Finance Digest for Week of September 5, 2005

CONSUMER CASH FLOW

This paper analyzes the sources and uses of household cash flow. We use the basic corporate cash flow statement format to identify operating, investing, and financing cash flow. In order to meet current financing and investment requirements, we discover that households need to generate new cash equal to at least 13% of GDP every year.

Prior to 1993, the sources of household cash flow were split about 55% from income and 45% from new debt. Beginning in 1993, new debt increasingly became the source of cash flow. In 2005, new debt of about 12% of GDP should provide nearly 86% of household cash flow. We apply the standard corporate cash flow statement model to U.S. households. Using this format, we discover that U.S. households are now limited to one basic source of cash flow: new debt. Simply put, the access to new debt is the only thing that matters in analyzing the ability of U.S. households to spend or invest money. This analysis provides insight into the sources and uses of aggregate U.S. household cash flow.

An analysis of the uses of cash flow indicates that even the most minimal investment, residential construction, debt repayment and consumer liquidity requirements will lead to new borrowings totaling about 11% to 12% of GDP. A scenario analysis of these financing requirements did not indicate any obvious short-term way to reduce this level of debt financing without effecting economic activity. The scenario analyses indicate that reductions in consumer liquidity would be the only reasonable path by which the economy could begin adjusting these financing needs.

It is not clear that even reducing consumer liquidity would be sufficient to support the process of slowing debt accumulation. It appears more likely that any attempt to reduce the growth of debt could result in an underperforming economy. The scenario analysis left open a tantalizing opportunity to manage the transition to a stable economy with lower annual debt financing. The rate of growth of personal consumption expenditures would need to decline significantly while the rate of growth of personal income stayed near its current level.

The only way that we can envision this would be a managed deflation transferring corporate profits to households through price reductions on goods and services. Though this would lower profits appreciably, it would also enable the economy to cut household debt financing needs to reasonable levels. Other than our tantalizing possibility, we were unable to identify any reasonable path of reducing the growth of household debt. The sources and uses of cash flow indicate that households are completely dependent on access to new debt.

THE ENDOGENOUS OIL SHOCK

In the macro world, strikes, wars, and natural disasters have long been thought of as classic exogenous shocks – those out-of-the-blue disruptions that jolt economies and markets. For stable economies, the impact of the exogenous shock is fairly predictable – a temporary reduction in growth followed by the rebound of recovery. Such are the impacts that are likely to follow from the devastation of America’s Hurricane Katrina. But the energy shock of 2005 may be of a very different breed. It could well be an endogenous shock – an unfortunate outgrowth of excesses that have been building in the macro system for a long time.

The Federal Reserve has set the stage for this endogenous shock. As it has supported the U.S. economy from bubble to bubble, it has fostered a climate of excess demand and excess liquidity. First equities in the late 1990s and now property – the Fed has nurtured the steady transformation of an income-based U.S. economy into an asset-dependent spending machine. Belatedly, Alan Greenspan has finally paid lip service to the mounting perils of the Asset Economy. In his recent swan song at Jackson Hole, the Fed chairman cautioned that “history has not dealt kindly” with investors (i.e., American consumers) who may have gone too far in “accepting lower compensation for risk” on their asset holdings. Even couched in all the oblique caveats so typical of Fedspeak, this is quite a confession. The Father of the Asset Economy now fears he has created a monster.

Those fears are well founded, in my view. The tragedy is that the powers that be are only now just coming to this realization. Alas, there has long been ample evidence that America’s asset-dependent spending mindset has gone too far. That is the message from unconscionably low saving rates – now below “zero” for individuals (a record low of -0.6% in July) and at low single digits for the nation as a whole (on a net, after-depreciation, basis). That is also the message from a gaping U.S. current-account deficit – a record 6.4% of GDP in early 2005. Such excesses are further corroborated by an unprecedented debt binge by asset-dependent American consumers; debt-servicing expenses are near all-time highs in what is still a rock-bottom interest rate climate. And if there was any doubt over the bubble-like underpinnings of the Asset Economy, the latest report on nationwide home prices says it all – a 13.4% y-o-y increase in 2Q05, the sharpest increase since mid-1979. Saving-short American consumers have gone deeper and deeper into debt in order to spend freely out of artificial purchasing power extracted from overvalued homes. All that paints a very compelling picture of an excess-demand-driven U.S. economy.

It is the resulting excesses on the demand side of the U.S. macro equation that have set the stage for an endogenous shock. That is very much the case with respect to the oil shock of 2005. Hurricane Katrina may well go down in history as the tipping point to another energy crisis. But it is important to keep in mind that oil prices had already pierced the $65 threshold before this devastating natural disaster occurred. Had it not been for America’s asset-induced spending binge, there probably would have been a greater margin between aggregate supply and demand that would have left prices of oil and other energy products on a very different trajectory. With the United States still accounting for fully 25% of worldwide oil demand – more than three times the share of China – the impacts of excess U.S. consumption on global oil prices can hardly be minimized. The endogenous energy shock is very much an outgrowth of this phenomenon, in my view.

Nor should the oil shock be treated as an isolated occurrence. America’s Asset Economy is perfectly capable of generating other endogenous shocks, as well. The two most worrisome possibilities – a bursting of the property bubble and a current-account crisis. These are typically low-probability events. But for an Asset Economy that has gone to excess, those probabilities are higher today than would otherwise be the case. Of these two possibilities, a post-bubble shakeout in the U.S. housing market is more worrisome. As the housing bubble grows larger and covers more and more of the U.S., the perils of a post-bubble endgame for overly indebted American consumers grow larger by the day. Such are the perils of an Asset Economy that has long gone to excess.

The same would be the case with a US current account crisis. All it would take would be a desire on the part of America’s foreign creditors to seek compensation for taking currency risk – or an inclination on the part of foreign central banks to diversify their official foreign exchange reserve portfolios that are so heavily over-weighted dollar-denominated assets. Both of these possibilities are entirely feasible and not without important implications for the global economy.

The oil shock of 2005 now poses an immediate threat to the U.S. and global economy. The significance of that threat will only become apparent with the passage of time. In the end, it is always the duration of any shock that matters the most in shaping macro outcomes. But this oil shock did not exactly come out of thin air. It was, in effect, set up by chronic excesses on the demand side of the U.S. macro equation. Such an outcome could have important implications for financial markets. Fed tightening could be brought to a premature conclusion, as U.S. monetary authorities pause to assess the damage from Hurricane Katrina. In response, bonds could rally further and equities could sag under the weight of prospective shortfalls to corporate earnings.

