Finance Digest for Week of June 13, 2005

BELIEVING (AND BELIEVING AND BELIEVING) IN BULLION

On a recent early spring morning, I made my way down to the appropriately poker-faced and austere building that houses the Federal Reserve Bank of New York. In its sub-basement, 80 feet below street level, there is a vault that rests on the granite bedrock of Manhattan. “No man-made floor could hold the weight of all this,” Peter Bakstansky, a Fed spokesman, assured me. The vault holds 7,000 tons of gold. This represents the world’s largest stash of the precious metal, and it is worth about $100 billion. To view it, you descend to an underground bunker and pass through a narrow passageway cut into a 90-ton steel cylinder. Like most people, I had seen gold before, though only in small quantities – a filling here, a vanity wristwatch there. In front of me now, stacked in bricks atop wooden pallets, lay some pretty serious bling.

Gold is a majestic condenser of wealth. A standard bar is 7 inches long, 3 5/8 inches wide, and about 1 3/4 inches thick. It weighs 27.4 pounds, and at the current market price – roughly $420 a troy ounce, the unit in which gold is measured – is worth about $170,000. As miraculous as gold is in itself – it is soft, dense, ductile, sectile, highly conductive, all but indestructible and, of course, very beautiful – when you look at any quantity of it, you immediately exchange it in your head for something else. One bar … college education, 10 bars … Brooklyn town house. The cage in front of me appeared fairly small. Filled to the ceiling with gold bars as it was, it might well hold the financial health of a nation in the balance.

Most of the bullion at the New York Fed is kept – in 122 separate lockers – in custody for foreign countries. (Most American gold is in Fort Knox.) There is something ancient and strange about the vault, in which workers wear magnesium shoe covers to protect their toes from falling ingots. Egyptians were casting bars of gold thousands of years ago; but the thrust of human history has been away from hard money and toward virtual money, like paper bills, or even little electronic pulses shot off by the trillion across the ether. When I remarked that all this brute physical wealth represented an anachronism, Bakstansky seized upon the word brightly.

“Yes, exactly. Gold is an anachronism.”

“And yet,” I said, “all these nations, they hold on to this anachronism, just in case. …”

At this, a light chill entered his voice. “I don’t think anyone in a policy-making position,” he explained to me politely, “seriously believes that everything else of value could disappear, leaving only gold.”

To a small but extremely avid subculture in the American financial community, gold does not mean bling, or King Midas, or them thar hills. Gold is money; and not just money, but the one true money. The gold subculture divides along several lines – some of its members are gold speculators, some gold hoarders, some gold philosophers and some outright nut jobs – but it unites behind a single idea: Paper money issued by governments, when not redeemable for actual gold, is fraudulent. Most of us accept the existence of dollar bills unconsciously. To the gold faithful, however, a dollar bill is “ink money”, or better yet, “fiat currency”, a nearly constant term of abuse at gold conferences and in gold chat rooms. “Fiat currency – it’s a floating abstraction,” Doug Casey, a star speaker on the gold circuit, bellowed at me over the phone. “What’s its worth? I don’t know what it’s worth! It’s a figment of some government bureaucrat’s imagination!”

THE UNITED STATES OF EUROPE IS DEAD, LONG LIVE EMU!

As a card-carrying euro-skeptic, I have certainly expressed my doubts over the years about the hopes and dreams of Euroland. From the start, I worried that “one size did not fit all” – that Europe was still a heterogeneous combination of diverse nation-states that would not take well to a single currency, a single interest rate, and a fiscal rule. The conditions for the “optimal economic zone” were far from satisfied, and political fragmentation only served to underscore the region’s inherent differences. How could Europe pull together, if its macro disparities were pushing it apart?

That question now takes on much deeper meaning in the aftermath of the stunning rejection of the EU constitution. It boils down to an assessment of the potential synergies that might have arisen from the interplay between political, economic, and financial-market integration. While the theory made sense, the proposed application of that theory never did, in my view. A supra-bureaucracy was the last thing Europe needed at this stage in its drive for unification. In my opinion, it was far too soon in the integration process for Europe to bring political unification into the equation. With this possibility now having been all but quashed by the French and Dutch electorates, Europe is free to focus its energies on the sad state of its economy. That gives Europe a much cleaner shot at the heavy lifting of structural change and productivity enhancement. That is a very positive development, in my view.

The U.S. experience tells us that private-sector corporate restructuring is the main agent of change. That has also been the case in Japan in recent years, and is now the case in Europe, especially Germany. In all of these instances, politics was a secondary consideration, at best. All the government had to do was get out of the way and let competitive forces take their normal turn of events. By endorsing trade liberalization and deregulation of long sacrosanct service industries, politicians exposed bloated and complacent companies to the harsh market-driven pressures of creative destruction. Once sheltered, then exposed, the choice for businesses boiled down to restructure or perish. It was that simple – that brutal.

So now the French and Dutch have spoken – the EU will have to face a future without a constitution. As long as Europe does not put up new walls – either externally through trade protectionism or internally through re-regulation – I suspect that corporate restructuring will continue to gather momentum over time. The odds of Europe putting up significant barriers to foreign trade are exceedingly low, in my view. For an externally-dependent European economy and the world’s dominant exporter, Europe has everything to lose and nothing to gain by going protectionist. For Smokestack Europe, competitive pressures are likely to get increasingly intense in the years ahead – leaving restructuring and efficiency imperatives as the only means of survival.

Germany, once the engine of Europe and still, by far, the largest economy in the region, may well hold the key to what lies ahead. If that is the case, there is good reason for optimism. Corporate restructuring is taking off in Germany right now. M&A activity is surging and our bankers tell me the pipeline looks stronger than ever. Private equity investors are swarming over Germany right now – encouraged by visible signs of turnaround in investments they have made in the past several years. German labor markets are far from flexible but they are changing before our very eyes. Germans are despondent but their corporate turnaround story is increasingly powerful. From my perspective, today’s German angst has much in common with the experience of the American worker in the early 1980s and again in the early 1990s. For both cases in the U.S., there was no gain without pain. Germany is certainly going through the pain phase, but the gains cannot be minimized.

Timing is everything in shaping sudden swings in asset prices. Europe is currently being hit both by the downside of the business cycle and an important shift in the political cycle. Markets know this – suggesting that the bad news is largely in the price. The depressed sentiment on the Continent speaks to the same point – a crescendo of capitulation out of which important market bottoms are often formed. The world has given up on Europe. Europe has given up on itself. As a long-standing Euro-sceptic, I never thought I would pound the table on this region. But there is something big happening in Europe right now that cannot be ignored. Now that the political decks have been cleared of the ponderous constitutional debate, Europe can finally get on with its long overdue restructuring.

WHERE WILL GOOGLE GO?

There are not too many ways to turn 100 grand into $80 billion: Win the lottery … strike oil … marry into the Hilton family … Create an Internet search engine out of your college dormitory? Yep, and seven years later, $80 billion is valuation the creators of Google can claim for their search engine company. Talk about a seven-year rich. But seriously, in case you missed the 1,710 plus articles which recently covered the matter, a June 7 USA Today article has the gist: “After going public a mere ten months ago, Google stock has ‘defied gravity’ by soaring 237%. Today, it sits but a ‘whisker’ away from the magical $300 level while the company itself, with a market worth of $80 billion, bested Time Warner to become the most valuable media corporation in the world.”

For its part, Wall Street went simply “gaga”, “goo-goo”, and “giddy” over the news, raising its annual growth forecast for the company faster than you can say “Search: Google and Groundswell.” One by one, the chief experts followed suit, e.g., Citigroup Smith Barney placed a $360 target on shares and wrote: “Google has an under-appreciated potential for expansion.” Reuters Estimates noted that not one of the 30 analysts polled listed Google as a “sell”. As the June 10 Financial Times observes: “Google’s status as a must own stock is cemented. The tech-world’s next great company has arrived.”

What has not arrived is real tangible proof to justify the über-bullishness. Fact: Google does not offer its own forecasts for growth to the public. “Investors must guess whether the company is sitting on good news or bad,” explains a recent Wall Street Journal. “Right now,” it continues, “they assume the former.” What investors do know is limited to the following: Google’s profit does not come from retail. In 2004, sales hit $3.2 billion, 1/13 the sales made by its competitor Time Warner ($42 billion). The bulk of its earnings derive from advertising. FYI: From April ’05 to May, the average price paid by advertisers for search-engine key words sank 15%.

Also, according to the June 7 London Times, “the biggest Google skeptics come from inside the company.” In the words of one founder, “Growth rates of the costs and expenses (up two-thirds in 2004) may exceed the growth rate of revenue during 2005 and beyond. … We face formidable competition in every aspect of our business.”

