Finance Digest for Week of July 11, 2005

THE FORBES 2005 INTERNATIONAL INVESTING GUIDE IS OUT

From South Africa to India, Forbes’s 2005 guide to investing abroad for U.S.-based investors includes country profiles on France, Chile, Japan, The Netherlands, Israel, and Portugal. Featured articles include investment opportunities in “Old World” Europe, emerging market telecom stocks, indirect plays on China’s growth, South Africa, India, Canada, environmentalism, and international bonds. Other articles include the best international investing resouces available on the Web, “best buy” international mutual funds, and more.

WINNING BY QUITTING

Who could not like the South Korean market? Its stocks are cheap at nine times expected 2005 profits; it is home to Samsung, the hottest of cool brands; and it is a play on China’s growth. It is one of the more liquid Asian markets and has the strongest year-to-date gain, a return of 15%. William Kaye does not like it one little bit. The 51-year-old manager of the $140 million Greater Asian Hedge Fund says South Korea is the market that most “terrifies” him. Kaye, a Mississippi native, alum of Goldman Sachs and former Paine Webber board member, left a good job as a risk arbitrage manager in New York 15 years ago to start his own hedge fund in Hong Kong. That is long enough to have seen a few fits of euphoria and a meltdown or two, and long enough to know when to cut and run. Kaye’s funds have made money every year except 1994 and boast a 5-year annualized return of 8%.

Kaye says of South Korea, “Global growth is the highest it’s been in a long time, and no economy is more geared to global growth.” But the happy story is about to change. Higher energy prices and interest rates in the U.S. will crimp South Korean exports by the end of the year, argues Kaye. And China will slow. Capital investment is already down, and government attempts to cool the Shanghai property market are starting to bite. So are trade spats with Europe and the U.S.

Kaye says that South Korean business groups are still switching assets between companies and guaranteeing loans to troubled subsidiaries without telling investors. Many of the country’s richest businessmen are quietly transferring as much money offshore as they dare. “Why are foreigners so excited about this market when Koreans can’t get their money out fast enough?” he asks. The clincher for Kaye came in March when Goldman Sachs declared in an 88-page tome that the South Korean market would double in the next few years. Kaye says he would short almost everything in South Korea, even Samsung Electronics. “When is the last time you paid more for a flat-screen TV because it said ‘Samsung’ on the label?”, he asks. If you want to stand with Kaye against the crowd, it is possible to short the South Korean market without sending any money overseas. The iShares MSCI South Korea Index Fund (EWY) trades on the American Stock Exchange.

The Philippines is another market that Kaye hates. He thinks that temporarily low interest rates are dangerous for a country addicted to dollar-denominated debt. The benchmark Philippine Composite Index is up 10% so far this year.

IN AT THE TOP

When the tech boom went bust A few years ago, New Jersey’s public pension fund was among the hardest hit in the country, suffering a loss in its tech-laden portfolio of nearly one-third of its value, or $30 billion. Now the State Investment Council has another great idea: In January it decided to jump into – this cannot be a surprise – real estate. Plenty of other public pension officials have decided to make the same play. After getting out of real estate altogether in the late 1990s, the Teacher Retirement System of Texas has decided to invest up to $2.7 billion, or 3% of its $90 billion in assets. For the first time the Arizona and New York City funds are buying up property. All told, the top 50 public funds increased their commitments to real estate last year by $9.8 billion, equal to 11% of their property holdings, according to the newsletter Real Estate Alert. Now they have set a target of loading another $34 billion into land and buildings as quickly as is practical, representing a 37% hike to $128 billion, or 7.2% of their assets.

The rush of public money into real estate has many signs of the rearview-mirror investing that cost New Jersey so dearly during the tech bust. As with homes, commercial real estate has been on a tear for several years. The S&P Index of real estate investment trusts returned 17% a year over the past three years, versus 6% for both the S&P 500 and corporate bonds. The run-up has pushed down the yield on commercial property (rent minus expenses) to 7.9%. That is the lowest it has been since at least 1989, according to Real Estate Research Corp.

“We’re drowning in liquidity,” says Dale Anne Reiss, who heads Ernst & Young’s real estate practice. “Banks are lending aggressively, and every flavor of institution thinks real estate is the best alternative out there. Some of us remember an equal degree of enthusiasm in the late 1980s just before the market collapsed.” Public pension managers may feel particular pressure to follow the trend because of actuarial expectations that they will wring 8% or so in returns out of their assets each year. Money managers are going to be hard pressed to deliver such results from their stocks and bonds.

To get that 8% using property, investors are not just buying shares of publicly listed REITs or owning easy things like leased office buildings. They are taking chances. Alaska’s state pension, for instance, has invested $500 million in five “high risk” real estate funds to try to meet its target, concedes investment officer Michael Oliver. He expects these investments to earn 15% to 17% annually, after fees.

REIT insiders are selling.

Is it time to sell off your real estate investment trust stock? Some company insiders seem to think so. Among the directors and managers of real estate investment trusts, selling outpaced insider buying 173 to 1 in the 2nd quarter of this year. According to Lehman Brothers analyst David Harris, total insider sales volume during the three months ended June 30 was $296 million. Granted, that is a pittance if you consider that REITs have a total stock market value of $338 billion. And 85% of the sales were related to options grants and thus may not be indicative of insiders’ true sense of whether the market has reached a top or not. Yet even stripping out the options-related transactions, the insider sales volume increased 35% over first quarter, Harris reports. And this is the highest level of insider selling since Lehman began watching the metric in 2002.

What prompted the sales? “Soaring stock prices,” says Harris. Anybody who bailed out of the S&P 500 stocks in mid-2000 and headed for the safety of REITs, which own vast collections of office, apartment, shopping mall and other types of commercial properties and distribute rental income to their shareholders in the form of dividends, will tell you it was a great move. REITs have returned an average 20.4% per year since July 2000. Now REIT price-to-earnings ratios are significantly higher than those of the stocks in the S&P 500. The insider selling adds a bit of fuel to the debate over whether real estate investment trusts are overpriced. In quarters when REIT stocks were rising fastest, the insider sales have tended to shoot up. The previous insider sales record was set in the fourth quarter of 2003, when the stocks returned 11% and insider sales exceeded $275 million.

BLACK GOLD

The price of oil is one very big factor that makes this stock market tough to navigate. Every time oil prices edge up, investors get nervous. In late June, when per-barrel costs moved above $60, the market swooned. Meanwhile, economic growth has slowed, along with employment increases. To further disconcert investors, prices of non-oil commodities and industrial materials are off. Add in low long-term interest rates, whose nature is an enigma even to Federal Reserve Chairman Alan Greenspan. The holder of a ten-year Treasury gets only 4%, despite rising short-term rates and hints of inflation. A flat yield curve seems imminent, and that does not generally portend good economic times. Is what we are seeing simply a pause in a rising economy, or something much worse?

People, understandably, are wondering what to do. If you own bonds, keep your positions small and your maturities short, preferably under a year. If inflation accelerates, which appears likely, holding long bonds would take a chunk out of your capital. By staying short, you may not make anything after inflation and taxes, but you will keep your capital intact for opportunities ahead. In your stock portfolio avoid deep cyclicals (autos, airlines, steel, heavy machinery) and other issues heavily dependent on riding a robustly growing economy. Even if economic growth ticks up from its current rate, the play in these stocks is over for a while. More attractive are health care and consumer staples, which are less sensitive to economic rhythms.

A truly good place to be during these times of rising oil prices is, yes, oil stocks. A year ago I gave some reasons why higher oil prices were likely to stick, such as surging Chinese demand and terrorism threats. I recommended Chevron, Kerr-McGee and Burlington Resources. Including dividends those stocks are up 26%, 47% and 54%, respectively. The integrated oil companies, which encompass everything from drilling to gas stations, and the pure exploration-and-development companies still provide good value despite large rises in their stocks. Because their profits are up smartly as well, their price/earnings multiples have stayed low.

A year from now we will still be seeing significantly higher oil prices than were prevalent during the invasion of Kuwait in 1990 – conservatively, $40 to $55 a barrel. Any crisis could push prices higher, perhaps substantially. If oil prices hold near current levels, significant room for multiple expansion exists. Most companies have already paid down a good part of their debt and can now apply their enormous cash flows to share buybacks and dividend increases. Also, for both the smaller integrateds and the exploration-only groups, there is a good chance that the increasing pace of takeovers will continue.

FORTUNE FAVORS THE BRAVE

America in the 1800s was much like Aisa is today, benefiting from cheap labor, abundant natural resources and rapid economic growth. Asia in 2005 has problems similar to those of the 19th-century U.S.: corruption, lawlessness, dubious banks and stock markets. But as I have written before, Asia is the place to be if you want to be part of a bountiful future. Good investments are to be found there by a discriminating eye. This is a region where corporate governance is deficient and financial accounts are late and of poor quality. Yes, no one ever said making money was easy. As Robert Farrell, an astute investment strategist, has said: “Everybody has an opinion but not everybody has a conviction.” In other words, this is not the time for paralysis by analysis. This is the time to put your money where your mouth is.

