Finance Digest for Week of October 2, 2006

IT IS “DEAL OR NO DEAL” AS THE HEDGES CLIP INVESTORS

We are living in interesting times. A popular TV program called “Deal or No Deal” – a high-stakes game show of odds and chance – says it all. On the show, contestants compete for cash inside 26 sealed briefcases. The show is exciting because so many contestants take very big risks and at each stage they are offered a “Deal” of a certain free winning or “No Deal”, which means they risk it all for a chance to win even more. The critical thing to realize here is that the contestants can only win because their own money is never at risk. This show is a sign of the times and parallels the mentality of many money managers and financial institutions. “Deal or No Deal” is, indeed, a study in human nature and has great bearing on more than a few hedge funds, financing institutions and companies. The message here is that there are too many people willing to make extraordinarily risky bets with other people’s money if they personally have a chance to win big.

Many hedge funds collect 2% for assets under management, and 20% of any winnings, but they do not offer a “claw-back” clause in their agreements. If a claw-back clause existed, investors in a hedge fund would be able to take back the previous winnings of their asset managers if too much of the hedge fund’s money they managed was gambled away foolishly. When financial interests are not clearly aligned, a trader can literally bet the bank. The recent Amaranth Fund story is just one example where a 32-year old “kid” bet tens of billions of investor dollars and lost $6 billion.

Think about it. What lunatic pension, endowment or advisor, would trust billions to someone who has barely lived through one economic cycle, or was just a child when Nelson Bunker Hunt and his brother lost everything on March 27, 1980 on “Silver Thursday”. The memories of today’s young asset managers are so short that they cannot even remember when 28-year old Nick Lesson blew up the Baring Investment Bank, a 233 year-old institution, or when Long Term Capital collapsed and folded in 1998 when it lost $4.6 billion in less than four months. Even after going through the 2000 stock market crash, the financial markets today are still running without adult supervision. I am placing my bets that Amaranth is not the last giant hedge fund disaster to play out.

The real risks to the market are not in the tens of billions of dollars that can be lost in highly-leveraged commodity futures, but in the hundreds of billions that can change hands now that total derivatives are around $270 trillion, and credit default swaps are over $23 trillion. In the credit default swap market, a hedge fund or a firm like JP Morgan or Goldman Sachs can collect cash payments today, with a promise to pay tomorrow if a bond or note defaults. Wall Street traders and hedge fund managers take the credit default swap premiums into income and assume that low volatility and low loss will run forever. The mentality on Wall Street is still all about making a year-end bonus big enough to retire.

Do the traders and money managers really care that they are gambling pension, endowment or shareholder money? Are they overly concerned if the losses pile up in housing, bonds, or corporate credits? Everywhere we look there are instances of decision makers getting to reward themselves over and over again. Accounting frauds, such as Enron, are in the headlines every day and back-dating options for corporate management has now been discovered at hundreds of firms. Corporate executives, money managers and traders, who get to measure their own performance, are putting their hands into your cookie jar and grabbing as many cookies as they can.

Low market volatility and credit spreads indicate that the markets perceive credit risk to be minimal. However, risk appears low only because the growth of derivatives, such as credit default swaps, has been exponential. All the hedge funds and major Wall Street players have been selling volatility and credit default swaps – especially credit default swaps on mortgages to buyers collecting far too few premiums to insure the risks. The retired Chairman of the Fed also assured us that the growth in derivatives lessens risk. Sadly, the same retired Chairman was on record just a few short years ago urging individuals to take out adjustable-rate mortgages when there was an incumbent President to re-elect and an economy to jump start.

Given human nature, the real risk in the markets is not just whether a stock goes up or down, but rather in the behavior of your asset manager. Investors beware! It is time to go back to only risking the money you can afford to lose, otherwise someone may already be playing “Deal or No Deal” with your money.

Weak results dim hedge funds’ luster.

When the hedge fund Archeus Capital opened to investors in 2003, it did so with high hopes and a glittering trading pedigree. Its co-founder, Gary K. Kilberg, was one of the aggressive Salomon Brothers bond traders memorialized in Liar’s Poker. By 2005, investors, enamored of its complex trading strategies, had poured $3 billion into the fund. Within a year, however, some bad bets and administrative troubles resulted in a spate of investor withdrawals and its funds shrank. Now, its assets are down to $682 million, several partners have left and its return for the year is a negative 1.9%, making Archeus the latest hedge fund to fall from its gilded perch. Hedge funds – investments for institutions like pension funds and endowments and the wealthy – have hit a rough patch.

Recently, a well-regarded fund, Amaranth Advisors, made a wrong-way bet in the energy markets and lost more than $6 billion in a week. It will dispose of its remaining assets. Even the flagship hedge fund run by Goldman Sachs, whose trading prowess has few peers on Wall Street, fell 10% in August. A fund at Vega Asset Management, once among the 10 largest hedge funds in the world, fell more than 11.5% in September, leaving it down 17.5% for the year. Its assets, which once topped $12 billion, are now $2 billion to $3 billion, a person close to the fund said.

If bull markets make geniuses, uncertainty unmasks them. Volatile energy markets decimated Amaranth, and bad bond bets and administrative issues sideswiped Archeus. The turnaround in the stock market – the major indexes fell sharply in the late spring and have since climbed back – has also tripped up hedge fund giants as well as some big-name start-ups that have struggled to meet already-diminished investor expectations. Returns for many hedge funds, which are supposed to be the market beaters, have paled in comparison with stocks. Hedge Fund Research’s weighted composite index is up 7.23% through September, according to a preliminary estimate, compared with the Standard & Poor’s 500-stock index, which, with dividends, has a total return of 12.4% over the same period. And yet investors have hardly blinked. Eager for the rich, if not always predictable, returns that hedge funds promise, they continue to pour money into them and hope the next fund with a big problem will not be one of theirs.