Well, there are only two reasons why shares would skyrocket as Google’s has: Irrational exuberance, rather than objective value, has propelled prices – OR – the substance of Google’s strength is equal to the bullish sentiment. You can “assume” the latter, as the professionals would have you do. Or, you can gain objective analysis of the company, including a detailed labeled price chart of Google stock (GOOG) versus the relative strength index. One look at this eye-popping picture and you will know whether the seven-year rich is here to stay.

SIX YEARS, STUCK AT 10,000 …?

More than six years have passed since the Dow Jones Industrial Average first closed above 10,000 (March 1999). In the time since, the index has mostly stayed within a few percentage points of that nice round figure. 6+ years is a long time to linger in a trading range, especially when you recall what the Dow had done in the six years before it hit 10,000 – namely triple in size, from around 3,400 in March 1993. Humor my saying so, but that was the time to be bullish.

Still, I do have a reason for stating the obvious. The DJIA’s initial arrival at 10,000 roughly parallels the start of another noteworthy epoch: The unprecedented period when, according to Investors Intelligence, the percentage of bullish advisors exceeded bearish advisors for 339 of 348 weeks. It is, the biggest orgy of investment optimism of all time. This one mega-indicator reflects what many other long- and near-term indicators now show. Several of these, including Google’s stock price/valuation (see article above), price action in the IPO Index, and a closely followed daily sentiment measure show that traders are actually more bullish now than they were at the all-time highs of 2000.

WHOLESALE PRICES TUMBLE

Prices paid by businesses tumbled last month due to the biggest drop in oil prices in two years, the government said in a report showing lower inflationary pressures than economists had expected. The Labor Department said its Producer Price Index, a measure of inflation on the wholesale level, sank 0.6% in May after rising 0.6% in April. Economists surveyed by Briefing.com forecast that the PPI would fall 0.2%. Energy prices fell 3.5% during the month, the department said, accounting for about three quarters of the decline in the PPI. Food prices also fell, down 0.3% during the month. The so-called core PPI, which excludes often volatile food and energy costs, rose 0.1% after a 0.3% gain in April – the third month in the last four that the core reading rose 0.1%.

U.S. Consumer Prices declined 0.1% in May; core rate rose 0.1%.

Prices paid by U.S. consumers for goods and services unexpectedly declined last month for the first time since July 2004, restrained by cheaper energy, suggesting tame inflation. The CPI fell 0.1% in May after rising 0.5% in April, the Labor Department said. Core prices, not subject to larger fluctuations because they exclude food and energy, rose 0.1% in May, less than economists forecast. Federal Reserve Chairman Alan Greenspan last week told lawmakers that “inflation at this stage remains modest” even as some companies find it easier to pass on raw materials costs, which have increased in the last year. With prices going up slowly and labor costs rising, Fed policy makers are likely to keep raising interest rates, economists said.

Consumer prices were up 2.8% for the 12 months ended in May, while core prices were 2.2% higher than a year ago. So far this year, consumer prices are rising at a 3.7% annual rate compared with a 5% increase at the same time last year. Core prices are rising at a 2.4% annual pace, down from a 2.5% rate in the first five months of 2004.

RE-SEQUENCING

A lopsided world economy continues to be dominated by two growth engines – the American consumer on the demand side of the equation and the Chinese producer on the supply side. Both of these engines are overheated and in need of cooling off. I had long thought the American consumer would be the first to slow. But now the sequencing looks different – with China likely to lead the way. This could keep the U.S. growth engine in high gear for a while longer – but at a cost that could make for an even more treacherous endgame than might have otherwise been the case.

I have long argued that the over-extended American consumer was the weakest link in the global growth chain. In what I thought was the increasingly likely event of a U.S. current-account adjustment – and a falling dollar and rising real interest rates that seemed likely to accompany such an adjustment – I stressed the mounting vulnerability of the American consumer. In my mind, it all hinged on the interest rate piece of this risk assessment. A normalization of real interest rates in the U.S. would temper excesses in property markets and sharply curtail the asset-dependent spending excesses of the American consumer. As a result, consumers would once again have to save the old-fashioned way – out of earned labor income. The domestic saving rate would then rise – helping the U.S. to wean itself from excessive reliance on surplus foreign saving. The result would be a textbook rendition of a classic current account adjustment.

The interest-rate piece of this scenario seemed to be falling into place. The Federal Reserve appeared to be on a path of interest rate normalization. In short, in a rising real interest rate climate, there was good reason to believe that the asset-dependent American consumer was about to lead the charge in a long overdue global rebalancing. That was then. No longer do I feel that the American consumer will be first to go in this adjustment process. I now believe that the Chinese producer will lead the way. A two-pronged slowdown now seems likely to unfold in China – with internal policies aimed at a bursting of the property bubble and external forces putting pressure on China’s export dynamic. Chinese GDP growth, which has fluctuated in a 6-9% range over the past six years and is currently holding at the upper end of that range, could well move to the lower end over the next year. Consequently, I now believe that the Chinese economic growth dynamic is about to come under far more immediate pressure than the American consumer.

This is a very important shift in the sequencing of global rebalancing. That is because the rising probability of an imminent China slowdown is likely to have important and constructive interest-rate implications that could keep the American consumer in the game for longer than I had previously thought. A China slowdown is bullish for bonds. Like most things we buy today, even the bond market now appears to be “made in China” as well. Despite all its bluster about policy normalization, I believe that a pro-growth, pro-market Fed will be reluctant to tighten much more if a China-led slowdown unfolds first, as I now suspect. The net result could be a surprisingly benign US interest rate climate for some time to come.

If such an outcome occurs, it would undoubtedly provide the interest-rate-, asset-dependent American consumer with yet another breath of life. While that might offer some support to the near-term U.S. growth outlook, this would not be a constructive development over the longer haul for an unbalanced global economy. It could lead to a final blow-out in already frothy U.S. property markets, along with a last-gasp surge of refi activity to tap such newfound wealth. Not only would that push household indebtedness to ever-higher highs, but it would undoubtedly depress income-based saving even more. The result would be a further widening of an already record current U.S. account deficit – setting the stage for a far more treacherous endgame. All this means that the ever-present excesses of America’s Asset economy could be seriously compounded by the seemingly bullish interest rate implications of a China slowdown. In the end, such a re-sequencing of global rebalancing is the last thing an unbalanced world needs.

Textiles just start of a flood of Chinese goods.

From metals to machinery, China is increasingly relying on exports to find an outlet for excess production pouring out of factories built during a two-year investment frenzy that authorities are now laboring to tame. The consequences of the oversupply will be far-reaching. Within China, inflation is likely to remain at bay as firms cut prices rather than output in order to preserve market share. That would weaken the case for higher interest rates. Beyond China’s borders, a fast-growing trade surplus will provide ammunition for critics calling for a stronger yuan and could provoke more trade disputes like the row with the U.S. and the EU over surging textile exports.

“We remain concerned that there remains a general underestimation of the scale of the supply shock which is unfolding in China,” economists at Barclays Capital wrote in a report. “It is difficult to see anything other than a deepening of trade tensions with China over the coming months.”

NEWS FROM THE HOUSING BUBBLE FRONT

Californians taking big risks to buy homes, report warns.

Desperate to enter the housing market before prices soar even higher, Californians are taking on larger and riskier mortgage debts, Harvard University warned in its annual report on the nation’s housing. “Desperation is driving people,” said Nicolas Retsinas, director of Harvard’s Joint Center for Housing Studies. “They think, ‘If I don’t get it now, I will never get it.’ People are not looking at what they are going to have to pay over the long term. They are asking what is the lowest possible payment I have to make over the next 12 months so I can get in.” In high-cost markets such as San Diego County, most purchases are made with adjustable-interest-rate loans, he noted. The greater buying power such “creative” loans offer is offset by the increased risk of default. In the priciest metropolitan real estate markets, assuming greater risk is becoming the norm, Retsinas said.

Get ready for a housing slowdown, says report.

The housing market’s foundation is finally starting to shows signs of stress. This, according to the “State of the Nation’s Housing 2005” report by Harvard University’s Joint Center for Housing Studies. Despite strong fundamentals supporting the residential home market, says the study, housing affordability is waning, and at least three major areas – Southern California, the New York metropolitan area and Southern Florida – are showing signs of a pricing bubble.

Another problem, particularly in those areas, is the disparity between the residential home and rental markets. The after tax cost of owning now exceeds the cost of renting a comparable home by 28% nationally, and by much more in certain areas of the country, according to the report. In 2003, it cost 23% more to own than rent a comparable home, says a researcher at the center.