Endogenous shocks are of a different breed than the more typical exogenous disturbance. They reflect systemic risks in economies that could well take a good deal of time to purge. That was always the biggest risk for America’s Asset Economy.

BEIJING’S TACTICAL RETREAT

Under a barrage of fallacious arguments from the Bush Administration and the U.S. Congress, Beijing made a tactical retreat on July 21. It “reformed” China’s exchange-rate regime. After a decade in which the yuan had been linked to the U.S. dollar at a fixed rate, China adopted a managed floating-exchange-rate regime. And on the new system’s initial day of operation the yuan was allowed to move from 8.28 to the dollar to 8.11, a 2.1% yuan appreciation. U.S. Treasury Secretary John Snow hailed these changes as a positive first step. For months he had been piously lecturing the Chinese about why it was in China’s interest to dump its fixed-rate system and engineer a yuan appreciation. According to Secretary Snow, these changes would “allow China to more easily and effectively pursue price stability, stabilize growth and respond to economic shocks.”

That latest version of Uncle-Sam-knows-best is laughable. It is not as if China has been making a mess of its economy. Since the yuan’s fix to the dollar in 1995, China’s real growth rate has been second to none, exceeding 8% per year on average. It also passed the Asian financial crisis shock test with flying colors. But it is not the first time U.S. special interests have prevailed in the name of helping China. During his first term Franklin D. Roosevelt delivered on a promise to do something for silver. Using the authority granted by the Thomas Amendment of 1933 and the Silver Purchase Act of 1934, the Roosevelt Administration bought silver. This and bullish rumors about U.S. silver policies helped to push the price of silver up by 128% (calculated as an annual average) in the 1932-35 period.

Bizarre arguments contributed mightily to the agitation for high silver prices. One centered on China and the fact that it was on the silver standard. Silver interests asserted that higher silver prices – which would bring with them an appreciation in the yuan – would benefit the Chinese by increasing their purchasing power. Things did not work according to Washington’s scenario. As the dollar price of silver and of the yuan shot up, China was thrown into the jaws of depression and deflation. In the 1932-34 period GDP fell by 26% and wholesale prices in the capital city, Nanjing, fell by 20%. In an attempt to secure relief from the economic hardships imposed by U.S. silver policies, China sought modifications in the U.S. Treasury’s silver-purchase program. But its pleas fell on deaf ears. Realizing that all hope was lost, China was forced to effectively abandon the silver standard on October 14, 1934, though an official statement was postponed until November 3, 1935. This spelled the beginning of the end for Chiang Kai-shek’s Nationalist government.

History does not have to repeat itself and probably will not. After all, a significant yuan appreciation against the dollar today would result in a nasty deflationary impulse, as it did in the 1930s. Beijing knows this. Perhaps this explains why the People’s Bank of China chose to adopt the type of “flexible” monetary setup employed in Singapore. Since 1981 the Singapore dollar’s exchange rate has been managed against an undisclosed basket of currencies. Under Singapore’s unique version of a managed floating exchange rate the Singapore dollar has shadowed the U.S. dollar. Indeed, today’s exchange rate of 1.67 to the U.S. dollar is almost exactly the same as the average value in 1991 and 1999.

China’s choice of Singapore’s basket approach to managed floating could portend a wise combination of emollient rhetoric with a realistic defense of China’s economic interests. For yuan bulls it could mean some pretty big disappointments. The ones who are taking out dollar loans to buy and hold yuan are incurring significant carrying costs while waiting in vain for a payday.

Ready to Run

Is it the tip of the iceberg, or merely a tempest in a teacup? Should we be pleased and relieved by Beijing’s move – as Washington so clearly seemed to be on hearing the news – or should we be worried, fearing what may come next? Concern is warranted, but there is little point in worrying. The purpose of worry, after all, is to spur some sort of productive action. Global currency movements are complex, but the action to take in response to the yuan revaluation is simple: If you have not done so already, buy gold. Not as a knee-jerk response to a single announcement, of course, but as a calculated and farsighted response to what is coming.

China’s revaluation of the yuan is the equivalent of a hairline fracture in the Hoover Dam. On first glance it appears, to be nothing serious … and yet it is the beginning of something deadly serious. Over time, the hairline fracture will grow. A network of cracks will spread. And the dam itself will eventually burst. We do not know when the climax will occur, but we do know the endgame has begun. But why worry, the perma-bulls say. After all, the consumer is getting along famously, the dollar is still the world’s reserve currency and Asian exporters have no better place to stash their cash than Treasury bonds.

Before answering the perma-bulls directly, it is helpful to recall the natural human tendency of projecting trends out to infinity. For a combination of psychological and empirical reasons, it is the easy thing to do. Thus, real estate investors currently expect house prices to rise for the next decade – and by “decade”, they really mean “as far into the future as we can imagine.” Just as ‘90s investors expected dot-com stocks to rise ad infinitum, ‘80s investors had Japan, ‘70s investors had inflation, ‘60s investors had the Nifty 50, and so on. The pattern of extrapolation excess appears consistent, going as far back as market history records. Whether the masses believe in infinite trends or not, they often act as if they do. This is an odd thing, because market history so clearly teaches the opposite. With very few exceptions, even the longest trends tend to end, often abruptly. Bull and bear markets have life spans, just like people. As do empires.

For all the talk of China’s rise, it is not a given that one superpower will simply be replaced by another, either. It may be that multiple countries come to share the 21st-century world stage, with none gaining a clear and permanent advantage. No one knows exactly how things will unfold. We can say with certainty, though, that the old order of things is passing. Globalization is remaking the world in ways that few expected – and in many ways, these changes are the results of success, not failure. The creation of 2 billion new capitalists (in China and India) is an incredibly positive development in the long run. But in the short run, massive change creates turmoil and upheaval – and the more it is resisted, the more chaos is created in the transition. This is where the role of gold comes in.

