation overseas demand for U.S. assets is waning also sparked a dollar slide in the second half of the year, said Marvin Barth, a global currency economist at Citigroup Inc. in London and a former Fed employee. “The dollar is going to come under funding pressure,” said Barth. “It’s not a concern on the ability of the U.S. to attract foreign funding, it’s a concern it will attract enough foreign funding to compensate for the growing deficit” in the current account, he said.

Plumbing the depths.

Forecasting exchange rates, warns Alan Greenspan, the chairman of the Federal Reserve, has a success rate no better than calling the toss of a coin. But the dollar keeps coming up tails. At the start of 2004, holders of America’s currency had to part with $1.25 to buy a euro. In New York trading on December 30th, it cost almost $1.37 to buy a euro -- a record low for the greenback for the sixth consecutive trading session.

The record current account deficits are adding to America’s foreign debts at an alarming rate. But as yet, America still earns more from its foreign assets than it pays on its foreign liabilities. That is about to change. As interest rates rise, refinancing America’s debt will become more costly. Goldman Sachs forecasts that net foreign-investment income is likely to shift to a sizeable deficit during 2005, growing thereafter. The investment bank estimates that, if America’s current-account deficit remains steady as a share of GDP and interest rates average 5% in future, net foreign debt-service payments will reach 4% of GDP by 2020 -- a significant drag on American living standards.

To avoid shelling out such large sums to foreigners, America will, ultimately, have to rely more on its own savings and less on savings imported from abroad. The country as a whole saved just 1.7% of national income in the first nine months of 2004. Households saved just 0.7%. As the dollar falls, foreigners will demand more American goods. This will put pressure on America’s manufacturers, which are already operating at 78% of capacity. As supply is stretched, inflationary pressures will build. The Federal Reserve will raise interest rates, curbing domestic demand, and thus creating room for an export boom. The higher interest rates will thus promote the saving America has so sorely lacked.

This process has barely begun. Over the past two years, the dollar has lost almost 23% against the euro. But it has shed less than 13% against a broader basket of currencies, and it has not lost a cent against China’s yuan -- as a matter of official Chinese policy.

WALL STREET BEARS LOOK TO 2005, NURSE 2004 WOUNDS

After ending the year with a whimper, Wall Street bears are foraging for new prey, with home builders, banks and oil producers likely targets. Short-sellers, or bearish investors who profit from stocks falling, are also holding on to their bets that high-flying Internet stocks will be humbled in future quarters. And while the fate of these sectors remains uncertain, many financial experts say rising interest rates, decelerating earnings and an economic slow down could put the majority of short-sellers in the black this year -- the first time since 2002.

“Most people think it’s going to be a banner year for short-sellers,” said Harry Strunk, an investment consultant based in West Palm Beach, Florida who has tracked short-sellers for more than 20 years. “There seemed to be a lot of speculation in the late-year rally. The expectation is that the market will return to fundamentals next year.” This year, in fact, looked to be a banner year for short-sellers, with the market flat for most of 2004. Then November rolled around. The late year rally dragged the short bias fund category down 7.7% last month, according to CSFB/Tremont. The category, a group of short-heavy hedge funds, is down 3% year-to-date after being up as much as 9.1% late in the summer. Last year, it ended the year down 33%.

Short-sellers who questioned Corporate America’s obsession with the low-carb diet craze and who bet on further woes for the airline industry won big this year. Those who bet against new Internet stocks such as Overstock.com, an online seller of close-out goods, and Web search engine Google mainly lost out. But the technology sector is due for a pull back, making it still tempting for the bears, said Michael Metz, chief investment strategist at Oppenheimer & Co. “To me, the most vulnerable sectors next year will be consumer retail and technology,” Metz said. “I think you’ll see capital spending disappoint, which will put the tech sector under pressure. Next year will be dotted with earnings disappointments. It’s a great opportunity for short sellers.”