The “State of the Nation’s Housing Report 2004” was far more upbeat than this year’s edition, with no mention of housing bubbles and only minor concerns over affordability. The 2004 report mentioned the risk that if job growth faltered or interest rates spiked, the housing market could suffer. The most likely outcome in that event, however, was a soft landing in which home prices, sales and new construction eased rather than dropped off sharply. This year, the language is more cautionary, particularly regarding the three bubble regions. “We want to be sure people are aware that, notwithstanding these past few years, buying a house is not a risk-less investment … this is clearly near the apex of the cycle,” says Nicolas Retsinas, director of the center.

To be clear, Retsinas is not predicting a nationwide housing crisis. Indeed, 77 of the 110 largest metro areas show no affordability troubles and would likely be untouched if the housing bubble popped in the hottest markets, says Retsinas.

White House, GOP leaders want tougher controls on mortgage finance firms.

Both the White House and Federal Reserve Chairman Alan Greenspan argue that the two companies, which are involved in financing nearly half of U.S. home mortgages, have too many mortgage-backed securities in their portfolios. The language in House legislation did not include a White House proposal to require the two companies to reduce those holdings. The administration’s call to reduce those portfolios has support of Sen. Richard Shelby, R-Alabama, chairman of the Senate Banking Committee.

Real-estate insanity is becoming the norm in Florida.

Somebody has bought the beige stucco house on Water Lily Way in Bradenton, but its for-sale sign lacks the usual “SOLD” label. Instead, the real-estate agent has slapped on a neon-orange banner that screams “TOO LATE”. That is pretty much the story in Bradenton and nearby Sarasota, Florida, these days. The two cities are the hot spots du jour in a state where the housing market has passed the boiling point. Bradenton’s home prices have leapt 45.6% in the past year, the highest rate in the nation. In second place is Sarasota, where prices rose 36%. In all, Florida metropolitan areas hold eight of the nation’s top 10 spots for price growth, according to the National Association of Realtors. “Florida is the new California,” said Jack McCabe, a Deerfield Beach, Florida, housing-industry consultant. “It’s the most wild-and-woolly market in the country.”

Experts say a confluence of factors has sent Florida’s housing market into the stratosphere. Booming population, cheap mortgages, a healthy employment scene, Latin Americans looking for a secure place to park their money, well-heeled baby boomers and deep-pocketed speculators have combined to wrestle away California’s longtime monopoly on house-price insanity. Housing analysts say last year’s disastrous series of hurricanes barely dampened Florida home buyers’ enthusiasm. Leading the demand, they say, is the state’s avalanche of new residents: The U.S. Census Bureau estimates that 1,000 people move to Florida every day.

Bradenton and Sarasota home buyers say they have been forced to adopt a survival-of-the-fittest mind-set. Agents say it is not unusual for homes to sell instantly, in almost the literal sense of the word. Those homes never even reach the multiple-listing service because sellers’ real estate agents easily find buyers represented by other agents in their own offices.

Federal Reserve Chairman Alan Greenspan expressed concern last week that housing markets in some areas are showing “signs of froth” that could hint of plummeting prices. David Seiders, chief economist for the National Association of Home Builders, told a meeting of the National Association of Real Estate Editors earlier this month in Washington that home prices never have plunged on a nationwide basis. “Most booms have ended in price stagnation instead of decline,” Seiders said. “But this time could be different.” He said that the introduction of the popular adjustable-rate and interest-only mortgages, plus the influence of speculators, are wild cards that might alter the historical expectations.

The mortgage trap.

Nicki Randolph, a San Francisco real estate agent, has not been scared off by talk of a housing bubble. Although she already owns both a home and a condo in Palm Springs, California, Randolph just closed on a third property – dropping more than $1 million on a 1,400-square-foot loft in the heart of San Francisco. How does she juggle so many properties in the overheated California market? Lots of leverage, thanks to banks all too willing to provide ever more. To finance her loft purchase, Randolph took out a mortgage that lets her pay only interest for the first five years – a tactic that helps her ease into the hefty monthly payments. “Fears that the market is going to crash are way overstated,” she says confidently. “It’s a seven-mile-by-seven-mile city and a premier place people want to live. You have to be more aggressive here because the prices are so high.”

Randolph’s story is a familiar one – and it shows the lengths to which buyers are willing to go to snatch up real estate as well as the extremes lenders will stretch to accommodate them. As prices continue to skyrocket in much of the country, banks and lenders are cranking out an ever-growing array of products ranging from no-money-down or interest-only mortgages, to special “Payment Power” loans that allow homeowners to defer monthly payments altogether twice a year. Such creative financing is letting even marginal buyers purchase houses with price tags that used to appeal only to the rich and famous. In the process, banks and mortgage companies appear to be taking on more risk than ever before – and if rates rise sharply or prices tumble, many of their customers could find themselves in deep trouble, too.

All those innovative mortgage products are a sure sign that lenders are doing everything they can to keep the housing boom going and to capitalize on yet another round of falling interest rates that no one expected. There are plenty of other signs of frenzy as well. Home appraisers complain that mortgage originators are demanding the optimistic appraisals needed to close on loans. “They started warning me to ‘be a team player’ and to ‘hit the number’ they needed to seal the deal,” says Robert Burnitt, an appraiser in Midlothian, Texas.

Will the proliferation of interest-only and option ARM mortgages leave many buyers strapped down the road, causing higher default rates? David Liu, a mortgage strategist for UBS in New York, notes that after similar products were introduced in the red-hot California market in the late 1980s, they ultimately incurred a default rate that was three times as high as conventional mortgages when the local economy went into recession in the early 1990s. Already there are signs that current option ARM borrowers are straining to make their monthly payment: Liu notes that among a bundle of mortgages originated by Washington Mutual and securitized into the secondary market last year, fully 60% of borrowers made only the minimum payment this past March. “That’s definitely a sign that people are stretching,” says Liu.

There is plenty of other evidence suggesting that homebuyers and their lenders are climbing out on a limb. According to a survey of homebuyers released last November by the National Association of Realtors, 25% of those polled were able to get a mortgage with no money down, vs. 18% in early 2003 and virtually none in the late 1990s – a trend that could leave many of these new homeowners under water if home prices take even a small dip. At the same time, lenders are extending far more loans to borrowers who have had credit problems in the past. “I think there are going to be some blowups,” says Bert Ely, a bank consultant based in Alexandria, Virginia.

The trillion-dollar bet.

American homeowners have made a trillion-dollar bet that mortgage rates will remain near record lows for at least a few more years. But with some interest rates already rising, economists worry that the bet could turn bad. The problem is that new types of mortgages that hold down monthly payments for families – helping many buy homes that they would not otherwise be able to afford – also require potentially far higher payments in future years. The bill will soon start to come due in a serious way, as the initial period of fixed payments, typically set at artificially low rates, expires for millions of homeowners with adjustable-rate mortgages.

This year, only about $80 billion, or 1%, of mortgage debt will switch to an adjustable rate based largely on prevailing interest rates, according to an analysis by Deutsche Bank in New York. Next year, some $300 billion of mortgage debt will be similarly adjusted. But in 2007, the portion will soar, with $1 trillion of the nation’s mortgage debt – or about 12% of it – switching to adjustable payments, according to the analysis. The 2007 adjustments will almost certainly be the largest such turnover that has ever occurred.

Dallas housing is hot property to investors.

Carloads of Californian speculators shopping for suburban tract housing. Wealthy speculators snapping up in-town condos. The buzz in the Dallas housing market is about investors. Depending on whom you talk to, these opportunistic buyers are either a boon or bad news. “Is it happening? Yes,” said real estate broker Kyle Crews. “Can I tell you how deep and wide this market is? No. But I hear more and more chatter about people coming in from out of state and buying housing,” said Mr. Crews, an agent with Allie Beth Allman & Associates who recently sold two new high-rise condos in Uptown Dallas and one in Austin to the same California buyer. “Compared to prices in other markets, Dallas has got to be looked at very favorably.”

Average residential prices here are half or less what they are in many West Coast cities, which is bound to attract speculators, brokers say. Coming up with statistics on the investor market is almost impossible. It is never easy to tell who is buying a home to live in and who is making an investment play. One market that is easier to gauge for investor demand is high-rise condominiums. Developers report that a great many of these expensive homes are going to investors. “The last number I saw for our building was 20 percent investors,” said Jonas Woods, president of Hillwood Capital, which is building the W Dallas Victory Hotel & Residences in Uptown. “There is no question that this is a phenomenon we are seeing in markets around the country.”

Builders are always reluctant to turn away wealthy buyers, but investor sales are not something they promote, Mr. Woods said. “It’s a disaster waiting to happen for people who develop in this market,” he said. “It gives you a false sense of security about buyer demand. But someday the investor market will shut down overnight,” he said. “If 20 and 30 percent of your buildings have been taken by speculators, and your price has been driven up, then we can all find ourselves in a tough spot.” Some of the country’s top housing economists share those worries.