Financial crises are far more common than many might expect, and the basic workings of international finance are far older than many might realize. The technology has changed, but it is the same old game – like toddlers learning to walk, countries and capital markets mature through a series of blunders, bruises and mistakes. For example: in the 19th century, the United States Treasury nearly went broke multiple times. As for calculated currency movements and mercantilist foreign exchange policies, Europe had been playing the game for centuries by the time the 20th century rolled around. The difference today? Scores are kept with electronic blips on computer screens, rather than gold and silver reserves. And yet, just in case, the gold reserves remain. It was only with the onset of the Great Depression that the standard-bearers wavered as the ideas of John Maynard Keynes gained traction and persistent hoarding caused gold to lose its glitter. Keynes argued that the traditional gold standard policies of austerity and fiscal rigidity had only made the Depression worse.

What government must do, Keynes further argued, was to act as a counterweight to the business cycle, spending money when times were hard and saving money when times were good. Spending money in hard times, of course, requires running persistent deficits, potentially substantial ones. Such an idea was considered sacrilege at the time. More than 15,000 banks (!) failed in the four years following the 1929 crash (with the Federal Reserve nowhere in sight). An environment like this naturally encouraged more hoarding of the yellow metal, with seemingly no safe place to put the last of one’s money. Into the breech stepped the recently elected President Roosevelt. Public surrender of all gold and silver was required, in exchange for paper notes, as declared by the Emergency Banking Act of 1933. (It is hard, if not impossible, to imagine such a brazen act being pulled off today.) FDR then took the apostasy further by declaring the right to adjust the dollar/gold ratio as he saw fit, prompting at least one fiscal observer to declare “the end of Western civilization.”

But Western civilization kept plugging along, and after a managed creep upward, the price of gold was fixed at $35 per ounce in 1934. There it stayed for almost four decades, through the Second World War, the establishment of Bretton Woods, the challenge of De Gaulle and the rise of Keynesian policy. Indeed, around the time Nixon finally shut the gold window in 1971, he uttered frighteningly appropriate words: “We are all Keynesians now.”

HALO EFFECT

Chicago’s magnificent skyline has numerous landmarks: the Tribune Tower, the Wrigley Building, the Aon Center and the Sears Tower. The one I find most meaningful is Johnson Publishing’s headquarters on Michigan Avenue. Erected in 1971, the building remains both an impressive structure and the only Chicago skyscraper built by an African-American. Company founder John H. Johnson, one of the greatest entrepreneurs of the 20th century, died August 8 at 87. Mr. Johnson started a small business in 1942 that would become the largest black-owned publishing company. He was the mastermind behind Ebony, the first magazine celebrating black lifestyle and achievement, which 60 years later is read each month by 11 million people. This quintessential brand-builder showed his genius and imagination with other hits like Jet, the newsweekly, and Fashion Fair Cosmetics, the largest black-owned makeup and skin care company.

Mr. Johnson’s autobiography, Succeeding Against the Odds (coauthored with Lerone Bennett Jr.) describes how he turned a $500 loan against his mother’s furniture into an empire generating $500 million in annual revenue, employing thousands and giving hope to millions more. Mr. Johnson was an incredible role model. His life’s work became tangible proof that people of color could succeed not only in journalism but in any vocation of their choosing. As an entrepreneur, I am awed by his vision and business acumen. His generosity and concern for humanity were boundless. Mr. Johnson’s concern for others made him a better entrepreneur and ultimately made privately owned Johnson Publishing a great business. As a tribute to his life, I am highlighting other businesses that also champion the human spirit.

YOU BOUGHT A WHAT?!

Should I have written a column on annuities? I have been in this space for 21 years but have never seen the need to say the obvious, which is that an annuity is just a mutual fund dressed up with some punitively stiff fees. (I am talking only about the most common form of annuity – the deferred annuity sold as an investment account. The other kind, the instant annuity that converts a lump sum into a monthly lifetime payout, is another matter.)

A reader recently reminded me that it is sometimes useful to state the obvious, if that will protect investors from making serious mistakes. The reader told me that he had bought a variable annuity and wanted advice on what to do next. The damage, though, was done. Broker-sold annuities levy killer annual fees, in large part to compensate the brokers who sell them. You are required to keep your money in place for a while – seven years is typical. You can get out early only by paying a huge exit fee to make up for the vendor’s lost chance to extract that annual fee.

Maybe I was too hard on the poor fellow who wrote in. I instructed him that he should never, ever again make any financial decision. Have a spouse or offspring do it. If no one loves you, have your county court conserve you. Buying a deferred annuity proves you are a serious dupe. Seriously. The only ones benefiting from annuities are the insurance companies issuing them and the sales reps selling them. The fundamental fact is that you would be better off investing similarly outside the annuity – for example, in a plain old mutual fund. Instead of losing money while insurers use yours to buy stocks for themselves, buy good stocks directly and hold them.

MORTGAGES TAKE A BIGGER BITE

Amy and Bob Salessi are cutting a few corners to meet their mortgage payment, which consumes about a third of their income. They have reduced their 401(k) retirement contributions, eat out less and rely on relatives to help with child care. They are also counting on quarterly work bonuses to pay insurance and taxes. The couple, both restaurant employees, bought a three-bedroom Glendora home in the $500,000 range three weeks ago with 100% financing. “We’ll have to struggle for a while, but it’s worth it for the house,” Amy said. “With the market going up, we couldn’t wait any longer.” Apparently a number of Californians feel the same way.

More than 50% of state residents who bought in the last two years spent more than a third of their pretax household income on housing, the top threshold recommended by the Department of Housing and Urban Development. An additional 20% paid out more than half their earnings, according to a study released last month by the Public Policy Institute of California.

The run-up in debt has been fueled by soaring home prices and made possible by lenders willing to give borrowers mortgages that eat up 40% to 50% of their total income, the study noted. And even among those who spend less than 30% of their income on housing, an increasing number have interest-only, no-down-payment and negative-amortization loans, leaving themselves vulnerable down the road. Although the state median income is the ninth highest in the country, homeowners are paying the second-highest monthly housing costs, according to American Community Survey data released last week by the U.S. Census Bureau.

Las Vegas plummets in housing appreciation for second quarter.

After five consecutive quarters in which Las Vegas ranked among the nation’s top 20 metro areas with the highest housing appreciation, the city dropped off the federal government’s list. The Las Vegas metropolitan area plummeted from a national ranking of #2 during the first quarter of this year to #21 in the second quarter, according to a report released by the Office of Federal Housing Enterprise Oversight (OFHEO). The rankings are based on annual percentage change. Even though Las Vegas dropped down the list, Nevada still ranked #1 in terms of housing appreciation year-over-year with a 28% increase. Since 1980, statewide housing prices have risen 267%, according to government data. One reason Nevada remained at the top of the heap is because of the Reno-Sparks area.

