Finance Digest for Week of March 27, 2006

A MINIBUBBLE IS FORMING IN THE GOOGLE AD REVENUE STREAM

Two years ago Ted W.N. Rheingold was riding out the tech slump doing Web design jobs from home. He and his wife wanted a dog, but his landlord said no. So the Rheingolds lived the dog life vicariously by browsing photos on dog rescue sites. This was his inspiration for Dogster and Catster, two sites he runs for pet fanciers to share photos and stories. Like Friendster, it is a social networking site – but with fur – and 211,000 member animals. Before you crack jokes, know this: Rheingold’s firm is profitable, growing quickly and on track to hit $1 million in sales this year. Rheingold spends $2,000 a month to rent servers in Virginia and $1,000 a month for a few rooms in a San Francisco warehouse that once housed a soap factory. He has eight employees. So far Dogster fans are doing the selling on Dogster’s behalf by sending Dogster invitations to friends with dogs.

“I wanted to cover my rent. That was the business plan,” says Rheingold. Rheingold has done a bit better than that by following a strategy now consuming Silicon Valley: Throw up a site using cheap hardware and open-source software and get users to do all the work. The new Web breed repackages what is already there – photos, news, music, searches, blogs – and makes its money by suction-cupping to the back of Google’s AdSense program, which distributes ads to sites willing to split the revenue earned each time someone clicks on a paid link. AdSense is now generating $2.7 billion a year, roughly 80% of it distributed to partner sites. Rheingold now has enough traffic to attract his own advertisers, including Walt Disney and Dad’s, a premium pet product company. Only a sliver of revenue now comes from Google ads.

Silicon Valley is abuzz again with firms such as Kaboodle, Kosmix, Become.com, Wink, Digg and Browster. These goofily named Web newbies are being nourished by Google, often compete with Google and, given how similar their business plans are to a half-dozen other startups in the Valley, hope for a quick buck by selling themselves to Google, Yahoo, IAC or News Corp. “Google created a marketplace that allows new sites like us to get started,” says Michael Tanne, founder of the Web search service Wink. He does not have to pay salesmen and instead can use the cash to improve his search technology. “The motto of the bubble was get big fast. The rule today is get big cheap,” says David Cowan of Bessemer Ventures. “What tickles my checkbook is the success of capital-efficient startups where the users themselves often contribute the feature road map, software and marketing.”

In the past two years David Sze, a partner at venture firm Greylock, has seen a fivefold increase in the number of pitches from consumer-targeted outfits. The new breed of entrepreneurs are not so foolish as to think they are the next Google. Digg founder Jay Adelson knows that frugal operations and Google ads can take him only so far. “If you get enough customers, you need to invest in server farms and expertise. Lots of these companies will simply get lost in the noise.” The best they can hope for is to make a quick buck selling out to one of the Web giants.

If the last bubble taught Valley denizens anything, it may be the wisdom to take the money and run – even if it is only a million or so. Slaving it out for the big bucks is very 20th century.

TIME TO BUY GOLD?

Since President Nixon took the dollar off the gold standard in 1971, the price of an ounce of gold has been, on average, 16 times the price of a barrel of oil. Now, with gold at $555 but oil going crazy at $64, the ratio has collapsed to 9. Seemingly a sure winner: a bet on a rebound in the gold/oil ratio. To make the bet, you would buy gold and short oil. But the same logic would have dictated shorting oil and buying gold four years ago, when the ratio was at a below-normal 12. David Tice, a Dallas money man who advises money managers what stocks to avoid, thinks the ratio will go up but more from a rise in gold’s price than from any decline in oil’s price. Gold will hit $1,000 within the next year or two, he predicts. But he is not guaranteeing it.

LIKE FAT YIELDS AND LONG-SHOT PROSPECTS OF BIG CAPITAL GAINS? TRY BUSTED CONVERTIBLES

Take a junk bond, attach a junky stock to it and what do you have? A busted convertible. These are sometimes sketchy securities, but you can make good money from them, believes Charles Carlson, manager of the Greenspring Fund. Convertible bonds are hybrid creatures that have some equitylike characteristics and some bondlike characteristics. The bond is like any other in carrying a coupon and the issuer’s promise to repay the par value (generally $1,000) at some point in the future. But the bond can be converted, at the option of the holder, into a fixed number of common shares of the issuer. If the stock takes off, the bondholder does well – not as well as someone holding the shares but pretty well. If the stock just sits there, the bondholder pockets his coupon and principal repayment. Nick P. Calamos, investment chief at Calamos Investments, a fund family that owns converts, calculates that there are $260 billion (par value) of convertible bonds outstanding.

A busted convert is one whose associated stock is doing so badly that there is little prospect the conversion feature will pay off. More precisely: The convert is busted when its value, if immediately converted into shares, would be less than half its current price. Busted bonds make up 15% of the convertible bond market. Carlson, 46, has 40% of his $175 million fund invested in them. What is Carlson looking for? Sometimes a payoff from the equity kicker. Usually nothing but the coupon and the principal repayment. “With busted convertibles, there are a lot of ways to make money,” he says, exaggerating a bit.

During the late 1990s bull market a lot of technology companies issued convertible bonds. Issuers saw this kind of security as a cheap way to raise capital since the interest paid on convertible bonds is lower than the interest paid on straight debt. Investors were willing to take the low coupons because they aspired to make a killing if tech stocks continued to soar. Which is not what tech stocks proceeded to do. Come 2001, Wall Street was awash in busted converts. Had you bought then, you would have done quite well. Convertbond.com, a Web site owned by Morgan Stanley, reports that over the last five years busted converts have averaged a total annual return of 16%, vs. 4% for the stock market.

The next five years probably will not be as lucrative, but Carlson still sees value in the sector. These securities are, for the most part, junk bonds delivering pretty good yields to maturity at a time when a good yield is hard to find. By contrast, many unbusted convertible bonds trade at only a small premium to their equity values, and they are better understood as equity investments than as bonds. In that case you anticipate earning back that premium by collecting bond coupons rather than the low or nonexistent dividend on the stock. If there are lots of ways to make money in converts, there are as many ways to lose it. The bond will go down if market interest rates go up, if the issuer’ ability to repay deteriorates or if the underlying stock falls even more out of favor.

TOKYO’S DAY

Is dawn breaking at last over the long-slumbering Japanese economy? “Yes” is my emphatic, admittedly unobjective, answer. Whether or not you have money invested there, Japan is calculated to intrigue. Here is a living laboratory in what the learned economists call “behavioral finance”. In their propensity to sell low and buy high and to perceive risk where there is actually reward, Japanese investors strongly resemble their American counterparts. That is, they are only human.

In the aggregate they are phenomenally risk-averse, after 15 years of collapsing land prices, failing banks, soaring budget deficits, sagging share prices, falling interest rates and stagnating business activity. In this time of woe, cash was king. Bonds, too, were investment royalty. Though they yielded a pittance, the principal was safe, and the yen in which the debt was denominated was buying more with each passing year. To this state of affairs – loosely styled deflation – the Bank of Japan addressed itself in 1999 by inaugurating a policy of 0% interest rates. In 2001 it instituted “quantitative easing”, or monetary force-feeding, in which it stuffed the banking system with money. Few were willing to borrow any.

Now a solvent banking system is beginning to accommodate a rising demand for credit. In February, for the first time in eight years, bank lending showed positive growth. The campaign to stamp out deflation has borne fruit in the form of three consecutive monthly CPI growth readings above the zero mark. Under the printing-press standard, inflation is customarily the top monetary concern. Not in Japan. It was the lack of inflation that has had the central bank on the defensive. But that peculiar phase of Japan’s monetary history ended March 8, when the BoJ announced the suspension of force-feeding, although not – for the time being – of 0% interest rates. A pair of economists from Bear Stearns observe that the new policy remains accommodative.

Which spells bad news for Japanese bondholders but good news for Japanese stockholders. With the Nikkei 225 index quoted at 43 times trailing earnings, the Tokyo market is not precisely cheap on an earnings basis. And gone are the days when hundreds of Japanese companies were valued at less than their net current assets. But plenty of Japanese companies continue to hoard cash, as plenty of American companies would if they had been through a decade and a half of rolling recession. These asset-rich businesses are ripe for restructuring. Small wonder that merger-and-acquisition activity is strong or that Western private-equity investors are circling Tokyo in expectation of a new wave of dealmaking.

I believe a huge reallocation of Japanese investment capital is only just beginning. Bonds with flyspeck yields – the sure things during the long slump – will prove exactly the wrong things to own in the continuing expansion. Late last year the Nikkei Weekly noted that life insurance investment committees continue to stay away from the stock market. “Young fund managers know only a bearish market,” one Japanese asset manager told the paper. If, as I expect, these fund managers will come to know a bullish market, a couple of New York-listed exchange-traded funds offer a convenient way for a non-Japanese investor to participate: iShares MSCI Japan (14, EWJ) and iShares S&P/Topix 150 (120, ITF).

FIND ENERGY AT HOME

There is plenty of cheap energy in the earth’s crust, just not in North America. Easily accessible sources, like the big East Texas oilfield, were exploited long ago. The rest is expensive to get to, such as crude oil and natural gas in the deep and hurricane-infested waters of the Gulf of Mexico. Or it i locked up in forms that are costly to process, such as Colorado shale oil and Canadian tar sands. Or it is out-of-bounds for political reasons, like East and West Coast offshore areas and the Arctic National Wildlife Refuge. Or the energy cannot be used because people do not want to live near oil refineries and liquefied natural gas terminals. They do not want nuclear power plants near them, either.