Don’t get shaken loose. I went to a stock pickers’ lunch where one of the attendees was asked, “How are you?” He replied: “’qm up 3% this month.” Not: “Fine, feeling well; kids are great.” In a hedge-fund world obsessed with immediate results, there is a tremendous pressure to panic and sell on bad news, which tends to come along frequently in Asia.

Indonesia looks quite scary. The world’s largest Muslim nation has a problem with Islamic jihadists. The U.S. embassy in Jakarta and other American diplomatic posts were closed temporarily in late May because of threats. The Bali bombing of October 2002, whose 202 victims included many Western tourists, has made the archipelago nation a no-go zone for many. Despite these fears, Indonesia is on the upswing economically and politically. Growth (net of inflation) came in at an annualized rate above 6% in the first quarter, the fastest pace since Asia’s 1997-98 financial crisis. Three years ago, when Indonesia seemed like the next Yugoslavia, I recommended it as a prime investment opportunity. The Jakarta Composite Index has doubled since then.

A new president, Susilo Bambang Yudhoyono (known as SBY), won election last September amid an enormous voter turnout, thus demonstrating that once-dictator-dominated Indonesia can have a democratic transfer of power. The corrupt plunderers are out of the government. Local elections, part of a program to disperse authority from the central government, took place in early June. These encouraging developments have helped buoy Indonesia’s once-despised currency. The rupiah has been moderately stable for several years and now trades at 9,700 to the dollar; in 1998 the rupiah traded at 15,000. New Age religions, inspired by Eastern mysticism, encourage us to grow as individuals by moving out of our “comfort zone”. That is a fair description of Indonesia for Western investors. Move out of your comfort zone, too.

PARADIGM FOR A FLEECING

Doctors, lawyers, firemen, public school teachers and even reporters have all graced the small screen with politicking, scandal and drama allowing viewers a voyeuristic peek at what allegedly goes on behind closed doors. I propose management consultants be added to the roster. Just read an insider’s self-published soap-opera, Rip-Off!: The scandalous inside story of the management consulting money machine, and you will see the need for a series called “Conniving Consultants”.

“It’s like robbing a bank, but it’s legal,” writes author Neil Glass (using the pseudonym David Craig). Consultants snake money out of companies to the point where getting a consultant’s opinion becomes an addiction. The addiction gets worse over time until the dealer does not even have to deliver a quality product. The scale of the obsession drives a $100 billion a year business – just about the same size as the global legal casino gambling industry. Glass spent 20 years in consulting before writing his tell-all. It falls slightly short, because it never reveals the consultancy or client names.

Despite the lack of explicit finger pointing, Glass does not hold back when describing the consulting “money machine”. He is most taken aback by the “incredible amounts of money our clients would pay us.” A straight out of university neophyte, with no business background, could be billed out to clients for more than $10,000 a week according to Glass. Unbelievable? I can back Glass up on that one.

Glass details other financial shenanigans (note to Eliot Spitzer: here is your next target before you run for office) such as travel rebates, where consultants bill clients full fare while actually getting discount rates. Buying consulting projects continues, according to Glass, because managers feel they need backup for tough decisions – consultants are a crutch. Consultants know this, and, once they win some influence, set to work “creating client dependency”. Because consultant fees can be hidden in the balance sheet, companies never have to disclose the depth of this addiction.

When they are not bilking their clients, consultants spend their time slitting each other’s throats. In an interview, Glass reminded me that a consulting firm is just like any other business trying to make revenue and profit targets. But what it sounds like in the book, and what I came to see it as, is an anything-goes gypsy bazaar. Rip-Off is not yet available in U.S. retail stores. Amazon.com lists a 4- to 6-week delivery time.

WHY IT IS THE RIGHT TIME FOR MARKET TIMING

One of our analysts, Pete Kendall, was quoted last week in a New York Times story about market timing, called “Some People Pick the Stock. Others Choose the Moment”. The writer pointed out that “fortunes have been made on the ability to recognize or even anticipate big swings in the stock market.” And he went on to ask, “So is it sensible for ordinary investors to try to predict a market top or bottom?”

Pete answered affirmatively: “Pete Kendall, co-editor of the Elliott Wave Financial Forecast, said: ‘There’s a reality in the marketplace; it moves up and down. If you’re saying buy and hold, you’re essentially denying that reality.’” Let us revisit some of Bob Prechter’s thoughts on this same subject in an interview excerpted from the book, Prechter’s Perspective.

You know, if the most popular investment gurus of the day, Peter Lynch and Warren Buffett could hear our discussion, they would say, “It’s nice to talk about declines, but nailing down when they are going to occur is almost impossible. So, individual investors should just buy the best stocks they can.” What would your response be to that?

Bob Prechter: I have a lot of respect for those people, because they have risen to the top of their field. However, their field is stock picking. They have been professionals during one of the most rewarding periods in history to be a stock picker. The trend, for the most part, during the past 40 or 50 years has been up. When that situation changes, so will the fortunes of the stock pickers.

But they have a point. Buying and holding works.

Bob Prechter: It has worked. That is different from saying it works or will work. It is also easy to say now. It was not easy to say in 1949, when almost no one followed that advice. So this supposed intellectual point is simply a description of the past. Has it “worked” for bonds since the mid-1940s? Has it “worked” for gold for the past twenty years? Buying always pays off as long as the relevant trend degree is up. When the trend is down, you could just as easily say that one should sell short and hold. If buy and hold is in, then market timing should be out, which it is today. It is more or less routine to hear about some new study that shows all the gains over the last 100 years came in less than 100 specific days, and investors should therefore be in the market every single day. In the second half of the 1970s, after the market had cycled for a decade, market timing was all the rage. … Once you are satisfied that the trend is safe, you can then concentrate on stock selection … Technical analysis is the correct way to approach markets, because it accommodates both bullish and bearish positions. “Buy and hold” is not ever right philosophically. It only appears so when the trend is up.

A BEARISH LOOK AT THE REAL ESTATE BUBBLE

Is housing in a bubble or not? The signs of a bubble are hard to ignore, especially in California. But all this bubble talk also makes me think maybe there isn’t one. In my experience, markets rarely behave the way people expect them to. This time last year, for example, virtually every expert I talked to was certain long-term interest rates were going up. Instead they have gone down. At the beginning of this year, everyone was pretty sure the dollar would continue to fall and had some pretty convincing arguments. Instead, the dollar has rebounded smartly. Today, I will highlight some major reasons why housing could be a bubble ready to burst.

What is the opposite of the perfect storm? It is what the housing market is enjoying. Prices are rising because long-term interest rates are low, the economy is strong enough to keep unemployment from rising and lending standards are lax. If any one of these things changes for the worse, the housing boom would probably end. Because this boom has been so much bigger than past ones, the bust could be far worse. Stay tuned for the other side of the story.

How to detect a bubble? Try the original-use test.

In 17th century Europe, some people hocked everything, including their houses, to invest in tulip bulbs. In the early 21st century, some people around the world are hocking everything to invest in houses. Same story, different details? That question has become the subject of a long and windy debate. To complicate the discussion, the world has recently gone through a boom-bust in technology stocks from the late 1990s to 2002 that has been widely compared in the annals of financial “bubbles” to the tulipmania of almost 400 years ago.

Captivating as it may be, the theoretical argument over what constitutes a bubble does not help ordinary investors much. No matter how many I-told-you-so stories we hear now, a clear consensus identifying the recent tech-stock experience as a bubble did not emerge until after its collapse – satisfying a famous rule of thumb that bubbles are known only by their bursting. In the making of investment decisions such as whether to buy a house in Malibu or a technology mutual fund, after-the-fact information comes too late. That is a problem, because nobody who makes those decisions can afford to ignore the issue.

So what to do? In the absence of better answers, investors can at least imprint on their minds the idea that bubbles represent a separation of the market price from the basic purpose of the asset in question. As one authoritative writer on the subject, the late economist Charles Kindleberger, described them, participants in a bubble are “generally speculators interested in profits from trading in the asset rather than its use of earning capacity.” When something comes to be viewed as a “trading tulip” rather than a flower bulb, we understand that the asset’s price has probably broken loose from its moorings.

For all its wide usage, the label “bubble” carries limited information. The Internet stock bubble, as it turned out, was not the empty phenomenon that the bubble metaphor suggests. At its center was important progress in technology and productivity. Still, the prices it put on numerous stocks could not be sustained. Between them and the value inherent in their original purpose, there was too much empty space.

Condo-mania.

Apartment conversions are all the rage in Las Vegas. Anyone looking for an entry-level priced home in a nice area will likely be relegated to buying what amounts to be – an old apartment. More than 17,000 apartment units in Las Vegas are to be converted into condos, according to Dennis Smith, president of Home Builders Research. Approximately 7,500 are currently on the market, with another 10,000 to be converted by year-end. These former apartments of various vintages are priced from $120,000 to $250,000. Buyers of lower priced units will park under carports, while higher-priced units include garages. All are affordable alternatives to the $304,734 median new home price.

