Finance Digest for Week of July 25, 2005

CHINA RINGS THE “MOTHER OF ALL BELLS”

The old saying “no one rings a bell [at the market top]” certainly does not apply today, as China rang the “mother of all bells”. So deafening was its sound, that its vibrations will be felt around the world. Nowhere will the amplitude of these waves be more pronounced than in the U.S. China’s decision to change the nature of its currency peg means that it will no longer be in the dollar buying business, or by extension, the U.S. Treasury buying business. That means that America will be losing its biggest benefactor. China will no longer act as the principal enabler of America’s irresponsible extravagance, ending its subsidies to American consumers and borrowers.

Changing the nature of the yuan peg is a first step in the ultimate direction of either allowing the Yuan to float freely or possibly pegging it to gold. In the meantime the Yuan will remain undervalued, as it will likely be pegged to a basket of other currencies using current exchange rates that clearly undervalue the Yuan. Chinese imbalances will continue to grow, along with all the domestic inflationary implications that result. However, the pressure on China to prop up the dollar will be greatly diminished. To maintain the peg against its new basket, Chinese monetary authorities will most likely now be buyers of those other currencies likely to be included in its basket, such as the Euro or Yen. Since its reserves are already disproportionately held in dollars, it will likely rebalance those reserves to more accurately mirror the basket to which the Yuan will be pegged. Such a rebalancing will only exacerbate the dollar’s decline.

The implications for America are enormous. Far from being the panacea that American politicians proclaim, China’s decision to alter its peg could be the pin that finally pricks America’s bubble economy. In conclusion, July 21, 2005 will be another date likely to live in infamy. This time the aggressor is China not Japan, and the bombs are purely economic. Though there will be no immediate loss of life, and no American retaliation, the financial damages will be devastating. History will remember this date as the beginning of Chinese independence, and the beginning of the end of America’s ability to depend on China.

An awesome move by China.

China’s long-awaited currency adjustment is unambiguously positive for the global economy. Yes, it is a first step – and a tiny one at that. But it qualifies China as an active participant in the global adjustment process. Up until now, the Chinese were on the outside, looking in, insofar as global rebalancing was concerned. That was a recipe for increased trade frictions and protectionism – a hugely destabilizing possibility for an unbalanced world. China’s move on the currency front diminishes those risks and could well provide an important kick-start to an increasingly urgent global rebalancing.

I applaud China’s action for three reasons: First and foremost, it derails Washington’s protectionists and the serious threat they posed to geopolitical stability. The China-bashers certainly did not get anything close to what they were seeking, but the wind is now out of their sails. The shift in Chinese currency policy is an important downpayment on the nation’s long-term commitment to a flexible foreign exchange mechanism and an open capital account. China has committed itself to this endgame for years, but up until now, this promise was more rhetoric than action.

A second reason why this action is a plus is that a small currency adjustment does little damage to China export competitiveness. China has already taken actions to cool off its overheated property sector, and it does not want to risk overkill by crushing exports. On balance, the shift in Chinese currency policy reinforces my conviction that a China slowdown is in the cards at some point in the next 6-12 months. Thirdly, China’s new currency policy is a much more stable arrangement for the world financial system. From the Chinese perspective, it will help relieve the tensions that have been building from failed sterilization tactics – the inability of China to issue enough domestic debt to offset the massive purchases of U.S. Treasuries required by the now-abandoned dollar peg. This was leading to excess money and credit creation – underscoring the mounting risks of inflation and/or asset bubbles.

This is also a plus for the rest of the world – but with a potentially painful twist. By moving to a currency basket, China will need to diversify its enormous portfolio of foreign exchange reserves, which totalled some $660 billion at the end of 1Q05. Other Asian central banks – also massively overweight dollars – should follow China’s lead. The near-simultaneous announcement by Malaysia to abandon the Ringgit peg in favor of a managed basket float confirms such a possibility. Other central banks, such as the Bank of Korea, have been itching to diversify out of dollars. Consequently, a more flexible RMB mechanism raises the odds of an Asian shift out of dollars, in effect removing the artificial bid for dollar-denominated assets that has provided a subsidy for U.S. interest rates. This will undoubtedly put pressure on the interest rate support to U.S. asset markets – especially property. This is a plus for a long overdue global rebalancing but will be admittedly painful. Unfortunately, that is probably the only way for the U.S. and the rest of the world to come to grips with its most glaring excesses.

The financial market implications of this shift in Chinese currency policy cannot be minimized. At the most basic level, the FX reserve diversification play is likely to be negative for the dollar and bearish for U.S. interest rates – mirroring the classic trappings of a current-account adjustment. That, however, is not the only consideration bearing on the U.S. interest rate outlook. The combination of persistently low inflation and a still-likely China slowdown remain important prospective developments on the bullish side of the interest rate equation. Over the near term, I suspect that the balance will now tip more toward the bearish outcome than I had previously thought. Over the medium term, however, I still believe that pressures on longer-term U.S. interest rates will be contained by subdued inflationary expectations and the likelihood of a China-led shortfall in pan-Asian economic growth.

The Chinese leadership has made a wise and prudent adjustment, in my view. The best news in all of this is that a flexible RMB is a big plus for global rebalancing. The peg was a major impediment to this process. My advice is to look at what now lies ahead: Do not focus on the July 21 action as the end, in and of itself. While this first move was small and belated, China’s currency adjustment is emblematic of an endgame that could be a linchpin to long overdue global rebalancing. This is awesome news for an all-too-precarious world.

China’s rebalancing tactic.

China’s long-awaited shift in currency policy is an important milestone on the road to global rebalancing. Yes, the initial 2% renminbi revaluation was small, and, in and of itself, will accomplish very little. But this was not the point of the 21 July action. By finally putting a flexible currency regime in place, the Chinese leadership has removed an important impediment to global rebalancing. That raises the probability of a “benign” rebalancing endgame. China understands that a 2% currency adjustment is only a down-payment on a much larger revaluation. Yet my suspicion is that just as America’s Federal Reserve does not know with great precision what the “neutral” federal funds rate is, Chinese authorities do not have a precise target for the RMB. While that introduces a certain ambiguity to the currency endgame, the good new is that Sino policymakers have finally activated the currency lever as a legitimate tool of macro stabilization policy.

By abandoning its peg, China is sending a clear signal that its “natural” demand for dollar-denominated assets is likely to be reduced. Stephen Li Jen notes that China’s trade weights would imply only a 27% weight of the dollar in the new currency basket; adding in the still dollar-pegged Hong Kong currency would raise the dollar weight to about 50% – well below the current 64% portion that the BIS would impute to the dollar-denominated share of official reserves. Other Asian central banks have also been massively overweight dollars, and they are likely to rebalance their reserve portfolios as well. Dollar diversification could well set in motion adjustments that might prove quite vexing to America’s asset economy. Other things being equal, dollar diversification is tantamount to dollar depreciation. And that raises the distinct possibility that America’s creditors will then seek compensation in the form of an increased interest rate premium. The key in this instance is the pace by which that compensation is provided. While I would attach a low probability to the dollar-flight scenario, I would certainly concede that it should not be ruled out.

An orderly RMB revaluation should not, however, lead to a back-up in the level of U.S. interest rates. That possibility, in my view, is more dependent on domestic considerations such as the U.S. inflation outlook. Nor do I believe that this shift in Chinese currency policy will lead to higher levels of real world interest rates.

All this is good news for the benign strain of global rebalancing. By putting its currency into play, China tempers the threat of protectionism. At the same time, China is now conceding the downside risks to its all-powerful export trajectory, which, in conjunction with an investment slowdown, should temper its overheated excesses. As a result, China’s shift in currency policy could well swing the pendulum of global adjustment back to the U.S., where asset-dependent consumption excesses remain a great source of concern. Spread considerations keep U.S. rates biased to the upside. But I am not yet convinced that the overall level of real U.S. interest rates is likely to rise enough to spark a more disruptive strain of global rebalancing. Given the unprecedented state of global imbalances, that could well be the best news of all.

China’s revaluation: “stability” and “flexibility” are fundamentally incompatible.

It was almost anti-climactic when it came (which is probably how Beijing wanted it to be). And it certainly was not the 5-10% revaluation that Treasury Secretary Snow confidently predicted just days earlier. While on the surface, it appears that China has bowed to intense foreign pressure and growing domestic economic imbalances by replacing its decade-old currency peg to the U.S. dollar with a more flexible exchange rate system that will be tightly managed by the central bank, the move itself is more apparent than real. Speculative pressures will almost invariably be whetted by this move, since it will almost certainly be recognized for what it is: an entirely political event, cleverly timed to make President Hu Jintao’s state visit to Washington in September less contentious. Yu Yongding, a member of the People’s Bank’s monetary policy committee and a long standing supporter of revaluation, said he did not think China would allow dramatic changes in the exchange rate.