Still, $2.50-a-gallon gasoline can do wonders to change voters’ thinking about the environment. Then there are the political and military risks of importing 60% of our petroleum. Think about Russia’s withholding of gas exports in its price dispute with Ukraine, Saudi Arabia’s refinery bombers, Iran’s pursuit of atomic weapons, Iraq’s oil pipeline saboteurs, Nigeria’s warring tribes and Venezuela’s leftist hothead, Hugo Chavez. Energy prices are high now in large part because underinvestment in new sources over the past decade left supply falling short of demand at the prices of two years ago. The good news for investors is that today’s steep prices, plus the risks of imported oil, make high-priced North American energy interesting again.

The warm winter depressed natural gas prices, but clean-burning gas is attractive in the long run. North American supplies will rise in future years when pipelines are built south from Canada’s MacKenzie gas fields and the North Slope. Natural gas is plentiful in the Middle East and often flared for lack of demand. Countries like Qatar are investing heavily to liquefy some of their gas for shipping to Western nations and to turn the rest into synthetic diesel fuel. Washington is superseding state and local governments to expand the U.S.’s LNG terminals beyond the current five that regasify LNG and feed it to pipelines.

The U.S. has a 250-year supply of coal at current production rates, and though coal and natural gas each account for 30% of U.S. energy consumption, coal is much cheaper. Further, technological advances are removing more of the sulfur and other undesirables, and also raising the likelihood that chemists will find a way to economically convert coal into diesel fuel. Power plants at coal mines can eliminate the current lack of rail capacity to move more coal on some routes.

In petroleum, look for Washington to encourage the approval and construction of new refineries, and the opening of more offshore areas to drilling. Nuclear energy may regain favor as public hysteria is overcome by high energy costs and concerns about the global warming effects of fossil fuel. Note that France produces 80% of its electricity from nuclear, and the U.S. only 20%. The Canadian tar sands contain huge quantities of bitumen that can be converted to petroleum. Tar sands production is very profitable at current crude prices, and new processes are reducing the costs. A number of companies are involved in this mushrooming energy play.

Yes, there was also a big push for domestic energy after the oil shocks of 1973 and 1979. Then crude prices collapsed in 1986, leaving geothermal projects and windmill farms on government-subsidy life support. By the 1990s Americans were forgetting the gas lines and climbing into enormous SUVs. It will take periodic crises to remind people that foreign supplies can be cut off quickly and disastrously. I believe that, unfortunately, these supply crises will be common enough to make North American energy an excellent investment play for the next decade.

“BRIC” FUNDS ALL THE RAGE, POINTING TOWARDS UPCOMING CRASH OF INDIAN STOCKS

The latest fad in mutual fund circles is yet another indicator pointing to the upcoming crash of Indian stocks. Mutual fund companies, infamous for introducing hyped-up products tied to mania-plagued markets, are launching so-called BRIC funds in 2006. BRICs, or “funds investing in Brazil, Russia, India and China,” are now all the rage as billions flood mutual fund coffers following meteoric gains in Brazil, Russia and India since 2003. China, the world’s fastest-growing economy over the last 20 years, is the only dog in the BRIC fame, down 20% over the last five years.

BRIC funds are no different than the Greater China funds launched over 10 years ago, following the great emerging markets bubble in 1991-1993. From 1993 to 1995, dozens of China-dedicated funds were launched. By 1997, the Shanghai and Shenzhen bourses had collapsed, down more than 75%. The same phenomenon occurred in the post-1995 period as technology stocks went ballistic. Yet by 2002, the NASDAQ was well on its way to losing over 75% of its value from the March 2000 bull market peak.

The hottest country at the moment is India. No doubt, India merits high praise for drawing massive foreign direct investment over the last decade after liberalizing its economy. Over the last three years Indias economy has averaged an 8% GDP growth rate. But the stock market is now clearly in full-blown, tulip-bulb land, up a staggering 300% since 2002. Twice in the past six months, Indian finance officials have warned that stocks are overheated. Warnings like this are reminiscent of Alan Greenspans irrational exuberance foretoken in 1997, three years before the bull market ended. Indias stock market will crash before 2007, simply because it is the Eighth Wonder of the emerging world today. From investment articles, newsletters, conferences and the popular newsstand press, everyone is touting India. And when everyone is buying the same market or trend, its always a matter of time before that rally ends very badly. Market history is littered with shattering crashes and the enormous loss of wealth as investors overstayed their welcome or purchased a secular trend after it peaked. India will be no different.

Russia and Brazil, two incredibly over-inflated markets, might continue to rally further this year simply on the thrust propelled by the commodity bull market. Both countries derive a major share of their export revenues from raw materials. But India does not. The overheated BRIC nations are too hot to handle now – all except China.

Emerging-market stocks’ two-year rally may falter as rates rise and valuation case diminishes.

Shares of companies based in developing countries rose for a seventh quarter, extending the longest string of advances since the 1980s, as faster economic growth and a commodities rally drew record funds. Further gains may be hard to come by. The ratio of stock prices to earnings in so-called emerging markets is the highest since 1999 when compared with the developed world. Companies in these markets may suffer as rising borrowing costs in the U.S. and Europe limit global economic growth. “We’re starting to move into expensive territory,” said Allan Conway, who oversees some $8 billion as head of emerging- markets equities at Schroders Investment Management in London. “It’s a flag of caution.”

The Morgan Stanley Capital International Emerging Markets Index, a dollar-denominated gauge of 26 markets in Asia, Latin America, Eastern Europe, the Middle East and Africa, increased 9.2% for the quarter through March 28. The index dates back to 1988, and its longest winning streak is eight quarters in 1988-89. Emerging markets also extended their winning streak versus developed markets to a seventh quarter. Since the rally began in the third quarter of 2004, the MSCI emerging-markets index has surged 78%. The gains have encouraged investors to plow money into the shares.

Not all emerging markets rose. Prices dropped in Arab markets, where trading is largely limited to local investors. The Dubai Financial Market Index plummeted 35%, the biggest loss among 77 indexes that Bloomberg tracks globally. Elsewhere, almost all of this quarter’s gains occurred in January. After rallying 11% in the first month of 2006, the MSCI Emerging Markets Index suffered losses of 1.4% since then. In the second week of March, the index slid 4.1%, the steepest weekly decline in 14 months. Speculation that the Federal Reserve will keep raising interest rates in the world’s biggest economy triggered the loss. The Fed boosted its key rate by a quarter point, to 4.75%, on March 28.

Emerging-market shares trade at a 20% discount to developed- market stocks when measured by price-earnings ratios, according to UBS AG. That is the smallest percentage in about seven years. Higher borrowing costs in the world’s largest economies may also limit stock gains. The Fed, in boosting rates for the 15th straight time yesterday, indicated more increases may be coming. The European Central Bank gave a similar signal on March 2, when it raised rates for the second time in three months. “The valuation case is no longer obvious and the global cost of money continues to rise,” UBS AG’s London-based Darren Read, rated the No. 1 emerging-market equity strategist in an Institutional Investor survey, wrote in a note two weeks ago. “A couple of clouds have appeared in a very blue sky.”

THE JOY OF NEUTRALITY?

There is a widespread belief that the U.S. Federal Reserve remains on track to boost interest rates back towards more “neutral” levels. The only question is, what is neutral? To figure that out, it makes sense to look at what has been the norm over several decades. Not only for nominal interest rates, but for inflation-adjusted – or “real” – interest rates, too. As it happens, the median monthly nominal and real effective federal funds rate during the past 50 years has been 5.31% and 1.76%, respectively, while comparable yields on 10-year Treasury bonds have been 6.31% and 2.65%. The monthly year-on-year gain in consumer prices has averaged out to 3.30%.

Under the circumstances, one could argue that with February’s 4.49% fed funds rate lying 82 basis points beneath the median – and the 0.89% inflation-adjusted rate 87 basis points shy of its average – we should be looking for at least three more 25-basis point hikes. Moreover, with February’s 4.57% 10-year Treasury yield 174 basis points below normal – and the real rate of 0.97% a similarly wide 168 shy of its 50-year median – we should expect to see much higher bond yields – and sharply lower prices – than we have now. Not to mention the fact that if reported inflation turns out to be understated – as many now believe – the rate rises to come are likely to be far more dramatic.

Whatever the case, it seems wrong to assume that the 25-basis point rate hike set to occur at next Tuesday’s FOMC meeting will be the last – as bullish proponents of the so-called “one-and-done” perspective have been arguing. Or that the sell-off in bonds, which has boosted longer-term yields by around 40 basis points over the past two months, will be ending any time soon. So much for the joy of neutrality?

MORE RATINGS DOWNGRADES COMING, SAYS S & P

Global corporate-credit quality is starting to show signs of cracking. Standard & Poor’s says in a new report that the number of companies at risk for potential credit-rating downgrades jumped to a high of 659 in mid-March, compared with 636 in mid-February. The number represents the highest level since the rating agency began preparing the report last September. Nearly 86% of those at risk of downgrades are located in either the U.S. or Europe, with the telecommunications and automotive sectors facing the greatest likelihood of downgrades. The rating agency reports that many of the companies vulnerable to a downgrade are in the consumer-discretionary domain – telecommunications, automotive, retail/restaurants, and health care – where pressures have been building from growing consumer debt, uncertainty about the housing market, and high energy prices.

THE COMING REBALANCING OF THE CHINESE ECONOMY

China is sending the world an important message: A key mid-course correction in its development model is coming – a shift away from export- and investment-led growth to more of a consumer-driven dynamic. This change will not be abrupt but it will be an increasingly dominant characteristic of the Chinese growth outcome over the next five years. It is aimed, first and foremost, at providing greater stability to the Chinese economy. It will also have profound implications on the global economy and world financial markets.