Real Estate Review: Subdivisions

At the height of the current real estate boom, housing of all types appreciated at a record pace. But the boom has shown subtle signs of cooling in recent months, and the market is now looking a lot more fragmented. Rising inventories, falling mortgage applications, declining affordability levels and a letup in the previously torrid condo market suggest the period of all-encompassing housing appreciation is probably over. Clearly, it is overly dramatic to say the presumptive housing bubble has burst, as demand remains strong for affordable starter homes. Meanwhile, Federal Reserve tightening may be less aggressive due to Hurricane Katrina, which should help the housing sector. But real estate investors will have to be more discriminating going forward. Here is a guide to some emerging developments in the sector.

The Financial Sorcerer’s Apprentices

Rising home prices are the obvious part of the real estate bubble, yet the full story goes far beyond the activity of buyers and sellers only. Less conspicuous are the financial sorcerer’s apprentices whose dark magic generated the hot air that filled the bubble to its present size. Take the largest mortgage lender in the U.S., for example. At the end of 2004, the principle value of this firm’s negative amortization loans stood at $33 million. Yet as of June 30, that figure had multiplied nearly 100 times – to $2.9 billion.

Negative amortization mortgages, as you may know, allow the borrower to underpay on the loan each month; the amount of debt keeps going up, not down. In other words, the terms of this mortgage are a lot like a car loan, with borrowers “losing value as soon as they drive off the lot,” or in this case, as soon as they make their first “underpayment” on the house. And I am not singling out one firm for its lending practices, either – it is industry wide. A recent MSNBC report said, “40 percent of mortgages over $360,000 that have closed so far this year are ‘neg-am’ loans.”

The “neg-am” lending trend is still a relatively new trend, and has become widespread only in the past year or so. What is not widespread is our collective experience regarding the consequences. But that will come soon: neg-am loans stipulate that the monthly payments increase annually. It brings to mind the old proverb about borrowers and lenders, to wit: If you owe the bank $10,000 and you cannot pay, you have a problem. If you owe the bank one million and you cannot pay, the bank has a problem. What eventually happens in an economy where people treat home purchases the way they do the balance on their credit cards?

A PEEK INTO PEAK OIL THEORY

Many of us would rather pretend the 1970s – or at least the part we played in that wild and zany decade – never happened at all: Think platform shoes, polka-dotted polyester, and disco parties to name a few. Over the past two weeks though, flashbacks to the financial “spirit” of that time have been rampant at gas stations across the country – with price spikes, panic, long lines, and newspaper headlines calling for a global energy crisis on par with the 1970’s oil embargo. It all seems to fit with “Peak Oil Theory” which claims that the last few ounces of oil are now being squeezed out of the planet, causing a scarcity of supply that is behind the current spike in prices – the likes of which has not seen since, oh, you do the math.

Mind you, this is no un-“educated” guess, either, as everyone from crop-circle conspiracy theorists to Cambridge educated scholars to the U.S. Congress believes a 1970s-like deficit in oil is the devil in red. We just have one problem with this idea: namely, there is NO SHORTAGE OF OIL to speak of in America today. Of course you have to hire a translator to decode this fact from such sources as the U.S. Department Of Energy (DOE) website and foreign press. Fortunately, we have done the work for you. Most of mainstream media misses the mark, which begs the question: if they cannot get the present right, what else are they getting wrong about the future of oil prices.

U.S. ECONOMY AND THE STOCK MARKET BOOM LOOKS SUSPICIOUSLY LIKE HISTORY REPEATING

History does not repeat itself: people just keep forgetting it. No matter how many stock market bubbles there have been, or will be, investors and their advisers always seem to treat the current one as permanent, sometimes even calling it a “new era”. In the meantime, others, myself included, have abandoned all hope of people permanently remembering the lessons of history. Casting my mind back to the Dow Jones index in the 1990s and thinking about the crop of explanations that were used to justify its rise caused me to reflect on what is probably the world’s most infamous stock market bubble. In fact, it was this particular explosion in share prices that gave us the word “bubble” to describe the phenomenon. No, I am not referring to the 1920s. I am referring to the market collapse of 1720.

In 1711 the foundations for the South Sea Bubble were laid. It was in that year that the South Sea Company was set up to take over £10,000,000 of England’s debt for a limited period at 6% interest. The company was also granted a monopoly on trading in the South Seas. Innocent enough, to begin with, or so it appeared. The company’s directors, however, quickly developed a vision of massive wealth. Mesmerised by the alleged riches of the east coast of South America, they persuaded investors that these Spanish colonies were waiting to exhaust their gold and silver mines in exchange for English manufactures. Rumours were spread that Spain would open up these colonies to English merchants. As the company held a government monopoly on trading in the area, profits were bound to be enormous. Receiving royal support and the imprimatur of Parliament, the Bank of England only added credibility to its claims.

As its reputation flourished and its claims became more extravagant its shares rose in value, even though, like so many Internet companies, it never made a profit. Fuelled by growing public support the directors deluded themselves into thinking that the value of the company’s shares could rise indefinitely, regardless of the profit situation, and that there would always be sufficient credit to underwrite them. (Does any of this sound vaguely familiar?) But it was in 1720 that lift-off really occurred. In that year Parliament passed a bill in which the company assumed the national debt at an initial interest rate of 5%. Virtually overnight the company’s stock rose from 130 to 300. All were not happy with the arrangements and the market’s immediate response. Sir Robert Walpole publicly warned that it “was an evil of the first magnitude”. Lords North and Grey opposed the bill and argued it would render many destitute. Their warnings were ignored.

A speculative frenzy swept London and the surrounding counties. After all, it was argued, Parliament supported the company and 83 peers voted in favour of its. But the aristocracy, losing all sense of proportion, had also joined frenzy along with the parson, the baker, the shoemaker and the candlestick maker. Few seemed immune to the contagion: houses and businesses were mortgaged, jewels sold, unsustainable loans were made, inheritances and legacies sacrificed, all to buy stock in the South Sea Company.