The rise of hedge funds’ fame and fortune happened quickly. In 2000, the stock market began to slide, and almost overnight, a band of obscure money managers became the new millennium’s masters of the universe. Soon, huge buckets of money rained on these stars – $99 billion flooded into hedge funds in 2002, according to Hedge Fund Research. Since the beginning of 2001, nearly 7,000 hedge funds have been started. With eye-popping compensation – the top manager took home $1.5 billion last year – hedge-fund performance, and the pay derived from it, redefined everything from job prestige on Wall Street to the price for art and real estate. So while there has been nothing like a sweeping shakeout in the business or a market crisis like the near collapse of Long-Term Capital Management in 1998, some hedge funds, including some of the high-profile “safe” names, have failed to show any Midas-like magic. Many of the big-name debuts of 2004, 2005 and even 2006 have produced lackluster results.

Hedge funds are Darwinian by nature. When returns are good, money flows in and when they are bad, investors scramble to get their money out as soon as possible. So the spigot of new money into hedge funds has run hot and cold. After tapering off in 2005, with $46.9 billion flowing in, there has been a revival this year, with more than $66 billion poured into hedge funds in the first half of 2006 alone. That flood of money is not likely to end even amid the recent stumbles by hedge funds. Pension funds, seeking to make up for years of being underfunded, have increasingly turned to hedge funds. Many funds that cater to such institutions boast they can deliver consistent medium-range returns – 8% to 12% – that permit institutions to better manage their liabilities. And endowments, which were among the earliest adopters of hedge fund investing, do not appear to be backing away.

Changes that are likely to come in the wake of Amaranth will be in the form of increased vigilance by investors. Managers of funds of funds and consultants say investors may now temporarily delay their investments in hedge funds as they try to negotiate better terms to redeem their funds in the case of a crisis. And there may be calls from investors for greater disclosure, especially regarding how the funds are using leverage and derivatives. In the case of Archeus, its marketing pitch, like that of most hedge funds, was its grasp of some of Wall Street’s more abstruse trading strategies. But as their case shows, a fund’s fortunes can change ever so quickly once the market turns. It shows, too, that beyond the flashy public implosions, many funds are struggling to survive, just a few years after successful starts.

Archeus is paring down. It has closed its London office, laid off workers and refocused its investment strategy. So far, results are less than promising. The fund was up only 1% in September. Now the founding partners are asking investors for a second chance. “We have learned a great deal from the various circumstances, events and issues we have encountered and, admittedly, some of the mistakes we have made,” they wrote in a letter to investors. What remains to be seen is whether investors, chastened by the events of the last month, will give them one.

HEDGE FUNDS HAVE GOTTEN RICH FROM CREDIT DERIVATIVES. WILL THEY BLOW UP?

The downfall of Amaranth Advisors, the hedge fund that lost $6 billion in a single week by betting on natural gas, was a special case. There was no domino effect taking down energy traders generally, no meltdown of an industry. But if you want to fret over the next financial catastrophes, turn your gaze away from energy futures and focus on something far more obscure: credit default swaps. Hedge funds are neck-deep in these derivatives, and if something goes wrong, the pain will be widespread.

A credit swap is an insurance policy on a bond, often a junk bond. The fellow selling the swap – writing the policy, that is – collects a premium. If nothing goes wrong, he pockets the premium and looks like a financial genius. But if the bond defaults, the swap seller has to make good. The notional amount – the aggregate of bonds, loans and other debt covered by credit default swaps – is now $26 trillion. This is a staggering sum, twice the annual economic output of the U.S. Hedge funds account for 58% of the trading in these derivatives. Selling protection has been a big moneymaker for funds like $23 billion (assets) D.E. Shaw and $12 billion Citadel, say market participants, and for specialized outfits like Primus Guaranty (NYSE: PRS) in Bermuda, which took in $57 million in the first half of 2006 selling protection on $1.6 billion in debt.

With corporate debt defaults low these days, the temptation is high to write insurance policies on bonds. A hedge fund can make $60,000 to $1 million a year selling protection on $10 million in bonds. It is like finding money in the street. Unless, of course, the economy suddenly enters a recession. If that happens, hedge funds addicted to the credit market will be in deep trouble. There must be a lot of investors – or credit speculators – who are cavalier about corporate defaults because junk bonds are trading at yields only modestly higher than the yields on safe U.S. Treasury bonds. Today’s tight spreads do not leave much of a cushion to cover defaults. There is a close correlation between yield spreads and credit default swap prices. Selling a credit swap is equivalent to buying the corporate bond on margin. If you buy a junk bond with borrowed funds, you collect the high coupon on the bond while paying out a lower amount. Either way – with a swap or a margined bond trade – you pocket the spread, unless and until the corporate bond gets into trouble, at which point you are sitting on a painful capital loss.

The credit-derivatives business is dominated by 14 dealers, including JPMorgan Chase, Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. All have staggering amounts of derivatives on their books: JPMorgan’s notional exposure was $3.6 trillion as of June 30, according to the Federal Deposit Insurance Corp., which is almost three times assets and 30 times capital. Credit derivatives at Wachovia Corp. have jumped 7-fold since 2003 to $170 billion, more than three times capital. Banks love derivatives because they provide multiple ways to make money. Revenue from all types of derivatives will hit $34 billion or so this year at U.S. banks and securities firms, says Tower Group, a financial-research outfit, with hedge funds generating much of the money.

