Finance Digest for Week of September 26, 2005

WHO’S BLAMING WHOM?

An unbalanced world is getting caught up in the blame game. As the IMF and World Bank gather in Washington for their annual meeting, the risk of finger pointing is high. There are two sides to this increasingly contentious dispute: The United States is pinning the blame for its massive trade and current account deficits on the rest of the world – bemoaning sluggish growth in Europe and Japan, along with unfair trading practices in China. The rest of the world holds the saving-short U.S. accountable for a disproportionate share of the global economy’s unprecedented imbalances. Where should the blame be placed?

Unfortunately, the answers are painfully obvious. America is to blame in shaping its own destiny. Sadly, that destiny is now manifested in the form of record excesses in the U.S. economy. That is true of the national saving rate, the current account deficit, household sector indebtedness, the consumption share of GDP, and the bubble-prone state of asset markets. As a result of these excesses, the U.S. now accounts for fully 70% of the world’s imbalances – well above any measure of its share in the global economy. Like it or not, the U.S. deserves a disproportionate share of the blame for global imbalances.

For financial markets, the implications are profound: The longer the world continues to play the blame game, the more the imbalances will build, and the greater the likelihood of a hard landing for the global economy and world financial markets. America’s failure to own up to its major role in fostering global imbalances is especially disturbing. By refusing to address its ever-mounting imbalances, the U.S. flirts increasingly with a classic current account adjustment. That underscores downside risks to the U.S. dollar and upside risks to real U.S. interest rates. America’s lack of leadership in resolving global imbalances is hardly commensurate with its dominant position in the world economy.

HIGH CHOLESTEROL, LOW HOME PRICES

A couple of nagging thoughts have been vexing your editor lately: 1) Why do so many of God’s tastiest dietary creations contain so much cholesterol? 2) Could the U.S. housing bubble burst at the very moment when so many people – Chairman Greenspan, in particular – expect it to occur?

Two years ago, the “housing bubble” proponents comprised the lunatic fringe. One year ago, they seemed a little less crazy, but still constituted a distinct minority. Today, almost everyone seems to fear a housing bubble and expects it to burst – or to begin deflating – very soon. We have counted ourselves among the bubble-phobic majority of housing market observers, and have written several columns chronicling the bubble’s dangerous development. But this negative viewpoint has become so pervasive that we are forced to consider alternative scenarios.

We do not doubt that the housing market contains numerous pockets of excess and elements of risk. Even so, the bubble need not burst in September of 2005, right when so many folks – including Greenspan – seem to expect it. The fact that Chairman Greenspan has begun to worry about the housing market is exactly what worries us most about worrying about the housing market. In other words, if Greenspan is worried, we probably should not be. The Chairman is a kind of contrary indicator in pinstripes, always giving voice (and lots of words) to the prevailing investment opinions – the very same opinions that tend to be the wrong opinions. In 1996, Greenspan fretted aloud about the frothy stock market. Over the ensuing three years, the Nasdaq Composite Index quadrupled. But instead of worrying more about soaring stock prices, the Chairman worried less. In 2000, he was praising a productivity revolution that seemed to validate the elevated share prices of the day. THAT is when the bubble burst and the stock market cratered.

As we fast-forward to August 27, 2005, we find Chairman Greenspan musing aloud once again about asset values. But this time the topic is housing, not stocks. It is true that the housing boom will “inevitably simmer down”, as the Chairman predicts, but maybe it will not do so over the “near term”. Indeed, yesterday’s home sales report suggests that the housing market has absolutely no intention of simmering down.

So what might keep the U.S. housing boom humming along for much longer than most of us can imagine? Maybe a confluence of factors. Specifically, the price of oil and most other commodities might “simmer down” for a while, thereby allowing consumer confidence to perk up. Quiescent commodity prices might also allow interest rates to dip again. And we all know what confident consumers do with low interest rates: They borrow and buy … especially houses. A drop in interest rates would also help mortgage lenders to help home-buyers to buy “more home” than they could otherwise afford. The housing boom will end, but it may not end exactly on Greenspan’s cue.

Prices sky-high in Hamptons.

Median prices for single family homes in Southampton Village are up almost 70% since the end of 2004, almost tripling the gains of other haughty Hamptons hamlets, according to the latest figures released by Suffolk Research Service, a real estate tracking company. The median price now stands at $1.6 million, up from $945,000 at the end of last year. East Hampton Village still leads in the highest median price category at $2.1 million. That is up only about 15% from $1.8 million the year before.

Paul Brennan, the regional manager for Prudential Douglas Elliman, says Southampton’s spectacular price rise is cyclical. “We’re dealing with the upper echelon, as opposed to the rest of the country where things appear to be a little weak,” he explains. “When interest rates start to go up, you’re likely to see this [market] start to cool off.”

New phrases, same old bubble sentiment.

No investment market ever sees a “new” kind of sentiment, only different degrees of the emotions which are common to us all. The sentiment in a given market cannot be measured with the same precision as the price levels can, yet we do know that when historic price extremes appear, a predictable series of emotions will follow. The “predictable” part shows up in the emotional phrase-of-the-moment that you are bound to read and hear.

For instance, at the peak of the tech stock bubble in 2000, it was the notion that “The only risk is being out of the market.” After the initial sharp declines in the NASDAQ, it was “Okay, some sanity has returned to the market.” In 2001, well, “Nobody knew prices would fall this far.” At the 2002 lows, “Everybody knew it was a bubble!” That was just about the time that an all-too recognizable sentiment began to build in a “safer” investment, which a CNN/Money headline on October 25, 2002 characterized as “Riding the Real Estate Wave”.

The article observed that “with most stock portfolios on a slow road to recovery, investors have begun turning their attention to the relative safety of home sweet home.” The real estate industry began to report unprecedented enrollment in classes to get a realtor’s license, likewise the mortgage industry regarding a mortgage broker’s license. But that was three years ago. A different trend is unfolding now: The inventory of new homes for sale has been rising in recent months, even as the prices for those homes have been falling. In answer to the question “How much have they been falling?”, consider the chart below. As for sentiment – is the real estate market at or nearing the “sanity has returned” stage?

FINDING THE UNEXPECTED IN ARGENTINA

My recent journey to Buenos Aires gave me everything I expected – and plenty I did not. I did not expect, for example, to whirl around in a crowded bar and spy my friend being licked in the face – like a kitten being bathed by its mother – by a tall, 30-something Argentine man. The fellow claimed that is how passionate Argentineans kiss their ladies. My friend, unfortunately, was not elated at her need for a mop after the “passion”, and we fled the bar. I did not expect to find a mullet haircut on the head of seemingly every male around. I did not expect to find Irish bars on every corner. I did not expect to get an incessant parade of curious stares because of my blond hair and American clothes. I did not expect to feel relatively safe from thugs, thieves and kidnappers during my entire stay. And, despite everything I had read, I certainly did not expect to find the country on such a firm track to stability just three years after its complete economic collapse.

Sure, I got everything I expected – the seductive tango dancers around every corner, the charming street fairs, the European architecture and cobblestone roads, the incredibly tender free-range beef and phenomenally cheap prices. But it is what I found in the unexpected that truly amazed me. Imagine waking one bright morning, hurriedly lacing up your shoes and heading out early. You walk briskly to your first stop, the bank. Passing some curious protests in the streets, you are slammed with a life-altering realization when you reach the bank: Your account balance has been slashed by one third, and you cannot even touch the remaining two thirds because the government has put a 90-day freeze on all bank accounts. And we are not talking risky investments here – we are talking supposedly cast-iron savings accounts. You cannot pay your mortgage, you cannot take out money for lunch, you cannot buy gas, you cannot pay your child’s tuition, you cannot even get a few bucks for the bus home. Though this scenario sounds like nothing more than a ghastly dream to us, this living nightmare actually happened to the people of Argentina just three years ago.

