Finance Digest for Week of April 4, 2005

THE BUCK STOPS HERE

Betting against the U.S. dollar seems like a sure way to make money. After all, the dollar has been falling for years, and as traders say, “The trend is your friend.” Then there is Warren Buffett, the leading investor of our time, telling all and sundry that his Berkshire Hathaway conglomerate has big bets against the dollar. There is Forbes magazine saying one reason there are lots more billionaires in the world is that it takes far fewer euros or yen to make a billion U.S. dollars than it did three years ago. Finally, there is Wall Street, which is rushing to offer mutual funds and foreign currency bank accounts to let retail investors like you and me bet against the dollar the way the big boys do.

So should you bet big bucks (or yen or euros) that the greenback will keep falling? I think not. History shows that rushing to buy an asset class that is popular is an almost sure way to lose money. In hindsight, the best time to have bet on the euro’s rise against the dollar was three years ago, when Europeans were despairing of their currency and some people were worried that the dollar was too strong. These cycles have a tendency to reverse themselves – look at any long-term currency chart – and it is easy to get caught going the wrong way.

To a contrarian like me, the down-on-the-dollar products that Wall Street is offering are a sign that the dollar may be close to its bottom. So is the heavy media attention to the dollar’s decline. I say this with my tongue tucked somewhat into my cheek, of course. But the media focus on what is popular – and the Street sells what it thinks you will buy, not necessarily what is good for you.

The Dollar’s Revenge

According to the establishment folks, the greenback came back to life when Federal Reserve Chairman Alan Greenspan gave the go ahead to raise rates to 2.75% on March 22 (The seventh hike in seven months). E.g., “The dollar is up since the Fed raised rates and said ‘pressures of inflation have picked up.’ The market’s reaction to the statement makes perfect sense.” (Bloomberg, April 4) In a totally imperfect kind of way.

The recent uptrend in the dollar started on March 11, over a week BEFORE the Fed’s March 22 rate hike. And, in our March 14 Short Term Update, we kicked off with a special section on the greenback, giving readers the following analysis to mull over: “A picture of the ‘Incredible Shrinking Dollar’ appeared on this week’s Newsweek magazine. By the time a financial trend appears as a cover, usually the persistence and force of the trend has already had its maximum effect on prices. The emergence of the cover signals that the dollar’s downtrend has exhausted itself. We would afford the benefit to the immediate bullish case so long as a [certain price level] remains intact. Thus, expect the dollar to continue to work higher from current levels.”

Continue higher it did, rallying 4.9% in the first quarter of 2005 to a two-month high against the euro and six-month high against the yen as of April 5.

AMERICA AND FOREIGN CENTRAL BANKS ARE LOCKED IN A CODEPENDENT RELATIONSHIP

America is addicted to spending, and the foreign central banks cannot stop throwing money at it in order to keep their currencies down. This is unhealthy for both parties, say the IMF and the World Bank. But is there any political will to change it? America has been warned many times in recent years that its profligate spending is dangerous, for itself and for the world economy. So far, however, Americans have ignored such doom-mongering, gleefully driving their current-account and budget deficits to record levels. Now the World Bank and the IMF seem to be trying to stage an intervention. This week, both have come out with reports on the global financial situation – and both reports give warning that America’s fiscal irresponsibility poses serious risks to the world economy.

Neither organisation issues the kind of scathing indictment that might offend its most powerful constituent. Nonetheless, both make it pointedly clear that America’s copious spending is a real, and growing, problem for the rest of the world. America’s 12-month current-account deficit now stands at $665.9 billion, or 5.7% of GDP. Since a negative balance in the current account must be complemented by a positive balance in the capital account, this means that foreign funds are streaming in. America is mortgaging its future to pay for current spending.

Part of the reason this spending is so hard to get a grip on is that it is happening on multiple levels. With interest rates low, consumers have been tapping into their home equity and taking on credit-card debt – the latest figures show individuals’ savings were just 0.6% of their income in February. Meanwhile, even after massive tax cuts, the Bush administration has forged ahead with ambitious spending programs. Thus, in 2004 the federal government’s budget deficit hit $412 billion, a worrying 3.6% of GDP. It is projected to fall only to $365 billion, or 3% of GDP, in 2005.

The gap between income and spending has been financed by foreigners, especially central banks; more than half of all publicly available Treasury bonds are now held abroad (see chart). But the central banks that are buying up all this paper, particularly Asian ones, are trapped in something of a vicious circle. The World Bank estimates that roughly 70% of global foreign reserves are now in dollars. That growing portfolio of dollar assets is vulnerable to currency correction. This is not such a problem if the dollar declines gently, but an abrupt change in its value could spell trouble, as central banks find themselves with gaping holes in their portfolios.

World Bank warns on dollar “risk” for poor countries.

Developing countries that have amassed large US dollar reserves face a growing threat of big losses from a sudden decline in the dollar, the World Bank warned. In its 2005 Global Development Finance Report, the bank identified the “gravest risk” for emerging markets as a deep and disorderly dollar decline that would create financial market volatility and push up interest rates. A dollar collapse, below what the bank’s economists see as its long-term equilibrium level, could also result in “a costly restructuring of world industry that would have to be undone in following years as the dollar returned to its equilibrium level,” the bank said.

But even in the event of a steady decline in the dollar, the bank warned that countries with big dollar reserves faced capital losses, following the pattern of the past two and a half years. Foreign reserves held in developing countries, up $292 billion in 2003, rose a further $378 billion last year, the bank said. Asia, and particularly China, accounted for much of this accumulation, but 101 of 132 developing countries increased their reserves last year. The enormous build-ups in foreign exchange reserves also make it harder for countries to manage their domestic economies, the bank said, owing to potential inflationary impacts and fiscal costs.

At the end of last year, developing countries held $1.6 trillion of foreign exchange reserves, with China accounting for almost 40% of the total. The bank estimates that 70% of those reserves are held in dollar assets. Countries have run current account surpluses and built up reserves in part to protect themselves against swings in international financial markets.

IS IT A BUBBLE? EXPERTS DEBATE SURGING U.S. REAL ESTATE PRICES

Is real estate another bubble ready to burst? Experts are cautiously watching the red-hot U.S. housing market, but remain divided on the likelihood of a crash that could be a devastating economic blow. On a national level, home prices last year rose 8.3%, the fastest pace in a decade, to a median level of $184,100, government figures show. But in some big metropolitan areas including Washington and San Francisco, prices are up about 20% and $1 million homes are becoming increasingly common.

Part of the rise is due to an increase in housing speculators. The National Association of Realtors found 23% of homes sold in 2004 were bought by investors, and there are widespread reports of buyers “flipping” homes for quick short-term gains in many markets. David Berson, the chief economist for mortgage finance group Fannie Mae, notes that the level of investor ownership of housing has not been this high since the late 1980s, which led to a crash in housing prices.

Economist John Makin of the American Enterprise Institute argues that there is “objective evidence of a housing bubble in the United States.” He notes that home prices have risen 40% since 2000, while “the ratio of average yearly rents to house prices has bee dropping steadily.” This, says Makin, is “reminiscent of the way earnings plunged relative to soaring equity prices before the tech bubble burst in 2000.” Economists say super-low interest rates have fueled the rise in home prices, making it easy to borrow money for real estate investments. But like many other hot investments, real estate could go cold quickly and send shockwaves through the economy.

