Finance Digest for Week of July 17, 2006

AN INTERVIEW WITH AN ESTEEMED ELDER STATESMAN

There should be at this point no dispute that a hostile geopolitical backdrop places inflated U.S. and global equities markets at considerable risk. And as last week progressed, it was almost as if I could sense that we were witnessing reality beginning to break through what has been to this point a well-fortified world of delusional wishful thinking. At a minimum, terror attacks in India, the specter of war in the Middle East, the ongoing disintegration within Iraq, $78 crude oil, along with Western drought and wildfires, made for a downright disturbing week of media coverage. Hopefully the current turmoil that has quickly besieged Israel and Lebanon does not escalate into a full-fledged war. Yet there is the very real possibility for conflict to not only erupt but to fan out and envelope an unstable region. It is difficult to envisage a scenario that, at least in the near-term, frees oil markets from the fear of Iran and/or others seeking at some point to use tight global crude markets as a weapon of war. The U.S. consumer and economy is faced with an extended period of very high energy prices and will have no choice but to adjust.

Expanding on the theme that the U.S. Bubble economy is especially poorly positioned for the unfolding environment, it is worth a cursory examination of last week’s stock market sector performance. Notably, consumer and technology related stocks were under heavy liquidation. The S&P Computer & Electronic index was hammered for 11.5%, S&P Homebuilding index 10%, the S&P Retailing index 4.3%, and S&P Internet Retailers 8.8%. For the year, the Morgan Stanley High Tech index is now down 12.1% and the S&P Homebuilding index 37%. And while the Morgan Stanley Retail index is down only 2.5% y-t-d, it is worth nothing that the index has declined 7.3% over the past three months. Wal-Mart was pounded for 6.4% last week, while many of the specialty retailers were hit as hard or harder. On the upside, the AMEX Oil index gained 1% this week, increasing y-t-d gains to 19.3%. The S&P Oil & Gas Equipment index jumped 5%.

It is increasingly apparent that important developments related to the flow of speculative finance are beginning to take hold throughout the markets and, hence, the economy. This is an integral aspect of the commencement for the long overdue economic adjustment. Market rattling developments only accelerate the process. And, sure, there will be opportunities associated with the unfolding financial and economic realignment – especially if the credit system continues to fire on all cylinders. But such a massive endeavor will not proceed without major upheaval for our highly imbalanced financial and economic systems. Overall, the U.S. economy will struggle mightily in the changing global environment, and there will be many more losers than winners.

I could not resist viewing an interview of former Fed Chairman Paul Volcker on Bloomberg television. I then could not resist transcribing much of the interview for readers. I hope you value the candor and wisdom shared by of one of our Most Esteemed Elder Statesmen as much as I do.

Al Hunt for Bloomberg: “The global economy today. Is it healthy and vibrant or is it skating on thin ice?”

Paul Volcker: “Well, (chuckling) it’s skating along nicely now but I think the ice is not as thick as I would like to see it. But we’re certainly gliding along very nicely at the moment. But it’s dependent upon some unsustainable trends: lack of savings in the United States – that deficiency is made up by a tremendous in pouring of capital and money from abroad – from Asia and now from the Middle East and elsewhere. And the amounts are large enough, so I think it is without question unsustainable…”

THE BATTLE FOR CENTRAL BANK INDEPENDENCE

The independence of central banking is at risk. The world’s major central banks – namely those in the U.S., Europe, Japan, and China – all face serious constraints that limit their scope for action. In some cases, the constraints are political – especially in Asia. In other instances, the limits are institutional – underscored by cumbersome arrangements in newly integrated economies such as Europe. And then there is the U.S., where the combination of systemic risks and a serious moral hazard dilemma now constrain Fed policy. The common thread is worrisome – the efficacy of monetary policy could well be compromised as a result. This could be the moment of truth in the battle for central bank independence.

IS JAPAN’S PAST OUR FUTURE?

The decision by the Bank of Japan to raise the Overnight Call Rate from zero to 0.25% marks the definitive end of Japanese recession, which has lasted more than 16 years. Its onset was caused by excessive monetary expansion, and a consequent tsunami of speculation in stock and real estate markets. Here in the U.S., we have had the monetary expansion and the speculation, so are we due to rot in near-recession until 2022?

We now have a pretty good handle on what caused the Japanese economy to under-perform for 16 years. The Bank of Japan expanded money supply too rapidly in the late 1980s, causing stock and real estate bubbles that reached peaks higher than had ever been seen in a major market. When the stock market index is selling at 100 times earnings, and the Emperor’s palace is worth more than the state of California, the overvaluation is not debatable, only the extent and timing of the crash to come.

In the early 1990s, stock prices approximately halved, and real estate prices began to decline. The Bank of Japan dropped interest rates, and the Japanese government expanded the public sector, indulging in Keynesian deficit spending as had become the accepted cure for a deflationary recession. As a result, the Japanese economy did not sink into deep recession, as might have been expected by those looking at the 1930s, but simply underwent mild deflation combined with low growth. As the 1990s proceeded, the economy’s refusal to recover properly became increasingly worrisome and the stock market, which had stabilized for several years at about 50-60% of its peak level, began to decline further.

In 2000, the apparent beginnings of recovery caused the Bank of Japan to attempt to raise the Overnight Call Rate above zero, but the move backfired. The banking system was now overburdened with bad loans, and the continuing recession was undermining the strength of borrowers previously thought invulnerable. A further burst of public spending (primarily on infrastructure in rural districts with important Liberal Democrat party Diet members) caused Japan’s public debt to rise above 130% of GDP and the state budget deficit to soar above 7% of GDP, but economic growth stubbornly refused to reappear.

That was the position when Junichiro Koizumi became prime minister in April 2001. He correctly diagnosed the main problem: the inevitable deflationary effect of declining stock and real estate prices had been exacerbated by the increases in public spending. If as in most countries the private sector is more productive than the public sector, continually increasing the public sector’s share of output produces a major drag on growth. This is common sense. In advanced OECD economies the growth rate is inversely correlated to the size of the public sector and its growth as a percentage of the economy. Thus in 2001 the public sector needed to be reined back while monetary policy remained loose to allow asset values to stabilize and begin to recover, which in turn would prevent the further erosion of the banking system. That was the policy Koizumi followed, and after a delay of about two years, it worked. Resources were redeployed to the private sector, which at last had room to grow. Corporate profits began to recover as, after a delay did stock prices and asset prices. The Tokyo Stock Exchange bottomed out at about 20% of its peak value, and then doubled over the next 3 years.

Since the beginning of 2006, the Bank of Japan has decided that the economy is strong enough to bear a normal monetary policy, and the excessive easing of the previous few years is thus gradually being removed. With Japanese economic growth per capita as rapid as in the U.S. and inflation positive there is little reason to fear a return to recession.

Since the long Japanese recession began in a period of over-extended asset prices and monetary easing, we need to ask to what extent the Japanese experience might be repeated in the U.S. or the world as a whole, and what steps can be taken to avoid it. That is not to assume that Japanese policy was uniquely incompetent, far from it. The last U.S. episode of such an overvaluation terminated in the Great Depression. Even if in retrospect a tighter Japanese fiscal policy, combined with its loose monetary policy, could have made its economic downturn shorter than it became, avoiding the Great Depression is itself an achievement worth celebrating.

SKIRMISHES, SCARES, AND REAL WAR …

All the stories about the stock market Friday (and the whole week) repeated the same script: “Stocks tumbled again Friday as traders weighed the exchange of blows between Israel and Hezbollah.” Gosh, I wonder what investors would do if they had to weigh something bigger than an “exchange of blows between Israel” and its enemies. Something like, well, huge troop movements, surprise attacks, immense tank battles, tens of thousands of casualties – aka, a real Middle East war. But wait, there is no need to wonder – the past 60 years have seen several conflicts which fit that very description; indeed, you can see precisely what the Dow Jones and S&P 500 stock indexes did from the time the fighting started in the charts below. Note the dates on the maroon vertical lines.

Had enough? Go re-read today’s financial news with the above in mind, the laugh’s on me. I will not bother to show you a chart of the period when Israel previously invaded Lebanon – most historians date it from 1982 through 2000. Should not take any deep thought to recall what U.S. stocks did during those years. If conflicts in the Middle East move the stock market, then you tell me: Which direction does the “movement” appear to take? In truth, wars in the Middle East DO NOT move the stock market. Every single day includes “good” and “bad” news of some sort, and it is easy to retrofit that news to an up or down close in the Dow. It is very believable, once you stop thinking for yourself.

TO FIGHT THE GLUT, HOME SELLERS PUSH THEIR PRICES DOWN

Home sellers are learning what any retailer, from Wal-Mart to the owner of the corner gas station, already knows: Low prices are one of the surest ways to beat the competition. Coldwell Banker Residential Brokerage, Massachusetts’s largest real estate firm with more than 3,500 agents, is coaching agents on how to persuade clients to list their homes at an asking price that undercuts those of comparable ones on the market. The hope is low prices will attract more prospective buyers, leading to faster sales. Other real estate agents in the Boston area report success with similar strategies in a housing market with an unprecedented glut of properties for sale.