I have reached this conclusion largely on the basis of very clear statements made by senior Chinese officials. It is also consistent with my own macro analysis of the Chinese economy. And it is a conclusion that stood up well to a full-blown debate that I was part of during my recent visit to Beijing. The essence of the adjustment is actually very simple: A long-standing strategy of resource mobilization – powered by the recycling of a huge reservoir of domestic saving into an export- and investment-led growth dynamic – has now outlived its usefulness. Senior Chinese officials believe that the time is right to shift to more of a self-sustaining internal demand model, driven by private consumption. This rebalancing will not only enable China to deal more effectively with both internal and external imbalances, but it will also enable the reformers to turn their attention to the critically important quality dimensions of the growth experience that are now being actively debated inside of China.

China’s rebalancing imperatives are obvious. The economy has become far too reliant on two sectors – exports and fixed investment. Depending on the metric chosen, these two sectors now account for between 70% and 80% of overall Chinese GDP. And, as of this point in time, they are still expanding collectively at around a 25% annual rate. If those trends were to continue, the sustainability of the Chinese growth model would be at considerable risk. Years of rapid export growth have already led to serious trade frictions and heightened risks of protectionism. Moreover, a continuation of rapid investment growth could lead to excess capacity and deflation. In order to rectify these imbalances and avoid their potentially destabilizing implications, a shift in the mix of the Chinese economy must now occur.

The Chinese leadership is going out of its way to inform its own citizens, as well as those in the broader global economy, that it will now push for just such a rebalancing. The Chinese leadership stressed three important aspects of the rebalancing imperative – the first being a moderation of the overall growth objective. The new five-year plan calls for 7.5% average real GDP growth through 2010 – a marked downshift from the 9.5% average pace over the preceding 25 years. This should not be viewed as a worrisome shortfall but, instead, as an effort to raise the quality of China’s growth experience. The second leg of the stool is the government’s pronouncement on the intent to rebalance the mix of GDP growth over the next five years. Ma Kai, Chairman of the National Development and Reform Commission, stressed the need to boost both the consumption and the services shares of Chinese GDP at the cost of lowering the portions going to exports and fixed investment. Financial reforms are the third leg to China’s macro rebalancing stool. The focus, so far, has largely been on banking reforms. But there are equally strong needs to push into the area of capital markets reforms – especially the development of a corporate bond market. Currency reforms have also been given considerable attention recently – especially in light of mounting bilateral trade tensions with the U.S.

The implications of this rebalancing are likely to be profound – both for China as well as for the rest of the world. The tilt away from exports and investment toward consumption, along with the moderation of aggregate GDP growth such a rebalancing implies, could challenge many of the perceptions now held in the financial markets about the “China factor”. (1) As the pace of Chinese industrial activity slows in the years ahead, pressures on the demand side of industrial materials markets should ease – underscoring the downside risks to commodity prices at just the time when most investors have concluded that there will be no stopping the upside of a “super commodity cycle”. (2) Courtesy of rebalancing, China may be more inclined toward RMB appreciation as a means to promote a shift away from the excesses of export-led growth. The combination of RMB appreciation and reduced external surpluses should play an important role in relieving the anti-China trade tensions now building in the international community. (3) The Chinese consumer will not spring to life over night. But this is likely to be a major story over the next 3-5 years.

China remains the world’s greatest growth story. But there is far more to its transition and development than the sheer speed of an industrial growth dynamic. An important rebalancing is now at hand that will temper the excesses of the current strain of growth and insure the sustainability of a more balanced and higher-quality economy for years to come. That message came through loud and clear in the 11th Five-Year Plan and in the debate and exchange I witnessed last week in Beijing. Over the years, I have learned not to under-estimate the will and determination of the macro managers who shape the character of the Chinese economy. Time and again, they have made the right moves at the right time. I see no reason to doubt the wisdom or the execution of the coming rebalancing.

NO MERCY NOW, NO BAIL-OUT LATER

As Ben Bernanke knows all too well, monetary policy is like pulling a brick across a rough wooden table with a piece of elastic. Tug, tug, tug: nothing happens. Tug a little harder: it leaps off the surface and knocks your teeth out. A garrulous professor, he could scarcely have taken charge of the U.S. Federal Reserve at a more hazardous moment, just as the credit cycle nears it peak. The departing Fed chairman Alan Greenspan has done the easy work, lifting U.S. interest rates to 4.5% in 14 brisk steps from the aberrantly low – perhaps fatally low – level of 1% in June 2004. This may be near the “neutral” level … or not.

A mistake now could put millions out of work, or worse, and since it takes a year or more (the Swiss National Bank says three years) before the full effects of monetary policy are felt, Mr. Bernanke will not find out until it is far too late. He will have to trust his instincts as he picks up a chalice brimming with the nastiest of toxins: a current account deficit of 7% of GDP, covered for now by fickle flows of capital from the Chinese central bank and petro-dollar sheikhdoms, a negative flow of global investments earnings for the first time in modern memory, a dollar hanging by a political thread, and hair-raising levels of debt. “Bernanke is not inheriting the best of situations,” said Greenspan-predecessor Paul Volcker, the grizzly voice of orthodoxy. “How would you like to be responsible for an economy that’s dependent upon $700 billion of foreign money every year? I don’t know what I would do about it, but he’s going to have to do something about it sooner or later,” Mr. Volcker said.

Whatever his inner doubts, Mr. Bernanke seems bent on pushing full steam ahead with interest rate rises, and damn the torpedoes. In a speech to the Economic Club of New York this week, he said he would not let a faltering housing market deter him from the necessary action to wring inflation out of the system. As for the dreaded “inversion” of the yield curve as long-term rates dip below short-term rates – harbinger of slumps through the ages – he said it may even be a bullish signal this time, stemming from investor confidence.

Fellow governor Donald Kohn hammered home the Fed’s hawkish strategy in blunter language during a speech in Frankfurt. “If real estate prices begin to erode, homeowners should not expect to see all of the gains of recent years preserved by monetary policy actions,” he said. In other words, no mercy now, and no bail-out later, regardless of warnings by financier George Soros that Fed tightening could combine with sliding house prices to cause recession in 2007. So much for the rosy “hand-off” scenario in which the Fed begins to ease just as Europe and Japan tighten in earnest. All three could now be raising rates in unison.

Early signs of stress are already showing at the edges, from Iceland, to Egypt, Turkey and Hungary. However, the American housing boom is now the mother of all bubbles – in sheer volume, if not in degrees of speculative madness. Mr. Bernanke’s steely line is all the braver given the disquieting data coming from the East and West Coasts. January home sales were down 14% year-on-year in Massachusetts, and down 24% in California. Prices usually follow.

The levels of U.S. household debt are vertiginous, rising 8.6% in 2000 from already dizzy heights, then again 8.6% in 2001, 9.7% in 2002, 11.4% in 2003, 11.1% in 2004 and 11.7% in 2005. The Fed itself has warned that millions of punters are “in over their heads” with 100% mortgages and zero up-front interest costs. The personal savings rate has turned negative for the first time since the early 1930s. As fitting testimony to the bubble, estate agents, surveyors, and the army of workers linked to property made up 55% of the 2 million jobs created by the U.S. economy from 2000 to 2005, according to Moody’s.

The Americans are now drawing down 6% of GDP from the equity in their houses each year, much of it to pay bills or splash out on a spanking new V-6 Chevrolet Equinox. Goldman Sachs estimates that 68% of this home equity withdrawal is spent outright on consumption. It warned that the drag on growth could reach 1.5% of GDP by next year if property stalls. It is portrait of a nation that is living further beyond its means than any advanced society has ever dared before.

By Britain’s world-beating standards, the 13% rise in U.S. house prices last year (35% in Arizona, 27% in Florida) seems paltry stuff. But the two markets are chalk and cheese. America has abundant land, easy planning laws, and now a record 5-month inventory of unsold homes in sprouting suburbs across the country. It is hard to believe that Mr. Greenspan would have stood by impassively as this – the biggest of all his serial bubbles – began to pop. For 17 years, “Easy Al” was always there with sacks of liquidity, ready to rescue one wave of speculators after another: the Latin Tequila crisis in the mid 1990s, the Asian meltdown, the Russian default and the tech bubble. He recoiled from raising rates to halt excesses, insisting that it was not for central banks to meddle in asset markets. Yet he stepped in time and again to cut rates when values plunged, putting a floor under investment losses. Traders even have a nickname for this variant of moral hazard, the “Greenspan Put”.

The Bernanke Fed seems made of sterner stuff and is clearly of the view that there is no free lunch in economics. Those who expected Mr. Bernanke to prove an “easy money” bet may be in for a shock. Dubbed “Helicopter Ben” by his legions of critics, he put his foot in it in a speech as a junior Fed governor in 2003, exuberantly rehashing the old quip (Milton Friedman’s) about dropping bank notes from helicopters to stave off deflation. It was the Princeton professor in him speaking, not the banker, but the damage was done. It would be human nature if he now proves as tough as nails.

THREE LOW-RISK STOCKS EVEN BEARS LOVE

First they assassinate the generals. Then the colonels. Then they lure the captains and foot patrols into a trap and slaughter them en masse. And finally, they grab some pretzels, pop open a beer and light a cigarette. No, that is not a secret Pentagon war plan. It is the typical game plan for a “secular”, or long-term, bear market – which is what a lot of prominent market forecasters believe we have been experiencing, off and on, since 2000. With the broad market averages at four-year highs, this might seem like a very odd time to bring it up. But in the interest of public-service financial journalism, I feel obligated to let you know – during the week that marks the 6-year anniversary of Nasdaq 5000 – that this view is advancing in popularity among much of the Wall Street intelligentsia.