The principle is stability as well as flexibility,” Prof Yu said. “We don’t want to encourage speculative capital inflows.” But the paradox is that by introducing limited flexibility, the Chinese may have actually undermined the principle of stability. Ironically, in choosing a period of comparative market tranquility (in part to demonstrate that China could not be bullied by speculators or U.S. politicians), the Chinese have simply revived dormant animal spirits and will therefore likely to have cope with further significant speculative pressures in the future when the inefficacy of the revaluation becomes more readily apparent. Some “gift” to Washington!

Of immediate concern is that the revaluation itself will probably not accomplish anything of substance in the short term, notably alleviating America’s chronic current account deficit and concomitant protectionist pressures emanating from Congress. Tinkering at the edges with a 2.1% adjustment will just cause frustration and rising expectations of a much bigger adjustment to come. And what about Europe? By re-pegging the Yuan to a basket of currencies, including the euro, China has now likely placed itself on the radar screen of the euro zone protectionists who, if anything, are even less wedded to the notion of free trade than their American counterparts. Ultimately, one has to question the scope, timing and methodology of the Chinese move. Perhaps the move does signal China’s willingness to accept the system responsibilities that come with being a leading member of the world economy. But it does not appear that way today. In any event, this story is still in its early days and to judge from the mixed action in the markets, nobody truly knows how this will play out.

China central banker says hedge funds delay yuan convertibility.

China will not make its currency fully convertible for at least 5 years because it worries hedge funds may force the yuan to plunge, much as happened to the Korean won and Thai baht during the 1997 Asian financial crisis, said Li Deshui, a member of the central bank’s monetary committee. “There’s more than $800 billion to $1 trillion of hedge funds in the world and the Chinese financial system is relatively weak,” Li said in an interview. “If the (yuan) becomes fully convertible it would be attacked by these hedge funds.”

SURFING THE TSUNAMI

Last December we watched the devastating impact of a Tsunami. For those living away from the area, what we saw, horrifying as it was, was impossible to grasp. How could so much destruction occur? How could over 240,000 people die from a natural disaster that started from shifting plates on the earth’s floor? How can water top speeds of 500 mph? We heard stories of individuals looking at the ocean as it pulled back hundreds of yards from the beach only to then be totally surprised by the high wall of water that returned. It left the observer no time to prepare. Today, as we look at our financial markets, most of the talk is of comfortable retirements, funded pension plans, and safe Social Security and Medicare Benefits. And yet, as the event of last December has shown, things are not always what they seem and they can change quickly. Now is the time for every investor to ask, “What evidence is there that a major decline could occur in the financial markets and what actions can I take to address any systemic risks?”

As we look out across the exchanges, everything appears calm. The bond market continues the bull that started in the early 1980’s. The Dow Jones Industrials, after dipping below 7200 in 2002, looks to be safely resting on a 10,000 floor. Nationally, real estate has appreciated moderately for years, and substantially in the last few. However, as we look below the happy talk about “how the Dow has held strong above the 10,000 level since late 2003” or “how resilient the American markets are”, we begin to notice that long term investing records are still tarnished by the “downturn” of 2000-2. When we consider that the S&P 500 is still down 10.6% over the 6-year period ending June 30, 2005, or that the Dow is down 3.2% during the same timeframe, then the first signs of concern start to creep into our thinking.

Some dismiss 2000-2 as an aberration that was dealt with by the Federal Reserve lowering interest rates and making credit readily available to help kick start our economy. Most Wall Street pundits and government officials continue to talk about “comfortable retirements” and our “strengthening economy”. If they are right, then we can feel confident that the breather the Dow has taken between 10,000 and 11,000 over the last 19 months is but a pause before it resumes upward movement as reflected by our stronger economy. Articles like this can be dismissed as nothing more than another hair shirt who is worried over nothing because he has read too many gloom and doom newsletters and scary books. If, on the other hand, the information presented is from various U.S. government sources, then we must take the data over the rhetoric and prepare for the wave that is coming. Let us leave the surface statistics and look beneath to see if we can better understand our current situation. We need not look too far. All we need is to go to the trouble of downloading a few government documents.

Like a real Tsunami, these numbers, and the ramifications behind them, are frightening. They could leave us numb and apathetic or we could dismiss this information, thinking our lives have too much stress right now and there is nothing we can do about this anyway. If these are your thoughts, I implore you to start learning from the many great sources about the money game. Do not think, “They are smart and I am dumb”. Until we come to our own conclusions, versus blindly accepting those of others, we are all susceptible to a great deal of risk. We must stop asking, “What was the bottom line last quarter?” and start asking, “What are the chances of losing a substantial amount of my portfolio in the future?”

In 2000-2, I was at the mercy of the market, hoping that the bull market would return. I will never expose those I serve to that risk again. Reading and researching has brought me to the conclusion that markets move in cycles and I must act accordingly to benefit from what comes next. The markets movement is beyond my control. Positioning my clients properly to benefit from the highest probability of what is to come is my job, and even more, my duty. For the thousands who lived near and around the Indian Ocean, they had no warning. Yes, today the warning systems are in place, but only after the tragic event. Fortunately, investors today have a great deal of information warning them of events to come. History warns us to avoid the pitfalls of not heeding its voice.

CALIFORNIA LEAVIN’

One-third of Los Angeles residents now tell pollsters they are sick of their city. The percentage of L.A. malcontents has doubled in only two years, according to polls cited by Anne Taylor Fleming, a local essayist. Of course, one learns to take any poll analysis with a grain of salt. But my gut tells me this one has it right. The radio talk shows in L.A. these days yap constantly about the prices of houses, car commutes that never end and the breakdown of public services. For the 33% of L.A. residents who hate their city and want to move out: Go for it! Now! Yes! There will never be a better year than 2005 in which to sell your house and pick up stakes. Here is why.

RETIREMENT BLUNDER: RAIDING THE 401(K)

A survey, conducted by Hewitt Associates, a global human resources services firm, revealed that 45% of 200,000 individuals participating in 401(k) plans, opted to cash out of the retirement plan after leaving their job. “Our findings show that too many workers are not looking at their 401(k) savings as long-term in nature, but are instead using termination of employment as an opportunity to spend this money,” said Lori Lucas, director of participant research at Hewitt Associates, said in a statement. Besides forsaking a key source of retirement savings, individuals who cash out of their 401(k) before they are 59 1/2, are typically forced to pay taxes on that balance plus an additional 10% penalty.

EXCESSIVE CEO PAY IDENTIFIED AS A SIGN OF TROUBLE

Of 43 companies rated B3 or higher that defaulted between 1993 and 2003, 22 offered their CEOs larger-than-expected bonuses or stock option grants or both, at least once. Of the 214 that had downgrades of three or more rating levels within 12 months, executive compensation was higher than expected in 140 cases, according to a Moody’s Investors Service report. “Companies that pay their executives more than you’d expect tend to default more than other companies,” Christopher Mann, a Moody’s vice president and author of the report, said in an interview Monday.

REAL ESTATE BUBBLE’S FALLOUT? TWO VIEWS

There is a good chance the housing bubble carries severe macroeconomic implications, a point Alan Greenspan disputed in his congressional testimony last week. If prices fall, he said, “they likely would be accompanied by some economic stress, though the macroeconomic implications need not be substantial.” Let’s start with some factoids from Merrill Lynch: 1.) Real estate accounts for 70% of the rise in household net worth since 2001. 2.) 40% of private-sector jobs created since then are housing-related. 3.) Consumer spending and residential construction have accounted for 90% of U.S. economic growth. Merrill’s analysis concluded that 60% of the country is in a housing bubble. I do not see how the other 40% escapes the fallout.

Dean Baker, founder of the Washington think tank Center for Economic and Policy Research, has also studied the housing market. The regions of the country he qualifies as bubbly include the East Coast north of and including Washington, most of the West Coast, and many pockets in between. “The bubble areas are far too large to be explained merely by the fact that they have become more attractive relative to other regions,” Mr. Baker said. He also noted that homebuilders are adding 2 million units annually, far outpacing household formation of 1.4 million. This imbalance may be the bogeyman that pops the bubble despite low interest rates. Maybe the best thing to do is respectfully agree to disagree with Mr. Greenspan and let time render its own decision.

As home prices rise, so does buyer risk.

Sharply rising home prices are making a risky housing market even riskier. Six hot markets now face a greater than 50% chance of price declines the next two years, says a study to be by PMI Mortgage Insurance. Rapid price escalation has outpaced income gains and rent increases, making homes less affordable and increasing the odds of a price correction, PMI found. Mark Milner, PMI’s chief risk officer, points out that even in high-risk Boston, there is a roughly 45% chance prices will not fall. Least-risky city: Pittsburgh (5.6% chance of a price drop).

Doomsday: The final months of the “housing bubble”.

I sold my home three weeks ago anticipating what I believe will be “Economic Armageddon” in the United States. It was not an easy thing to do. My wife and I have lived in the same home for 25 years, raised both of our children there, and owned the property outright without any loans or mortgage. The house was paid for in “sweat-equity”, that is, by wielding a shovel day in and day out in my one-man landscape business. I do not say that for sympathy, but to illustrate that we played by the rules, worked hard, paid our taxes, and took advantage of the American dream of home ownership. All that has changed.

