Finance Digest for Week of February 21, 2005

POST-BUBBLE PITFALLS -- YET ANOTHER LESSON FROM JAPAN

Japan’s fourth recession in a dozen years is a grim reminder of the downside of a post-bubble economy. So, too, is the nation’s lingering deflation, which has now persisted for more than seven years. So far, America’s post-bubble experience has been very different -- merely one recession and nothing worse than a brief deflation scare. Yet it may be premature to conclude that the U.S. has avoided the dreaded Japan syndrome.

Since the bursting of Japan’s equity bubble in late 1989, there has been a painful rhythm to the nation’s post-bubble recessions. The first downturn commenced quickly in early 1991 and lasted for about 2½ years. The next contraction did not occur for another 3½ years -- beginning in mid-1997 and running through early 1999. Japan’s third post-bubble recession came a scant seven quarters later, starting in late 2000 and running through early 2002. And then two years later, in Q2 2004, the most recent downturn commenced. The pattern is important -- an immediate post-bubble shock followed by several years of recovery, which then gave way to a more frequent series of rolling recessions. There are some striking similarities in the U.S. experience. To be sure, there are scant signs of an imminent relapse that would put the U.S. on track to match the next twist in the Japan experience. But America’s fragile underpinnings certainly do not rule out that possibility.

The shifting incidence of Japan’s post-bubble recessions also bears on the U.S. experience. Japan’s first recession was dominated by a severe contraction in business capital spending, as was the case with America’s first post-bubble recession. In both cases, these recessions largely reflected a purging of the massive overhang of excess capacity that was built up during the equity bubble. The corollary of that observation is that consumers are usually spared from the first wave of post-bubble aftershocks. That was the case in Japan in the early 1990s and has also been the case so far in the U.S. But that initial resilience may be deceiving. In Japan’s downturn of 1997–99, the sharp contraction of real consumer spending accounted for fully 72% of the cumulative decline in real GDP. Nor has the Japanese consumer quickly bounced back. Japan was quick to purge its bubble- induced overhang of excess capacity. But it has taken a much longer period for its consumers to adjust to harsh post-bubble realities.

By contrast, the U.S. has yet to face this phase of its post-bubble adjustment. The consumer has been the bedrock of America’s post-bubble resilience. In my view, this was a direct outgrowth of the Fed’s aggressive post-bubble containment strategy -- one that attempted to draw heavily on the lessons of Japan. On the surface, and so far, the Fed’s success looks stunning. But I have long argued that the Fed’s success has come at a real cost. Courtesy of extraordinary monetary accommodation and a building sense of froth in asset markets, wealth creation shifted seamlessly from equity to property markets, and American consumers migrated from the job- and income- dependent spending models of yesteryear to the asset-based mindset of today. As a result, households have been more than willing to take the income-based personal saving rate down toward zero, while, at the same time, turning to the home mortgage refi market as the principal means to extract newfound purchasing power from increasingly overvalued property assets. And, of course, U.S. consumers have gone deeply into debt in order to monetize this claim on the asset-based portion of their income stream.

But now the Fed faces a most perilous post-bubble exit strategy -- taking real interest rates up to a more normal level. That, in my view, will be an exceedingly delicate exercise. The U.S. central bank bought time with its “prevent-Japan” drill in the immediate aftermath of the bursting of the equity bubble. But that time has now run out as the Fed seeks to normalize interest rates. Ironically, the U.S. probably has more to lose from a consumer capitulation than Japan, in large part because the excesses of America’s consumer culture dwarf the role of the Japanese consumer. The key lesson from Japan, in my view, is that the consumer ultimately holds the key to the severity of the post-bubble endgame.

America is not Japan. Market structures of the two economies are different, as are the two financial systems. But both economies have had to cope with the aftershocks of a major asset bubble. And there are similarities to the time profile and mix of the two post-bubble shakeouts. Initial consumer resilience crumbled in Japan but has yet to do so in the U.S. The coming normalization of U.S. interest rates could well be the catalyst that takes its economy into the next phase of its post-bubble adjustment. Financial markets are priced for ongoing resilience of the American consumer. Should that not turn out to be the case, the dollar would undoubtedly fall further and the U.S. bond market could stage a Japanese-style rally. It is far too soon, in my view, to dismiss the lessons of Japan.

THE CURSE OF CHEAP MONEY

Labor productivity figures announced last week were poor, surprising the market, which since 1997 has believed the U.S. to be in a new era of rapid productivity growth. But there are more inputs into a modern economy than labor. Multifactor productivity, including both labor and capital as inputs, is a much closer proxy for the real economic gains caused by technological and organizational change. Multifactor productivity, calculated with a substantial lag, showed a positive tendency for 2002, the latest figures published, up 1.9% for the year, a figure well above its long term trend rate.

However, over the 10 years 1992-2002, when compared with the longer term trend, the figures tell a different story. The 1990s did not in reality bring a secular increase in U.S. productivity, as has been widely and triumphantly claimed, which might justify the sky-high stock valuations of the decade, the general optimism about U.S. economic prospects and the incessant sneering at supposedly “sclerotic” economies such as France and Germany. Instead, the rate of increase in multifactor productivity in the business economy actually SLOWED during the decade. From a rate of increase of 1.30% in the decade 1982-92, multifactor productivity growth almost halved in the decade 1992-2002, to a rate of 0.72% per annum.

Labor productivity in the decade 1994-2004 increased by 2.91% per annum (or 2.2% per annum in 1992-2002, to be comparable.) And in the five years 1999-2004 it was 3.70% per annum. Compare this with 2.28% per annum in 1982-92, 1.26% in 1972-82 and 3.31% in 1948-73 and, if you do not think about it too closely, you see a disaster under Nixon/Ford/Carter, a modest recovery under Reagan, and a further spurt in growth under Clinton and ... George W. Bush. Under this scenario, Baby Boomer presidents are good for the economy, U.S. productivity has accelerated to a new level that justifies fancy stock price valuations and Bill Clinton, in particular, was a genius.

Capital productivity can be tracked just like labor productivity, but shows a very different path. It peaked as long ago as 1966, and has since been showing a steady decline, which decline accelerated during the 1990s. In 1948-66, that efficiency was steadily increasing, as a the U.S. recovered from the war and modernized its plant, retiring capital assets left over from before 1929. After 1966, the efficiency of capital usage began to decline, as a surge in inflation, the economic diversion of assets to the Vietnam War, and pollution control measures such as the Clean Air Act of 1970 took productive assets out of service. Then in 1973 the price of a key input -- petroleum -- suddenly quadrupled, making a huge range of capital assets suddenly obsolete. Gradually through the 1980s, the economy adapted to higher oil prices, but all the time the capital intensity of the economy was increasing, so capital productivity never regained its 1966 level.

Then in the late 1990s and following 2000, we had a surge of capital inputs into the economy. First, the stock market rose towards Pluto, so that any new venture could get financed, no matter how hopeless. Then, before that bubble had been dealt with, interest rates were cut aggressively to a short term interest rate well below zero in real terms, igniting a blaze of consumer “investment” in housing, automobiles, boats and other fixed assets. Consequently, the capital efficiency of the economy dropped to a level far below that ever seen in recorded history, though I would guess that of 1932, when assets were being shuttered or used at half capacity, may have been lower. There was a record level of economic waste.