This writer can attest that business is brisk in condo conversion land. I toured a 424-unit conversion project last week and was given the opportunity to take the plunge before the units would go on sale to the general public the next day. Insiders had snapped up all but a dozen or so of the units according to the agent who showed us around.

While most everyone has seemingly been getting rich in Las Vegas real estate, I have been putting extra money toward my mortgage balance and buying gold. Silly me. Being so wrong for so long, I thought I should get another opinion on these things. I related my condo tour story to a long time Las Vegas real estate appraiser. His response: “condos are the last segment of the housing market to catch fire in a boom and the first to crater in a bust.” We may not be there yet, but we must be getting close.

Real estate talk through the roof.

Almost as dumbfounding as the feverish U.S. real estate market are the feverish conversations about the market at dinner and cocktail parties or wherever homeowners gather. Does anybody talk about anything else? Apparently not, and never mind that there is a war on, a Supreme Court battle looms, Social Security is insecure and, oh, yeah, Tom Cruise is jumping on couches and dissing psychiatry. None of that is as compelling as boasting about our real estate triumphs. Even if they are only on paper. Even if we had virtually no hand in achieving the triumph. Even if all we did was buy a house and watch as it magically rose in value. No matter: We have bragging rights, and we are exercising them to a fare-thee-well.

Real estate speculation is pushing up prices.

Home builder Marsha Elliott is selling two units in a brand new stucco and stone duplex. But the buyer is not planning to move in or rent. Hoping to capitalize on rapidly rising home prices, the buyer intends to sell the units shortly after the July closing, Elliott said. It is part of the speculative activity in the sizzling housing market that is drawing concerns from Federal Reserve Chairman Alan Greenspan and others. In Elliott’s suburban Chicago development, the buyer locked in a deal months ago to purchase each unit for $775,000, she said. They are currently selling for $840,000 apiece.

Seeking to discourage such activity, Elliott now includes a provision in her contracts that gives her the option of buying back a property at the original price if the owner wants to sell within 18 months after closing. Other sellers are taking similar steps. “If the buyer doesn’t find someone to ‘flip’ the property to right after closing, it sits empty. Is it going to be maintained? Is it an open invitation to vandalism? And, does it have a negative impact on the overall community? Absolutely,” says Elliott.

While a vacant house can be a turnoff to house hunters, buying and quickly unloading a house to make a profit can help drive up prices. Speculative activity, surging home prices and renewed interest in risky mortgages, such as interest-only loans, are all by-products of the booming housing market.

Soaring prices of homes ending search for many.

After So Young Kim took a teaching job in Florida, her friends in Chicago gushed that she and her husband would be able to afford twice the house when they moved. Kim had just received a doctorate and a job offer from a university that would double her salary to more than $47,000. But the prices of even small bungalows climbed far beyond what the young couple could afford, even when they stretched their target price to an uncomfortable $300,000. So after several disappointing drives around the area and countless Internet searches, they ended up back where they started – in an apartment.

The red-hot housing market in booming cities across the country has made the dream of owning a home out of reach, not only for low-income families but also for white-collar professionals. “Many of the overheated real estate markets throughout the country have become unaffordable for the majority of the population,” said Jack McCabe, a housing industry analyst in Deerfield Beach, Fla. “Many people are paying well over 50% of their income for shelter. It leaves no money for savings or, sometimes, even for recreation.” Real estate experts warn that housing prices in many markets are too quickly outpacing the incomes of most workers. In California, only 17% of households could afford a home with a median price tag in April.

National statistics show that families can afford a home in many other cities around the country. The typical household earns about $56,323, enough to buy a home costing $250,900 and 133% of what is needed to afford the median-priced home of $188,800, said Walter Molony, a spokesman for the National Association of Realtors. The 10 most exorbitant cities include such warm-weather locations as San Francisco, Honolulu and West Palm Beach, and huge urban centers, such as New York and Boston. To break into these hot markets, buyers are resorting to new and uncertain options for mortgages.

Two months in house-hunting hell: how one L.A. couple survived a tight market, head-spinning bidding wars.

When my husband and I finally decided to buy a home in the Los Angeles area after renting in various cities for so many years, we were genuinely excited. More closet space! No more white walls! A backyard for the baby! But we were not at all prepared for the two months of drudgery, desperation and downright insanity that came next. We knew we would not get much for our money in L.A.’s super-hot housing market. Still, we were surprised at just how little we would get. Tiny run-down homes – more like glorified boxes – were going for considerably more than half a million dollars. But sticker shock was only the beginning of our house-hunting hell.

We also were stunned at just how slovenly people can be when they know that no matter how terrible their house looks – or smells – they are going to sell it for far more than they could have dreamed even a few years ago. I am not just talking about a few breakfast dishes in the sink, but last night’s dinner mess piled high. And crayon markings on every room in the house, like cave drawings. And a cat litter box on the living room carpet, next to the couch. And so much clutter we actually had to step over piles of dirty laundry to get through the bedrooms. Some homes were neat and clean but just out of date. And that’s OK. We realize grandma does not decorate like we do, but the house with the overgrown doll collection freaked out my husband. Clearly, many sellers have never watched the HGTV show Designed to Sell, because if they had they might have gotten even more outrageous sums for their ridiculously expensive homes.

Of course, everything is not like it is on TV. I had become a fan of House Hunters, where buyers choose among three houses and seem to easily get the one they want. So it was more than a little shocking when the first house we bid on had 50 other offers. Yes, 5-0, for a two-bedroom home listed at $549,000. That is not what you want to hear when you have grown weary of house-hunting. We had been searching for nearly two months in two neighborhoods (chosen for their great public schools, which are uncommon in L.A.), looked at more than 60 houses (with baby in tow) and pored over dozens more listings on the Internet.

We decided to concentrate on finding a home in a neighborhood closer to Los Angeles. The drawback was that homes in our price range were smaller and, for the most part, rather unsightly. That is why we were so completely taken with a charming old English Revival with lots of curb appeal and a good-size backyard. We loved this house from the moment we saw it, and even more when we stepped inside. It had hardwood floors, a cute little breakfast nook and lots of character. It was only a two bedroom/one bath. But after seeing so many undesirable houses, we knew we could live in this one.

So we decided to write an offer on it. But for how much? The great guessing game began. We looked at the comps (the selling price of other homes in the area) and quickly learned that the house we wanted was dramatically underpriced. Why? Probably because the sellers or their agent wanted to get a bidding war going. And a bidding war they got. …

Fun in the sun: property prices along the New Jersey shore are soaring.

Anyone need more evidence that the housing bubble is approaching the terminal stage? Property prices along the New Jersey shore are soaring. “Home prices along the coast from Sandy Hook to Cape May have more than doubled since 2000,” Bloomberg News reports. “That compares with a 62% increase in the rest of the state, according to data from the National Association of Realtors. The rise in prices along the 127-mile (204 kilometer) stretch of Atlantic Ocean is three times as fast as in the rest of the U.S.”

Maybe the Jersey Shore deserves every bit of its resurgent popularity, but we doubt it. Your editor just returned from a weekend in Belmar, New Jersey – home of sand and sun and not much else. He did not visit this oceanfront town to luxuriate in a 5-star spa. There are none. Nor did he trek two hours south of Manhattan to dine at one of Belmar’s renowned seafood restaurants. There are none. Rather, he ventured to the seaside town to watch the nation’s finest volleyball players strut their stuff.

Unfortunately for the residents of Belmar, however, the tournament lasts only three days. The other 362 days of the year, they must content themselves with whatever delights the town produces on its own. We would imagine that tranquility – bordering on ennui – tops the list of principal off-season attractions. Belmar is a non-descript strip of sand along the Jersey Shore, not far from several non-descript strip-malls. Even on a 90º Sunday in early July, the town feels a bit forlorn. To be sure, one finds blocks and blocks of cute little cottages clustered along the coastline which, collectively, create a somewhat charming effect. Not charming enough, however, to attract hoteliers or restaurateurs or even Starbucks. But Belmar’s greatest deficiency is not aesthetic; it is atmospheric. Belmar is a delightful little strip of sand … for three months of the year. The rest of the time it inhabits the same artic climate that the rest of us in the Northeast endure.

“Why are hotels non-existent in Belmar?”, we griped to a local. “Who’d want to make the investment?” the local replied, “You’d only have demand for rooms from Memorial Day to Labor Day?” At first, the explanation seemed reasonable, but we immediately recalled that luxury hotels dot the coastlines of Brittany and Normandy – two places where the sun rarely shines, even in summer. Likewise, hotels operate in the Hamptons and in Cape Cod and in many, many other seasonal locales. But not in Belmar. But even if hotel operators shy away from the Jersey Shore, real estate speculators do not.