I sold my home for one reason: George W. Bush. He and his protégé at the Federal Reserve have submerged the country into a morass of “unsustainable” debt, disrupted the nation’s economic equilibrium and thrust us towards fiscal disaster. They have also generated a humongous housing bubble through their irresponsible and self-serving manipulation of interest rates.

The facts are astonishing. The current housing bubble is “larger than the global stock market bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stock market bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.” (The Economist, June 16, 2005) The banks have lowered the standards for home loans to such an extent that the traditional loan of 20% down and a fixed interest rate is virtually a thing of the past. Instead, those conservative practices have been replaced with “creative financing” schemes that put the entire housing market at risk. Consider this: In 2004 “one-fourth of all home-buyers – including 42% of first-time buyers – made no down payment.” (New York Times, July 7, 2005)

No down payment?! Sorry, but if a buyer cannot come up with at least $5,000 for a down payment, he should not qualify for a home loan. Equally troubling is the fact that “nearly one third of all new mortgages this year call for interest-only payments (in California, it is almost half)” (NY Times) This tells us that a large number of new buyers can barely make their payments, but are gambling that their property value will go up enough to justify their investment. This is “equity roulette”, a shell game that anticipates that salaries will go up while interest rates stay low. Is that a reasonable judgment?

No, Greenspan has said that he will continue to ratchet up interest rates to head off inflation. This means that an economic slowdown is a near certainty, and doomsday for over-extended homeowners. Greenspan assumed he could carry out his plan without too much unnecessary carnage. Unfortunately, gluttonous mortgage lenders have lowered long-term loans while the prime rate continues to go up. This has upset the Fed master’s strategy for a “soft landing”, and Greenspan has begun feverishly issuing warnings about an inevitable “adjustment” when the market bogs down. The bottom line is that the housing bubble is getting bigger by the day and increasing the potential for catastrophe.

Why would banks foolishly loan money to people who cannot even scrap together a few thousand dollars for a down payment or who can scarcely meet their “interest-only” obligations? The reason is simple: they are not the ones taking the risk. Mortgage loans are acquired by investment banks and chopped up into various securities where they are sold in mutual funds, hedge funds and pension funds etc. To some extent, this takes the lenders off the hook, but it also means that the shock to the system will be much more widespread when the day of reckoning finally arrives. If we encounter a major glitch in the economy the shock waves will be felt throughout the world.

Shaky lending, interest-only loans, no down payments, a U.S. government that is $8 trillion in debt, and a ticking-time bomb of adjustable-rate mortgages that will reset within 3 years – the table is set for a disaster of Biblical proportions. If we hit a bump in the economic road ahead (rising gas prices? recession?) the “Land of the free” will be knee deep in bankruptcies and foreclosures. We will all be fighting for a soft spot under the freeway onramp. The fatuous Greenspan believes that all this can be avoided by regulating the money supply. He is dead wrong, and I bet my house on it.

Booming real estate prices cloud the view from the top.

Reza Doutie commands a stunning view of some of Africa’s most expensive real estate. His two plots in Cape Town’s traditionally Muslim quarter of Bo Kaap offer a panoramic view of Table Bay, the city center and Table Mountain, on whose steep slopes they perch. Mr. Doutie wants to profit from South Africa’s property boom by subdividing the land in his family for six generations to build six houses. But Cape Town’s Muslim Judicial Council has thwarted his plan by issuing a fatwa, or Islamic decree, prohibiting development in the area. The dispute has divided one of Cape Town’s oldest neighbourhoods and shed light on the friction caused by rocketing property prices. It comes as a growing number of economists and policymakers warn of a global housing bubble.

Alan Greenspan has warned of “froth” in some local housing markets in what some see as an ominous echo of his warnings about the “irrational exuberance” surrounding equities in the 1990s. Globally, house prices in some urban markets, including parts of Australia, are beginning to fall. South Africa has seen some of the world’s steepest property price increases in recent years. Prices have risen by more than 20 to 30% a year since 2003. Absa, the country’s biggest retail bank, forecasts another increase of at least 20% this year. Some of the biggest rises have been in Cape Town and the Western Cape province, where prices have shut many potential working-class buyers out of the market and imperiled the land reform programme. Alarmed by the price surge, the government last year convened a working group that is looking at curbing foreign land purchases.

Bo Kaap, a slum area founded by freed slaves from Indonesia, India and Sri Lanka, has for more than two centuries maintained its cohesion and Muslim character. When the apartheid government removed non-whites from the city center under racist “Group Areas” legislation, Bo Kaap’s defiant residents managed to stay put. But gentrification is now doing what apartheid could not as rich whites buy cottages in the area, securing their properties with walls and fences. Bo Kaap adjoins Cape Town’s rapidly changing city center, where 3,000 new apartments, many in office-block conversions, have come on the market in the past two years.

De Waterkant, another formerly Muslim neighbourhood near Bo Kaap, has gentrified in recent years, and is now predominantly white and largely gay. House prices have risen 10-fold or more in less than five years, a sign of things to come say developers for Bo Kaap. Patrick O’Shea, of estate agents Engel & Volkers, said: “Bo Kaap is de Waterkant with way better views and better access to the city. It’s an awesome, awesome location.” But some of Bo Kaap’s new residents have irritated their neighbors by complaining about the call to prayer from the neighborhood’s mosques.

The council issued its fatwa in March after Mr. Doutie sought local authority blessing for his development. Muslim clerics claim the land, and other plots near it, belong to the adjoining Tana Baru cemetery, a holy site that contains the grave of South Africa’s first imam. Mr. Doutie acknowledges his property contains graves, probably victims of a 19th-century smallpox epidemic. But he holds a title deed in his grandfather’s name. The fatwa also covers three other landowners, two of whom want to sell. Other owners in Bo Kaap who have had property for generations are selling, or looking to sell. Osman Shobodien, chairman of the Bo Kaap Civic Association, says he has been beset by real estate agents seeking to sell his house. “Many of us don’t know how many noughts there are in one million rand, not to mention what one million rand looks like,” he jokes. More seriously, he worries that rising property values will drive residents out of the neighborhood as local utility rates are based on property values. Property speculation, he says, is “tearing the community apart.”

Don’t let me burst your (housing) bubble.

After writing an Internet column last month ruminating on the astounding real estate price increases, I received requests from strangers for specific advice about whether or not they should sell their homes in places ranging from Florida to Hawaii. When people ask me whether to buy or sell real estate, then I gotta start thinking about moving to a trailer. One recent newspaper article focused on the real-estate boom in Bakersfield, of all places. Prices there are soaring, with one in four purchases being made by an investor. I suppose those investors are hoping there is always a bigger sucker, willing to pay even more for that house. Maybe these investors are on to something. Home prices have basically tripled in six years in Orange County, with the median now topping $600,000. Hey, this can go on forever, can it not?

Then again, only a tiny percentage of local residents can now afford the median-priced house. With a 30-year mortgage at 6.25%, 20% down, the borrower would have to pay about $3,600 a month in principal, interest, taxes and insurance. What kind of income supports that payment? And who has 120 grand lying around? Even with creative financing, that house is costly. Equity-rich Californians are swarming all over Western housing markets, hoping for another market to double or triple. It is a feeding frenzy in the loneliest towns. Someday, someone is going to wake up and wonder why he has a $300,000 mortgage on a ranch house in Brawley.

Go to Realtor.com, a useful Web site that gives prices on houses for sale in markets across the nation. Orange County will always cost more than Nowhere, Kansas, at least until the Big One hits. But in small cities near my wife’s Appalachian hometown, you can find pages of single family houses for sale under $20,000, with structurally sound houses on the market in the $6,000 range. How is that for perspective? This is a market. Home prices usually go up, and are good investments in the long haul, but they can go down. Plus you have got to feed the beast: pay utilities, make repairs.

Remember columnist Jim Glassman’s prediction in 1999 of a 36,000 Dow? Well, keep that in mind as some experts predict median home prices over a million bucks. Esmael Adibi, an economist at Chapman University, is no pessimist, but he sees trouble in the housing market. Current prices, he says, are driven by psychology and easy credit.

People are spending wildly on remodeling and flat-screen TVs, buoyed by the feeling of wealth they get from soaring home values. What happens when they are feeling low about their declining equity or increasing debt? Others say there remains too little inventory, continuing job growth and the enduring appeal of Southern California. Demand is still greater than supply. No end in sight. Perhaps, but I am worried. As the onetime owner of a house in Tennessee that I could not unload, I can attest to the amount of pain that burden can cause in one’s finances and even in one’s family when one is stuck with an expensive, hard-to-unload asset. I am not trying to burst anyone’s (housing) bubble here. I am only making the case for a little bit of caution. Then again, I would not bank too much on my real estate advice.