We have only 2002’s figures for multifactor productivity, but at this point we can make a pretty shrewd guess about what 2003 and 2004 will show. The surge of cheap money and artificial consumer asset investment already visible in 2002 grew to extraordinary levels in 2003 and remained very high in 2004. Thus the high figures for labor productivity growth seen in 2003 and 2004 were simply an artificial surge, produced by increases in capital input that may well have exceeded 2001’s record. True productivity, multifactor productivity, increased very modestly, or even declined.

We can also see what is likely to happen going forward. Interest rates are now rising significantly, the housing bubble is beginning to cool, and the 2003-04 tax benefit for capital investment has ended. Consequently, in 2005 capital inputs to the U.S. economy will slow their increase or even decline. If multifactor productivity continues to grow at the slow but constant rate it has exhibited since 1992, we are likely to see a very sharp decline in the published labor productivity increases, or even a fall. It will represent nothing more than a long overdue correction to the imbalances of recent years.

Very slowly increasing or even declining labor productivity has other implications. On the bright side, the monthly jobs figures will cease being unexpectedly poor, and will become more closely aligned with expectations generated by other economic data. On the negative side, this alignment will be achieved through deterioration of the other data. This should produce a deep and long-overdue fall in the stock market, which itself will correct imbalances that have been present for far too long.

There never was a productivity miracle. There was only a recovery, from the imbalances caused by the 1973 oil shock and the early 1970s environmental legislation, which took productivity growth back close to its historic level. That recovery took place in the 1980s, not the 1990s. It was followed by a surge in capital investment, caused by excessively cheap money, first in the tech sector and then in housing. That surge has now ended. The years ahead, in terms of reported labor productivity growth, economic growth in general, and the stock market are likely to be grim ones indeed. If you must blame anyone for this, blame Alan Greenspan.

THE OTHER STEPHEN KING ON THE ECONOMIC HORRORS FACING CENTRAL BANKERS

My occasional trips to the U.S. can sometimes involve strange experiences. Admittedly, it is partly my fault; or, at the very least, my parents’ fault. My name, you see, is the trigger for many a joke about whether The Shining is better than Carrie, or whether I am on the verge of finishing my next novel. Remarkably, many of these “comedians” think I have not heard the joke before. And, because many of them work for Homeland Security in various U.S. airports, I feel obliged to laugh. The alternative -- a full body search -- is not terribly appealing. My name also conjures up expectations that anything I may say on economics is likely to be a horror story. And, much as I would like to avoid this stereotype, I sometimes cannot stop myself.

Last week I visited a number of U.S. cities, talking about the outlook for the global economy and America’s role within it. I warned of the perils of ever-increasing current account deficits and the dangers of a sudden rise in the risk premium on financial assets. Although markets have done well and the U.S. economy has continued to expand, this kind of argument tends to trigger unease among investors. It is almost as if people are expecting Jack Nicholson to appear, holding a bloodied axe, screaming: “Here’s Johnny!”

The difficulty facing investors and policymakers lies in working out the most relevant yardsticks for economic performance. We have had it drummed into our heads over the past 20 years that price stability is the ultimate macroeconomic objective; so much so that this aim is enshrined in the constitutions of most central banks. The good news is that the objective of price stability has been broadly achieved. Few countries seem haunted by the ghost of inflation past. Does this mean that we are living in an era of macroeconomic stability? I doubt it. Stability at the domestic level, for example, has not necessarily been mirrored by stability internationally. As Mervyn King, the Governor of the Bank of England, said,“qThe aim of central banks to make monetary policy ... more boring needs to be complemented by a collective effort to bring boredom to the international monetary stage.” In other words, there are international limits to the influence of national central banks, and of national policymakers more generally.

External imbalances tell us something about domestic savings and investment patterns across countries. A country that saves more than it invests will run a current account surplus: it will be exporting capital. A country that invests more than it saves will run a current account deficit: hence it will be a capital importer. So, if central banks are concerned about external imbalances, they are also expressing concern about savings and investment behavior; not necessarily in their own country, of course, but around the world as a whole. This, however, puts central banks in a peculiar position. Why should they be concerned about saving and investment behaviour if their various targets for price stability have been met? The answer lies in the dual role played by interest rates.

Interest rates can be manipulated to create equilibrium in the money markets. Too low a level of interest rates will lead to excessive monetary expansion and, hence, higher inflation: too high a level of interest rates will do the opposite. Interest rates can be manipulated, however, to create equilibrium in the capital markets. Too low a level of interest rates will lead to excessive capital spending; too high a rate will lead to excessive saving. And, in a world where inflationary expectations are remarkably low and stable, it is this second function of rates that is likely to be the more important.

Central bankers who express concern about external imbalances are also, implicitly, expressing concern about domestic savings and investment behaviour which, in turn, is likely to be influenced by inappropriate levels of real interest rates giving rise to bubbles. That central bankers have nightmares about external imbalances tells us that the horrors facing them are not encapsulated in the outlook for inflation alone. It may well be that domestic price stability is the only thing that central banks are mandated to achieve. But policymakers know well enough that there is always the danger of a mad axeman popping up at an inconvenient moment, ready to hack to pieces the inflation-targeting framework which has served the world economy so well.

NEW LEADERS HELPING ASIA GET ITS GROOVE BACK

Singaporeans are still talking about it: The diplomatic love-fest between their leader and Indonesia’s. It is not what Southeast Asians are used to. Petty squabbles with neighbors? Yes. Hollow pledges of economic cooperation? Absolutely. Grand visions of Asia taking on the West? Oh yeah. Genuine teamwork between leaders? Nope. Yet that is precisely what Singaporeans observed last week when Susilo Bambang Yudhoyono made his first trip here as Indonesian president.

Such warmth toward a key neighbor like Singapore indicates how much has changed in Indonesia since President Suharto was toppled in 1998. Yudhoyono noted, for example, that Singapore Prime Minister Lee Hsien Loong sometimes calls him with barely 10 minute’s notice. It makes the tensions of the Suharto era seem like distant history. In office since October, Yudhoyono also is pledging to tackle some huge impediments to foreign investment: corruption and cronyism. The same thing comes from the Malaysian leader, in office since late 2003, and the recently re-elected ones of the Philippines and Thailand.

The common thread is a determination to end the legacy of graft that is left an enduring impression on foreign investors. While Southeast Asia has made progress in rooting out so-called “crony capitalism”, much remains to be done. That a critical mass of Asian leaders is intensifying the effort is a plus for economies and markets. The region’s new leadership could end up being a head fake, just like previous periods of optimism. A healthy dose of skepticism is always advisable.

FED’S RATE BOOSTS UNEXPECTEDLY STIMULATE ECONOMY

Fed Chairman Alan Greenspan calls it a “conundrum”. Former Fed colleague Laurence H. Meyer calls it “extraordinarily unprecedented”. The Fed has raised its target interest rate six times since June 30, intending to prevent the U.S. economy from overheating later this year. Instead, the increases are having the opposite effect: They are spurring the economy, not reining it in. “Rather than the rate hikes slowing the economy as some analysts had expected, they’ve acted as a stimulant,” David Malpass, chief economist at Bear, Stearns, said in an interview.

