Finance Digest for Week of March 13, 2006

THE PRICE OF INFLATION

It is not a zoo story nor a jungle story nor a circus story, but you would not know it from the way the media deals with the monthly inflation rate numbers. Inflation is presented as a tigerish beast to be handled with a whip and chair. Maybe because they think the subject is innately boring or maybe because they are prone to spiking their drinks, business journalists routinely use force-of-nature or invading-enemy expressions when they speak of inflation. It is “inflation was held at bay this month” or “inflation was checked this month” or “inflation receded or surged this month.” Inflation is not a wild animal out there, wherever out there is, looking to pounce. Nor is it a meteorological phenomenon like Hurricane Katrina. Like money itself, inflation is man-made. It does not wax or wane month to month according to the phases of the moon.

Compared to what things cost last year, the general price level has gone up. To use one of those wild nature similes, inflation may not be rising as fast as a bat out of hell, but it is gaining altitude fast enough to wreak havoc with your nest egg. From 2005 to 2006 the dollar in your purse lost 4% of its purchasing power. So unless you got a 4% raise to compensate, you are working for less than you were a year ago. A 4% rate may not sound like much, but thanks to the “miracle of compound interest”, it can postpone your retirement or keep you on the job until you drop dead. It can play hob with your health savings account. In 10 years a 4% inflation rate will wipe out almost half the value of your savings.

There is a big plus side to inflation if you are in debt. Suppose that you overpaid for your house: In 10 years, the value of your mortgage will have been cut in half. What holds for private debt holds for public debt, too. Should inflation stay at the present rate or go higher, the gigantic deficits incurred by George Bush will not, after all, have to be paid off by our grandchildren as they keep warning us will happen. The deficits will disappear in a flood tide of cheap money. From time immemorial, inflation is how governments have wiggled out of repaying what they owe. Back in the days when all money was copper, silver or gold, its purchasing power was lessened by minting coins with less precious metal in them. Next came printing more dollar bills. Nowadays debasing the currency is accomplished by a few computer keystrokes.

Economists and finance big shots will sometimes talk about “an acceptable level of inflation”. They do not discuss who decides what that level might be. Since inflation, depending on how bad it is, always attacks savings, frustrates financial and personal planning, causes sky-high interest rates, lowered investment, unemployment, recession and, if it is bad enough and goes on long enough, chaos, panic, despair and social disintegration, how can it ever be acceptable?

WORLD GAINS 102 MORE BILLIONAIRES, ACCORDING TO FORBES

As emerging stock markets surged during the past year, 102 wealthy people around the world won a much-coveted title along with their stellar gains – they all became billionaires. But tepid returns in the U.S. ate into the fortunes of some of the richest Americans, including the founding family of Wal-Mart Stores. The number of billionaires around the world rose by 102 to a record 793 over the past year, and their combined wealth grew 18% to $2.6 trillion, according to Forbes magazine’s 2006 rankings of the world’s richest people.

Forbes editor Luisa Kroll noted that Russia’s stock market jumped 108% between February 2005 and February 2006, while India’s market rose by more than 54% during the same period. Brazil “was another bright star” with a market gain of 38%. Kroll said the changes on the list were not driven by U.S. investments. “The more exciting story is these emerging markets. The U.S. stock market was quite a laggard with only a 1 percent increase.”

Microsoft founder Bill Gates was again the world’s richest man for the 12th year running. Gates grew wealthier, with his net worth rising to $50 billion from $46.5 billion. Investor Warren Buffett, the chairman of Berkshire Hathaway Inc., again ranked 2nd. His fortune fell by $2 billion to $42 billion. The rest of the top 10 underwent a major reshuffling, with three familiar names dropping out of that select group: German supermarket company owner Karl Albrecht, Oracle’s Lawrence Ellison and Wal-Mart chairman S. Robson Walton. Mexican telecom mogul Carlos Slim Helu moved up one notch to #3 with $30 billion, replacing Indian steel magnate Lakshmi Mittal, who fell one place to #5 with $23.5 billion. Ikea founder Ingvar Kamprad of Sweden rose two slots to #4 with $28 billion. Microsoft co-founder Paul Allen edged up to 6th place from #7, with a net worth of $22 billion.

The Walton family, which dominated the upper echelons of the Forbes list in recent years, tumbled in this year’s ranking as stock in the world’s largest retailer dropped more than 10% in the past year. Martha Stewart, who was new to the list last year, dropped off completely this year. Her fortune shrank from $1 billion to an estimated $500 million following her conviction for lying about a stock sale and her 5-month prison term. J. DeLeon and Ruth Parasol, both of the U.S. and tied for #428, represented the online gaming industry with $1.8 billion each. Interestingly, most of their company’s revenue comes from the U.S., where online gaming is illegal, Kroll said. “Somehow, they have been able to skirt that,” Kroll said.

THE LAST SPECULATORS

Condo flippers in south Florida will tell you that they are sure, real sure, that they will sell out at a profit.

Robert Jenkins, 30, found religion, quit his job as a disc jockey at a strip club and, in 2003, began speculating on real estate in hot-hot south Florida. He borrowed heavily and flipped 19 houses in Fort Lauderdale, reaping profits of $750 to $71,000 on each property and plowing two-thirds of his $300,000 in profits into still more homes. He now owns seven, worth $2.5 million and doubts a crash will happen. He vows to keep flipping, even if it does.

Donna Franklin, a 52-year-old former direct-mail publisher, owns five homes. Last year she and a partner borrowed against a Miami apartment they own and rent out to make down payments on three $400,000-plus “preconstruction” condos in Fort Lauderdale. They are confident they can flip the three condos at a nice markup soon – well before construction ends, at which point they must take mortgages for the $1 million they owe developers.

That could be wishful thinking. The number of unsold condos for sale in and near Miami has more than doubled from a year ago to 2,232, says Miami Realtor David Dweck. Foreclosures nationally are up 45% in a year and in Miami now occur at twice the national rate of one per 1,117 homes, according to RealtyTrac. Some 25,000 condos are under construction in the Miami-Dade area – more than the total number of purchases in the last 9 years combined. 75% of those are in the hands of speculators, says Jack F. McCabe, a Deerfield Beach, Florida consultant to developers. “The demand is artificial. Most south Florida speculators have been selling to other speculators,” he says. “It works fine – until you’re the greater fool and nobody else comes along to pay that higher price.” Condo prices in Florida have gone up 63% since 2002, and most speculators credit the state’s population growth – 1,000 newcomers per day. Others credit the speculators themselves.

In the aftermath of every crash come a few fearless souls, intent on making money on the misery of others. Jack McCabe, the Miami consultant, is raising a $250 million vulture fund to buy condos. He aims to pick up $1 billion of south Florida apartments on the cheap. Lenders are already offering him blocks of condos repossessed from distressed homeowners.

Mortgage rates up … affordability down.

Mortgage rates have hit their highest level in nearly four years, and that has a direct impact on home affordability – and home prices. The average rate on a 30-year fixed mortgage stands at 6.37%, up from 5.58% last summer. “I think it’s indisputable that demand in the housing market has declined in the past few months,” says Richard DeKayser, chief economist for National City Corp., an Ohio-based mortgage banker. “It’s very clear that rising interest rates figure very large in that decline.”

Rising rates had already begun to take their toll in the fourth quarter of 2005, when the 30-year mortgage averaged 6.22%, according to a report from Global Insight, a financial information provider, and National City. The report figures 71 of the 299 largest U.S. housing markets were “extremely overvalued” at year” end, up from 62 markets a quarter earlier (table rankings below). The report arrives at a fair market value based on population, income and interest rates and factors in historical premiums or discounts.

A jump in interest rates from 6% to 7% on a 30-year loan adds about 10% to a monthly mortgage bill. A homeowner who financed a loan of $200,000 at 6% would pay about $1,200 a month. At 7%, the bill would come to $1,330. As rates rise, homebuyers who were already stretched may start demanding lower prices. “Low rates had offset unaffordability in past years,” said DeKayser. California and Florida accounted for 18 of the 20 most overvalued markets, with Naples, Florida leading the way. Undervalued markets are much less common and tend to be priced only slightly below where they should. They are especially common in Texas; eight of the top 10 are in the Lone Star State.

U.S. nationwide delinquency rate on home mortgages rises to 4.7%.

More Americans are falling behind on their housing payments, with the nation’s seasonally adjusted delinquency rate on residential mortgages rising to 4.7% in the fourth quarter from 4.44% in the third quarter and 4.38% in 2004’s fourth quarter. Hawaii had the lowest rate of any state at 1.97%. Hurricane Katrina caused past-due problems across the Gulf Coast, underscored by rates of 20.81% in Louisiana and 16.89% in Mississippi. Outside the Gulf Coast, Indiana had the worst rate, 7.38%. If the Katrina impact was removed, the nation’s past-due rate would be 4.55%.

TAKE MY STOCK, PLEASE

This is a great time to have part of your portfolio in the shares of takeover candidates. You do not even have to try very hard to wind up with at least a few. January’s cash-based takeovers (24 deals with a combined $15 billion purchase price) tripled 2005’s record level, according to Bloomberg. I expect February, March and all of 2006 to be no less robust. It is growing, not fading. After stocks got very cheap in 2002, corporations became very avid buyers of them. They either buy in some of their own shares or buy other companies outright. When either kind of buying takes place at a low enough price, the result is a boost in the earnings per share of the acquirer.