As many of you will recall, Argentina was a Wall Street darling in the late 1990s. U.S. investors loved the country like a fat kid loves cake. But Argentina was borrowing vast amounts of money, and by 2001 the rubber band snapped and a catastrophic economic collapse ensued. Fortunes evaporated overnight. Riots broke out in the streets. Poverty levels soared to new highs. And the flailing Argentinean government could not even begin to pay back its IMF loans or honor its bonds. The country found itself in debt totaling more than $102 billion. Now, just three years after defaulting on the largest debt in modern history, Argentina is a screaming buy. I can attest to the notion that Buenos Aires is a world-class city in a thriving country. In fact, I believe Argentina to be the absolute cheapest country in the Western World.

Argentina has a truly Western culture, as more than 95% of its citizens can directly trace their roots back to Europe. Buenos Aires is a very European city, often dubbed the “Paris of South America”. That Western feel is particularly attractive to investors who are hesitant about the South American political wild cards. Argentina benefits from a highly literate population, and many foreign companies are even beginning to move their outsourcing centers from India to Argentina because of the country’s well-educated (and cheap) workforce, as well as the more favorable time difference.

When inflation was skyrocketing in Argentina in the early 1990s, many transplanted Europeans trekked back to their homeland. But now, with prices in Argentina so cheap, the Europeans are going “bottom-fishing” and returning once again to live and invest. Here is just one example of “cheap”: wine, appetizer, tender juicy steak and potatoes, and coffee for 10 pesos – roughly $3.45. A 10-minute cab ride across town? Five pesos, or about $1.74. I took a ride of comparable length in New York City a few weeks ago that cost $20.

After visiting several top publicly traded companies, being treated to a private tour of the Buenos Aires stock exchange, interviewing busy CEOs and exploring the burgeoning real-estate market firsthand, I stand firm in my belief that Argentinean stocks, for the most part, are overlooked and undervalued. But the rise is already starting … so please, forget everything your gut tells you about investing in a country recently arisen from the ruins. Argentina is not the first and probably will not be the last country to break out after a severe economic crisis. During Mexico’s so-called “Tequila Crisis” of 1994-1995, the currency lost half its value in just a few months. Mutual funds that invest in Latin American stocks saw their value slashed by 16% ($600 million) in a matter of days. Mexican media giant Grupo Televisa’s shares plummeted following the peso devaluation, falling to lows of $11.84 in March 1995. But by April 1996, shares were on the rebound and already back to trading at $30.24. By 2000, shares were trading north of $80!

I traveled to Argentina with a basic premise: that Argentina had probably survived the worst of its economic crisis, that conditions in the country and its economy were steadily improving, and that there were still strings of profitable opportunities in the country for savvy investors. And it looks like my hypothesis is proving true month after month. Argentina’s benchmark Merval index just hit a fresh record high of 1,665 – a 52-week surge of 54%. And if you look at a two-year chart of the benchmark Merval, you will see that the index is not going to stop here. Here is to the unexpected.

THREE CALLS ON THE “CREDIT SPREAD”

In the debt market, higher-risk debt typically pays a higher yield to the debt holder, as in junk bonds pay more than Treasury bills. The rationale for this should need no explanation. The surprise would be if investors did not demand higher yields for riskier debt. Yet in 2004 and into early 2005, an exception to this rule of the debt markets unfolded – namely the collapse of the credit spread, or the difference in yield between high vs. low risk bonds. In February of this year, the appetite for risk brought the spread to its most narrow point ever. Junk bond yields were only slightly higher than Treasury yields, yet investors were buying “junk” hand over fist anyway.

A host of indicators (both sentiment and technical) loudly made the case that this upside-down psychology could not last, and in fact would reverse itself soon. Below is a chart of the credit spread, with arrows pointing to our commentary at crucial junctures during the year. The quotes themselves are beneath the chart. The obvious question now: Does this latest leg have further to widen?

TWO RED FLAGS FOR THE FTSE-100

This summer, the British FTSE 100 did something it has not done in three years. On June 17, it popped above the psychologically important 5,000 level to close at a 3-year high. And since then, much to the pleasure of the British index funds investors, it added almost another 500 points. Call index fund investors lazy, but they are not too big on picking stocks. Rather than looking for that one needle-in-a-haystack winner, they put their cash in the entire stock index. If it goes up, like the FTSE has done, they make money. Besides not having to worry about which stocks to buy, another advantage of index investing is that by playing in all of the index stocks at once, you spread the risk between dozens of issues. Or so they say.

In the FTSE-100’s case, the risk is supposedly spread between 100 blue chips. But the devil is in the details, and the details are quite surprising. The FTSE-100 is becoming an increasingly risky place, some analysts say. Way too much money is now concentrated in the stocks of just a handful of firms. Ten biggest companies make up more than 50% of the index, compared with only about 20% ten years ago. And if you dig deeper, you find that of those ten firms, five are real monsters: BP (10%), Shell (7%), with HSBC, GlaxoSmithKline and Vodafone not far behind. Shell’s percentage was smaller until it merged its UK and Dutch operations in August. Other British firms are also consolidating; in fact, mergers have been all the rage in the UK lately. At least 20 of the FTSE’s blue chips “are thought to be takeover targets, with merger and acquisition activity in the UK approaching the 1999 level” (The Independent).

A well-done merger can only add to the competitiveness of the business. So while the ten behemoths may indeed represent half of the FTSE’s value, the firms themselves are becoming leaner and stronger. Perhaps it is not so bad then that the FTSE’s risk is spread out less than before? Perhaps, but over the years, we have observed that M&A activity usually follows the stock market’s larger trend. As stocks go up, the number of mergers increases. When stocks fall, merger talks quiet down. The Wave Principle says that the health of the stock market is a reflection of the society’s overall mood. Could M&A activity be subject to social mood as well?

Indeed, we have noticed that in bull markets, one way that companies express optimism is by taking over other companies. Company officers are very much a part of the market’s psychological fabric just like everyone else, and they tend to become bold when the company outlook appears strongest. With the FTSE-100 sitting at a 3-year high, it is only natural that CEOs are so optimistic now. Just as they were back in 1999. Of course, the UK’s M&A frenzy by itself is not a definitive sign of a top in social mood – and, therefore, the British stock market. But these two potential red flags – the increasing company concentration and the flurry of mergers – are worth keeping in mind. They would become a real omen, though, if the FTSE’s Elliott wave patterns were also indicating a potential top.

STOCKS, REWARDS, AND PATRIOTISM

What kind of stories end up on page C-12 (literally) of the newspaper? I know the answer regarding this morning’s Wall Street Journal, though on most days I rarely get as far as A-12, never mind sections B or C. The headline was about how short interest had “edged lower” on the Nasdaq, a topic that is probably mundane enough to deserve C-12 placement. Yet here was the real news: With an average portfolio gain of 4.4% so far this year, “short sellers have beaten major stock indexes like the Dow Jones Industrial Average, Nasdaq Composite, and Standard & Poor’s 500.”

As you probably know, short selling is an investment that becomes profitable when stock or stock index prices go down. Short sellers have long been Wall Street’s black sheep, to the point that for many years the SEC imposed regulations that make it harder to short sell a stock than to buy it. Recent years have even seen episodes when prominent figures implied that buying stocks amounted to a patriotic duty; you can see the not-so-subtle suggestion of what this means a short-seller would be.

There is no equivalent indignation when lots of people or institutions drive up prices, beyond any semblance of value. Much of Wall Street still functions on behalf of touting stocks, so-called reforms notwithstanding. In truth, the stock market is ill equipped to reward patriotism. It is perfectly equipped to give to investors who anticipate price trends in BOTH directions; it takes away from those who do not.

ARE OIL RESERVES INCREASING?