Hedge funds also buy the potentially toxic waste that banks create when they bundle credit derivatives into so-called synthetic deals. By separating a portfolio of derivatives into different tranches, banks can create virtually default-proof securities for conservative investors – if somebody else is willing to buy riskier “equity” tranches whose value vaporizes when as few as one or two of the underlying bonds default. Banks once kept such tranches on their books as a cost of doing business. Now, says Fitch Ratings, hedge funds are buying them to goose returns. Regulators say there is no reason to worry. Yet.

But banks can make only rough guesses at the value of swaps and thus how much collateral their counterparties need to ante up. Even the smartest guys can come up shorthanded. Ask Charlie T. Munger, vice chairman of Warren Buffett’s Berkshire Hathaway, which lost $404 million unwinding credit, interest-rate and foreign-exchange derivatives positions in its General Re unit. “When we ran it off, it didn’t run off at anything like book value,” Munger says. “I would bet a lot of money there are some terrible valuations on the books of corporate America.”

Like swaps on interest rates and foreign currency, credit swaps outstanding dwarf the underlying bonds in circulation. That can be a problem when a creditor defaults, as with Delphi and other auto parts makers earlier this year. With most swaps, the buyer of protection has to hand over defaulted bonds to get its money – tough to do if, as with Delphi, $20 billion in protection has been written on just $2 billion in bonds. Calamity was averted by the International Swaps & Derivatives Association, which held an auction to determine the amount of cash protection buyers would get.

The derivatives market weathered its last near-death experience in early 2005, when credit agencies downgraded the debt of General Motors and Ford, devastating the value of the most risky synthetic derivatives. Hedge funds thought they had been smart by locking in a 3-to-4-percentage-point spread by selling protection on those tranches and buying it on less risky ones. Suddenly, though, they had to close out their moneylosing positions. So many funds had made the same bet that it “magnified the deleveraging process,” in the dry words of the Bank for International Settlements. Translation? “Banks refused to buy or sell,” says Randall Dodd, who runs the Financial Policy Forum, a Washington think tank. “These guys couldn’t trade out of their positions.”

Bottom-fishing investment banks eventually bailed hedge funds out of their problems. But Dodd and other critics wonder if banks have extracted enough collateral from their hedge fund clients to protect themselves in a wider crisis.

NEAL WOLKOFF IS TRYING TO MAKE THE AMERICAN STOCK EXCHANGE SAFE FOR INVESTORS AGAIN. GOOD LUCK

Tag-it Pacific is a hot little company to invest in. Put aside that the distributor of zippers lost $15.5 million on sales of $43.5 million in the 12 months ending June 30. If you had bought $10,000 worth of its shares at the beginning of the year, you would have $26,000 in your pocket right now. You could have done well by Globix Corp. (GEX), too. Shares of the New York City Internet services provider have quadrupled since January 3 – after losing half their value in late 2005. Such are the gut-clutching swings of shares on the American Stock Exchange, which, year-to-date, has outperformed Nasdaq and the New York Stock Exchange.

There are also plenty of losers on the Amex: 45% of its listed companies have dropped in market value this year. Outfits like GlobeTel Communications Corp. (GTE), which recently traded at 59 cents a share after scratching $3.96 last December. The Florida company purports to have a state-of-the-art voice telecom network. But its communications “Stratellites” turn out to be high-altitude, solar-powered, helium-filled blimps. The Amex recently threatened to delist the company for overhyping press releases, “filing incomplete, misleading and/or inaccurate” financial statements and “providing materially false and misleading information” to the exchange’s compliance cops. Yet GlobeTel still trades on the Amex.

So does Imergent, which claims to help small businesses set up Web sites. This Orem, Utah company junk-mails thousands of free invitations to all-day seminars at hotels across the country, promising Internet riches in the course of peddling do-it-yourself e-commerce software from $2,500 to $5,400. There have been scores of client complaints about the company (visit ripoffreport.com) as well as its sketchy customer support. There has also been a fistful of investigations by Australia and several U.S. states into whether Imergent engages in deceptive or problematic business practices, and the company has paid out millions of dollars to settle many of these cases. The S.E.C. is looking into Imergent’s disclosures. Then there is Tri-Valley Corp. of Bakersfield, California, which calls itself an oil and gas exploration and production company but has not drilled a producing well since 1997. Tri-Valley has lost money in 38 of the last 44 years.

What is it with the Amex? For a 164-year-old institution that should be a mighty oak of capitalism it has an undeniably seedy appearance. Since an options-trading scandal brought investigations from the Justice Department and the SEC, the Amex has shrunk to 427 domestic companies, 9% of all listed U.S. stocks. Its $565 billion in total market cap disappears in the shadows of the NYSE ($22.6 trillion) and the Nasdaq ($3.8 trillion). It costs only $211,000 to buy a seat on the exchange, a 65% plunge since 2001. It has even managed to lose some innovative business it spawned. In 1993 it opened trading in exchange-traded funds (ETFs), the baskets of securities that trade like stocks. Its share of that business, 98% five years ago, is now down to 65%. Once the center of stock-options trading, the exchange now ranks fourth in volume.

Still, for investors who think that newer and untested business ventures should have an incubator in which to hatch, or who just want some lively action, the Amex has its place on Wall Street. By providing liquidity, 600 floor traders and a network of broker-dealer firms, it offers life support to many enterprises that do not qualify for the NYSE and might get overlooked on Nasdaq. Yet, of the 201 companies that left the exchange since 2004, 89 were delisted. Lynn Turner, a former chief accountant for the SEC, says the Amex has become the new “version of the Vancouver Stock Exchange,” Canada’s now defunct magnet for scandal and fraud.