A low price, in this context, means that the acquired stock has an earnings yield better than the aftertax cost of borrowed money (or the aftertax return on idle cash). At the moment, the market’s earnings yield – that is, the inverse of the price/earnings ratio – is 6%. Pay a dollar and you get yourself an earnings stream that starts off at 6 cents. The aftertax value of cash is more like 3 cents. Use borrowed money or loose cash at a cost of 3 cents to get 6 cents of earnings and you are ahead. This process can continue until either the stock market or global long-term interest rates are way up, or earnings fall apart. You can play the takeover game by owning cheap companies that lack controlling insiders. Here are four acquisition candidates: Korn/Ferry International (21, KFY), Tiffany (37, TIF), Bank of Ireland (72, IRE), and Principal Financial Group (49, PFG).

BEVERLY HILLBILLY BONDS

In the bad old days of 1970s inflation the price of gold served as a nuanced barometer of fear. A small revolution in a geopolitically sensitive country or a misstep by one of the world’s secretive central banks would send the price of bullion skyward. Today the spot price of oil serves exactly the same function, instantaneously turning the latest terrorist threat or supply shortage scare into so many pennies per barrel. In The Beverly Hillbillies, dumb luck made Jed Clampett rich. Today’s Clampetts, also rich from dumb luck, mostly live in unstable foreign locales and are far less well-meaning.

The current consensus is that the price of oil can only go up, whether because of Mideast tensions or Asian demand. What if conventional wisdom is wrong? Some results would be entirely desirable – less cash going to parts of the world where terrorists reside. Some would be undesirable, at least for certain portfolios. Not only oil company shares are sensitive to the price of oil. One area where it will not be pretty is emerging market debt, which is strongly linked to oil prices. If oil tanks, as it has in the past, the U.S. economy will benefit, but owners of these popular bonds will be slammed. Since everyone assumes oil prices cannot go down, the yields on the bonds are far lower than they should be, given the risks involved. The highest yields, 8.7% on Iraqi bonds and 8.6% from Ecuador, are not an adequate return.

Currently, the JPMorgan EMBI+ (an expanded version of the old Emerging Markets Bond Index) yields 6.6%, a mere two percentage points more than U.S. Treasurys. This index tracks U.S. dollar debt issued by emerging market governments and quasi-government entities. 60% of the emerging market index is investment-grade today. The big issuers, like Russia and Mexico, boast significantly stronger fiscal positions than ever before. Yet what goes unsaid is the huge dependence of this improvement on the sky-high price of oil. Mexico, Russia and Venezuela, all oil exporters, collectively account for 41% of the EMBI+ basket. I am all for taking risk if you get paid for it. But emerging market bonds do not fairly compensate you.

FUND MANAGER USES GEOGRAPHY FOR STOCK BETS

Scottish tobacco traders got an edge on their English rivals by exploiting Glasgow’s proximity to North America. Even though the geographic advantage was tiny, by 1771 Scots handled nearly half of all the tobacco exported from the American colonies. Might geography be a tipping point in the fortunes of corporations? Four years ago B. Randolph Bateman, chief investment officer at Huntington Bank, decided to find out. He launched Situs Small-Cap, a mutual fund that would let geography – the situs of business, that is – guide its portfolio choices. “In the small-cap arena, it does make a difference where you are physically located,” says Bateman, 50.

Since its launch the $94 million Situs portfolio has delivered a 24% annualized total return, beating the S&P 500 by eight percentage points through February. A large part of the fund’s success is probably due to its emphasis on smaller companies, which have done well recently. So it is too early to know whether Bateman has a winning formula, but the theory behind it is intriguing. How do you get an investing edge from geography? Look for companies that do business in states with strong economies and low tax burdens. A caution is in order here. Bateman gets his appraisals of state tax burdens from Laffer Associates, the San Diego firm run by famed supply-sider Arthur Laffer. With a partner, Laffer himself tried running money according to the theory that corporations headquartered in states with favorable tax environments will beat the rest. Four years later the venture folded. Educated guess: their company did not go out of business because it was beating the S&P by eight points.

Bateman’s fund is pricey, with 1.7% in annual expenses plus a sales load of 5.75%. But you can copycat its picks on your own.

MORE HORRIFYING FOREIGN INVESTMENT NUMBERS FROM THE LATEST FED FLOW-OF-FUNDS DATA

As recently as the mid-1980s, the United States was a net creditor nation. As of the end of 2005, however, the U.S. was in the hole to others to the tune of more than $5.8 trillion. And this numbing figure continues to expand at an alarming rate! This is one of the horrifying revelations contained in the Federal Reserve’s latest flow-of-funds data, released late last week.

URANIUM MAY LEAD RALLY IN METALS

Nuclear energy’s revival can best be seen in uranium, which outperformed the metals markets in 2005 and may do so again this year. Uranium is poised to climb 27% to $50 a pound in the next six months because “there’s not a lot of uranium available,” said Jean-Francois Tardif, who put 8.4% of his C$300 million ($259 million) Sprott Opportunities Hedge Fund LP into uranium. The Toronto-based fund jumped 39% in 2005, when its peers on average returned 9.3%.

Wellington Management Co. of Boston, which oversees $521 billion, in the fourth quarter raised its stake in Saskatoon, Saskatchewan-based Cameco Corp., the largest uranium producer. The fund holds 13.6% of Cameco worth C$2 billion, according to Bloomberg data. The Anglican Church in Sydney took uranium off a list of unethical investments last year, and its funds benefited from a 23% gain in BHP Billiton, the No. 4 uranium miner. Uranium last year gained 76%, beating all but one of the 19 commodities in the Reuters/Jefferies CRB Index. Only sugar jumped more.

EIGHT YEARS AGO … AND COUNTING

In August 1998 the financial world came perilously close to systemic collapse following the near demise of hedge fund Long Term Capital Management (LTCM). In just a few weeks, the S&P 500 Index plunged 17% taking all global markets to the basement and wiping out over a trillion dollars of stock market capitalization. Although the Federal Reserve and numerous Wall Street banks have striven to clean up the derivatives mess since 1998, the problem still lingers, threatening another systemic shock to a highly leveraged market.

The derivatives threat remains largely unresolved. Over 45,000 contracts remain unaccounted for in the U.S., down from 97,000 contracts a few years ago. In fact, you could say that America’s largest banks are casinos, plagued by several hundred billion dollars worth of credit exposure that most traders cannot even settle. The 10 largest American banks have approximately $600 billion dollars in potential credit exposure in the derivatives market, and that exposure represents a staggering 20% of their total credit exposure.

Worse, the housing market, fueling America’s consumption since 2002 courtesy of the growth of reverse mortgages, is also tied to derivatives. Both Fannie Mae and her smaller sister, Freddie Mac, remain the focus of government scrutiny since 2005. Fannie and Freddie are certainly no ordinary companies. The mortgage lenders have almost $1.5 trillion of debt outstanding, which they borrowed to buy and carry portfolios of mortgages and mortgage backed securities. To hedge their market risk, both companies are heavily committed to derivatives. In 2005, Fannie Mae restated earnings after aggressively marking up her derivatives book.

Derivatives derive their notional value from instruments tied to stocks, bonds, currencies, commodities and mortgage-backed securities. It is a massive industry that has literally gone out of control where counter parties to a trade have created third counter parties, unable to identify trade settlement, or the underlying owner of the contract. You could say we are in the midst of a “derivatives time bomb” in 2006. The global derivatives market, which Warren Buffet claims is a major threat to the U.S. economy, is currently worth $372 trillion – more than seven times the size of the entire global economy.

The scary part of this market is that virtually every time the Fed has tightened credit over the last 35 years, a systemic shock or crash has surfaced as a consequence of rising interest rates. And the ongoing yield curve inversion since late December in the U.S. suggests the Fed is indeed tightening the screws too tightly. Wall Street’s complex creations have now become the world’s most feared financial beast. The derivatives market remains the single largest threat to the global financial system and time is running out to clean up the mess Wall Street created.

THE SWEET SMELL OF SUCCESS

Here is a public relations challenge. You want your company to list on the prestigious London Stock Exchange, as a blue chip stock in the FTSE 100 index, no less. But your tax haven-based company is in the online gambling business; your founders, a Californian husband-and-wife team, made their reputations in the “adult entertainment” business; your biggest single shareholder and chief operating officer is an unknown young Indian techie named Dikshit; and the bulk of your customers (over 80%) are in the U.S., where the Justice Department has declared that internet gambling is illegal.

Those were the formidable obstacles facing PartyGaming in the run-up to its flotation last June. But it joined the London Stock Exchange as a FTSE 100 company with a market value of €7 billion ($8.6 billion). The float was the biggest in London in five years, and the share price soared by more than 50% in its first month. After the float, the CFO of the Gibraltar-based company, Martin Weigold, who had been recruited by PartyGaming from entertainment group Jetix (formerly Fox Kids Europe) only six months before the listing, was being lauded in the business press as a finance guy to watch. How did it all go right for PartyGaming?

U.S. DEBT? $8.3 TRILLION AND GROWING

Between 1989 and 2000, the electronic display near New York’s Times Square tracked the rise of the nation’s red ink until it reached $5.7 trillion. When it shut down, the federal budget was running a surplus. Today, the national debt totals $8.3 trillion, a level that is expected to force Congress this week to raise the debt ceiling for the fourth time in George W. Bush's presidency. The prevote debate may be tinged by election-year rhetoric, but the underlying issue goes beyond partisan politics. The rising debt tally is a reminder, economists say, that the nation is on an unsustainable fiscal course. The economic burden posed by the national debt, economists say, is more serious now than in 1980, when a $1 trillion figure stirred national anxiety.