THE YEAR ON WALL STREET: TREATING INVESTMENT BANKERS LIKE BARTENDERS

It was a great year for Wall Street, or so the earnings numbers seem to say. New stock issues are selling again and corporate bond underwriting set a record. President Bush is pushing a Social Security plan that would divert huge sums of money into investment accounts, generating fees for Wall Street. Brokerage stocks have been market leaders in the postelection rally. But the real man of the year on Wall Street -- or at least the man whose plight is emblematic of the new Wall Street reality -- will not be sharing in those bonuses. Instead, Daniel Bayly is awaiting sentencing in federal court in Houston, where he is likely to be ordered to spend a few years in prison for doing something that few on Wall Street would have seen as a crime.

Mr. Bayly, the former head of global investment banking at Merrill Lynch, was caught up in the Enron scandal. He signed off on a deal that Merrill did with Enron, in which Merrill “bought” the now-infamous Nigerian barges from Enron at the end of 1999, thereby allowing Enron to report phony profits. The government persuaded the jury that Merrill officials understood the purpose of the transaction was to inflate Enron’s profits and that the accounting was phony. Mr. Bayly’s lawyers said he believed it was proper. The risk that bankers now confront is that they will be treated the same way bartenders are in some states, where the man who sold the drunk driver his final drink can be held liable for the damages that result. It used to be that when a company went bankrupt as a result of fraud, the only deep pocket available belonged to the auditor. The collapse of Arthur Andersen after the Enron fraud served as a warning that that pocket might not be so deep, a fact that has been reinforced by the limited insurance now available to auditors.

The current reality is that investment and commercial bankers are the new deep pockets. They used to get high fees for devising transactions whose primary purpose was to mislead investors. Now they will be sued by the S.E.C. and by private lawyers if there is any evidence the bankers knew the company’s accounting was suspicious. The Justice Department may even deem such an act to be a felony, and there is no assurance that it will not bring criminal charges against an investment bank as well as against its officials. As the profits pour in from the rebound in investment banking fees, investors might hesitate in bidding up the industry’s shares. As Mr. Bayly’s conviction demonstrates, the risks of the investment banking business are much greater than they used to be.

LET THE GOOD TIMES ROLL

Foreign workers seem to be able to make anything we can make -- but much cheaper ... foreigners save their money ... and these savings give them huge piles of capital with which to build more modern factories and more convenient infrastructure. What this means is that U.S. labor is suddenly over-priced. Americans’ real hourly wages have gone nowhere in the last 30 years. They are likely to go nowhere in the next 30 years too -- since so many jobs can be done overseas by much cheaper workers. While the foreigners got richer, U.S. passport holders became delusional. Let the Chinaman sweat, they said to each other. We’ll think! This gargantuan conceit allowed Americans to sink into one of the most flattering fantasies the world has ever seen: That they could get richer without saving ... or without really earning more money. Household debt soared to $10 trillion -- 115% of earnings. After WWII, it was only 20% of earnings. Indeed, Americans came to think that the more they borrowed and spent, the richer they got.

For a long while, it seemed almost to be true. The world’s financial plumbing has become so curiously put together that the oddest things have been mistaken for commonplace. We turn on the stove and champagne fizzes out. We open the faucet and it runs with Kentucky bourbon; the whole thing is strange, but it does not take long to get to like it. The U.S. economy has been so strong for so long, people all over the world have come to accept its currency as though it were real money; they took it and asked nothing in return. In exchange for a shipment of TV sets, for example, the Japanese would take a wad of $100 bills and call it even. Until very recently, the foreigners seemed perfectly happy merely to hold the U.S. paper. They liked the feel of it. By the end of 2004, they had racked up some $10 trillion worth -- nearly $3 trillion more than Americans had of their assets. And because Americans continued to spend more than they made ... each day the foreigners tossed nearly $2 billion more on the pile.

Something else is new in this new millennium. Not only does America face economic competition; it faces monetary competition too. Drug dealers and central bankers have a choice. They could just as well fill their stomachs and safes with euros as with dollars; besides, the higher-denomination euro bills are easier to swallow. With as much as $100 trillion of the world’s wealth denominated in dollars, how did the world watch so complacently as the value of its main asset was marked down? The dollar went down. By 10%. Then 20%. And then 30%. When Warren Buffett began putting his money in euros, he could buy one for just 86 cents. Now, the euro costs nearly $1.36.