Eugene Island is an underwater mountain located about 80 miles off the coast of Louisiana in the Gulf of Mexico. In 1973 oil was struck and off-shore platform Eugene 330 erected. The field began production at 15,000 barrels a day, then gradually fell off, as is normal, to 4,000 barrels a day in 1989, Then came the surprise: it reversed itself and increased production to 13,000 barrels a day. Probable reserves have been increased to 400 million barrels from 60 million. The field appears to be filling from below and the crude coming up today is from a geological age different from the original crude, which leads to the speculation that the world has limitless supplies of petroleum.

This really interested some scientists. Thomas Gold, astronomer and professor emeritus of Cornell held for years that oil is actually renewable primordial syrup continually manufactured by the earth under ultra hot conditions and tremendous pressures. This substance migrates upward picking up bacteria that attack it making it appear to have an organic origin, i.e., come from dinosaurs and vegetation. As best I have found so far Russian scientists support his position, at least that petroleum is of primordial origin. There is now plenty of evidence around proving the presence of methane in our universe. It is easy to see it as a part of the formation of the earth. Under the right conditions of temperature and pressure, it converts to more complex hydrocarbons.

Roger Andersen, an oceanographer and executive director of Columbia’s Energy Research Center proposed studying the behavior of this reservoir. The underwater landscape around Eugene Island is weird, cut with faults and fissures that belch gas and oil. Andersen proposed to study the action of the sea bottom around the mountain and the field at its top and persuaded the U.S. Dept of Energy to ante up $10 million which was matched by a consortium of oil giants including Chevron, Exxon, and Tex Corp. Anderson was able to stack 3D images resulting in a 4D image that showed the reservoir in 3 spatial dimensions and enabled researchers to track the movement of oil. Their most stunning find was a deep fault at a bottom corner of the computer scan that showed oil literally gushing in. “We could see the stream,” says Andersen. “It wasn’t even debated that it was happening.”

Work continued for five years until funds ran out and they were unable to continue. With the world having 40 years of proven reserves in hand it is difficult to interest the major oil producers in much exploration, let alone something done merely for research, and so far from the current accepted theory of a fossil origin for oil. Similar occurrences have been seen at other Gulf Of Mexico fields, at the Cook Inlet oil field, at oil fields in Uzbekistan, and it is possible this accounts for the longevity of the Saudi Arabian fields where few new finds have been made, yet reserves have doubled while the fields have been exploited mercilessly for 50 years.

Not only can the doom and gloomers not show us running out of the natural resources we recycle, but now there appears to be good odds of a limitless supply of petroleum working its way up to where we can capture it. A caveat: Gold’s theory is not yet accepted by all scientists … probably all the more reason to trust it.

Reality Bites

The era of cheap crude is over … expensive oil is here to stay. Puru Saxena’s research shows that the supply and demand of crude is seriously out of balance.

E-Day!

On September 19, Byron King, editor of Whisky and Gunpowder, dispatched an email to several of his colleagues that contained an article by Jim Kunstler. The gist of the article may be gleaned from its first two paragraphs: “Take a good look at America around you now, because when we emerge from the winter of 2005-6, we’re going to be another country. The reality-oblivious nation of mall hounds, bargain shoppers, happy motorists, NASCAR fans, Red State war hawks, and born-again Krispy Kremers is headed into a werewolf-like transformation that will reveal to all the tragic monster we have become.

“What we will leave behind is the certainty that we have made the right choices. Was it a good thing to buy a 3,600 square foot house 32 miles outside Minneapolis with an interest-only, adjustable rate mortgage – with natural gas for home heating running at $12 a unit and gasoline over $3 a gallon? Was it the right choice to run three credit cards up to their $5000 limit? Was I a chump to think my pension from Acme Airlines would really be there for me? Do I really owe the Middletown Hospital $17,678 for a gall bladder operation that took forty-five minutes? And why did they charge me $238 for a plastic catheter? All kinds of assumptions about the okay-ness of our recent collective behavior are headed out the window.”

Two days later, Byron added a few choice comments of his own … just to get the debate rolling: “‘Peak Oil’ is real,” he asserted. “Peak Oil is the intersection of resource depletion of the world’s most commonly used fossil fuel, with the expansive activities of the world’s central banks, and particularly that bank of the USA. Too much money-creation over the past 90 years has accelerated the world’s ability to exploit and use a finite resource. We have plundered the future. So Peak Oil will happen.

“Now, the world can either let Peak Oil happen and do little or nothing along the way. In that case, Malthus will be vindicated in the manner forecast by the folks at www.dieoff.org. I kind of think that many nations are on that track, including the U.S. Or the world can adapt itself to Peak Oil, and change the way that mankind does business. I know that this latter notion is rather fanciful. But it is the ‘other’ option at the ‘other’ end of the argument.”

A few days later, Justice Litle, editor of Outstanding Investments, offered a reply: “I submit that the peak oil scenario still represents more of a political threat than a physical one. I remember reading not long ago that the American public spends more on yogurt than they do on the entire political election process. To invoke Senator Dirksen, force Americans to give up yogurt, ice cream, frozen pizza, and a few dozen other non-essential items, and suddenly you’re talking real money. The US is a $12 trillion economy grown fat on entitlements and a me-first political process. The point of that observation is that there is a lot of fat we can trim before it’s time to start talking about people dying in the streets.

“… I don’t foresee the worst peak oil predictions coming true. But if they did, it might look like a Mussolini style nightmare from a political standpoint... but I doubt that mass numbers of Americans would be starving or dying off.

“… in my opinion, the peak oil predictions suggest political Armageddon more than anything else. From a technological standpoint, it remains true that we have the capability of solving our energy problems for the long run. It is just a matter of how much pain we face in the short run due to deadline compression.”

Dan Denning writes: “Justice, I think that you haven’t entirely answered the claim that the ‘peak oil’ problem is a real physical problem. You wrote: ‘I submit that the peak oil scenario still represents more of a political threat than a physical one.’ But I see these two threats as inseparable realities. You assert that peak oil can’t ever produce a genuine and lasting energy crisis, because eventually high oil prices will make other unconventional energy sources ‘economic.’ In other words, there is plenty of energy in the world. It just may cost us more to get it.

“But this is exactly the peak oil argument; that the production of cheap reserves of high-quality petroleum are declining, and that this phenomenon will unleash a series of geopolitical and domestic economic consequences.

“… We’ve invested a lot of political capital, as well as real capital, in the Middle East, not to mention lives. Surely that has to be figured in the net petroleum yield we get from that part of the world. By this math, oil isn’t nearly as cheap as we’ve been making it out to be. And if the last 50 years have proved more energy intensive on the cost side than first meets the eye, these intangible costs may seem as nothing compared to the future costs of relying on Middle East oil. This week, China put its first blue water warship to sea, no doubt just the beginning of its effort to secure the sea lanes through which China receives its oil and other commodities. And Iran, with its huge energy reserves, is developing a nuclear insurance policy to prevent an eventual American attack.

“Does the oil price include these costs? If it did, maybe Middle East oil wouldn’t be as ‘economic’ after all. There are no mullahs in Utah, hurricanes in Colorado, or communists in Wyoming. But you will find a lot of gas, coal, and shale in the Powder River, Green River, and Piceance basins.

“The second point Byron [King] and I have been trying to establish is by far the more important point. It refers to what Jim Kunstler calls, ‘the greatest misallocation of resources in the history of the world … America took all its post-war wealth and invested it in a living arrangement that has no future.

“The American economy is not prepared for expensive energy. The American economy was built on an aberration and abetted by a mistake. The aberration is cheap oil, which will prove to be the exception and not the rule of industrial development. The mistake is fiat money and low interest rates, which, when coupled with cheap oil, created an American economy whose current structure can’t survive higher energy prices.