When you are laying out your investment game plan for the year, it helps to know what your enemy may be thinking – or how you should act if you happen to share their views. And right now, they are shunning growth companies and sticking to the safe stocks of foodmakers, brewers and tobacco companies. Did I say enemy? It is an unfortunate fact of life that the stock market is not an “I’m OK, you’re OK” kind of place. It is not a team sport. With a finite number of shares available at any given time, not counting derivatives, you can win only if someone else loses. If you want to win in the long term, you need to understand the schemes and dreams of your opponent.

The first thing you need to know is that bears are crafty and lay out elaborate long-range plans. A key element of their approach was to knock off the 1982-2000 bull-market leadership, and then make believe it never happened. This occurred when growth commanders Microsoft, Dell, Yahoo! and Intel were cut down in their prime six years ago. Despite the market hitting highs of late, they are still down 44%, 48%, 68% and 71%, respectively, from 2000 levels. So do not let anyone con you into believing the market is in two-horned bull mode, even today, just because the small-caps and mid-caps have done well. Until the big-cap growth leaders arise from their death chambers, the bears boast, the recent two-year rally is just a head-fake in a bigger campaign. The latest step in their war of attrition, say the bears, came with the broad-daylight assassinations of twin colonels Apple Computer and Google. Both are down 25% since mid-January, even as the Nasdaq Composite has advanced rather smartly. It is important to note that Apple and Google – which could revive at any time, like cats with nine lives – were cut down amid a chorus of good news, not bad.

And now, finally, we may be witnessing the third step in the progression of a tilt from bull to bear. The shares of dreary old consumer-staples makers are rising like the equity equivalent of Lord Voldemort from their own 5-year hibernations. These stocks are termed “defensive” by the market-cliche handbook, as they are purchased by portfolio managers who need to own stocks but believe it is not the right time to play offense. They buy the makers of food, toothpaste, beer, cigarettes and drugs because they think their earnings growth will be safe, if far from spectacular. Evidence of this evolution has come with the revival of stocks such as brewer Anheuser-Busch, grain giant Archer Daniels Midland, ketchup king H.J. Heinz, candy makers Wm. Wrigley Jr. and Hershey, soda seller Coca-Cola, and snuffmaker UST. These are exactly the kinds of stocks that move to the fore at the start of a bear market as portfolio managers stock their bomb shelters with companies that will be harmed least by a slowdown in consumer spending.

In short, even if you do not think that a bear is growling at the door, there are ample reasons to start stocking the larder with the shares of food and beverage makers. With their prices, expectations and valuations near historic lows, they could fatten up your portfolio by the end of the year.

SUGAR ON TOP

One fine morning in Paris, Jim Rogers met a French business writer for breakfast at a local hotel. They talked about sugar. Rogers, as many of our readers are aware, is the famous “Investment Biker” – a globetrotting investor who made a fortune running a hedge fund. He retired years ago, at the age of 37. Now he travels around the world and writes books. On March 2nd of 2005, in a very prescient column entitled “Sugar High”, Rogers recalled his conversation with the French writer: “During one breakfast interview in a Paris hotel, a congenial writer from a French business magazine who was much more eager to discuss the falling dollar and the surging euro – for obvious reasons (Vive la France!) asked me what I would recommend for an ordinary investor like her. I plucked a wrapped sugar cube from the bowl on the table and handed it to her. She looked at me as if I had gone mad. ‘Put this in your pocket and take it home,’ I advised, ‘because the price of sugar is going to go up five times in the next decade.’

She laughed, eyeing her sugar with skepticism. I told her that the price of sugar that day was 5.5 cents per pound, so cheap that no one in the world was even paying attention to the sugar business. I reminded her that when sugar prices last made their all-time record run – soaring more than 45 times, from 1.4 cents in 1966 to 66.5 cents in 1974 – her countrymen were planting sugar all over France. She nodded – ‘Supply and demand,’ she said – and pocketed her sugar. But I suspect that she has not put any of her money where her mouth – or her pocket – is.” He concluded with, “[I]f I’m right and we’re in another long-term bull market in commodities, we’re likely to see another sugar high. ...”

The beauty of this story is that Rogers was dead-right. And his prediction looks to come true early, as you can see by the chart titled “Eye Candy”. Since Rogers’s prediction, sugar is up threefold to more than 17 cents a pound – its highest price in 24 years. That is a better performance than oil, gold or a lot of other commodities. Sugar has had some great runs in the past. It soared 45-fold from 196–1974, hitting a record high of 66.5 cents.

In his book, Rogers lays out a compelling scenario of tight supplies and growing demand. The biggest part of the argument involves Brazil, the world’s largest producer and exporter of sugar. The pieces of his argument have all come together, with new wrinkles that he could not have imagined: Hurricanes rolled over the Gulf Coast and damaged refineries in Louisiana and destroyed sugar cane fields. The storms devastated crops in south Florida, too. As a result, the U.S. is importing more sugar to make up for the shortfall in domestic production. Adding to the tight supplies is a dramatic decline in Thailand’s production, one of the world’s bigger exporters of sugar, due to drought and then flooding. China, too, has experienced bad weather, dropping production to a three-year low. Europe will not make up the shortfall, because the 25-member EU must comply with a recent edict from the WTO limiting exports of sugar. It is absurd, but true.

All of these factors are driving sugar to new highs and putting the squeeze on companies like Kellogg’s and Coca-Cola. According to Deutsche Bank Securities, “If conditions remain as tight as our industry sources suggest, some refiners may not have sufficient raw cane to process and packaged food companies may not have enough sweeteners to produce product.” Ah, the refineries. The sugar refineries are busy. In fact, most are running at full capacity. After years of listless performances, sugar stocks are hot. In April 2005, I recommended shares of a small, sleepy sugar refinery, Imperial Sugar Co. (NASDAQ: IPSY). With roots going back to 1843, it is one of the oldest companies in Texas.

It was a cheap stock, trading for less than 9 times earnings. Plus, the company had a strong financial condition. It had lots of cash, nearly $4 per share, and virtually no debt, vs. a then $14 stock. On an enterprise-value basis, it was trading for less than 3 times its trailing EBITDA. Insiders were buying. It was trading for only 80% of net tangible asset value. Incredibly, even though the stock has tripled over the last 12 months, it still sells for less than 6 times the company’s estimated earnings for 2006 – its profit growth is outpacing its share price gains. I always feel nervous about holding a stock that has had such a big run. But if Rogers is right, Imperial might keep running for a good, long while.

A PUBLIC SERVICE … OR DISSERVICE

22-year highs in silver; 24-year highs in sugar; 25-year highs in gold; 26-year highs in platinum; all-time highs in copper, crude oil and natural gas. … Welcome to the commodity markets of 2005-06. Commodity prices have been soaring to such heights that tremors of acrophobia have become difficult to suppress. Rare is the commodity bull who does not occasionally ask himself, “Is this rally almost over?” We remain ardent bulls on the commodity sector. But we also remained perpetually terrified by the fear that our beloved commodities will suffer some wicked set-backs en route to much higher prices. We suspect investors would do well to simply buy whatever resource stocks they wish to buy, then cancel their subscriptions to the Wall Street Journal and toss their brokerage statements in the trash until sometime around 2010.

But some investors may wish to place occasional bets against the resource sector. (As when, for example, Ben Bernanke’s FOMC kicks this sector in the teeth by raising short-term interest rates to 4.75%, despite a recessionary economy and a slowing housing market). Thus, for those investors who might like to bet against resource stocks, we bring two new securities to your attention: Short Oil & Gas ProFund (SNPIX), an open-end mutual fund that endeavors to produce “daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones U.S. Oil & Gas Index.” ProFund’s also offers a fund that bets against precious metals stocks. The Short Precious Metals ProFund (SPPIX) seeks to produce the inverse of the daily performance of the Dow Jones Precious Metals Index. Both funds have lived up to their mandate. As the nearby chart illustrates, the Short Oil & Gas ProFund exhibits a distinct inverse correlation with the Dow Jones U.S. Oil & Gas Index.

For good measure, the gang at ProFunds has also launched the Short Real Estate ProFund (SRPIX), which – you guessed it – bets against real estate stocks like Simon Property Group, Equity Office Properties and the other names inside the Dow Jones U.S. Real Estate Index. Happy short-selling!

BLASÉ DEBTORS SNUB THE BANK

As we sit back and survey the global financial landscape a series of remarkable events and bent perceptions leap out at us. It would seem that debtors have had it a little too good for a little too long. Of course the issuers, ushers, traders and designers have had it even better. But we have all heard much on that subject – or should have by this stage in the game. Less widely understood and debated is the new debtor aggression. America is the worst offender in this area. By this we mean that The U.S. Federal Government, households and indeed the macro economy are in rising hock to a world that they have fading interest in, patience for and understanding of. This strikes us as just plain nuts! We are a huge net debtor, over $2.5 trillions in the hole. This number is just waiting to be revised upward as the data is updated. We consume more than 2/3 of world savings. Thus, foreign states, firms and transactions that we are increasingly suspicious of, and hostile toward, are the bank. We are becoming snooty, condescending debtors.

Where better to start than with the craziness over Dubai Port World’s (DPW) acquisition of British Peninsular and Oriental Steam Navigation Company (P&O). Proving this seems silly but, here we go. The selling firm was not American. The buying firm is a well thought of global operator hosted by a state at least equally fearful of, and targeted by, Islamic extremists as the U.S. The aggrieved parties are essential allies in the war on terror. UK authorities, our strongest allies, approved the deal without reservation. Clearly this was an incident of bipartisan grandstanding. Much of America’s port infrastructure capital is already foreign owned. This is true globally.