Called “drama pricing” or “energy pricing”, it is a drastic measure for difficult times. And it seems to run counter to the conventional strategy of selling your home for the highest price possible. Buyers are “overloaded” with options and “only respond when they see a perception of value,” said Angela Stamoulos, who teaches Coldwell Banker’s course on this pricing technique, which the firm rolled out this spring in Connecticut and last month in Massachusetts. By grabbing buyers’ attention, she said, “the true market value of the property comes to fruition.” While the real estate industry has been reluctant to publicly acknowledge a downturn, that is not what they are telling their clients.

While it may seem obvious a house will sell faster at a lower price, Coldwell Banker’s efforts reflect a sea change in the market’s psychology. During years of record house-price gains in Massachusetts, a prospective seller would examine “comps” – reports prepared by agents listing comparable houses that have sold in the prior six to 12 months – and then determine how much more he could get for his home. Today, what is important is what is not selling. Drama pricing focuses on what buyers see on the market, forcing sellers to look at the prices of active listings. “It’s another indication that it’s clearly a buyers’ market,” said Timothy Warren Jr., chief executive of The Warren Group, a Boston real estate research and publishing firm that tracks the market. “There’s a lot of stuff on the market, and it’s going to have downward pressure on prices.”

Coldwell Banker’s course “is formalizing something that’s happening anyway” in Massachusetts’s declining market, said Sue Hawkes, managing director of The Collaborative Companies, a Boston real estate marketing firm. The effort may help push the market’s inevitable evolution “along faster and will give it impetus,” she said.

For San Diego real estate, the skies are not so sunny.

For a long time, this was a cruel place for any would-be homeowner who did not have a wad of bucks or a tolerance for the high-risk, short-term mortgages that some call suicide loans. Last week, reports showed that the city’s median home price dropped 1% in June from a year earlier, the first decline in a decade. That should be good news for Carmen Buck, a 29-year-old homemaker who has been saving and hoping for a house. But she sees little to celebrate. Prices might have been a bit higher a year ago, she noted, but interest rates were a whole lot lower.

The long-awaited shift in the market’s direction is not pleasing many others, either. Sellers are chopping prices to get deals done. Buyers worry that values will continue to fall, putting their investment at risk. There is widespread uncertainty, and some anxiety, about what happens next.

San Diego had the wildest run-up among major California cities, with prices tripling since the mid-1990s. The craziness seemed to peak about two years ago, when bidders routinely submitted letters saying that they and their children would be forever honored if the seller would consent to choose them. Whatever happens here, optimists and pessimists agree, will happen later in the rest of the state. That is about the only thing everyone agrees on. The size of the coming hangover is a particularly contentious matter. Most analysts and people in the real estate industry insist it will be mild. The housing bears say the bulls are either misguided, uninformed or shills.

It’s time to get, before the gettin’ gets worse.

I remain in “awe” of some of the wisdom offered by those in the real estate industry. Please consider, “This Could Be the Right Moment to Sell”: “‘Buyers today are more committed, which is good for sellers,’ says Susann Haskins, co-manager of the Long & Foster Real Estate Inc. Potomac/Cabin John office. ‘When we had the frenzied buying of recent years, we saw people buying without giving thought to what they were doing. Sometimes, they would find ways to back out of contract. But today’s buyers are more committed to the transaction because they’ve had time to see the house more than once. They’ve thought about it, and made a conscious decision, rather than an impetuous one.’”

I am going to nominate the above for the “silliest comment of the week” award. For starters, Haskins is point-blank wrong about cancellations. They are soaring right now versus a year ago. But more to the point, the best time to be a seller of anything is when there is frenzied buying. That fact should be inherently obvious to everyone. Furthermore, I suspect she was harping about how great it was during that frenzy. Well, what a great time it WAS. But it is time to face the facts, Haskins. It is a very difficult time to be a seller. Now, that may not be true in every market, but it is certainly true in many of them. You can play all of your phony games, saying how this market is more normal and how great that is for everyone, but I am calling you on it.

You know you are speaking nonsense, I know you are speaking nonsense, and, most importantly, the public is finally catching on to the fact that cheerleaders like you are speaking nonsense. But yes, in a sense, it is a good time to sell. That sense is as in “get while the gettin’ is good.” Well, actually, it is too late for that. The correct logic now is more like “get before the gettin’ gets worse.” That logic not only pertains to houses, but, more obviously, to the stock market, and also to real estate jobs in general.

Lower prices, fewer sales, fewer jobs, increased competition, and lower commissions lie dead ahead. This is all very deflationary, of course. More amazing is the fact that hardly anyone sees it. Whether you are a flipper trying to flip a house or a marginal real estate agent/broker struggling in this turndown, you may wish to consider “gettin’ before the gettin’ gets worse.” Unfortunately for the latter group, and for the economy in general, real estate has provided close to 50% of the jobs in this recovery. Where to “get to” is likely to become a real problem.

“The housing market’s in trouble,” says economist.

Confidence among U.S. homebuilders dropped this month to the lowest level in more than 14 years as sales fell and orders were canceled. The National Association of Home Builders/Wells Fargo index of builder confidence declined to 39, the lowest since December 1991, from 42 in June. It was the 8th decline in nine months for the index. “The housing market’s in trouble,” said Joseph Lavorgna, chief U.S. economist at Deutsche Bank AG in New York. “We have become decidedly more cautious on the outlook since the index has started falling.” The home builders survey asks builders to characterize current sales as “good”, “fair” or “poor” and also asks them to gauge prospective buyers’ traffic. Readings below 50 mean more builders view sales conditions as poor than as good.

Homebuilders have lowered profit forecasts for the year as demand dwindles and cancellations mount. While the homebuilders’ survey has painted a dimmer outlook than other housing reports, home sales still are expected to fall this year for the first time since 2000, weighing on economic growth, economists said.

Rates on 30-year mortgages are highest since 2002.

Freddie Mac says rates on 30-year, fixed-rate mortgages increased to a nationwide average of 6.80%, from 6.74% last week. That is the highest they have been since they stood at 6.81% the week of May 24, 2002. A year ago, 30-year mortgages averaged 5.73%, 15-year mortgages stood at 5.32%, one-year ARMs were at 4.42% and five-year ARMs averaged 5.26%. Rates on 15-year, fixed-rate mortgages, a popular choice for refinancing, increased to an average of 6.41% this week, from 6.37% last week.

D.R. Horton cancels land deals.

Texas-based builder D.R. Horton has taken a write-off in excess of $57 million to get out of purchasing land for new homes. “We don’t need to start nearly as many homes as we anticipated, and we also don’t need to have as many lots as we anticipated,” Horton CEO Don Tomnitz said. “We are scaling back our production machine simply because our sales machine is scaling back.” Horton took the pretax charge in the quarter ended June 30 as part of a plan to reduce its nationwide building operations. “Clearly the industry has excess inventory,” Mr. Tomnitz said. “We are slowing our starts dramatically.” Most of the land purchase options and contracts are for building sites in California, where home sales have declined dramatically. “The market right now is weak. We are going to assume it even gets tougher in ‘07. We are preparing for the worst.”

Feds say that banks’ futures tied too closely to commercial real estate.

As commercial real estate sales and construction surge across the country, federal officials worry that many banks are carrying more real estate loans today than during the 1980s boom. And what the feds are doing about it has some community bankers shaken. Several regulatory agencies – including the FDIC, the Federal Reserve and the Office of Thrift Supervision – are working on guidance that would implement a range of risk-management controls, such as strongly encouraging banks to have more capital if they have a significant number of commercial real estate loans.

CREDIT DERIVATIVES PLAY A DANGEROUS GAME

As the markets roil, manyanalysts predict a “flight to safety”, warning that investors will pull out of risky stocks and bonds and head for a safer spot. But if investing has become a game of musical chairs, who will be standing when the music stops? A clue lies in the nascent but massive market for credit derivatives. Credit derivatives are essentially side bets on a company’s creditworthiness. You might pay us $1 a year in exchange for our promise to pay you $10 if General Motors defaults on its debt. In such a trade, you buy protection against a default, whereas we sell protection. Thus, credit derivatives resemble insurance.

There are reports of more than $17 trillion of such bets outstanding, about the value of the entire U.S. and UK equity markets combined. But that is almost certainly an understatement. One multinational bank, JPMorgan Chase, has said it holds $2.2 trillion of credit derivatives. Many of JP Morgan’s trades, such as those of banks generally, are designed to hedge the risk associated with making loans. If a bank not only makes a loan but also places a credit derivatives side bet that the borrower will default, it might break even, losing on the loan but winning on the bet. If banks that lent money to companies such as Enron, WorldCom and Swissair had not used credit derivatives, some surely would have failed in the wave of defaults that followed.

While credit derivatives can generate benefits, they present two critical challenges that can precipitate a flight to safety and perhaps a financial crisis. Neither has received much attention.

First, credit derivatives create “moral hazard” when banks use them to shift risk. Moral hazard occurs when people take on excessive risk because they are insured. Fire insurance is the classic example. Those who have it are more likely to play with matches. Likewise, credit derivatives encourage banks to lend more than they otherwise would, at lower rates, to riskier borrowers. Banks with credit derivatives lack incentive to keep a close watch on borrowers. Because credit derivatives leave borrowers unmonitored, they fuel the credit expansion. And, as Charles Kindleberger, the late financial historian, noted, unmonitored expansion of credit precipitates the manias that lead to market panics and crashes. In theory, the pension funds and insurance companies that sell credit protection should do the monitoring. But because they do not make the loans, they have no relationship with the borrower.