Neal Wolkoff takes a different view. “We’re not limited by the prejudice against small entrepreneurs and capitalist dreamers,” he retorts. Then, again, he has to say such things. Wolkoff, 51, is Amex’s chairman and chief executive. He is charged with rescuing it from scandal and financial misery, and making it safe again for investors so that, maybe, he can take it public next year. It is a nearly impossible task. Chase away the companies with flaky balance sheets and there might not be enough left to sustain the exchange.

Wolkoff is Wall Street’s Mr. Clean – just the kind of fix-it guy the Amex needed. In late 2004 Wolkoff crawled aboard as a troubleshooter, lured by Amex seat owners who had seen him in action at the New York Mercantile Exchange. He came up with a plan to lop off some heads – forcing out 15 higher-level executives – and get the SEC off everyone’s back. Wolkoff took over as chief executive in April 2005. Slowly, things seem to be turning upward. But the Amex is fast becoming a second home for pink-sheet stocks. That includes “special purpose acquisition companies” – shells with no operating history and no revenue, just the intent to buy another enterprise. While SPACs have been shunned by the NYSE and Nasdaq and targeted by state regulators, the Amex has welcomed them. Akin to SPACs are small enterprises that gained public life through a reverse merger.

The Amex is still very much a casino. “If you invest in these companies,” Wolkoff says, “you’re taking a risk.” Fair warning.

THE $100 MILLION CLUB

Riled up over backdated stock options? This is a mere distraction, a tempest in a teapot. The thing shareholders really ought to be worried about is not the date on the option but the number of zeros on the count of shares. You want your chief exec to be motivated, of course, but would a $20 million or a $50 million jackpot not be pretty good motivation? “In the late 1990s,” says Michael Melbinger, head of the exec comp practice at law firm Winston & Strawn, “executives typically got whatever they wanted.” Here are some sitting on at least $100 million worth of options.

COMPANY’S TAX FOOTNOTE MAY SIGNAL WEAKNESSES IN THE CASH FLOW

Praxair (NYSE: PX), maker of industrial gases, has expanded earnings per share at a 15% clip over the last five years, which seems to justify the steep price/earnings ratio of 24. But here is one reason to be a little cautious: Its cash tax bill is low. Over the past five years, according to its profit-and-loss statements, Praxair’s income tax tab has totaled $1.1 billion. But the cash flow statement reveals that checks written out to the tax collector totaled only $512 million. The difference has to do with deferrals. The $1.1 billion figure is according to Generally Accepted Accounting Principles (GAAP), which use the pretax income reported to shareholders as the starting point. The lower figure implies a lower pretax income reported on tax forms.

Deferring taxes is a good thing. By claiming accelerated depreciation and other breaks a company in effect gets an interest-free loan from the government. But a wide discrepancy raises questions. Is the depreciation used in reporting profits meager? Brian Hamilton, director of research at Sageworks, a research firm, says a GAAP/cash tax discrepancy is a reason to look further. His study of 35 companies over five years found $15 billion was reported as owed on the P&L, 57% more than what was reported as paid on the cash flow statement. With Hamilton’s help, we found companies with big tax gaps and also another hint of weak earnings quality, namely, low free cash – cash from operations minus capital expenditures. The companies in the table have much lower free cash than earnings. Some capex is for expansion, and Praxair is no exception. But some merely replaces worn-out equipment. The flow-of-funds statement will not make the distinction for you.

SELL SHARES OF SMALL AND MEDIUM-SIZE COMPANIES, BUY THE SHARES OF BIG COMPANIES

Since the end of 2002 the small- and midcap indexes have been the place to be. From Dec. 31, 2002 to the middle of this September, the Russell 2000 small-cap index is up an annualized 20.4% and the Russell midcap index is ahead 21%, which handily bests the 13.5%-a-year performance of the S&P 500 (all sizable stocks) and the 14.3% on the Russell 1000 large-cap index. Is the fact that small companies have been hot a reason to buy them now? No, just the reverse. You should sell shares of small and medium-size companies. Put the proceeds into the shares of big companies.

Currently the Russell 2000 index of small stocks is trading at 34 times trailing earnings. The Russell midcap index will cost you a multiple of 25 of its earnings. You can get a much better buy on the big-company S&P 500, at 17 times earnings. If anything, smaller companies should trade at a price/earnings discount to their larger kinfolk. The balance sheets of smaller companies are typically weaker than those of big companies and their shares more volatile and less liquid, so investors should demand higher returns from smaller companies. That usually translates into lower multiples.

Stocks indexes can be trendy. For the past several years the small companies have been outperforming the big ones. Time for the cycle to reverse itself. In the 1960s and early 1970s large-cap stocks dominated. In the two-tier market from 1970 to early 1973 the Nifty 50, as the 50 big-cap favorites were known, had outstanding showings, while small and midcaps floundered. Then in the late 1970s and early 1980s small and midsize issues were the rage, smartly outpacing the large stocks. Small caps went on to fade for a decade. However, just as the pronouncement was made in the mid-1990s that the days of smaller-stock outperformance had gone the way of the pterodactyl, they recovered and gave their happy investors sizzling appreciation to the end of the decade.