NEXT GENERATION LEARNING OUR BAD SPENDING HABITS

Hectic lifestyles and the changing nature of money have made it more difficult to teach the basics of finance to our children. It is a world that blurs the distinction between spending and saving. “Buy Now and Save!” the ads say, as if buying and saving are on the same side of the equation. By definition, buying is the absence of saving. I am, perhaps, over-simplifying the financial arrangements of my youth, but they contained basic lessons of savings and self-denial. One was that a good deal waits for you. Another was that a low price is not a mandate for purchase. Or more to the point, if you do not have the money, you do without.

Not anymore. Not in an age where our leaders embrace deficit spending, and lenders charge us higher rates for not going into debt. Instead, we spend money we do not have while our children watch and learn. The lure of the impulse suppresses cold analysis. We live in a world of rebates, instant savings, limited-time offers and rewards programs that promise us cash back based on what we spend. We get what we want, when we want it, and we pay for it years later at 19% interest. If we cannot teach our children the lessons of sound money management, who will?

GREENSPAN HINTS AT RISK-FREE TRADE IN TREASURIES

It is not often that Alan Greenspan hints at a risk-free profit opportunity in the bond market. The central bank chief’s remarks last week about monetary policy, the economy and the yield curve can be interpreted as signaling the kind of trade that used to be called a no-brainer when low-hanging fruit seemed easier to pick. Greenspan said that sustaining growth and keeping inflation subdued “will require the Federal Reserve to continue to remove monetary accommodation.” With the U.S. central bank driving up its key lending rate at every meeting, 2-year yields look set to climb in tandem, driving down their prices. At the same time, 10- year bond values are likely to gain as higher borrowing costs restrain future consumer-price increases.

That is boosting the likelihood that 2-year yields will be driven higher than those on 10-year bonds, producing what is called an inverted yield curve in the U.S. bond market. It is hard to draw any other conclusion from Greenspan’s remarks. He repeated the Fed’s mantra that rates may rise “at a pace that’s likely to be measured,” suggesting that the nine consecutive increases since June 2004 that have driven the overnight lending rate to 3.25% are far from being the last. That prompted David Rosenberg, the chief economist for North America at Merrill Lynch in New York, to raise his forecast for where Fed funds are headed by the end of the year to 4% from 3.5%. “In addition, the risks that the yield curve flattens/inverts by year-end have risen materially,” he wrote in a research note published earlier this week.

So 2-year yields look poised to extend the climb that has driven them almost 90 basis points higher this year, to about 3.95%. Investors seem disinclined to demand anything more than about 4.25% for lending to the U.S. government for a decade. By selling the current 3.625% note maturing in June 2007 at a yield of 3.95%, and buying the 4.125% bond repayable in May 2015 yielding 4.25%, you would make $1,351 on a $1 million trade if yields are unchanged until the end of the year, Bloomberg analysis shows. Your profit climbs to $5,653 if the 2-year yield rises to match the current 10-year rate by Dec. 31. You make more than $24,000 if the yields match in the opposite direction, with the two-year unchanged while the 10-year level declines to 3.95%. And if the curve inverts by 30 basis points, with the two yields swapping places, you make almost $29,000.

Of course, it is not really risk-free. You lose more than $3,000 if the bet goes wrong even by 5 basis points in each direction, should the two-year yield drop to 3.9% while the 10-year climbs to 4.3%. Set against those potential losses is Greenspan. In these days of low yields, low volatility and skimpy returns everywhere, trade recommendations do not come much better than that.

A PARABOLIC RISE, NOW AT THE “VERTICAL” POINT?

“Parabolic” price moves are uncommon in the financial market averages. They are confined mostly to commodities, where the emotional temperatures run naturally higher than in the stock and bond markets. Still, there are rare occasions when a parabolic price rise does indeed unfold in an equity index. For example, the blow-off into the NASDAQ’s all time highs, when March 2000 alone saw a net $13.8 billion flow into tech stock funds. The parabolic “signature” was unmistakable, just like we learned it in geometry class: prices curve so steeply upward that the line eventually looks vertical. Yet in the financial markets, the parabolic pattern includes a sudden reversal that falls with at least the same speed as the rise.

My point, of course, is to introduce a parabolic rise that we have identified in an equity index, one which now looks to be at the “vertical” point of the pattern. This move is immense both in the time it took to develop (five-plus years) and in the percentage gains to date (928%). The Short Term Update has the chart of this equity index, and you will understand it at a glance; in fact, the index sector will not surprise you.

A parabola then, a parabola now.

From early February 2004 to late March 2004, a parabola in the “poor man’s gold” rocketed prices up 43% to hit a 16-year high. The slope of the rise began as a curve and finished like a ruler, propelling bullish sentiment among silver investors its second highest level in over 15 years. The mainstream news stories at the time were equally parabullish: “Silver is in the early stages of a major bull run.” … “Silver has found new life.” … “Silver has a good wind behind its back.” … “Silver prices are rising like a helium balloon caught on a steady breeze of bad news.”

But in the April 2004 Elliott Wave Financial Forecast (published March 26), our recognition of parabolic price patterns prompted us to go on high alert for silver’s southbound future. An excerpt from our analysis: “Silver often ends major rally legs in a blowoff just this one. It did the same in February 1998, April 1987, and most famously, in January 1980. The initial reversal leg of from this parabolic rise is likely to be just as violent as the final move up into the high.”

This chart of silver prices captures the ensuing trend reversal like nothing else: On March 29, silver’s parabola-landslide began, plunging the white metal 36% into the red in less than two months. Bottom line: Parabolic price rises precede steep and sudden declines. The key is identifying the completion of the uptrend before the turn begins. Because of this unique signature, parabolas therefore offer traders one of the safest and significant opportunities out there.

And it just so happens that the parabolic John Hancock has appeared in the prices of another major financial market. As the July 25 STU observes: “After bottoming in 2000, this index has started a parabolic rise that has carried price 928% higher.” With bullish sentiment toward this sector firmly in place, our analysis can only lean in one direction, one our labeled chart of the index makes plain. You now know how that story should go. What you may not know is this: the implications of this particular market turning down could very well change the face of economic history.

Okay, I did not wring my hands … but those indexes are lower.

The headlines this week have twice delivered “positive” economic news: Monday’s report of record-high home sales (2.7% in June), then today’s reported rise both in new home sales (4%) and durable goods (1.4%). Naturally, today’s late-afternoon articles said that the “surge” in the major stock averages flowed from “optimism” surrounding this economic data. Yet a curious thing happened on the way to confirming the connection between the positive news and the stock market surge. It was my bright idea to think that, if the overall market went up on home sales and durable goods, then of course the stock indexes of those particular sectors should go up even higher!

So imagine the hand-wringing dismay I felt upon seeing that the DJ Home Construction Index and the DJ Durable Household Products Index were BOTH DOWN this week – the latter by nearly 5%. Okay, I did not really wring my hands – but those indexes are indeed lower over the past three days, which once again shows the “news drives the market” idea to be complete rubbish.

On the other hand, could there be a deeper reason that these sectors are lower despite good news about their industries? We believe there is. The July 25 Short Term Update presents a mind-blowing chart of the home building sector, complete with commentary and analysis about the potential opportunity we see unfolding.

ARE YOU BUYING WHEN EUROPEAN MARKETS DIP?

European stocks are red-hot. They have been rallying continuously for almost a year now, and none of the recent troubles in Europe – not the negative EU Constitution votes nor the London bombings – have slowed them down, to most everyone’s surprise. To boot, July saw the highest number of IPOs and the most money raised through them on the London Exchange since November 2000. Of course, back in 2000 tech stocks were all the rage. Now, it is online gambling sites that are going public. One such website raised so much money at its London IPO this month that its current market capitalization allows it to be listed among the FTSE 100 stocks – the blue chips of the UK stock market. The second biggest July IPO also went to an “online gaming industry” firm. The faces of the market’s biggest players are changing, and it is only fitting that gambling companies are getting all the cash. (We have commented before on why we think people are flocking to gambling these days.)

But in every market, no matter how “resilient” it seems in the face of bad news, there are always some valleys between the peaks. That is why one wildly popular investment strategy in the late 1990s was to “buy the dips”. It worked like a charm in the good old bull market days because every dip was followed by another rally to a new high. But from December 1999 until March 2003, the trend in the FTSE-100 was down. “Buying the dips” during those three years was suicidal because every counter-trend rally would only lead to a new decline. During that period, the more nimble European investors who were not afraid to short the market learned the opposite technique – “selling the rallies”. They also did well for a while … until that trend changed too, in March 2003.

From March 2003 until the present, the FTSE-100 has been advancing again, and every dip was followed by a stronger bounce. Twice in 2005, the FTSE recovered quickly from sharp declines. And investors again are starting to see market dips as buying opportunities. But given the length of the advance in European stocks, here is a wise question: Are we seeing a new bull market with a lot more potential left, or is it just a long bear market rally? We think that the rebound from March 2003 in the FTSE is approaching an “interesting” price juncture. Two indicators suggest a strong potential for trend change not very far ahead. So if you have been “buying the dips” lately, find out how much longer this strategy may pay off.