When the Fed raised the overnight bank-lending rate in the past, long-term interest rates rose as well. This time around, investors took comfort in the Fed’s commitment to what it calls a measured pace of rate increases as a way to head off faster inflation. Instead of rising, yields on 10-year Treasury securities and rates on 30-year mortgages fell. Banks expanded their corporate lending and merger activity sped up. “This is a unique experience,” Meyer, a Fed governor until 2002, said in an interview. “From the very moment the Fed began to tighten, long rates are falling. In 1994, the last time the Fed raised the rate significantly, long-term rates just shot up much more than most people were expecting,” he says.

BEHIND THOSE MEDICAL MALPRACTICE RATES

For all the worry over higher medical expenses, legal costs do not seem to be at the root of the recent increase in malpractice insurance premiums. Government and industry data show only a modest rise in malpractice claims over the last decade. And last year, the trend in payments for malpractice claims against doctors and other medical professionals turned sharply downward, falling 8.9%, to a nationwide total of $4.6 billion, according to data compiled by the Health and Human Services Department.

Lawsuits against doctors are just one of several factors that have driven up the cost of malpractice insurance, specialists say. Lately, the more important factors appear to be the declining investment earnings of insurance companies and the changing nature of competition in the industry. The recent spike in premiums -- which is now showing signs of steadying -- says more about the insurance business than it does about the judicial system.

STOCKING UP FOR GOLD’S REBOUND

Gold is a dollar thing. When the dollar rallies, gold falls. When the dollar falls, gold rallies. Last November and December, the dollar was falling out of bed. Gold was probing $460 an ounce. The gold bugs were all “atwitter”, projecting that $500 gold or higher was just around the corner. By Christmas, you could not find a dollar bull anywhere. I am a gold bull; but my opinion was that we were about to see a temporary dollar rally, and that would put pressure on gold. Here we are in mid-February, and the U.S. dollar index has rallied from its December low of 80.40 to 85.40. Conversely, gold has dropped from its December peak at $460 to a low at $414 -- a modest 10%. However, the Philadelphia Gold and Silver Index of precious metals mining stocks (the XAU) has dropped from 111.50 in November to 87.60 lately -- a not so modest 21.4%. The dollar is moving higher, and the pressure is on.

This was expected, and the dollar’s rally has now all but relieved the oversold conditions that existed in December. In fact, the dollar is getting quite close to becoming overbought. Gold is giving us the same technical signs in reverse, and it has recently dipped into oversold readings. At any rate, gold should now have decent support at $420, and the XAU should see support at 90.00. My advice is to put open (good until cancelled) orders in under the market. I have a list of precious metal stocks I feel are suitable for “buy” and “hold”, along with specific downside buy prices at which subscribers should buy. If I had to pick one, I would recommend Novagold (AMEX: NG). Novagold is an emerging gold producer, and they have been exceptionally successful. I think you can purchase this at or under $9.00. You should also take a look at Newmont Mining (NYSE: NEM), an institutional staple in the precious metals sector. I also like the action in Anglogold Ashanti (NYSE: AU).

ADIOS, AT&T

This newsletter, and my career as a stock analyst, was launched with a ludicrous prediction: that AT&T would soon go out of business. It happened. Last month AT&T agreed to sell out to SBC for a measly $16 billion. The essential reason AT&T failed is not hard to find. Nor was it hard to see in 1999 either -- but back then nobody was willing to listen. AT&T, over the course of several decades, made a fundamental business error: it became a company of process and not of function. AT&T defined itself as a voice long distance company. It had numerous opportunities to choose another path, but it chose to be America’s “long distance” company. And by that it meant circuit switched, dedicated voice. It was a company about a process: the process of switching dedicated circuits. That business came to an end with the Internet, which uses packet switching, not circuit switching. No more dedicated circuits, no more AT&T.

Had AT&T defined itself differently, AT&T could have easily been one of the world’s biggest companies instead of being out of business. Do not believe the hype that the 1996 Telecom Act destroyed AT&T or that the breakup of AT&T in 1984 is responsible. The worst choices AT&T made, it made all by itself. It always perceived communication as something that happened on its circuits, rather than something that happens between people, whatever the medium. Had AT&T perceived its mission to be empowering communication, many things would have happened differently.

For example, it was at AT&T’s Bell Labs that the transistor was discovered. The transistor, as the basic building block of an integrated circuit and the heart of every computer chip in the world, is undoubtedly the greatest invention of the last century. Next to electricity and perhaps the pathology of bacteria, the transistor is the greatest scientific development in the history of mankind. AT&T developed the transistor as a way to amplify long distance calls and it never realized any other significant value from the invention. In 1956, in order to keep its long distance monopoly, AT&T agreed to give away, for free, its license to the transistor, placing its designs in the public domain.

You might make an argument that back then AT&T did not know what it had -- but that is simply not true. Texas Instruments, General Electric and Fairchild all spent $25,000 buying licenses to AT&T’s transistor patents before they became public. Lots of people in engineering knew how important transistor technology would, and did, become. Besides, the transistor was not the only time AT&T dropped the ball. Another great example is the cell phone, which as you will see, led directly to the sale of the company.

THE WEALTH ILLUSION

Mr. Vernon W. Hill, a Monroe County banker, considers the “wealth” accumulated in the housing market an illusion, as we do. He believes it will lead to big problems among both borrowers and lenders. To avoid the big problems personally, Mr. Hill, like Warren Buffett, lives in the same house he bought nearly 40 years ago. Avoiding the big problem professions, Mr. Hill requires prospective borrowers to show him their finances without considering the house they live in. Whatever value there is in the lived-in house, he says, is “inactive”. It does not really earn any money for you; if you were to sell it, you would just have to buy another one. And you cannot ship it to China to pay for your flat-screen TVs or to Japan to pay for your SUV.

This point brings us back to today’s news and to the duo appearing in today’s International Herald Tribune. Mr. David H. Levey was formerly managing director of Moody’s Sovereign Ratings Service. His sidekick, Stuart S. Brown, is a professor of economics and international relations at Syracuse University. The two argue, “U.S. Hegemony Has a Strong Foundation”. The two are talking big. They are talking macroeconomics, with no trace of Mr. Hill’s modest insights, or his private knowledge, nor his 37 years of experience lending money, nor the keen and immediate attention of having his own money at stake. Instead, the two economists merely play their role in the public spectacle.

What Levey and Brown are trying to tell us is that we have nothing to worry about. Yes, it is true that we Americans spend 6% more every day than we earn. Yes, that $8.1 trillion worth of U.S. assets are in foreign hands ... and that our net international investment position has gone negative at more than $3 trillion. And yes, it is true that we save nearly nothing. But we can still feel good about ourselves, they say.

The two economists note, “when you include capital gains, 401(k) retirement plans, and home values, U.S. domestic saving is around 20 percent of GDP, the same as in most other developed nations.” They should talk to Mr. Hill. They do not seem to realize that home values are “inactive”. We have yet to hear of a factory built with increases in house prices. We have yet to see a debt paid from a rising house price -- without an equal debt arising somewhere else.