Today, the public debt is larger as a share of the American economy, more than half is held by foreigners, and the wave of baby-boomer retirements is no longer decades away. “The situation now is really very different from the 1980s,” says Alice Rivlin, former vice chair of the Federal Reserve. As the costs of programs such as Medicare rise, she says, “we can’t go on into the next decade … still running deficits as our major way of coping.”

Economists do not have a simple formula for calculating how big a debt, as a share of America’s GDP, is sustainable. But many warn that devoting an ever-larger share of GDP to paying off interest on the debt is not healthy. That could happen as government spending rises during the baby-boomer retirement wave. And the trend could be worsened if those who finance the debt – including foreign investors – start demanding higher interest rates due to the risk that the debt level will fuel U.S. inflation.

In some cases in the past, the debt ceiling imposed by Congress has spurred lawmakers to restrain the growth of deficit spending that adds to the debt. Deficit-reduction plans coincided with debt-limit votes in 1990, 1993, and 1997. The current $8.3 trillion total debt tally includes two types of debt: the kind owed to the public (including foreign lenders), and the kind owed from some government entities to others. In the strange accounting of Washington, the current surpluses run by the Social Security program add to the national debt. The public debt is what is most worrisome. At $4.8 trillion, it is now a higher share of GDP than it was in 1980.

As a share of GDP, today’s total public debt and the annual deficits look somewhat high, but not outrageous to many economists. The EU, for instance, expects member nations to hold deficits below 3% of GDP and debt below 60% of GDP. The U.S. has reached the first target but not the second, using publicly held debt as the benchmark. The bigger issue is how well America’s fiscal health will hold up under the strain of costs associated with baby-boomer retirements, which begin in just a few years. Taxes would have to be raised 50% to cover entitlement costs, says Glenn Hubbard, a former economic adviser to President Bush.

SPEAKING TRUTH OR CRYING “WOLF”?

Back during the 1970s recession I was a real estate expert with Morgan Stanley. We helped banks and REITs work out billions of loser portfolios, reorganize, file bankruptcy, even advised the U.S. Dept of Housing & Urban Development on the collapsed Federal New Towns program. I have worked for developers and mortgage bankers, got degrees in architecture and city planning, taught commercial real estate at Cornell University. But oddly, like the rest of America, most of the time I do not think about the housing bubble that is about to pop. We ignore the coming storm. But when it gets up close and personal – like my family’s home – well, suddenly I am shocked out of my denial. The shocker? I just learned we live in a metro area that could see a devastating 55.8% decline in home prices in the next five years. Worse yet, most of the real estate north and south of us – from San Francisco to San Diego – is predicted to decline 50% in the next five years. Ouch!

That dire prediction was made by former Goldman Sachs investment banker John Talbott in his new book, Sell Now! The End of the Housing Bubble. Next time you are in a bookstore check out his top 130 metro areas. The chapter is titled, “Are You in Trouble?” Warning: Chances are you are in big trouble, or in denial. And folks, this is not just an isolated West Coast phenomenon. Talbott points out that America’s top 40 cities are facing a average 47.2% decline: Boston is 49.4%. Miami 44.8%. New York 44.6%. And Chicago is 27.3% overpriced. Yikes!

But “so what?” you say. You have heard it before. Right? Warnings reported month after month. For example, Talbott reminded me of an editorial in The Economist last summer: “Never before have real house prices risen so fast, for so long, in so many countries. Property markets have been frothing from America, Britain and Australia to France, Spain and China. Rising property prices helped to prop up the world economy after the stock market bubble burst in 2000 … This is the biggest bubble in history.” Yes, the irrational exuberance of our failed stock market simply shifted over into a new irrational exuberance in housing. In five short years an estimated $30 trillion was added to housing prices worldwide, an unsustainable 75% increase to $70 trillion, largely due to then Fed chairman Alan Greenspan’s cheap money policies. Greenspan dismissed the global bubble, telling Congress it was just a little “regional froth”. Happy-talk, while our housing and mortgage industry has been taking advantage of naïve home buyers and sellers with loose underwriting practices.

My files are full of warnings from America’s top economists predicting a housing market collapse and a widespread global disaster: Gary Shilling, Bill Gross, Jeremy Grantham, Robert Shiller, Robert Rubin and others take exception to the deceptive happy-talk of self-serving spinmeisters in Washington, Wall Street, realty brokers and homebuilders. Unfortunately, bubble warnings are routinely dismissed. Our brains cannot handle all the bad news. Besides we have been brainwashed into short-term thinkers, incapable of long-term planning. Witness the collective denial and paralysis toward mounting deficits from out-of-control federal budgets, foreign trade, war debt, state, municipal and consumer debt, under-funded pensions, Social Security and Medicare shortfalls.

Still, experts like Gross, Shilling, Talbott and others are dismissed as “crying wolf” one too many times. The housing bubble has not popped, warnings accumulate, we are overwhelmed, confused, numb, feel helpless, so we fade into denial. And our leaders are even more oblivious, hardened and ineffectual. But … am I going follow Talbott’s advice and “sell now”? No. We love our home and our town. Besides, even if prices do fall 55.8%, we are still ahead of the game, out of harm’s way. But maybe you should sell now. A lot of people are going to get badly hurt in the real estate crash, far worst than in the 2000-2002 recession when we lost $8 trillion in market cap.

If your stock portfolio were out of whack there would a possible solution. Dump equities. Sadly, unlike the stock market there is little you can do once the illiquid housing market collapses. If you cannot sell now, you will have no choice but bite the bullet. If you live in one of America’s top 40 metro areas and, e.g., you bought last year for $500,000 with $450,000 in mortgages and the market drops just 10%, your equity is gone. And if it drops the predicted 47.2%, your home is worth $250,000, you really are in trouble. If you lose a job, or suddenly get hit with extraordinary expenses, or just cannot make tax and mortgage payments, or otherwise forced to sell, you could be wiped out under the tough new bankruptcy laws.

So please read Talbott’s book closely: Is your home is at risk? Then quickly decide whether you can hang on in a housing collapse, a stock market bear and another long recession. And if not, consider taking his advice to sell now.

OUR WORST NIGHTMARE: THE PUNCTURE OF THE CURRENT U.S. HOUSING BUBBLE

The key to holding up the entire speculative U.S. financial system with its current excessive levels of debt – federal, state, municipal, corporate and household - is maintaining the U.S. housing bubble. Anything less would result in America’s worst nightmare and, in short order, the entire world. The housing market is dominated by Fannie Mae and Freddie Mac who hold 75% of all outstanding home mortgages (and the Federal Home Loan Bank Board to a much lesser extent). One too many additional increases in the Fed rate may well turn out to be the U.S. economy’s Achilles’ heel and lead to a major crisis at these two institutions generating an out-of-control systemic breakdown situation and disastrous financial implosion.

Here is why. Fannie’s and Freddie’s (F/F’s) original functions were to provide liquidity to the housing market. After a mortgage lending institution (MLI) originated a mortgage – say, $100,000 – F/F would purchase that mortgage from the MLI for a fee and hold the mortgage to maturity. The MLI now had $100,000 to make yet another mortgage loan and earn yet another fee. By the repeating of this process F/F injected liquidity into the housing market making it possible for MLIs to increase the number of mortgage loans they could make each year and earn considerably more fees in the process.

Where did the money come from for F/F to raise money to purchase these mortgages from MLIs? It was easy. F/F simply issued bonds at a somewhat lower interest rate, which was their spread or profit. The more mortgages they bought from the MLIs covered by the issuance of their bonds the more money they made. And it was all totally secured by the assets of the houses themselves. A risk free arrangement. Not bad. The MLIs made money, F/F made money and the consumers owned houses on which they could afford to make their monthly mortgage payments.

Beginning in the 1980’s F/F got greedy! They began to encourage the MLIs to sell mortgages to purchasers who would have to spend more than the recommended 28% of gross income to service the housing (mortgage payments, insurance, property taxes) costs involved. The demand for houses went up, the price of houses went up, the number of mortgages went up, the size of mortgages went up, the profits of the MLIs went up and the profits of F/F went up. But the degree of financial risk for F/F increased dramatically. Many mortgagees had to pay out 50%-60% of their household income in housing costs and were extremely vulnerable to any economic setback they might encounter. As a result, the rate of delinquencies and foreclosures went up. In many cases the down payments made by these new mortgagees were so small that the only way F/F could recoup its outstanding mortgages was if the resale prices of the homes appreciated considerably from the date of the initial purchase.

Next, in the unending search for increased profits, F/F undertook some financial innovation. They began bundling groups of mortgages together as mortgage-backed securities (MBSs) on which they guaranteed, in case of default, to pay interest and principal “fully and in a timely fashion”. They sold these MBSs for a fee, to mutual and pension funds and to insurance companies around the world. This gave the funds a claim to the underlying principal and interest stream of the mortgage. In doing so the risks entailed in the owning of mortgage debt were broadened beyond F/F. If F/F were unable to fulfil their guarantee (and the monies provided by the government are totally inadequate) these funds, too, would be adversely affected and depending on the extend of the default, gravely so.

And finally, to squeeze out even more profits, F/F began taking 50% of their MBS holdings and pooling them once again into derivative instruments called Real Estate Mortgage Investment Conduits, i.e., “restructured MBSs”, or into what are called Collateralized Mortgage Obligations (CMOs) for which they are paid a fee. These instruments are highly specialized derivatives – bets on the direction of future rates of interest. F/F’s profits went up even more but the risks associated with these actions became excessive! Thus, what started out as a simple home mortgage, has been transmogrified in to something one would expect to find at a Las Vegas gambling casino. Yet the housing bubble now depends on precisely these instruments as sources of funds.