After all, the market returns to realistic valuations over time. When any of these groups become cheap, they bounce back and outperform – and are not content merely to catch up to the reigning favorites but, driven by momentum, move to overly lofty levels for a while. That is the danger point, the time to think of shifting out and taking profits before the inevitable descent. We are near that point today, with the large caps again likely to trounce their smaller brethren. Investors should follow up by buying strong large-cap stocks with good earnings outlooks and growing yields. They are cheap. Particularly cheap are the energy producers. It stands to reason that earnings comparisons will start looking unfavorable, what with oil off from its $77 high to a recent $60. But even allowing for that, oil companies are too cheap.

IT MAY BE TIME TO GET MORE DEFENSIVE WITH YOUR PORTFOLIO

Most major polls of economists have said the chances of a recession and its ill-begotten progeny – a bear market – are very low. While stock market bulls may take comfort in that, they should remember this: Not one recession in the past 50 years was forecast in advance by a major poll of economic forecasters, said James Stack, a market historian and editor of InvesTech Research. Recessions and bears can and often do arrive unexpectedly. Savvy investors simply cannot rely on assurances that the economy will not lapse into recession – generally defined as two consecutive quarters of negative economic growth. Recent polls of economists put the odds of this at less than 25%.

“At this stage of an economic recovery – now going into the fifth year – it is time for investors to get more defensive and more conservative,” Mr. Stack said. “They have to navigate their portfolio through treacherous waters for the next six to nine months.” That is because bear markets typically presage recessions and can lop off 20% or more of an investor’s portfolio. Remember, a particularly vicious bear market preceded the recession of 2001, and before it was over many stock and mutual fund investors saw the value of their stock portfolios sliced in half.

No one is predicting that kind of carnage this time because the economic and investing climate is much different. For starters, there is no technology bubble or manic menagerie of day traders driving stock prices to outlandish levels. But even many bullish prognosticators say this is a mature bull market, the economy is clearly slowing, and it is probably time for prudent investors to take steps to protect their portfolios. “People shouldn’t overreact, but there are some warning flags out there,” said James Weiss of Weiss Capital Management.

Bulls argue that the economy is ginning along nicely, expanding at a 2.5% clip. Inflation, while worrisome, is contained. Stock valuations are modest, at about their historical averages; and corporate earnings growth is still in the double digits. “The odds still favor an OK market, and there are enough positives to keep it from going negative,” Mr. Weiss said. “But there are enough warning flags flying that investors should take precautions.”

Many market analysts put the drop in new-home sales and prices at the top of their list of concerns. Rising home prices stimulate the economy because consumers feel wealthier, and that encourages spending. Conversely, falling prices should curb consumer spending. The number of new-home sales has dropped 20% over the past year. A recent Merrill Lynch economic report said that up to half of the nation’s economic growth is related to housing sales, construction and spending from home equity loans. Another warning sign is that new-car sales are down about 5% from a year ago. This has happened six times over the last 40 years, and in every instance the economy was either lapsing into recession or already in recession.

Perhaps even more troubling is the so-called inversion of the bond yield curve. The issue is a bit technical, but market pros place a lot of significance on the difference between short- and long-term U.S. Treasury yields. Generally, investors demand a higher interest rate yield on, say, a 10-year U.S. Treasury bond than on the shorter-term bills, to compensate for the risk of higher inflation and interest rates later. However, in recent months the yields have inverted, with the two-year note currently yielding 4.68% and 10-year Treasuries yielding a slightly lower 4.63%. A recession has followed seven out of the last eight times that the yield curve has inverted. “The yield curve shows an 88 percent probability of a recession beginning sometime between now and the end of next year,” Mr. Stack said.

Finally, investors should not make too much of the recent rally in the Dow Jones industrial average. The Dow is up about 8% since mid-July and seems poised to break its all-time closing high set in 2000. But while the Dow index has performed well of late, the Russell 2000 index – the most-watched index of small-cap stocks – has dropped more than 10 percent since May. In other words, the rally is narrow, not broad-based, and that is typically not a good thing. “More than a little disturbing is the deterioration in these smaller, secondary stocks,” Mr. Stack said.

Prudent investors can take steps to lessen the financial pain if the market goes in the tank, and at the same time not completely miss the bull if it continues. It is never a good idea to suddenly jump completely into or out of the stock market. Skittish investors might be tempted to dump all of their stocks and shift to cash or certificates of deposits. Unless you cannot sleep at night, don’t do that. “Stock market declines are normal, happen frequently and are not a reason to sell quality investments,” Alan Skrainka, chief market strategist at Edward Jones, wrote in a recent report. And he said investing success or failure is often determined by “your actions during a stock market decline.” Below are some tips from the pros. “Investors shouldn’t structure their portfolio with only one view in mind,” Mr. Weiss said. “Don’t assign to any scenario a 100 percent probability of that happening. Things just don’t work that way.”

FEAR WILL FADE

In a national election, structure trumps popularity. Structure means things like which seats do not have an incumbent running, which party has more Senate seats up for reelection, which party has more money in the bank. These factors count more than the fact that George Bush is unpopular. I predict that the GOP will lose seats but not enough seats to lose either house of Congress.

If I am wrong there are only three possibilities. One is that the Democrats win one house but not both. Another is they win both houses but with weak majorities. The third is a Democratic landslide. With the first two, the outcome is gridlock, the mirror image of what we had in the late 1990s, when Republicans had Congress and Bill Clinton was President. The market loves gridlock. Nothing gets done. That is, we have no tax or regulatory upheavals. For structural reasons, I believe there is zero chance the Democrats will win by an amount greater than gridlock – by enough, in other words, to override a Bush veto. There just are not that many iffy seats. Not even close.