Most investors plan to rent the house out for a year or so and then resell. Good luck, says Bill Sabino, manager of Re/Max Premier Group Realtors. “I do’qt know how they are going to rent them,” he said. The North Texas Multiple Listing Service currently shows about 3,900 rental homes and condos on the market. That is up from about 1,600 in 2002. Investors “are definitely more prevalent, especially in the last six months or so,” said David Brown, director of the Dallas office of housing analyst Metrostudy Inc., which tracks the new-home market in North Texas. Most big homebuilders do not want to sell to speculators, Mr. Brown said. “They don’t want a new subdivision with seven or eight ‘for lease’ signs,” he said. “You could wind up competing against yourself.”

John Landon, co-chairman and chief executive of Meritage Homes, which has dual headquarters in Dallas and Scottsdale, Arizona, says investor sales are still only a small part of the North Texas new home market. “There have definitely been many investors in the Phoenix market, in California and the Las Vegas market,” Mr. Landon said. “But in Dallas-Fort Worth, we are not going to see great appreciation like you have in those markets. The barriers to entry are much less in the housing market, and there is no housing bubble here,” he said.

More sell homes to lock in big gains.

Looking to cash in on a red-hot housing market that has lifted prices an estimated $5 trillion in the past decade, some homeowners are selling and pocketing the profit. Home values have more than doubled in the past five years in some states, and the median price of existing homes nationwide topped $200,000 for the first time. Real estate agents in hot markets say more of their clients have sold their homes to lock in gains or are considering the move. Although it is impossible to quantify such activity, and the National Association of Realtors estimates the numbers are small, anecdotal evidence suggests house-rich folks are cashing out. Unlike a typical situation where sellers take profits and plow them into bigger homes, some people worried about an upcoming price drop are getting out of real estate altogether.

For Ken Koegl, 63, a retiree from South Lake Tahoe, California, the idea of cashing out “just started going through my mind”. A broker told him his main residence, bought in 1993, is worth $400,000 more today. Koegl, who owns three homes, is not shying away from real estate, but thinking of selling and going back to Texas, where housing prices have posted modest gains. “I’ll sell high and buy low,” he says. The huge potential profits to be made might have many others contemplating similar moves. Dean Baker, co-director of the Center for Economic and Policy Research, estimates $5.2 trillion in “bubble wealth” has been created since the real estate boom began in 1996.

Still, the decision to sell one’s home – and uproot the family and give up the mortgage tax deduction – should not be taken lightly, especially if the decision is driven by the market. “How do you know where the top or bottom is?” sales associate Roberta Murphy asks. One of her clients, figuring prices had peaked, sold a home 18 months ago in the high $500,000s. “The same homes are now in the high $700,000s,” she says. There are circumstances where selling in a hot market makes financial sense, Murphy and others say. People with second homes or rental properties might consider reducing their exposure to real estate and reinvest the proceeds elsewhere. Older people with big houses who want to scale down also have an incentive to sell, as do those in or nearing retirement looking to hatch an instant nest egg. In such cases as those, the prudent move can be to take the money and run.

Housing envy: soaring prices create divide.

The sharp increase in housing values in the Washington, D.C. area has created a great divide between those who own houses and those who do not, and nowhere does this play out more than in the workplace. Those who do not own homes look enviously at their colleagues who do, and their different financial situations can lead to strains, stress and some veiled anger.

Michael Stadter, a clinical psychologist and organizational consultant in Arlington, Virginia, said that in hard-charging cities such as Washington, known for its high-achieving careerists, people traditionally have been very much defined by their jobs. But suddenly, housing has become a new identity marker. “Peers often socialize. One might have the other over for dinner, and he says, ‘Boy, this is a much nicer neighborhood, a much nicer house,’” Stadter said. “That fuels an issue of identity: ‘Am I really doing well? Am I really good enough?’

“When you’re in a culture like Washington or New York, and a person lucked out and now has a place worth 10 times what they bought it for, how do you deal with that?,” said Douglas LaBier of the Center for Adult Development in the District and author of Modern Madness: The Hidden Link between Work and Emotional Conflict.

Is the housing bubble GLOBAL?

For all the recent news chatter about a real estate bubble, the conventional wisdom – from the mouth of Mr. Alan Greenspan – is that a “bubble” in housing prices does not seem likely to develop in the U.S. … recent home price gains are better described as “froth” in local markets. And obviously if U.S. home prices cannot be in a bubble, it is even more farfetched to imagine that the world is seeing a real estate bubble.

And I for one will be happy to buy into this logic … just as soon as someone explains why home prices in BULGARIA have shot up 48% in the past 12 months. That is what the Wall Street Journal reported, along with these tidbits about home-price rises from around the rest of the planet: In the past 36 months, gains in Shanghai were 68%; Spain 63%; South Africa 95%. In the past 12 months, gains in New Zealand were 16%; Thailand 13%; France 15%. Yes, I am citing the most extreme of the gains, yet the variety of the locales leaves no doubt that the trend is global. A trend this broad and deep depends on one cause more than any other: Psychology. Yet the importance of psychology was absent in the WSJ article. In our analysis of the housing bubble – which is all-too real, by the way – we BEGIN with the psychology of the market.

THRIFTY INVESTING

Financial Historian David Mason calculates that between 1980 and 1993, 1,307 S&Ls with more than $603 billion in assets went bankrupt, at a cost to taxpayers of nearly $500 billion. The reputation of S&Ls had plunged. Once seen as the humble local institutions of It’s a Wonderful Life fame, they now conjured up the image of Charles Keating in handcuffs and became symbols of greed and corruption.

Into this mess stepped Peter Lynch, then the manager of Fidelity Magellan, and on his way to compiling one of the most amazing track records in the history of investing. Lynch took the reigns at Magellan in May of 1977, when the Dow was at 899 – and headed to 801. He left in May 1990. If you had put $1000 with Lynch in 1977 and just left it there, you would have had over $25,000 when Lynch retired in 1990 – an average annual return of 29.2%. Among his favorite stocks were S&Ls. At one point, he owned over 150 of them. As he writes in his book Beating the Street, “Once, I confessed to the Barron’s panel that I’d invested in 135 of the 145 thrifts whose prospectuses landed on my desk. The response from Alan Abelson [Barron’s editor, long known for his wit] was typical: ‘What happened to the others?’”

Lynch bought S&Ls when they were still among the untouchables of the investment world. Yet there were many S&Ls that survived the debacle of the early 1980s. Lynch also noted that in terms of financial strength, as measured by the equity-to-asset ratio, there were many S&Ls that were stronger than the strongest bank in country, then J.P. Morgan. Lynch had his own schema for separating S&Ls. He had the “bad guys”, who perpetuated the fraud. Most of the frauds, Lynch notes, were privately owned (Charles Keating’s Lincoln Savings and Loan being an exception) and would not have survived the scrutiny of being a public company. Then there were the “greedy guys”, who could not leave well enough alone. In their thirst for greater profits, they followed the old hackneyed measure of borrowing as much as they could and putting it to work in risky ventures.

The last of the lot were the “Jimmy Stewarts”, as Lynch called them. They were the no-frills, low-cost neighborhood thrifts that concentrated on making old-fashioned mortgage loans. Lynch loved these S&Ls. As he explains it, he bought them in such large quantities because they were often small and Magellan was so large, such that “to get nourishment out of them, I had to consume large quantities, like the whales that are forced to survive on plankton.” One reason he loved them was the unique way in which they go public. Mutual companies, such as thrifts, cannot issue stock to raise capital. Sometimes the easiest and best way for a growing thrift to add capital is to go public. This process is called a thrift conversion, because the thrift converts from an organization of mutual ownership to one of public ownership. There are other reasons a thrift may want to convert to a public company.

At year-end 2004, there were 1,345 thrifts operating in the U.S. Of these, 47% were publicly held companies, and the remaining 53% were still mutual thrifts (that is, they remained owned by depositors). The current mutual-to-stock conversion process for a thrift was established in 1976. This process created a favorable investment situation. Lynch describes it this way: “Imagine buying a house and then discovering that the former owners have cashed your check for the down payment and left the money in an envelope in a kitchen drawer, along with a note that reads: ‘Keep this, it belonged to you in the first place.’” When Lynch learned about the “hidden cash in the drawer” rebate, early in his Magellan career, he bought almost every S&L that he could get his hands on. While the environment today is different than it was then, these conversions still present value opportunities.

Back then, S&Ls were widely unpopular. Not so today. But if you look hard enough, there is still plenty of value out there. In fact, I think many of these recent thrift conversions may be the last relatively safe plays in the banking world.