“Think about it … Large tract houses 30 minutes to an hour away from where folks work. The houses are only affordable through easy credit. The cars and SUVs that transport those people to work are only affordable when the automakers practically give them away or turn themselves into financiers rather than manufacturers. Swarms of shopping malls sprout up around these suburban developments in order to furnish, fuel, and feed the locals. And guess what? The stores themselves are also granting credit to their customers, or home equity lines of credit perpetuating the cycle. The retail/consumption economy becomes joined at the hip to the housing cycle: a mega consumption and credit bubble. … It would be nice if solving the peak oil problem were just a matter of suffering a little pain. But my contention here is that we’ve created something that can’t survive because it wasn’t built to survive the conditions we’re headed for.

“In the grand scheme of things, this puts the industrial revolution and the American dominance of the 20th century squarely in a strange light: a one-off boom/bubble begot by the marriage of easy money and cheap energy, creating an expectation for higher standards of living – standards which are not possible for six billion people at the American level of energy intensity. The competition for this standard of living and the disappointment people will feel when they realize it is not possible for everyone on the planet is about to create a geo-political firestorm, not to mention disappoint a lot of people in the West who thought that infinitely higher standards of living and abundant energy and credit are enshrined somewhere in the U.S. Constitution.

“Like you, however, I’m an optimist. People will adapt. There’s other energy out there. Money will be made. But I don’t see any theoretical or technological bullet to save our fat from the fire. We’re just too damn fat.”

To which Justice immediately replied: “… Death of frivolous consumption, certainly. Death of representative democracy, quite possibly (in fact we are already witnessing this). Death of people for lack of basic survival necessities? Doubt it. We have been coddled for so long, we have lost perspective as to what the basic rudiments of survival really are. We will still have food, water, and shelter in abundance, even if the majority of creature comforts are given up by the majority of the populace. The rhinoceros will be in for a hell of a shock, but he will not die. His way of life will be stripped to the bone, but not extinguished.”

“Perhaps one could view peak oil as a desert that the civilized world must trek across. What we cannot know for certain is how long the journey will take, or the highest temperatures we will need to endure along the way. While I don’t have a firm stance on those questions, I am confident that we’ll make it to the other side.”

(With the flood of response we received yesterday regarding this debate, we sense a round two in the works, so keep an eye on this space.)

FANNIE MAE PROBE TURNS UP MORE FIDDLES

Investigators combing through Fannie Mae’s (FNM) finances have found new and pervasive accounting violations showing executives embellished the company’s earnings over the years by overvaluing its assets, underreporting credit losses and misusing tax credits – on top of what has already been disclosed, according to people close to, or who have been involved in, the inquiries.

Several of these people examining Fannie’s books also said evidence indicates the company purchased so-called finite insurance policies to hide earnings losses after they were incurred. Securities regulators, including New York State Attorney General Eliot Spitzer, are cracking down on corporations they say bolstered earnings by using abusive financial reinsurance policies that are more akin to loans where little or no risk is transferred to the insurer. These people said Fannie’s accounting problems uncovered thus far stand in stark contrast to those found at fellow government-sponsored enterprise Freddie Mac (FRE), whose earnings restatement in 2003 showed the company deferred roughly $5.3 billion in excess, after-tax profits to future quarters. The GSEs – which buy mortgages, guarantee their payment and bundle them as securities that are sold off or held in portfolio – own or guarantee nearly half of the $8 trillion residential mortgage market.

At Fannie, much of the company’s accounting violations have helped them to conceal losses over the years – rather than delay gains, according to these people. In addition, they said Fannie’s restatement is likely to show that its total cumulative losses will be higher and will include more “realized” losses, as opposed to paper losses, than the company has previously disclosed and many investors anticipate. That is attributed, at least in part, to new evidence that Fannie has artificially pumped up the underlying value of its $768 billion mortgage portfolio and other investments, compounding the size of the errors that need to be corrected. Unlike Freddie, the real economic losses at Fannie simply are not going to show up in future quarters period since the underlying value of their assets was inflated.

Fannie Mae be kicked.

The accounting disaster at Fannie Mae, the giant mortgage guarantor already in the midst of a multiyear investigation of financial shenanigans, appears to be much worse than previously thought. Investigators now say that the $11 billion estimate of Fannie Mae’s accounting gimmicks appears to be a best-case scenario. The company ran into trouble because it overvalued derivative losses and the value of hedges on its $760 billion portfolio.

The new woes also include the misuse of lower-income housing tax credits and the potential use of a controversial form of insurance called finite reinsurance, said the investigators cited by Dow Jones. “The question the new revelations really raise is fraud,” said Bert Ely, a former Fannie Mae consultant turned critic. “Were these accounting errors or done intentionally? If they were intentional, we are beginning to approach record levels of deceit.” Ely said the tax credit problems could change Fannie Mae’s tax rate and cost the firm a fortune. “A 5 or 10 percent change in tax rate on $8 billion in earnings is massive,” he said.

GOLD’S PERFECT STORM

To highlight gold’s virtues at this juncture runs the risk of sounding like one of those financial zealots castigated last Saturday in the Lex column of the Financial Times. In spite of the ongoing disparagement, the yellow metal has continued to shed its “barbarous” reputation, taking out fresh 18-year highs last week. Even more impressive is that for the first time in years, bullion is showing strength, not just in dollar terms, but also euros, Swiss francs, and yen.

Such a broadly-based advance has elicited the reluctant attentions of the mainstream press, which generally raise the subject of gold with the same degree of enthusiasm that President Bush does in discussing the mistakes of his administration. The usual politically correct reasons have been outlined: The inexorable rise in the price of oil, mounting monetary disorder, President Bush’s increasingly banana republic-like budget policies, the German elections, and hurricanes Katrina and Rita have all contributed. Perhaps none of these explanations in and of themselves can explain the reasons behind the yellow metal’s persistent strength, but taken in aggregate they have all contributed. In essence, we have the “perfect storm”, bringing new entrants into the market, all of whom have played a significant role in overwhelming long time central bank efforts to manage the gold price.

After a rally of almost 10% this month, and the inevitable participation of price-chasing momentum investors, it is conceivable that we could see a short term period of weakness in gold. Gold’s newfound prominence in the mainstream press may also be suggestive of a temporary top. The metal tends to do best when quietly operating under the radar of most market participants and pundits.

It is an unfortunate truth that the mainstream economics establishment has managed to smear gold enthusiasts with the tar of either irrelevance or craziness or both. Not only are these charges unjust, but they the purpose of keep discussion of the virtues of gold off the pages of “serious” publications like the FT or the Economist (except when the objective is to disparage the metal and its supporters). Nevertheless, this should not obscure the fact that the international economy is essentially pursuing a continuation of the same economic policy that has been followed for the better part of the last century. This, by and large, involves borrowing larger and larger amounts of money that are monetized by the Fed and the major central banks at rates varying with the business and credit cycle. With a seemingly never-ending U.S. credit bubble now stoking an extraordinary global liquidity glut, the fuse has been lit: ongoing financial fragility, coupled with an increasingly unstable political backdrop, high oil prices, and Europe’s soggy economic growth, have all created the perfect storm to ensure gold’s continued robustness in the medium to longer term.

BIG, BIG POCKETS IN INDIA

A trip to a real estate agent’s office in Chennai, India, was quite an eye-opener. We arrived five minutes early for our appointment. Outside the agent’s office building, we saw a man in white pants and a white shirt. He was lazily pacing up and down, his white flip-flops slapping loudly against his feet. I rolled down our car window and asked him, “Is this Mr. Natesan’s office?”

“Natesan, yes,” he replied in English.

“Is he in? He’s supposed to show us some properties.”

“Myself Natesan.”

OK, I thought to myself, flip-flop man here is our real estate agent. Natesan was a small man with an ample handlebar mustache. And his white flip-flops were at least two sizes too big. And really loud. “Follow me, madam, I show you land,” he said.