“People are realizing that real estate is a smart investment to make, a safe investment,” beams Bonnie Fitzgerald, president-elect of the New Jersey Association of Realtors. “It’s one of the only investments where you’re pretty much guaranteed to get a return on your money.” Really? Real estate provides a “guaranteed return?” Even from highly seasonal vacation properties? The effusive Fitzgerald might not have ALL the facts at her disposal. Home prices along the Jersey Shore tumbled about 40% shortly after the stock market crash of 1987. But why worry about such disquieting “one-off” events when prices are still soaring year-after-year?

Real estate has been a terrific investment for several years, especially since 2000. It has been so terrific, in fact, that many investors consider it a “can’t lose” proposition, which is often the state of mind that prevails immediately before a given asset class is about to become a “can’t win” proposition. Like gold in 1979, Japanese stocks in 1989 and U.S. tech stocks in 1999, real estate seems like the greatest, most reliable, and safest of all investments on earth. But we suspect it is somewhat less than that. While basking in the summertime warmth of continuous capital appreciation, it is easy to forget that the wintry chill of softening prices is sure to arrive. The pleasant days of summer rarely last long. Especially in Belmar, New Jersey.

Risk, innovation, and reality in the housing market.

The first sentence of a New York Times article today said that in recent months, “federal banking regulators have signaled their discomfort about the explosive rise in risky mortgage loans.” I read that and thought to myself, “Welcome to the party, guys.” Alas, I did not read much further before I realized that in this case, “discomfort” is a code word for bureaucratic CYA. In other words, whatever discomfort the “associate director for risk management policy” at the FDIC may be feeling, he also wants to be on the record saying “We don’t want to stifle financial innovation,” because, of course, “We have the most vibrant housing and housing-finance market in the world, and there is a lot of innovation.”

This gentleman did not exactly define what he meant by “innovation”, so I will infer a few possibilities: 1.) The roughly “60% of mortgages last year [that] had adjustable interest rates, many with artificially low teaser rates that expire after the first few years.” 2.) The more than “25% of all new mortgages in the last year have been interest-only loans, which allow buyers to postpone principal payments for three to five years but which become much more expensive afterward.” 3.) The “hottest new loan[,] the so-called option adjustable-rate mortgage, or option ARM, which gives borrowers the choice of paying interest and principal, interest only, or even less than the normal interest. If the home buyer picks the lowest possible payment, the mortgage debt goes up rather than down.” 4.) Lending practices such as “granting loans equal to 100% of the value of the homes; granting large loans without due attention to the likelihood of higher monthly payments in the future; and granting ‘no-doc’ (no documentation) or ‘low-doc’ loans that require little or no proof of income or assets.”

Debt involves risk for the borrower and lender, yet the facts above make clear which party has shifted an ever-greater degree of risk onto the other. And it is not that new homebuyers are failing to think through the terms of their mortgage; the problem is that they only think long enough to imagine a beneficial outcome. Then they do what they wanted to do from the start. The “beneficial outcome” they imagine is, of course, that the boom in home prices will be as strong in the next couple of decades as it has been in the past couple of years. Instead of paying for equity, they hope to get it by fiat; worst-case scenario, if they really cannot afford the payments, they will “flip” the house in a year or two for a profit.

This may be a new way of thinking about houses, but it is certainly not a new way of looking at overpriced assets – heck, millions of new stock market investors gobbled up NASDAQ shares in 1998-99. They too were certain that share prices would be as strong in the future as they had been in the past.

Financial crack-cocaine.

Ben Bernanke, in his first speech as the new Chairman of the White House, assured the public that the Bush administration is closely monitoring the housing market. Now, that certainly makes us feel better, dear reader. We can all sleep a little better tonight knowing that the world-improvers in Washington are on the case. But what, pray tell, are they doing? How exactly, are they “monitoring” the housing market?

First, by denying that there is really any problem. Bernanke said, “While speculative behavior appears to be surfacing in some local markets, strong fundamentals are contributing importantly to the housing boom … those fundamentals include, low mortgage rates, rising employment and incomes, a growing population and a limited supply of homes or land in some areas.” He goes on to say, “The administration will continue to monitor developments in the housing market. However, our best defenses against potential problems in the housing markets are vigilant lenders and banking regulators, together with perspective and good sense on the part of the borrowers.”

Bernanke, who could fill Greenspan’s shoes as Fed Chairman when the time comes (a scary thought), is having way too much faith in borrowers. Good sense is not something that neither the lender, nor the subprime borrowers involved in this “frothy” market have in abundance. Little action has actually been taken by the banking regulators, although a NY Times article tells us they have “signaled their discomfort about the explosive rise in risky mortgage loans.” But why would they want to step in? The Fed has a good time making macroeconomic policy – who wants to worry about the pizza delivery guy who just bought a $300,000 house?

Although some small steps are being taken for more scrutiny into potential home-purchasers background; from the Fed to the Office of Comptroller of the Currency, the federal banking regulators have not backed up their warnings with any sort of major interference, because they would not want to stand in the way of a new method of lending, or more “financial crack-cocaine”, as our Pittsburg correspondent would put it.

More choices, and more ways to Super-size our debt … that is exactly what Americans need. God forbid, we would put regulations out there that may “stifle” the mortgage lenders’ creativity. Even so, some analysts feel that the mortgage industry has hit its top with their pièce de résistance – the ARM. “No other product can compete with the low monthly payment of an option ARM … even interest-only loan products fall short.” Douglas Duncan, chief economist at the Mortgage Bakers Association agrees that this may be the end of the road in the mortgage affordability cycle. He says, “While I don’t think they are at the point of giving out free toasters to get customers, loan creativity appears to be at maximum level.” We can only hope that much is true.

GOODBYE MIDDLE CLASS; HELLO HOUSE POOR

There is no question that home building, home sales with large capital gains, and record mortgage financing drives the economy, creating millions of jobs and generating billions of dollars in wages and tax revenues each year. Nothing plays a more crucial role in providing individual financial security for millions of Americans than homeownership. Obviously, the drivers of homeownership are a good steady income and cheap and readily available mortgage credit. Indeed, looking at housing prices rocketing up, our government tells us we have never had it better!

For many households, however, who have not stepped onto the first rung of the housing ladder, affordability conditions have deteriorated, especially among lower income households. The homeowner rate is less than 50% for households in the lowest income bracket, while it surpasses 90% for those in the top income bracket. Higher income clearly widens the choice of available homes for purchase and increases the likelihood that a household will qualify for a mortgage. Around 1980, when asked what level of personal income would qualify as middle-class, George H.W. Bush replied: $50,000. Only 5% of the U.S. population made that amount of money at that time. With inflation, that is over $100,000 today.

While the U.S. has traditional values of hard work, entrepreneurship, and individualism, we have a large and growing number of people in our country who live hand to mouth and paycheck to paycheck. Since factories are no longer built in our country and the cost of living is increasing at an astounding pace, it is likely that the lower-middle class will struggle to own a home for generations to come. The working poor are dreaming about white picket fences and becoming middle-middle, while the middle-middle aspire to become upper-middle and beyond so they can afford to build one of those McMansions we have all seen that absolutely dwarfs the older, split-level homes the baby boomers grew up in.

There are five separate social classes in American society. They are the Upper, Professional Upper-Middle, Middle-Middle, Lower-Middle or “working poor”, and the Lower. A new class seems to be developing. I call it the “House Poor”. In this overheated real estate market where homes are selling above list prices and speculative buyers are quickly flipping properties at a record pace, the House Poor are keeping up with the rising cost of living by paying the bills through home equity extraction, home-equity loans and cash-out refinancing. While many homeowners believe they can live like the upper class and appear to be wealthy, they will be the first to end up in the poor house. Those easy money real estate speculators who purchased several investor properties are now beginning to see that renters are more difficult to find these days but the bills to maintain their properties keep coming in.

Indeed, homes have a tendency to actually make you poor because new ones need to be finished and furnished, while older homes become deep money pits. Worse yet, when it comes to the state and local government, they are always looking for someone to tax. As soon as you buy a house, you have just raised your hand and announced “please tax me”! While some localities offer tax breaks to primary residents, second home and investor property owners get hit full bore on tax increases!

A growing number of homeowners are realizing they can no longer afford to live in their home even though they are “mortgage free”! The conservative sane homeowner who purchased a home over five years ago and refinanced a 30-year mortgage – without taking money out – is now stuck paying higher inflated taxes. Indeed, the home’s value has not really gone up because the price and the cost of everything associated with maintaining it is spiraling out of control. In a very real sense, as the house price rises, the value is forced down because it becomes so much more expensive to pay for the darn thing!

In paying so much for real estate today, it is virtually certain the middle class homebuyer will never really own the home outright. While the statistics say 69% of people own their homes, at least a full 10% have no stake in the property and with the slightest disruption in income, will give the house back to the bank. For the investment property market, I really wonder how many people will stick around to pay the insurance, property taxes and mortgage when the price is going down. Calling them homeowners is a joke.

Only the upper class can really afford what was once a middle class house unless, of course, you are willing to “take cash out of your house” just to pay for living in it. When housing prices cool down but the cost of living keeps going up, the “phony equity” in the house will quickly vanish. When that occurs, today’s buyers will be literally eaten alive by housing costs. So, when it comes to class, the Middle will lose it and truly become the House Poor.