HAVE THINGS IN THE DEMOCRATIC REPUBLIC OF CONGO (FORMERLY ZAIRE) FINALLY HIT BOTTOM?

One of the bloodiest wars in history has turned a potential economic powerhouse into one of the world’s 10 poorest nations. Here is the kicker: the fortunes of this country look to have turned the corner, yet the investment community has no idea. This war, which officially ended in 2002, was the world’s deadliest since the Second World War: 3.8 million people were killed. Nine nations were directly involved in the fighting, as well as over 20 distinct armed groups, which make this the widest interstate war in this continent’s history. For perspective, 300,000 died in the Balkans as Yugoslavia split up. In the second Gulf war, still in progress, the body count is less than 30,000.

They call it the African World War and it took place in the Democratic Republic of Congo, formerly known as Zaire. DR Congo is a very rich and fertile country. It is the size of Texas, California and Alaska combined. It is loaded with natural resources, including large deposits of copper, diamonds, tin, silver, gold and tungsten. More importantly, DR Congo’s climate is one of the wettest in the world, which means anything will grow, including cash crops like coffee, rubber and cocoa. But in DR Congo’s case, these resources are a curse; they are the only things in DR Congo worth fighting for.

I decided to bone up on the DR Congo’s history after reading Jim Rogers’s 1994 book, Investment Biker, again last week. In the book, Jim rides around the world on a motorcycle, observing and analyzing every country he visits from an investing perspective. He is very good at this. His analysis is interesting, well thought out and ten years later, many of his predictions have come to pass. Back to the Democratic Republic of Congo… When Rogers rode through there in 1994, the country, then called Zaire, was a mess: “Not only was city after city in ruins, but also the farms, plantations and ranch houses we passed; vast amounts of capital and energy and lives tossed away by careless Zairians. … Zaire hasn’t had its final civil war yet. That horror will come as local chiefs and barons snatch at the country’s wealth.”

Rogers’s prediction came true. Zaire plunged. But this was not warfare. This was wholesale massacre. These conflicts contained some of the most horrific war crimes ever witnessed. Gang rape, genocide, AIDS, amputations … the weapons of this war were as devastating as any nuclear bomb, if not more so. In the midst of war, one of the world’s potentially wealthiest countries had been reduced to one of its poorest. “As an investor, I wait for until the wars are fought, the borders are redrawn and the newly elected governments are eager to make something of the country’s resources,” Rogers concludes his chapter on DR Congo, “Here there ought to be a period of stability once the borders are redrawn and Mobutu is gone. That would be the time to pile in.”

Now Mobutu has gone and the power-sharing administration, agreed to by the different factions in the country’s civil war, is about to be replaced by a democratically-elected government. Yesterday, Reuters reported that voter registration has started in two provinces outside Kinshasa, as DR Congo prepares for elections in 2006 and its first democratic government in 40 years. If the DR Congo has not already reached rock bottom, it cannot be far away. Maybe time to pile in…

GREENSPAN ERA’S LEGACY: LESS SAVING, MORE DEBT

Economic prosperity under Fed Chairman Alan Greenspan has changed the way Americans handle their finances. Encouraged by rising home and stock prices, they have taken on more debt and saved less. Managing risks from that legacy may be one of the toughest tasks for whoever eventually replaces Greenspan when his term expires Jan. 31 after more than 18 years at the Fed. “The American economy is in a very precarious position,” Joseph Stiglitz, a professor at Columbia University in New York and winner of the 2001 Nobel Prize in economics, said in an interview. “We have a very high legacy of debt. That is what his successor is going to have to deal with.”

Consumers have come to expect long periods of prosperity and the soaring asset prices that accompany them. The result of this unbridled optimism ranges from house prices that have risen 50% since 2000 to the lowest savings rate in more than 70 years. Fed officials including Greenspan already are stepping up warnings that households and the markets financing them may have been lulled into a false belief that asset gains and moderate business cycles are guaranteed. “Long periods of relative stability often engender unrealistic expectations of its permanence,” Greenspan said in his written semi-annual testimony before Congress last week. That can lead to “financial excess and economic stress.”

The investor and consumer attitudes that Greenspan frets about are in some ways the result of his own success. Fed policies wrenched down inflation, leading companies to compete on efficiency gains. Incomes rose, unemployment fell, and the central bank’s rate cuts kept two recessions to just eight months each. Household wealth boomed as long expansions pushed stock indexes to records, and the low interest rates of the past three years accelerated purchases of durable goods. “The precautionary motive to save has been reduced,” says Lou Crandall, chief economist at Wrightson ICAP in Jersey City, New Jersey.

Consumer spending accounted for more than 70% of the economy every year starting in 2002, the most since the end of World War II. Household saving fell to just 1.3% of income in 2004, the lowest since 1934, and below the averages of 5.1% in the 1990s and 9.5% in the 1980s. Debt is becoming an ever-larger burden. A Fed measure of estimated payments of mortgage and consumer debt stood at 13.4% of household disposable income in the first quarter, the highest since records began in 1980. Behind it all are buoyant asset prices that raise perceptions of wealth. Household net worth, a measure that subtracts debt from assets including real estate and stock portfolios, averaged 5.57 times personal disposable income for the decade ending in 2004 compared with 4.41 times for the 10 years that ended in 1994.

HEDGE FUNDS FLOURISH DESPITE POOR PERFORMANCE

Poor hedge fund performance in the first half of 2005 has not slowed the flow of money coming into the industry, the trade publication EuroHedge said. A survey carried out by EuroHedge showed a record 150 new European hedge funds raised more than $13 billion in the first six months of the year, compared with 128 new funds and $9.5 billion a year earlier. Analysts had thought that investors would be put off by weak average returns of 1% to 2% in the first half, compared with around 3% a year earlier. Average hedge fund returns are expected to fall to between 5% and 7% this year compared with 7% and 9%in 2004.

Hedge funds try to deliver absolute, or real, returns as opposed to relative returns based on benchmark indexes. Traditional fund managers normally track benchmark indexes and must keep most of their assets in the market even when prices are falling, one of the reasons many investors lost large amounts of money during the 2000 equity crash. Hedge funds can withdraw completely from markets if they want and put all their money on deposit, so that they at least earn money market interest rates. They can also use derivatives and short selling to manage investment risks. A significant change this year is the number of larger hedge fund start-ups. In the first half of the year, there were five new funds with assets of $1 billion or more. In all of 2004 there were just two.

A CARBORUNDIUM – HOW TO HEDGE A RETIREMENT?

This commentary is about the possible ways to hedge a retirement. For those readers who question the title, please consider that the Optimist strives to provide an inspirational and uplifting positive message in each of his writings. Today’s message is Illegitimus Non Carborundium. That roughly translates to “Don’t let the bastards grind you down!” Although he admits that this is a weird title, he is happy that it worked to capture your attention for a few moments. The Optimist trusts that readers will not be too abrasive with him.

A person who either recently has or soon will retire has a vested interest in the equivalent of a substantial amount of equity. It is reasonable to expect the company providing the retirement benefit to handle that equity with care, and to take steps to protect most of the value of the retirement equity from obvious concerns, such as a modestly rising rate of inflation. If one anticipates a possibly substantial and potentially abrupt change in the financial force field which impacts on that equity, however, then it might be reasonable to consider supplementing the protective envelope that surrounds the retirement equity. As with most true hedges, the focus is not on investments which offer additional profit potential, but rather to essentially purchase an insurance policy that returns a portion of the equity that would have been lost due to events which cannot be otherwise controlled.

There have been many unfortunate instances in which a company went bankrupt and the employees lost much of the retirement equity they expected to receive. That is a nightmare which not even the Optimist can present a positive perspective about. For this discussion, however, we can contemplate a much brighter prospect. Let us consider a company that will pay the retirement benefits, and that has zero risk of any problem that might negatively impact the ability of that company to pay all agreed benefits, in full and on time. For example, assume for this discussion that a hypothetical corporation has a monopoly on and manufactures really expensive little widgets which the entire defense establishment adores. Obviously, there will never be a slowdown in that company’s earnings, and its promises to pay a defined set of retirement benefits are as safe as anything can be in this troubled world.

So why would one waste time and energy worrying about the defined set of retirement benefits which our hypothetical company will certainly pay? The answer is that there are potential risks which are not covered by the company retirement plan. As one simple and relatively slow example, the retirement payments will be indexed to increases in the CPI. Consider the impact if the CPI does not move up as fast as the real cost of living, as the Optimist considers likely. The difference between the higher costs due to more rapid rises in real inflation, minus the lower gain obtained by indexing the retirement benefits to a slower rising CPI, would be a consistent net loss of purchasing power.

A helicopter symbolizes the concern. If on a bright and clear day the sky darkens because the sunshine is blocked by millions of freshly printed hundred dollar bills fluttering aimlessly down from a fleet of helicopters chartered by the Fed, one might reasonably be concerned about the purchasing power of a few hundred dollar bills obtained by cashing a retirement check the following week. Perhaps the most rapid risk could be visualized as a herd of large elephants all trying to exit through a small fire door at the same time. That pachyderm pandemonium is similar to the chaos that would ensue if the USA’s creditor nations all panicked and tried to dump their trillions of dollars and bonds simultaneously. For a few days (would you believe years?!) after that financial meltdown, it might be difficult to exchange a retirement check for anything edible.