In just four decades, India will be the most populous nation on Earth. India’s middle class alone will be 983 million strong by 2015. And already, one half of India is under the age of 25. Now that is a powerful dynamic. And India’s demographics alone will be its greatest asset. This is a young and increasingly wealthy nation. Natesan will be selling a lot of houses. “See that house, madam? Big cinema star living there,” Natesan explained as we stood on an empty plot of land under the afternoon sun. Many wealthy Indians and Indians abroad have bought land or built beachfront houses in this part of Chennai.

“Everyone got big, big pockets, madam, plenty money. Business being good.” Big pockets, indeed. India’s net income has doubled in the last 10 years. Everything is more affordable. In fact, India is the second largest mobile phone market on Earth. It is also home to the world’s second largest two-wheeler market. “Past years, clearing title not important, madam. But now we are being very careful. Lot of foreigners coming to live here.” Natesan explained as we walked a sandy pathway by the beach to another property.

In recent years, Natesan’s trade has changed. Unclear titles, poor building standards and ridiculous tenancy laws have historically plagued Indian real estate. That is why foreign investors have stayed away. Today, Natesan maintains better records and goes to great lengths to ensure that the title on a property is clear. The government is even considering computerization of land records. Foreign direct investment is now allowed in real estate. And the sector is truly coming of age – financial institutions have filed for permission to introduce $1 billion worth of real estate mutual funds in India.

Does all this activity mean the Indian real estate market is in a bubble? Scarred by the devastating collapse of the dot-com era, we in the United States like to cry bubble at any asset that’s appreciating in value. But there is a difference between a bubble and a robust market. Let us compare India with the U.S. Are Indians consuming more house than they can afford? No. In India, the ratio of the total value of mortgages to the GDP is only 2%, whereas it is 52% in the U.S. That means in the U.S., for every $100 we produce, we owe $52 as mortgage. Indians, however, owe just $2.

Has Indian home buying sent prices through the roof? Hardly. Over the last 10 years, real estate prices have almost remained the same in India, with the exception of a few large cities like Bombay and Bangalore. Median real estate prices in the U.S., however, have risen nearly 15% in the last 12 months alone. Are Indians taking out mortgages simply because rates are low? Interest rates are a healthy 4.3%, an 18% decrease from 2001. In the U.S., interest rates were slashed a whopping 83% since 2001. Indians are using higher incomes (far more than lower rates) to buy homes.

The Indian housing market, unlike the U.S.’s, is not thriving on an artificially propped-up fiscal structure. Growth in the housing sector has been mainly income driven and only partially interest-rate driven. Indian net income has increased nearly 100% over the last 10 years. As Marc Faber puts it, “The most overlooked asset class is Indian real estate, because it is so difficult to develop, given the regulatory environment. The world still has lots of opportunities, and real estate in some unusual areas is an attractive proposition.” India is now trying hard to ease its regulations and encourage foreign direct investment.

And the investment is coming. Driven by the information technology and outsourcing booms, more and more foreign companies are setting up shop in India. Five million square feet of retail space is being developed. And over $25 billion will be spent on urban housing. At the end of our meeting, I told Natesan I would keep in touch. He dusted the sand off his feet and perched on his motorbike. “This is better than America, madam,” he yelled as he drove off.

HOW THE BUSINESS CYCLE HAPPENS

[This excerpt from the first chapters of Murray Rothbard’s America’s Great Depression (1963) appears in celebration of full publication online.]

Study of business cycles must be based upon a satisfactory cycle theory. Gazing at sheaves of statistics without “pre-judgment” is futile. A cycle takes place in the economic world, and therefore a usable cycle theory must be integrated with general economic theory. And yet, remarkably, such integration, even attempted integration, is the exception, not the rule. Economics, in the last two decades, has fissured badly into a host of airtight compartments – each sphere hardly related to the others. Only in the theories of Schumpeter and Mises has cycle theory been integrated into general economics.

The bulk of cycle specialists, who spurn any systematic integration as impossibly deductive and overly simplified, are thereby (wittingly or unwittingly) rejecting economics itself. For if one may forge a theory of the cycle with little or no relation to general economics, then general economics must be incorrect, failing as it does to account for such a vital economic phenomenon. For institutionalists – the pure data collectors – if not for others, this is a welcome conclusion. Even institutionalists, however, must use theory sometimes, in analysis and recommendation; in fact, they end by using a concoction of ad hoc hunches, insights, etc., plucked unsystematically from various theoretical gardens.

Few, if any, economists have realized that the Mises theory of the trade cycle is not just another theory: that, in fact, it meshes closely with a general theory of the economic system. The Mises theory is, in fact, the economic analysis of the necessary consequences of intervention in the free market by bank credit expansion. Followers of the Misesian theory have often displayed excessive modesty in pressing its claims; they have widely protested that the theory is “only one of many possible explanations of business cycles,” and that each cycle may fit a different causal theory. In this, as in so many other realms, eclecticism is misplaced. Since the Mises theory is the only one that stems from a general economic theory, it is the only one that can provide a correct explanation. Unless we are prepared to abandon general theory, we must reject all proposed explanations that do not mesh with general economics.

It is important, first, to distinguish between business cycles and ordinary business fluctuations. We live necessarily in a society of continual and unending change, change that can never be precisely charted in advance. People try to forecast and anticipate changes as best they can, but such forecasting can never be reduced to an exact science. Entrepreneurs are in the business of forecasting changes on the market, both for conditions of demand and of supply. The more successful ones make profits pari passus with their accuracy of judgment, while the unsuccessful forecasters fall by the wayside. As a result, the successful entrepreneurs on the free market will be the ones most adept at anticipating future business conditions. Yet, the forecasting can never be perfect, and entrepreneurs will continue to differ in the success of their judgments. If this were not so, no profits or losses would ever be made in business.

Changes, then, take place continually in all spheres of the economy. Consumer tastes shift; time preferences and consequent proportions of investment and consumption change; the labor force changes in quantity, quality, and location; natural resources are discovered and others are used up; technological changes alter production possibilities; vagaries of climate alter crops, etc. All these changes are typical features of any economic system. In fact, we could not truly conceive of a changeless society, in which everyone did exactly the same things day after day, and no economic data ever changed. And even if we could conceive of such a society, it is doubtful whether many people would wish to bring it about.

It is, therefore, absurd to expect every business activity to be “stabilized” as if these changes were not taking place. To stabilize and “iron out” these fluctuations would, in effect, eradicate any rational productive activity. To take a simple, hypothetical case, suppose that a community is visited every 7 years by the 7-year locust. Every 7 years, therefore, many people launch preparations to deal with the locusts: produce anti-locust equipment, hire trained locust specialists, etc. Obviously, every 7 years there is a “boom” in the locust-fighting industry, which, happily, is “depressed” the other 6 years. Would it help or harm matters if everyone decided to “stabilize” the locust-fighting industry by insisting on producing the machinery evenly every year?

We may, therefore, expect specific business fluctuations all the time. There is no need for any special “cycle theory” to account for them. They are simply the results of changes in economic data and are fully explained by economic theory. Many economists, however, attribute general business depression to “weaknesses” caused by a “depression in building” or a “farm depression”. But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression – a phenomenon of the true “business cycle”.

In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange – money. Money forges the connecting link between all economic activities. If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere. Only changes in the demand for, and/or the supply of, money will cause general price changes.

Yet, while it is true that any cycle in general business must be transmitted through this money relation – the relation between the stock of, and the demand for, money – these changes in themselves explain little. If the money supply increases or demand falls, for example, prices will rise; but why should this generate a “business cycle”? Specifically, why should it bring about a depression? The early business cycle theorists were correct in focusing their attention on the crisis and depression: for these are the phases that puzzle and shock economists and laymen alike, and these are the phases that most need to be explained.