“The big mistake, in my view, came when the Fed condoned the equity bubble in the late 1990s,” said Morgan Stanley chief economist Stephen Roach. “It has been playing post-bubble defense ever since, fostering an unusually low real interest rate climate that has led to one bubble after another.” A study by finance firm National City Corp. found housing “bubblettes” in one-fifth of U.S. housing markets, where home premiums were in excess of 20%. Richard Berner, economist at Morgan Stanley, says the heady days of real estate are over, but does not see a collapse.

Forrest Gump effect could be what pops housing bubble.

The same week Alan Greenspan and his merry band of Federal Reserve officials raised rates for a 7th time, vowing all the way to become more aggressive, the use of adjustable-rate mortgages hit an all-time high. I keep saying something has to give, but I am starting to wonder. I feel as if we have time-traveled back to 1999, when logic and reason lost out to the manic mindset of the speculative masses. What is more striking about the use of ARMs hitting 36.6% of the total applications processed is how much one-year ARM rates rose for the week. According to the Mortgage Bankers Association, one-year ARM rates surged to 4.39% from the prior week’s 4.12%.

Granted, 30-year fixed rates crossing 6% threatened to shut out many would-be home buyers, who are struggling to afford the highest housing prices on record. But there is a limit to how much people should stretch themselves to own a home. The bottom line: The use of ARMs should be declining in the current environment as wide swaths of the populace wait out the bubble’s bursting by renting. Even in the markets that have experienced the least appreciation over the last few years, such as Dallas, renting is still a cheaper alternative to buying. In Boston and San Diego, renting is about half the cost of buying. Instead, people are buying houses with little or no equity.

Higher payments might not pose such dangers if the average American had anything in the way of a rainy day fund. “The downside risk is that there remains a lack of savings in this country,” said Kathleen Bostjancic, senior U.S. economist at Merrill Lynch in New York. “People are pretty much spending everything they make.” One last comment Ms. Bostjancic made reminded me of the movie character Forrest Gump. After crisscrossing the country on foot, one day he simply stopped – for no apparent reason. That is what I think of when I listen to the chants from the armies of home buyers taking out ARMs. They all plan on being in the home for a few years and then selling – presumably at a nice profit. “Maybe we won’t have to see a spike in interest rates. People may wake one day and simply realize this can’t go on forever,” Ms. Bostjancic said. “The problem is once the herd starts rushing, it can be impossible to get out of the gate.”

Every time I write about the housing bubble, I get e-mails from people on both coasts, families anxious to plant roots, looking for guidance on relocating to less expensive states. Ken Buntrock, a portfolio manager with Loomis Sayles in Boston, marveled at the fact that Massachusetts lost more people than any state last year. Can anyone claim we are not trapped in a housing bubble when we have become a nation of nomads?

Fresh pricks in housing bubble.

There is a sharp debate over whether there is a bubble in the U.S. housing market generally or in certain localities, or whether there is a bubble at all. But the past two days have brought fresh warnings that home prices are unsustainable. First, a new study by the National Association of Realtors shows that 23% of all homes purchased in 2004 were for investment, while another 13% were vacation homes. Traditionally, one of the bulwarks against a sharp decline in housing prices has been the fact (or belief) that most people live in their homes and would be unlikely to sell even if the market heads downward. But the same logic would not apply to investment homes or vacation homes. While there has long been anecdotal evidence that non-occupant buyers are fueling the rise in home prices, the NAR study claims to be the first to thoroughly analyze the phenomenon.

So far, there has been no problem. Since 2001, the median price of an investment home has risen 25.4%, from $118,000 to $146,900. (In most markets, the average price is much higher than the median.) But if prices start to fall or if mortgage rates start to rise, there could be a rush to sell and a crash. Otherwise, some investment buyers could find themselves unable to get renters at all, as rental vacancy rates are near historic highs. With many buyers putting down almost no cash, they could simply let their bank foreclose and walk away.

Investment buyers could be made even more sensitive to interest rate increases than is normally the case. The reason is the increasing popularity of adjustable rate mortgages. According to the Mortgage Bankers Association, more than 32% of mortgages are now adjustable. The popularity of ARMs is on the rise even though the spread between the so-called teaser rate and the fixed rate on a standard 30-year mortgage has narrowed. An adjustable mortgage is most attractive to a borrower who figures he will not own the house for long. That could be a person who figures he will move to a different area or will soon be able to afford a better home. Or it may be a person who figures he will unload the place to a greater fool.

Why the dollar could demolish your home.

During last year’s presidential campaign, the Bush Administration’s economic record was widely assailed by Democrats. In large part, this was because the U.S. suffered a net job loss during President George W. Bush’s first term. This is the first time the economy has lost jobs during a single presidential term since the Great Depression. However, a key factor, which has received comparatively little attention, and which may well have offset this in the perceptions of many voters is the large increase in house prices in recent years.

U.S. residential real estate values increased by about 36% from 2000 to 2004. In addition to this housing boom, the U.S. ratio of home ownership has risen to 68.3% (in 2003) from 63.9% in 1989. In highly rural and suburban states such as New Hampshire, the ownership ratio is nearly 75%. Low interest rates have made it possible for more low-income families to afford a home. The Administration has greeted increased home ownership as part of a larger program of promoting its so-called “ownership society”. Congress gave a boost to the housing market in 1997 by enacting a tax law that allows couples to withdraw $500,000 of capital gains from a property tax free (this can be done every two years without purchasing another residence). Homeowners previously had to purchase another house in order to roll over capital gains tax-free.

However, the main factors that have driven the large house price gains center on monetary policy. Following the capital-spending slump that began in 2001, the Federal Reserve began to reduce interest rates and then further decreased them following the September 11, 2001, terrorist attacks. By June 2003, interest rates had fallen to only 1% (the lowest level in a half-century). This monetary easing helped trigger an upsurge in home sales and house prices. It also helped sustain the growth of consumption by encouraging the greatest mortgage-refinancing boom in U.S. history. In 2002 and 2003, the U.S. populace refinanced $2.5 trillion and $3.5 trillion of mortgages respectively. In the absence of the housing boom, the economy would have experienced a harder landing in response to the collapse of the technology bubble and wider stock market falls in 2001 and 2002.

House prices are likely to stabilize or even decline in Bush’s second term. The Fed has raised interest rates by 175 basis points since June 2003 and will tighten them further. The U.S. is experiencing large and sustained dollar devaluation because of its huge current account deficit. Resources are being reallocated from domestic consumption to tradable goods exports and import substitution in order to reduce the current account deficit. The Fed is playing a role in this process by pursuing policies that restrain domestic spending as capacity utilization rates increase. The adjustment will include interest rate increases large enough to depress the housing market, reduce capital gains on property and increase the private savings rate.

It remains unclear precisely how the U.S. will manage the process of exchange rate adjustment to the current account imbalance. However, a falling dollar will probably eventually encourage an increase in bond yields that would undermine the housing market.

Economists argue about what Feb should do about housing bubble ... assuming there is one.

Fed Chairman Alan Greenspan and his policy making colleagues are sloughing off repeated criticism from some analysts that the central bank has fostered a dangerous housing bubble by keeping interest rates too low for too long. “It would be a bad mistake to try to target asset prices,” Fed Governor Edward M. Gramlich said April 2 during a conference about the Fed’s future sponsored by the Center for Economic Policy Studies at Princeton University. “The Fed has a basic mandate to stabilize prices and stabilize employment at a high level,” Gramlich said. “Asset prices play a role in the process, through the wealth effect and credit market effects.” Responding separately, even systematically, to changes in asset prices, by altering monetary policy would almost always run afoul of the Fed’s mandates because such actions “will often be destabilizing” to the economy, he said.