IF YOU MUST BUY PROPERTY, GO FOR SOMETHING OFF THE BEATEN PATH

It was good to get back to Spain, where I spent considerable time in the mid-1980’s, before it joined the EU in 1986. Subscribers my newsletter in those days will recall my urging them to take a look at the country, especially Andalusia’s Costa del Sol, running east from Gibraltar. The reasoning was that, since Spain was only a decade out of the Franco dictatorship that had isolated it for so many years, it was one of the least developed and cheapest places in Europe. That, and the fact that it has the continent’s best climate (Andalusia is further south than Sicily), would draw lots of northern Europeans looking for a place in the sun.

It was a good call. The price of coastal land has gone up close to tenfold; even condos are up three to five times. It is no longer cheap, though, so I no longer recommend it as an investment. Even though the phones now work and you can get broadband Internet everywhere, I am not even sure I can recommend it as a lifestyle choice, as crowded and expensive as it has become. At the same time, in the mid-1980’s, I drew readers’ attention to the fact that the Spanish stock market was showing an average yield of over 12%. No more. It is just as pricey as all the other European bourses. I still harbor a predilection for places that are off most people’s radar screens. With that in mind, I spent the best part of a week in Turkish Cyprus. ...

Le Strip Mall

“I only get one good idea per year,” the voice on the other end of the phone began, “but I’ve got a decent one now ... I think.”

“It’s only February,” your editor replied. “Are you sure you wanna commit this early in the year?”

“Yeah, I think so ... the main idea is pretty simple: Buying global commercial real estate. ... [A] couple months back I was poking around for foreign real estate stocks. In the process of looking, I found a few stocks -- mostly foreign REITs -- that interested me. And then I discovered that a REIT by the name of the ING Clarion Global Real Estate Income Fund (NYSE: IGR) kept showing up as an owner of the stocks I liked. So I decided to stop working so hard, and just buy the fund.”

After hanging up the phone, we took a closer peak at IGR. The fund market’s itself as “a global portfolio of public real estate companies which are in the business of owning, operating, developing, repositioning, acquiring and selling commercial real estate properties” At the current quote, the fund sells for about a 14% discount to its net asset value and yields almost 8%.

THE MAESTRO CHANGES HIS TUNE

Nearly 40 years ago, Federal Reserve chair Alan Greenspan wrote persuasively in favor of a gold monetary standard in an essay entitled Gold and Economic Freedom. In that essay he neatly summarized the fundamental problem with fiat currency in a few short sentences: “The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. ... In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. ... Deficit spending is simply a scheme for the ‘hidden’ confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”

Today, however, Mr. Greenspan has become one of those central planners he once denounced, and his views on fiat currency have changed accordingly. As the ultimate insider, he cannot or will not challenge the status quo, no matter what the consequences to the American economy. To renounce the fiat system now would mean renouncing the Fed itself, and his entire public career with it. The only question is whether history will properly reflect the destructive nature of Mr. Greenspan’s tenure.

I had an opportunity to ask him about his change of heart when he appeared before the House Financial Services committee last week. Although Mr. Greenspan is a master of evasion, he was surprisingly forthright in his responses to me. In short, he claimed he was wrong about his predictions of calamity for the fiat U.S. dollar, that the Federal Reserve does a good job of essentially mimicking a gold standard, and that inflation is well under control. He even made the preposterous assertion that the Fed does not facilitate government expansion and deficit spending. In other words, he utterly repudiated the arguments he made 40 years ago. Yet this begs the question: If he was so wrong in the past, why should we listen to him now?

BOOM OR BUST?

To paraphrase Mark Twain, it’s a difference of opinion that makes a horse race. At the Mises Institute conference on Austrian Economics and the Financial Markets held in Las Vegas last weekend most speakers admitted that the investment world is filled mostly with risk and offers few bargains. But, the authors of two recently published investment books believe that their crystal balls are crystal clear and that they hold the road map to riches for the coming decade. Harry S. Dent, Jr. says that a person should be piling into stocks because by the year 2009 the DJIA will reach 40,000 and the Nasdaq will explode to at least 13,500 and possibly 20,000.

The predictions Dent makes in his book The Next Great Bubble Boom: How to Profit from the Greatest Boom in History: 2005–2009, are based on what he terms a new science: Demographics. In Dent’s view, consumer spending patterns can be projected down to neighborhood blocks. And with this data, “there is a new information-based science built on predictable cause-and-effect impacts of how we change as we age that is just as predictable on average as life insurance actuarial tables for when we die.” Writes Dent, “Demographics as a new science is the greatest breakthrough we have seen in economics. It is inherently very simple and understandable in principle as we all do these predictable things to some degree or another as we age.”

Dent sees the technology bubble continuing to the end of the decade after its brief correction from 2000 to 2002. Tech bubbles are different from asset bubbles (Japan land, Tulipmania) and structural instability bubbles (OPEC and Middle East) because new infrastructures are created such as the Internet and personal computers that “would not be created by normal economic incentives.” It is the innovation from the tech bubble combined with the size of the baby boom generation and the fact that investing in stocks has become a mainstream trend that is creating this great bubble boom. Dent of course makes no mention of Austrian Business Cycle Theory or the gargantuan amount of liquidity created by the Federal Reserve in his bubble thesis. It is all about demographics and technology. “Bubbles are almost impossible to prevent,” Dent writes. “The bubbles finally end when everyone is in and there is no one else to keep buying.” By the way, the end will occur sometime in 2009 or 2010. Go ahead and set your clock.

Anyone worrying about inflation should stop it, according to Dent. Inflation will be low and then there will be a “major wave of deflation”. Gold newsletter writer, James Turk and his co-writer John Rubino see things much differently. These writers believe that you must invest in gold and other hard assets to earn your fortune by the end of the decade. In The Coming Collapse Of The Dollar And How To Profit From It: make a fortune by investing in gold and other hard assets, Turk and Rubino write that debt and deficits matter, that the central bank cannot be trusted to manage the currency, that foreign exchange markets effect the U.S. economy and that gold has a constructive role in the modern economy. The authors contend that much of our prosperity is an illusion and that the dollar, like all fiat currencies before it, will fail.

By any measure the growth curve of government has been “shockingly steep”. Turk and Rubino write that 21.5 million people now work for governments at all levels compared to 4.5 million back in 1940. It takes lots of money to pay for all of this bureaucracy and the Treasury is floating trillions in debt. If unfunded liabilities are included, the federal government owes $43 trillion. Households and businesses have also joined the borrowing party. The authors estimate that total debt per family of four is $500,000, and increasing at an accelerating pace. The combined effects of the trade, current account and budget deficits will eventually destroy the dollar, a currency that “has lost an astounding 90 percent of its value versus gold, and 70 percent versus the cost of living.”

Turk and Rubino consider three likely scenarios of what will happen when the dollar implodes. The first, similar to the 1930’s, has gold being confiscated and the emergence of a “bigger, more authoritarian government”. The second has virtually all markets collapsing and a new generation of politicians demanding a return to gold. In the third scenario, as currency markets around the world collapse, the market chooses gold and “The Age of Paper ends with a whimper rather than a bang…” So now it’s time to place your bets: Harry Dent’s Bubble Boom or Turk and Rubino’s Coming Collapse.