If too great a portion of F/F mortgages were to go into default and cease to pay interest or principal, F/F would default on its bonds, which in total are at least 10 times greater than that of any corporation in the U.S. Such a default would put an end to the U.S. financial system, right then and there. Yet a second obligation compounds the problem – its guarantees on the MBSs. In a crisis in the housing mortgage market, F/F would not be able to meet the terms of their guarantees and the pension and mutual funds, which had bought the MBS on it guarantees, would suffer tens of billions of dollars in losses. Finally, F/F’s derivative obligations in hedges, allegedly to protect it from risks, could themselves go in to default against the banks and other counter parties.

The above-mentioned obligations of F/F total over $5 trillion. Another $1 trillion in obligations are held by the Federal Home Loan Bank Board and private issuers of MBS. These $6 trillion in risky obligations are distinct from, and in addition to, the more than $6 trillion in mortgages themselves. As such, a total in excess of $12 trillion is laden on to the homes and attached to to the incomes of America’s homeowners. And then there is credit card debt, car lease debt, bank loan debts, margin debt, etc.! Nothing, absolutely nothing, must stand in the way of consumers fulfilling their financial obligations – and they absolutely must not default on their mortgages. Cheap money must prevail. Not dirt-cheap like before but still very cheap by historical standards. Regretfully, though, this FF house of cards is on the verge of collapse. Bond prices have fallen and interest rates are approaching 5%. The ramifications are dire. A wide variety of partners hold large chunks of F/F debt.

The Fed is between the proverbial “rock and a hard place”. They engineered low interest rates in the first place, both to keep the financial markets going, and in large measure to keep the housing bubble afloat. They are now in the final stages of raising interest rates to prop up the collapsing U.S. dollar and to forestall rampant inflation. Were they to initiate one quarter percent increase too many it would destroy the interest rate environment that is essential to keeping the housing bubble alive. Have they gone too far already? The bubble seems to be loosing air slowly at this point but what will the impact be of the next increase? It is just a matter of time before further increases in mortgage rates will result in increases in monthly mortgage payments than some borrowers cannot handle. This will be particularly so for borrowers of sub-prime loans who were able to purchase their first homes with almost nothing in the way of a down payment and who, even now, have a delinquency rate at near record levels.

But rest assured the Fed will do absolutely everything in its power to prevent the puncturing of the housing bubble! Indeed, the Fed are so concerned about avoiding this that they are flooding the economy with almost limitless liquidity. There must be a crisis of historic proportions coming, and the Fed is making sure that there is enough liquidity in place to protect our nation’s fragile financial system. The amazing thing is that the Fed’s actions mean they know that something is about to happen.

So where should we be investing our money? Certainly not in real estate. Definitely not in bonds. Absolutely not in the general stock market. What is left? Well, there is cash (at least you will not lose your shirt if you hold it in something other than U.S. currency), gold bullion which performs well in such a chaotic environment (and by extension mining company shares and/or their warrants), and also energy stocks because of the political climate being the way it is in the Middle East. Pay off your debts, build up your savings and invest accordingly and you will be protecting yourself from what could well become our country’s (and the world’s) worst nightmare and enjoying sweet financial dreams for years to come.

GOT DEMOGRAPHICS?

For better or worse, we live in an economy dominated by consumer spending. This fact is a cause of concern for many traditional economists, as they believe that it is largely capital investment on the “supply side”that drives economic growth. An economy that consumes more than it produces is bound to collapse into insolvency, right? And by this rationale, the U.S. is due for a massive economic correction to purge these excesses? It is highly likely that these economists will be correct about an eventual crash, though the reasons they list are effects, not underlying causes. And this inevitable crash will happen a little later than most economists think. Our forecast, at the H.S. Dent Foundation – and we have been largely correct thus far – is for our economy and markets to boom for the rest of this decade. But around 2010, the day of reckoning that economists have long feared is likely to finally come.

First, a little background. We acquired a fair amount of notoriety in the late 1980s by forecasting that the Japanese boom was quickly going to go bust and that the U.S. was on the verge of its own two-decade boom. At the time, every major financial figure, with the sole exception of Sir John Templeton, forecasted that the 1990s would be a miserable time for American investors and that Japan would soon be the preeminent world economy. In our book, The Great Boom Ahead (1993), we forecasted falling interest rates, falling inflation, growth in productivity, and – perhaps most audacious given the economic mood of the day – we even forecasted that the Dow would hit 10,000 and that the U.S. government’s unprecedented deficit in 1992 would turn into a surplus between 1998 and 2000 due to a massive increase in revenue.

Traditionally, there are two ways of explaining how an economy grows. An old-school classical economist would insist that savings and investment in productive assets is what pushes the economy forward. “But what happens when there are no buyers for what you have to sell? The key is aggregate demand that spurs production,” a Keynesian might retort. In fact, both of these points of view are true to an extent, but neither sees the full picture. Both of these views attempt to explain the “how” of economic growth, but neither explains the “why”. And both are focused disproportionately at the macro level. It is the micro level – the extreme micro level where we find the answers. The single biggest expense to the average family is children, and the older they get the more expensive they become until they finally leave home. Raising the standard two children would set an American family back nearly half a million dollars, and these figures do not take university education costs into account. It is this highly predictable spending by families that drives our modern, mass-affluent economy. This spending continues even during very difficult times, as the first half of this decade has shown.

Since the year 2000, Americans have suffered through one of the worst bear markets in history, a disputed presidential election in 2000, and the worst terrorist attack in American history, two subsequent wars in Afghanistan in Iraq, and a massive oil bubble. Yet despite the chaos, consumer spending has actually risen every quarter though it all. It appears that even calamities of biblical proportions cannot stop the American consumer. Are Americans blind to the world around them? Of course not. At worst, they can be accused of being a little stubborn. Americans will do anything in their power to maintain their standard of living, even if it means taking on more debt than they should. As a general rule, people simply do not consider the macro economy when making household decisions. They may fret about it, but at the end of the day they still buy that big, gas-guzzling SUV when Junior and his friends start carpooling to soccer practice.

Enough about Junior. What about the economy and the stock market? Well, as it would turn out, Junior leads us to quite a bit of insight. On average, people progress through a set of very predictable stages; marrying, having children, purchasing homes, and finally retiring in successive chapters of their lives. Understanding that this life cycle exists, and then seeing how it can be forecast, is the key to understanding the economy and the stock markets. By studying consumer purchasing data compiled by the U.S. Bureau of Labor Statistics, we can forecast demand for hundreds of goods and services, and also for aggregate household spending. Total household consumer spending tops out when the breadwinning hits age 48, just as the average kid is leaving home. The good news is that the largest section of the Baby Boomer generation is quickly approaching their peak spending years, which will shift our economy into another bubble boom. The bad news is that once this mass of Boomers passes that threshold, consumer spending will slow down progressively for over a decade. When it does, our economy and stock markets will suffer.

And unlike recent recessions, where an accommodative Federal Reserve and free-spending Congress were able to muster enough demand to produce a relatively quick recovery, no amount of government stimulus will compensate for the loss of spending this time. For an idea of what to expect, look east. The Japanese consumer got old. As he slowed his purchases in the early 1990s, the economic bubble burst despite all efforts to keep it inflated. The Bank of Japan cut interest rates from 6% to zero, essentially giving money away in the hopes that someone would spend it to build a factory, increase production, or to consume. In the standard formula, lowering interest rates spurs consumption and investment. As the reward for saving money gets smaller, the incentive to spend it gets bigger. But consumer spending stayed flat and then fell. New investment in productive assets stalled – Japanese business already had more than enough capacity.

The U.S. will start “turning Japanese” around mid to late 2010. The demographic trends that have powered the economy since the early 1980s will peak at this time and finally reverse as the Baby Boomers begin to save every dollar they can spare for their impending old age. Demographically, we will be in the same place as the Japanese when they began their slow, grinding decline in 1990. And when consumer demand falls, American businesses will have a hard time turning a profit. Stocks will likely enter a long bear market, and investor portfolios will be ravaged. Consumer spending will fall, and the economy will scratch and claw frantically just to avoid falling into the abyss of deflation, the likes of which have not been seen on American shores since the 1930s.

The moral of the story? Save and invest as much money as you can in the next five years, and put your money more in growth stocks as opposed to real estate or bonds. Enjoy the grand finale of the greatest boom in history! But as we get closer to the demographic turning point, you need to get conservative. You will need to start “acting Japanese”.

LIFE AFTER OIL

“Hey Guy: A word to the wise,” writes a reader who identifies himself as Curmudgeon, “most Bio fuels are energy sinks. In short they take more energy to make than they are worth. EXAMPLE – Corn is used to make alcohol. First you use a lot of fertilizer to grow it, after using fuel to plant and then harvest it. Why then do we make alcohol – because people like Archer Daniels Midland receives billions and billions every year to do so – politics again. Use the alcohol properly – DRINK IT!!!!!!!!!!!!!”

Despite ethanol’s energy-inefficiency, however, we would not be quick to dismiss its investment prospects. Ethanol production seems likely to remain on a growth path for many more years. Therefore, for those investors inclined to consider direct plays on ethanol production, reader Patrick Lim suggests Pacific Ethanol, Inc. (NASDAQ: PEIX). Pacific Ethanol seems a fascinating, if somewhat speculative enterprise. We would remind all readers to conduct their own due diligence before acting on any of the ideas that the “Group Research Project” produces.