FEDERAL DEFICIT REALITY: AN UPDATE

From time to time, the U.S. financial markets manifest some concern about the nation’s twin deficits – the federal budget and the current account shortfalls. These episodes have been short-lived, however. Generally, the markets have been very sanguine about these problems – much too sanguine, in our view! We believe there is a great deal about which to be concerned in both areas, and that longer run, the U.S. markets will indeed reflect it – negatively, of course.

For nearly four decades, officially sanctioned accounting gimmicks have masked federal deficit reality. Surpluses in trust accounts, such as Social Security, have been used to obscure the true shortfall in government spending. With less than one tenth of the actual deficit being reported each year, a cumulative negative net worth for the U.S. government has built up in stealth to a level that now tops $45 trillion, with total obligations of $47.3 trillion (more than four times annual GDP). The problem has moved beyond crisis to an uncontrollable disaster that threatens the existence of the U.S. dollar and global financial stability.

The dollar, as we know it, soon will be history. Dollar inflation has been through a number of cycles since the founding of the Republic, but its current perpetual uptrend – net of some bouncing during the Great Depression – only began once the Federal Reserve was created in 1914. Now, with fiscal policy careening beyond any chance of containment, the Federal Reserve will get to oversee the U.S. currency’s demise. It is not that the Fed wants to monetize the federal debt and trigger a hyperinflation – the U.S. Central Bank certainly will do its utmost to avoid that outcome – but it will have no politically acceptable alternative. The system otherwise would tend to right itself anyway through the economic shakeout of a hyperinflationary depression. While the Fed might hope to mitigate and to control the disaster, given the Fed’s nature, it is more likely to exacerbate conditions rather than to improve them.

When the dollar loses most of its value, through hyperinflation and/or currency dumping, the global currency system and economy will be in shambles, and a new currency system will have to be established. Those setting up the new system will need to establish its credibility, and there is only one monetary asset that can accomplish that: Gold. Gold is the only commodity that has held up as a liquid store of wealth over the millennia. The amount of gold used to buy a loaf of bread in Ancient Rome still buys a loaf of bread today. In like manner, the amount of gold that bought a regular haircut for a man in 1914, still buys a similar haircut today. Where the public does not trust today’s politicians and central bankers, it does trust gold.

Whatever structure evolves for the new currency system, it most likely will have gold at its base. That is one reason that central banks rarely have followed through on threatened gold sales in recent years. The threats usually were nothing but jawboning aimed at depressing current market prices. Those countries holding the most gold will have the greatest advantage in any new currency system, and the central bankers know that, including Mr. Greenspan.

Central banks, OPEC, corporations and investors, both foreign and domestic – as holders of U.S. dollars – increasingly will sense or realize the greenback is headed for the dumpster. It only is a matter of when, not if. The dumping of the U.S. dollar and/or U.S. debt by investors likely will hit quickly, with little advance notice. All the official actions that in turn could trigger hyperinflation would follow rapidly, with a full-fledged dollar collapse and developing hyperinflation possibly unfolding in a matter of weeks. When this will happen is the tough question. It could be years; it could be next week. Without knowing the precise proximal trigger of the shift in sentiment against the U.S. currency, the timing is impossible to call. Nonetheless, some early warning signs may be evident in unusual anti-dollar activity in the currency markets, or in unusually sharp and unexplained spikes in the price of gold.

It would be extraordinarily surprising if the ultimate dollar collapse can be held off a decade, let alone 3-to-5 years. The pending global financial crisis conceivably could break in the immediate future, triggered possibly by one or more of the following developments: action by China to peg its currency to a basket of currencies instead of the dollar, OPEC pricing oil using a basket of currencies instead of the dollar, a sovereign credit rating downgrade on U.S. Treasuries, a major terrorist act, a very bad monthly trade report, a misstatement by an Administration official or some other event that may appear obvious in retrospect.

FEELING BLUE ABOUT THE MARKETS

The New York Times caught our attention today with a “feeling blue about the market” article (PDF file). The offers: “I’m shocked at the level of apathy – perhaps even pessimism – about the market, given the current environment for stocks … The public has this thing really, really wrong. … The dollar rallied when it wasn’t supposed to … bonds rallied when they weren’t supposed to. … All eyes are on the Fed … and how far they are going to go and how long it’s going to take them to get there.”

Our thoughts: 1.)Why does the mainstream press focus only on one market – the broad stock market index? The great traders do not do that. Why should you? 2.) You cannot predict the dollar’s direction. So why was it supposed to do anything? 3.) You cannot predict bond directions. So why was it supposed to do anything? 4.) Great traders do not watch and make decisions off the Fed. Great traders watch and make decisions off market price movements.

FIRMS PILE UP EARNINGS WARNINGS

Earnings season has barely started, and companies already are sending out warning signs. So far, for every Standard & Poor’s 500 company that has told investors to boost expectations for their second-quarter earnings, 2.5 have said their results will disappoint, says Thomson Financial. That is worse than the typical 2-to-1 ratio and the highest since the first quarter of 2003, says Thomson Financial’s John Butters. It is coming from a range of industries. Craft seller A.C. Moore, restaurant Applebee’s, business software makers Altiris and Vitria, and motorcycle maker Harley-Davidson all told investors to lower their expectations for quarterly earnings.

Yet investors do not seem worried, as was clear when the Dow Jones industrials capped last week with a 147-point gain on Friday to 10,449. Small-company stocks are sizzling. The fact negative preannouncements are higher among the S&P 500 than in the universe of stocks shows how strong small-company stocks are, says Nicholas Bohnsack of International Strategy & Investment. This detail has not been missed by investors who keep pushing shares of small companies higher. The Russell 2000 index, which tracks small-company stocks, rose last week to a record 662. It has gained 15% the past 2½ months.

Some say the wave of warnings is actually good. Bohnsack says when the negative-to-positive ratio is higher than average, stocks gain 2.7% during reporting season, vs. a 0.3% drop when the ratio is lower than average.

KKR, BLACKSTONE FUEL RECORD BUYOUT FEES FOR INVESTMENT BANKERS

Kohlberg Kravis Roberts & Co. and Blackstone Group LP, the world’s two biggest buyout firms, are making 2005 an unprecedented year for leveraged buyouts, generating more than $4 billion of fees for investment bankers. LBO specialists, which borrow about two-thirds of the purchase price to finance acquisitions, disclosed $148 billion of takeovers during the past six months, putting the industry almost 65% ahead of 2004’s record pace, data compiled by Bloomberg show. The combination of stagnant stock markets and relatively low interest rates are enabling KKR, Blackstone and at least a dozen other firms to arrange another $100 billion, including LBOs for Grupo Auna, owner of Spain’s No. 3 mobile phone company, and the Dutch bank NIB Capital NV.

KKR and Blackstone – now completing the $10.6 billion purchase of SunGard Data Systems, whose software handles most Nasdaq Stock Market trades – helped the industry to increase its share of the $1.3 trillion global mergers market by 15% this year to 11%. SunGard will be the biggest LBO since 1989 when KKR acquired RJR Nabisco for $31 billion.

LBOs are booming because stock markets are down more than 20% from the 2000 peak while borrowing costs are almost half what they were a decade ago. Fees from LBO firms are so important to bankers, who get paid for arranging the deals and providing the credit needed to finance them, that JPMorgan Chase, the third-biggest U.S. bank, decided in March to spin off its own takeover unit to avoid losing LBO firms as clients.

Blackstone has made more than $80 billion of acquisitions since the company was started in 1987 by Peter G. Peterson and Stephen Schwarzman. By comparison, KKR, which was founded in 1976 by cousins Henry Kravis, George Roberts and Jerome Kohlberg, has completed more than 120 deals valued at more than $136 billion. Buyout firms will attract about $200 billion of net new investments this year, London-based Private Equity Intelligence Ltd. estimates. That would exceed 2000’s record of $177 billion. “The large funds attacking the large end of the market are finding it quite easy to raise money,” Blackstone’s Schwarzman, 58, said in a June 10 interview. The New York-based firm paid about $800 million of fees to Wall Street firms last year. To capture a bigger portion of these fees, JPMorgan is spinning off its $13 billion buyout unit, JPMorgan Partners LLC, after clients led by Texas Pacific Group co-founder Bill Price threatened to take advisory work away from the bank because it was competing on deals.

HEDGE FUND INVESTORS SEEK QUICK EXITS

Hedge fund investors are copping an attitude when it comes to the terms they will accept for sinking money into these popular investment pools. A survey by Deutsche Bank shows 77% of some 1,000 hedge fund investors said they would only accept investment lockups of one year or less. That is up from the 68% who responded similarly in last year’s survey. Lockups can be a bone of contention because they prevent investors from yanking money out of poorly performing funds before a set date. Of course for fund managers, the lockups are critical to maintaining stability in a fund, especially through rough patches. Throughout the hedge fund industry, fund performance has faltered this year after the heady returns of two and three years ago, weighed by poor market conditions.