Greenspan, who also has been criticized by some analysts for not raising interest rates in the second half of the 1990s to prevent development of a bubble in stock prices, has argued that it is impossible to know an asset price bubble has developed until it has burst. In addition, the Fed chairman has said there is no evidence that a small increase in interest rates would keep a bubble from developing or would limit one’s size. And he has challenged the view that there is a bubble in values in the nation’s diffuse real estate markets. Princeton Professor Burton G. Malkiel, author of the well known book, A Random Walk Down Wall Street, acknowledged that “markets can go crazy” on occasion. Nevertheless, central banks should “never” respond to what may appear to be a bubble, he argued. “My very strong view is that one cannot identify a bubble or its size until after it has burst,” Malkiel said.

Malkiel challenged some of the conclusions of Yale economist Robert J. Shiller, author of the 2000 book, Irrational Exuberance. In the book, Shiller said the stock market boom that began in the 1980s and accelerated in the latter 1990’s was “a speculative bubble, not grounded in sensible economic fundamentals.” Malkiel said that Shiller incorrectly said that a bubble was present in the stock market in 1992 and in 1996. “Only in 1999 and 2000 was there a bubble,” and that was true only for high-tech stocks, he said. “The stock market as a whole was not in a bubble.” Similarly, Malkiel said, today “in the property market, there is not a general bubble.” In some individual markets on the East and West Coasts, there may be bubbles, he acknowledged.

Asked about the impact of extremely low interest rates engineered in 2003, including an overnight lending rate target of just 1%, on real estate prices, Gramlich said the Fed understood there would be an impact. The Fed did that “because of conditions in the real economy. We know it would affect asset prices, but we thought it was necessary,” Gramlich said. While he did not address it, Gramlich might have said the same sort of thing about the shift in policy that has caused officials to raise that 1% target to 2.75% in seven steps since last June. The increases have had very little to do with a possible bubble in housing prices and everything to do with the officials’ assessment of what the economy needed to keep prices stable while encouraging rising employment.

The only person at the symposium who argued that the Fed should respond to asset price bubbles was economist Stephen G. Cecchetti of Brandeis University, a former research director at the New York Federal Reserve Bank. Cecchetti, a member of the panel with Gramlich and Malkiel, said it is possible to identify bubbles and that their existence distorts economic decisions. For instance, consumers may have a “false impression of wealth” and as a result “accumulate unsustainable debt”. None of the questions from the audience, many of whom were economists, suggested much support for Cecchetti’s position.

FANNIE, FREDDIE IN CONGRESS’S CROSSHAIRS THIS WEEK

The week ahead may prove pivotal in the push to rein in Fannie Mae and Freddie Mac as heavyweights from Federal Reserve Chairman Alan Greenspan to Treasury Secretary John Snow lay out their views to Congress. In fact, the weight of the testimony from Greenspan and administration officials, coupled with the unveiling of legislation that is expected to propose substantially stronger federal power over Fannie and Freddie, are seen as critical to setting the stage for overhauling regulation this year, Washington lobbyists and Wall Street analysts said. “I don’t think we've ever had a week in which we’ve had testimony at this level all in the same week,” said Mike House, executive director of FM Policy Focus, a group representing financial services firms that are seeking greater restrictions on Fannie Mae and Freddie Mac. “It shows Congress is intent on getting this legislation this year,” he said.

Congress tried unsuccessfully to boost oversight of the government-sponsored enterprises last year. But key Republicans in the House and Senate have said the climate was much improved for a bill this year, as both Fannie and Freddie have now been wounded by multibillion-dollar accounting scandals. Greenspan and Treasury Secretary John Snow will likely reiterate their critical views of Fannie and Freddie, arguing again for tougher oversight and limits on the companies huge mortgage portfolios. Bigger surprises may emerge in testimony from the head of the Office of Federal Housing Enterprise Oversight, the regulatory agency leading a probe of Fannie Mae’s evolving accounting problems, lobbyists and analysts said.

Most studies of housing markets are conducted by people with a vested interest in keeping spirits high. As a result, even those who issue warnings tend to mute their gloom. As with all bubbles, it is fun to ride up and scary to get off while the roller coaster is still climbing. But if prices have doubled in four years, unfueled by income gains of anything close to that level, what is to stop, say, a 30% or 50% drop?

Greenspan says oversight alone will not reduce financial risks of government-sponsored enterprises.

Alan Greenspan urged Congress to curb the rapid growth of Fannie Mae and Freddie Mac, saying this was vital to cut the risks the mortgage finance giants pose to the nation’s financial system. Fannie Mae and Freddie Mac were created by Congress to pump money into the home mortgage market. The companies do not lend directly to home buyers, but rather buy mortgages from lenders and repackage them as securities for sale to investors. They also hold some mortgages in their own portfolios. The companies together account for nearly half of total residential mortgage debt outstanding, with portfolios of some $1.5 trillion. Greenspan previously has proposed those portfolios be cut to $200 billion for each company.

Fannie and Freddie already face the possibility of tougher supervision. Congress is due to weigh legislation that could give their regulator more power over the companies, including authority to approve any new products or programs they want to launch. But in his testimony prepared for the Senate Banking Committee, Greenspan said that stiffer regulation alone was not enough to ease – and could actually worsen – the risks the two government-sponsored enterprises (GSEs) pose. “World-class regulation, by itself, may not be sufficient and, indeed, might even worsen the potential for systemic risk if market participants inferred from such regulation that the government would be more likely to back GSE debt in the event of financial stress,” Greenspan said. “This is the heart of a dilemma in designing regulation for GSEs.”

But he proposed a solution. “We at the Federal Reserve believe this dilemma would be resolved by placing limits on the GSEs’ portfolios of assets, perhaps as a share of single-family home mortgages outstanding or some other variation of such a ratio,” the Fed chief said. Greenspan, citing a study by the Fed, the nation’s central bank, said limits for the portfolios would not affect mortgage rates for homeowners.

Snow wants tight reins on Fannie, Freddie.

Treasury Secretary John Snow urged Congress to restrain Fannie Mae and Freddie Mac, giving the Bush administration’s blessing to efforts to create a new regulator with broad power over the huge mortgage companies. Recent accounting scandals at the two biggest U.S. buyers of home mortgages – expected to result in an $11 billion restatement of earnings in No. 1 Fannie Mae’s case – have heightened the administration’s concern that they pose a potential risk to U.S. financial markets if they fail, Snow told the Senate Banking Committee. Because so many big financial institutions hold large amounts of the $1.8 trillion in debt issued by Fannie Mae and Freddie Mac, a crisis at or failure of either could ripple through the markets, he said. With a legislative push under way, driven by Republicans in Congress, to strengthen the government’s hand over the two companies, Snow’s comments opened a partisan breach among senators and provoked a sharp reaction from some Democrats.

The remarks by Snow brought a rebuke from Sen. Charles Schumer, D-N.Y., who accused the administration of trying to “virtually eliminate” Fannie Mae and Freddie Mac and using their recent accounting lapses as a pretext for doing so. With the housing market functioning so robustly as an engine for economic growth, Schumer asked Snow, “Why are we radically changing” the two companies? “We ought to proceed with a great deal of caution and maybe some humility,” Schumer said. Other Democrats on the panel echoed his view.