CHARTING THE COURSE OF THE SECULAR BEAR MARKET

Four years ago, I introduced the Stock Cycle and the price to resources (P/R) valuation measure I use to track the cycle. Figure 1 shows a plot of P/R defining the previous Stock Cycles. The Stock Cycle can also be identified using other valuation measures such as Tobin’s Q [ed: essentially total stock market valuation to GDP] and price divided by 10-year average earnings, a measure I call Shiller’s P/E because it was described by economist Robert Shiller in his book Irrational Exuberance. The most basic idea behind using the Stock Cycle as an investment tool is to detect when the secular trends that make the bull and bear halves of the cycle are close to their ends.

The most recent turning point was the shift from a secular bull market to a secular bear market in 2000. My book Stock Cycles was written in early 2000 to forecast this turning point explicitly using the P/R concept. This forecast was based on P/R reaching an all-time high in January 1999, indicating that the secular bull market had reached levels at which all previous secular bear markets had ended. This same argument could be made (and was) using Shiller’s P/E. In the case of P/E, the forecast would be based on P/E reaching an all-time high in January 1997, two years before the P/R signal. As I discussed in a 2002 article, the P/R-based forecast was more useful than the P/E-based forecast.

One of the advantages of P/R is its simple construction, which allows simple analyses to be performed that can give insight in market dynamics. Figure 2 shows a plot of P/R for the current and four previous secular bear markets. P/R declines at an average rate of 6-7% per year -- a 70% decline in P/R over the entire secular bear market. This downwards trend is countered by the rising trend in R, which over the long term averages about a 5% increase, thus growing some 2.4-fold over the average secular bear market. Combining the 70% decline in P/R with the 140% increase in R yields an approximate 30% decline in P (stocks) for the “typical” secular bear market. This decline is roughly equal the average decline in an ordinary [cyclical] bear market.

Since the projected decline in price for the entire secular bear market is about the same as that for an ordinary bear market, this means that the net trend in a secular bear market is zero. Thus, an appropriate investment strategy for a secular bear market is to exploit the ordinary bull and bear market cycles. On average, ordinary bear markets last about 17 months and are spaced about four years apart. Ideally, if one were invested only during the recovery periods (the ordinary bull markets), one could obtain an average capital gains return of 9% from stock investments during a secular bear market. Since typical capital gains returns during a secular bull market are larger than this -- about 12% -- attempting to play the ordinary bull and bear market cycles during a secular bull market is generally not worthwhile; the long-term trend provides a more than adequate return.

To explore the idea of capturing some of this 9% annual gain we must further develop the topic of shorter-term stock market cycles. A possible timing strategy would be to buy stocks in the fall of non-presidential election years, and sell at the end of presidential election years. Backtesting the strategy suggests that it produces worthwhile results only during secular bear market periods, giving superior results during these periods while preserving most of the gains during secular bull markets (when one should just buy and hold).

Thus once the P/R signaled that the end of the secular bull market was near in January 1999, one would shift to the above 4-year cycle strategy. The 4-year rule would have said to sell in December 2000, the delay in selling in spite of P/R reaching record levels in 1999, and then to re-enter the market in September 2002. Average capital gain returns over secular bear markets are ~0%, while use of the 4-year cycle provides about a 4-5% capital gain return during the secular bear market.

So far it appears that the present bear market is roughly conforming to “typical” secular bear market behavior as described by the model. Figure 5 shows the application of the model to the last secular bear market. The model does a fairly good job of describing the cycles in that secular bear market. Part of the reason for the weak start of the secular bear market in January 1966 was the fact that it was not accompanied by an economic recession. This time, the current secular bear market began with a powerful bear market that was associated with a recession. It is likely that the second four year cycle of this secular bear market will not fit the actual market behavior very well just as the first four year cycle did not fit well for the last secular bear market. The reason for this is yet another cycle, the Juglar cycle, which is a cycle in fixed investment. Baring special circumstances, I do not expect the downturn heading into fall 2006 to be particularly severe when compared to the downturn in the following 4-year cycle, the one which should bottom around the fall of 2010.

So far I have constructed an abstract model to describe the twists and turns of the stock market over the course of this secular bear market. Another approach would be to look at the historical record to determine the actual ranges of P/R observed in bull/bear market cycles in past secular bear markets. Figure 6 presents these ranges. These ranges can be used to forecast the range of P that can be expected, based on historical precedent, for future ordinary bull/bear market turning points. If we ignore 1929-1949 -- no depression developed after the bursting of the tech bubble and the post-1929 example is not really relevant to today, a useful result can be obtained. Projected ranges for the location of the market in a future cycle turning point for the current ordinary bull market was done in Figure 7.

As can be seen in the figure, the S&P 500 has yet to move into the projected region for the next ordinary bull market high, despite the fact that we are already past the average location of the top of the four year cycle. This suggests that any decline into the 2006 4-year cycle low from today’s levels will likely be small. On the other hand, this decline may not have started yet, in which case the index may rise further in 2005, penetrating into the projected zone before beginning a decline into 2006. If the 4-year cycle peak is already in, I expect the next bull market peak (in ~2008) to be sufficiently high to justify holding positions at current levels. If the 4-year cycle top has not yet appeared, there may still be opportunities to reduce stock exposure in the future as P/R rises into the “sell” zone.

THE ASIAN MONETARY FUND REARS ITS HEAD AGAIN

Even prior to the Asian financial crisis of 1997, the Japanese had begun to sell the idea of creating an Asian Monetary Fund (AMF) to provide regional liquidity. Almost as soon as the trial balloon was launched, Washington shot it down with great force, sending Lawrence Summers, then Deputy Secretary of the Treasury to the region to make sure the message was not misunderstood. In spite of the subsequent travails experienced by the region, the idea apparently died a quick death. Or did it? When Haruhiko Kuroda, former Japanese Deputy Minister of Finance for International Affairs, took over the helm of the ADB on February 1st of this year, he quietly began to promote the idea again.

In the spring of 1997, before the onset of the Asian financial crisis, Japan and Taiwan had offered to put up $100 billion to help their fellow Asians cope with any potential fallout which might arise in the event of a precipitous withdrawal of short-term portfolio capital from their respective economies. The idea was killed by the U.S. Treasury, which saw the idea as a threat to the monopoly of the IMF over international financial crises. The Treasury in particular did not want Japan taking the lead in this area because Japan would not have imposed the IMF’s conditions on the Asian recipients, and as a policy objective for Washington, this almost superseded the importance of restoring the region to full economic health. We all know what happened subsequently. Instead of forestalling global economic instability, the Treasury/IMF proposals helped make further instability inevitable.

By killing off the idea of a competing AMF, Rubin/Summers enabled the IMF to continue in its guise as an ostensibly “neutral” agency, thereby facilitating the implementation of the Treasury’s agenda whenever a financial crisis which required the IMF’s intervention arose. Of course, the “medicine” the IMF proffered had the ultimate effect of weakening pre-existing financial structures by imposing Western restructuring measures, thereby giving Wall Street a huge stake in the subsequent “reform” agenda introduced. All the “reforms” introduced required lots of assistance, and who better to offer it than America’s finest investment bankers?