These risks are related to the second problem, “informational asymmetry”. Simply put, the gap between the complexities of credit derivatives and what the people who deal in them can understand. Even the savviest investors and regulators are surprised and exasperated by the opacity of these instruments. Warren Buffett, the renowned investor, once described credit derivatives as “financial weapons of mass destruction”. If such a wise man cannot understand credit derivatives, what is a typical credit officer to do? And how should an investor evaluate the credit derivatives exposure of a bank or pension fund? Credit derivatives contracts are intricate and payouts can depend on legal terms that are not well understood. Nor is information easily available. The market remains maddeningly opaque, even to insiders.

If corporate defaults increase and investors seek safety, likely victims will include not only pension funds and insurance companies but hedge funds, which have a growing share of the credit derivatives market. Because hedge funds take concentrated positions and have sharp incentives to perform, they are better able to evaluate credit derivatives risks than insurance companies or pension funds. Their buying and selling creates market pressure that indirectly can do some of the monitoring banks no longer carry out directly. But the growing role of hedge funds also generates risks. Many have placed highly leveraged and unhedged bets on credit derivatives, and tend to act in concert. Markets lately have been awash in liquidity largely because banks are confident they can use credit derivatives to offset the risk of loans. But if the hedge funds and others who have been selling insurance to banks decide to seek safety, the music will end.

Unfortunately, opinion on the credit derivatives issue is polarized between alarmists who oppose financial innovation and supporters who naively embrace it. The truth is in the middle. Credit derivatives help banks reduce risks but in doing so, they create the danger of systemic market failure. Ideally, confidence is built by requiring enough disclosure to enable investors to assess risks. The problem with unregulated derivatives markets is that investors learn too late. When they simultaneously lose faith, everyone looks for a seat.

TROUBLE BREWING

Gold’s 5% increase last week was generally attributed to escalating tension in the Middle East yet at the same time the Gold Fields Mineral Services (GFMS) Base Metal Index rose 7.8%. Base metals should not respond positively to war since wars destroy capital and cause misallocation of available capital, both of which in the end are detrimental to economic growth and prosperity. What gold and base metals are doing is signaling weakness in paper money. Gold is a monetary asset and protects its owners against the devaluations of fiat currencies only, and massive amounts of institutional money have been allocated to hard assets as a hedge against a decline in the dollar.

What is busy happening in Japan is far more important to the price of gold, the value of your house, interest rates, your job and the value of the money in your bank account than what is happening in the Middle East. I am not downplaying the current Middle East violence. Personally I believe that the Third World War has already begun and that our lives are going to change dramatically over the course of the next several years as the War spreads and gains momentum. For starters you can expect further confiscation of your personal liberties, whatever is left of them. This commentary, however, is about markets, money and gold, not about liberty or war. During previous wars and skirmishes the gold price seldom responded positively for very long. Any rally in the gold price due to conflict was usually (very) short-lived. So if the current rally in the gold price is merely due to Israel and Lebanon bombing each other, and fear that the violence will spread, then we should all sell into the rally for it will soon end.

On the other hand, if it has more to do with Japan raising interest rates for the first time in five years, marking the end of an era of yen-stimulated liquidity, then the rally could have legs (see last week’s commentary for more on the yen and the yen-carry trade). The weakness of the dollar against the yen (one of the few currencies that the dollar was weaker against last week) can be directly attributed to Japan raising interest rates and not Middle East turmoil.

But if the base metal bets were made on the premise that the dollar will weaken, what about traditional base metal demand? Slower economic growth and the end of the real estate boom will cause reduced demand for base metals and weakness in base metals prices. Copper has no business trading where it is. Neither do zinc, lead, nickel or many other metals. Base metals prices are so far ahead of themselves that I believe there is substantial risk of a meltdown in that sector. Because institutional money seems to have been allocated across the spectrum of metals, I fear that a severe correction in base metals could drag the gold price down as well.

So what will happen first? Will the dollar collapse causing more money to be allocated to metals thus pushing metals prices even higher, or will base metals correct dragging gold down with them?

Unstable markets – precious metals update.

The second major leg up in the precious metals bull market will see large increases in buying from both the public, and also money managers. Certainly some of the more savvy money mangers have already been in this market, but we are referring to a great deal more interest coming into this sector from those that work at an institutional level and are just now waking up to the precious metals. Before leaving town it is appropriate that I leave you with our current thinking. First of all the markets have shown very volatile movements recently due to the conflicts in an unstable world. Gold has rallied from the mid-June spike low to the $666 level and yet as silver has strengthened, neither silver or the mining shares are confirming this move higher.

It is our view that the precious metals and possibly the mining shares (mid-tiers and higher) will peak out soon, probably before July 21st. Most of the junior mining shares have shown weak indecision patterns on low volume. This is a good time keep a careful eye on juniors you wish to add to your holdings but you do not need to be in a rush. Richard Russell whom many consider to be the “master” in this business has said “It is going to be a matter of months before gold can establish a real bottom.” We agree. You do not need to chase the precious metals or the mining shares here, and yes, there may times when that statement may appear to be in doubt.

The best approach is to buy into solid companies that have been the leaders on weakness which we expect to see over the next six to eight weeks. Whether the spike lows we saw in mid-June are the low point or not remains to be seen. Even as oil is breaking into new territory many of the leading oil stocks are breaking down which indicates to us that waiting for better buying opportunities is the smartest approach currently. The overall stock market has taken a beating and even the strongest sectors were feeling the strain.

AMERICA: THE NEXT URANIUM GIANT?

When it comes to uranium mining, it is expected that the United States would play second fiddle to world heavy weights like Canada and Australia. But thanks to years of depressed pricing and an unpalatable political climate, the U.S. actually lags behind many developing nations – many of whom have significantly lower reserves – in uranium production. In fact, even though the U.S. accounts for about 7% of the world’s uranium reserves, according to the World Nuclear Association, it is currently responsible for only 2.5% of worldwide production from mines.

Worldwide annual uranium demand currently far outstrips supply from mines – with the shortfall currently being met by recycled uranium for nuclear warheads. But, with uranium power requirements on the rise, it is almost certain that increased mine openings are in our future. In the next decade, the American uranium industry is in for a massive change. Thanks to re-emerging domestic support for nuclear power, and a pricing environment that allows for profitable extraction, the American uranium mining industry is finally finding support after nearly 20 years in decline.

The biggest issue facing domestic uranium mining in recent years was the depressed demand – and pricing. Unlike countries with high-grade uranium deposits like Kazhakstan and Australia, much of the U.S.’s uranium is based in low-grade sandstone deposits. Located primarily in the western states of Wyoming, Colorado, Utah, New Mexico and Arizona, much of America’s uranium can only be extracted with a comfortable profit margin with spot prices over $35 to $40 per pound. With pricing currently topping $46/lb., we are finally entering the “sweet spot” for U.S. production. With high oil prices and a desire for increased energy independence, the political environment for uranium mining is also seeing a boost. If pricing remains elevated, it is likely that this is just the beginning of a change in the U.S. uranium industry.

Reflecting this change, action among the small number of publicly traded uranium companies involved in the U.S. uranium game has begun to heat up. For example, in a major announcement last month, International Uranium [TSX:IUC] announced it would restart its mothballed U.S. uranium mines after a whopping seven years of down time. The company plans on producing a 3.4 million pounds of U308 in its initial year of production, before leveling off at between 1.5 million pounds of 2 million pounds of yellowcake later on. In all, the company plans to operate nine mines located in Colorado, Utah and Arizona by 2008. There are not a terribly large number of companies currently involved in U.S. uranium exploration and production. Industry heavyweight Cameco [NYSE:CCJ] currently only operates two small uranium mines in the U.S.

It is quite certain that not every company discussed is sure to become a major presence in the U.S. uranium market. But with U.S. uranium production likely to see significant growth over the next several years, it is likely that exploration activity and deal-making will both continue to expand. Investors looking to take part in the overall surging uranium market would do well to own stakes in a number of companies with U.S. operations.

AVOID THIS RETAIL PLAY

The furniture business is not an easy one to get into. In my experience, some of the more popular furniture stores in most American cities and towns are family-owned operations that have been in business for generations. Not many public companies have gotten into the action, and some of the ones in business have been struggling. But there is one tiny furniture chain that has done well recently, while other companies have hit rough waters. But despite its recent strong performance, you should avoid this furniture chain for the time being.

The name of the company is Jennifer Convertibles (JEN: AMEX). It operates 175 Jennifer Convertibles stores and 16 Jennifer Leather stores. Their stores sell sofa beds, along with other furniture such as chairs, loveseats and recliners. But even though this is still a small company, Jennifer Convertibles is the largest sofa bed specialty retailer and the largest Sealy and Simmons sofa bed dealer in the U.S. Unlike many furniture stores that cater to a particular demographic, Jennifer Convertibles carries both high and low-end pieces in an effort to appeal to a broader customer base.