CAN SAUDI ARABIA KEEP ITS PROMISE TO PUMP MORE OIL?

With global oil demand undeterred by a $50/barrel price tag, oil producers are pumping as fast as they can. So the semi-annual haggling over output quotas – ordinarily the gathering’s main event – is all but irrelevant. Leaders of OPEC said they have agreed to raise their formal production limits by 500,000 barrels a day to try to lower soaring oil prices. Though widely expected, economists have dismissed the move noting that the 10 member nations bound by it are already pumping that much. They said oil markets – and drivers suffering sticker-shock at the gas pumps – are unlikely to see much of a difference.

Meanwhile, the discussion about what to do about high oil prices has already been overtaken by promises from Saudi Arabia – the only oil producer seen able to boost capacity from current levels – to raise production to keep prices from rising even further. But a just-released book by veteran oil industry investment banker Matthew Simmons is raising questions about those Saudi promises. Based on research drawn from hundreds of technical papers spanning four decades, Twilight in the Desert argues that the kingdom’s aging oil fields will not be able to sustain the higher levels of production needed to satisfy the world’s growing thirst for oil. “We’ve had an illusion for the last 40 years that there was so much oil in the Middle East that it would never run out,” Simmons said in a recent interview. “What I’m offering is evidence. And all the optimists are offering is hope.”

Where oil is mined, not pumped.

Fort McMurray, Alberta – Along Highway 63 here the rolling hills give way to massive open pits, huge waste ponds and tangles of pipes and refining equipment that spew smoke into the air. In the pits, shovel trucks load dirt into dump trucks that are so gigantic a driver has to climb a ladder attached to the front grille to get behind the steering wheel. The changing landscape reflects an ambitious quest to develop a new source of oil. Major companies – faced with tougher prospects for developing big new oil fields around the world – are doing what was once unthinkable: sinking billions of dollars into projects to wring oil out of deposits of petroleum buried amid sand and clay.

Until a few years ago, such projects – called “oil sands” or “tar sands” – sputtered at the fringes of the oil industry. But since technological breakthroughs brought down costs and oil prices have soared, companies have been investing heavily here. Oil-sands production is now profitable when a barrel of oil sells in the low $20s, analysts said – far below the recent $50 range.

Factoring in the oil sands, Canada’s proven oil reserves are reported to be nearly 180 billion barrels, second only to Saudi Arabia. U.S. energy officials say Canada’s oil-sands deposits are among the largest in the world. The oil sands are buried under an area about the size of New York state. Fort McMurray, the hub of oil-sands activity, boasts on billboards: “We have the energy”. Companies here are producing increasing amounts of oil from this unconventional source – about 1 million barrels a day, or roughly 5% of daily U.S. consumption. In 1995, oil derived from the sands was less than half the current amount. Alberta officials expect production to triple from today’s level by 2020.

THE ECONOMIST’S BIG MAC INDEX FOR 2005 RELEASED

How much burger do you get for your euro, yuan or Swiss franc? Italians like their coffee strong and their currencies weak. That, at least, is the conclusion one can draw from their latest round of grumbles about Europe’s single currency. But are the Italians right to moan? Is the euro overvalued? Our annual Big Mac index suggests they have a case: the euro is overvalued by 17% against the dollar. How come? The euro is worth about $1.22 on the foreign-exchange markets. A Big Mac costs €2.92, on average, in the euro zone and $3.06 in the U.S. The rate needed to equalize the burger’s price in the two regions is just $1.05. To patrons of McDonald’s, at least, the single currency is overpriced.

The Big Mac index, which we have compiled since 1986, is based on the notion that a currency’s price should reflect its purchasing power. According to the late, great economist Rudiger Dornbusch, this idea can be traced back to the Salamanca school in 16th-century Spain. Since then, he wrote, the doctrine of purchasing-power parity (PPP) has been variously seen as a “truism, an empirical regularity, or a grossly misleading simplification.” Economists lost some faith in PPP as a guide to exchange rates in the 1970s, after the world’s currencies abandoned their anchors to the dollar. By the end of the decade, exchange rates seemed to be drifting without chart or compass. Later studies showed that a currency’s purchasing power does assert itself over the long run. But it might take three to five years for a misaligned exchange rate to move even halfway back into line.

David Parsley, of Vanderbilt University, and Shang-Jin Wei, of the IMF, estimate that non-traded inputs, such as labor, rent and electricity, account for between 55% and 64% of the price of a Big Mac. The two economists disassemble the Big Mac into its separate ingredients. They find that the parts of the burger that are traded internationally converge towards purchasing-power parity quite quickly, but the non-traded bits converge much more slowly. Seen in this light, our index provides little comfort to Italian critics of the single currency. If the euro buys less burger than it should, perhaps inflexible wages, not a strong currency, are to blame.

CHINA IS SAID TO CONSIDER $15 BILLION BAILOUT OF STOCK MARKET

The Chinese government is considering creating a $15 billion fund to help bail out the nation’s ailing stock market, according to a senior government official and people told of the proposal. The creation of a huge fund to invest in mainland stocks would be the government’s most striking effort yet to prop up share prices and try to restore confidence in a market that has fallen to its lowest level in about eight years. The proposal comes at a time when China’s economy is sizzling hot, but the nation’s Communist Party leadership is struggling to fix a stock market that has been broken for several years. The Shanghai and Shenzhen stock exchanges, where about 1,400 state-owned companies are listed, are each down 40% to 50% from the highs they reached in 2001. In recent months, struggling brokerage houses and large investors have been aggressively lobbying for a government bailout fund.

Government bailouts have a weak track record, however, and the proposed support is unlikely to nurse the growth of the capital markets here. When authorities in Hong Kong and Tokyo stepped in to aid their local stock markets, the moves only provided a short psychological lift and failed to produce a sustained turnaround. Analysts say the government is considering the huge bailout proposal because the market has fallen so sharply in the last year that some government officials fear a bigger drop could seriously impede the long term development of China’s financial markets. Indeed, China’s weak system for raising money and putting it to profitable use is not just hurting investors and state-owned companies, experts say. At the heart of the problem is that private companies, which have a much better track record, are not allowed to list on the Chinese stock exchanges.

U.S. FED’S KOHN WARNS ON RISKS FROM ASSET PRICES

Federal Reserve Governor Donald Kohn warned that the U.S. current account deficit and surge in house prices may not be sustainable and urged banks to shield themselves against unlikely but potentially harmful events. “Our economy is in unexplored territory in many respects,” he said in remarks prepared for delivery to the Bankers Association for Finance and Trade and the Institute of International Bankers. “The risk of rapid adjustments and unusual configurations of asset price movements is higher than normal,” he said in remarks to be delivered in New York.

Kohn’s comments echo stepped-up warnings from Fed officials, including Chairman Alan Greenspan in recent weeks, that a swift rise in U.S. real estate values may not last and may have led to speculative behavior and risky lending practices. Kohn said low long-term interest rates have fanned the 4-year U.S. housing boom, with home buyers rushing to take advantage of historically cheap credit. But he also said the Fed’s focus on keeping inflation low may not always maintain stable prices for some assets. “Our capabilities are limited; ultimately we are working with only the overnight interest rate and we concentrate on the price level more generally, which may not always be compatible with the stability of the prices of particular assets,” he said.

Americans buy more than they produce, and the current account deficit has risen to more than 6% of the GDP, Kohn said. Americans save little, and their spending has been spurred by the rapid rise in house prices – a byproduct of low interest rates, he said. The growing deficit and climbing home values cannot continue indefinitely, he said. Global investors will eventually seek higher rates of return from dollar assets, and house price gains will slow as they become disproportionate to incomes and rents, he said.

Low long-term rates no puzzle, says president of the St. Louis Fed.

All of the fuss on Wall Street about low long- term interest rates despite steady Fed tightening is misplaced, said William Poole, the president of the St. Louis Federal Reserve bank. In a speech prepared for delivery to the Money Marketeers in New York City, Poole said low rates simply reflect an unchanging view in the market about Fed policy and the economy. In fact, economic data over the past year has come in about as expected, he said. Likely Fed responses to the data were also well known in advance and in the absence of economic surprises, FOMC decisions on the funds rate were much as expected.

“Thus there was no particular reason over this period for the market to revise its expectations of future interest rates continuously in one direction. The bond rate fluctuated in response to arriving information, but ended up about where it started,” Poole said. The St. Louis Fed president, a former academic, said his views are based on the “expectations theory” of the structure of interest rates. He said longer-term rates are a weighted average of the short-term interest rates expected to prevail over the life of the bond. Poole’s comments suggests that he disagrees with Fed chief Alan Greenspan, who has called the behavior of long-term rates this year “a condundrum” that defies most explanations.

WHICH MACRO ECONOMY?