What does this embarrassing, xenophobic episode have to do with debtors snubbing the bank? Our perennial imbalances with oil exporters and others build up huge dollar holdings in foreign hands. Much of this is lent back to us so we can continue to “function”. We have no issue selling our future tax receipts. Borrowing suits us just fine, playing the role of debtor is apparently another matter altogether. We sit in false nationalist judgment of our creditors these days with blasé disregard for the possible ramifications and self congratulatory ignorance of our position.

No where is this more true or aggressively out of control than with China. The People’s Republic and Hong Kong owned over $310 billion of U.S. Government Securities at the end of January 2006. This fits nicely with the rise in China’s Official Dollar Reserves to just under $820 billion, up over 30% across 2005. Cheap Chinese goods and massive lending have artificially supported U.S. purchasing power – particularly for the earnings-poor bottom 80% of the U.S. household income distribution. Waves of Chinese lending have supported low interest rates, cheap home mortgage rates and the deficit profligacy in Washington. What have we learned?

We are poised to pressure China with a 27.5% tariff threat to get them to revalue the Yuan. This is done so we can pretend we are not codependent with China and that their currency policy is the cause of our yawning $800 billion+ trade deficit. It may be worthy of note that the U.S. ran trade deficits with 14 of its largest 15 trade partners in January 2006. These 15 trade partners account for 74% of U.S. trade. To some this might suggest that China’s currency is not the only problem. If you think the above is silly and we will be just fine, you are in good company. We are getting a little nervous. The whole, let them eat Greenbacks thing has gone very far very fast. Heaping insult on the injuriously overweight dollar exposure of trading partners, allies and lenders seems foolish and crass.

BANKS HAVE PUT HUGE BETS ON HOUSING

For many people, the concept of systemic risk has never been experienced outside a textbook. But many financial experts worry we are closer than ever to experiencing it, thanks to stresses on the ubiquitous mortgage market. Lately, lax mortgage lenders have all but maximized the potential for systemic risk. Regulators are finally stepping in. “Regulators are obviously very concerned,” said Paul Kasriel, chief economist at Northern Trust. “They’ve issued guidelines with regard to home-equity lending and are working on guidelines for nontraditional mortgages.”

Mr. Kasriel said he has been concerned for some time that banks had too many chips on one bet. “So what if mortgage defaults are on the rise?” he asked. “No biggie except that U.S. commercial banks have a record exposure to the mortgage market.” When you add mortgages they hold on their balance sheets – the ones they do not sell off – to mortgage-backed securities and agency bonds, such as those issued by Freddie Mac and Fannie Mae, you find that mortgage-related assets making up a record 62% of commercial banks’ earning assets. As recently as 1985, banks’ holdings were south of 30%. We are talking about a huge bet that housing stays afloat here. If the housing bubble bursts, it is safe to say banks’ ability to lend will be seriously pinched for a time.

Now meet the cowboys, better known as hedge funds. Recall that many mortgages are sold off by those doing the lending. That explains the letter you got shortly after you closed on your home that asked you to make your monthly check out to someone else. Most of the mortgages being sold are of the plain-vanilla, 30-year-fixed variety. But so-called smart mortgages have risen in popularity – the no-document, no-down-payment, no-principal … heck, no-payment-every-once-in-a-while, adjustable-rate jobbers. Believe it or not, these mortgages too are sold off. In a world plagued by low interest rates, they are gobbled up by investors hungry for yield and not so concerned about risk. Many of these investors are hedge funds. “[S]omebody has to own the worst of it; hedge funds hold a lot of this toxic waste,” said Mr. Kasriel.

Here is where things get tricky. To juice returns, they are buying these investments on credit – or, as they say in the business, leveraging them up. And where do they get the loans to buy the “waste”? Well, who makes loans? In the worst-case scenario, banks could get it coming – in the form of defaults that directly impact their highly concentrated holdings – and going – in the form of bad loans to hedge funds. This scenario has yet to unfold. But have no doubt that the risk is there. Systemic risk is in place.

The “danger years” for homeowners.

Millions of mortgage borrowers are entering their “danger years”, when delinquencies peak and owners risk losing their homes. Although borrowers are often told that the first year is the hardest, delinquencies have historically reached their highest points during the third and fourth years of mortgages, according to Doug Duncan, chief economist for the Mortgage Bankers Association (MBA). “As a mortgage ages, things can go wrong,” he says.

There are a few forces at play: After years of strained budgets, borrowers may have little in savings to draw on to handle a crisis. This is also the period when major repairs begin to crop up. Finally, many home buyers go through life changes, including starting a family. The number of Americans affected by the coming danger years could be huge. Half of all mortgage loans are three years old or less, according to the MBA. Nearly $3 trillion in mortgages originated in 2002, $4 trillion in 2003 and $3 trillion again in 2004. Many were refis, but there were also record totals of new purchases as well.

In addition, many of these transactions involved risky loans, such as interest-only ARMs and no-down payment loans. A recent report from the National Association of Realtors found that the median new home buyer put down just 2% in 2005. 43% put down no money at all. And according to SMR Research, some 25% of loans were interest-only, do nothing to reduce the debt on the house. “Lenders used to offer interest-only loans to only the best credit-quality prospects. That’s no longer true,” said Stuart Feldstein, founder of SMR Research. Adjustable rate loans accounted for nearly half, by dollar volume, of loans issued in 2004 and 2005. Because interest rates have risen and are expected to increase further, those loans will adjust upward and monthly payments will be higher. With a $200,000 loan adjusting upward from 4% to 6%, the monthly bill would increase to about $1,200 from $955.

The MBA’s Duncan tends to downplay the perils of non-traditional mortgages. He points out that 35% of all homeowners carry no mortgages at all and another 50% have traditional fixed-rate loans, which leaves only 15% of all homeowners at risk. Those who bought a few years ago in hot markets may already be in safe territory, as the value of their homes has grown enough that they now have enough equity to ride out financial storms. But even if the percentages of borrowers who may go into default remains modest, even an increase of a few percentage points can add up to millions of households. “People are really stretched,” says Dean Baker, macroeconomist and Co-Director of the Center for Economic and Policy Research. “They are banking on everything turning out right for them. That they won’t lose their jobs, that they won’t run into unexpected expenses. They’re betting that the housing market will continue to appreciate.”

WALL STREET’S ATTENTION FALTERS IF YOU ARE NOT WORTH $2.5 MILLION

People with less than $2.5 million are largely being ignored by financial advisers. At least that is what a new industry report says about the “emerging affluent”, as they are called. “The disconnect between investor needs and adviser capabilities in this marketplace continues to widen,” the Boston-based research firm Cerulli Associates said. “They are not truly addressing all of the needs of this market, because investors in the emerging affluent market have extremely disparate needs.” In other words, Wall Street firms are not focused on this lot.

Indeed, many firms refer to people with such in-between wealth – more than $500,000 but less than $2.5 million – as “leftovers”. However, this segment represents almost 10% of total households in the U.S. looking to invest. The amount of money they already have is more than $8 billion in total, almost twice what they had in 1989. Still, “leftovers” often succumb to advisers who are reaching up from businesses that cater to lower wealth tiers or playing down from firms that court those even richer. In any case, they are not being directly served. And the proof is in the types of products and services they are rendered, none of which directly fits their needs.

Cerulli Associates expects investment planning and product sales to become increasingly commoditized, so advisers will have little opportunity to differentiate themselves outside of their advice offerings. “Commoditized service may be enough for many investors in the mass-market wealth tier, but will fall short of serving the needs of emerging affluent investors,” its report says. Personalized service just is not there for people without several million dollars to wave in front of an adviser to get his or her attention. The problem is that Wall Street firms are not equipped to handle this group – people who want product and service, not just one or the other. For example, those who may need only resources devoted to retirement, retirement income and wealth transfer or business owners seeking a variety of services may end up shortchanged. Merrill Lynch has a policy whereby investors with less than $100,000 get dumped to an online account, serviced by a call-in center. Most of the other Wall Street firms have similar policies, which provide increased service only with increased account sizes.

Clearly, the attention bar on Wall Street keeps getting raised. And it may be silly to ask “how much is enough?” But if $5 million is the number (and it is, just check the breakpoint status on fees at a full-service brokerage firm, or the new minimums for the much-ballyhooed “wealth management” services) a big percent of the population can count on getting automated service. High-net-worth individuals with eight figures or more in their bank account often receive “family-office-like” treatment, where they get estate planning, trusts services and preferred investor status. These are the kind of investors who were made privy to shares of hot Internet IPOs of the 1990s. Meanwhile, the rest of us suffice with “commoditized service” as Cerulli puts it. That is a nice way of saying “off-the shelf”.

The average net worth of a U.S. household is $55,000, according to the U.S. Census Bureau. This is the terrain of discount brokers like Charles Schwab. So if Wall Street does not start talking to people with money, you can bet more will “Talk to Chuck”, as the ad goes.

BY 2020, MORE THAN $1 OUT OF EVERY $5 SPENT IN AMERICA WILL GO TOWARD HEALTH CARE

America may be headed for an era in which it might spend more on health care than it does on manufacturing. That could lead to more pressure to send jobs overseas, more employers would stop offering health insurance and more people would be uninsured. The grim prognosis was part of a global survey on health care by PriceWaterhouseCoopers to a group of Arizona health care executives. Rising health care costs are a global issue, with aging populations and workforces demanding better health care. But the U.S. faces an even more pressing problem: It spends the most on health care but gets middle-of-pack results, including average life expectancies.