So intense was the frenzy that Exchange Alley was literally blocked with the gullible struggling to part with their savings. The mania was not just confined to the South Sea Company, other schemes were floated and their stocks quickly bought up. People were trading in coffee houses, pubs, shops, street corners and even in brothels. Mob hysteria reached such a scale that one fellow floated a scheme he described as “A company for carrying on an undertaking of great advantage, but nobody to know what it is.” Incredibly enough, people queued to subscribe to what was obviously a confidence trick. He disappeared with the money and was never seen again. Otherwise intelligent people had completely lost their senses. As one banker observed in 1928, “the more intense the craze, the higher the type of intellect that succumbs to it”.

By May 1720 the company’s stock had risen to 550; five days later it was 890 but within hours it dropped to 640. Some people were getting nervous. The company primed demand by buying its own shares, raising them to 750 by the evening. This helped to restore confidence, which the company reinforced with rumours of imminent prosperity for shareholders. Come August, the stock stood at 1000, despite more stock having been issued. But it was becoming obvious to a growing number of people that their shares were grossly overvalued. This emerging awareness saw the stock fall to 400 by the middle of September and to 121 by December. It was now over, and so were a lot of lives. The boom’s excesses were only exceeded by the railway mania of 1845-46. (The world’s first hi-tech market boom).

At the peak of the boom the total value of British shares were estimated at £500 million, about five times greater than Europe’s cash base. What happened? The same thing happened in 17th century Holland. In his book Tulipomania, Mike Dash reveals that the volume of trading around promises to buy and sell during the mania “was not less than 40 million guilders” while the Dutch banking system only contained deposits of 3.5 billion guilders. Credit and paper fuelled the frenzy and carried it to unforgettable heights of human folly and greed. This folly was followed by John Law’s Mississippi Boom that had a similar devastating effect on the already weak French economy in the early 18th century. Another lesson that was not learned by British investors and was even forgotten by the French revolutionary regime, with disastrous social, political and economic consequences.

It is no coincidence that these booms shared the characteristics. Just as the money supply rapidly grew under Greenspan in the 1990s, the same thing happened under the Bank of England in the 1840s. So where did a most of this money go? Into hi-tech speculation, i.e., railway investment. More than £180 million were poured into railway schemes in 1845 and 1846, about twice the investment of the previous 10 years. By September 1847 it was all over. Almost as if it were describing the 1990s The Economist painted a grim picture of the boom, contemptuously referring to “the folly, the avarice, the insufferable arrogance, the headlong, desperate, and unprincipled gambling and jobbing, which disgraced nobility and aristocracy, polluted senators and senate houses, contaminated merchants, manufacturers, and traders of all kinds, and threw a chilling blight for a time over honest plod and fair industry”.

Once again, we are back to credit expansion. The Fed’s monetary policy plus the herd instinct is what drove hi-tech shares, not any mythical “new era”.

THE WRECKED TECHS

When I first ran across this company, I thought there must be some mistake. How could there really be a $3 stock with over $8.50 per share in cash, and no debt? A little research showed it was no error, but there are good reasons why it trades that way. Talk about a company with a knack for poor timing. Remember Aether Systems? This was one of those jaw-dropping IPOs back in the day of the tech bubble. The shares opened at $16 on its first day of trading in 1999 and then soared to close at $48. Less than six months later, the stock was $315. Back then, investors were enamored with Aether’s vision of delivering information over virtually any medium and David Oros was the chief visionary working out the recipe for the company’s mind-bending future.

But, as it turns out, what the company had really discovered was a recipe for losing over $1 billion. Today, the company is just a shell. It has sold its old businesses and has only seven employees. Its biggest asset is about $450 million in cash … and the more than $1 billion in accumulated losses, which can be used to offset taxes on future income. So now what? The company has renamed itself Aether Holdings (AETH) and is looking to find a way to profitably use its cash. It appears that a buyout is out of question, since the company has adopted anti-takeover measures, such as forbidding anyone from acquiring more than 5% of the stock without permission from the board of directors. Ostensibly, it has done this to protect the accumulated losses, because IRS rules forbid their transfer in the event of a change in ownership. But Aether and profits do not seem to mix well. The company has decided to, get this, go into the mortgage business! It is investing its cash in mortgage securities. As of March 31, it had about $440 million invested in mortgage-backed securities. Poor Aether. It seems timing is not their forte.

Interestingly enough, there are a number of cash-rich busted-up and bombed-out tech stocks lingering around. Some are like Aether, mere shells. For others, there is something closer to a pulse. Many have loads of cash. More recently, the idea has gotten some attention in the mainstream press. On August 25, the Wall Street Journal ran a small piece on “Cash Stockpiles” that featured eight stocks – all of them technology companies. And the latest Barron’s cover story is about “cash cows and buyout bait”, as they put it, which included mainly cash-rich tech stocks.

I ran a scan of the nearly 9,000 stocks in the market and found 808 stocks where cash per share exceeded the price of the stock. In that dustbin, you are bound to find a lot of troubled companies and a lot of dogs, like Aether, that cannot seem to do anything right. But, every once in awhile you will find as company with some real possibilities.

In today’s economy, the market is littered with wrecked tech stocks. Usually, these types of companies will be small software companies or telecom has-beens, the kinds of companies that struggle along making small profits or small losses. As a result, they often trade for large multiples of earnings, assuming they have positive earnings. However, the enormous amount of cash on the balance sheet usually accounts for the bulk of their market cap, and then you find the underlying business trading for hardly anything at all.

These kinds of situations are like waiting for lightning to strike. Owning these companies is like dangling a key on the string of your kite and setting it off during a storm. If it strikes, the results are dramatic. In any event, I think this is an interesting phenomenon and I am betting it will be profitable to speculate among in the wreckage of the great tech bubble.

1973 OIL EMBARGO REDUX

Today we have an equivalent of $100 barrel oil. With oil selling for over $67 a barrel, what is not well understood on Wall Street is that now gasoline is selling close to $100 oil equivalent. Most economists are used to watching the price of oil in predicting consumer behavior. This is the case because oil and gasoline typically move up and down together percentage wise. In the past when oil was in short supply there was not a refinery shortage so the price increases moved up the supply chain equally. In today’s markets we have a shortage of crude oil and refining capacity. This has led to a dramatic increase in the price of oil and the crack spread. The crack spread is roughly the difference between the price of crude oil and the refined products that the oil refinery produces (gasoline). In other words, the spread of gasoline over oil measures how much value the refinery adds.