Still, suppose I am wrong. Look ahead. We are only three months away from the third year of George Bush’s term. In the entire history of the S&P 500 there have been only two negative third years of any President’s term. They were both long ago: in 1931, in the midst of the 1929-32 crash, and in 1939, as we entered World War II. Both very weird and unusual times. All other third years were double-digit positive, except single-digit positives in 1947 and 1987. The average return in third years is 20%.

In fact, there have been only five negative S&P 500 years in the back half of presidential terms. Market risk is highest in the front half of Presidents’ terms, which is historically when most attempts at redistributive legislation have occurred. Once the midterms are over, it gets better. It will be no different in 2007. If the S&P 500 is up, the world market will be, too. Good times are close at hand. The time to buy is now, before the perception of political risk fades.

LENDERS BEHAVING BADLY

More than a year after Alan Greenspan warned of the “potential for individual disaster” from a new breed of mortgages that were helping to fuel the housing boom, federal regulators finally are trying to do something about it. Last week, in a jointly crafted message on so-called exotic mortgages, multiple government agencies warned banks in strong terms to make sure borrowers can pay back the full amount of what they borrow and that homeowners know that a low monthly payment today could be shockingly high later.

America’s real-estate boom may be over now, but millions of homeowners who thought they were borrowing their way into wealth find themselves instead holding a ticking time bomb, a toxic mortgage with a potential payment far larger than they can afford. Bank regulators knew more than a year ago that lenders were aggressively marketing interest-only and payment-option adjustable-rate mortgages to consumers who did not fully understand what they were buying. In July 2005, several government agencies teamed up to write guidelines intended to set lenders straight.

In the meantime, the runaway writing of these mortgages went on unchecked, and the fact that nobody in government stood in the way highlights the fact that a patchwork of government bureaucracies was ill-equipped to bring the practice under control, lawmakers and regulators say. The regulatory void took time to fill, as the Office of the Comptroller of the Currency tried to get four other federal agencies to unanimously endorse the guidelines that went into effect last week. “We saw the potential for problems occurring,” said John Dugan, the comptroller of the currency, a Treasury Department unit that regulates nationally chartered banks. “There have been some very abusive problems [by institutions not covered by the guidelines]. … We just don’t have jurisdiction,” Dugan said, expressing hope that state regulators would follow with strong guidelines soon.

While Dugan’s group wrangled among themselves and with the industry about how to word their warning, the popularity of the mortgages exploded, particularly in the booming subprime market that targets borrowers with lower credit ratings who are generally less sophisticated. The subprime market is largely outside the jurisdiction of federal regulators. About one-third of the mortgages sold in the last year were devised to minimize the initial monthly payment to make it seem as if buyers could afford a more expensive home. The cost of that Mephistophelian bargain comes later, when the monthly payment is reset to cover all the deferred interest charges, plus, in some cases, the extra principal. Banking industry officials are quick to defend exotic mortgages as financial innovations that have enabled more people to be homeowners even when prices were soaring. In some instances, according to regulators, the lenders knew that the only way the loan could be repaid was to either refinance or sell the home. Studies show that a large number of borrowers with simple ARMs do not understand the terms and underestimate the amount their mortgage payment could rise. Nontraditional ARMs are even more complex.

The housing credit bubble led to the growth of exotic loans, which, in a vicious spiral, drove prices even higher, said one observer. In a bubble, “the financing gets progressively worse. At the end, you get nuttiness,” said Dean Baker, an economist for the Center for Economic and Policy Research, a Washington think tank. Finally, prices got so high that “the only way people could buy houses was by bending the rules,” said Baker, who has been warning about the real-estate bubble for years.

In the Orwellian parlance of the mortgage industry, loans that ignore the true ability of the borrower to pay for the loan are called “affordability” products. Most of the exotic loans have low introductory interest rates that ultimately adjust to market rates, usually after two years. Some loans require that only the interest be paid, putting off the day when the borrower must start to pay down the principal. Some of the loans allow borrowers to make a monthly payment that does not even cover the interest, resulting in a negative amortization when the unpaid interest charges are added to the principal. And most of such loans sold in the subprime market have large prepayment penalties that make it expensive to refinance.

Now, with housing prices flattening out, many buyers will find they do not have enough equity in their homes to refinance, and it may be difficult to find someone who is willing to take the house off their hands at the inflated price they paid. Their only option could be foreclosure. The payment shock can be extreme even if interest rates do not rise. For example, Sandra Thompson, acting director of supervision for the FDIC, told senators recently that the monthly payment on a $200,000 option ARM could rise from $643 in the first year to $1,578 by the sixth year. And the unpaid principal would rise from $200,000 to $214,857.

Once upon a time, mortgage lending was as staid a business as you could find. Bankers offered 30-year fixed mortgages to borrowers who had a 20% down payment and sufficient income to make the monthly payments. They would reject any loan that required a payment more than 29% of a buyers’ gross income or that would result in total debt service higher than 36% of gross income. Those stringent standards kept a third of American families renting. Gradually, the industry began offering mortgages to families that did not previously qualify. Adjustable-rate loans, balloon loans, second mortgages and other innovations allowed more people to buy. Today, a near-record 68.7% of U.S. homes are owner-occupied, up from 63% in the early 1960s. Since 2000, the pace of change has intensified, contributing to an unprecedented housing boom.