The explanation of depressions, then, will not be found by referring to specific or even general business fluctuations per se. The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors? This is the first question for any cycle theory. Business activity moves along nicely with most business firms making handsome profits. Suddenly, without warning, conditions change and the bulk of business firms are experiencing losses; they are suddenly revealed to have made grievous errors in forecasting. How did all the country’s astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory. It is not legitimate to reply that sudden changes in the data are responsible. It is, after all, the business of entrepreneurs to forecast future changes, some of which are sudden. Why did their forecasts fail so abysmally?

In the purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The “boom-bust” cycle is generated by monetary intervention in the market, specifically bank credit expansion to business. The “boom” is actually a period of wasteful misinvestment. It is the time when errors are made, due to bank credit’s tampering with the free market. The “depression” is actually the process by which the economy adjusts to the wastes and errors of the boom, and reestablishes efficient service of consumer desires. The adjustment process consists in rapid liquidation of the wasteful investments. Some of these will be abandoned altogether (like the Western ghost towns constructed in the boom of 1816-1818 and deserted during the Panic of 1819); others will be shifted to other uses. Always the principle will be not to mourn past errors, but to make most efficient use of the existing stock of capital.

In sum, the free market tends to satisfy voluntarily-expressed consumer desires with maximum efficiency, and this includes the public’s relative desires for present and future consumption. The inflationary boom hobbles this efficiency, and distorts the structure of production, which no longer serves consumers properly. The crisis signals the end of this inflationary distortion, and the depression is the process by which the economy returns to the efficient service of consumers. In short, and this is a highly important point to grasp, the depression is the “recovery” process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a “bust”.

Greenspan says asset prices often fall after eras of “Euphoria”.

Federal Reserve Chairman Alan Greenspan said long eras of economic stability and low risk often give rise to “human euphoria” and that is later followed by declines in asset prices. “A decline in perceived risk is often self-reinforcing in that it encourages presumptions of prolonged stability,” Greenspan said in the text of his remarks from the National Association for Business Economics meeting in Chicago. “History cautions that extended periods of low concern about credit risk have invariably been followed by reversal with an attendant fall in the prices of risky assets.”

Greenspan did not address the near-term course of interest rates in his speech, which focused on the virtues of deregulation and economic flexibility. Increased flexibility in the U.S. economy has helped it weather several shocks in recent years, including the rise of energy prices, he said. The chairman pointed to an issue he has addressed before over the past few months: the “irony” that economic stability produces its own risks when markets become overpriced. It is not realistic to expect central banks to prevent increases in asset price bubbles such as the technology stock surge of the 1990s, he said.

“Such developments apparently reflect not only market dynamics but also the all-too-evident alternating and infectious bouts of human euphoria and distress and the instability they engender,” Greenspan said. “Because it is difficult to suppress growing market exuberance when the economic environment is perceived more stable, a highly flexible system needs to be in place.” The Fed chairman was not specific about whether he was referring to some regional home prices or bond prices, two markets he has referred to as being abnormally priced in recent months.

Real Estate and the Money Supply

This paper shows how the real estate market effects consumer money supply. We bring together the results of our research in the “Interest Rate Conundrum”, “The Housing Bubble-An Update”, and “The Sources and Uses of Household Cash Flow” papers. Home equity loans have become the primary source of M-1 growth. Home resales have become an important source of non-M-1 M-2 growth. This situation is under-recognized. M-1 is already under liquidity pressure. As M-1 increasingly draws funds from non-M-1 M-2, non-M-1/M-2 will also face liquidity pressure. With home resales an important source of non-M-1 M-2 growth, slowing resales could limit M-2 liquidity.

We wonder: Has the Federal Reserve created a consumer liquidity trap? If lower home resales causes M-2 to decline, we could have an answer.

JUST ANOTHER MANIC MARKET

There was a quiet but telling moment earlier this month when two of the investment banks that had led the underwriting of Baidu.com’s (BIDU) explosive IPO initiated coverage on the Chinese search company with underperform ratings. That is right. This is a stock that has lost half its value since going public not even two months ago. Even at such a hefty discount, Goldman Sachs and Piper Jaffray were warning investors to stay clear. Neither worried about Baidu’s future. It was a question of valuation: Both felt the stock price – currently around $77 – would begin to approach reality around $45. Goldman analyst Anthony Noto pegged Baidu’s implied value at or below the $27 offering price.

And that sums up the market for technology stocks in 2005, or rather the market’s split personality. You have some people – to their credit, Goldman’s and Piper’s analysts among them – who are trying to adhere to the hard lessons of the recent crash in the Nasdaq, which is still 59% down from its March 2000 peak. Then there is the camp of investors who, if they remember the tech crash, do little more than pay lip service to its lessons. A few short years after lifetime fortunes were wiped away by speculative trading, it is mind-boggling to think that someone would not think twice before paying $153.98 after Baidu’s IPO.

Tech mania is on its way back. Sure, the speculation is contained in a few isolated pockets, and there remain bargains in the tech sector for investors willing to do their homework. And tech companies keep surprising with new innovations, which may give careful investors genuine opportunities. But it also gives careless investors false hope that the spectacular returns promised in the 1990s may finally be here. Much of the press is still in the 2003 mentality that investors are once-bitten, twice-shy about tech stocks, as they were in stories commemorating the five-year peak of the Nasdaq last March. The San Jose Mercury News, for example, declared, “investors remain deeply skeptical of tech stocks” and quoted a strategist that it would take another 10 years for tech stocks to reach the old highs.

Others, like former stock analyst Henry Blodget, offered anodyne rationalizations to numb painful memories of the crash: “Our exuberance helps build industries, however boneheaded it may later seem,” he wrote in an op-ed in The New York Times last month. Blodget is right that the tech industry is doing just fine. But for investors, complacent thinking about stock corrections is just as dangerous as complacency during bubbles. It is just when everyone is so certain that there cannot be another bubble that it becomes possible again. And the idea that a bubble like we saw in the late ‘90s is a once-in-a-generation occurrence is especially misleading.

“It is true that bubbles are separated by a long period of time on average,” says Stefan Nagel, a professor of finance at Stanford. “But they’re not going to be separated by the same amount of time every time. So, that’s not a safe assumption.” In fact, there is reason to believe that the demand for shares is already growing faster than the supply. As housing prices stabilize, or even correct in the overheated markets like Florida and California, some of the speculative money that drove it higher will be desperate to find a place that can offer more returns. Besides the stock market, where can it go?

Some of that money may already be heading in. Nagel says there are clear signs, both quantifiable and behavioral, that mark the beginning of a return to a bubblelike mentality. One is an increase in stock volume and another is a rise in buying stock on margin. While volume on the NYSE and Nasdaq is steady and at most rising slightly, margin debt in August stood at $208 billion, even higher than it was in November 1999.

What is the most elementary truth about the stock market?

What is the most elementary truth about the stock market? The face-value answer to the question is: To own a share of stock is to own part of a company. Yep, that is as elementary as it gets, and from this premise flow other basic truths: To purchase shares in a company is to assign value to that company; and, the share value should grow as the company grows.

But even as all this may read like Finance 101, you could never glean these truths from the way investors behave today. The number of U.S. mutual funds surpassed the number of publicly traded stocks in 2001, and in fact the number of publicly traded stocks has been shrinking since 1997. At the same time, what has not been shrinking is the variety of exotic financial vehicles that are linked to the stock market – futures, options, hedges, swaps, all manner of derivatives, etc. My point is simple: U.S. stock market investors have never been so utterly disconnected from the share values of what they supposedly own.

What is more, this historic “disconnect” is measurable in several reliable ways. Consider dividend yields, for example. We have data going back more than 80 years for the dividend yield in the Dow Jones Industrial Average: at long-term price lows, dividend yields typically paid 7% or higher; at long-term price highs, yields typically fell to about 3.5%. These historic norms changed dramatically in the 1990s, with the dividend yields falling to lows that remain extreme to this day; right now the yield stands at some 2.5%, so it needs to rise 40% to reach the level where a market top would normally be!