“Despite the uneven character of the expansion over the past year, the U.S. economy has done well, on net, by most measures.” ~~ Federal Reserve Chairman Alan Greenspan June 09, 2005

The above assessment suffers from one problem: it is not really true. The remarks are important as a stark reminder of a powerful sea change in thinking and talking about the economy. For many on Wall Street and at the Fed, the macro economy has been reduced to Fortune 500 profitability and asset market performance. These are certainly important metrics. However, the economy they are not!

The IMF has lowered its forecast for global growth and called attention to risks from U.S. imbalances. The National Association of Business Economists (NABE) just reduced its US GDP growth forecast by 0.2% to 3.4%. More sanguine forecasts are increasingly driven by a differently defined macro economy. We are no longer all on the same page regarding the object of analysis. The relentless search for the positive while ignoring asset bubbles and income redistribution from public view has required shifting focus. It has also required equating the health of the macro economy with equity and bond market performance, corporate profits and the housing market. Maybe this is what they really meant by “the new economy”?

LOW-CUT DRESSES AND UGLY DUCKLINGS

Making money in the small-cap market is like finding a woman. If you are only looking to get some “action”, you will head down to the smoke-filled tavern and seek out the woman with the low-cut dress, cheap perfume and a nearly empty drink. Buy her enough rum and Cokes, and you may find the immediate satisfaction you desire. But if you are looking for a wife, a life-long companion, you will pick the woman that has morals, integrity and a friendly smile. Instead of scouring the seamy bars and nightclubs, you have to look in far more boring places – like the local library, the neighborhood coffee bar or your corner grocery store. That is the basic metaphor Ralph Wanger, the finest small-cap fund manager of the last 50 years, used to describe investors when Chris Mayer and I flew to Chicago to interview him.

Wanger is to the small-cap market as Buffett is to value investing. From 1970 to 2003, Wanger ran and managed the Acorn Fund – a small-cap fund that invests in fundamentally sound companies that the rest of Wall Street turned their noses to. During his tenure at Acorn, he averaged a robust 17.2% return. A mere $10,000 investment in 1970 was worth $174,059 by 1998. Not too shabby. And when Chris said he was able to get an interview with him, I was not going to pass up the opportunity to pick his brain.

I asked Wanger what separates successful small-cap investors from those who lose their shirts. He put it to me like this … Small-cap speculators (those who tend to lose a ton of money in the market) buy the hottest biotech or semiconductor stocks hoping to make a quick return. They seek out the sexiest stories on Wall Street – the stories everyone is talking about – and lay their money down. If they are lucky, they walk away with a bundle of cash. But more often than not, they come up empty, wishing they would not have indulged in the first place. Wanger referred to these people as “loony”. They are the same people who go to the bar looking for a one-night-stand with the girl that is being swarmed with dozens of drunk men. Their chances of winning are slim to none. Yet most people who dabble in the small-cap market take this approach.

The more prudent way to make money in the small-cap market, Wanger contends, is to focus on the boring and beaten down companies that no one else is looking at. And that is exactly how he averaged a 17.2% compounded return for 30 years as the fund manager for the Acorn Small Cap Fund. Some of his biggest winners were a brick maker, a slot machine business and a “boring” frying machine company. If those companies were women, they would be buried in the back of a library, wearing a turtleneck and cardigan sweater, reading the latest edition of Home and Garden.

To truly make money in the small-cap market you have to be willing to invest – not speculate. You have to be willing to look at the ugly ducklings versus the sexy vixens that everyone is watching. And you have to hold solid companies for a long time so your gains can compound. Wanger’s average holding period was between four and five years. But, as he was quick to point out, he held onto some winners for decades while he cut others loose after a few months. This is key. What separates a great investor like Wanger from a schmuck who loses money every year may be one or two investments over the span of several years. You may only have one, two, or three grand slams in a career – those 30-baggers that you can write books about. That is exactly what Wanger has done time after time. He let his winners compound and he cuts his losers.

You have to know when to sell – something most investors do not have a clue about. Wanger said your sell strategy is actually built into your buy decision. Unlike most amateur investors, he does not necessarily use stop-losses or trailing stops to figure out when to exit a position. Instead, he writes (in plain, simple English) why he is buying stock in a company. In other words, he spells out his buy decision. But he also makes it easy to figure out when to sell. When his reason for buying is proven false, he sells.

Every time you buy a stock, write down why you are buying it. Keep it short – no more than a paragraph or two. Make sure the reason you are buying is simple and clearly laid out. And when the reason you bought the stock is no longer true, sell. This will save you a lot of sleepless nights, costly transaction costs and wild price flucutations that scare most other investors. In the short term, even the best of small-cap stocks are subject to a lot of ups and downs. And the worst thing in the world is to sell a solid company just because the price went down. That is what speculators do … and you know you cannot make a lot of money being a small-cap speculator.

If you are not willing to do the same, you should stay away from the small-cap market now. With valuations neutral at best, your chances of getting lucky are not very good. Chances are, you will end up sleeping alone and have less money in your bank account than you had the day before.

THE TIDE HAS TURNED FOR URANIUM

Similar to the commodity bull market, the uranium story is not brand-new. The price of yellowcake has more than doubled in the past two years, from $10.75 per pound circa early 2003 to around $25 as of this writing. Also similar to the commodity bull, uranium has barely scratched the surface in terms of upside. With the volatile action and hefty upside seen earlier this year, uranium stocks have drawn comparison to the dot-com stocks of old. Because the universe of uranium stocks is quite small, investors have piled into the same clutch of names, driving prices up sharply. In recent months, the bloom has come off the rose, prompting momentum investors and short-term traders to head for the exits. This weakness gives us a chance to take a fresh look at uranium and assess the long-term prospects for nuclear energy.

The first privately funded nuclear power plant came on line in Illinois in 1959. In the 1970s, with the OPEC-instigated energy crisis in full swing, nuclear power looked more attractive than ever. Then came The China Syndrome, Three Mile Island, and the Chernobyl mega-disaster. The nuclear power option became politically radioactive in the U.S. Plans for hundreds of new plants were stopped dead in their tracks. Plants under current construction were decommissioned by regulators, at the cost of billions to utilities (and ultimately, taxpayers). With nuclear power a political pariah and all new construction mothballed, demand for uranium took a beating. After the fall of the Soviet Union, Russia added to the glut by extracting enriched uranium from shelved bombs and diluting it to reactor grade, dumping supply on the market. The Clinton administration then depressed uranium prices further by releasing tons of surplus highly enriched uranium for conversion to reactor fuel to be sold via a privatized government entity.

Like most of what originates in Hollywood, the political aversion to nuclear power was always more sound than substance. Nuclear energy never really left the scene; it just avoided the spotlight for a long while. Today, nuclear power accounts for approximately 16% of total electricity generation worldwide. As you might imagine, uranium prices have seen a wild ride. In the late 1970s, before the public relations disasters of Three Mile Island and Chernobyl, yellowcake ran to $50 a pound on current and anticipated demand. After Chernobyl and the close of the Cold War, a supply glut relentlessly hammered prices to an all-time low near $7 per pound in December 2000, before recovering to the aforementioned $25 per pound. Mining guru Doug Casey expects uranium to hit $100 before all is said and done.

The tide has turned, for multiple reasons. For well over a decade, the world has been consuming more uranium than mines have produced. This was made possible through the massive supply overhang of past decades, born of reasons already mentioned. In the ‘80s and ‘90s, supplies of uranium grew as demand receded. Now, we have the opposite situation: Demand is rising as supplies are dwindling. As expected, appetites are most voracious in the developing countries. China and India alone have plans to build more than 40 new nuclear power plants in the next 15 years. South Korea and Mexico could take the tally of new plants over 50... enough new capacity to easily triple nuclear demand by 2020. And the U.S. and Britain are re-examining the nuclear option as well.

The change of heart that has revived nuclear power can be boiled down to three areas: environmental concerns, energy demand, and technological safeguards. China and South Africa are currently in competition to build the world’s first fully operational pebble bed reactor. The pebble bed design is both safer and less expensive than the monstrous pressurized-water reactors built in the past, relying on spheres rather than traditional fuel rods.

THOMAS LEE SEES “GOLDEN AGE” AS HE PREPARES NEW BUYOUT FUND

Thomas H. Lee, the billionaire founder of U.S. buyout firm Thomas H. Lee Partners LP who is planning to raise at least $7.5 billion for a new fund, said his industry has entered a “golden age” of high returns. The annual gains of some buyout funds are as much as 50%, and the number and size of acquisitions are increasing, said Lee, 61. “It has been a golden age for large-scale buyouts,” he said.