Due to increased demand for gasoline, and now Hurricane Katrina, the crack spread has jumped by as much as $25 in the last 2 weeks. Typiclly this spread is closer to $5. This higher spread along with oil prices trading above $70 yielded gasoline prices of more than $95 a barrel. Put another way $70 crude oil + $25 crack spread = $95 a barrel gasoline. The reason this is important is that many economists are predicting a consumer slowdown if oil goes to $100 a barrel. Recently Standard & Poor’s projected a consumer slowdown should oil hit $100 a barrel. But Katrina has effectively created $100 oil by taking out a number of refineries in Louisiana and Mississippi at the same time as record high-energy demand. This has created a price spike in gasoline that U.S. consumers are now paying for.

We were projecting a consumer slowdown before Hurricane Katrina. After the hurricane, we have seen GDP cuts of 0.5%-1% due to the storm. This storm, together with already tight energy markets, is having the same type of effect as the Arab oil embargo of 1973. Although reduced in scale, Katrina combined with the worldwide demand growth in oil has achieved the same result. That result is a major energy shock that should cause a consumer slowdown. According to Daniel Yergin in the Wall Street Journal discussing Katrina “what has happened is on a scale not seen before, and the impact of the price spikes and dislocations will roll across the entire economy.” What is tough to answer is how long will energy prices stay high and how much will they slow economic growth.

In addition to New Orleans, ports in Mobile and along the Gulf coast were also damaged or destroyed. The Port of New Orleans is the largest bulk commodity port in the United States and the fifth largest in the world. Its imports and exports include grains, coffee, bananas, coal, chemicals, lumber, rubber and metals. All of these commodities have been subject to price movement as a result of Hurricane Katrina. As these commodity price movements work through the system they will affect the cost of a wide range of products reaching the consumer. We expect this to be inflationary as many commodities are already in short supply.

In 1973 the Arab oil embargo started with the Dow Jones Industrial Average at just under 1000. Subsequently, the oil price spike and inflation drove the market under 600, a 40% decline. Another event to look at is the 9/11 attack where the market plunged from 1150 to 950, a 17% decline before the return back to 1150 in December of that year. The S&P 500 remains below the high of 1315 in May of 2001 when the market begin its original decline. Recently, the S&P 500 peaked on August 3 at 1245; one month later it is down 2% from the high after Katrina. We do not believe the stock market has correctly discounted the full effect of Hurricane Katrina at this level and would keep in mind the results of energy shocks in the past.

PIMCO’S GROSS: END OF BUBBLE IS NIGH

Go short and avoid real estate, equities, corporates.

Investors should prepare themselves now for the end of the U.S. housing bubble by avoiding assets like equities, real estate, corporate debt and junk bonds, said Bill Gross, managing director of Pacific Investment Management Co. In his monthly investment outlook, Gross advised investors to “cut the fat” from their portfolios. Gross, a well-regarded bond bull, said the housing bubble is likely to either stop inflating, deflate or pop within the next few months, leading to a slowdown in economic growth.

Pimco is the largest bond fund manager in the U.S., with $493.3 billion in assets under management. If the bubble ends, investors must prepare for the “debt liquidation” that Federal Reserve Chairman Alan Greenspan warned about 10 days ago, Gross wrote. “That means a focus on high-quality investments with anticipation for an eventual Fed easing at some point in 2006,” he said. Gross recommended a “bullish orientation towards the front-end of the curve … coupled with an avoidance of anything that carries those low-risk premiums that Greenspan finally diagnosed.” In other words, buy short-term securities that have the most to gain from a reversal in the Fed’s policy of measured increases in interest rates.

“That is not to say that long government bonds won’t go up in price if the ‘system’ suffers some elimination, slower growth, or to be frank, a recession in 2006,” Gross wrote. “It’s just to acknowledge that the better duration-weighted paper lies at the front-end of the curve, especially now that it provides similar yields to longer maturities.” Gross said he wrote his commentary before Hurricane Katrina hit, suggesting that the storm only “adds to the potential for ‘caution.’”

DO-NOTHING FED IS DANGEROUSLY DISENGAGED

Talk is cheap. But when it comes to bubbles and potential bubbles, that is all we get from the U.S. Federal Reserve. Greenspan and company can sure talk the talk. But walk the walk? Forget about it. And I think that is going to get us – and Alan Greenspan’s successor as Federal Reserve chairman, come January – in trouble. Again. In 2006, I would estimate.

Remember the run-up to the popping of the technology stock bubble in March 2000. As easy money, which the Federal Reserve itself provided, drove up stock prices, we got lectures on irrational exuberance. Bad things were bound to happen to investors who forgot about risk, Greenspan warned. (As the bubble continued to inflate, the Federal Reserve chairman changed his tune: Higher productivity justified some portion of these “irrationally” higher stock prices.) When it came to action, though, the Federal Reserve punted. The central bank ignored all calls – some from the Wall Street establishment itself – for higher margin requirements that would have forced investors to borrow less and put up more of their own cash to buy stocks. Would that have helped deflate the bubble more gradually? It might have. But we will never know.

Now, belatedly, the Federal Reserve has decided to warn us that housing prices are getting worryingly high in some markets. Some local housing markets might even be experiencing, dare we say it, a bubble. Some consumers are adding variable-rate mortgage debt without a thought of risk. The Federal Reserve would be much obliged, thank you very much, if all you irresponsible borrowers and real-estate flippers – you know who you are – would stop. But is the Federal Reserve doing anything about the causes of this potential bubble? Not that I can see. When it comes to U.S. banks, the part of the financial system where the Federal Reserve has real, honest-to-goodness clout, Greenspan and his colleagues are curiously passive. And that is truly dangerous. Because the real problems in the financial system, the ones that could blow up at individual institutions and then cascade to affect the entire financial market, are on bank balance sheets. And the Federal Reserve – like other bank regulators – seems content to let the problem build.

Homeowners and home buyers may indeed be taking on too much debt. Too much of that debt may carry a variable rate that could explode on real-estate borrowers if interest rates rise. Too much of it has undoubtedly been extended to home buyers and home borrowers who cannot afford the interest payments that kick in after some initial period of no or below-market interest. But it is easy to understand why borrowers would be tempted to borrow more than they should. Who has not felt the allure of a bigger house? Or of that slightly extravagant vacation? Or of borrowing a few hundred now – and oh, maybe next month, too – to get through an end-of-the-month rough patch? Lecturing consumers on the need to borrow less, as the Federal Reserve has done, when money is so cheap thanks to its own policies, is like standing in front of an open bar and telling your party guests not to drink more of the free liquor than is good for them. It is great if you like to hear yourself talk and want to be able to say “I told you so” to your hung-over friends. But, please, let us not kid ourselves that it is an effective way to change behavior.