So it is not only that investors are detached from value; the evidence makes clear that they are detached from decades of stock market history. Thus we believe the question is not “if” history will assert itself, but “when”.

BANKS IN UNCHARTED WATERS VIS A VIS HEDGE FUNDS

Not every academic is treated well by hedge fund managers. But when Andrew Lo, who is both a finance professor at the Massachusetts Institute of Technology 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.

Clash looming over credit derivatives backlog.

Leading U.S. and European investment banks are set to tell the New York Federal Reserve on that they will take wide-ranging action on back-office backlogs in the fast-growing credit derivatives market. In a formal letter they will pledge to eliminate “virtually all” their backlogs by June and adopt market practices aimed at standardizing and automating future trades.

However, the proposals could set the stage for a clash between the banks and their lucrative hedge-fund customers. For, while regulators are pressing banks to improve back-office processes, they have no direct sway over lightly regulated hedge funds, in spite of their increasingly critical role in the credit derivatives world. The move by the banks follows the unusual decision by the New York Fed to summon 14 leading banking groups, together with international regulators, to a meeting earlier this month to discuss the back-office problems.

GET READY FOR THE DEMISE OF PENSIONS

The latest airline bankruptcies offer more evidence that our system of private pensions is crumbling. It is inevitable that Delta Air Lines and Northwest Airlines will argue to their bankruptcy judge that they must jettison their pension obligations onto the Pension Benefit Guaranty Corp., the public’s insurer. Then, American Airlines and Continental – the only two carriers that offer pensions and are not in bankruptcy – will say that they have no intention of doing the same, but that it sure is unfair for them to have this burden while their competitors do not. And eventually, every airline will be like Southwest and will not offer a pension plan. That is just the way it will be.

Meanwhile, to cover the shortfalls caused by this rush, pension providers soon may have to pay more into the insurance fund. That would be further disincentive for companies offering pensions to 40-odd million Americans. Yet another disincentive looms. The Financial Accounting Standards Board dictates the way corporate America keeps its books. In a long-overdue act, the FASB is expected to add pension reform to its agenda this fall. The reason for the extended delay is self-preservation. The FASB likes being around.

Lobbyists for the corporations that treasure their legal right to obfuscate the health of their pensions could make life very difficult for the standards board. (Recall that the battle over stock options expensing nearly killed the FASB.) The FASB could propose doing something radical – such as requiring companies to show the market value of pension assets and the future costs of pension obligations on their balance sheets. It may come as a surprise to know that these hard promises have always been kept off the balance sheet. The reason it happens gets to the heart of why Enron failed to reflect all its debts on its books – the truth would have revealed the company for what it really was, an unattractive investment.

The fact is, pension accounting reform is the right thing to do. But Credit Suisse First Boston accounting analyst David Zion predicts it will toss many a retiree into the cold. “A big change in pension accounting could be the tipping point that sparks significant changes in behavior by companies that sponsor defined-benefit pension plans,” he wrote recently. These changes include a shift in assets – probably to bonds – plan restructurings, more plans being frozen or all-out dumping of plans. These battles typically drag on for years – which should give soon-to-be retirees a chance to take advantage of accelerated contributions to new retirement plans, such as IRAs, before employers shutter their pension plans.

EUROPE: CONFIDENCE RETURNS

What do all these statistics have in common? 1.) The 7000 participants in the September Business Climate Survey by Germany’s Ifo Institute for Economic Research evaluated the current business climate as the best it has been in the past year. Their expectations for the next two quarters were the highest of the past eight months. 2.) The 309 analysts and institutional investors who responded to the recent Financial Markets Survey by Germany’s ZEW Centre for European Economic Research remain confident in the current economic situation in Germany and the eurozone. 3.) The number of unemployed in Germany, Europe’s biggest economy, declined to 4.65 million in September, down from over 5 million in April. 4.) Business investment in the UK in the 12 months to the end of Q2 was 4.2% higher than in the previous year (UK’s Office of National Statistics). 5.) The 10-day average of the European Daily Sentiment Index has been pegged near 80% bullish since June.

Obviously, these are all very upbeat economic figures. And this is just a small part of a long list – Europe’s economic performance and business climate have shown a lot of improvement this year. Based on these and other indicators, most financial advisors would undoubtedly recommend that you beef up your European stock portfolio – and hurry! Because the investment and business climate this good is a sure sign of the continued strong growth in European stocks. Right? Well, so goes the conventional wisdom. But as regular readers of this column know from many examples we have shown here, when it comes to investing and trading the stock market, conventional wisdom often gets you nowhere.

We fully expected the latest economic improvements across Europe. In the March and April issues of the European Financial Forecast, editor Tom Denham wrote: “Start preparing now for increasingly favorable fundamental numbers to come out in the next several months. Unfortunately, these lagging indicators will likely capture the attention of most analysts, and they will ignore the new information that the stock market will be offering.” Is this not exactly what is happening now?

HEDGE FUNDS EXTEND TRENDS; HOUSING’S TREND IS ENDING

During a week when the CEO and CFO of the Bayou Management hedge fund came out of hiding to plead guilty to charges of conspiracy in misrepresenting their hedge fund’s performance since 1997, it is only fitting to look at the role that hedge funds play in the markets. Similarly, in a week when sales of existing homes rose to their second-highest level on record and prices zipped up to a record median of $220,000, it is also fitting to look at how much longer this behavior can persist. Bob Prechter addresses both of these hot topics in his recent August 24, 2005, Elliott Wave Theorist:

Hedge Funds: The Trend Extenders

In 1983, we predicted a mania for stocks, and we have been well aware of its spread to other markets ever since the Elliott Wave Theorist first coined the term, “The Great Asset Mania,” back in 1996. The Elliott Wave Financial Forecast postulates that the hedge funds are a major mechanism through which investors have extended so many trends. People have created and supported the hedge fund industry to express an extremely optimistic social mood.

Why is this particular mechanism special? Because: hedge fund managers are paid primarily on profits and they play with other people’s money. If a seasoned investor were buying only for his own account, he would never pay 1240 for the S&P, 680 for the Russell 2000, $450 for an ounce of gold, $65 a barrel for oil or $3 [million] for a house with no money down. But novices don’t know better, and managers of other people’s money don’t care.

The only way that the Russell 2000 index could have climbed to new all-time highs while the Dow, S&P and NASDAQ have lagged so substantially is that hedge funds have been targeting that index because other hedge funds are targeting it. It’s herding at its most primitive level; there is little rationalized analysis of companies, just the bulling of an index. “Commodity markets are in the same situation. Oil and copper have made new highs while agricultural commodities languish at low prices. Nevertheless, every mania ultimately ends. There is no free lunch, no endless trend.

Real Estate Reaching the End of Its Trend

Property prices in Sydney have fallen 15 percent. The property market in London has turned soft, with eager sellers discounting about 15 percent. One seller called the market there “dismal,” but he has no idea what dismal is. Dismal is when there are no shoppers, and the only way to effect a sale is to offer a price so low that the lone potential buyer you have managed to locate sees it as a can’t-lose gift.

U.S. property prices have held up, but the glut of homes on the market is near a record, and supply is finally catching up not only to occupancy demand, which it surpassed some time ago, but also to investor demand. Meanwhile, Fannie Mae is limping through investigations of impropriety, and the marketplace is running out of bodies to offer full credit, so the credit engine is sputtering. New credit and new debtors are the fuel of all bubbles, and while credit is still freely available, the supply of potential debtors is exhausted.

When I turned professional in 1975, one of my first tasks was updating P&F (point and figure) charts of individual stocks. I was struck by several issues that had gone from about 100 down to 1/8. They were real estate investment trusts (REITs). Today REITs are selling at insanely high prices. Look for these issues to collapse as they face the double whammy of a resuming bear market in stocks and an emerging bear market in real estate.