HOW A TITAN OF INSURANCE RAN AFOUL OF THE GOVERNMENT

Legendary insurance executive Maurice R. “Hank” Greenberg, 79, has suffered a public and humiliating end to his career, and he faces a future of potential civil litigation and criminal investigations. By the accounts of people who have spoken with him, Mr. Greenberg, ranges over bewilderment, rage and self-pity from the turn of events. In recent weeks, he has told A.I.G. directors that his lawyer is advising him to take the Fifth Amendment rather than testify in a broad inquiry, people involved in the case said. How could such extraordinary changes occur? How could a man who ruled for almost 40 years see his legacy slip away in a matter of days over events that, at another time, might have been dismissed as immaterial to a company of A.I.G.’s financial prowess?

The answer, associates say, is found in the life of this one man who was becoming a throwback to another era – an executive working in a business world still shaken by the corporate scandals of recent years, but who failed to recognize the swirl of change engulfing him. Mr. Greenberg, his associates say, clung to the model of the imperial chief executive, steadfast in his belief that the market would lose faith in the company without him. This at a time when the domineering, iron-fisted corporate leader was increasingly being viewed as a liability.

A.I.G.: Whiter Shade of Enron

The American International Group is no Enron. Of that we can be sure. A.I.G., after all, is a real company with global operations, generating genuine profits from a variety of financial enterprises. As companies go, Enron was all smoke and mirrors; A.I.G. is substance. Moreover, A.I.G. was run by Maurice R. Greenberg, a brilliant man who was both visionary and micromanager, a far cry from the know-nothing that Ken Lay, Enron’s former chief executive, claims to be, now that his trial looms.

There are, however, some disturbing similarities between A.I.G. and Enron: Asleep-at-the-switch auditors. Secretive off-balance-sheet entities that should have been included on the company’s financial statements but were not. A management team willing to try any number of accounting tricks to make the company’s results appear better than they actually were. And one more likeness: As A.I.G.’s shares have plummeted, the financial position of one of the company’s insurance subsidiaries has taken a big hit.

Enron, remember, had ownership stakes in off-the-books entities in which its shares were pledged as collateral. As long as the company’s stock remained above a certain level, those pledges were fine. But when the shares started to slide, Enron had to cough up more collateral to shore up those interests. The unwinding was ugly, and the need to shore up the entities hastened the company’s demise. Unlike Enron, the situation at A.I.G. is not remotely as dire. But the ownership stake by its subsidiary, the American Life Insurance Company, illustrates the problems that can result when a company has too much of its capital tied to its parent company’s stock price. The decline in A.I.G.’s stock could be temporary, of course, and a rebound could bring American Life’s surplus back to previous levels. But the unfortunate fact remains: The aftershocks from the A.I.G. tremor are not likely to stop anytime soon.

THE BIG SQUEEZE

A U.S.-centric global economy continues to run on fumes. In the developed world, the current recovery has been notable for a lack of organic income growth – the wage earnings derived from productive employment. For Europe and Japan, this income shortfall has restrained domestic consumption – forcing these two economies to rely largely on external demand as their only real source of growth. America has been different: Consumption has boomed even in the face of subpar labor income growth. Can this anomaly persist?

The simple answer, in my view, is not for long. America’s income-short, consumer-led recovery is the aberration – not the norm – in this Brave New World. It is all about ever-declining personal saving rates, ever-widening current account deficits, mounting debt burdens, and increasingly wealth-dependent consumers. It personifies what I believe is one of the most precarious macro models that has ever existed for a major economic power. It is a model that not only puts pressure on future prospects in the U.S. but also underscores the tensions bearing down on the rest of the world. In my view, income-short growth models are not sustainable – the only question pertains to the circumstances of their demise.

Strong words, I realize that. The endgame is not in doubt, in my view. The American consumer will ultimately cave. It is the only means by which the US will ever “fix” its twin saving and current account problems. It is the timing and circumstances of that fix that we endlessly debate. But the clock is ticking – especially now as interest rates and energy prices rise. Yet another in a long string of crummy US labor market reports only serves to underscore the obvious: Excess consumption is on a collision course with subpar labor income growth. Courtesy of an unrelenting global labor arbitrage, the “big squeeze” is getting tighter and tighter on the world’s only real consumer.

U.S. launches probe into Chinese textile imports.

The U.S. took the first step towards reimposing quotas on some clothing imports from China, as the Commerce Department announced it would launch its own probe into whether China’s burgeoning sales were disrupting the U.S. market. The action makes it almost certain that the U.S. will impose new quotas on cotton trousers, shirts and underwear, just three months after the global quota system for textiles and apparel was abolished. Chinese sales of those goods in the U.S. were worth about $625 million last year, but in the first month of this year alone they totaled $160 million.

While World Trade Organization rules allow the U.S., Europe and other importing nations to re-establish quotas if there is a flood of imports, the Commerce Department’s action marked the first time Washington had launched such a probe on its own rather than waiting for a formal application from U.S. textile companies.

China: U.S. should fix own economic woes.

China, answering a U.S. threat to slap tariffs on Chinese goods unless Beijing revalues its yuan currency, urged the U.S. to tackle its own economic imbalances. “We have noticed that the U.S. trade and budget deficits have continuously expanded in recent years,” said Foreign Ministry spokesman Qin Gang. “However, the United States should look for the reason from itself so as to adjust the unbalanced sectors in its economy.”

DEFLATION’S MEDIA SHARE

After months of deliberation, the final verdict in the financial court case Inflation v. Deflation has come in, finding the former guilty on all counts of injury to the U.S. economy. The ruling was cemented after a key witness – Federal Reserve Chairman Alan Greenspan – made this remark in lieu of the Fed’s March 23rd hike in short-term interest rates to 2.75%: “Though longer-term inflation expectations remain well contained, pressures have picked up and pricing power is more evident.” Let the record also show that, according to one chief economist, “This is really the first significant indication that the Fed is shifting toward fighting inflation in earnest” (Bloomberg).

The defense asked members of the jury to consider these examples of “a shift in consumer’s attitude toward debt,” from acquisition to absolution – as listed in the March 2005 Elliott Wave Financial Forecast: 1.)From cars to college textbooks, “highly unusual” price reductions are underway. 2.) Treks to foreign countries for cheaper medical treatment are on the rise. 3.) Dues owed by the world’s poorest countries are being forgiven. 4.) Brick-and-mortar retail stores are being replaced by on-line EBay look alikes.

We now know the outcome of the case, as “Inflation Fears” fill the front-page headlines of the mainstream press at lightening speed. In fact, as the April 2005 EWFF points out: “According to Proquest’s database of six major U.S. newspapers, the number of stories in March that covered deflation declined to 2, compared to 139 inflation articles. Deflation’s 0.7% share of the coverage is miniscule.” Our chart of the “ratio of media’s references of Deflation to Inflation” over the past two years makes no mistake: Deflation’s media coverage has declined to a level that is almost non-existent in recent months, to the lowest in recent times. And, the way we see it, the near death of the “D” word means ... it is prime time for a full-scale version of one kind of monetary phenomenon to take hold.