Jennifer Convertibles has worked to turn around its fortunes recently. This past quarter was their fifth in a row that was profitable, and the company closed 20 unsuccessful stores last year and improved profit margins. One store was closed during the most recent quarter, and no new stores were opened. The company’s operating margins increased during the current 3- and 9-month periods. All of this has been accomplished as other furniture chains have lost business to big discount stores like Target. Pier 1 Imports (PIR: NYSE), the furniture store that caught shoppers’ eyes with unique items at reasonable prices, has not turned a profit in five quarters. And vintage-inspired items from the more upscale Restoration Hardware (RSTO: NASDAQ) have not helped the company make a dime in profits for five quarters as well. But to truly judge the performance of a retail chain, there are two more factors that need to be strongly considered.

One of the most important things to look at when it comes to retail is same store sales performance. This shows how sales at stores that have been open for at least a year have faired. While overall sales growth is important, growing same-store sales is a better indicator of a chain’s success because it shows the company is doing something right by attracting more buyers to its existing locations. Growing same-store sales also proves that a company is not relying on rapid expansion to line its coffers. Chains that grow too quickly can spin out of control just as fast. And when the rapid expansion stops and competition starts chipping away at their market share, disaster could be just around the corner. Jennifer Convertibles has improved same-store sales drastically. The most recent quarter saw same-store sales jump 15.9%, added to an even more impressive 31% same-store sales growth. The same-store sales growth adds up to more than 20% year-to-date.

The other factor is debt. Former fund manager and author Peter Lynch said he likes to invest in retail that carries very little debt, since these are the companies that are better prepared to ride out a recession. Jennifer Convertibles has $100,000 in long-term debt, and $9.8 million in cash. So the company’s current debt is obviously not a factor that would affect the business.

While Jennifer Convertibles looks good on paper, I have two major concerns with this company that make me want to steer clear. First, as much as I like how the folks at Jennifer Convertibles have worked to turn a profit again, it is important to note that the strength of the economy will play a strong role in Jennifer’s success. Generally, sofa beds and other furniture are big-ticket items – purchases that families will put off if money is tight. And I have a feeling that higher gas prices will not only have an affect on the company’s operational expenses, but also on the number of customers who cross furniture off their “buy now” lists. Second, as the number of houses being built slows, fewer families will be moving into brand new, empty homes that need furniture. These factors – totally out of the company’s control – could affect Jennifer’s ability to grow and prosper as much as management would like. The P/E ratio of 7 makes this stock look tempting, but now is not the time to pull the trigger.

THE DEATH OF THE CARRY-TRADE AS JAPAN RAISES INTEREST RATES

Borrow low and invest high. That has been the global trader’s mantra over the last 5 years amid the lowest Japanese interest rate environment in a generation. Hedge funds, private banks and many high net-worth investors have made a fortune borrowing in low-yielding Japanese yen and reinvesting those proceeds into higher-yielding assets, mostly in dollar-based markets and in euro. This, in essence, is known as the “carry-trade”. Low Japanese interest rates have partially fueled a global stock market boom since 2003 as a declining yen accompanied by super-low borrowing costs made the “carry-trade” a formidable speculation.

For example, the spread between Japanese government bonds and U.S. Treasury bonds remains very wide at 3.2%. Effectively, an investor can borrow just above 0% in yen and place those proceeds into dollar-based bonds earning an interest rate advantage, possible currency appreciation and of course, multiply his returns through leverage. That is a conservative carry-trade speculation. Most investors have been borrowing in yen and reinvesting those borrowed assets into dollar-based emerging market equities over the last four years – incredibly profitable as benchmarks have gained almost 200%.

But it looks like the carry-trade party is almost over as The Bank of Japan raises interest rates this summer for the first time in 6 years. In May, the news that The Bank of Japan was draining liquidity from the banking system ahead of monetary tightening this month was a primary catalyst to the recent global market correction. Japan has been the world’s largest supplier of cheap money since the bear market low of October 2002. The Japanese economy is finally on the path to recovery. Unlike previous fake-outs, which saw only temporary GDP expansion in the post-1991 period, Japan continues to expand vigorously since last year. And The BoJ is now cornered, facing the prospects of rising inflation after a decade of falling prices, or deflation. As Japanese short-term rates rise this year, more speculative capital emanating from the yen carry-trade will find its way back to Japan, lifting the yen’s value versus the dollar and euro. As this process matures over the next several months, more speculative “hot money” will come out of risky assets like emerging markets and commodities as traders readjust their risk premiums.

The unwinding of excessive speculation is a healthy development. In most cases, this has created terrific values for most global markets, including U.S. Treasury bonds. Global economic growth is now moderating, but should remain above-trend as global inflation remains historically low and bank credit is still buoyant. The real threat to the world economy and global markets over the near-term is geopolitical events, not central bank monetary policy. I believe that investors should continue to carry above-average cash positions this summer, reverse index mutual funds and commodities, especially gold and silver.

BOLIVIOUS

A friend with a talent for malapropisms conceived the above. It happened to be used to describe a surf fisherman with a “sidewinder” cast not noticing that his lure was describing an arc within millimeters of the next guy. We introduce this variant of oblivious as an attention catching description of current global financial markets up until the late May increase in volatility and modest sell-off.

Prior to this “correction”, as any downturn is usually described by the financial pundits, or “healthy correction”, as described by the more religiously bullish, virtually every area of financial transaction aspiring to the name “market” was in parabolic ascent. Equities, certainly in the U.S. (where the Dow was nearly exceeding its 2000 all time high) but even more so in markets overseas, debt, with spreads at near record compression, commodities, with gold at 20-year highs and copper a comet in its own right and the financial engineering of new derivative product to create constant new highs in issuance. Most currencies, with the exception of the dollar, also were ascending. Some of the winners were what had been the disasters as short a time in the past as 1998. Russian equities were particularly evident in this respect. Mergers and Acquisitions set a new record. Margin lent also reached new heights. By May 25, the “correction” looked to have run its course and the brief anxiety overcome again with a return to bolivious!

There is a fascinating chart in the July 3 edition of Barron’s done by Ned Davis Research showing credit market debt as a % of GDP. Credit market debt is now more than $40 trillion, or 315% of GDP. Rising interest rates on that debt are a deflationary force in the face of short term inflation. A further look at the chart reveals the 50 year median to be below 200% and, it is in the late 1980’s (the beginning of the Greenspan era at the Fed) that it first exceeded 200%. The line climbs thereafter with rate cuts and liquidity expansion accelerating the climb each time the Fed fought off “incipient deflation”. What is the upper limit on how much credit market debt the economy can sustain to create the next dollar of GDP? This is obviously an unknown. It is also unknown territory that the nation is already venturing into. Yes, the Japanese debt is proportionately greater after 15 years of deflation fighting but that nation enjoys a savings rate in the high teens. Virtually all of the debt is held internally in their case. In the case of the U.S., the creditor is increasingly foreign.

There really is no responsible adult out there! From the buyers of the humongous amounts of debt being issued at ridiculously low spreads and Mexican Government 10 year paper at 6.10%, to the press such as the Economist article fawning over Goldman Sachs, through domestic and international regulatory entities, the global coterie of central banks, the U.S Federal Reserve with Ben and his new acolyte with unlimited buying power for U.S. Govvies to the wily Paulson now controlling the Exchange Stabilization monies there really is no place to look to for true restraint on the creation of bad credit. This far into the global expansion, there is no way bad credit is not being created in great amounts. There is already a lot of it out there. Example: the residential house/mortgage market with demand in trouble and supply increasing just as a couple of trillion of the stuff written as ARM’s in recent years hits reset! Furthering the conclusion are the analyses above of the tens of trillions of credit created outside the regulated banking system. Reading BIS and IMF reports tells one these guys are praying, not teaching. As an old credit hand, we are willing to go out on a limb and predict a coming credit debacle. We will also predict that it will be a lot bigger (orders of magnitude) than any previously seen. What we cannot predict is when or what the trigger will be.

PEAKING EARNINGS EXPLAIN WHY THE MARKET IS EXPENSIVE

Earlier this year, another street.com contributor and I had a debate that included the issue of whether the market was cheap or expensive on earnings. I was even willing to concede what appeared to be his point, that the market was not expensive on normal earnings, while alleging that the market was expensive on the scenario “I project going forward.” That was another way of saying that 2006 earnings were probably peak earnings, rather than mid-cycle earnings, thereby behaving in much the same way as the profits of cyclical stocks.

In fact, earnings are acting in much this way because the growth in the aggregates is being driven by cyclical industries such as energy, metals and mining, and until recently, housing. Unlike the 1990s, when profit gains were led by growth engines such as tech, pharmaceuticals, and financials, these standbys have not been much in evidence recently. While overall recent gains so far have been good, they have also been “lumpy”. The moral of the story is that the composition of growth is as important as growth itself in determining valuations, and ultimately stock price movements.

A REQUIEM FOR PENSIONS

Younger workers would rather invest in 401(k)s (pensions carry a musty smell). At retirement, older workers often reject their plan’s offer of a monthly income for life in favor of taking a lump sum to invest themselves. Hundreds of companies have closed or limited their plans in recent years, switching to 401(k)s instead. Most tech firms, among others, never offered them in the first place. That is too bad, because guaranteed lifetime incomes should not be thrown away lightly. They can offer better returns than you will ever get from your investments, and more personal security, too.