It is time now for specific nuts and bolts answers! Buy more silver and gold. That seems to pass most of the “Does it walk like a duck?” test. If the retirement value is lost, or other investments deteriorate, or the house is destroyed, equity will remain in the gold and silver, and that equity would be easily available to use for financial reconstruction. The annual costs of owning silver and gold are relatively low, the value of silver and gold will probably rise faster than inflationary increases in costs, and silver and gold will still be there for you when many companies are fighting for position at the take a number machine outside the bankruptcy courts.

Since we are all close friends, the Optimist can confess that he did briefly harbor another thought. If the coming bad times will coincide with rising long term interest rates, then a simple hedge would be to sell short a T-Bond future, and to subsequently just roll it forward. As with most simple solutions, however, his one has a potentially fatal flaw. Long term rates might not drop! Despite rising real inflation and a world wide economy that is booming (that description mostly applies to Asia of course), long term rates have persistently declined instead of rising as would be rationally expected. To paraphrase Keynes, market insanity can be an asphalt roller if you let your finances be the pavement.

Send us your baby boomers, states plead.

More states are trying to recruit retirees – and the money they bring – by promising an affordable paradise within their borders. This month marks the first time oldest members of the baby boom generation can make penalty-free withdrawals from retirement savings accounts. States such as Alabama, Florida, Louisiana, Mississippi, West Virginia, and Wyoming have taken note of the impending retirement of the post-World War II population bulge and are ready with Web sites, guidebooks and tax breaks to try to lure well-off retirees to relocate.

While people tend to pay less in income taxes and demand more taxpayer-supported services such as health care after they retire, those with the wherewithal to relocate are a different breed and can be an economic boon for states, researchers said. More than half of migrating retirees in 2004 reported incomes over $60,000, and 25% had incomes over $100,000, according to U.S. Census data. “Migrating retirees pay more in taxes than they will cost in services. That’s the main reason states are interested. They can increase the tax base without increasing the tax rates,” said Mark Fagan, a professor at Jacksonville State University in Alabama and an expert in retiree recruitment.

A higher percentage of baby boomers are planning to relocate than did previous generations, Fagan said. Affluent seniors are like permanent tourists in their new states, enriching communities and bringing up the standard of health care and services, Fagan said. Overall, baby boomers will wield $2 trillion in buying power by 2007, according to AARP. Many states advertise financial benefits to relocating. More than half the states with a broad-based income tax give exemptions to seniors. The largest breaks for seniors are, in order, Michigan, Kentucky, Georgia, South Carolina, Hawaii, Indiana, Idaho, Oregon, Wisconsin, Connecticut and Illinois, according to a study by the Center on Budget and Policy Priorities.

But income tax may not be the only consideration. Taken together with sales, gas, car and real-estate taxes, plus vehicle licensing and registration fees, the best states for retirees’ pocketbooks are Hawaii, Wyoming, Delaware, Alabama and Louisiana, according to Bloomberg Wealth Manager’s June 2005 ranking of wealth-friendly states. Bloomberg compared tax bills facing retirees with identical tax profiles and found the least tax-friendly retirement state was Texas, followed by Missouri, Minnesota, Illinois, and Maine.

NEWS IS GOOD … DOLLAR FALLS ANYWAY?

“The dollar retreated against the euro on Wednesday despite the release of stronger than expected US data.” (Financial Times) Yes, folks. A stellar U.S. durable goods number came out, and what did the dollar do? It lost over 100 pips to the euro – when it “should have” gained. Those who say that markets are rational should try to explain this one. And boy, have they ever tried.

Some said it was EURUSD’s “fall below $1.20 that triggered buying.” Well, in the past 24 hours, EURUSD dipped below $1.20 at least 7 times. The 8th and final time was at 5 a.m. today. Come on, if it took 8 violations of the $1.20 mark to finally “trigger buying”, could that really be the reason for this morning’s rally? Another explanation for this “counterintuitive move” was a possible “central bank intervention”. Maybe. But the bottom line is, none of these guesses will help you position your trades next time a durable goods number comes out. The fact remains: Forex speculators lost money this morning if they bought USD upon hearing the “good news”.

Oil prices: “supply worries” vs. psychology.

A major financial Web site today ran a headline about the stock market rally which said, “Street On High Note”. Yet just above this headline was a “Bulletin” across the screen, and in smaller type it said “Crude-Oil Futures Top $60 a Barrel.” This juxtaposition led a colleague of mine to quip: What happened to the oil/stocks connection? What happened indeed. How many times this year has the media repeated the “oil up, stocks down” formula? As for “why” oil prices themselves were higher today, here too it was the same “worry about supplies” nonsense being recycled. In the face of repeated nonsense I can only repeat the facts: there is no supply shortage in oil. And at the risk of further repetition still, I will say that the explanation for rising oil prices lies elsewhere.

Prices in a freely traded market are always a function of what the seller asks and what the buyer bids. Innumerable factors will affect the psychology of the buyer and seller – yet when their minds meet, you get a price. And make no mistake: that meeting of those minds is, above all, psychological. That psychology unfolds in recognizable patterns. One week ago Specialty Services editor Steve Craig was NOT thinking about “supply worries” in his energy analysis. Instead, he was thinking about what really matters, namely the psychology of the market as reflected by the price patterns.

A LOW VOLATILITY ENERGY PLAY

High volatility and restful nights just do not go together. We like restful nights, which is why we are intrigued by BlackRock Global Energy and Resources Fund (NYSE: BGR). A little bit of volatility is tolerable, perhaps even exhilarating … but a little bit goes a long way. Therefore, we are forever in the pursuit of investment ideas that hold out the possibility of producing a positive return, but do not subject investors to harrowing ups and downs. We rarely find them, but we always search. A successful stockbroker who shares our affinity for low volatility – and who is also very accomplished at producing superior returns for his clients – mentioned BlackRock last weekend.

It is a fund with a very heavy weighting in high-yielding resource stocks. So the idea is that it pays a nice current dividend, while also providing plenty of upside to the resource bull market. This 7-month-old closed-end fund trades for a 10% discount to net asset value (NAV). In other words, every 90 cents spent to purchase the stock controls one dollar worth of assets. Although a 10% discount to NAV occurs frequently in the closed-end fund world, we always appreciate availing ourselves out of this “free” leverage. None of its top five holdings, for example, appear in the Goldman Sachs Global Natural Resources Index. The Goldman Index, which trades as an exchange-traded-fund under the symbol “IGE”, holds stocks like British Petroleum and ExxonMobil as its largest positions. Not so for BGR. It holds lesser-known securities like Enterprise Products Partners and Teppco Partners among its top five holdings.

The fund’s marketing materials provide no clue whatsoever about its unique investment approach. A quick peek at the portfolio, however, reveals that the fund gains exposure to the resource sector in very creative ways. It emphasizes high-yielding stocks like “master limited partnerships” (MLPs) and “investment trusts”. Both of these structures convert operating assets like pipelines or coal terminals or oil fields into utility-like vehicles that pay high dividends. BGR’s top five holdings, all of which are MLPs, pay an average dividend of 5.8%. Thanks to BGR’s heavy weighting in these high-yield resource stocks, the fund pays an annual dividend of 6%.

However, despite the fund’s many utility-like holdings, it is hardly a stodgy performer. Since May 16, when the most recent rally in resource stocks kicked off, BGR has delivered a total return of 18%, compared to 23% for IGE – a smaller return to be sure, but achieved with much lower volatility. And that is a good thing.

IN ROYALTY WE TRUST (BUT TAKE A CLOSE LOOK FIRST)

Even though we believe the big bull market in natural resources is going to flourish for many more years, nothing goes up in a straight line. So we do not mind receiving some steady dividend income along the way. Royalty trusts, also known as income trusts, convert operating assets like pipelines or coal terminals or oil fields into utility-like vehicles that pay high dividends. The primary goal of the trust is to provide long-term income to the unit holders, rather than capital gains. To that end, income trusts distribute most of the cash flow generated by the income-producing assets they hold. There are many types of income trusts. The most well known are probably REITs (real estate investment trusts) and oil and gas trusts. There are also specialty trusts involved in many different businesses, holding a wide range of assets.

The Pembina Pipeline Income Fund (Toronto: PIF-U), for example, operates oil and gas pipelines, Westshore Terminals Income Fund (Toronto: WTE-U) operates coal terminals in British Columbia, and Algonquin Power Income Fund operates hydroelectric facilities in Eastern Canada and New York. Or, if investing in canned sardines, fish meal and fish oil appeals to you, The Conners Brothers Income Fund (Toronto: CBF-U) provides a means of doing so. In short, there are almost as many sorts of income funds as there are industries. Investors may buy or sell income trusts just like any other stock. While income trusts can offer significant capital gains under the right circumstances, their historic attraction has been yields.