“BUST” ANALYSIS – THE BEFORE AND AFTER

On March 11, the country’s largest financial newspaper ran a long story which began with this sentence: “Emerging markets, long associated with extreme boom-and-bust cycles, may finally be gaining some stability.” It went on to say, “Emerging-market stock funds enjoyed their biggest month ever in February, with inflows globally reaching $4.6 billion.” That is a big pile of money all right; perhaps you wonder if anything could be more, well, notable. Glad you asked: this same article had an answer at the ready: “Yet more notable than this faith in a continuing boom is a growing belief that a bust doesn’t have to follow.” As for what this boom actually looked like, consider Pakistan’s Karachi Stock Exchange, were a ten-fold rise in three years made it the poster-child for emerging market growth.

The chart is dated March 16, which just happened to be the day that the trend happened to turn. From that day through April 1, the Karachi Stock Exchange lost nearly 30%. Losses of that kind lead to a different sort of headline, such as this one from Toronto’s Globe and Mail: “Troops deployed after riot at Karachi Stock Exchange” (March 26). The article solemnly observed that, “Analysts said sharp gains in recent months had been largely speculative and unjustified by fundamentals.” Well, what did you expect “analysts” to say? Something screwy like, “A bust doesn’t have to follow a boom”?

SIN CITY’S BOX OFFICE SUCCESS REFLECTS SOCIAL MOOD

In the #1 box-office hit for the first weekend of April 2005, a heart-broken loner vows to avenge the murder of his one, true love. Sound romantic? Well, we do recommend bringing a box of tissues – to hold over your eyes and block out scenes that make Pulp Fiction look like Pee Wee’s Big Adventure. The “loner” is actually a depraved outlaw with a deformed face whose die for an eye take on revenge inspires punishment that range from decapitation to dismemberment to castration – and/or electrocution. And the “love”, well, she is a beautiful prostitute whom the loner knew for all of one night. Welcome to Sin City, the comic-book big-screen adaptation film critics everywhere are calling “The most excessively violent movie ever made”, “a film noir on steroids”, and “a relentless reduction of skull and brain matter into pulp”.

Set in the city of fallen angels, the heroes of this tale are cigarette-smoking, gun-toting corrupt cops, ex-cons, brutes, and hit men “who would have been villains if they weren’t up against foes viler than themselves.” Those “vile foes” are pedophiles, rapists, filthy politicians, priests, and man-eating psychopaths who converse with severed heads in the backs of taxicabs. The heroines are – with the exception of one pole-dancer and another barmaid – all “self-policed ladies of the evening”, clad in next to nothing save for the classic dominatrix wear and lethal weapon accessory.

In the words of the movie’s creator, “Sin City is a trend setter. People just haven’t seen anything like it. The visuals, the storytelling and the audacity of the story itself. People will be astonished by what they see” – which is exactly what people are doing, as it raked in $29.1 million (75% of the total production cost) in the first three days after its release. We cannot say we are shocked. If the current trend in social mood were a State in the Union, “Sin City” would be its capital. Sick-flick? Fear-jerker? Call it what you will so long as you call it for what it is: the silver-screen embodiment of a downturn in social mood. The question is, has the trend hit rock bottom, signaling the start of a new bull market in psychology, pop culture, and stocks?

MANY WORKERS SAVE TOO LITTLE BUT THINK IT IS ENOUGH, SURVEY SAYS

Many workers are kidding themselves when they say they are saving enough to have a comfortable retirement. After all, most have not even figured out how much they will need to live on and have saved only a pittance, a new survey shows. These misperceptions show only some of the problems facing future retirees as revealed in the 2005 Retirement Confidence Survey, scheduled for release today.

While 65% of workers feel very or somewhat confident that they will have a sufficient nest egg, most are not saving nearly enough, say experts at the Employee Benefit Research Institute, which conducts the closely watched annual survey. Three-quarters have socked away less than $100,000, not nearly enough to last through a retirement that could last three decades. The survey reveals several troubling perceptions among American workers and shows their confidence is likely misplaced, experts said. For instance, many underestimate how much money they will need in retirement and overestimate how long they will be able to work. What is more, their estimates are probably worse than unreliable. Only 42% have figured out how much they will need for retirement – and of that group, 10% said they simply guessed.

Though he knows he has not saving enough, Joel Press, a Manhattan lawyer, has not dared to calculate how much he will need in retirement. “I don’t want to see how far off I am,” said Press, 35, of Baldwin. “It’s intentional.” Instead, he is busy coping with mortgage payments, paying off law school loans and dealing with the region’s high costs of living. He hopes he can start saving more for retirement once his two daughters, ages 3 and 5, are in school and his wife goes back to work.

But even serious savers who have figured out their yearly income needs in retirement still have doubts of whether they will have enough, especially as taxes and other costs escalate. For 15 years, Ted Choate, 59, has been serious about saving. He contributes the maximum he can to his 401(k), and his wife did the same when she had a retirement plan at work. The Syosset couple also have outside savings. But Choate still is not sure it will be sufficient to see them through. “I’m much more confident about the first 10 or 15 years, but after that I’m not,” said Choate, controller at Intercounty Appliance Corp. “Who knows how long we will live?”

RETURN-HUNGRY INVESTORS SNAP UP RISKIER LOANS

Krispy Kreme Doughnuts is a troubled company. Its accounting is under investigation by regulators, and it has not filed any financial statements since August. Bankers froze access to its credit lines. And yet, with relative ease, Krispy Kreme obtained $225 million in new loans this week. The company was able to raise the money because it is paying high rates to attract hedge funds and other investors, who are increasingly willing to elbow aside banks when it comes to lending to riskier companies. Hedge funds are particularly active buyers of a type of loan known as a second lien, which accounted for much of the money raised by Krispy Kreme. In the event of a bankruptcy, buyers of these loans get their money back only after other creditors – the first-lien lenders – are paid.

Corporate loans were once tightly held by banks. But over the last decade or so, the riskiest form of the business, known as leveraged lending, has been transformed to an actively traded market. Besides hedge funds, other large buyers of these loans now include managers of pools of loans known as collateralized loan obligations, which are sold to insurance companies and the like. But there are concerns that these lenders, in their zeal for high returns, will end up losing much of their money, particularly as rates rise and companies have a harder time paying their debts. If the value of a company declines sharply, there may not be enough assets to cover the value of the second liens. In a report in October, Standard & Poor’s estimated that investors in second liens could recover less than 25% of their principal in the event of a bankruptcy.

“Every lending cycle has its excesses,” said Mark L. Gold, a managing director at Trust Company of the West, a longtime investor in bank loans. “Last cycle it was telecommunications; this time it’s second liens.” Mr. Gold and other skeptics point to a second-lien loan made in November 2003 to Atkins Nutritionals, the diet products company founded by Dr. Robert C. Atkins, who promoted a low-carbohydrate diet before his death two years ago. The loan financed a $533 million buyout of the company by Parthenon Capital, a private equity firm, and a division of Goldman, Sachs & Company. Atkins disclosed three weeks ago that it expected cash flow of just $25 million this year, down from its projection of $176 million at the time of the buyout. Bids for its $79 million second-lien loan have fallen to just 15 cents on the dollar, as investors anticipate a bankruptcy filing by the company.

Second-lien loans have been a boon for companies like Krispy Kreme that are facing a short-term liquidity squeeze. The loans became popular two years ago, part of a wave of what bankers refer to as rescue financings. A series of such deals were done on behalf of utility companies; in the throes of deregulation and tarred by the bankruptcy of Enron, they were having trouble raising funds through the bond market. But more recently, a rising number of second-lien loans have been used for more aggressive purposes. Half of the loans so far this year have backed acquisitions or one-time dividend payments to owners of companies, according to the Loan Pricing Corporation, a research firm. And the ratings on second-lien financings have been falling, with more than a third rated CCC+ and below by S&P.