Lee’s comments contrast with those of Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co., who in February said the era of “quick-flip” profits for buyout firms was “largely over” because of increasing competition. Buyout executives often talk up their prospects as they start new funds. In 2003, Texas Pacific Group’s David Bonderman said he was seeing the best investment opportunities for a decade. His firm completed raising a $5.3 billion fund in 2004.

Buyout firms have announced $118 billion of takeovers this year, up 61% from the same period last year, according to data compiled by Bloomberg. Hedge fund managers, led by Edward Lampert’s ESL Investments Inc., are even allocating cash to make acquisitions. Lampert used his fund’s control of retailer Kmart Holding Corp. to buy Sears, Roebuck & Co. for $12.3 billion. “Our deal flow is strong, and the deal flow into other large private-equity firms is also strong,” Lee said. Lee said he typically makes bids for 50 of the 1,000 deals that he looks at each year. Buyout firms use a combination of cash and borrowings to acquire companies, which they then typically sell three to five years later at a higher price.

WILL AIRBUS BE THE NEXT LUCENT?

The A380, Airbus’s new megajet, is an amazing sight. It is even beautiful in a sense, with curved wings that seem almost bird-like when viewed from behind the plane. But while the A380 inspires awe, its eventual success is doubtful. That is not because Airbus lacks orders for the plane. It has plenty of them, even without any purchases of passenger versions of the plane by American or Japanese airlines. The two big questions are whether passengers will like the plane and whether Airbus’s customers have business plans that will work.

The risk Airbus is running is the same one that devastated two other industries: telecommunications and genetically altered food. In each case companies saw sales rise rapidly, only to plunge because the buyers had their own business problems. In telecommunications, the stock market bubble financed new companies that ordered equipment based on business models that did not work. Lucent shares went to $1 from $64 as its customers defaulted and then flooded the market with secondhand equipment. In genetically engineered food, Monsanto produced something new that its customers wanted, only to discover that the focus was on the wrong set of customers.

The issue is whether the A380 will be “a game-changer” that cuts costs for airlines while wooing passengers. Or will passengers shun it, leaving Airbus with a sudden collapse in orders as airlines try to sell planes they bought but could not fill?

DOW JONES TRANSPORTATION COMPANIES OPERATING AND STOCK PERFORMANCES DIVERGE

The year is 1998. The setting: a sunny day on Wall Street. You are an investor, holding stock in the Dow Jones Transportation Average (DJTA). Doing business by planes, trains and trucks could not possibly look better: Oil sells for a dirt-cheap $11 per barrel, and DJTA prices stand at the astronomical height of $300 a share. To celebrate, you buy an extra-large mochaccino and copy of the morning paper – only to see the date on the upper right corner of the front page: The year reads 2005, seven years into the future!

You flip quickly to the economy section, dumbfounded to discover story after story detailing the complete turnaround of the Trannie world from picture perfect to downright perilous. For starters, oil prices have quintupled to an all-time record high of $58 a barrel. Every one of the airlines listed on the DJTA has or is within wingspan of declaring bankruptcy. The shipping news is just as grim. Since peaking in December 2004, the Baltic Dry Index (main industry indicator for commodity freight rates) has sunk 52%. To say the nation’s two largest railroads endured a “difficult” period in 2004 is to be kind. Earnings for the top railway Union Pacific slid 60% while runner up Burlington Northern Santa Fe was derailed by track disruptions and higher fuel costs. Not to mention the “Elephant” in the Train Caboose described by a June 14 Reuters story: “Railroad employees are approaching retirement in record numbers.” In the next several years, 80,000 jobs will need filling, yet “the industry can’t find enough [people] to even ‘consider’ the job.”

You have had enough – it is still 1998, and you have just seen the future. The fundamental economic wisdom – “Good news is good for the market AND bad, well, bad” – hits you like a ton of bricks. In a matter of minutes, you are on the phone to your broker screaming, “Sell, Sell, Sell” my Dow Transport stock. Grateful for the insight and happy to get out of the market, you imagine how far down the DJTA will actually fall over the next seven years. Well, fast-forward to today. The facts have all come to pass, yet the outcome is exactly what you DID NOT expect: Over those years the DJTA actually soared 65%.

The scenario we just described is based on one Bob Prechter offers in the June 13 Elliott Wave Theorist: “Those who think that markets are priced to reflect so-called fundamental values cannot possibly spend much time watching markets or studying market history. The action in the DJTA over the past seven years is a testimony to the stupefying optimism that has prevailed during [that time] in the stock market.” Bottom line: External events do not drive the market’s price trends. Social mood, which unfolds in clear Elliott wave patterns, does.

WHAT HAPPENS AFTER THE HOUSING BUBBLE POPS?

First: measuring the current state of the housing bubble.

Most of us are sick and tired or reading about the housing bubble, which is why your New York editor has decided to devote ONLY two of this week’s columns to the topic. We would prefer to avert our editorial gaze from the proliferating signs of excess in the national real estate market, but these signs seem to appear everywhere we turn – they have become even more numerous than the voices in our head. Today, we will take a peak at a few of the latest signs of home-buying exuberance. Tomorrow, we will gaze into the future and try to imagine the after-life of the housing bubble. Perhaps, by contemplating this inevitable Day of Reckoning, we may achieve a partial salvation. But first, let us consider the here-and-now…

When we queried Google yesterday for the term “housing bubble”, we received 476,000 responses. The phrase “stock market bubble” produced only 144,000 responses. “Oil bubble” returned 9,910 responses, while “soybean bubble” yielded a mere 6 results. Clearly, therefore, the notion of a housing bubble is no secret to the masses. (But wouldn’t we all be blindsided by a soybean bubble!) The topic attracts debate and discussion nearly every day in nearly every media outlet. Therefore, could anything as widely anticipated as the end of the housing boom ever come to pass? Our contrarian instincts rebel at the thought. Perhaps, therefore, we have not yet reached the terminal stage of the bubble, but are merely drawing closer to it. On the other hand, for every 10 individuals who scorn the housing bull market as a “bubble”, 100 seem to embrace it as a “sure thing”.

We have no idea when the red-hot housing market might turn stone-cold. But we do know that asset markets are stubbornly symmetrical. Any investment that can produce large, rapid profits can also produce large, rapid losses … at some point. And that point often arrives at the very moment when prices are rising most rapidly. Despite this historic tendency however, few property investors admit to any fear. Meanwhile, the real estate investors on Wall Street exude just as much optimism as those on Main Street – most homebuilding stocks have quintupled over the last four years. These stocks are rising so sharply that their trajectory bears an eerie resemblance to the trajectory of Nasdaq stocks between 1996 and 2000 (see chart). Admittedly, housing stocks do not appear to be very expensive. Most still sell for less than eight times earnings. But those earnings would shrink dramatically, or disappear, if the gait of home sales were to slow from a gallop to a trot.

Elsewhere on Wall Street, real estate investment trusts (REITs) are becoming a bit pricey. These securities, which hold a portfolio of investment properties, typically pay plump dividends. Occasionally, REIT shares will also produce plump capital gains. For the last few years, they have been delivering both. Since the end of 2002, the S&P REIT Index has produced a total return of almost 75% – or about double the return of the S&P 500. They have climbed so high that their dividend yields have fallen to multi-year lows relative to the S&P 500’s dividend yield (see chart). This trend does not inspire terror, but neither does it instill confidence that REIT shares will continue their strong relative performance.

We would not dare to plant a flag on June 16, 2005, declaring the end of the real estate bull market. But neither would we join the hordes who are rushing in to buy ever-pricier “investment” homes and homebuilding stocks and REITs. We would prefer to “sell into strength”, rather than chase after it.

Life after the bubble contemplated.

Financial bubbles are mortal organisms. Even though they might seem immortal for a time, they never live forever. The housing bubble will be no different. It will perish … eventually. Are we ready for the after-life? Are we prepared to cross over into that netherworld where home prices tumble from the heavens like falling angels, and where property speculators weep and gnash their teeth and where the U.S. economy itself abides in the outer darkness of excess debt and inadequate savings?

Based on America’s limited capacity to absorb a substantial bear market in housing, we fear that very few homeowners will find salvation in the afterlife of the bubble. A select few of us might achieve a partial salvation, provided we have not committed the mortal sins of borrowing too much or saving too little. “U.S. economic growth depends entirely on the continuation of the frenetic housing bubble,” warns Dr. Kurt Richebacher, editor of the Richebacher Letter. Dr. Kurt may be wrong, of course. But what if he isn’t? Is America prepared for the end of the bubble? Are any of us prepared? Most macroeconomic indications do not inspire confidence.