While the AMF proposal itself has ostensibly failed to gain any further traction in spite of the many manifest failures of the IMF since the Asian Financial crisis, the Asia Times has recently noted that in substance, if not in form, a less direct route toward the same objective has steadily been gaining steam over the past several years. It is understandable why Washington would continue to resist the notion. Even leading Asian conglomerates -- whose products are readily gobbled up by the American consumer -- are forced to pay several hundred basis points above the yield of Treasuries. The Western investor or banker is extracting a wholly unmerited premium, while the U.S. continues to trade on its reserve currency and safe haven status to subsidize its over-consumption and perpetuate the country’s growing financial imbalances.

It is a great deal for Washington and readily explains the Treasury’s violent opposition to an AMF (or anything else that would disrupt the existing status quo, such as restrictions on capital account mobility). But must the world’s largest creditor bloc continue to act from such a position of weakness, which is more apparent than real? The actions by Asia’s leading policy makers suggest an implicit, albeit belated, recognition that they have been getting a raw deal from the existing global financial architecture and are taking incremental steps to redress the current imbalance. In spite of these periodic setbacks, the trend appears clear. Ironically, if, as we suggested last week, America ultimately repudiates existing obligations to its (largely) Asian foreign creditors, it will simply catalyze this process and likely ensure the AMF’s swift arrival, in spite of ongoing efforts to render this idea stillborn since 1997. In any event, time is definitely not on the side of the existing status quo.

WHO IS TO BLAME FOR EUROPEAN RADICALISM?

Reports of racism and right-wing radicalism in Europe are on the rise. It is not a new problem: Racist incidents, ethnic divisions, and right-wing political victories based on an appeal to racism and exclusionism began in Europe as early as 1997, when the Austrian extreme-right-wing Freedom Party got nearly 28% of the national vote for the European Parliament. Since 2000, however, the number of such episodes has strongly increased. The most recent findings by the Council of Europe show that, “racism ... as well as anti-Semitism, is very active in France and Austria. Anti-Semitism has increased alarmingly in France, notably in the school environment. In Austria ... racism is a part of daily life. Turkey, Bosnia and Herzegovina and Macedonia also indicate problems with racism.” In Germany, right-wing political parties are getting especially vocal.

Economic and extremist problems in Germany and Europe at large have the same root: a depressed social mood. When mass psychology turned negative at the start of the bear market five years ago, that shift first brought a decline in European stock prices, then a deterioration in economic performance, and now, increasingly, the persecution of various people who are seen to be “not like us”. What does the increase in European radicalism have to do with the financial markets, you ask? Everything. Both are products of the same social mood. Only when the bull market returns to Europe, so will “good will towards men”.

6 SECRETS OF A SUCCESSFUL TRADER

Refresher: The No. 1 requirement for being a successful trader is to get a method. The No. 2 requirement is to be disciplined. Links here and here.

No. 3 -- Get Experience (Part 1)

I do not care how much you read or how brilliant you are, you will not find out how easy it is to lose the market game until you trade with your own real money. When you are actually speculating you must physically pick up the phone or click the mouse and place orders. You perform under the scrutiny of your broker or clients, your spouse and business acquaintances, and you must operate while thousands of conflicting messages are thrown at you from the financial media, the brokerage industry, analysis, the market itself, and you own inner demons. In short, trading real money successfully requires you to conquer a host of problems, most of which relate to your own inner strength in battling powerful forces and your emotional reaction to them.

THE GOLDEN SMIRK

“Do you want to know the secret way to get really rich investing in gold coins?” coin expert David Hall had asked. “Don’t listen to tips ... especially if they come from me!” David Hall knows what he is talking about. Nearly 25 years ago he set up PCGS, one of the top two coin grading services in the world. “I’ve seen it time and time again ... you cannot make fast money in coins by trying to make money fast. And that is the secret ... buy what you like, not what you think will go up. That way, you’ll have no problems holding onto your coins for the next twenty years.”

Hall had just expressed the sentiment we found so pervasive at the New York Numismatic Convention we attended in January. Approach these coins as a collector, not as a trader looking for profits, we had been advised then. “95% of the guys you’ll see buying coins at the expo tomorrow,” Hall reassured,“qwill be collectors. The prices move big when investors and speculators come into the market, like in the late 1980s, but so far that hasn’t happened.”

At dinner the night before, Porter Stansberry explained his interest in coins. “If I get fired from my job, my speculations go horribly wrong, America hits the wall, my house burns down, and my bank gets targeted by cyber-gangs, I’ll still have my gold coins and an opportunity for a fresh start. I’qs insurance ... and right now, insurance has never been cheaper.”

Choosing a suitable coin was the next step. It has to be rare, said Burt Blumert, owner of Camino Coin, but not that rare you cannot buy it and sell it easily. Some coins -- like MS-65 $10 Libertys -- have populations less than 3,000. A coin this rare commands a premium as high as 10-times the melt value of the gold it is made from and today sells for around $5,000. On July 1, 1989, the peak of the last hot coin market, this coin sold for $15,000. A nice investment grade coin for sure, but a little out of our league in terms of price. We went for the highly liquid, but otherwise similar MS-65 $20 Saint instead. They cost us $1,250 apiece and we bought five.

“Value is the key,” said Burt. “No matter how fine the coin, or how badly it’s worn, you should always look around before buying. Prices vary greatly and you should only ever buy from someone you trust. Never buy a raw coin either -- a coin that hasn’t yet been graded by either PCGS of NGC -- that’s a sure way of getting ripped off.” In 10 years, perhaps we will be the one with the smirk -- a golden smirk -- but until then, we will let you know how the coins get on....

THE HOUSING BULL THAT DEBT BUILT

Each year the Bush White House produces a budget, it also produces a report called Analytical Perspectives, Budget of the United States Government. As the title suggests, it is a real page-turner. But if you are patient and you look hard, you will come across some gems. In this year’s version, I found an entire section on Fannie Mae and Freddie Mac, the Government Sponsored Enterprises (GSEs.) The risks section was especially interesting.

The Washington Post reported that the Bush administration may and try to limit the growth of GSE assets. Practically speaking, the new regulation would limit the amount of mortgages the GSEs add to their balance sheets. And practically speaking, this would make the market for new mortgage credit tighter, conceivably leading to slower home price growth (and many other darker consequences.) It is clear the Bush folks are taking the GSE problem seriously. From the report: “The risks undertaken by the GSEs, if not properly managed, may pose a threat to their solvency. Under some circumstances, they also may threaten the stability or solvency of other financial institutions and the economy.” It is not clear they can do much about it.

Fannie Mae scrambles for new ways to raise capital.

Fannie Mae, the nation’s largest buyer of home mortgages, said that its primary regulator had discovered a host of new potential accounting violations at the company that had raised a fresh set of “safety and soundness concerns”. Fannie Mae also said that regulators had decided to give it a 3-month extension, until the end of September, to carry out a plan to raise billions of dollars in capital and reduce its portfolio of mortgage securities.