Bankers say that some hedge funds are compounding the risks by buying second-lien loans and then borrowing at three to five times the value of the loan. In certain cases, second-lien loans are taking the place of junk bonds, especially as recent jitters in that market have made it harder for companies to raise money. Still, in some ways, second-lien lenders could be better off than bond buyers. Because their loans, unlike many junk bonds, are secured by assets, they often have a seat, albeit less of a seat, at the negotiating table with the first-lien lenders. That could make it harder for a company to write off these debts in the case of bankruptcy, investors said.

GM DEBT RATINGS LOWERED BY MOODY’S; FORD UNDER REVIEW

GM’s debt ratings were cut one notch to Baa3, the lowest investment grade, by Moody’s Investors Service. The ratings company also said it was reviewing Ford Motor’s debt for a possible downgrade. Moody’s said the cut at Detroit-based GM stems from “an uncompetitive fixed-cost structure” and “steadily declining market share”. Moody’s began reviewing GM’s ratings on March 16, when the automaker forecast its biggest quarterly loss since 1992. “Neither firm should be considered investment grade, and the reasons are rapidly becoming painfully obvious,” said Sean Egan, managing director at Egan-Jones Ratings Co., an independent debt-rating firm in Haverford, Pennsylvania, in an interview. He estimated GM’s borrowing costs could rise $300 million to $450 million annually.

Falling credit ratings have increased borrowing costs at GM and Ford, the two biggest U.S. automakers, prompting them to issue less unsecured corporate debt and rely more on bonds that use auto loans and collateral and debt sold directly to individual investors. Both automakers cut North American auto production in the first half of this year as sales have declined. The review of Ford’s ratings was prompted by “increasing risk”. Ford, based in Dearborn, Michigan, may not meet a 2006 target of $7 billion in pretax profits. Moody’s rates Ford debt at Baa1, three levels above non-investment grade.

GM and Ford have lost U.S. market share to Toyota and other competitors. GM’s market share declined to 25.7% in the first quarter from 27% a year ago. Ford declined to 19.5% during the period from 20.4% a year ago.

The General Motors questions S&P needs to answer.

Why has S&P not cut General Motors’ rating to “junk”? How about, because GM owes its bondholders almost $114 billion, of which $16 billion is repayable this year. A cut to junk would make it harder to refinance that borrowing. And the jobs of 324,000 employees would be on the line.

ASSET CLASS OF THE NEXT GENERATION

Recently, at a party in New York, I mentioned that I had been talking to various groups in the U.S. and Europe about investment opportunities in commodities. Before I could get out one more word, a woman interrupted me. “Commodities!” she exclaimed, with the kind of incredulity in her voice that Manhattanites reserve for people moving to Los Angeles. “But my brother invested in pork bellies and lost his shirt. And he’s an economist!” Everyone seems to have a relative who took a beating in the commodities market, and this fact (or fiction) is considered sufficient reason that no sane person would ever risk playing around with such dangerous things. That this particular victim was also a professional economist makes the warning seem even more ominous. I, however, could not help laughing.

Billions of dollars are invested in commodities every day. Without the commodity futures markets, many of the things that you depend on in life, from that first cup of coffee in the morning to the aluminum in your storm door to the wool in your new suit, would be either scarce or nonexistent, and certainly more expensive. To be sure, investing in anything has its risks. A lot of Ph.D.s in economics lost money in the dot-com debacle, too.

There are several other bromides out there for why “ordinary people” should not invest in commodities, and I want to lay these myths to rest, once and for all, so that we can get on with the more interesting business of how you can begin to make some money investing in the next-generation’s asset class. About that relative of yours who got wiped out ... he was inexperienced. You can learn. Most likely, he was buying on thin margin – the minimum deposit a broker requires to take a position in a particular commodity – and when the market went against him he lost big-time.

Whenever I mention commodities in public, someone always points out that we now live in a high-tech world where natural resources will never be as valuable as they were when we had a smokestack economy. But if you read your history you will discover that technological advances are as old as history itself – and in the midst of all of the truly revolutionary technological breakthroughs came periodic, multiyear commodity bull markets. Even a revolutionary technological breakthrough in a particular commodity-related industry will not necessarily lower prices. When the supply and demand in raw materials is seriously out of whack, the emergence of new technology will not necessarily restore the balance quickly. To be sure, changes in technology, for example, have made the economy less dependent on oil. But we still use plenty of it, and whenever there is not enough prices will rise. Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear. Both the dollar and speculation can have a marginal effect, but the market itself is bigger than they are.

If you do your homework and remain rational and responsible, you can invest in commodities with perhaps less risk than playing the stock market. There has been more volatility in the NASDAQ in recent years than in any commodities index. Cisco, Yahoo!, and even Microsoft have been much more volatile than soybeans, sugar, or metals. Compared with the risk record of most tech stocks, commodities look safe enough to be part of any organization’s “widows and orphans fund”. According to the Yale study, “Facts and Fantasies About Commodity Futures”, the “high risk” of investing in commodities does not square with the facts. Comparing returns for stocks, commodities, and bonds between 1959 and 2004, the authors found that the average annual return on their commodities index “has been comparable to the return on the S&P 500”. They found that the volatility of the commodities futures analyzed was slightly below that of the stock in the S&P 500. They also found evidence that “equities have more downside risk relative to commodities.”

How about buying shares in commodity-producing companies instead of buying commodities themselves? Supply and demand will move the price of copper, for instance, while the share prices of Phelps Dodge, the world’s largest publicly traded copper company, can depend on such less predictable factors as the overall condition of the stock market, the company’s balance sheet, its executive team, labor problems, environmental issues, and so on. Oil skyrocketed in the 1970s, but some oil stocks did not do that well. The Yale study found that investing in commodities companies is not necessarily a substitute for commodities futures. The authors found that from 1962 to 2003, “the cumulative performance of futures has been triple the cumulative performance of ‘matching’ equities”. And let me remind you of one more important difference between commodities and stocks: Commodities cannot go to zero, while shares in Enron can (and did).

PREDICTIONS OF $105 OIL PRICE “SPIKE” GIVE PAUSE

On March 30, 2005, a Goldman Sachs analyst named Arjun Murti predicted that crude oil would spike to $105 a barrel. The price of crude jumped dramatically over the next three trading days to reach an all-time high of $58.20 a barrel. The Goldman analyst’s audacious prediction – along with a bevy of other worrisome indicators and omens – suggests a short-term top in the crude market may be fast approaching. To summarize, we would be “fading” Goldman Sachs – that is, we would be tiptoeing away from the very same crude oil market into which Goldman Sachs and many latter-day oil bulls are now charging.

But we would not tiptoe very far away. As faithful readers should be well aware, your editor has been a resolute oil bull over the last many months. Even so, he cannot escape his growing sense of unease over the signs of short-term speculative excess that are appearing in, and around, the crude oil market. Such audacious predictions have a way of tempting fate, and of eliciting the exact opposite result ... at least initially.