Deutsche Bank found in its 4th annual survey of alternative investments that the demand for shorter lockups cuts across all investor classes, from fund of funds and high net-worth individuals and family offices to pensions, banks, corporations and insurance companies. Fund of funds managers, who pool hedge fund investments the same way mutual funds pool securities investments, may be helping to drive the shorter lockup phenomenon, says John Dyment, the global head of Deutsche Bank’s hedge fund capital group. They are trying to balance the lockups of their investments against the lockup provisions they give to their clients to make sure the overlap works in their favor.

A RETURN TO THE DRAWING BOARD REAFFIRMS THAT U.S. LABOR INCOME IS INDEED STAGNANT

The stagnation of earned labor income reflects a breakdown of the relationship between worker pay and productivity. A few times every year, I get the opportunity to present my view to the academic community. The challenge is very different with this group. Unlike investors, where accountability takes place on a mark-to-market basis, in the academic world, it is the rigor of the analytical framework that is tested. Recently, I sung for my supper in front of a group of superstars at Stanford University. Predictably, they went right for the jugular – challenging one of the major building blocks of my macro framework. Nobel laureate Kenneth Arrow politely suggested that I might want to consider reworking a key assumption. That stopped me dead in my tracks. For a moment, I felt like I was in graduate school again. It was back to the drawing board.

The debate was over my core premise of the income-short American consumer. For some time, I have argued that consumers were being squeezed by an unprecedented stagnation in real wages and an equally profound shortfall in the wage earnings component of personal income. I have stressed that this development is all the more extraordinary in the context of America’s high-productivity-growth economy. After all, one of the time-honored axioms of a free-market capitalist system is that workers are paid in accordance with their marginal productivity contribution.

The Stanford crowd hardly quibbled with this basic point. They suggested, however, that I was wrong to test this hypothesis by scrutinizing trends in real wages and wage and salary income. The theoretically correct construct, they argued, was the linkage between productivity and the broader measure of real compensation – wages plus benefits. They were right, of course. And so I have redone the analysis from the standpoint of compensation. Interestingly enough, my earlier conclusions hold: The extraordinary stagnation of earned labor income in the past four years reflects a fundamental breakdown of the relationship between worker pay and productivity. The saga of the income-short American consumer remains very much intact.

Needless to say, the implications of this development are profound. Three big conclusions jump off the page: 1.) American consumers are, indeed, as income-constrained as I had previously thought. Broadening the focus to compensation only underscores the key point that labor earnings are behaving very differently than might be expected of a high-productivity growth economy. 2.) U.S. policymakers – especially the Fed – have responded by providing stimulus to asset markets in order to provide a substitute for lagging organic income generation. Increasingly wealth-dependent consumers then drive their income-based saving rates lower – leading to an ever-wider current-account deficit and ever-mounting global imbalances. Meanwhile, asset markets go to excess and bubbles become the rule, not the exception. 3.) As the angst of economic insecurity has spread from concerns over jobs to wages, and as the U.S. trade deficit mounts, the risks of politically inspired protectionism rise. Washington’s focus on China bashing is in fashion these days for precisely these reasons.

There is nothing like the test of academia to prompt a careful rethinking of any macro argument. If you do not expose yourself to the pros, the risk is that your conclusions will become tired and stale. The Stanford crowd forced me to re-examine one of my core premises. They made me sweat. My framework is hopefully more robust for the effort.

HAIRSHIRT ECONOMICS

Christopher Farrell, writing the essay, “Greenspan: Wizard or Villain?” on msnbc.com, divides people into two camps. On the one side, we have what he calls “The hairshirts”, which “believe that for the health of the economy to be restored, the inevitable bust that follows a boom must be at least as great as the boom.” Apparently we, speaking for the hairshirts everywhere, are the stupid scumbags of the world. On the other hand, we have what he calls: “Growth proponents – and there’s none greater than Greenspan – believe that it’s better to limit the fallout of a bust and get the economy growing again as quickly as possible.” Did you note that one side is dismissed as the pejoratively labeled “hairshirt” idiots, and the other side is gloriously called “growth proponents” instead of “raving lunatics”?

So it is better to let my daughter speed dangerously in her car and clean up the mess when she inevitably crashes, rather than stop her from speeding? And it helps the economy for me to constantly put bigger and bigger engines in her car the whole time? Wow! No wonder I always win the “World’s Worst Dad” award!

Then to make sure that you understand that he is a “journalist” and not an economist, he goes on to say, “To the hairshirts’ way of thinking, the great mistake Greenspan made was not allowing for a vicious economic and financial downturn to purge the speculative excesses built up during the heady ‘90s.” No, you little twerp! That is not it at all! The great mistake was allowing the damned speculative excesses in the first damned place! But nooOOoooo! Greenspan is directly responsible for the creation of so much, so excessively much, so incomprehensibly much, so impossibly much money and credit, which financed every damn one of the damn speculative excesses, which now need to be purged, because there is nothing else to be done with them, and with all of the attendant misery.

So we are NOT quibbling about how best to correct huge boneheaded and criminally stupid mistakes with monetary policy. What we should be quibbling about is where in the hell YOU were, you and your rapier-like journalistic wit and vast economic-savvy, the entire time this Greenspan putz was doing this monetary insanity? And now we are supposed to think that this Greenspan fool, who caused our misery, is the best person to correct the mistakes he himself made? Hahahahaha! Journalists! Hahahahaha!

Mr. Farrell then writes, “The critics say Greenspan has transformed the economy into a giant bubble, concocting one even greater than the one that already burst. The longer he delays the day of reckoning, the worse the fallout will be when the bubble pops.” Yes, that is EXACTLY what I say, and that is exactly what history process, and that is what everybody who knows the least bit about economics says.

But Mr. Farrell is not interested in any of that. In fact, he dismissed me with a wave of his hand, as if shooing away a pesky fly, as he goes on to say “That’s a severe indictment - but not necessarily a valid one. A problem with the anti-Greenspan mindset is that hairshirt economics was largely discredited during the Great Depression.” Huh? It was? Excitedly, I pull my chair up closer, because this is big news to me! I am on the edge of my seat to hear how this was “discredited during the Great Depression”! “Mainstream economists of all schools, from Keynesianism to monetarism, turned away from hairshirt economics after the Great Depression,” he continues. Huh? Sensing my stupefaction at the enormity of what he is saying, he explains, “They realized that the government could play a positive role in counteracting contractionary forces in the economy.” Hahahahaha! I laugh in contempt at such a statement!

Wiping the tears of laughter from my eyes, and it is difficult for me to stop laughing, because everyone, in all periods of history, all know from the cradle to the grave that the government can cause a boom! And then every government, facing the inevitable economic contraction, then went after more money, usually by declaring a war, so that they could, as he says, “play a positive role in counteracting contractionary forces in the economy.” And yet this Farrell guy thinks that only after the Great Depression, not even 80 years ago, (which was caused by the newly-formed Federal Reserve acting like profligate jackasses even then), did people realize, and pardon me from laughing out loud, but I cannot seem to help myself, that deficit-spending by a government could counteract “contractionary forces”? Hahahaha! I cannot help myself! Hahahaha!

STEEL STOCKS UNCHARACTERISTICALLY DIVERGING FROM THOSE OF IRON ORE AND COAL PRODUCERS

China surpassed Japan to become the world’s biggest iron-ore buyer in 2003. As the country inhales growing quantities of iron ore, it exhales growing quantities of finished steel. China lifted it steel production by a stunning 38% in May, adding tonnage equal to almost the supply of Germany, France, Spain and the U.K. combined. Not surprisingly, therefore, the prices of iron ore and coal are both rising sharply, thereby driving up the cost of steel production for every other steel mill in the world, including those carrying the U.S. Steel logo. In short, Shanghai’s stargazers are not the only casualties of China’s booming steel industry; so are the steelmakers who dare to compete against the Chinese.

The sharply rising cost of steel production would not be unbearable if steel prices were keeping pace, but they are not. U.S. steel prices fell for the 9th straight month in June – down a sharp 35% from a record $756 a ton in September, according to Purchasing Magazine. The prices of most other commodity steel products are also falling. Unfortunately for U.S. Steel, therefore, input costs are rising while revenues-per-unit received are falling. Blame the Chinese. (Go ahead, everyone else does). The declining share price of U.S. Steel since February amply reflects the grim situation in which “Steel” now finds itself. Curiously, however, the share prices of most major coal and iron ore companies continue to float near all-time highs. Something might be wrong with this picture. The selling of steel stocks might be overdone, at least relative to other steel-related issues like Peabody Coal and BHP.

If steel prices fail to recover, steel production will drop. Already, several U.S. steel makers have trimmed their production forecasts for the current quarter. At some point, we would imagine, demand for coal and iron ore would also decline. And if coal demand stalls a bit, we would expect the stock prices of companies like Peabody Energy to stall as well. As this chart above illustrates, steel stocks and coal stocks shared a magnetic attraction for one another … until about three months ago. To be sure, these two stocks rely upon different underlying dynamics, but not as different as their divergent price trends would suggest. The two share a common root system – a root system nourished by global economic growth. Therefore, coal stocks are not likely to continue flourishing while steel stocks wither.