And besides, the Federal Reserve has an alternative for attacking this bubble: The central bank can go after the banks that are making these loans. For every underqualified investor taking out a loan that is likely to go south, there is a bank making that loan and a banker stretching the rules of sound lending. And the Federal Reserve could do a lot about this deterioration of lending standards … if it wanted to.

KATRINA PLAYS

We do not make the rules; we just try to play by them … without getting hurt, of course. Therefore, whenever a disaster strikes, we endeavor, first and foremost, to avoid numbering among the victims. Next, we remember that disaster often begets opportunity. We do not relish the thought that widespread human suffering often sows the seeds of opportunity, we merely observe that it is true. Hurricane Katrina has provided a textbook example of this phenomenon. All last week, while Katrina was visiting misery on hundreds of thousands of Gulf Coast residents, she was also lavishing riches on hundreds of thousands of investors.

Because the massive hurricane destroyed oil platforms in the Gulf of Mexico, oil service companies like Tidewater (NYSE: TDW) will receive new multi-million dollar service contracts. Because Katrina flooded 10% of the nation’s refineries, the non-flooded 90% of the nation’s refineries will receive much higher prices for the refined products they produce. Because the hurricane devastated residential and commercial structures throughout the Gulf Coast region, a purveyor of construction and repair materials like Hughes Supply will enjoy a brisk demand for its products. You get the idea … and so do many other investors, which is why numerous “Katrina plays” have jumped sharply since the hurricane struck New Orleans last week.

But event-driven gains in the stock market tend to wither as quickly as they first appear. After the 9/11 terrorist attacks, for example, the share price of defense contractor, EDO Corp., jumped 50% immediately. But the stock quickly surrendered all of its post-9/11 gains, and then some. Today, the stock languishes about 10% below its post-9/11 peak. The trick, therefore, is to distinguish between fleeting fancies and enduring trends. So let’s consider for a moment what sorts of companies might enjoy an enduring benefit from the New Orleans tragedy.

Short-term bullish trends excite us much less than long-term bullish trends. We are more interested in long- term ideas. We are much more interested identifying companies that inhabit a changed world, thanks to Katrina. Perhaps we are expecting too much to believe that one storm – even a very big storm – could permanently improve the economic environment for any company. But perhaps not. When Katrina disabled large swaths of our nation’s oil-production infrastructure, she also destroyed much of the nation’s complacency about future energy supplies. We now realize just how vulnerable we are to supply shocks, whether by acts of God or by acts of terrorists. It is now clear to all of us Americans that we live hand-to-mouth, energy-wise. In the wake of this realization, Americans may be much more inclined to embrace – or at least tolerate – nuclear power. Likewise, they may be much more motivated to secure foreign sources of oil, or to expedite the construction LNG terminals, or to increase the production of ethanol.

Katrina Plays, II

Yesterday afternoon, we dispatched an email to various colleagues, acquaintances and investment gurus to solicit their favorite “Katrina plays”. Almost everyone replied. So please permit us to share a sampling of their responses.

Dan Denning has been pretty bearish toward the homebuilders, but suspects that the monetary aftereffects of the hurricane will give the homebuilders a second wind … so to speak. Chris Mayer likes Plum Creek Timber (NYSE: PCL), the U.S. timberland REIT. Karim Rahemtulla recommends long-term, covered-call positions on slot machine manufacturer International Game Technology (NYSE: IGT). Dan Ferris is partial to reinsurers, who he says will make a ton of money next year. And Carl Waynberg thinks we can clean up with small-cap, environmental services company Global Development and Environmental Resources (OTC: GDVE).

THE HEDGE FUND REPORT: BANKS IN UNCHARTED WATERS

Not every academic is treated well by hedge fund managers. But when Andrew Lo, who is both a finance professor at the M.I.T. and a quantitative manager for AlphaSimplex Group, writes a research paper, the industry takes notice. In an article titled “Systemic Risk and Hedge Funds,” Lo sounds an alarm over the “symbiotic relationship” between hedge funds and banks. He says that the risk exposure of the hedge fund industry may have a material impact on the banking sector. As Long-Term Capital Management illustrated, hedge funds are exposed to two main risks: illiquidity and leverage. With banks becoming more and more dependent on hedge funds as sources of banking and brokerage fees, their exposure to the same problem is “currently on the rise,” Lo says.

Citing a 2003 analysis of more than 100 liquidated hedge funds, Lo says that half were the result of operational risk, including fraud. Common operational issues included the misrepresentation of fund investments (41% of the cases), misappropriation of investor funds (30%), unauthorized trading (14%) and inadequate resources (6% of the sample). The upshot is that hedge funds represent a different type of risk than banks are used to dealing with.

GOVERNMENT INTERVENTION IN STOCK MARKET IS DETAILED BY NEW REPORT, GATA SAYS

A major Canadian financial management firm that a year ago published a compilation of evidence of central bank manipulation of the gold price has just done the same in regard to the U.S. stock market and has reached a similar conclusion. The new report is titled “Move Over, Adam Smith: The Visible Hand of Uncle Sam”, and has been published by Sprott Asset Management of Toronto. It was written by the firm’s president, John P. Embry, and his assistant, Andrew Hepburn, and concludes that the U.S. government has intervened to support the stock market so many times that “what apparently started as a stopgap measure may have morphed into a serious moral hazard situation, with market manipulation an endemic feature of the U.S. stock market.”

The new report relies largely on reports of news organizations and the essays and research papers of economics academics that, as might be expected, have not been well-publicized in the United States. But some of these reports have been circulated by the Gold Anti-Trust Action Committee over the years. The Sprott report does not maintain that the government should never intervene in the stock market; it recognizes that certain emergencies may argue strongly for temporary intervention, such as the 1987 stock market crash and the terrorist attacks of September 2001. But, the Sprott report notes, frequent surreptitious intervention, conducted through intermediaries, the government’s favored financial houses in New York, gives those intermediaries enormous advantages over ordinary investors. Frequent intervention, the Sprott report adds also makes it impossible to distinguish between national emergencies and political expediency.