“My favorite bio energy is solar,” writes Tony Gavali. “Look at Solarworld AG (listed in Germany). SWV GR on Bloomberg.” (It also trades over-the-counter in the U.S. under the symbol: SRWRF.) Continuing the solar the theme, a reader named Gerry writes, “Greetings, the only stock in my portfolio that fits your criteria is ATS Automation Tooling (ATA CN on Bloomberg). The name is weird, but the division that is going to make them a ton of $$$$ is their solar division, which will probably be spun off as a separate entity in the not too distant future. That is where the real money will be made.” Next up, reader Patrick Lim offered up a suite of solar energy plays: Sunpower Corporation, Energy Conversion Devices and Evergreen Solar. Several readers seem to concur with Lim’s favorable assessment of Evergreen Solar. Kevin Kerr and Justice Litle, the editors of Outstanding Investments recently recommended Evergreen to their subscribers.

“A silicon shortage has limited the supply of solar panels and frustrated potential buyers,” Kevin writes. “The real winners will be those companies that benefit from the lack of silicon. Primarily, producers of less efficient, yet available, thin film solar panels. Of course, other beneficiaries include companies that have emerging technologies, such as plastic solar cells. Solar energy is just a really exciting area right now. … The worldwide solar market is booming – growing by 40% annually in just the last five years. … So Justice and I intend to track this industry very closely and to continue trotting the globe to look for investment opportunities in solar energy.”

Coal is abundant and cheap … and filthy – a quality that would not naturally commend this fuel source as an “alternative energy”. Nevertheless, one reader suggested a “clean coal” investments for our consideration. Another suggested a variation on natural gas. Since we find these ideas compelling, we will happily divulge them. Headwater (NYSE: HW), writes one reader, “[has] a great patented process for cleaning America’s coal supply to make it environmentally friendly to burn in our power plants … dramatic reduction in emissions.” Switching to natural gas, reader Curtis Timm asserts, “Syntroleum Corp. (Nasdaq: SYNM) has a technology that, at today’s prices, affordably converts natural gas to liquids like diesel fuel.”

“What about Vestas Wind Systems (Nasdaq: VWSYF), the Danish wind turbine producer. They seem to be getting all around the world … Wind power is supposedly the cheapest form of alternative energy (see chart),” offers another reader. Lastly, reader Jon Prober suggests, “For those who want to get some alternative energy sector exposure without taking on any single stock risk, may I suggest Powershares’ Clean Energy ETF, ticker: PBW.”

Blood, Guts and Feathers

“Will the growth of ethanol production help to push down the price of crude oil?” a CNBC journalist recently asked billionaire oilman T. Boone Pickens. “Well,” he replied, “I don’t think so. Ethanol will provide some of the fuel we need, but when it comes right down to blood, guts and feathers, there’s really no substitute for crude oil.” Boone is mostly right. He should have said that there is no perfect or complete substitute for crude oil. Nevertheless, there are a growing number of imperfect and incomplete substitutes – many of which may provide enormous investment potential for forward-looking investors. Related industries also stand to benefit. If bio-diesel production is to gain market-share, for example, many diesel technologies should also flourish?

Reader John Barber raised this very idea. “Of the 2 most commonly talked about bio-fuels, ethanol and bio-diesel, bio-diesel appears the easiest to make,” he suggested. “[L]ook for companies that make diesel engines. Particularly smallish diesels that can move into what may be an expanding market for them around the world. Maybe in that universe of companies there are some attractive investment opportunities.” How to invest in any facet of bio-diesel production or in the growth of diesel technologies themselves? Since our readers pleaded the 5th in response to this question, we will toss in three ideas of its own: (1) Cummins Engine (NYSE: CMI), (2) Corning Inc. NYSE: GLW), (3) IOI Corp. (IOI MK -this stock trades only in Malaysia, and (4) A player to be named later.

RISK, SUCCESS, AND BEING “PROUD OF MY HUMILITY”

The effort to measure financial risk is a good thing, in that it is an exercise in humility. This humility appears first in recognizing that you may well lose money when investing; second, it takes humility to rely on objective analysis in assessing risk, instead of trusting your instinct and emotion. There is nothing new about measuring financial risk – gifted mathematicians have done theoretical studies of the problem for more than a century, particularly over the past 40 years. Yet the unending irony comes when the theoretical work spawns formulas that show promise in the real world of markets. Even a small degree of success in quantifying risk often becomes the worst thing that could happen to the person(s) using the formula. They relive the paradox Ben Franklin captured with the phrase, “proud of my humility.” In other words, a successful effort to be humble leads not to deeper humility, but to self-destructive arrogance.

The past decade has seen two of the most catastrophic examples of this on record. In 1998, Long Term Capital Management leveraged $4.72 billion of equity into derivative positions totaling $1.25 trillion. When LTCM imploded, fears of a ripple effect were so great that the Federal Reserve had to help sort out the mess. Nobel Laureate Myron Scholes was an active partner in LTCM, and was famous as the brains behind the Black-Scholes model, which was the recognized standard on Wall Street for valuing derivatives. The best book about the fiasco is appropriately titled, When Genius Failed.

Enron is the other recent and more famous example. The company successfully used arbitrage and derivatives to mitigate risk in the natural gas market in the 1980s. Eventually Enron tried to duplicate that success by making markets for more than 800 different products. Its collapse and bankruptcy came at the expense of $70 billion in market valuation, the jobs of 21,000 employees, and the virtual dissolution of the Arthur Andersen account firm and its 28,000 employees. “Smartest Guys in the Room” indeed.

All this and more came to mind this week as I read a page one story in the Wall Street Journal about a math professor in Paris who teaches the “skills required to create and price derivatives, the complex financial instruments based on stocks, bonds or loans.” Graduates of this professor’s courses are in extraordinarily high demand, as “banks are hiring an increasing number of recruits who understand derivatives. Inside banks, they are known as ‘quantitative analysts’.” If you are wondering about the workload these new recruits face, I will let this chart speak for itself.

The thing is, the word “Managing” should have been deleted from the headline of that chart. The WSJ story says the Parisian math professor is apprehensive about the trend in derivatives, and “is perturbed that an instrument that began primarily as a hedge for banks and financial firms against market risk is increasingly being used as a way to make a profit.” How large a risk has “quantifying the risk” become? Too large to quantify, probably, though NOT too large for wise individuals to protect themselves from.

A CONGRESSIONAL TANTRUM

Long-time readers know that I do not think the world is going to devolve into a soft depression because of the imbalances in our trade deficit and our large and growing debt. Those will have to be dealt with, of course, but I think it will happen in the normal context of the business cycle. A recession here, a falling dollar there, and slower than trend average U.S. growth over the next five years or so and we get to where the reset button has been hit. It will not be fun, but it will not be the end of the world. It is what I call the Muddle Through Economy. I am actually quite optimistic about the investment opportunities once we get through that period, with the usual caveats and asterisks.

But I have maintained for many years that the one thing that could change my basic optimism is a new wave of protectionism. Senator Smoot and Representative Hawley infamously sponsored a bill in 1930 that raised tariffs on a variety of products in order to “protect” American jobs. Of course, the rest of the world retaliated and soon we went from a recession into a global Depression. Unemployment soared and all those jobs we “saved” went away.

Recessions are part of the business cycle. The Fed cannot stop one, try though it might, nor can Congress write legislation outlawing recessions. And in the main, and with a few exceptions, they have not on balance been all that bad. One can make the argument that they are needed to correct imbalances and “irrational exuberances” here and there. I am not trying to be cavalier. If it is your job or investment or profits that get hit, it can mean some very long and sleepless nights. Been there. Done that. But for the vast majority of U.S. citizens, the last recession had little effect. But while recessions are part and parcel of the economic cycle, it takes a government to really mess things up and create a depression. Show me a depression (not a shorter term recession!) in a free society that was not the result of government incompetence or some form of direct government involvement. You cannot.

Yes, I suppose you could say that Smoot and Hawley were just responding to the zeitgeist of the times, that the voters were demanding their jobs be protected, so that the American people got what they deserved, but Congress and the Fed aided and abetted. President Hoover should have used a veto. For that alone, he deserved to be defeated two years later. Last week, an updated version of Smoot and Hawley’s Congress put together a veto-proof gaggle to stop the United Arab Emirates from buying a British port management company that ran six of our nation’s ports. Security was the ostensible reason, but anyone who did their homework knows that national security on any level was never at risk. This congressional tantrum bothers me on several levels.

We have spent decades persuading nations around the world to open up their countries to investment. And they have. We have over $10 trillion invested outside of the U.S., which made American firms $500 billion last year, a little under 5% of our GDP. Last year, foreigners increased their investments in the U.S. by $1.4 trillion, in a wide variety of investments. Without those dollars, the U.S. currency would have collapsed, interest rates would be through the roof and we would be facing (or in!) a REAL recession, not the garden variety ones we have had since 1990. About 8% of American workers are employed by foreign-owned companies. You can bet they are happy they have the higher paying jobs.

But now, there are those in Congress who would like to stop that wealth and job creating foreign investment. “In recent weeks Members of Congress have suggested that the foreign-ownership ban should apply to roads, telecommunications, airlines, broadcasting, shipping, technology firms, water facilities, buildings, real estate and even U.S. Treasury securities.” (The Wall Street Journal editorial, March 10, 2006) How does this sound to those nations that we are trying to get to open up to U.S. investments? Why should they cooperate if we re not going to practice what we preach, when it is in our clear interest to do so?