If the steel industry is indeed beginning an important downturn, neither the coal or iron ore industries will enjoy a lengthy immunity. Net-net, we would be a buyer of steel stocks relative to coal stocks, or relative to iron ore stocks – “relative” being the operative word. A buyer of steel stocks would also enjoy the psychic support of relatively (there is that word again) low valuations. Most steel stocks sell for a paltry 4 times estimated earnings, compared to 20 times for Peabody Coal. To be very clear, you editor is not recommending a purchase of U.S. Steel or a sale of Peabody Coal or BHP. He is merely highlighting the fact that these three securities are unlikely to diverge from one another for much longer. One way or another, Steel stocks, coal stocks and iron ore stocks are likely to regain their magnetic attraction to one another. Long term, we expect all three sectors to flourish.

OIL SERVICE COMPANIES PROVIDE MORE PLEASURE, LESS PAIN

Investment strategies that try to capture most of a stock’s power while also taking bumps out of the road seem particularly worthwhile in today’s volatile energy stock sector. Most investors, for example, would love to have captured the big gains these stocks have delivered over the last few years. But very few of us possessed the conviction or chutzpah … or, perhaps, stupidity, to stick with them through thick and thin. Consider Valero Energy (NYSE: VLO), one of the brightest of the oil sector’s bright lights. Since the fall of 2002, Valero’s share price has soared 600%. Yet, on six separate occasions during that spectacular run the stock tumbled 15% or more. In other words, the ride has been anything but serene.

Oil stocks are as volatile as refined oil itself. In controlled environments – like a V-8 engine – refined oil produces locomotion. But when mishandled, this same volatile compound can blow apart refineries. Oil stocks are no different. If properly controlled, they can propel a portfolio to impressive returns, but this same “rocket fuel” can also blow portfolios apart. The trick is to achieve the locomotion without the unintended volatility. We know of no perfect means of containing volatility, but we have stumbled upon a two-part tactic that may advance the cause: 1.) Favor the least volatile sectors of the oil-share market, and 2.) Favor the least volatile securities.

At current valuations, the stocks of companies that facilitate the production of crude oil seem to offer a better risk-reward proposition than those that track down oil and pull it out of the ground – the so-called exploration and production (E&P) companies. The share prices of some “facilitators” have already soared dramatically, Valero being a prime example. But some have not, at least relative to other stocks in the sector. Most oil-drilling and oil services companies have merely kept pace with the oil sector in general. Yet, the longer-term investment prospects for these companies seem superior to the E&Ps … or at least more certain.

“Evidence from the last sustained energy bull market,” Barron’s observes, “suggests that a long period of high [oil] prices creates disproportionate gains for drilling and service companies, not just relative to the broader market, but also to oil and gas producers … While energy producers are flush with cash from record-high prices, the scramble to develop new fields and maximize output from existing ones has forced them to sharply raise spending on services.” Because most oil companies are just beginning to ramp their exploration and development spending, this new investment cycle will not likely end soon … even if oil prices slump somewhat. That means that oil service stocks should begin to exhibit less sensitivity to daily oil price volatility than E&P companies. “While a short-term dip in oil prices would translate into an immediate hit to producers, it would have to be severe to affect service companies,” Barron’s asserts.

Over the last two years, XLE – the ETF that holds mostly integrated oil stocks like Exxon and Chevron – and OIH – the ETF that holds oil services stocks – have produced nearly identical returns. But during the most recent rally in oil stocks off their mid-May lows, OIH outperformed XLE. Interestingly, the price of OIH call options relative to the price of XLE call options has been falling since mid-May, despite OIH’s superior performance. Indeed, the relative pricing of OIH call options has been dropping for two years. To use the parlance of the options trade, the implied volatilities of call options on OIH have dropped dramatically over the last two years compared to the implied volatility of call options on XLE. Two years ago, OIH call options cost almost twice as much as comparable options on XLE. Today, the prices are nearly identical.

These observations lead directly to our second tactic: Emphasizing less volatile securities. To wit, we would suggest buying OIH itself, rather than any of the individual oil services companies that OIH holds. But a better idea still, might be to buy one of the relatively cheap OIH call options. The January 105 call option, for example, seems relatively inexpensive at $8.00. (This option, for example, is about 33% cheaper than a similar call option on Valero Energy). OIH calls might expire worthless, of course – that is the risk every option-buyer takes. But at least the potential loss would be limited to the cost of the option. Sometimes, in the context of a larger portfolio, that is a good bet to make. On the other hand, long-date OIH calls might deliver as much power as a “Fireball Engine”, while also cushioning the ride along the way.

THE SHOPPING SEASON FOR JUNIOR MINING STOCKS IS HERE

The Quiet Season is an enduring paradox in the junior mining sector. It is a paradox because it is actually the busiest time of the year for most Canadian exploration companies. For the simple reason that, in most of the Northern Hemisphere, exploration is easier and cheaper in the summer than the winter. Once the snow melts and the mud dries up, geos and company executives alike head out into the field, kicking rocks and keeping the drills turning pretty much around the clock. Naturally, with everyone off in some remote corner of Labrador or Outer Mongolia, the flow of news, so important to generating trading volume, dries up. And it pretty much stays dried up until, typically, late summer or early fall when results begin to come in from the summer drill programs.

Exacerbating the summer slump is a well-known tendency of brokers to cut back on their hours and take holidays during this time. And why not? With the explorers in the field generating samples for the assay labs, there are few new stories to tell. And with most of their clients – especially the Europeans – on vacation as well, there are fewer people to tell the stories to. Exploration companies make the situation worse still by holding back on releasing good news, in fear that nobody will notice it. As a consequence, unlike the rest of the year when stocks move up or down based on any number of relevant factors, during the Quiet Season, the controlling factor is the lack of volume that causes share prices to retreat.

All very logical. All very predictable. It is why the old adage “Sell in May, and go away” is at least as true with mining stocks as it is with the broader market. But this year things have deviated from the expected in ways that are at once problematic and opportunity-creating for attentive resource speculators. Starting as early as February this year, many brokers began telling their clients to hold off on buying, or even to sell, in anticipation of the coming Quiet Season, helping to produce a self-fulfilling prophecy and accelerating the slump this year. Therein rests the opportunity. Because the Quiet Season started earlier, and for reasons I will explain shortly, I think it will end sooner than most expect. The important thing is that you need to start thinking of the Quiet Season as the “Shopping Season”, then you will be thinking about it in the right way.

If you are convinced that a particular company has the goods, you want to be long now, and not hold out for the exact bottom. If a stock you like goes down more, great; buy more. What you do not want to do is sit back until you are absolutely convinced it is safe to go back in the water. By that point, you will have missed the boat on the biggest upside. By the time something seems “safe”, its price usually reflects that perception.

My first reason for expecting the markets to get back to business sooner than most people expect is simply that, due to this year's heightened anticipation of the Quiet Season, many stocks sold off harder and certainly earlier than “should” have been the case. Speaking as a lifelong contrarian, the acceleration in the sell-off has set the stage for an earlier bounce. Second, there was a huge amount of money raised by the junior explorers in 2003 and 2004, money that has provided fuel for exploration programs on a global scale. Time and again I have heard mining executives complaining about the shortage in drills and drill crews. All that activity will lead, and soon, to results that the market will be forced to pay attention to. Along the same lines, we are increasingly seeing reserve-needy major producers joint-venturing with the competent junior explorers to effectively serve as their de facto exploration divisions. That gives these juniors access to both exploration funds and intellectual capital, both of which are needed to pull a big find.

We are late in the typical two-year exploration cycle (the period between mounting an exploration program on a specific project, and learning whether or not something of interest is actually in the ground) for this resource bull market. That greatly increases the odds that this Shopping Season will be periodically punctured by important news, or entirely shattered by one or more major discoveries that bring a herd of investors rushing back into the markets. Before the herd returns, be sure that you have loaded up on the quality plays.

ENERGY’S LIQUID FUTURE

China, South Korea, and Japan are already some of the world’s largest oil importers. It is a precious energy lifeline that could easily be cut, either at the Strait of Hormuz or at another chokepoint, the Strait of Malacca. How will a country like South Korea keep its powerhouse export driven economy going without getting sucker punched by high oil prices? The answer is unknown. But continued development of its energy infrastructure – with companies like KEPCO – will help. Another answer may lie in liquid natural gas (LNG).

This is a golden age for oil and energy investments. Either that, or a fiery sunset that ends with oil and resource wars. But I prefer to look on the bright side. At the moment, however, the bright side of the oil and gas market is dimly lit. Continuous supply disruptions – whether by acts of terrorists or acts of God have altered traditional relationships between supply and demand, while also obliterating America’s long-standing complacency about oil and gas supplies. Uncertainty reigns.