The Sprott report concludes: “Given the available information, we do not believe there can be any doubt that the U.S. government has intervened to support the stock market. Too much credible information exists to deny this. Yet virtually no one ever mentions government intervention publicly, preferring instead to pretend as if such activities have never taken place and never would. … Administered in extremely small doses and with the most stringent safeguards and transparency, market stabilization could be justified. But a policy enacted in secret and knowingly withheld from the body politic has created a huge disconnect between those knowledgeable about such activities and the majority of the public, who have no clue whatsoever.” The Sprott report can be found here or here (PDF format).

WHAT IS HOLDING GOLD BACK?

After the price of gold spiked over $850 in January of 1980, gold production increased substantially – and it stayed up, even with the steep falloff in gold prices. Production has gone from about 1,200 tonnes per year in 1980 to its current level, over 2,500 tpy. Where did all that new gold production come from? Aside from the dramatic increase in price incentive in 1980, new technologies have matured, such as heap leaching and satellite prospect identification. In addition, since the collapse of communism, many prospective areas of the world have opened to modern exploration.

Another economic factor keeping the price of gold down recently has been producer hedging. This is a particularly complex part of the puzzle, but in a nutshell, when gold was falling, as it was from 1980 to 2000, many big producers, starting with Barrick, “hedged” against decreasing prices by selling large portions of their future production at substantially over the then-current prices. Since gold is a “carrying charge” market, it is usually possible to sell several years forward at a price reflecting current interest rates and storage costs. In the mid ‘80s, when gold was, say, $400, that meant they could sell three years out for, say, $520. When time came to deliver, the metal might actually have traded for only $350. That was a very smart thing to do … at the time. What was not so smart was failing to recognize when gold bottomed out and prices started rising again. The producers have started de-hedging in the last couple of years but they still have massive short positions. By some estimates, on the order of 1,700 tonnes of gold – almost half last year’s entire gold supply from all sources – is still sold forward.

Obviously, gold sold forward in the last 5-7 years at prices considerably below today’s is costing these companies a fortune, but the big impact on price may come from the bullion banks. Why? Because they could borrow gold from central banks for nominal interest rates (0.5 to 1.0%), sell it on the open market (believing they will be able to return it when they take delivery on futures contracts bought from hedging mines) and invest the proceeds, conservatively, to clear a 4 to 5% profit margin. This had the effect of increasing the global supply of gold, basically adding already produced (borrowed) reserves onto the production/supply side of the scales.

Another purely economic factor holding the price of gold back may simply be short-term traders selling every time gold approaches $440. In addition, investor fascination with real estate is drawing capital from other investments, even undervalued ones like gold. Why did investors focus on real estate, rather than gold, after the tech bubble burst, the dollar started falling, and broader equities markets started trading sideways? I attribute it mainly to the fact that gold was in a secular bear market from 1980 to 2001. As a consequence, a whole generation of investors grew up thinking of it as an investment “dog” as well as a monetary anachronism. Though we are seeing the beginnings of a change in attitude, most institutional and retail investors still think putting capital in gold and other precious metals is a little loony.

When the housing bubble bursts, though, I suspect things will begin to change. Stocks, bonds, and the depreciating dollar will not provide a refuge. The herd is going to head into commodities in general, and gold in particular. Gold is, after all, the crisis commodity – and I am more convinced than ever that we are heading for a financial crisis that is going to dwarf what we saw in the 1930s.

As long-time readers know, I do not generally subscribe to conspiracy theories. Occam's Razor dictates that the simplest solution to a problem is likely the most correct one. And anybody who has tried to get a few friends to agree on something as simple as what movie to watch can imagine how hard it might be getting dozens of the most powerful malefactors in the world to agree on how to suppress the gold price. But I have to say that the folks at the Gold Anti-Trust Action Committee (www.gata.org) present a pretty compelling case. [Ed: Also see article immediately above.] Central banks may not be able to control the price of gold, as was the case before 1971, but they have the motive, means and appearance of influencing it. The U.S. in particular, since its dollar has in good measure replaced gold as a reserve asset around the world, has an interest in seeing low gold prices, and a quiet gold market.

The key component of GATA’s claims is that the central banks are lending gold to bullion banks and still keeping the gold on their books as reserves. In these “swaps”, each bar of gold essentially gets counted twice, exerting a negative pressure on the gold price when the borrowed gold gets sold on the open market. There is no question that bullion banks are selling borrowed gold – what makes this the stuff of a “conspiracy” is that GATA says the central banks are not being truthful about whether or not they are counting gold not actually in their vaults as reserves. Specifically, GATA chairman Bill Murphy says the central banks are reporting an aggregate of about 31,000 tonnes of gold held in reserve, but only have about half as much in their vaults. In GATA’s words, “… deceptive accounting, countenanced by the IMF, has allowed official sector gold to hit the market without a corresponding drawdown on the balance sheets of central banks.”

Could central bankers really be stupid enough to lend out gold to people who are selling it, in return for a measly 0.5% interest? Yes. My impression of central bankers is that most are not smart enough to buy low and sell high; they are a bunch of stumblebums from wealthy families who know how to dress well. They likely feel quite clever getting 0.5%, when before they were getting nothing. I also do not doubt the favor to the bullion banks often gets repaid with cushy jobs or consulting contracts after the bureaucrats go out into the private sector.

What happens if production from Barrick and the other hedged producers (many of whom are taking a severe beating from rising costs and commitments to sell gold at below-market prices) falls off and J.P. Morgan and the other bullion banks cannot replace the gold they have sold at prices they can afford to pay? It will be a scandal of a scale that, by itself, could move gold much higher. But even if that does not happen, it is easy to see that the bullion banks must feel a well-deserved and thoroughly unpleasant jolt of panic every time the price of gold heads north. Fear of the possible consequences could certainly drive them to lend even more gold to the bullion banks, adding selling pressure whenever the price of gold goes up, making the hole they are digging deeper each time.

Whether or not there is any deliberate price manipulation may be hard for GATA to prove. However, GATA’s questions of the central bankers regarding their policies on reserves, swaps, sales, etc. are valid and deserve answers. I have made light of GATA’s efforts to force disclosure in the past only because I have felt they were doomed to failure, not because I disapproved of the intent. I asked Bill Murphy how long before the bullion banks and central banks hit the wall and the whole house of cards collapses. Bill answered: “I think we’re there now. I’m not sure the central banks can lend any more gold out – the scandal could break at any moment.”