But more on that later. Pensions currently face an obstacle even more serious than waning worker interest, and that is underfunding. Current pension rules allow companies to contribute less than they should, even though they have the money. In a few cases, they cannot afford to pay the benefits they promised. The federal Pension Benefit Guaranty Corporation, which picks up part or all of the payments owed by bankrupt plans, warns that its deficits are alarmingly large. To fix the system, the U.S. Senate and House of Representatives are hammering out a pension-reform bill. But it is a strange “reform”. All parties agree that it will push many more companies into freezing or dropping their plans. (A frozen plan will not cover new employees and may also end benefit increases for current workers.)

In brief, the reforms require firms to put more money into their plans. Underfunded plans will have to make up their shortfalls faster. There will also be changes in the way all companies calculate how much they owe. When pension executives were asked what they would do if at least two of the provisions passed, 60% said they would freeze their plans. “Private pensions are going the way of the dodo,” says David Wyss, chief economist for Standard & Poor’s. “The more that’s required of plans, the sooner they’ll go extinct,” along with the future benefits of 17 million workers.

Ironically, part of the pension-funding problem no longer exists. Plans are coming back to a sounder footing, thanks to rising interest rates, massive corporate catch-up contributions to their plans, limitations on benefits and the recovery in the markets. The premiums that companies pay for PBGC insurance were raised earlier this year, so its deficit should shrink, too. A recent report by the Government Accountability Office put the odds at 90% that the PBGC could cover all failed plans at least until 2020. In short, the funding crisis may have been oversold. But fears that government would be on the hook for failed plans has “scared the heck out of everybody,” says Congressman Earl Pomeroy, one of the few pension experts in the House. He favors reform at a slower pace to encourage willing companies to keep their plans going. But even if Congress lightens up on the funding burden, accounting changes expected next year will make the plans less attractive to their corporate sponsors.

When companies freeze plans, they usually sweeten workers’ 401(k)s. But that probably will not make up for what you lost. Pension plans also earn more on their investments than a typical 401(k) due to better management and lower expenses. “We’re moving from an efficient retirement system to a less efficient one,” says consulting firm Watson Wyatt’s Kevin Wagner. It is a loss. But only if you are a working stiff. Top executives are not only keeping their pensions, their payoffs are leaping even as yours are being pared. Tough luck. Today, the money flows to the “deserving rich”.

DEBT FORCES ONE IN FOUR AMERICANS TO FALL BEHIND ON MONTHLY BILLS

Despite a growing economy and low unemployment, nearly one in four Americans say they frequently fall behind in their monthly bills because they are in debt, according to a national survey. Worries over debt are so pervasive that 82% of the 1,000 people surveyed said debt is a “very serious or somewhat serious problem” that is growing worse. The survey, conducted by a Republican pollster and a Democratic pollster on behalf of the Center for American Progress and the Center for Responsible Lending, shows the country’s growing “economic anxiety”.

American Progress is a Washington think tank founded by John Podesta, former President Bill Clinton’s chief of staff. Responsible Lending focuses on consumer issues such as predatory lending. U.S. credit card debt, cited as the No. 1 source of people’s debt in the survey, stands at $813 billion, according to John Halpin, a senior fellow at American Progress. He said the average American family is carrying more than $8,000 in credit card debt. Personal savings, meanwhile, is at 7-decade low, with Americans dipping into their savings or borrowing against lines of credit.

Despite those sobering statistics, Americans actually are carrying debt well beyond credit cards, the study found. More than half of those surveyed said they owe more than $10,000. Two in 10 of those are $20,000 in debt, the survey found. Mortgage debt is not included in those figures. Seven in 10 Americans reported their debt has grown or stayed the same during the past five years. They traded disposable income for homes and cars, college loans and impulse purchases. But they also cited factors beyond their control – a higher cost of living, low wages, unemployment, rising gas and energy prices as well as child care and medical costs.

Once thought to be a problem of the poor, household debt is “clearly seen as a middle class issue now,” said Halpin, also an opinion analyst at American Progress. “It is a real threat to middle class aspirations.” One of the most troubling findings in the report is that 86% of those surveyed said they believe more Americans are struggling with debt in the past five years. “Eighty-six percent is a stunning number as a pollster,” said Bill McInturff, partner of Public Opinion Strategies, a Republican polling firm that helped conduct the survey. “This survey adds a dimension about what’s happening in people’s personal lives. … [T]his survey tells us why people have been resistant to adopt a more positive outlook about the economy.”

A BUYER’S MARKET IN WATER UTILITES

The Roosevelt Hotel is one of the great old hotels in New York. It opened its doors in 1924. It is in a prime location, on Madison Avenue and 45th Street in Midtown. A vintage bronze relief of Teddy Roosevelt stands watch over the main lobby, as he has for over 80 years. The hotel also illustrates the seen and unseen in the architecture of our physical economy. What we see is a grand old hotel. What we do not see is behind the walls and underground – all the pipes, pumps, valves and more. These things get old. And they need replacements and repairs. Now imagine that entire unseen infrastructure on a national scale. What you have is a multibillion-dollar crisis. Or is it an opportunity? It is a bit of both. In fact, it may be the next great investment theme.

I was at The Roosevelt Hotel attending Gabelli & Co.’s First Annual Water Infrastructure Conference. Here, 11 executives told their story to a small group of investors – including famed billionaire Mario Gabelli himself. All of these companies are involved in water infrastructure in some way. What struck me was the consistency of their stories. They all see the same thing – a whole lot of work that needs to be done. And estimates for the amount of work just keeping going up. For investors in their shares, it is going to be a long stretch of good years. Surprisingly, there were no more than two dozen or so attendees at this conference – fewer in the morning hours. But one day soon, conferences like this will be standing room only. Most investors have not caught on yet.

When you think of the “water industry”, most people think of water utilities. Water utilities are the big slice of the pie in the water industry. They have the potential to be an even bigger slice, because most of our water still comes from government-owned water utilities. Investor-owned utilities have only 15% of the market. However, investor ownership of water utilities is on the rise. First, I want to show you what a good investment water utilities have been over the years. Water utilities have crushed the markets – they have chugged along at an 18% annual clip, while the rest of the market barely eked out a positive return (and the Nasdaq posted a negative return).

Lest you think the last 10 years represent some special circumstance, John Dickerson of Summit Global Management has gone back further. Going back 25 years, he found that “Water utilities usually topped the list of the best-performing industry groups in the U.S. stock market on a total return basis.” And, he points out, these numbers understate the results. Merger and acquisition activity over the years has thinned the ranks. The indexes drop the acquired utilities. “Many of the better-performing companies are no longer part of the group,” Dickerson wrote, “and some of the laggards remain.”

When you think about the business it is not hard to see all the good things that go into making those stellar returns. Water utilities are unlike other utilities – or any other business, for that matter. For one thing, demand for water is as steady as she comes. It is immune to the larger macro forces that so bedevil other investments at times. There are no substitutes for water. Then, too, water utilities are monopolies in the regions they serve. Electricity can move over the grid so that cooler northern cities can help meet demand on hot days in Baltimore. Likewise, gas from St. Louis can move through the pipeline system to provide heating oil in Boston. In the world of water, such shifts are uneconomical. Water is prohibitively expensive to move over any significant distance. Why? Basically, water is too cheap – at least today. As a result, water is an intensely local issue.

There are over 53,000 water systems in America. The great bulk of these are tiny, serving fewer than 4,000 homes. In these smaller systems there are looming problems. Most are under the purview of local politicians. Typical of government-run enterprises, they are poorly maintained and inefficient. We lose 60 billion gallons of water every day through old, leaky pipes and mains – enough water to serve the state of California. There are lots of stories about breakdowns in aging pipes leading to interruption of service or, worse, leading to dangerous contaminants in the water itself.

The EPA estimates our water systems need hundreds of billions of dollars in upgrades and repairs. By its estimates, water is the single largest expenditure in our entire economy – behind only defense spending and Social Security. Many water systems are beyond the ability of local municipalities to finance repairs, even if they wanted to. They have two options. They can merge their systems with others. Or they can sell them to the investor-owned utilities. Investor-owned businesses are efficient and well financed. They are buying up these assets at cheap prices from cash-strapped municipalities. It is a buyer’s market with prices so low that even accounting for the substantial investments needed, the buyer is looking at good, persistent long-term returns.

One of the steady acquirers over the years has been Aqua America. It made 26 acquisitions in 2004 and 30 in 2005. Over the last 10 years, Aqua America purchased 175 water utilities. There is a lot more to go. We are just at the beginning of this trend. The privatization of Americas water systems is still in its toddler years. The larger companies are consolidating, too. There were once 23 publicly traded utilities. Now there are only 11. As consolidation continues, a further shortening of this list would not surprise me. In a big-picture sense, water utilities look like a great place to be. The conditions that helped produce those great returns in the past look only more favorable going forward.

TRASH TALK

Remember the classic ‘80s movie Back to the Future, in which Marty McFly (Michael J. Fox) traveled to 1955 in a time machine built by Doc Brown (Christopher Lloyd)? The initial version of the time machine, a souped-up DeLorean, was fueled by plutonium. At the end of the movie, Doc Brown returns from the future with a new-and-improved version that runs on garbage. Getting a nuclear reaction from coffee grinds and banana peels seems a bit of a stretch. In fact, turning the contents of your garbage can into any form of clean energy sounds like a pipe dream. But Covanta Holdings Corp. (NYSE: CVA) does just that. It turns garbage into electricity, in a process known as waste-to-energy (WTE).