Today, nearly all the experts agree: The dollar will continue to go down. But no seems to want to connect the hipbone to the thighbone. No one seems to want to look beyond the dollar’s decline. Somehow, the dollar has been decoupled from almost all other financial transactions: it can go down while the assets it measures do not. The dollar falls; U.S. stocks and bonds go up. Go figure. We figure it is pretty strange. But we have become used to strange things in the financial world. One additional oddity, more or less, should not make any difference. But there is something especially strange about this new strangeness.

Here at The Daily Reckoning, at the beginning of the year, we thought we saw a tsunami coming. The dollar would collapse, we believed, under the weight of the twin deficits -- trade and federal. We are masters of hyperbole. But even we could not seem to find words to match the impending doom. And yet, we might as well have been a black-frocked deacon standing on a pier in Long Beach, warning sailors that, coming ashore, they might be tempted by loose women and free booze. Never did such a warning fall upon such deaf ears.

Americans thought they had merely discovered another sailors’ paradise -- a Tahiti with women in grass skirts and liquor trickling down the rocks. For years, the kind strangers had offered merchandise at Everyday Low Prices, taken their IOUs, in payment and used them to buy U.S. Treasury bonds -- thus keeping U.S. lending rates exceedingly low. Then, just at the moment when the foreigners begin thinking about unloading some of this debt along comes a decline in the dollar. America’s overseas debt burden is being marked down, day after day. Not only did Americans never have to make good on their overseas IOUs, they never will have to. So you see, dear reader, the pessimists and doom-mongers were wrong again ... there really is a free lunch, after all. Or so it would appear on the last day of 2004 A.D.

HAVE WE BEEN HERE BEFORE?

It seems uncommonly easy to make lasting memories on New Year’s Eve. As you prepare to celebrate the New Year, either in quiet at home or by carousing the night away, it is probably not hard to remember past celebrations that you would like to duplicate and those that you would rather forget. It is harder to remember a time when the overall market environment looked like it does now. Nearly every major market -- stocks, bonds, commodities, and the dollar index -- have been in more or less trending together for many, many months. In 2002, Bob Prechter’s Conquer the Crash observed a four-year confluence between trends in the CRB commodity index and the S&P 500. Bob explained, “As I see it, this correlation means that most assets lately are moving up and down more or less together, probably as liquidity expands and contracts.”

Bob wrote in February and affirmed last month, “Rising liquidity equals more money, which makes the value of each monetary unit decline, thus the falling dollar and rising precious metals and commodities prices. Rising liquidity in a credit-based system -- in all but highly inflationary monetary markets -- is considered good for the economy, thus the rising prices for stocks and junk bonds. My point is that such a confluence of effects can occur only in a disinflationary or deflationary world. During inflationary times (such as the teens and the 1970s), the trends in these two sets of markets go opposite ways.”

When this unusual alignment of paper assets and commodities began with a shared uptrend during the first half of 1980, it was followed by a brief deflationary crunch into the summer of 1982. Obviously, deflation did not exactly take hold and choke the economic life out of the 1980s. But the rare circumstances warrant the deeper look into the past. “The brief deflationary crunch of 1919-1921 was an advance warning of what the 1930s would bring after an intervening paper asset boom. In the same way, the deflationary crunch of 1980-82 was an advance warning of what is to come when the current asset boom ends.”

Who’s the stock market dead ringer?

Imagine that you are private eye Phillip Marlowe, taking a nap in your dusty office, and in walks one of Raymond Chandler’s trademark vamps. Suppose this vamp reminds you of someone you have seen before, but you can’t place her. Suppose she says something like, “I don’t like your manners.” And you say, with dialogue straight out of The Big Sleep: “And I’m not crazy about yours. I didn’t ask to see you. I don’t mind if you don’t like my manners, I don’t like them myself. They are pretty bad. I grieve over them on long winter evenings.”

Well, on these long winter evenings, you might want to ponder this notion: It takes one to know one -- as in, it takes an all-time stock market peak to know one. And that is the vamp you will want to keep your eyes on. Our just-published Elliott Wave Financial Forecast describes the current “dead ringer” for the all-time peak. What we see are seven parallels between the economy and the financial markets now and an all-time peak from not very long ago. Here is a tip: some of these parallels include monetary tightening, old line investment banks selling out, insiders bailing out, and an attempt to have stocks bail out Social Security. Now do you see the parallels?