But amid the uncertain conditions of our changing petro-political world, liquid natural gas will certainly assume a prominent role. As I see it, there are two major opportunities in LNG: terminal construction and tanker construction. With LNG demand likely to rise from 120 million tonnes in 2003 to 200 million tonnes by 2010, and then 315 million tonnes by 2020 (according to estimates from the International Energy Agency), it is a question of getting the right mix of investments.

With major oil and gas companies just beginning to develop LNG terminals and gas fields all over the world, the place to look at future investment opportunities is in the LNG shipping business. That brings us directly to South Korea, which has the good fortune of being in the heart of one of the most energy ravenous regions of the world. It also has some of the most successful LNG ship makers in the world. LNG ships are made of the kind of materials that can keep the gas cool once it has been liquefied, which involves thick aluminum, nickel steel, and balsa wood (for insulation). It is an art the South Koreans have perfected. And you can expect the South Korean shipbuilders to profit handsomely.

WHAT WOULD YOUR FORECAST BE?

Suppose you were a financial analyst. You are invited for an interview on a financial TV network and asked to make a forecast for the future direction of Market X. Here are the facts and “fundamentals” you know about this market: 1.) Market X always follows Market A, and Market A has been mostly flat for over a year. 2.) The political situation in the geographical area where Market X is located – let’s call it Area X – has been unstable. There is a widespread feeling of disappointment among the citizens. 3.) The broad economy of Area X has been weak for several years. In fact, the Central Bank of Area X has kept interest rates at historically low levels for over two years in the hopes of stimulating the economic growth, but to no avail. 4.) One of the largest cities in Area X has recently experienced its worst terrorist attack in history, and fears of more attacks abound.

What would your forecast be? Well, since “everyone knows” that the news and the political and economic conditions drive the stock market, most financial analysts would say, “Under these circumstances, I do not see big prospects for growth in Market X.” This is why many financial analysts so often miss the target.

You have already guessed, of course, that Area X in this exercise is Europe, and Market X is European stocks. But every fact and “fundamental” indicator listed above is true. Europe is widely expected to follow U.S. stocks, and U.S. stocks have gone nowhere for a year-and-a-half. The EU has been in a serious political turmoil after France and the Netherlands rejected the new EU constitution. The economic growth of several EU members has been weak or even negative, e.g., that of Germany. And of course, last week’s bombings in London are still sending shockwaves across the continent and the world. Yet, inexplicably, European stocks continue the rallies they started in September 2004. How is that possible?

It is possible because the broad stock market is not rational, as it is commonly assumed. In other words, the stock market, i.e., investors’ collective psychology, does not really depend on what is going on in the world or even in the immediate geographical area. If investors in aggregate feel optimistic about the future, they do not tend to view bad news as a threat to their investments – so they keep buying stocks. That is exactly what has been happening in Europe for almost a year.

The good news is that investors’ collective psychology, while being irrational, also unfolds in a pattern. We call it the Elliott wave pattern. At its basic level, it consists of 5 waves up and 3 waves down. And by knowing which wave the market is in currently, an Elliott wave analyst can make a reasonable forecast about the market’s direction.

WHY ARE WE SO AFRAID?

Hmmm. Statistics of the past decade show that crime rates in Germany, the UK and the U.S. have declined. Yet amazingly, the citizens of all three countries believe that crime is up for the period. In Germany from 1993-2003, car theft decreased 70%, but Germans felt it had increased by 47%. The murder rate went down 40%, but Germans believe it is up 27%. Sexual murders’ declined 37%, but the public thinks they are up a whopping 260%. In the UK from 2001-2003, crime rates fell by 2%. Yet in 2003, 38% of Britons thought that crime rates had gone up strongly in the previous two years. In the U.S., crime has been falling fairly consistently since 1991 as well, but the public’s perception seems to be the opposite, as evidenced by the multiplication of gated communities across the nation and the booming business done by home security industry.

The reason for this “disconnect” between reality and perception is said to be the media, primarily TV, where the number of gruesome crime shows has skyrocketed on both continents. Maybe, but first, let us look at another issue that has been at the forefront in the U.S. and Europe: immigration. According to the International Organization for Migration (IOM), citizens of “Western countries” increasingly feel that “immigrant numbers are spiraling out of control, causing job loss and hikes in welfare spending.” But despite the public’s perception of the “growing immigration problem”, the IOMs figures show that any increase in global immigration in the past five years has been very modest. Worldwide, the number of migrants is now estimated at 185-192 million – up only slightly from 175 million in 2000, when immigration was not yet viewed as a “problem”. Maybe you could blame “crime TV” for the public’s false view of the soaring crime rates. But how do you explain the growing immigration fears? There are not any TV shows about “evil” immigrants who are taking away jobs from the hard-working natives. Not yet, at least.

Bottom line, crime is down, but fear of crime is up. Immigration is down or flat, but fear of immigration is up. These perceptions are not based on facts, and that is why we believe their roots are deeper than pop culture. They are caused by a shift in the prevailing social mood that began to occur globally back in 2000, as evidenced by the broad declines in the stocks markets that year. Since then, global feelings of fear, opposition and separatism have only grown. Clearly, social mood is a powerful force that can and does overtake people’s rational thinking. And it has a direct effect on the financial markets, too.

Willie Wonka and the changing culture.

The movie Batman Begins opened a month ago, with director Chris Nolan supplying a psychological, dark origin for the young Bruce Wayne. This week, it is director Tim Burton’s dark remake of a classic offbeat movie: In Charlie and the Chocolate Factory, Johnny Depp stars as a quirkier, more dark-hearted version of Gene Wilder’s Willie Wonka.

Socionomics explains how changes in social mood will permeate the culture, with the stock markets serving as the most visible barometer. An upbeat social mood was in place throughout the 1990s (as reflected in the bull market). Starting in 2000, the mood began to change to a darker downbeat one (as reflected in the market turning down). Bob Prechter recently commented on the changing tone of the social psychology and culture. Here is an excerpt.

WINNING THE LOSER’S GAME

In his book, Extraordinary Tennis for the Ordinary Tennis Player, Dr. Simon Ramo found that, “professional tennis is a winner’s game: The outcome is determined by the actions of the winner. Amateur tennis is a loser’s game: the outcome is determined by the actions of the loser, who defeats himself.” War is another loser’s game. According to historian Admiral Samuel Eliot Morison, “the side that makes the fewest strategic errors wins the war.” Tommy Armour’s book, How to Play Your Best Golf All the Time, says, “the best way to win is by making fewer bad shots.”

Investing is a loser’s game. And it never becomes a winner’s game. All you have to do is not make huge mistakes. You never focus on beating a competitor. The greatest investors do not pull financial rabbits out of their hats or solve difficult scientific problems. They mostly just play it safe and avoid big errors. Warren Buffett’s quote on this matter cannot be repeated often enough: Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.

I am beginning to believe that investing is mostly about ruthlessly following basic precepts like, “Never lose money”. You never really graduate to the advanced class, because there is not one. You simply realize that it is all about the basics, and then you stop losing money … and start getting rich. Like most of the traits that make a successful investor, this one goes against human nature. We humans love to complicate things. But with investing, the simple answer is the one towards which you should gravitate. As Ben Graham writes on page 147 of The Intelligent Investor, “security analysts today find themselves compelled to become most mathematical and ‘scientific’ in the very situations which lend themselves least auspiciously to exact treatment.”

Not only do we humans want to complicate things. We also have a bias toward action. This is simply the tendency to want to “do something” and not remain passive. It is even worse that this bias serves you well in virtually any other business but investing. Tom Peters listed “a bias toward action” as the number one trait of effective managers in his classic work, In Search of Excellence. Warren Buffett once said something like, “Lethargy bordering on sloth strikes us as intelligent behavior.” If I were to recommend more than five or six stocks a year in these pages, maybe you should question the quality of those ideas.

Unlikely as it may sound, I think that if you do nothing but decide right here and now that you will make fewer investment decisions and avoid bad ideas, your performance will improve dramatically. This is something you hardly ever read about in newsletters, because newsletter editors have a bias toward feeding the typical reader’s desire for new stock picks. Editors are not bad people. It is just that most readers think they are paying for the production of a certain number of ideas. Most editors lose subscribers if they do not recommend a brand new stock every month. How many stocks should you own at one time? Any amount you want, as long as it is not too many. Says Buffett, “Your default position should always be short-term instruments. And whenever you see anything intelligent to do, you should do it.”

Jim Rogers is somebody else you ought to listen to on the subject of managing your own money. Rogers told author John Train in 1989 that you should, “take your money, put it in Treasury bills or a money-market fund. Just sit back, go to the beach, go to the movies, play checkers, do whatever you want to. Then something will come along where you know it’s right. Take all your money out of the money- market fund, put it in whatever it happens to be, and stay with it for three or four or five or ten years, whatever it is. You’ll know when to sell again, because you’ll know more about it than anybody else. Take your money out, put it back in the money-market fund, and wait for the next thing to come along. When it does, you’ll make a whole lot of money.”