Real Estate, both as an asset class and as an industry, has assumed such an outsized share of US economic activity, that the entire economy would mourn the passing of the housing boom. Let us consider a few surprising – if not alarming – facts. Since the end of 2001, housing-related industries have produced a whopping 43% of the nation’s total net private sector employment growth. Obviously, therefore, any slackening of real estate activity would slow employment growth in the industry. Indeed, this massive job-creator could become a job-destroyer. The nation’s banking operations have also become heavily reliant on the real estate sector. Mortgage-related assets at U.S. banks have swelled to more than 60% of total assets. As the chart below illustrates, mortgage lending used to comprise a much smaller share of total bank lending.

Back in the days of Eisenhower, Kennedy and Johnson, U.S. banks would lend to businesses for the purpose of investing in plant and equipment. Today, banks lend to homeowners for the purpose of buying garden plants and stereo equipment. Additionally, the American homeowners of 40 years ago were far more likely to pay off their mortgage debts than to increase them. Net-net, the U.S. economy has become increasingly reliant on real estate transactions. The proceeds of used home sales as a percentage of nominal GDP have soared to new all-time highs. Clearly, therefore, any prolonged slackening in the real estate market would directly imperil job growth and GDP.

“All bubbles essentially end painfully, housing bubbles in particular,” warns Richebacher. “They are an especially dangerous sort of asset bubble, because of their extraordinary debt intensity. The debt numbers speak for themselves: In 1996, U.S., private households borrowed $332.2 billion … With the housing bubble in full force, it hit $1 trillion in 2004. “This debt intensity has its compelling reason in the particular way that accruing ‘wealth’ has to be converted into cash,” Richebacher continues. “Since homeowners normally want to stay in their house, ‘wealth effects’ have to be extracted through additional borrowing against the inflating property value; that is, through mortgage refinancing.”

“Yet,” Richebacher notes, “there is a second, even more dangerous, aspect to housing bubbles: they heavily entangle banks and the whole financial system as lenders. For this reason, as a matter of fact, property bubbles have historically been the regular main causes of major financial crises.” Clearly, a post-bubble economy would be no friend to the debt-heavy, savings-lite U.S. consumer. As we never tire of mentioning, therefore, American households have never before dared to face the future with so much debt and so little savings.

“For consumer spending to slump in the wake of a fading housing bubble,” Richebacher warns, “house prices do not need to fall at all. It is sufficient that the stop rising, thereby depriving households of new wealth effects…” The housing bubble has not crossed over the after-life, but that day approaches. Are you ready?

The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.

Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stockmarket bubble burst in 2000. What if the housing boom now turns to bust?

According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stockmarket bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.

The global boom in house prices has been driven by two common factors: historically low interest rates have encouraged home buyers to borrow more money; and households have lost faith in equities after stockmarkets plunged, making property look attractive. Will prices now fall, or simply flatten off? And in either case, what will be the consequences for economies around the globe? The likely answers to all these questions are not comforting.

Some housing booms have now fizzled out. In Australia, according to official figures, the 12-month rate of increase in house prices slowed sharply to only 0.4% in the first quarter of this year, down from almost 20% in late 2003. Wishful thinkers call this a soft landing, but another index, calculated by the Commonwealth Bank of Australia, which is based on prices when contracts are agreed rather than at settlement, shows that average house prices have actually fallen by 7% since 2003; prices in once-hot Sydney have plunged by 16%. Britain’s housing market has also cooled rapidly. The Nationwide index, which we use, rose by 5.5% in the year to May, down from 20% growth in July 2004. But once again, other surveys offer a gloomier picture. The Royal Institution of Chartered Surveyors (RICS) reports that prices have fallen for ten consecutive months. The volume of sales has slumped by 1/3 compared with a year ago as both sellers and buyers have lost confidence in house valuations.

The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents. The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier. Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over- valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries.

To bring the ratio of prices to rents back to some sort of fair value, either rents must rise sharply or prices must fall. After many previous house-price booms most of the adjustment came through inflation pushing up rents and incomes, while home prices stayed broadly flat. But today, with inflation much lower, a similar process would take years. For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America’s ratio of house prices to rents back to its long-term norm. Elsewhere it would take even longer. It seems more likely, then, that prices will fall.

A common objection to this analysis is that low interest rates make buying a home cheaper and so justify higher prices in relation to rents. But this argument is incorrectly based on nominal, not real, interest rates and so ignores the impact of inflation in eroding the real burden of mortgage debt. If real interest rates are permanently lower, this could indeed justify higher prices in relation to rents or income. For example, real rates in Ireland and Spain were reduced significantly by these countries’ membership of Europe’s single currency – though not by enough to explain all of the surge in house prices. But in America and Britain, real after-tax interest rates are not especially low by historical standards.

America’s housing market heated up later than those in other countries, such as Britain and Australia, but it is now looking more and more similar. Even the Federal Reserve is at last starting to fret about what is happening. A study by the National Association of Realtors (NAR) found that 23% of all American houses bought in 2004 were for investment, not owner-occupation. Another 13% were bought as second homes. Investors are prepared to buy houses they will rent out at a loss, just because they think prices will keep rising – the very definition of a financial bubble. “Flippers” buy and sell new properties even before they are built in the hope of a large gain.

New, riskier forms of mortgage finance also allow buyers to borrow more. According to the NAR, 42% of all first-time buyers and 25% of all buyers made no down-payment on their home purchase last year. Indeed, homebuyers can get 105% loans to cover buying costs. And, increasingly, little or no documentation of a borrower’s assets, employment and income is required for a loan. Interest-only mortgages are all the rage, along with so-called “negative amortisation loans” (the buyer pays less than the interest due and the unpaid principal and interest is added on to the loan). After an initial period, payments surge as principal repayment kicks in. In California, over 60% of all new mortgages this year are interest-only or negative-amortisation, up from 8% in 2002. The national figure is one-third. The new loans are essentially a gamble that prices will continue to rise rapidly.

The rapid house-price inflation of recent years is clearly unsustainable, yet most economists in most countries (even in Britain and Australia, where prices are already falling) still cling to the hope that house prices will flatten rather than collapse. A drop in nominal prices is today more likely than after previous booms for three reasons: homes are more overvalued; inflation is much lower; and many more people have been buying houses as an investment. If house prices stop rising or start to fall, owner-occupiers will largely stay put, but over-exposed investors are more likely to sell, especially if rents do not cover their interest payments. House prices will not collapse overnight like stockmarkets. But over the next five years, several countries are likely to experience price falls of 20% or more.

British and Australian prices have stalled mainly because first-time buyers have been priced out of the market and demand from buy-to-let investors has slumped. British experience also undermines a popular argument in America that house prices must keeping rising because there is a limited supply of land and a growing number of households. As recently as a year ago, it was similarly argued that the supply of houses in Britain could not keep up with demand. But as the expectation of rising prices has faded, demand has slumped. Economists at Goldman Sachs point out that residential investment is at a 40-year high in America, yet the number of households is growing at its slowest pace for 40 years. This will create excess supply.

Another mantra of housing bulls in America is that national average house prices have never fallen for a full year since modern statistics began. Yet outside America, many countries have at some time experienced a drop in average house prices, such as Britain and Sweden in the early 1990s and Japan over the past decade. So why should America be immune? With prices looking overvalued in more states than ever in the past, average American prices may well fall for the first time since the Great Depression.

But even if prices in America do dip, insist the optimists, they will quickly resume their rising trend, because real house prices always rise strongly in the long term. Robert Shiller, a Yale economist, who has just updated his book Irrational Exuberance (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004. And if the current boom is stripped out of the figures, along with the period after the second world war when the government offered subsidies for returning soldiers, artificially inflating prices, real house prices have been flat or falling most of the time. Another sobering warning is that after British house prices fell in the early 1990s, it took at least a decade before they returned to their previous peak, after adjusting for inflation.

Another worrying lesson from abroad for America is that even a mere levelling-off of house prices can trigger a sharp slowdown in consumer spending. Even a modest weakening of house prices in America would hurt consumer spending, because homeowners have been cashing out their capital gains at a record pace. Goldman Sachs estimates that total housing-equity withdrawal rose to 7.4% of personal disposable income in 2004. If prices stop rising, this “income” from capital gains will vanish. The housing market has played such a big role in propping up America’s economy that a sharp slowdown in house prices is likely to have severe consequences.

One of the best international studies of how house-price busts can hurt economies has been done by the IMF. Analyzing house prices in 14 countries during 1970-2001, it identified 20 examples of “busts”, when real prices fell by almost 30% on average (the fall in nominal prices was smaller). All but one of those housing busts led to a recession, with GDP after three years falling to an average of 8% below its previous growth trend. America was the only country to avoid a boom and bust during that period. This time it looks likely to join the club. Japan provides a nasty warning of what can happen when boom turns to bust. Americans who believe that house prices can only go up and pose no risk to their economy would be well advised to look overseas.