In an attempt to control a crisis that began last fall after a highly critical report from its chief regulator, Fannie Mae said that its cost-cutting measures would include sharply curtailing its use of political consultants and lobbyists. For years, Fannie Mae has been one of the most prodigious employers of both Republican and Democratic lobbyists and political consultants as it successfully beat back attempts in Congress for tighter regulation.

Neither Fannie Mae nor its regulator, the Office of Federal Housing Enterprise Oversight, would say how the possible accounting violations could affect the company’s previous earnings, balance sheet or net capital requirements, noting that the inquiry was continuing and could take months to complete.

A CASE OF PENSION DEFICIT DISORDER

Proposed legislative reforms center around encouraging companies to better fund their pension plans and ensure the long-term solvency of the Pension Benefit Guaranty Corporation, which insures defined benefit plans. In November the PBGC estimated that the single-employer plans that it insures were underfunded by about $450 billion, up from $350 billion in 2003. Of those companies rated below investment grade and therefore more likely to run into trouble, plans were underfunded by $96 billion compared with $82 billion the year before. James Moore, product manager at Pimco for long duration and pension products, said the PBGC’s deficits could easily double in the coming years.

One proposal is to raise the premiums the PBGC charges for insurance. Premiums would vary according to the credit rating of the pension plan sponsor and, in some cases, its unfunded liabilities. This would encourage companies to improve their funding plans, which would tend to involve investing in more bonds rather than equities. Legislative changes that took place in President George W Bush’s first term have led to the 30-year Treasury yield being temporarily dropped as the discount rate -- the rate at which companies translate expected future benefit payments to current value -- in favor of a 4-year trailing average of three bond indices. For 2004 this was 6.10%, higher than actual market rates. Critics worry that it underestimates plans’ funding problems, since it lags current rates, which have been declining.

Attention is also being paid to the Financial Accounting Standards Board and the International Accounting Standards Board, amid a debate over the need for changes to pension accounting rules to force companies to better fund their plans. Any proposal that required a closer marking to market value of pension assets would be likely to increase investment in longer-dated bonds. Joseph Shatz, senior government bond strategist at Merrill Lynch, said many pension funds had “over-invested” in equities because current rules accounted for the investments in terms of long-term expected returns, not realized gains. A move to mark-to-market could produce huge balance sheet swings unless neutralized by a shift into longer-dated bonds to better match assets and liabilities.

Pension fund managers are already in a vicious circle as yields on longer-dated bonds, and coupons on new paper, have fallen even as the desire to more closely match assets with liabilities has boosted funds’ appetite for longer maturity debt. A dwindling supply of longer-dated paper is not helping either. According to Merrill Lynch, outstanding Treasury debt of more than 10 years to maturity now makes up about 21% of Treasuries, from 31% in 2000. Combined with Agency and corporate debt, outstanding supply is worth about 19%, down from 26%. “We have a pension deficit disorder,” said Mr. Moore. “Unfortunately, this disease has no quick fix.”

HEALTH CARE TAB READY TO EXPLODE

The nation’s tab for health care -- already the highest per person in the industrialized world -- could hit $3.6 trillion by 2014, or nearly 19% of the entire U.S. economy, up from 15.4% now, a sobering government projection says. Growth in health care spending will outpace economic growth through the next decade, and the government will pick up an increasing share of the tab. By 2014, the nation’s spending for health care will equal $11,045 for every man, woman and child, up from $6,423 each this year.

While the growth of health insurance premiums will continue to slow, the annual increases will still exceed growth in workers’ disposable income. More could become uninsured as a result. And as spending rises, public health programs such as Medicare and Medicaid will pay an increasing proportion, hitting 49% of all spending by 2014, up from 45.6% in 2003. The share of the nation’s drug costs paid by private insurers, individuals and state Medicaid programs will shrink as Medicare’s share grows. This year, Medicare will pay 2% of the nation’s $223.5 billion drug tab. In 2006, it will pay 28%.

HONEY, I SHRUNK THE DOLLAR

The dollar is falling! The dollar is falling! But the Bush team has basically told the world that unless the markets make the falling dollar into a full-blown New York Stock Exchange crisis and trade war, it is not going to raise taxes, cut spending or reduce oil consumption in ways that could really shrink our budget and trade deficits and reverse the dollar’s slide. This administration is content to let the dollar fall and bet that the global markets will glide the greenback lower in an “orderly” manner.

Right. Ever talk to someone who trades currencies? “Orderly” is not always in the playbook. I make no predictions, but this could start to get very “disorderly”. As a former Clinton Commerce Department official, David Rothkopf, notes, despite all the talk about Social Security, many Americans are not really depending on it alone for their retirement. What many Americans are counting on is having their homes retain and increase their value. And what has been fueling the home-building boom and bubble has been low interest rates for a long time. If you see a continuing slide of the dollar -- some analysts believe it needs to fall another 20% before it stabilizes -- you could see a substantial, and painful, rise in interest rates.

“Given the number of people who have refinanced their homes with floating-rate mortgages, the falling dollar is a kind of sword of Damocles, getting closer and closer to their heads,” Mr. Rothkopf said. “And with any kind of sudden market disruption - caused by anything from a terror attack to signs that a big country has gotten queasy about buying dollars -- the bubble could burst in a very unpleasant way.” When a country lives on borrowed time, borrowed money and borrowed energy, it is just begging the markets to discipline it in their own way at their own time. As I said, usually the markets do it in an orderly way -- except when they don’t.

THE INSTRUMENTS OF GLOBAL REBALANCING

Global rebalancing does not occur spontaneously. It takes adjustments in economic policies and asset prices to spark a meaningful realignment in the mix of global growth. Shifts in currencies and real interest rates are the two major instruments of rebalancing. The ideal prescription for today’s lopsided U.S.-centric world would be a combination of dollar weakness and a rise in U.S. real interest rates. However, there is serious risk that the Fed will not execute the full-blown normalization of real interest rates that the U.S. economy requires. If that is the case, then there will be even greater pressure on currency adjustments to correct today’s imbalances -- a development that could take world financial markets by great surprise.

Despite all its bluster, the Fed has actually accomplished very little in its interest rate normalization campaign. The nominal federal funds rate of 2.5% is still unacceptably low in real terms -- negative when judged against the headline CPI (3.0%) and barely positive when measured against the core CPI (2.3%). We debate endlessly what the so-called “neutral” level of the real federal funds rate might actually be. By all current indications -- the ongoing strength in the economy, to say nothing of the profusion of Fed-sponsored carry trades in a multitude of risky assets, as well as an acceleration of core inflation -- U.S. monetary policy remains highly accommodative. My own take is that neutrality is somewhere in the 2-3% zone for the real federal funds rate.

The issue is not whether the Fed should take the funds rate back to its neutral setting -- or even into the restrictive zone if it wishes to cool the economy. That is imperative, in my view. The question is whether the Fed will engineer such a tightening. As much as I hate to say it, I do not think that this Fed has either the courage or the political will to pull off such a maneuver. The logic hinges on my belief that the Fed has thrown its full weight of support behind the Asset Economy -- an economy that is built on a false foundation of unsustainably low real interest rates. In my view, systemic risk has built up dramatically during the low real interest rate regime of the past three years. A Fed that changes the rules of the game would have to confront that risk head on. This Fed is overly sensitive to political and market feedback and, in my view, not up to the time-honored independent role of being the tough guy and taking away that proverbial “punchbowl just when the party is getting good.” I fear at the first sign of weakness in the US economy or at the first hint of pyrotechnics in the financial markets, the Fed will flinch and abort its normalization campaign.