First, the growth of the secondary mortgage-backed securities market has meant that the risks of default or prepayment are being shunted away from the lender to others, such as pension funds or hedge funds, where potential losses are of no concern to federal banking supervisors. Second, the subprime market has exploded, rising from under 9% of the market in 2003 to more than 20% today. Third, competitive pressures have driven even the stodgiest and most conservative bankers into the embrace of exotic mortgages. “At a time of a speculative boom in real estate, market participants find themselves in a moral dilemma: lenders cannot easily maintain their high lending standards and stay competitive when other lenders are weakening standards,” said Robert Shiller, an economics professor at Yale who has become known as an expert on financial bubbles. “At this time, regulators of lending institutions have some of their most important work to do, and, at the same time, it is especially difficult for them to do it.”

Although the regulators have finally taken a tougher stance against the most aggressive marketing of exotic loans, it may be the market that finally reins them in. Such loans only make sense to most buyers if they think can build equity from rising house prices. But prices have flattened out and probably will decline in many areas. Few buyers will stretch their ability to pay for a home when they know they can just wait for lower prices.

ACROSS U.S., HOUSING COSTS RISE AS BURDEN

The burden of housing costs in nearly every part of the country grew sharply from 2000 to 2005, according to newly public Census Bureau data. The numbers vividly illustrate the impact, often distributed unevenly, of the crushing combination of escalating real estate prices and largely stagnant incomes. While many of the highest home values were on the coasts, in places like Southern California and Manhattan, many of the biggest jumps in the percentage of people paying a burdensome amount of their income for housing occurred in the Midwest and in suburbs nationwide, making it clear that the housing squeeze has reached deep into the middle class.

In New York City, more than half of all renters now spend at least 30%t of their gross income on housing, a percentage figure commonly seen as a limit of affordability. In Staten Island, the percentage paying at least 30% of income rose to nearly 60%, up from 40%. “Housing prices have gone up much more than incomes have,” said Christopher Jones, vice president for research at the Regional Plan Association in New York City. “Clearly, you can’t sustain that sort of imbalance over the long run. There’s only so long that housing prices can go up without sustained increases in income to support them.”

The data was collected throughout 2005, some of it before the real estate market began softening over the past year. While the escalation in house prices that began in the mid-1990’s has slowed down in most places, and while prices are even dropping in some markets, rents are currently rising.

Historically, it is not unprecedented for housing prices to rise faster than household incomes, since housing prices fluctuate more than median in. “People want to hang on and stay in the market,” said William H. Frey, a demographer at the Brookings Institution in Washington, “and they are willing to stretch themselves to find or to rent a house that is suitable.” The places with the highest overall percentages of people carrying a heavy housing burden were in fast-growing areas of California, Colorado and Texas. In Southern California, Temecula and Hemet had the highest percentages of renters paying at least 30%, with 74 and 73% of renters at that level. Boulder, Colorado, and College Station, Texas, held the record for renters spending at least 50%, with 47 and 46%.

CHINA IS ALLOWING THE MARKET TO PLAY AN INCREASING ROLE IN RENMINBI’S EXCHANGE RATE VALUE

China is allowing the market to play an increasing role in setting the exchange rate value of the renminbi, while weakening the influence of a reference basket of currencies, according to Zhou Xiaochuan, central bank governor. In an interview in Caijing, a leading Chinese news magazine, Mr. Zhou said Beijing was committed to moving gradually towards a more flexible exchange rate mechanism.

The remarks from the governor of the People’s Bank of China will fuel expectations that Beijing plans to allow both a further appreciation of the renminbi against the dollar and greater exchange rate volatility. It may also help to soften criticism from the U.S. in particular of what critics argue is an undervalued currency that gives Chinese exporters an unfair trade advantage. U.S. senators Charles Schumer and Lindsey Graham last week abandoned a bill that would have imposed a 27.5% tariff on Chinese imports but promised a broader attempt next year to encourage China to revalue its currency. Since a one-off 2.1% revaluation against the dollar last year, Beijing has maintained what it calls a “managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies.” The role of the currency basket was “gradually diminishing” in favor of market supply and demand, Mr. Zhou told Caijing.

VOLCKER, CORRIGAN, MCDONOUGH & GEITHNER

The Women’s Economic Round Table sponsored a panel discussion in New York that featured New York Federal Reserve Bank President Timothy Geithner, former N.Y. Fed President and Fed Open Market Committee Chairman Paul Volcker, former N.Y. Fed chief and FOMC vice-chairman Gerald Corrigan, and former N.Y. Fed President William McDonough. The discussion of monetary policymaking amongst some of our most seasoned central bankers ran the gamut from inflation, to asset bubbles, to communications, to Long Term Capital Management and supervision. I have extracted quotes from what I found to be (transcribing from a recording) an interesting and, at times, enlightening 90 minute discussion.

THE RETURN OF M3

Someone has figured out a way to keep the M3 money supply figures going since the Fed stopped publishing them back in March. The folks at a site called Now and Futures extrapolate an M3 number from some other stats the Fed still publishes. See the chart for how M3 has continued to grow since March.

DID HE REALLY SAY THAT?

In the past two weeks I was treated to two particularly moronic public statements from market experts.

Last week, during an interview on CNBC, Dennis Gartman, editor of the highly regarded Gartman Letter, asserted that the storage currency of choice among drug traffickers, arms dealers, and the Russian Mafia had switched from $100 dollar U.S. bills to €500 Euro notes. Gartman proclaimed the development to be bullish for the U.S. economy and bearish for the Euro zone. Say what? Gartman’s “logic” was that when the dormant $100 bills sitting in attaché cases, safety deposit boxes, and mattresses returned to America, the additional spending would boost the U.S. economy. Conversely, he asserted, the removal of euros from circulation would hurt the euro-zone economies. Basically, Gartman’s comments boiled down to the belief that economic growth can be created by introducing more money into circulation. Or, more precisely, that inflation creates prosperity.