If this was just the U.A.E. deal, I could rest easier. But last year it was the dust-up over China buying a mid-size U.S. oil company that had relatively little U.S. production. We have Senators Charles (Smoot) Schumer and Lindsey (Hawley) Graham cooperating in a bit of bipartisan idiocy to try and put a 27% tariff on Chinese goods. And let us be blunt. To suggest such a thing demonstrates either astounding economic ignorance or simple political pandering of the worst kind. Probably both. Do we really want to raise the price of everything from China by 27%? On items that we no longer make here? Do we want to risk the start another trade war? Or have the Chinese stop buying U.S. Treasuries? Can you say “recession”, boys and girls?

Perils of a new globalization.

Economics and politics are on a dangerous collision course. As the forces of globalization strengthen, the drumbeat of protectionism is growing louder. Made in France, the European strain of protectionism reflects a newfound nationalism that strikes at the heart of pan-regional integration. Made in America and exacerbated by fear of the “China factor”, a different strain of protectionism plays to the angst of middle-class U.S. wage earners.

Whether the threat is perceived to be from the inside (Europe) or the outside (the U.S.), the responses of increasingly populist politicians are worrisome, to say the least. French Prime Minister Dominique de Villepin is seeking to protect “strategic” industries from foreign ownership. In the U.S., it is not just resistance to foreign takeovers, with bipartisan support building in the Senate to impose steep tariffs on China. All this harkens back to the demise of an earlier globalization that many date by the enactment of the infamous Smoot-Hawley Tariff Act of 1930 – a political blunder that may well have been key in turning a U.S. stock market crash and recession into worldwide depression. Like the circumstances over 75 years ago, the current global trade dynamic has played an increasingly important role in boosting the world economy. Protectionism and the contraction in global trade it would trigger puts all that at risk.

Today’s world, of course, is very different than it was back then. So, too, are the forces of globalization that are causing such a powerful political backlash. In the early part of the 20th century, the world was brought together by the cross-border exchange of manufactured products. In the early part of the 21st century, globalization has swept into a very different realm of commerce – information flows, financial capital, and services. A globalization that moves from the tangible aspects of tradable goods activity to the more intangible functions of the Knowledge Economy is not well understood. But the impacts of this shifting character of cross-border integration could well be more powerful today than they were in the past. Blue-collar workers in factories have long been on the front line in facing global pressures. White-collar workers in services-based enterprises have not. That was then. The rules of engagement on the battleground of globalization have changed.

This is an extraordinary development in the continuum of economic history. Economists have long dubbed services as “nontradables” – underscoring the time-honored proposition that service providers had to be in close proximity with their customers to offer in-person delivery of expertise, advice, or assistance. In the Internet Age, that contract has been re-written. The result is an IT-enabled globalization that throws long-sheltered knowledge workers into the global competitive arena for the first time ever. As was the case in the early 1930s, the globalization of labor markets is at the heart of today’s protectionist backlash. With the pendulum of global competition now swinging toward services, the resulting white-collar shock has added a new and very destabilizing element to the globalization debate. It has created a deepening sense of anxiety that afflicts workers who have long harbored the belief that they would not have to face pressures from low-wage offshore talent pools.

Politicians have been quick to come to the defense of the new warriors of globalization. The numbers leave them with little choice. Unlike the sharply reduced ranks of manufacturing-based employment in the developed world, services are the dominant source of work, income generation, and political power. In the G-7 countries, services currently account for close to 75% of the total workforce. Little wonder that services reforms have stalled in Europe, or that the Doha Round of global trade liberalization has been stymied by a highly contentious debate over services. Significantly, the new globalization could be far more disruptive than the strain of the early 20th century. That is due importantly to the extraordinary speed of the transformation now at work. Unlike the relatively slow-moving globalization in tradable goods, IT-enabled globalization has moved at hyper-speed to the upper echelons of the occupational hierarchy in the white-collar services economy.

The debate breaks down over what needs to be done. The rich countries have opted for protectionism while the poor countries continue to bet on export-led growth. The combination of IT-enabled services globalization and real wage stagnation in the rich developed world is too tempting for populist politicians to resist. Unfortunately, there is no easy resolution of these political and economic tensions. The orthodox prescription is to counsel patience – that the “win-win” of globalization eventually will raise living standards in the developing world while creating new markets to be tapped by industrial countries. Yet the hyper-speed of an IT-enabled globalization draws the rewards of that patience into serious question – at least for the foreseeable future.

In the end, politicians are always best at counting votes. With workers in services outnumbering those in manufacturing by a factor of five to one, the body politic in the industrial world has cast its ballot in favor of protectionism. Opportunistic politicians are taking the bait – seemingly unconcerned about the tragic lessons of the 1930s. While today’s globalization is very different than it was back then, the risks of making a big mistake on trade policy should not be minimized.

IT WORKS UNTIL IT DOESN’T

Over the weekend the Internet died. Its death was sudden, and for that reason our personal loss was particularly tragic. Our computer had shown no signs of illness. The browser moved briskly between websites of major retailers. Google searches were made with ease, bookmarked recipes were found, Dallas Mavericks schedules were checked, and weather forecasts noted. Then, suddenly, there was no connection. No news. No weather. Even spam could not get through. Things had worked fine for months and months. And then they did not. So I called our DSL provider’s tech support and got Carl. Carl sounded competent, but anyone who believes “Carl” was this guy’s real name would take a firearm safety course from Dick Cheney.

I knew what Carl was going to tell me – that there was a configuration problem. It’s always a configuration problem. Every six months the Wicked Witch of the Internet flies over our house under cover of darkness and casts a spell on our machine so that things suddenly need to be “reconfigured”. There can be no other explanation unless Carl is sabotaging us so he can work on his English. I do not mind talking to Carl, but it would be nice if we had an early warning system. The computer should come with a siren that goes off 10 minutes before the reconfiguration curse hits. Then we would know to forget about poking around on eBay. We might even make plans to go outside for change.

Kenneth Solow and Michael Kitces appreciate that things do not always work forever. Like asset allocation. In their article in the March issue of the Journal of Financial Planning, the duo dare to suggest that traditional allocation models might not fare so well in a secular bear market. As executives for a wealth advisory group, their interest in asset allocation is more than academic. They fear that if their clients’ money is allocated under traditional assumptions, then their returns may fall well short of expectations. After all, asset allocation decisions often are determined by evaluating a client’s goals and using historical returns from various asset classes to achieve them.

Solow and Kitces figure that the assumed returns for the equity segment of client’s asset mix are now around 9%-10% a year. That sounds reasonable because stocks have delivered 9-10% over the long term. What makes Solow and Kitces question those assumptions is their suspicion that stocks are in a secular bear market. If that is the case, stocks could provide returns well below 10% for years to come. In fact a secular bear market can last as long as a client’s time horizon. The last secular bear, for example, lasted from 1966-1981. And while investors are intrigued with Japanese stocks today, the Japanese bear market dragged on for almost 15 years.

Solow and Kitces understand that it is hard for investment professionals to shake the idea that stocks will not deliver 10% over the next several years. But they remind advisors that 1982-2000 was an enormous growth period for the financial planning industry. It is probably no coincidence that it was also a period of rising stock prices, thanks in large part, to rising PE ratios. Still, the idea of plugging in sub-10% equity returns into an asset allocation model can sound ridiculous to advisors who quote Roger Ibbotson’s numbers in their sleep. But the Ibbotson’s numbers, while accurate, require a disclaimer or two. Here is a suggested one: Do not bet on a repeat performance.

Ed Easterling, renowned chronicler of secular bull and bear markets and world class number cruncher, has some interesting insights into the Ibbotson equity numbers. In an article that appeared on this website last fall, Ed acknowledged that the annualized total return from stocks from 1926 through 2004 was sure enough 10.4%. And, yes, the period under consideration was “long term”. But Ed’s sharp eye noticed that stocks in 1926 were much cheaper than in 2004. PEs started the period at 10.4 and wound up at 20. That PE expansion accounted for 0.9% of Ibbotson’s 10.4% long term return from stocks. Since PEs are still high, investors banking on continued multiple expansion to drive stock market returns are more optimistic than American Idol competitors.

Similarly, Easterling notes that the dividend yield averaged 4.5% over Ibbotson’s measurement period. With yields today closer to 2.5% (at best), that is another 2% we can lop off the 10.4% historic return. That takes our best case return below 8%. And if PEs contract, rather than remain at today’s elevated levels, annual returns will fall further, even if the period under consideration is a long one. The way Ed sees it, the only way for a new secular bull market to begin is to start from lower valuation levels. And that means slogging through a secular bear market to get there.

If the odds are that stock market returns will come in lower than “average” over the next several years, then expectations for portfolios with traditional equity asset allocations will have to come down. Either that or the odds will increase that return objectives will not be met. That makes Solow and Kitces wonder if the traditional allocation model should be altered, either by including new asset classes or by moving away from a buy and hold equity strategy. Just because something worked for 18 years, does not mean it will work for another 18.

CAN THE BIG-3 CENTRAL BANKS DERAIL THE “COMMODITY SUPER CYCLE”?