TOP-SELLING MUTUAL FUNDS OF 2000 DEEP IN RED, WHILE LAGGARDS SHOW GAINS

Never have so few lost so much for so many. The average stock fund has eked out a 1% gain the past five years. But investors who poured money into the 50 hottest-selling funds five years ago are down an average 42% since March 2000, according to Lipper, the mutual fund trackers. These are not just a bunch of tiny Internet funds. Consider Fidelity Aggressive Growth, which had $23 billion in assets in March 2000. Investors poured $15.1 billion into the fund the 12 months before the S&P 500 peaked that month. A $10,000 investment then would be worth $2,697 now – a 73% loss.

Other big top-sellers that have fared badly: Janus Worldwide, then a $13 billion fund, has fallen 45% the past five years; Nasdaq 100 Trust, then a $10 billion fund, has fallen 67%; Janus Global Technology, a $10 billion fund in March 2000, has plunged 73%. All told, investors put $228 billion into the 50 best-selling stock funds in the 12 months before the market peaked. Only two of them have shown a gain the past five years: American Funds New Perspectives, up 2.3%, and Vanguard Capital Opportunity, up 1.5%.

Technology stocks were the main culprit. Consider: Investors poured $2 billion into PBHG Technology & Communications the 12 months before the bear market began. Its largest holding on March 31, 2000, was InfoSpace, which sold at a split-adjusted price of $727 a share. The Internet search company now sells for $41.03. The fund has fallen 86%. Although most funds encourage investors to hang in for the long term, long-suffering investors in some funds will have a long time to wait. An investor who bought Fidelity Aggressive Growth in March 2000, for example, will have to gain 271% just to break even.

Investors who fled laggard funds have reason to kick themselves, too. The 50 funds that saw the most money flee in the 12 months ending March 2000 have gained an average 21.4%.

Funds vs. Investors: Who outperforms the other?

Most of the hottest funds from five years ago are still around, within the fund families of the biggest names in the industry: Fidelity, Janus, Vanguard, etc. Unlike the advertisements they were running in March 2000, I am sure that they would prefer NOT to show you their five-year averages. As for what I mean by the “hottest” funds, I am relying on the definition of choice in USA Today, namely the funds that saw the largest inflows in the 12 months before March 2000. Like the Fidelity Aggressive Growth fund, for example: It held $23 billion at the all-time peak, $15.1 billion of which had flowed in during the previous 12 months. Today that fund is down 73%. “All told,” says USA Today, “investors put $228 billion into the 50 best-selling stock funds in the 12 months before the market peaked.” The average loss among these funds is 42%.

This is not to say that all stock market investors saw their portfolios fall that far. The article also notes that the average stock fund has seen a 1% gain in the past five years. Yet what it does not say is that the average fund typically outperforms the average investor. In 2003, the financial research firm Dalbar Inc. released a study about the returns earned by equity fund and fixed-income fund investors from 1984 through 2002. Equity investors earned an annual average of 2.6% during those years, vs. the S&P 500’s 12.2% annual average; fixed income investors earned 4.2% vs. the 5.5% gain for Treasury Bills.

When the average fund gains 1%, the average investor is more than likely in the red. Do stocks “always go up in the long term”? You tell me what the evidence says. In truth, market trends go in BOTH directions, sometimes years at a time. Which fund you are in matters a lot less than whether you are going with or against the dominant trend.

AMERICA’S TRIBUTE

America and its Gulf Arab allies just pulled off the biggest central bank heist in the history of the world. The price of oil just went up 60% or more, which really cuts down to size those $3.4 trillion of net foreign holdings of U.S. financial assets. As a loyal American, we would like to cheer our government’s deft move to pick the pockets of our trading and financing partners. Moreover, America gets the Arabs to fund a large share of our deficit, subsidize our interest rates, and help keep our taxes low for another year! Surely, I can afford to buy another gas-guzzling Sport Ute, get a rifle, and wave a flag!

America is extracting Tribute on oil from the world. If the world wants Middle Eastern oil, they can pay for it through the Saudi branch of the United States Treasury. Why do the heads of Saudi Arabia, Kuwait, Abu Dhabi, Bahrain, Qatar, etc., hold dollars? Because they want to keep the money and the power! Think of Arabia as a family firm. If the dollar goes down in value, the Saudi Royal Family still gets to personally keep hundreds of billions of dollars. But, if they do not buy dollars, why would America keep them in power? Remember when Saddam Hussein talked about pricing Iraq’s oil in Euros? “Shock and Awe” followed.

This program of oil for dollars and dollars for the U.S. Treasury deficit is the simple tribute that we, as the Super Power, can expect. America is well paid for keeping the world’s supply of “black gold” safe and available to all. Unlike Vietnam – when America was trying to finance guns and butter – getting others to pay now for our guns, allows us to milk the oil out of the sand and turn it into butter! The next question will be how the Asians respond to a 60 percent hike in the price of oil? Please, stay tuned.

“PAIR-TRADING” IS THE NON-ALCOHOLIC WINE OF INVESTING

Pair trading – just like non-alcoholic wine or fat-free ice cream or any of the other culinary atrocities perpetrated by Americans – provides a worthwhile function in specific settings. Pair trading, by capitalizing on market volatility, provides the opportunity to profit, even when the broad equity indices are “range-bound”. Pair trading, quite simply, refers to the strategy of investing simultaneously in related long and short positions. For example, buying the shares of Daimler-Chrysler (DCX) and simultaneously selling short the shares of General Motors (GM) would establish a pair trade. Two stocks from the same industry – one long and one short.

The pair trader who established such a trade would expect/hope that DCX would outperform GM over the ensuing weeks or months. In other words, if both stocks rose, but DCX rose more, the pair trader could close out both sides of the trade for a profit. Conversely, if both stocks dropped, but DCX dropped LESS, the pair trade could close out the trade for a profit. Obviously, if GM outperformed DCX, either to the upside or the downside, the pair trade would produce a loss. Pair trading, therefore, is a kind of “Zen” approach to investing, in which the investor relishes the market’s volatility, rather than resisting it.

Not all pair trading relies upon fundamental (qualitative) relationships between securities. Indeed, most professional pair trading strategies employ some form of “black-box” approach that tries to capitalize upon brief statistical (quantitative) divergences between specific securities or baskets of securities – but today’s column will not address this particular form of pair trading. Whether one utilizes qualitative or quantitative process, pair trading relies on the mean-reverting tendency of securities. That is, when two related securities diverge from one another, they tend to re-converge at some point. Typically, therefore, pair trading opportunities present themselves more often in “oscillating” markets than in “trending” markets.

Now that we have defined our terms, let’s probe the possibilities that may now be unfolding among oil and gas stocks...

READING THE MIND OF MR. MARKET

In 1949 – having escaped from Soviet-occupied Hungary two years before – George Soros enrolled at the London School of Economics to study economics and international politics. The LSE was a hotbed of socialism, no different from most other universities at the time. But the LSE was also home to two very unfashionable thinkers, free market economist Friedrich von Hayek and philosopher Karl Popper. Soros learnt from both, but Popper became his mentor and a major intellectual influence on his life. Popper provided Soros with the intellectual framework that, later, evolved into both Soros’s investment philosophy and his investment method. In his student days, Soros’s aim was to become an academic, a philosopher of some kind. He began writing a book he called The Burden of Consciousness. Only when he realized he was merely regurgitating Popper’s philosophy did he put it aside and turn to a financial career. Ever since, he has viewed the financial markets as a laboratory where he could test his philosophical ideas.