AMERICAN CFO’S ARE PAID MUCH MORE THAN THEIR COUNTERPARTS IN OTHER COUNTRIES

U.S. finance chiefs take in an average of nearly $325,000 in total cash compensation a year, or more than five times the amount heir counterparts in India earn, according to new research by Mercer Human Resource Consulting. Finance directors in Canada and the UK averaged $263,000 and $237,000, trailing their U.S. peers at the top of Mercer’s findings of executive pay in 14 countries. In its survey of 11,600 companies, the consultancy defines annual total cash compensation as yearly base salary plus guaranteed cash plus the short-term incentive amount taken in a given year. At the bottom of the list, finance directors in India and Hungary make about $64,000 and $77,000 a year, respectively. Mercer defines finance directors as executives who put together strategies, policies, and procedures involving sales, costs, taxes, assets, budgets, credit, and cash flow.

The elevation and broadening of the finance chief’s role in the U.S. over the last decade or so has apparently taken hold overseas. “In many organizations, finance directors are the second highest paid individuals, receiving only slightly less than the CEO. The scope of their role has widened in recent years as new regulatory burdens and risk management responsibilities make them increasingly accountable for company governance,” said Mark Edelsten, a London-based Mercer consultant.

The consulting firm also released pay data on marketing and human-resource directors. Annual total cash payout for marketing heads ranged between $261,000 in the U.S. and $47,000 in India. In the number two and three slots were the UK, with $217,000 and Italy, with $201,000. “The high levels of pay for marketing directors in some countries reflect the fact that marketing and brand management are now considered key to enhancing company performance,” Edelsten said.

HR directors were the lowest paid of the three positions covered. In terms of annual total cash, HR heads in Germany averaged about $227,000, edging out those in United States, with $219,000, and the United Kingdom, with $202,000. In Hungary and India, the pay was again the worst, with personnel chiefs earning $72,000 and $56,000, respectively.

BANKS ARE FLOCKING TO CLAIM A STAKE IN CHINA, BUT CRITICS SEE POTENTIAL LOSSES IN THE CARDS

As China gets set to throw open its doors to foreign banks by the end of the year, there is a gold rush among global banks to claim their stake in China’s fast-growing financial services market. But analysts warn that banks in search of riches may find little more than fool’s gold in China, given the country’s tempestuous regulatory environment, the high cost of entry and the potential for significant loan losses due to the country’s often unstable lending environment. In the last year, China has seen an influx of about $15 billion from foreign banks with large players such as Bank of America and Goldman Sachs investing over $3 billion each to buy small 10% stakes in two of the Big 4 Chinese banks. And JPMorgan Chase, which actively sought to buy a controlling stake in troubled Chinese broker Liaoning Securities before the Chinese government rejected the deal, is on the hunt for other acquisition targets in China.

Richard Bove, analyst at Punk & Ziegel, said global banks are being lured by the promise of wealth in a country that has averaged about 9% annual growth over the last several years. And as part of China’s entry into the World Trade Organization, China will allow foreign banks to operate in any part of the country – opening up the possibility for global banks to expand within a market made up of 1.3 billion people. “China has a population that’s seven times the population of the U.S,” Bove said. “The growth potential is so phenomenal from a population-based standpoint … that banks have no choice but to pursue it as rapidly as they can.” In the short-term, global banks see plenty of potential for profit from underwriting and investment banking fees as the Chinese markets open up and a fresh wave of initial public offerings, including banks, hit the markets. But the real attraction, experts say, is the large untapped market for consumer-based financial services products such as credit cards, mortgages and car loans.

But some critics fear that global banks may be in for a rough road ahead. William Gamble, principle at consulting firm Emerging Markets Strategy, said the Chinese banking market is rife with corruption and side dealings, as banks – which are owned by the government – lend money based on political connections and influence rather than sound economic practice. In addition, there is no official credit bureau to highlight high-risk loan applicants and no solid regulatory oversight to insure that loans are paid back to banks. “The problem with investing in emerging markets is that although the growth rates are often much higher than for companies in developed countries, the economically inefficient or nonexistent legal systems also increase the risk,” he said. “If the profit potential is not commensurate with the risk, it might be a better idea to stay home.”

Bove said foreign banks, which already have to pay a hefty $50 million entry fee to expand within China, stand to “lose a lot of money initially as they try and put together a reasonable balance sheet” for the Chinese banks that struggled for years with high levels of non-performing loans and tricky transactions that have muddied their financials. Despite the risks, Bove said the flood of foreign banks is unlikely to dissipate as competition heats up and the long-term growth prospects, if all goes well, are appealing.

COMMODITIES BOOM RAISES FEARS

The commodity price boom of the past three years has aroused investor attention on an unprecedented scale, with most investors placing their funds into passively managed commodity indices. About $80 billion is estimated to be in funds tracking the main commodity indices – the Goldman Sachs Commodity Index, AIG-Dow Jones, the Reuters/Jefferies CRB index and the Deutsche Bank Commodity Index – up from $15 billion three years ago. This has been spurred by record-breaking runs for oil prices, natural gas, copper and zinc, together with long-term highs for gold, sugar, aluminium and silver. The funds tied to commodity indices swamp the estimated $10 billion that pension and mutual funds have allocated to actively managed commodity hedge funds.

More funds may be on the way: consultants such as Mercer and Watson Wyatt are advising UK pension funds to allocate more money to commodity funds. Yet fund managers and analysts are concerned that the index funds may eventually be a victim of their own success: the weight of money they have funneled into commodity markets has contributed to severe price distortions.

The GSCI has risen 160% in the past five years, buoyed by strong gains in commodity prices. However, commodity index levels are based not only on price movements of the underlying commodity futures, but on the rolling yield. Most nearby dated futures contracts expire each month so investors have to sell the contract that is coming up to expiry and purchase the next deliverable monthly contract. The difference between the sale and purchase is known as the rolling yield. This has mainly been positive in the past four years, a situation known as backwardation. However, with more money flowing into commodity indices, the yield is turning negative, creating what traders know as a contango. Here, nearby prices are below those of contracts for later delivery. A contango can be a sign of temporary surplus in physical commodity markets, and it encourages inventory building.

However, crude oil futures markets have been in contango for the past 12 months, as the oil price has hit record highs and remained close to $60 a barrel, reflecting market worries about the security of future supplies rather than about oversupply. The contango in the crude futures markets, West Texas Intermediate and Brent, have a big impact on the commodity indices. Together they represent 45% of the GSCI. Other energy futures are in contango: heating oil, U.S. natural gas, UK gasoil, as well as other commodities including gold, wheat and coffee. In all, commodities representing more than two-thirds of the GSCI weighting are in contango. Michael Lewis, head of commodities research at Deutsche Bank, said both the GSCI and AIG-Dow Jones index were down 5% so far this year, entirely due to the negative roll yield. Mr. Lewis said last year’s 40% gain in WTI and Brent prices outweighed the 20% negative roll yield.

With the WTI in contango until June next year, commodity indices will be relying on future positive performances from commodity prices that are already at or near record levels. “Oil prices would have to reach $77 in order for the energy component of the GSCI to break even,” said Mr. Lewis. David Mooney, portfolio manager at NewFinance Capital, a fund of commodities funds, said the contango in oil was a result of new money going into the crude futures market. “These commodity indices are a one-way bet. They are long only and do not offer the flexibility that more active commodity funds can offer,” said Mr. Mooney.

Douglas Hepworth, director of research at Gresham Investment Management in New York, said more worrying was the predictability surrounding the funds’ rolling of their exposure from the nearby futures contract into the next. Funds tracking the GSCI roll their contracts from the fifth to the ninth business day of each month. “The whole market knows when these guys are going to switch, so they position themselves to take advantage,” said Mr Hepworth. He said this can often result in the commodity index funds facing a steeper contango on the WTI come the roll date, which reduces fund returns.

Some pension fund managers are already looking elsewhere to place their money. Last week, J. Sainsbury, the UK supermarket chain, said it planned to invest 5% of the company’s pension fund into commodities, but would place the money in actively managed funds rather than funds tracking indices. “The passive approach to commodities was a no-brainer for the last four years, but today investors need to be more selective and active when they invest in commodities,” said Mr Lewis.

DOES HISTORY RESTART WITH EACH BIG PRICE MOVE?

About a month ago I noted that natural gas prices had recently fallen by more than 50% (December highs to the February lows). Which is to say, the decline unfolded in the dead of winter. This turn of events was (to put it politely) “unexpected”. In fact, in the weeks after the destruction from Hurricane Katrina, many analysts openly declared that this winter would see natural gas move 50% in the other direction. Mind you, the commodity price of natural gas had already doubled between late May and late August of 2005. So anyone who got bullish in September/October would have missed the rally at best. By then natural gas had become “the next big thing.”

So let us fast-forward to the February/March lows. The trend had been turned upside down, as were the headlines: natural gas inventories were “swelling”, and prices “have no place to go but down” – even though they had fallen a very long way already. Sentiment readings were near historic lows.

Market participants collectively behave in the same ways again and again, whether the market is stocks, currencies, metals, or natural gas. In this case they acted as if history started at the same time as the big price move they were following. The psychology turned resolutely bearish only after the trend had taken prices down a long way in a short time. What about the most recent action in natural gas? Well, prices have been mostly higher over the past three weeks or so.

TROUBLE AHEAD FOR JUNIOR URANIUM?

As my readers know, I have been bullish on uranium for almost eight years now. And despite the fact that uranium has more than tripled, I continue to like it today almost as much as when I was a lone voice in the woods. Although the uranium spot price has risen from $7.10 per pound (at its absolute bottom) to a current $40.25 – a 467% gain – I believe it has much further to run. According to Cameco, the world’s largest uranium producer, global uranium demand is now 175 million pounds a year. Mine supply is only 110 million pounds yearly. This is a gaping shortfall, and insofar that it can take up to a decade for a discovery to turn into production and there are dozens of new nuclear power plants on the drawing boards all over the world, the shortfall will keep prices rising for years to come.