Shortly after climbing to its highest level in 25 years, the Reuters Jefferies Commodity index (CRB Index) went into a nosedive in early February, and lost about 8% of its value. The selloff in the CRB was linked to unusual movements in Japanese yen interest rate futures (Euro-yen) in Singapore, which signaled for the first time in five years, that the Bank of Japan was prepared to tighten its money policy, and allow for higher Japanese interest rates. The Bank of Japan’s ultra-easy money policy, combined with the super-easy policies of the European Central Bank, inflated many asset bubbles worldwide, and is also igniting inflation in many industrialized nations. Until now, a tightening of monetary policy by the Federal Reserve alone has not been sufficient to discourage high levels of risk-taking in world markets, and buoyant private credit growth is everywhere resulting in bubble-like behavior in global housing and equity markets.

Financial markets have become so sophisticated and global in nature that traders can borrow cheap money in Europe and Japan as easily as they can in the U.S., to leverage their purchases of natural resource stocks, oil stocks, gold, or even Brazilian and Russian bonds, all benefiting from soaring commodity prices. To the extent there is a collective desire of the Group of Seven to contain inflation by draining global liquidity, it would require tightening from each of the big three central banks. Short-term Japanese bond yields jumped to 5-year highs last week, after the Bank of Japan governor Toshihiko Fukui warned the global markets that the five-year era of ultra-easy money in Tokyo is near an end.

From a technical point of view, the CRB index appeared to be ripe for profit-taking, with a few technical indicators flashing an overbought condition. When the CRB failed to take out an overhead resistance trend-line near the 350-level, schizophrenic commodity day traders quickly decided to turn their enormous paper profits into hard cash at a moment’s notice. However, the 8% sell-off in the CRB index in the first half of February, relieved the overbought technical condition, with the Relative Strength index falling from around the 75 level to the low 40’s. At that point, buyers stepped back into the CRB index, near the key upward sloping trend-line near the 320-level. After forming a double-bottom pattern near the 320-mark, the CRB steadied itself, accompanied by rebounds in copper, crude oil, gold and silver futures contracts, the premier leaders of the “Commodity Super Cycle”.

But for the first time in five years, the big-3 central banks, the BoJ, the Federal Reserve, and the ECB, are expected to tighten their monetary policies in unison. Last week, interest rate futures contracts for the Euro (Euribor) and Japanese yen (Euro-yen) fell below key horizontal support levels, joining the U.S. Eurodollar bear market, which itself, has trended lower since June 2004. If the downturn in yen, Euro, and U.S. dollar interest rate futures continues unabated into lower ground, then the global bond and stock markets could also be in for a rude awakening.

Finally, the LDP ruling elite admit that Japanese “core” consumer prices are emerging from eight years of deflation. But the price of gold has soared by 118% to as high as ¥68,400 per ounce, at an annualized rate of 23.6%, since the BoJ implemented its ultra-easy monetary policy in March 2001. Only a novice investor would have believed the phony inflation statistics coming out of Tokyo. In the Euro zone, the ECB, under the leadership of Jean “Tricky” Trichet, has been inflating the Euro M3 money supply to hold borrowing costs near 60-year lows, even as private bank lending soared at an annual rate of 9.7% last year. The self proclaimed anti-inflation vigilante, “Tricky” Trichet has presided over a massive 43% devaluation of the Euro against gold since August 2005, while inflating European stock markets to 5-year highs. With the price of gold spiraling above €400 Euros per ounce, despite heavy ECB gold sales, and with the Euro M3 money supply expanding at an 8.5% annual rate, Trichet was finally cornered, and forced to begin an unpopular rate hike campaign, amid howls of protest from European finance chiefs and labor unions.

Central bankers are not happy to see gold prices move swiftly higher, because it is a clear signal in the marketplace, that they have abused and violated the public trust over the purchasing power of their currency. Higher gold prices put pressure on central bankers to restrict their money supply and raise short term interest rates, which runs counter to their primary mission of pumping up equity markets. While the spectacular German DAX-30 rally of 40% since May 2005 looks great on paper, in “hard money” terms, it is actually 2% lower, falling behind gold’s 42% rally against the Euro. The hard money men at the Bundesbank are nowhere to be found.

In his Capitol Hill debut as Federal Reserve chief, Ben Bernanke on Feb 15th said higher interest rates may be needed to counter the risk of inflation. Bernanke wants to shed some of his dovish feathers, and establish his credentials as an inflation “hawk”. Eurodollar futures are pricing in two quarter-point rate hikes by the Fed to 5% by June, before it moves to the sidelines for the remainder of the year. So the CRB was hit by a triple whammy, from sliding Yen, Euro, and U.S. dollar interest rate futures in February and early March. Tighter monetary conditions could make the landscape for the “Commodity Super Cycle” a bit more slippery in 2006.

The bullish case for the CRB index rests on the fact that it has become a viable alternative to equities. At this point, there is a fair amount of skepticism about the anti-inflation resolve of the big-3 central banks, which created the worldwide asset bubbles in the first place. Also looming on the horizon is a crisis over Iran’s nuclear weapons program that is supporting a “war premium” for crude oil and buoying gold. “An attack on Iran will be tantamount to endangering Saudi Arabia, Kuwait and, in a word, the entire Middle East oil,” said Iranian Expediency Council secretary Mohsen Rezai. Iran already has complete control over 10% of the world’s oil reserves and 25% of its natural gas, and has partial control over the narrow Strait of Hormuz, the only waterway in and out of the Persian Gulf. Between 16.5 million and 17 million barrels of oil per day move through the Strait of Hormuz – about a fifth of the world’s oil.

BOOMING CHINA STRAINS MINING INDUSTRY

It is no mystery to George Sicklinger why it is so hard these days to keep mechanics at the Toyota dealership he runs in Emerald, a town in Queensland, Australia. Emerald lies to close to Queensland’s coal mines, and the coal mines are snapping up every worker they can get. “We can’t get labor, and we can’t keep labor,” said Sicklinger, who has resorted to importing mechanics from India and South Africa to replace those lured away by the mines. “It’s getting worse all the time.”

The surge in demand for minerals and other commodities brought on by China’s rapid growth, Japan’s recovery and a quickening economy in the U.S. has caught the global mining industry by surprise. Now, after a decade of cutting investment to cope with weak demand and prices, this once-sunset industry is scrambling to increase production. But the rush to increase supplies is creating global shortages of everything from dump trucks to tires. Supplies are so tight that miners warn that it is raising the cost of running existing mines, forcing them to either pay more to build new mines or postpone expansion. In some areas, even explosives are hard to find. And everywhere, mine workers are so scarce that companies are poaching from other companies, other countries and even other industries.

Many commodity industry analysts say that this commodities boom has become a commodities bubble and that prices will decline as the industry gradually catches up. The Australian Bureau of Agricultural and Resource Economics, for example, has predicted that, labor shortages aside, there are few real barriers to new supply, and that commodity prices should fall. Commodities markets are already responding: Copper prices have fallen from a record last month, and nickel, after reaching a 15-year high in late 2004, has fallen by 16%. Mining industry analysts, however, warn that commodities markets are overestimating the ability of miners to close the gap. “We could see prices ease from record highs, but it’s unlikely we’ll see them return to historical averages we’re used to,” said Glyn Lawcock, a resources industry analyst at UBS in Sydney.

Part of the problem, analysts say, is that few companies bothered to explore for the kind of mineral reserves now needed to keep pace with China’s demand. “People have not been exploring for the past decade,” said Andrew Pedler, senior resources analyst at Wilson HTM in Brisbane. “The thing that is of concern to me is how long it takes to bring on a major deposit and how few major deposits there are.” Miners therefore find themselves at the mercy of the very commodities boom from which they are benefiting, even competing for resources with other fast-growing industries. There are shortages of zircon for lining furnaces and zinc for galvanizing steel. There is a shortage of titanium for nickel mines and airplanes. The same goes for lye, which is used both in making aluminum and by paper mills. Among the coal mines of Queensland, even explosives are in short supply.

Equipment is also in short supply. Before they can start mining a new site, miners have to drill exploratory core samples, but drill rigs are difficult to obtain, said Lawcock. Big strip mines use massive shovel cranes called draglines, but BHP Billiton chief executive Charles Goodyear, the world’s largest diversified miner, said last month that the wait for a new dragline had increased to more than 30 months from as little as 18 months. This delay is forcing miners to use more hydraulic diggers and huge trucks from companies like Caterpillar. Miners now have to compete for those trucks with the oil industry, which, because of high oil prices, is moving to extract oil from oil sands and needs trucks to haul them. Miners now have to wait as long as 18 months for a new truck, BHP said.

This is assuming that they find tires. Dump-truck tires have to be replaced as often as every six months after rolling over rocks and gravel. But the three largest makers – Bridgestone, Goodyear and Michelin – have only recently gained sufficient confidence in demand to plan new production facilities. Caterpillar has resorted to shipping trucks without tires. Rio Tinto has smoothed out roads for its dump trucks so their tires will last longer.

The worst shortage by far, however, is in labor. Because of cuts in hiring over the past decade, the average age of mining engineers is 50. In Australia, starting salaries for graduates in geology or mine engineering are as high as $58,000 a year. BHP is hunting for engineers in India. Portman, Australia’s 3rd-largest iron ore miner, blames labor shortages for delayed expansion of its iron ore mine in Western Australia. In Canada, where oil sands projects are soaking up workers as well as trucks, British Columbia is spending about $2 million to train young people in rural areas and in aboriginal communities to work in mines. In the U.S., Wyoming’s coal mines are so desperate for workers that in January, officials from Campbell County, the source of 30% of America’s energy coal, spent three days recruiting among the growing ranks of unemployed autoworkers around Detroit.