On the face of it, therefore, an income trust paying out substantial yields looks like a great deal. But there are real risks to think about, and a few key points to consider carefully before investing. The first point of consideration is the long-term outlook for the underlying assets of the trust. In other words, do the assets and/or business model of the trust ensure the trust’s ability to thrive at least another 10 years down the road, if not longer? Or is the payout ratio self-destructive?

U.S.-based energy trusts are designed to produce until reserves run dry and then call it quits. On the other hand, Canadian energy trusts – widely known as “CanRoys”, shorthand for Canadian royalty trusts – are allowed to extend the life of the trust through acquisitions or exploration. As the reserve life of current assets depletes, many CanRoys will issue additional shares to fund expansion. This activity can dilute value quickly if the new purchases are not made wisely. If production in the new areas is below previous standards, or more expensive to operate or too costly a purchase, then unit values and cash distributions are both likely to suffer. Some investors are skeptical of the energy trust business model purely because of depletion concerns. In reality, though, traditional oil and gas stocks have to deal with a similar issue. Therefore, when it comes to income trusts generally – and energy trusts in particular – there are certainly a lot of concerns to address. But then again, the same story holds true for an investment in common stock or corporate bonds.

On the positive side, because these issues come down to quality of assets and quality of management, a well-run energy trust can be a sound investment. A quarterly or monthly dividend can provide income where many speculative E&P (exploration and production) stocks would offer none, and there is still room for upside appreciation as energy prices rise in the long term. Because of their commitment to distribution, energy trusts are not quite as volatile as E&P companies that retain all earnings (though the level of volatility for anything related to energy these days can still be significant). All else being equal, we favor the CanRoys that retain a large portion of their cash flow to fund future investment.

In order to survive and thrive for the long term, most businesses need to reinvest a portion of the cash they generate. If all the cash is paid out to shareholders, the business will eventually weaken and die. Because they are focused on cash distribution, income trusts typically pay out anywhere from 50–90% of earnings, and sometimes more, to shareholders. There is thus real risk of the underlying business spending itself into oblivion. If the income trust is treated as a cash cow, rather than as an ongoing concern, then the cow is in jeopardy of being milked dry. This is why an attractive yield is only the tip of the iceberg. An income trust boasting a juicy short-term return may look great at first glance, but horrible on closer inspection. If the underlying business is throwing off cash to shareholders but slowly being ground down by lack of reinvestment, returns could suffer sooner rather than later, sending the trust into a downward spiral. Given the concerns and potential pitfalls, “reaching for yield” without examining key factors could be dangerous.

“Wild Bill” Peyto’s legacy.

Ebenezer William “Bill” Peyto was a very unique individual, which is part of what made him such a superb mountain guide. The royalty trust that bears his name is also quite unique, which is part of what makes it such a compelling investment. “Wild Bill” Peyto, the legendary mountain guide, trekked throughout the Canadian Rockies like they were his own backyard. Like many an outdoorsman, he valued his personal space. One particular Saturday night, Peyto walked into a crowded Banff hotel with a live lynx strapped to his back. A few moments later, he found himself alone in the bar … just the way he liked it. Although he died in 1943, Peyto continues to actively explore Alberta’s Central Deep Basin today. Not Wild Bill’s ghost, but rather his namesake: Peyto Energy Trust. And much like the original character, Peyto Energy is bound and determined to distance itself from the rest of the pack – with an eye for producing legendary profits over time.

Recently, Peyto Chairman Ian Mottershead gave a presentation at the CIBC World Markets Energy Trust Conference. His remarks highlighted a few of Peyto’s characteristics: 1.) Peyto Energy Trust has a market capitalization of about $2.5 billion, putting it among the largest trusts. 2.) Directors and senior officers own about 21% of the units. The insider trading record shows a long string of buys, and sales virtually only to pay taxes. The smallest Peyto investment by a director is about $5 million. 3.) Peyto distributes about half its cash flow and grows at a substantial rate with the other half. 4.) Peyto’s assets are concentrated in the Central Deep Basin of Alberta – considered to be the province’s premier gas exploration area. 5.) As at the end of 2004, Peyto’s reserve life was a long 12.2 years “proved” and 17.2 years proved plus “probable”. 6.) Peyto’s growth has come entirely via the drill bit, and not by acquisition.

Because Peyto distributes only 45–50% of its cash flow to unit holders, Peyto produces an annual dividend of about 2.6%, which is lower than what most other royalty trusts. But the modest dividend payout facilitates Peyto’s sustainable business model. Rather than spending down the reserves or just trying to maintain the status quo, Peyto is actively building for the future. This is not an easy thing to do: Many income trusts promise “income plus growth”, but very few actually deliver. Peyto is one of those few. “In order to use reserve life as a measure of sustainability,” Mottershead explains, “you need to account for the payout ratio. If the trust is paying out all of its funds from operations to the unit holders, then the payout ratio is 100%. When you adjust the reserve life for the payout ratio, you can clearly see how much more sustainable the Peyto model really is.”

By keeping distributions in the neighborhood of 50% and investing the other half of cash flow for solid, long-term growth, Peyto has successfully extended its payout-adjusted proven reserve life to more than 20 years, as compared to just over 10 years for its closest competitors. This level of sustainability ensures asset valuations will remain rock solid, giving Peyto more long-run exposure to the positive trend of rising energy prices. If other trusts with unsustainably high payout ratios are a “yield grab” in the short term, then Peyto is a solid value play on energy for the long term.

HAUTE COU-TORMENT, THE “DARK SIDE” OF FASHION

Put on your comfortable walking shoes. It is back-to-school clothes shopping time again. And don’t say we did not warn you because the duds coming off the new fall line look more like they were designed by Darth Vader than Donatella Versace. Fashion has gone over to the “dark side”, and we are not the only ones who have noticed. On June 10, a Wall Street Journal column met the matter head on with this observation: “After more than three years of pushing bright colors, bold prints and femininity in fashion, designers are heralding the return of basic black for fall. Banished to the back of closets for much of the new millennium, black came barreling back down the runways of Milan and Paris in February and March.” And, from the catwalk to the clothing racks, retailers such as Neiman Marcus are doubling their orders from last year for black dresses and jackets in an effort to “boost sales”.

What is more, the growing trend from light to night can literally be seen from head to toe as a June 13 WSJ article reveals: “Lately, being brunette has gained a new chic.” A long line of fair-haired Hollywood starlets have turned heads with new, darker dos of late: Renee Zellweger, Charlize Theron, and Nicole Kidman, to name a few. Of course, this is not the first time high culture has toned down its color palate.

The June 10 WSJ article also presents a detailed graph recounting the rise and fall of black-hues in American fashion, When “mourning becomes elegance” AND when it becomes endangered. Comparing the dates with the trends of U.S. stocks at the time, the connection is clear: The rise and fall of black hues in American fashion moves in sync with the rise and fall of black times in American financial markets – which are the ultimate consequence of a downturn in mass social mood. This is precisely why the October 2003 Elliott Wave Theorist presented this forecast for the years ahead in popular apparel: “Concealment” and “drabness” will replace “friskiness” and “daring”, “hemlines will fall, and bright colors will go out of style.”

“The transition to darker tones is underway,” observes the July 2005 Elliott Wave Financial Forecast. The question is: will fall fashion 2005 mark the end of the trend in houte cou-torment AND the beginning of a brighter market in stocks?

HOME SALES: FINANCIAL VS. ECONOMIC BEHAVIOR

If the pace of sales of previously owned homes in the U.S. hit a new record last month, does that mean people will keep paying more for them? Depends on whether you view a house as a financial investment or a consumable product. Generally speaking, when supply of a certain item goes up, the price comes down. But not so with houses, it seems. The National Association of Realtors reported that previously owned homes sales climbed 2.7% in June, as the prices for these homes zoomed up 14.7% from a year ago. The trade group said that this increase was the largest jump in nearly 25 years. In addition, the national median home price rose to $219,000, up from $191,000 a year ago.

But let us look at the supply side, too: The inventory of existing homes has increased 11.6% over the past year, from 2.38 million to 2.65 million. So, more houses in stock, and the prices go and up. Bob Prechter explains the difference between valuing an item financially and economically in his book, called The Wave Principle of Human Social Behavior. In this excerpt from Chapter 20, he writes about some key fundamentals of socionomics, the new social science that describes the true causes of collective social behavior. …

Logical World of Supply & Demand Subverted

It is universally presumed that the primary law of economics, i.e., that price is a function of supply and demand, also rules finance. However, human behavior with respect to prices of investments is, in a crucial way, the opposite of that with respect to prices of goods and services. When the price of a good or service rises, fewer people buy it, and when its price falls, more people buy it. This response allows pricing to keep supply and demand in balance. In contrast, when the price of an investment rises, more people buy it, and when its price falls, fewer people buy it. In economic matters, rising prices repel buyers; in investment matters, rising prices attract buyers. This difference is not incidental; it is fundamental.