The prospects for the metal itself are outstanding, but the best way to play uranium is through the shares of junior exploration companies because they offer leverage and therefore prospects for greater gains. The good ones, anyway. On that note, I have to say that – despite my bullishness – I am concerned about the ever-growing number of junior uranium companies. Over the past two years, the number of companies looking for uranium has jumped over 700%. At last count, there are now about 145 such explorers. It is hard to arrive at an exact number since many companies only have uranium in their names. And others are actively exploring while still remaining primarily in other areas. This is a testament to how hot uranium is as a commodity. But it is also worrisome. With so many companies competing for the same number of investment dollars, can we as speculators still expect the same sort of gains that we have enjoyed over the past few years?

Although I usually pay little mind to the short-term fluctuations of the markets, it seems worth investigating whether the junior uranium sector is sagging under the weight of so many new players. To get an idea, our resident snap technical analyst Merv Burak put together an index of 51 junior companies – all those that have been around for a year or more and that are primarily focused on uranium. The results are somewhat surprising. While the sector did cool somewhat during the last few months of 2005 – following a protracted run that began in July – the beginning of 2006 brought new life to the uraniums. Our index soared nearly 25% in the first two weeks of the year alone. That said, all resource markets were hot during that time. This in itself is not convincing evidence that the sector is still buoyant.

While it is axiomatic that the higher stocks go, the less upside and the more risk they have, I remain extremely bullish. I suspect uranium is headed to over $100 in the next few years and, even at that level, it will only equal – in constant dollars – its peak in 1980. And the fundamentals now are much stronger than they were then. I am concerned about the flood of new uranium companies out there, but we are looking at something comparable to what happened during the Internet boom. When the public becomes involved, the top is going to blow off this market. But as yet, the public barely even knows how to spell uranium. My guess is that we are not even midway through this bull market, and when we enter the final stage, the chart will no longer just be a gradual upward curve but a hyperbolic curve. Someplace between now and then I will be a seller – but at the moment I remain a buyer.

Which stocks to buy? I am looking to concentrate the junior uranium portfolio for our Casey Energy Speculator on a modest handful of quality companies, the kind that have a real chance of making a discovery and creating value and are not just relying on hype to move higher. In order for a company to make that list, they will have to (a) have a management team with serious uranium experience, (b) own a serious property in just the right location, and (c) actually do some drilling to prove they have pounds in the ground (surprisingly, of the dozens of newly minted uranium companies now trading, less than 20 are actually undertaking any serious exploration work).

If you like uranium like I like uranium and are looking to leverage your returns through investments in a junior uranium play, do yourself a favor and start getting a lot more selective in what you own. If you fail to do so, not only do you risk missing the next big leg-up, you risk throwing your portfolio into reverse.

THE (COMMODITY) ETFS ARE COMING!

If Paul Revere were living today, and if he were a passionate investor, he might well ride through the corridors of Wall Street, shouting, “The ETFs are Coming! The ETFs are Coming!” Many ETFs (exchange traded funds) have arrived already, of course, but a new wave is on the way. A silver ETF sponsored by Barclay’s Global Investors is not yet a fait accompli, but it moves closer every day to joining the short list commodity-based ETFs. Anticipation of the new silver ETF has pushed silver prices to multi-decade highs.

The supply/demand situation for silver is potentially explosive, as we outlined some months ago. But it should be mentioned that not all silver bulls are sanguine about the ETF situation. Some are wary of “too much of a good thing.” In other words, if investor demand is too strong relative to the limited supply of silver, we could see the ETF structure tested to its limits, and potentially pushed to the breaking point. Will Barclay’s and the market makers be able to maintain an orderly market in the event of a silver bull stampede? We may well find out. The second ETF, long anticipated and long delayed, gives investors direct exposure to arguably the most important commodity in the world: crude oil. The American Stock Exchange plans to launch the new crude oil ETF, (AMEX: USO), next week, pending a routine stamp of approval from the SEC.

What does this mean? For one thing, some investors will soon seek exposure to crude oil directly, rather than trading energy stocks as a proxy. Does this make investing in energy stocks obsolete? Not at all. It simply enables investors to go straight to the source, if they wish. Because energy stocks are so correlated to the price of crude, USO could also prove its worth as a hedging vehicle for the energy-related portion of one’s portfolio.

Commodity ETFs expand investor participation in commodities dramatically because ETFs are perceived as “safer” than the underlying futures markets they mirror. ETFs are also wholly accessible from plain vanilla stock accounts. This is why the Street Tracks Gold ETF (GLD: NYSE) has become so popular. Gold futures were always available – able to achieve the same purpose as GLD. But futures markets are not accessible to the average investor. Futures are generally considered too “exotic” – and frequently too unwieldy in terms of contract size – whereas ETFs are more granular (one can buy a few shares at a time), and more familiar.

Many institutions are more comfortable with ETFs too. Some of these blue-chip pension fund managers would no sooner trade futures than take their grandmother to a Marilyn Manson concert. But an ETF that gives them exposure to an important asset class (commodities) without the taint of speculation? Well, that is a concept they can work with. Such a proposition is more “respectable”, flying under the radar of that “unacceptable speculation” label that futures have been tagged with. The net result here is that many monolithic institutions – of the type that run tens of billions or even hundreds of billions of dollars – will have another avenue into the commodity markets.

The last ETF of note, which we will only touch on briefly, is the Euro Currency Trust (NYSE: FXE). As its name implies, FXE is a sort of proxy for going long (or short) the Euro vs. the dollar. FXE is fascinating to me because the very introduction of a currency ETF represents a paradigm shift. In terms of equities, and in terms of trading and investing in general, we are clearly moving away from a U.S.-centric world and towards a global-centric world. Opportunities are no longer confined to one country, and they are no longer “long-only”. We are slowly witnessing a rise in sophistication and a rise in understanding that non-equity investment classes are important. Commodity bulls have never before enjoyed so many different ways to express their bullishness … or to hedge against it.

FOR HEDGE FUNDS, LIFE JUST GOT A BIT MORE COMPLICATED

The hedge fund industry has its fair share of complaints about news coverage, but one issue that particularly irks managers and that can be easily remedied is a frequently employed two-word description: lightly regulated. Many reports and news articles, including mine, have described hedge funds along the lines of “lightly regulated private pools of capital open to institutions and really rich people.” Sometimes we add the fact that these funds charge unusually high fees. Smart people I know read this description and still do not understand what hedge funds are, so here is a broader definition: a hedge fund is similar to a mutual fund in that a money manager, also known as a portfolio manager, invests money for other people, charging a fee for the service.

Mutual funds can invest money for people like me, who do not have a lot of money. Hedge funds are limited to investing for people who are rich – $1.5 million in net worth – or for institutions like pension funds and endowments. While mutual funds charge investors a percentage of the assets they manage, generally about 1.4%, hedge fund managers charge in the range of 1 to 2% of assets under management, as well as 20% of the profits. If they have good returns, they make a killing.

As of February, the S.E.C. changed the way it treated hedge funds. Previously, hedge fund advisers were granted a loophole that allowed them to operate in relative obscurity. Now, the S.E.C. requires advisers to hedge funds, essentially the brain power behind the investing, to register with the commission. Being unregistered was not carte blanche to pillage clients’ money. Unregistered hedge funds were and are subject to antifraud provisions of securities laws – you cannot tell your client you are investing in stocks and then buy yourself a Porsche with the money. If the hedge funds trade through broker dealers, those broker dealers are subject to regulatory scrutiny and they cannot lie, cheat or steal for their clients. They must observe “blue sky laws”, under which most states police securities and mutual fund sales within their borders, and they are subject to insider trading rules and securities law requirements related to owning more than 5% of a stock. Unregistered is not a code word for “take the money and run.”

Nonetheless, the S.E.C. determined that there were a lot of hedge funds with a lot of money and a lot of potential for fraud, so it passed a rule requiring that advisers register if they had more than $25 million under management and money that was not locked up for more than two years. Registration, while hardly boot camp, is no insignificant matter. It subjects advisers to random audits, strict requirements about books and records, the designation of a chief compliance officer and a form that asks questions like, Where do you live? How much money do you manage? And are you a criminal? Hedge fund advisers are now subject to the same rules as mutual fund advisers, except that they do not face the limitations that mutual fund advisers face on performance fees. Nothing lightly regulated about that. But compared with mutual funds or broker dealers, hedge funds still have it easy.

According to one S.E.C. lawyer, here is a short list of things mutual funds have to do that hedge funds do not: file quarterly reports to the S.E.C. listing all the securities they own, file semiannual reports to shareholders about their operations, disclose how they vote all proxies, have a capital structure that allows only one class of stock to be issued and restricts the fund adviser’s ability to leverage the fund, and a board with an independent chairman and a majority of independent directors. Unlike mutual funds, which must meet diversification requirements, hedge funds can bet the house on a trade they believe in, they can ratchet that bet up with leverage (borrowing money to double or triple the bet), and they can do business with just about anyone they want.

Hedge funds are lightly regulated next to mutual funds, broker dealers, commercial banks and all sorts of entities. But hedge fund managers are currently more regulated than their colleagues at private equity funds. For hedge fund managers, the world has grown more complicated since February. For instance, they can still bet $25 million on clam bellies, as long as there is a compliance officer to approve it, a record of it and copies of all the letters from investors wondering why there was a sign on the door saying “Gone Fishin’”.