CHINA’S FIXED-ASSET INVESTMENT SOARS 26.6%, DESPITE EFFORT AT CONTROL

China’s investment in factories, real estate and other fixed assets soared by 26.6% in January and February over the same period last year, despite official efforts to rein in such spending. Total fixed-asset investment in the two-month period was 529.4 billion yuan ($65.9 billion; €53 billion), the National Bureau of Statistics reported. The government is trying to slow such investment, warning it could fuel inflation or raise the risk of financial problems for banks if borrowers are left with unneeded factories and other assets.

The government also is trying to boost consumer spending in an effort to ease reliance on China’s export- and investment-driven boom. “This is not going to help rebalance growth,” said Qu Hongbin, an economist for HSBC Corp. in Hong Kong. “My sense is there is no sign investment-driven growth is correcting.” Retail-sales growth, an indicator of consumption, is about 12%, according to Qu. The government has been tightening controls on bank lending in an effort to stop construction of shopping malls, luxury apartments and other projects that Chinese leaders worry are not needed. The government’s economic plan for 2006, unveiled at the annual meeting of parliament this month, calls for fixed-asset investment growth of 18%.

China hints at easing currency limits.

China showed signs of allowing greater flexibility in its currency as the yuan appreciated past the 1% threshold for the first time since its July revaluation, ahead of a Beijing trip by two U.S. senators. The yuan finished at 8.0316 against the dollar after the central bank set the mid-point of the yuan’s exchange rate to the dollar at a strong 8.0286. At the mid-point level, the yuan would have appreciated 1.01% since Beijing revalued it by 2.1% July 21 and freed it from a dollar peg to float within managed bands. “Although the yuan’s gains were mostly propelled by market factors, such as the dollar’s weakness on global markets, political pressure is also mounting,” a dealer at a European bank said.

Sen. Charles Schumer, D-New York, and Sen. Lindsey Graham, R-South Carolina, will head to Beijing next week to hear firsthand what China is doing about its currency before making a final decision on a bill threatening the country with a 27.5% tariff on its exports to the U.S. The yuan is under pressure to appreciate further amid claims the currency is so undervalued that it gives Chinese products an unfair advantage in U.S. markets, costing millions of lost American jobs and fueling a record bilateral trade gap.

Its gains Friday also came ahead of a visit to the U.S. in April by China’s President, Hu Jintao, during which U.S. authorities will certainly raise the yuan issue. The dollar hovered near a 7-week low against the euro, staying on the back foot after a soft U.S. inflation report suggested the Federal Reserve’s tightening campaign could be drawing to a close.

ANALYSTS SKEPTICAL OF CLAIMS OF A LARGE MEXICAN OIL FIND

Analysts say they are skeptical of news this week from the Mexican state oil monopoly that exploratory drilling in the deep waters of the Gulf of Mexico shows signs of a giant new oil field. Petróleos Mexicanos, or Pemex, says that early indications suggest that the field could be as large as 10 billion barrels. But analysts said that it was premature to make an estimate based on preliminary drilling. “To me it’s entirely speculative and hypothetical,” said David Shields, an oil analyst and consultant in Mexico City. Even if further testing confirms that there is a significant deepwater find, the company has neither the money nor the expertise to exploit it. Mexico’s oil industry, long a symbol of national sovereignty, is essentially closed to outside investment. Analysts suggested that President Vicente Fox may have rushed announcing the find in a new attempt to prod Congress into opening up the industry.

Pemex officials warned that its figures on the discovery were preliminary. In its official report of reserves, the company said it was possible to infer that the new reserves could reach 10 billion barrels. Mr. Ramírez Corzo said it would take at least two years before Pemex would have enough information on the field to estimate the investment it would need to produce oil. Pemex needs to make new discoveries if it is to keep up its role as a major oil producer and replace declining reserves. Its main oil field, Cantarell, has begun to decline. The company estimates that production there will fall by 6% this year, and the decline is projected to accelerate.

ARE GOLD AND SILVER IN A BUBBLE MARKET?

We look at the real estate markets in coastal cities and conclude, “these are bubble markets.” Yet they have not risen as far and as fast as silver and gold have risen since 2001. Nevertheless, most recent first-time buyers of gold and silver give no thought to what should be obvious: the moves of both metals over the last four years are anomalies. Other than believing they are geniuses, why should precious metals investors not be getting nervous? Gold and silver are inflation hedges. Yet the Federal Reserve System is sending mixed messages regarding inflation. On the one hand, the Fed has been increasing the adjusted monetary base at double-digit rates since late 2005. The other monetary indicators have followed. This can (and should be) be monitored here.

On the other hand, the Fed has also raised the federal funds rate by a quarter of a point every time the Federal Open Market Committee (FOMC) has met since mid-2004. This is the classic sign of anti-inflation policy. The short rates have been rising faster than long rates, which has now produced a flat yield curve. An inverted yield curve is a prelude to a recession. The yield curve can (and should be) be monitored here.

So, which is it: recession or accelerating price inflation? Right now, we are in “anyone’s guess” territory, which is why wise investors had better monitor the statistics of these seemingly rival policies on weekly basis. It is not clear which Fed policy is dominant today. A great deal is at stake.

The Fed, beginning in late 2000, saw what had happened to the yield curve. It had inverted. That was when I predicted a recession in 2001. The Fed saw this, too, and began cutting the fed funds rate a quarter of a point at a time. Then came the 2001 recession. The Fed continued to reduce rates. Then came 9/11. The Fed continued to reduce rates. The housing market continued to rise, and gold and silver at long last began rising. That was when I issued a strong “buy” recommendation for gold: the fall of 2001. Gold in 2001 had been battered by 21 years of downward pressure. It had gone to $840 in early 1980. Despite a doubling of the price level, 1980–2000, gold declined to the mid-200s in 2001. I became convinced that an anti-bubble process was at the end of the road.

Gold is not a recession hedge. It is an asset that can be sold to raise funds in a crisis. It gets sold in recessions because people want to raise cash. Selling any asset is a way to raise cash. Silver is even less protected from recession-induced sales, which is why silver’s price is more volatile than gold’s. It has no central banks buying it during recessions. Meanwhile, demand slows because the economy is slowing. Silver is an industrial metal and to a lesser extent an ornamental metal. Demand for most metals falls when the economy goes into recession.

There is a longtime myth of gold that has been popular in every pre-recession period. Recent buyers console themselves by saying, “Gold did not fall during the Great Depression. It went up.” In the 1930s, the U.S. was still on the gold standard internationally. By law, the U.S. government bought gold from gold mines at $35/oz. So, the gold market had a legal floor. When Nixon unilaterally took the U.S. off the international gold standard, the experience of the Great Depression became economically irrelevant to today’s gold market. Central banks may buy gold or they may not, but they are not compelled by law to buy it. All we can say with confidence is that they will not buy silver, which is no longer a money metal.

Gold fell in the 1974/75 recession. Then it rose in the Carter-era inflation. Then it fell by 50% in the 1980/81 recession. Then it fell in 2000 prior to the 2001 recession. My point is that gold, as an inflation hedge when price inflation exceeds what the experts have forecast, should not be regarded by investors as a universal solution to the gyrations of Federal Reserve monetary policy. Silver is even less of a hedge. It has been de-monetized, so it is even more a captive of the overall economy.

The Fed is trapped long-term in a policy of “inflate or die”. Like addicts, investors, consumers, and debt-issuing governments demand ever more money from the Federal Reserve. Everyone has factored in 2% to 4% monetary depreciation. If the Fed fails to provide this, the entire debt pyramid is threatened with collapse. The Fed expands the money supply at varying rates. This process of varying rates of monetary expansion does not immunize gold and silver from wide swings in price. In the case of the period 1980 to 2001, the contraction wiped out 90% of investors’ asset value, if you factor in the 50% loss of the dollar’s purchasing power.

A new generation of investors has arrived. It took them at least two years to believe that a new bull market had arrived: 2001–2003. Then they hesitantly began getting into the precious metals’ market. They have done well. They are newcomers. They do not understand fully why they bought. They just understand that their investment’s market value has risen. “Genius is a rising market.” They are tempted to regard themselves as geniuses. If the economy goes into a recession over the next 12 months, the precious metals are unlikely to continue their upward move. The pressure on asset-holders to sell in order to gain cash is always a problem for asset holders who choose not to sell. They see the value of their holdings fall. Yet prices in general continue upward. I do not expect a fall comparable to what happened to gold and silver after January, 1980. Still, there will be selling pressure if the recession hits, as it looks as though it will hit, if we take seriously the flat yield curve.

In a recession, asset values tend to fall as people become desperate for cash. Fear is a great motivator. So are margin calls. The marginal sellers of assets are more active than the marginal buyers of assets. I am issuing this warning because I know how many of my subscribers have not gone through a recession-induced fall in the precious metals markets. I do not want new investors to conclude that the boom, 2001–2006, was a fluke, a bubble that will not return for decades, which was the case after January, 1980. The gold and silver markets, unlike the housing markets, are not driven by long-term government-subsidized mortgage money. So, I do not call them bubble markets. Nevertheless, they are markets. The quest for ready cash in a recession is a universal aspect of all recessions. Don’t expect the next recession to be different.

The Fed stands ready to inflate its way out of the next recession. It seems already to have begun. This is the case for the precious metals. But it is a long-run case, not a full-time case. [Ed: As we once saw it alternatively phrased, “Just because something is inevitable does not mean that it is imminent.”]