Most investors can quickly rationalize selling an investment because its price is falling or buying it because its price is rising, but there is not a soul who desperately rationalizes doing with less bread because the price is falling or who drives his car twice as much because the price of gasoline has doubled. In economic behavior, the law of supply and demand does not lie dormant ever. It is like the law of gravity; it works all the time. Prices are the balance beam from which the scales of supply and demand hang. Changes in buying patterns are virtually instantaneous in responding to price changes for bread, cars, TVs and shoes.

The Iron Law of Finance

In the same way, investment behavior has its iron law: the Wave Principle. This law governs unconscious, impulsive, collective herding behavior, while the law of supply and demand governs conscious, logical, individual economic decision-making. Attempting to apply the law of supply and demand to investment markets is akin to attempting to apply the laws of physics to falling in love. The law of supply and demand always produces practical behavior in the realm of economics. The Wave Principle & produces impractical behavior in the realm of finance. In the product marketplace, the rational goal of survival leads to price stability and objectivity. In the investment marketplace, pre-rational impulses of survival lead to wild overvaluation and undervaluation.

The decision to buy into rising prices and sell into falling prices is not governed by the reasoning neocortex [of the brain] but by the unconscious herding impulse, which generates inappropriate behavior in the financial realm as part of a generalized attempt to enhance the odds of survival. It is baffling only to those who insist that “supply and demand” rule finance.

Desire & Hope vs. Fear & Despair

It is not that reasonableness in finance is utterly absent; we are not talking about irrationality. People who invest in markets know through cold reason that they value their own lives and prosperity. Those who buy in bull markets are following the very reasonable desire to enhance their sustenance, while those who sell in bear markets are following the very reasonable desire to survive. Unfortunately, the portion of the brain that generates unconscious urges directs their behavior in this regard. The primitive mechanism employed is so inappropriate to the situation that instead of enhanced success, it produces guaranteed failure.

Because these desires per se are rational, they work just fine in the world of goods and services. In the product marketplace, the consumer wants prices lower while the producer wants them higher, and for the same fundamental reasons: survival and self sustenance. The process of mediating these identical goals between polarized dealers produces an objective, natural balance expressed as price.

In the world of investments, however, the consumer – who buys it – and the producer – who creates and wants to sell more of it – both want prices higher. Rather than become excited to buy as prices fall, as consumers of goods and services do, investors become excited to buy as prices rise. Since desire and hope are entirely on the side of price rise, only fear and despair can be on the side of price decline. Thus, when prices fall, investors are pressured past endurance to sell. Both of these impulses are contrary to the way consumers behave with respect to goods and services.

U.S. BANKS LOWER LENDING STANDARDS, SURVEY FINDS

U.S. banks, faced with rising mortgage competition as home sales advance, eased lending standards for the first time in 11 years, the Office of the Comptroller of the Currency said. “We see an increase in the easing of underwriting for both real-estate and commercial products,” said Barbara Grunkemeyer, the agency’s deputy comptroller for credit risk. “The banks can take on a little more risk because their portfolios are in good condition.” The comptroller’s annual survey of underwriting showed that banks also eased standards for commercial loans during the past year. The regulator, which oversees nationally chartered banks, surveyed the largest 71 institutions, whose $2.9 trillion of loans represent 90% of outstanding national bank loans.

“Ambitious growth goals in a highly competitive market can create an environment that fosters imprudent credit decisions,” Grunkemeyer said in a statement. “Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations have introduced more risk to retail portfolios.” The healthy economy has made it more likely that companies will seek out other forms of financing besides bank loans. That, in turn, forced banks to lower their standards to lure more customers. The survey said banks remain sound, even as it urged lenders to be more cautious in lending in the future. Banking regulators have said they are eyeing the growth of adjustable-rate and interest-only mortgages with some concern.

COUNTERPARTY CREDIT RISKS UNDER THE LENS

Financial institutions need to find out more about the credit risk of their counterparties, according to a new report by the Counterparty Risk Management Policy Group. The first report by the group – chaired by Gerald Corrigan, a former president of the New York Federal Reserve, and comprising representatives of Wall Street banks as well as TIAA-CREF, AIG, GM Asset Management, and others – was issued in 1999 following the multibillion-dollar bailout of hedge fund Long-Term Capital Management (LTCM).

The new study, “Toward Greater Financial Stability: A Private Sector Perspective”, differs from its predecessor in that it offers a number of pointed recommendations to financial institutions, Corrigan told Reuters. Among them: that firms gain a better understanding of their own portfolios, that they seek more data to better determine the credit risk of their counterparties, and that trade associations develop accepted standards for how confidential information should be exchanged among market participants, the wire service reported. The group’s recommendations, though directed at financial institutions in general, follow concerns that arose earlier this year about the stability of hedge funds after General Motors and Ford were downgraded to junk.

Though the report draws a clear distinction between “financial disturbances” and “systemic financial shocks” and maintains that concerns about systemic problems have declined since LTCM, The Financial Times noted that it warns of the threat posed by “a huge backlog of unconfirmed deals.” (Senior editor Tim Reason notes on the CFO Blog that the flip side of dispersing risk is that you do not really know where it goes, which can itself be risky. And last year, deputy editor Ronald Fink reported on concerns that the asymmetry inherent in credit default swaps contains the potential for serious abuse.)

MAKING NEW HIGHS

As I expected, the token revaluation of the renminbi has had no material impact on any markets thus far. Nevertheless, China and the renminbi remain key to the future of the U.S. economy. In the meantime, the U.S. economy is chugging along nicely with many stock indices making new highs this week on the back of better-than-expected corporate earnings. Strong corporate earnings are making the case that the economy is on solid footing, according to the Wall Street Journal. For some time now I have been making the case that the economy is not on solid footing based on the automotive sector. Americans love cars and they are not afraid to go into debt to buy newer and more expensive cars. So when the auto industry suffers it tells me that consumers are tapped out.

This week General Motors announced that its North American automotive division lost $1.2 billion during the second quarter. The company recently shook up the industry when it started selling its cars to consumers for the same price it offers its employees, forcing other car manufactures to do the same. Both Ford and Daimler-Chrysler entered the price war by offering their cars at employee prices as well. Since, GM said it would end its “employee discounts for everyone” promotion and cash rebates, and instead just reduce sticker prices permanently. I do not recall how many times in the past 18 months I have said that prices for durable goods and luxury items will go down (as the economy falters) while the prices of essential consumables such as energy and food could increase. It is busy happening.

Were we not still riding on the tail end of one of the largest economic expansions in history it might almost be tempting to buy the downtrodden automotive stocks. Had we been in the trough of a business cycle I would certainly have looked at it seriously. But we are at the top of a mega-cycle that was created during the 1990s, and that has not yet been corrected.

During the 90s there was a lot of talk about the wealth effect and its impact on stock speculation. While the rhetoric has died down, the wealth effect has not diminished. Both the real estate and stock markets are still rife with speculation. The major stock market indices (excluding NASDAQ) are almost at their all time highs again. Every business cycle expansion is followed by a contraction during which assets change ownership and excessive speculation is eliminated. We have not gone through that yet and, until we do, a lot of risk remains in the stock, bond, commodity and real estate markets.

No green light yet for stocks.

Anyone who has read this column for any length of time knows I hold dear the memory of a mentor who guided me through the ins and outs of investing when I first landed on Wall Street, green as can be. His sage rule, repeated over and over: You do not emerge from a bear market with a double-digit P/E on the S&P. Think back to 1982, before the landscape was littered with bubbles. Stocks were as unattractive as can be, with the P/E ratio on the S&P 500 in the high single digits. As things turn out, that was a bang-up time to invest in stocks – but you had to have the courage of your convictions. When people ask when I will know that the light is green, I repeat my mentor’s mantra: Bear markets do not end until there is a single-digit P/E on the S&P. When that time comes, I will relish being the only bull in a room full of bears. (My present existence is no fun.)

As for the interim, agile investors can make and have made a tidy profit in this market. The Bank Credit Analyst does fine work on relative valuations. From its vantage point as a global firm, it considers the world to be its investing oyster. According to its favored valuation metric, the U.S. just is not the place right now. The BCA uses a variation on the “Rule of 20”, which gauges how expensive stocks are by adding the trailing P/E ratio of a country’s benchmark stock index to the country’s 10-year Treasury yield. Using this modified rule, the U.S. comes in at 23 – the trailing P/E on the S&P 500 is at about 19, and the 10-year Treasury is yielding about 4.2% – fitting right in its 30-year average.

That same metric, though, is well below its 30-year average for the UK and Europe. And on a relative basis, these areas are much cheaper than the U.S. Asia is as cheap as any time in the last 30 years. And Japan, though still relatively expensive compared with its global counterparts, is as cheap as it has been in two decades. The BCA is watching Japan closely to see if signs of nascent growth solidify. Either method you choose – my old-fashioned rule of thumb or the BCA’s modified Rule of 20 – U.S. stocks are no bargain.