The bottom line could be a real shocker. I continue to believe that global imbalances will be vented one way or another. To the extent that the real rate adjustment is curtailed, the currency realignment would then have to pick up the slack. This underscores the distinct possibility of another sharp downleg in the dollar. The greenback could be expected to decline not just against Asian currencies (both yen and Chinese RMB) but also further against the euro as well. Most, including our own currency team, believe that the dollar has fallen enough. However, to the extent that the real interest rate adjustment is curtailed, the risk is that there could be a good deal more to come on the currency front.

Needless to say, currency adjustments do not occur in isolation. Another sharp downdraft in the dollar could well lead to a flight out of dollar-denominated assets -- or, at a minimum, a significant diversification of official foreign exchange reserves out of dollars. Asian central banks are already hinting at such adjustments to reserve portfolios. My guess is that at all it would take would be another protracted period of dollar weakness to trigger such diversification campaigns in earnest. A Fed that shies away from interest rate normalization will probably not be able to forestall the painful endgame that ultimately waits an unbalanced world. An adjustment in real interest rates is a long overdue and essential piece of the rebalancing equation. If the Federal Reserve is not up to the task, financial markets will then take matters into their own hands. That is when it could get really messy.

Think again about Alan Greenspan.

The U.S. experienced an extraordinary period of prosperity in the 1990s. Between 1993 and 2000, 21 million new jobs were created, and in 2000 the country’s unemployment rate briefly dipped below 4% for the first time in 30 years. During this boom, the U.S. economy grew at nearly 4% a year, adding more than $2 trillion to real U.S. GDP -- more than the annual output of France. But many stars aligned to produce that outcome, not just good monetary policy on the part of Greenspan’s Fed. For starters, a judicious focus on fiscal discipline by former President Bill Clinton’s administration brought the budget deficit under control. The Clinton administration managed to lower the deficit every year between 1993 and 1997. By 1998, there was a surplus that lasted until 2001. The 1990s also saw a powerful wave of corporate restructuring and technological change. Together, these two forces set the stage for sustained low inflation and a powerful acceleration of productivity and employment growth.

Greenspan’s leadership in monetary policy undoubtedly played an important role in fostering the conditions that allowed the U.S. economy to surge in the 1990s. The chairman helped achieve the economy’s high-performance potential during that time period. But no one should believe that the economic boom of the 1990s was the work of just one man or just one monetary policy. Credit for breaking the back of double-digit inflation goes to Paul Volcker, Greenspan’s tough and courageous predecessor. In the summer of 1979, when Volcker assumed the reins at the Federal Reserve, inflation was raging at 12% a year. Eight years later, when Alan Greenspan took over, the inflation rate stood at around 4%. During Greenspan’s 17-year era, inflation slowed further to 2.5% per year. But 80% of the drop in inflation occurred under Volcker’s stewardship at the Fed.

“THIS TIME IT’S DIFFERENT” ... AGAIN

You can sense that money managers loathe 10-year U.S. Treasuries at a skimpy 4.25%, hate emerging-market debt at 350 basis points more than Treasuries, and detest corporate bonds with yield spreads at record lows. You can also smell the fear that yields will be even lower for those who do not buy now. “This time it’s different,” said the snake-oil sellers at the turn of the decade, seducing millions of irrational investors into exuberant U.S. Internet stocks with slinky arguments about how the old investment rules did not apply anymore. By the first quarter of 2000, with the Nasdaq Composite Index up 160% in two years to 5000 points, money managers loaded up on stocks, terrified of missing the next leg of the ascent. Except it was not different; profitability still mattered, and the stock-market bubble did not so much burst as explode.

At a Euromoney bond conference in London this week, the fixed-income community gave its own version of the “this time it’s different” theory. A flock of fund managers attempted to explain in a panel discussion why the bond market does not care that the Federal Reserve is raising official interest rates. Worryingly, almost every speaker at the conference had the same view -- there are not enough securities to go around at a time when more money is flowing into bonds than ever before.

TIME TO BUY EUROPEAN STOCKS?

The old adage “crowds are never right” is as true as ever these days. When a lot of people share in the same activity, collective emotions take over, and the crowd turns itself into some kind of a single-cell, mindless organism. For that reason, average investors usually have horrible market timing. They buy at the highs, when “everybody” is buying, and they sell at the lows. Examples of this behavior are numerous. Back in 2000, how many people thought that one share of Yahoo! at $214 was a good buy?

Or, take British ISAs, Individual Savings Accounts (analogous to the American IRAs.) ISAs were launched in 1999, just as the FTSE was near its all-time high. As soon as ISAs appeared, UK investors, swept up in the bullish psychology of the day, pumped £10.9 billion in them -- the biggest chunk of cash ISAs have ever seen. Over the next thee years, as the bear market was erasing nearly half of the British blue-chip values, many investors’ hopes for an early retirement were getting likewise erased.

That unexpected loss put UK investors off stocks for a while. And, according to the BBC, they continue to “shun equity markets” even today, preferring cash and real estate instead. In 2004, “near record amounts of cash flowed into building society savings accounts (those are similar to regular bank savings accounts), as risk-averse investors shied away from the stock market.” At the same time, cash inflows to the UK’s investment funds dropped by 40% last year, and contributions to the ISAs fell to their lowest level ever. Needless to say, the past two years have been precisely the wrong time to be out of equities: The FTSE 100 rose 38%, and British mid-caps, the FTSE 250, gained 77%. Most other major European indexes have faired just as well lately. Is it too late to jump in?

TECH COMPANIES HIT HARD BY LABOR SUITS

Over the past 18 months, small and large companies in Silicon Valley have been hit by an increasing number labor lawsuits in which employees are demanding overtime pay, the Wall Street Journal reports. Those suits, say experts interviewed for the article, suggest that the high-tech job market is maturing, and the entrepreneurial spirit of working long hours for the promise of million-dollar stock option gains is all but dead. “Wage-and-hour class-action lawsuits have now invaded high-tech in the Valley,” defense attorney Lynne Hermle told the paper. Previously, the suits were mostly filed against companies in old-economy industries such as retailing and hotels, the paper points out.

In other words, noted labor attorney Harvey Sohnen, “reality has set in” in tech workplaces, according to the report. Sohnen argues that tech workers have become “net slaves” working “unconscionable hours and getting nothing ... when their options became worthless.” Indeed, anecdotal evidence supports the notion that labor lawsuits in the tech sector are on the rise, charging companies with denying overtime pay, substituting stock options of little value for cash bonuses, and not paying promised salaries, the Journal reported.

Start-up companies as well as established ones are feeling the lawsuit surge. Some are considering internal changes to quell the litigious atmosphere. For example, officials from video game maker Electronics Arts Inc. (EA), which was named in a recent suit by an employee demanding overtime pay, told the Journal that the company is thinking about reclassifying some jobs to make them eligible for overtime pay. But the company may drop stock-option grants for those jobs.