The EPA has declared that the WTE process has “less environmental impact than almost any other source of electricity.” A combination of strict regulations and mature technology have made waste-to-energy plants both green and efficient. The U.S. turns roughly 12-15% of its solid waste into electricity each year – more than 100,000 tons per day – and generates enough energy to serve 2.8 million homes. WTE makes more sense in some geographic locations than others. Dollar for dollar, coal, hydropower and nuclear power are still cheaper ways to generate electricity. But WTE has other advantages, like the reduction of landfill usage. In densely populated areas of the U.S., such as the Northeast, lack of landfill space is becoming a real problem. There is plenty of open space elsewhere in the country, but it does not make economic sense to transport garbage any great distance. The ash left over from the WTE process takes up just 10% of the space that unburned refuse requires.

The WTE process is also a winner in the global warming department. Conventional landfills emit methane, a smelly greenhouse gas, while burned ash does not. WTE produce zero net greenhouse gas emissions and they help cut down on fuel usage and truck emissions by reducing long-distance waste transportation. Environmental skeptics fear that WTE harms recycling efforts, but WTE plants have an economic incentive to presort the garbage they burn and set aside the recyclable materials.

Covanta Holding Corp. is the dominant player in the WTE industry. It owns or operates 31 WTE facilities spread over 15 states, with a heavy concentration in the lucrative Northeast region. It also owns or operates 10 power projects overseas. Covanta’s advantages as an investment include the desirable attributes of revenue stability, strong cash flow and good prospects for future growth. Strong cash flow and solid return on invested capital give Covanta the ability to significantly “de-leverage” itself over the next few years by paying off the bulk of debt on its books that was used to fund expansion and previous acquisitions. Covanta has excellent exposure to long-run energy market trends. The more costly it becomes to haul garbage any significant distance, the more attractive WTE looks. And Covanta has no reason to fear an increased power bill – the company powers itself.

At the stock’s current quote of $16.35, it trades for about 26 times estimated 2007 earnings. This pricey valuation might not appeal to die-hard value investors, but Covanta enjoys a unique advantage over traditional energy companies: The world’s supply of oil will run out long before its supply of garbage.

FOUR TINY STOCKS WITH TENBAGGER POTENTIAL

Tenbaggers, even hundredbaggers, are easy to find in retrospect. But to make money off of these stocks, you need to find them BEFORE they embark on their dizzy ascent. And to find these stocks before they run up, Chris Welch uses an interesting screen inspired from two of his favorite books: “One of the screeners I use frequently is based on Phil Town’s book, Rule #1. I find the results of this screener are a great list of sound companies at various stages of their growth. However, I’ve also read William O’Neil’s book, How To Make Money In Stocks, which provides alternative criteria for stock selection. So I thought it might be interesting to merge the two screens together to see what comes up.

“What I found, to my surprise, was a list of all-star companies that have been making headlines because of their excellent price performance. … But alas, there were no riches in these results because these famed companies had already achieved tenbagger++ status. So I thought, ‘How can I find them before they jump?’”

While analysing these tenbagger++ stocks, Welch noticed something. Nearly all of these stocks had a period of flat price performance followed by three or four years of rapid price increases. And their prices doubled atleast once every year. Welch figured if he could find companies just coming off that flat phase, he could find a tenbagger.

He says, “I put together a screen that searches for companies with valuations [market caps] between $50 million and $1 billion who have doubled in the last year but have grown less than 10x in the last 5 years. With these criteria, I’m hoping to find strong growers that have’qt peaked yet.”

Here, I have replicated Welch’s screening criteria and chosen four potential candidates.

DON’T ROLL THE DICE ON WALL STREET

Up until just recently the only bargains in the carry trade were achieved by borrowing at lower interest rates in the euro and yen. This can be risky, though, because of the uncertainty of exchange rates. Below is an example of what I mean:

Say a trader borrows ¥5,000 from a Japanese bank and converts the funds into U.S. dollars. He then purchases a bond for the equivalent amount, and this bond pays 5% or more (and the Japanese interest rate is set at 0%). Obviously, this trader stands to make a profit of at least 5% as long as the exchange rate between the countries does not change. But if the yen strengthens, this trader is easily wiped out.

Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. But if the U.S. dollar continues to fall in value relative to the Japanese yen (as in the example above), traders may become victims of their own greed and fearlessness. Transactions like this use a lot of leverage, so any small movement in exchange rates can result in big losses unless they are hedged appropriately. Surprise! Interest rates are now going up in Europe and Japan and the vast majority of central banks around the world are raising their cost of borrowing. The easy money trades are gone.

The U.S. financial markets for stocks, bonds and commodities are greatly affected by the willingness of market participants to behave like traders by placing bets. These bets are based on the belief that there will be a continuation of some trend or theme in the market that will ultimately affect stock prices. Contrary to the message from Wall Street professionals who say “stock prices will only go up,” I am placing my bets on a declining dollar, a stormy end to the housing bubble, and a long-term bull market in commodities, particularly precious metals. However, except for owning physical gold and silver, I do not believe it is wise to place bets every day.

Professional traders and investors who speculate by placing bets with borrowed money have two things to worry about: Paying the interest on the money they borrowed, and a declining market price for the asset they bought. This interest on the money borrowed is called the “cost of carry” named after the cost of carrying the position. When the Fed cut interest rates to 1%, the cost of carry was ignored because it was insignificant. (Borrowing money to gamble on stocks, bonds and commodities was virtually free.) Today, with the Fed Funds rate at 5.25% and likely to go up, the cost of carry is much higher. To make money today, they must place bets on assets that are rising faster than interest rates, otherwise they will be eaten alive by the cost of carry.

The second quarter of 2006, and so far in July, has been painful to anyone who “went long” by buying risky positions. Stocks were down, emerging markets were crushed, and commodities had a very severe price correction that is still ongoing. Massive amounts of credit were extended to put on these speculative positions and while some air has deflated out of the credit bubble, there are still hundreds and hundreds of billions of highly-leveraged speculative positions in the markets. To date, only a small amount of the excess speculation has been drained away. Remember, when greedy speculators get carried away, they can literally be carried out of the financial market casino with empty pockets on a stretcher.

The markets are beginning to wise up to the crushing cost of carry. Behaviors are beginning to change. Even managers of mutual funds have noticed that when stock prices are not rising, they can enhance their portfolio yields by increasing their cash position. What is a cautious investor should do? Sometimes the best thing anyone can do is nothing! Yes, be patient and wait. The worldwide rising cost of carry will eventually push down the prices of those assets you truly love. A big correction in the housing market will also adversely affect stocks and commodities, and the housing slide could last a few years. So, even though “opportunities of a lifetime” happen every day on Wall Street, do not be persuaded to rush into something today or even tomorrow. Waiting for asset prices to come down to your buy point is not so bad, particularly when you are paid to wait. On Wall Street, while the house is telling you how to bet and buy stocks, it is not time to roll the dice. Just wait!

HISTORY - THE GREAT TEACHER!

At present, there is a lot of noise about a “commodities bubble”. The majority of “experts” are convinced that commodity prices have risen too much and they will collapse. On the other hand, stocks and bonds are being touted as bargains – or as the foolproof road to riches and financial freedom. These days, the mainstream media is awash with analysts who are claiming that commodities will suffer due to rising interest rates. Frankly, I find their argument totally absurd. History has shown that commodity prices are positively correlated to the direction of interest rates. On the other hand, financial assets such as stocks and bonds are negatively correlated to interest rates.

During the 1970’s, interest rates soared and this period coincided with a gigantic bull-market in commodities. Despite sky-high interest rates, all the commodities went up several-fold. It is interesting to note that the 1970’s saw a vicious bear market in stocks and bonds. Back then, the U.S. underwent a huge recession and Britain had to be bailed out by the IMF. Interest rates peaked in the early 1980’s and this coincided with the end of the commodities boom. In the following two decades, both interest rates and commodities declined while stocks and bonds witnessed a huge boom. There is no doubt that the previous commodities boom took place amidst rising interest rates and a severe recession. So, next time when the “experts” claim that commodities are about to collapse because of rising interest rates and a slowing economy, perhaps you can direct them to a good history teacher!

Essential to your success as an investor is to understand that the central banks do not raise interest rates to fight inflation. After all, the modern-day central banking system is inflation. Central banks raise or lower interest rates in order to manage the public’s inflation fears or expectations. During such times when the public wakes up to the inflation problem and starts losing faith in the world’s paper currencies (present scenario), central banks raise interest rates to show that they are “fighting inflation”. Interest rates are pulled up in an effort to restore confidence in the world’s currencies as a higher yield makes currencies more attractive. On the other hand, when the public’s inflation fears are under control and confidence in the monetary system is high, central banks lower interest rates to create even more inflation. During cycles of monetary easing, the rate of inflation (money-supply and credit growth) accelerates, thereby creating an economic boom. During periods of monetary tightening (such as now), the rate of inflation (money-supply and credit growth) slows down temporarily, causing financial accidents in a highly leveraged global economy. Make no mistake though, the response or cure offered by the central banks to every financial accident is always more inflation and credit.

At present, every central bank has assumed the role of an “inflation-fighter”. Interest rates are being increased in the majority of countries under the pretence of controlling inflation. However, it is worth noting that despite rising interest rates, our world is still awash in liquidity. Recently, the non-gold foreign exchange reserves held by the central banks rose to a record $4.4 trillion – up nearly 10% year-on-year! Emerging nations held a record $3.07 trillion and the developed nations held a near-record $1.33 trillion.