SHOCKS SEEN IN NEW MATH FOR PENSIONS

The board that writes accounting rules for American business is proposing a new method of reporting pension obligations that is likely to show that many companies have a lot more debt than was obvious before. In some cases, particularly at old industrial companies like automakers, the newly disclosed obligations are likely to be so large that they will wipe out the net worth of the company. The panel, the Financial Accounting Standards Board, said the new method would address a widespread complaint about the current pension accounting method: that it exposes shareholders and employees to billions of dollars in risks that they cannot easily see or evaluate. The new accounting rule would also apply to retirees’ health plans and other benefits.

A member of the FASB, George Batavick, said, “We took on this project because the current accounting standards just don’t provide complete information about these obligations.” Congress is trying to tighten the rules that govern how much money companies are to set aside in advance to pay for benefits. The accounting board is working with a different set of rules that govern what companies tell investors about their retirement plans.

The new method proposed by the accounting board would require companies to take certain pension values they now report deep in the footnotes of their financial statements and move the information onto their balance sheets – where all their assets and liabilities are reflected. The pension values that now appear on corporate balance sheets are almost universally derided as of little use in understanding the status of a company’s retirement plan. Mr. Batavick said the new rule would also require companies to measure their pension funds’ values on the same date they measure all their other corporate obligations. Companies now have delays as long as three months between the time they calculate their pension values and when they measure everything else. That can yield misleading results as market fluctuations change the values.

A recent report by Janet Pegg, an accounting analyst with Bear, Stearns, and other company analysts found that the companies with the biggest balance-sheet changes were likely to include General Motors, Ford, Verizon, BellSouth and General Electric. Using information in the footnotes of Ford’s 2005 financial statements, Ms. Pegg said that if the new rule were already in effect, Ford’s balance sheet would reflect about $20 billion more in obligations than it now does. The full recognition of health care promised to Ford’s retirees accounts for most of the difference. Applying the same method to General Motors’ balance sheet suggests that if the accounting rule had been in effect at the end of 2005, there would be a swing of about $37 billion. At the end of 2005, GM reported a net worth of $14.6 billion.

Not all companies would be adversely affected by the new rule. A small number might even see improvement in their balance sheets. One appears to be Berkshire Hathaway. Even though its pension fund has a shortfall of $501 million, adjusting the numbers on its balance sheet means reducing an even larger shortfall of $528 million that the company recognized at the end of 2005. Berkshire Hathawaywts pension plan differs from that of many other companies because it is invested in assets that tend to be less volatile. Its assumptions about investment returns are also lower, and it will not have to make a big adjustment for earlier-year losses when the accounting rule takes effect. Berkshire also looks less indebted than other companies because it does not have retiree medical plans.

The rule would not have any effect on corporate profits, only on the balance sheets. The accounting board plans to make additional pension accounting changes after this one takes effect. Those are expected to affect the bottom line and could easily be more contentious.

STOCKS ENTER SCARIEST STRETCH OF A DANGEROUS YEAR

The same week half the world paused to marvel at an eclipse of the sun, investors in stocks and stock mutual funds could notice a similarly unusual array of calendar forces lining up in the market. First of all, as the first quarter of 2006 ends stocks are smack in the midst of what is notoriously the most dangerous year of the U.S. political cycle – Year Two of a presidential term. Of the 12 declining years endured by the Standard & Poor’s 500 Index since 1960, a check of my Bloomberg indicates, six occurred in the second year of a presidential administration. Those included the punishing declines of 24% in 2002, 30% in 1974, and 13% in 1966.

On top of that, we are nearing the part of any year, from the end of April through October, that has gained a reputation as most difficult for stocks. Recall the boardroom adage, “Sell in May and go away.” The most inauspicious part of an inauspicious year. It suggests a financial version of syzygy, the astronomical phenomenon that occurs when the sun and moon make a straight line, or nearly so, with the earth.

THE ABSENCE OF HISTORY

The absence of history is the absence of adversity. Nothing goes wrong. No need for puts. No need for savings. No need for insurance. We quote the Great Mogambo: “Ha, ha, ha, ha…” Ad-ver-si-ty. Our guess is that it is under-priced and under-appreciated. This morning, we pause briefly to laugh at Gilder and Fukayama and Bernanke and Bush. We thank the whole team of dreamers and schemers, world improvers and mountebanks who make our job so entertaining.

We guessed that the campaign in Iraq would be a mess. If we were a better man, perhaps, we would take no perverse, schadenfreude in being right. But we are only human, and like all humans, we slip into sin and error as eagerly as we put on a new sweater. That is why the dollar is doomed – the war on terror, and the empire too, dear reader. We may drive a Mercedes and watch cable TV, but we are still heirs to the same slimy beasts that crawled out of the warm sea – with hearts so feeble, they were expelled from Eden.

Meanwhile, on the money front, we return to George Gilder’s preposterous notion that record debt levels do not matter – because our houses are worth more. It is true that debt would be no problem if history really had stopped. But, the trouble with debt is that it cannot stand adversity. The Economist published the following figures for money supply growth in various countries over the last 12 months: Australia +9.1%, Britain +11.7%, Canada +7.7%, Denmark +14.7%, U.S. +8.1%, the Euro area +7.3%. Everywhere you look, the money supply is going up twice or three times as fast as GDP. Where does all this money go? Liquidity, like rainwater, has got to go somewhere. What has been going up two to three times faster than GDP? House prices! In other words, the supposed extra “wealth” that Americans enjoy is not real wealth at all. It is just inflated asset prices. Too bad monetary officials did not inflate at 20% per year, or 100%. Perhaps they might have taken a page from the Argentines in the ‘80s or the Weimar central bankers of the ‘20s. They might have just recalled all existing dollars and added three or four more zeros. Think how rich we would be then!

No, dear reader, it is not that simple. You cannot get rich just by printing money, and you cannot get rich by going into debt. The deeper you are in debt, the more exposed you are to ad-ver-si-ty. Just a small tide of setbacks and you are underwater completely. Even a hedge fund run by Nobel Prize winners – Long Term Capital Management–– was drowned like a kitten after its managers took on too much debt. All of their studies told them that Russian bonds would come back to a normal trading range – and they were right. The bonds did regress to the mean, but the poor geniuses at LTCM could not wait. They had borrowed too much money. Most households are not run by geniuses. Ordinary people with a limited line of credit run them. The typical family spends what it earns – and then some. It is already up to its neck in debt. On Tuesday, the Fed raised its key rate by 0.25%. The water is rising.

You can make a lot of money by watching what bankers are doing – just remember to do the opposite. In the 1980s, Texas banks poured money into the Houston oil economy. We remember reading stories of wildcat lenders drinking champagne from cowboy boots. Of course, then the price of oil collapsed and weeds grew up in the new housing developments. And who were the lenders to the Third World, just before the debt sold down to pennies on the dollar? Bankers only missed the Tech Bubble through no fault of their own. The scrappy young dot.com hustlers found that they could get even more money out of the gullible public and on easier terms – they did not even have to pay interest!

But at just the moment the Tech Bubble reached its zenith, Britain’s central bankers and its chancellor found a way to make up for lost time. All over the world, economies were in the middle of the biggest explosion of money and credit of all time. Central banks were greasing up their printing presses, trying to keep up with the stacks of dollars arriving in their vaults. And gold – that age-old antidote to financial trouble – had been going down for 20 years. Was there ever a worse time to sell it? We cannot think of one. Yet, the Brits unloaded much of their remaining stock of the yellow metal, getting about $6 billion in return. If they had waited until yesterday, they would have gotten twice as much. But that is history. What about the future? What are the banks doing now? What can we learn that might be useful?

Paul Kasriel, at Northern Trust, tells us the obvious: that U.S. commercial banks have record exposure to mortgage debt. In 1985, the mortgage market represented only 30% of their assets. Now, it is 62%. Not only that, much of their other lending is indirectly linked to mortgages. They lend to hedge funds, for example, that use the money to buy mortgages. If push comes to shove, says Kasriel, the banks will lose in two ways – their mortgages will go bad and the hedge funds will default. (More detail in article summary above.)

The median new buyer in 2005 put down only 2%. More than 40% put down nothing at all. How will these people respond to adversity? Will they not just walk away? Most defaults occur in the third or fourth year of a mortgage, we learned today. Half of all outstanding mortgages are in their third or fourth year now. The default rate is rising. The bankers, in other words, stand in the same deep pool of debt as their customers. Everywhere, the water is rising … to their chins. We, dear reader, want to make sure that we are on solid ground – on the bank … with a picnic lunch and a bottle of wine.

…

In theory, democracy is the end of history. People can vote for needed reforms. They can “throw the bums out.” So, there is no longer the need for revolutions to topple unyielding, self-serving governments. But, that is not the way it works. As an institution ages, more and more people find a way to take advantage of it – to game the system. These people have no interest in disturbing the status quo. Indeed, they put themselves in positions of power and find ways to prevent change: by controlling the media, the election process, gerrymandering districts, and so forth. When you read the newspaper, for example, you are not reading “what really happened.” You are seeing what happened as interpreted by a particular class of people, with a particular background, and a particular dog in the fight. Practically every headline and every editorial reflects the unconscious bias of the existing institution and its supporters.

Just as it is almost impossible to defeat a member of Congress, so is it almost impossible to reform a system in which so many people have an active interest. That is what the French are discovering. They have made life cushy for the controlling classes, and paid off the lower classes with bribes. Young, aggressive, entrepreneurial French people often leave the country – there are more than 100,000 of them in London alone. What is left – people who do not want to change the system. They want to be a part of it. A poll shows that three out of four young French people want to work for the government. Everything decays, degrades, degenerates, and ultimately dies, dear reader – even modern democracy and modern capitalism. We are sorry to have to tell you, but what kind of world would it be if they did not?