Lenders are certain of real estate’s magical properties of continuous rise. The lending binge has gone on for so long that when it reverses, repossessions will soar. Before the crash is over, the biggest owners of real estate will be banks.

GOD*MMIT, I’M AN AMERICAN

It is early spring in the southern hemisphere. A fresh warm breeze blows across the Rio Plata. Trees along Buenos Aires’ broad boulevards are budding out. Cherry trees are in bloom. Here and there, groups of American tourists peer in shop windows. Birds sing. Lovers stroll arm in arm. It looks as though it might be the beginning of something. Americans abroad have a mixed reputation. They are loud. They dress badly. And they have a superior attitude that foreigners take for arrogance. But they tip better than Europeans.

He judges the quality of everything he sees by how American it is. Is the toilet paper soft … just like it is at home? Do the shops take credit cards, just like they do in Flagstaff? Are the roads paved as well as they are in Michigan? If not, they soon will be, he tells himself; for he is convinced that the whole world is going his way. At least, that is what we thought on this trip to Argentina. The country is big, beautiful and cheap. Surely, Americans will want to live here. The Atlantic coast of Argentina is just like the Carolinas … but empty. The far northeast is like Utah or Montana … but at a third the price. And down in San Martin, it is just like Aspen … as it was in 1965. But won’t Americans find Argentina too, well, foreign? Not at all, down on the pampas they are becoming just like us back on the Great Plains. Soon, we will be able to live as comfortably in Patagonia as in Pennsylvania.

At the peak of an imperial cycle, the imperialists always seem to delude themselves. Looking at the world, they see neither a glass half empty nor one half full, but one spilling over. The Romans spread out all over their empire, building villas in France, in England, and out on the banks of the Black Sea. The Moorish empire reached its peak in the eighth century. Then, too, they were making plans for new mosques in Poitiers, just before they were chased from the country. And all over Africa, you see the ruined houses of the European imperialists who colonized the country. “I used to have a farm in Africa,” they still tell people.

The trouble with being on the top of the world is that the world turns, and there is nowhere to go but down. In national economies and markets, as in the movement of the planets, there are small cycles and big cycles. The world turns, and also revolves around the sun. Day follows night; winter follows summer. National pride is self-correcting.

Argentina recently had a dark night of crisis … one of many in a long season of bad weather. The 1930s brought Peronism – a popular brand of socialism – to the country. The nation’s politicians shot the country in the foot, and then in the leg. By the 1980s, they had the gun to their heads – with inflation running at 1,000 percent, per year and war with the English. One problem lead to another and in the 1990s, intending to stop inflation, the Argentine currency was pegged to the dollar, but at too high a rate. The economy collapsed again; much of the middle class was ruined.

But in 2002, the sun peeked over the horizon and began what might be not only a new day, but a new season. Since the second quarter of 2002, the country has seen 12 consecutive quarters of growth, with GDP shooting up at twice the rate of America’s “recovery”. We put the word in quotes to signal that we think there is something fishy about it. America’s dawning prosperity came without pain or sacrifice. Americans never stopped borrowing and spending in the recession of ‘01-‘02; they merely borrowed and spent even more coming out of it. See, they said to the world, our economy cannot be beat. Because, god*mmit, we’re Americans. But the recovery was phony. There was never much of a correction to recover from. So, when the time for an upturn came, all consumers could do was to borrow more money and go further into debt. They had never stopped spending, so they had no money saved.

South of the Rio Plata, on the other hand, the recovery seems to be real. Here is an economy that seems to be getting back on its feet, after a long spell on the sickbed. The recovery is driven not by debt, but by real savings … and not by consumption, but business investment, which rose recently at rates as high as 11.2% per quarter. Consumers could not lead a recovery in Argentina even if they wanted to. Who would be foolish enough to lend them money? Credit card debt is extremely limited. And if you want to buy property down here, we were told, “you have to pay cash.” Or, if you have good credit, you may get a bank willing to finance half of the price.

Not surprisingly, real estate is not very expensive. Apartments on Buenos Aires’s most fashionable streets sell for about a quarter of what they would fetch in Paris, London or New York. Out in the boondocks, prices fall even further. How much would you expect to pay for a vineyard/winery in the Napa Valley? Out in Salta Province, one is available at a price that must bring tears to the eyes of a California vintner: 1,000 acres of mature vines for only $1.5 million. And there, he would pay only $10 a day for a good worker, and only $2.50 for a steak dinner.

North of the Rio Grande a homebuyer needs only a pulse. He will pay $25 for dinner, and at least $50 a day for labor. His $1.5 million will barely buy a trailer. In both Argentina and in the United States, there is a light on the horizon. But on the pampas is the light of dawn. In America, alas, it is probably evening stretched out across the sky … like an emperor’s corpse on a viewing table.

ARTIFICIAL ALLOCATION OF RESOURCES IS UNSUSTAINABLE

The global economy is facing a severe crisis – perhaps the most severe in its history. The question now is not whether it will happen, but when. The later it happens, the more severe the crisis will be. This article will attempt to explain the reasons for the crisis.

When you boil it down, the economy, at both the personal and national level, is all about allocation of resources. The decision about allocation of resources is made according to personal (or national) priorities, and according to the prevailing prices in the market. The pricing mechanism is the most important mechanism in economics. In practice, it is the mechanism that regulates the activity in the economy, and the allocation of resources in it. Any intervention in the price mechanism will change the allocation of resources in the economy.

In an ideal world, competition is perfect, and prices are determined by market forces. Reality, however, is not usually ideal. The present situation includes artificial and massive intervention in two of the world’s most important prices: the exchange rate of the dollar against the Asian currencies, and the interest rate in the U.S. (and everywhere in the world, as a result).

This is how it works: The Chinese fix the exchange rate of the yuan against the dollar at a very low level by printing yuan. For lack of choice, in order to maintain the competitiveness of their economies. Other countries in Asia do the same for their currencies (including Japan in 2003 and 2004). The dollars obtained by Asian governments as a result of this intervention are invested in U.S. government bonds, leading to an artificial reduction in the interest rate there along the entire yield curve. In 2003 and 2004, world central banks (mainly in Asia) printed roughly $1.2 trillion, which has increased the global money base by over 60%. In 2005, the annual rate of printing is roughly $500 billion. This is the greatest quantity of money printed in history (other than in wartime).

As the saying goes, the greater the intervention, the greater the distortion. In Asia, the low exchanges rates of currencies against the dollar causes excessive demand for both Asian products, and for investment in factories of industrial production. In the U.S., the combination of low interest rates and a strong currency are causing a bubble in consumption of imports and real estate. In other words, the artificial prices are causing a correspondingly artificial allocation of resources. Asia is producing too much, the Americans are consuming too much, and there is a real estate bubble in both regions. Only massive printing of money by Asian governments has made this situation possible.

However, like a balloon that can either continue growing or burst, leaders in Asia and the rest of the world currently face two alternatives. They can go on printing money and supporting the artificial price system, or they can halt their intervention, and allow market forces to determine prices. At a certain stage, it will become impossible to continue printing money and intervening in the price mechanism. When that happens, a crisis will ensue. China and other Asian countries will undergo a deflation crisis, similar to that experienced by Japan in the past decade. The U.S. will suffer from a balance of payments crisis, similar to that suffered by Thailand and Argentina. The exchange rate will fall and the interest rate will rise, causing a sharp drop in the (artificial) American consumption and the bursting of the real estate bubble. A severe banking crisis is expected in both regions.

The rest of the world, including Israel, which has greatly benefited from the global printing of money over the past two years, will suffer from the hangover that ensues when the printing stops. The conclusion from all this is that the basic laws of economics (no free lunches, problems cannot be solved by printing money, etc.) are as strong and valid as the law of physics. The only difference is that the laws of economics can be bent and distorted, but only for a limited time, and by paying a corresponding price.