Opinion is divided as to whether interest rates will continue to rise. The majority seems to think that the Federal Reserve will not raise interest rates much further for the fear of seriously hurting the housing boom. However, I feel that the U.S. interest rates will have to continue to rise or else the U.S. dollar may stage a dramatic decline. Given a choice between protecting either the housing boom or an outright collapse in the U.S. dollar, I can assure you that the Fed will choose the latter. The truth is that the Fed exports U.S. dollars to the entire world and it will do everything in its power to delay the destruction of its merchandise.

If my above assessment is correct, you can bet your bottom dollar that stocks, bonds and property are going to come under serious pressure. Already, the real-estate market in the United States is showing signs of a slowdown as the establishment tries to engineer a soft landing. In my opinion, we now amidst a global housing bubble, which will eventually deflate due to rising borrowing costs. It is interesting to note that the bond yields fell between 1981 and 2003. As the cost of borrowing declined, housing as well as bond prices went through the roof. However, in June 2003, bond-yields bottomed out and have been rising ever since. The U.S. 10-year Treasury yield has now broken out of its 20-year downtrend and this is an ominous development. I would have to advise you to sell your leveraged properties and bonds without further delay. The great bull market in bonds ended in June 2003 and this is not a good time to be invested in fixed-income assets.

In a highly inflationary environment, stocks, commodities and real estate can all rise at the same time. Basically, an over-supply of paper money causes its purchasing power to diminish. I still maintain that over the coming decade, even if all assets (with the exception of bonds) continue to rise, I expect commodities to outperform all other asset classes.

WALL STREET’S WOEFUL WISDOM ON OIL STOCKS

China is exploding. The Middle East is imploding. Oil must be a “buy” … at least on dips. And if oil is a “buy”, oil stocks must also be a “buy” … at least on dips. Unfortunately, this sort of deductive reasoning has produced lackluster results of late. Near-record oil prices have failed to inspire much enthusiasm for oil stocks. Within this curious ennui toward oil stocks, we think we perceive a buying opportunity. But be forewarned, most of the sophisticated minds that populate Wall Street would disagree. Skepticism toward oil stocks remains as much a Wall Street hallmark as the “casual Friday” or the “glass ceiling”.

Wall Street analysts have been woefully underestimating the earnings potential of the oil sector ever since the oil bull market began. Eventually, such skepticism might produce an accurate forecast. But probably not while missiles are criss-crossing the Israeli-Lebanon border, nor while the Chinese economy is posting double-digit GDP growth. The fresh hostilities in Israel represent just one component of the supply risks that Wall Street analysts also underestimate. Perhaps that is why they spent most of the last three years underestimating oil company earnings. Early in 2005, for example, Wall Street expected ExxonMobil to earn $4.20 a share, while predicting that the oil giant’s earnings would FALL to $4.02 a share in 2006, and fall again to $3.95 a share in 2007. But so far, the energy markets have refused to accommodate Wall Street’s downbeat outlook.

ExxonMobil earned $5.35 a share last year, and is on track to book another big boost in profits this year. The current consensus estimate for Exxon’s 2006 earnings is $6.17 a share – more than 50% above the earnings that Wall Street expected just 16 months earlier. Ever since crude oil first broke above $35 a barrel in early 2003, Wall Street’s finest have been continuously chasing and revising their errant earnings estimates. And even now, despite being dead-wrong for several years, Wall Street stubbornly clings to its skeptical forecasts. The consensus expects Exxon earnings to FALL to $5.75 by 2008. Perhaps, as the oil skeptics seem to imagine, the Chinese economy will lurch to a halt, while peace suddenly breaks out in the Middle East. But in a world of scarce oil reserves, the bull market in crude deserves the benefit of any doubt. Especially when the doubt issues from Wall and Broad.

BROCADE IS JUST THE BEGINNING OF STOCK OPTIONS BACKDATING PROSECUTIONS WARNS SEC

The feds have put Silicon Valley on notice: there had better be a damn good reason for putting the wrong date on share allocations and then hiding options from Wall Street, otherwise you are in trouble – the kind of trouble that lands a man in jail for 20 years and costs him $5 million. Officials from the FBI and SEC took the unusual step of jointly announcing separate criminal and civil charges against three former senior Brocade Communications executives for securities violations covering $1 billion worth of stock options awards. These are the first charges brought in a national investigation involving 80 public companies, of which a “fair number” are based in Silicon Valley, the SEC said, with many believed to be in high-tech.

The Brocade trio face 20 years in jail and a $5 million fine each. It is not clear what, if anything, will happen to hundreds of Brocade employees who received the options. The FBI is prosecuting former CEO Gregory Reyes and ex-VP of human resources Stephanie Jensen, while former CFO Antonio Canova gets a civil action from the SEC for complicity. Hosting a packed press conference in San Francisco, investigators – sporting sharp suits, square jaws and poker faces – warned more prosecutions will follow. They refused to say which companies or individuals are next.

That is bad news for a Valley whose corporate culture was out of control in the late 1990s and early 2000s, the period covered by the Brocade indictment. Stock options were commonly seen by many as the best way to win and retain talent in an intensively competitive, bubble-fuelled dot-com environment. According to the SEC and FBI, backdating of shares to lure and retain employees became a way of life at Brocade. Reyes acted as a “one man” compensation committee – having been granted sole authority by the board – to award shares from the date Brocade went public in 1999. Jensen supported this by instituting a system that allowed Reyes to easily tack back and find low points in the company’s share performance. The scheme allegedly went as far to be formalized in an HR e-mail memo and to include the falsification of employee hiring documents.

The FBI and SEC said they are now taking a tough, and united, stand to help restore the public’s loss of confidence in the marketplace. Misallocation of shares in Brocade deceived investors and the public by back dating the company’s shares to a period when the price was low and then hiding the expenses that were incurred, they argued. The resulting restating of expenses has wiped at least a billion dollars off Brocade’s earnings between 1999 and 2004. The SEC expects billions more to be written off as other companies implicated in the growing scandal also restate their figures.

ARGUMENTS AGAINST INVESTING IN GOLD

Today, when asked about investing in gold, most people will just give you a curious look. This, however, is quite different from the response that would have been elicited just a few years ago. The events of the last year or so seem to have planted a seed in the collective consciousness of ordinary folks around the world who would have responded to the same question with a blank stare earlier in the decade. Today, many people may even get a little twinkle in their eye at the thought of buying precious metals as an investment – some perhaps recalling a recent article in the mainstream financial media about hedge funds, others remembering the words of a much older relative who spoke of purchasing gold coins many years ago. But, by and large, the arguments against investing in gold are still too compelling for most individuals today.

If you are under 50 years old, you likely have only the vaguest recollection, if any at all, of soaring gold prices years ago. As a college freshman in 1979, there are hazy memories of attending a lecture in Economics where gold’s ascent from $220 an ounce to two or three times that price was discussed. And, the early 1980s sale of a high school class ring that surprisingly fetched three times its 1978 purchase price can also be recalled. But aside from these events, a personal history involving gold is non-existent to me. That is, up until the turn of the century.

This is the strongest argument against investing in gold today – people are generally not familiar with the stuff after two decades of it being mostly irrelevant, and they do not feel comfortable laying their money down on something that their friends, family, or investment advisor have not yet sanctioned. It is OK to be wrong, but it is not OK to be wrong all by yourself. In that case, others just think that you are stupid, crazy, or both. The herd instinct and the preference for safety in numbers will forever make individuals poor investors – this is simply a fact of life that most, unfortunately, will never realize. This very much applies to the purchase of gold by individuals today.

Of course, this is one of the most compelling reasons to make an investment in gold at the moment – before friends, family, and every certified financial planner in the country is convinced of its enduring value when compared to paper money. Gold’s value relative to U.S. dollars is sure to rise dramatically in the years ahead as more and more ordinary citizens realize their government is devaluing their currency in order to make good on promises that it can not otherwise keep. Surely, the strongest argument against investing in gold today is that most people are not familiar with it, they may be wrong, and then they would feel stupid. But, what are the other arguments?

Ask almost any economist today and they will tell you that while gold is irrelevant in our current monetary system, it is also a poor investment because it provides no return. Stocks pay dividends, savings pays interest, bonds pay a coupon, and real estate generates rental income. But gold just sits there. It just sits there like it has been sitting there for thousands of years – never destroyed, rarely consumed, dug out of the ground at great expense, but most importantly (and in stark contrast to paper money or its electronic equivalent) gold is rare. Gold just sits there, waiting for the money/goods imbalance to be noticed by the population as a whole, who then assign a higher value to gold – not because gold has changed in any way or done anything at all, but as a reflection of the declining value of money created out of thin air. In the end, gold does not need to provide a return to investors – it simply goes up in value to reflect the growing imbalance between money and goods.

Many times the mainstream financial media has been heard to say that gold offers a “hedge against inflation”, and that some investors buy gold for this reason. Another argument against investing in gold is that there are other products available today that offer a better hedge against inflation than does gold. A prime example of such products are Treasury Inflation Protected Securities, better known as TIPS. With TIPS, the government uses the change to their index of consumer prices to determine an interest rate that guarantees holders of the securities a rate of return that is “protected” from inflation. First, the consumer prices used to calculate the guaranteed rate of return may not mesh well with your long-term plans. Second, since the government controls how much money is created, why do they not just create less money and then they will not have to offer “inflation protection”? Isn’t this similar to buying “protection” from the mob?