While struggling with philosophical questions, Soros made what he considered to be a major intellectual discovery: “I came to the conclusion that basically all our views of the world are somehow flawed or distorted, and then I concentrated on the importance of this distortion in shaping events.” Applying that discovery to himself, Soros concluded: “I am fallible.” This was not just an observation; it became his operational principle and overriding belief. Most people agree that other people make mistakes. Most will admit to having made mistakes – in the past. But who will openly acknowledge that they are fallible while making a decision? Very few, as Soros implies in his comment in the book, Soros on Soros, about his former partner, fund manager and author Jim Rogers (author of this article above): “The big difference between Jim Rogers and me was that Jim thought that the prevailing view was always wrong, whereas I thought that we may be wrong also.”

When Soros acts in the investment arena, he remains aware that he can be wrong, and is critical of his own thought processes. This gives him unparalleled mental flexibility and agility. Soros turned his realization that people’s understanding of reality is imperfect into a powerful investment tool. On those occasions when he could see what others could not – because they were blinded, for example, by their beliefs – he came into his element. When he started the Quantum Fund he tested his theory by searching for developing market trends or sudden changes about to happen that nobody else had noticed.

Where Buffett seeks to buy $1 for 40 or 50 cents, Soros is happy to pay $1, or even more, for $1 when he can see a change coming that will drive that dollar up to $2 or $3. To Soros, our distorted perceptions are a factor in shaping events. As he puts it, “what beliefs do is alter facts” in a process he calls reflexivity, which he outlined in his book The Alchemy of Finance. For some, like the trader Paul Tudor Jones, the book was “revolutionary”; it clarified events “that appeared so complex and so overwhelming,” as he wrote in the foreword. Through the book Soros also met Stanley Druckenmiller who sought him out after reading it, and eventually took over from Soros as manager of the Quantum Fund. To most others, however, the book was impenetrable, even unreadable, and few people grasped the idea of reflexivity Soros was attempting to convey. Changes in market prices cause changes in market prices? Sounds ridiculous.

But it is not. To give just one example, as stock prices go up, investors feel wealthier and spend more money. Company sales and profits rise as a result. Wall Street analysts point to these “improving fundamentals”, and urge investors to buy. That sends stocks up further, making investors even wealthier, so they spend even more. And so on it goes. You have no doubt heard of this particular reflexive process. Academics have written about it; even the Federal Reserve has issued a paper on it. It is known as “The Wealth Effect”. Reflexivity is a feedback loop: perceptions change facts; and facts change perceptions. As happened when the Thai baht collapsed in 1997. As the baht fell, the Thai economy imploded – and the baht fell some more. A change in market prices had caused a change in market prices.

His method is to look for situations where “Mr. Market’s” perceptions diverge widely from the underlying reality. On those occasions when Soros can see a reflexive process taking hold of the market, he can be confident that the developing trend will continue for longer, and prices will move far higher (or lower) than most people using a standard analytical framework expect. Soros applies his philosophy to identify a market trend in its early stages and position himself before the crowd catches on. To some, Soros’s method may appear similar to trend-following. But trend-followers (especially chartists) normally wait for a trend to be confirmed before investing. When the trend-followers pile in Soros is already there. Sometimes he would add to his positions as the trend-following behavior of the market increased the certainty of his convictions about the trend.

But how do you know when the trend is coming to an end? The average trend-follower can never be sure. Some get nervous as their profits build, often bailing out on a bull market correction. Others wait until a change in trend is confirmed – which only happens when prices have passed their highs and the bear market is under way. But Soros’s investment philosophy provides a framework for analyzing how events will unfold. So he can stay with the trend longer, and take far greater profits from it than most other investors – and profit from both the boom and the bust. Soros’s theory of reflexivity is his explanation for Mr. Market’s manic-depressive mood swings. In Soros’s hands it becomes a method for identifying when the mood of the market is about to change, for enabling him to “read the mind of the market.”

AN UPDATE ON INVESTOR PSYCHOLOGY

A waning interest in financial affairs is manifest in CNBC’s viewership ratings, which continue to plunge. According to Nielsen Media Research, CNBC’s daytime viewership fell 21% in 2004, from an average of 184,000 viewers to 146,000. Since 2000, the total is down 61%. Yet while investors may be getting tired of the stock market, they are holding fast to their stocks. According to Sindlinger & Co.’s weekly poll of U.S. households, commitments to stocks have barely wavered since the all-time highs. Sindlinger’s survey shows that 57.4% of households are in the market. The figure is only slightly below the all-time high of 57.8%, from November 2000. This attachment to stocks is extraordinary considering that until the 1990s, the highest percentage ever recorded was 36%, on September 7, 1987, within two weeks of a peak that led to the October 1987 crash.

Investors continue to hold stocks because, as first revealed in a book called One-Way Pockets in 1909, that is what investors do into early stages of a bear market. One important nuance of sentiment at the all-time high was the rejection of more experienced market voices for novices and man-on-the-street opinions. In June 2000, when the papers were filled with stories about the investment prowess of baseball players, plumbers and a wide assortment of young stock market mavens, Elliott Wave Financial Forecast wrote: “The bear market’s mission is to reveal the ignorance and naiveté that are the true source of their profits.”

The NASDAQ is down 60% over the last five years, but one recent ad illustrates that the bear market’s mission is far from complete. The ad reveals that the belief in easy money is alive and well. Even a 12-year-old soccer player, says the ad, can make 355% in six months. Another recent article offers investment advice from “once-fleeced” NFL players. “New York Giants quarterback Kurt Warner is investing in real estate, stocks and mutual funds. ‘I want as little risk as possible.’” Asked what will become of his Super Bowl winnings, one recent champ answered, “I’m a real estate guy.” From the frying pan to the fire, we say. Houses are far less liquid than stocks, and thus a more perfect final resting place for many investors’ mania-era ambitions.

As the rally from March 2003 peters out, one key indication that the developing decline is a continuation of the post-mania slide to much lower levels is that the backlash against many of the stars of the old bull market is reappearing. In August, an outline of a new wave of attacks was identified, and it is now visible across the breadth of corporate America. From Fannie Mae, where federal regulators have uncovered still more accounting irregularities, to new revelations about conflicts of interest in the investment banking industry, the scandal mills are heating up. After several investments banks settled suits, Reuters reported that derivatives litigation is “Set to Explode”.

Post-peak revelations are spilling forth in the trials of former mania-era heroes at WorldCom, Healthsouth and Tyco. Still to come: the New York Stock Exchange’s case against its former president, Dick Grasso, and the criminal trial of Enron’s former principles. Krispy Kreme, Bally Total Fitness and OfficeMax are also in the seminal stages of accounting inquiries. Investigations of the accounting, insurance and medical device industries are also underway by the Justice Department, IRS, SEC and various state agencies. Don’t be fooled by reports of besieged corporate leaders; it is only a preview of coming attractions.

Some formerly beleaguered leaders, like Martha Stewart, are also back on the high ground of 1999. Even though she has been in jail, Stewart’s star is soaring, with the landing of roles in two TV shows and a company stock that has soared back to heavenly heights. As long as the trend is rising, Martha Stewart Living Omnimedia can bask in its optimistic potential of the future. But Stewart’s smiling visage on the cover of the March 7th Newsweek suggests that another peak is near. Stewart will emerge from prison “thinner, wealthier and ready for prime time,” says the magazine, but the early celebration over her “recovery” is a sure sign that the countertrend rally is ending. As the bear market reasserts itself, Stewart will find her return to the business world a lot less accommodating than her jail cell. Bull market favorites tend to get singled out for special attention on the downside.