Although it is not clear why they keep gold in their vaults, the central banks of the world have in the past sold their gold into the markets causing prices to drop. The Bank of England famously sold about half of their stash when gold prices were at multi-decade lows back in 2001. While central bank gold sales have been occurring with much less frequency in recent years, and in fact the process seems to be reversing as central banks in Russia, Argentina, and elsewhere are now buying gold, these banks do still have a lot of gold – at least according to the records that they keep. Alan Greenspan once commented that the reason why central banks continue to hold gold reserves is in case there is a crisis. One look around the world today and the potential for crisis makes central bank selling of gold less likely.

With the stroke of a pen in 1933, Franklin D. Roosevelt outlawed the personal ownership of gold coins and bullion in the U.S. in an attempt to address one of the causes of the Great Depression. Citizens were required to sell their gold to the government at $20.67 an ounce, and shortly thereafter, the gold-dollar relationship was adjusted to $35 an ounce for purposes of settling international transactions. Gold was fixed at $35 an ounce until 1971 when Richard Nixon announced that the United States would no longer exchange gold for dollars at that rate, forever severing the link between paper money and gold. Three years later in 1974, the limitation on private ownership of gold was repealed, and the relationship between gold and U.S. dollars was left for markets to determine.

Some people believe that the U.S. government could once again confiscate gold should the situation warrant, and in light of government actions in the years since September 11th, this does not appear to be outside the realm of possibility. However, when you think about it, why would the government confiscate gold? It plays no role in any monetary system – paper money can no longer be exchanged for gold and the settling of international transactions no longer requires it. In the world of contemporary banking and finance, gold is irrelevant – a relic of the past – completely unnecessary. For the U.S. government and its central bank to confiscate its citizens’ gold would be the most colossal admission of failure for any monetary system in history, and conditions precipitating such action would surely be the end of the world as we know it. Perhaps shotgun shells would serve as better currency than gold coins in that case.

In the end there appears to be only one good argument against investing in gold today, and that is the possibility that you might look stupid in front of your friends and family. But ironically, this is probably the strongest argument for investing in gold, since these same friends and family will likely be buying gold for themselves in a few years. When every investment advisor in the land is advising that some portion of your investment portfolio be allocated to gold and when the shoeshine boy starts talking about gold mining stocks, that will be your cue to start selling, not buying.

My advice? Buy some gold, just do not tell anyone.

Rising global interest rates point to good times for gold.

Interest rates around the globe are going up because inflation and default risk are going up. Lenders want to be compensated for the chance they might not be repaid. When the currency seems to lose purchasing power, lenders want to recover the loss by collecting more interest, and borrowers are willing to pay it, in anticipation of even more currency depreciation. In the case of government debt, default risk is minimal since, if need be, the debtor government can always print what it owes. So rising interest rates on government debt are a clear reflection of rising inflationary pressure. And that is unquestionably a positive for gold.

The chart above shows that interest rates on 12-month government debt have been on the rise for 3 years, an indication of rising inflation expectations consistent with the strength in gold and silver over the same period. This chart and the next should debunk the theory you may have heard that rising interest rates are bad for the price of gold. The reality is quite the opposite.

A key measure of interest rates is how high they are after subtracting inflation. By that standard, they are not high now. Rates have risen, but inflation has also risen, so the effective real rate is still low. But higher inflation is going to lead to higher rates. In the past 12 months, the CPI has risen 4.2%, and it is running at a 5.2% annual rate so far in 2006, accelerating to a 5.7% annualized rate over the last 3 months. Yet, with rates on short-term Treasuries around 5%, they are still close to zero after inflation. And real interest rates are almost certainly lower than they look. To avoid reporting high inflation, the Commerce Department has been cooking the books over the last few years.

When viewed from this perspective, the recent short but sharp fallback in metals has little importance for investors. Gold ran ahead of itself, over-leveraged traders profited and then panicked, and the price took a dive. But there is been no change in the big picture for gold and silver. The world continues to be awash in a sea of debt, with sea levels still rising from the rivers of spending by the U.S. and other governments. The debt-heavy governments are egged on by organized constituencies and prevented from cutting spending – even if they ever wanted to – by statutory entitlement programs, entrenched bureaucracies and, in the case of the U.S., the war against Islam.

In fact, the situation is much worse – “intractable”, as Paul Volker recently put it – than it was leading up to gold’s bull market in the 1970s. Back then, the economy was not perched on a housing bubble perched on a pin. Back then, the world’s central banks still sought dollars. Back then, you did not have hundreds of trillions of dollars in exotic derivatives. And back then foreigners, many of them now truly hostile to the U.S., were not holding trillions of dollar assets as reserves.

It is important not to expect too much, too fast. Even as we write, the war rally has stalled, with traders selling gold due to the laughable contention that the U.S. dollar is a “safe harbor” currency, and because of the misperception that higher interest rates are bad for gold. The fact of the matter is that we are still in the traditionally slow season for gold, with Indian wedding season buying of gold still a month or so away. And while the now inevitable monetary crisis is coming soon, it likely will not come in the next month or two. Meaning the summer will continue much as it has, with weak volumes in the gold stocks and interim price swings as gold positions itself for a breakout this fall. Therefore, the best advice I can give for the next couple of months is to buy gold and quality gold stocks only on dips, and not on bomb-inspired rallies.

In time, you will know when the pieces have fallen into place for the next phase in this bull market of a lifetime. When it happens in a year or two years from now (I doubt it will be longer than that), inflation will be soaring, traditional equity markets in ruin, bond holders left holding empty bags, and gold will be trading well over that of the peak in the previous secular bull market. If you do not buy now, you may not regret it for the next month or two. But you will regret it soon. And for the rest of your life. Between now and then, by being disciplined and only buying the quality gold and silver stocks on the dips, you will have multiple opportunities to make life-changing returns.

WE’RE GONNA PARTY LIKE IT’S … 2006

The Berlin Wall came down in 1989, which just so happened to be the same year when Berlin techno-music lover and aspiring DJ Matthias Roeingh gathered about 150 of his fellow techno-fans on a local street, put speakers on top of his van, and “raves” – wild do-it-yourself dance parties that quickly gained worldwide popularity – were born. Who knew that just a couple of years later Matthias, by then known as DJ Dr. Motte, would throw the largest rave party on the planet? The annual event, called the Love Parade, grew bigger by the year. Eventually it got so huge that Berlin’s authorities officially registered it as a political demonstration. But there was hardly anything political about it. The several hundred thousand people came to Berlin every spring only “in the name of peace and love.” Hence the name: The Love Parade.

By the late 1990s, the Parade “developed into a worldwide symbol for peaceful youth culture” (Deutsche Welle). And in 1999 – just a few months before the all-time peak in German stocks – the Love Parade drew its biggest crowd ever. 1.5 million participants came for “24 hours of dancing and kindness among strangers.” But then, at the turn of the century, something changed. All of a sudden, Germans no longer wanted to “party like it’s 1999”. To the chagrin of the Love Parade fans, the event lost its status as a demonstration in 2001 and “began to slip into financial trouble.” Then, in 2004, after 16 consecutive years, the Parade was canceled. In 2005, it was canceled again. In fact, the whole rave movement was considered “near death”. But perhaps that diagnosis was a little premature.

Because this year, Berlin “felt the love once again as the Parade returned!” Due to a generous donation from a wealthy German entrepreneur, last weekend “hundreds of thousands of ravers” got a new chance to “hit Berlin to dance in the sun with their shirts off and revive the techno spirit of the 1990s.” But was that sudden “cash infusion” the real reason for the Parade’s comeback? Let’s look at it from an Elliott wave perspective.

Fans of the Wave Principle and socionomics, the science of social prediction based on it, know that the Principle governs a lot more than just prices in the financial markets. First and foremost, it defines the state of society’s overall mood. And the best indicator of social mood is the stock market. In 1999, Germany’s rising social mood pushed the DAX sky-high and brought out 1.5 million people to dance in the streets of Berlin. Then in 2000, the DAX went on a severe losing streak, indicating a shift in Germany’s mood from positive to negative. A year later, the number of the Love Parade attendees plunged, causing the event’s subsequent cancellation. But now that Germany’s social mood has recovered – as indicated by the DAX’s strong rally over the past three years – the tradition of the Love Parade has being revived.

Revived, and yet “something was missing,” as one 8-year Love Parade veteran put it. “Nothing is as much fun as this, but we can’t understand why we are not more people.” Why, indeed? Maybe Germans were just too exhausted from a month of football parties during the World Cup, which ended just the week before? Or maybe, after being canceled for two years, the Parade is still “too new” to attract the same huge crowds as before? Maybe. But it could also be that this year’s Love Parade drew a smaller crowd because judging by the position of the DAX – which is still below its all-time high – Germany’s collective psychology has not fully recovered yet from the plunge it took in 2002-2003. Furthermore, the losses the DAX has suffered since May also indicate that the country’s mood may be on a shaky ground. How will it all resolve? As is often the case, only a look at the long-term trend in the DAX can give you an answer.