The reality is that Americans receive a huge subsidy as a result of U.S. currency being stashed away in foreign suitcases. It is like writing checks that no one cashes. Dollars circulating abroad do not bid up consumer prices at home, which results in Americans having more goods to consume at lower prices. If the hoarded bills were to suddenly return to domestic circulation, the result would not be more growth but only higher prices and interest rates. Alternatively, were those dollars deposited in foreign bank accounts, Americans would be required to pay interest on balances that previously earned nothing. The fact that criminals increasingly prefer euros to dollars speaks volumes. If only Gartman had the good sense to listen.

Going from the sublime to the ridiculous, this week, in response to the first national year-over-year decline in housing prices since 1995, David Lereah, chief economist for the National Association of Realtors said “We’ve been anticipating a price correction and now it’s here. The price drop has stopped the bleeding for housing sales. We think the housing market has now hit bottom.”

First of all, when did Lereah ever predict a price decline? Isn’t he the same guy who constantly assured us that real estate prices would never fall? That all that would happen to prices is that they would rise more slowly. Second, Lereah is no more an economist than Henry Blodget was an analyst. Despite their titles, both were hired to help salesmen move inventory. For Blodget it was internet stocks, and for Lereah it is houses. Realtors cannot convince as many people to over-pay for houses if their own economist forecasts prices to drop. Why this man still gets taken serious by the media is beyond me. Finally, what the hell is he talking about? How can he say that the bleeding has stopped, when its barely just begun? It reminds me of the Monty Python skit where the Black Knight claims his severed limb is “just a flesh wound.” Does it seem feasible that the biggest real estate bubble in U.S. history would bottom out after a mere 1.7% price decline? What signs could he possibly see to confirm that the housing market has bottomed?

Anecdotally, the house I rented two years ago, and moved out of six months ago, sits vacant, despite its advertised rent being 15% below what I initially leased it for. In addition, when I first rented it in New Canaan, Connecticut there were only about a half dozen single family rentals available there. Now there are over a hundred. The reality for real estate is that the only visible signs are those confirming the formation of a major top. It is more likely that Mr. Lereah saw Elvis than a bottom in the housing market. My guess is that we are a very long way from a bottom, and by the time its visible, Lereah will be out of a job.

History always finds her man.

The U.S. housing market is not my beat any longer (although if it precipitates a recession in the U.S. and then the globe, I guess it IS my beat, even from Australia). But I love how history always finds her man, the man to personify all the mistakes and stupidities of financial folly. For the housing bubble, that man is indisputably David Lereah, the chief economist for the National Association of Realtors. The story of the housing bust would play out just fine without Lereah lifting his voice. The facts are what they are. Over the next 18 months, $2.6 trillion in ARMs will adjust – and many speculators, flippers, and first-time buyers will face rising payments and falling market values. Ouch.

We learned that median sales prices on existing homes fell 1.7% in the last 12 months. It was the second largest decline in prices in the 30-years data have been kept and only the 6th recorded year-over-year decline in the last 38 years. We suspect it will not be the last. What did Lereah have to say? “The price correction is a welcome development.” It is? To whom? “The price drop has stopped the bleeding, sales have hit bottom. Sellers are finally getting it.”

Here it pays to be even more suspicious. Back in 1999 at the height of the Internet bubble there were two kinds of investors. Those who “got it” and those who did not “get it”. I never got it back then, and I am not sure I get it now. Lereah is telling us that sellers have recognized that in order to sell their homes they will have to accept a smaller gain, or even a loss? He says falling prices will help sales from falling even further. “If that’s so, we’ll have achieved a soft landing,” Lereah said.

If falling prices and huge incentives are not already drawing buyers into the housing market, what will? The prospect of a quick gains and a flip? That is history. Compelling investment value? Not yet. Maybe after another 20% decline. But even then, we may never see another bubble in housing like the one we watched the last few years. Future housing gains will be the plodding, steady kind that come in the absence of easy credit.

In Shakespeare’s plays the fool is often the wisest character. Under the guise of buffoonery, he is allowed to speak the one thing that people in authority loathe to hear – the truth. But his wisdom is mistaken for wit by those in power, who usually do not have the wit to understand they are being ridiculed. David Lereah is not a fool. He is a moron. Or, as the Fool says to King Lear in Act One, Scene Four.

Have more than thou showest,
Speak less than thou knowest,
Lend less than thou owest,
Ride more than thou goest.

SUCKER HIGH

Sad but true: inconsistency and short-sightedness are virtues on Wall Street. To be a successful talking head, forget about logical arguments. Sound bites and bullet points are the way to go. The key is not consistency, but opportunism. The goal is to make the facts say what you want them to say. Take oil, for example. If the price of oil is going up, that is bullish because it indicates strong global demand. If the price of oil is going down, that is supposedly bullish too because it acts as a tax cut for consumers. Never mind that the second argument contradicts the first.

When there is an excuse to strut and crow, watch out. Consider the recent Dow high so many are jazzed about. Clearly a sign of how wonderful things are going, right? Maybe not. Richard Russell, editor of the Dow Theory Letters since 1958, recently noted, “21 of the [30] Dow stocks are 20% off their all-time highs and 17 Dow stocks are at least 30% below their all-time highs.” Hmmm. So even though the Dow just hit a “new high”, more than 70% of the stocks that compose it are well and truly under water. And we last saw these “new high” levels in January 2000 or so. So the Dow is like a man who took a tumble down a flight of stairs, and has taken nearly 7 years to climb them again. And of course, if you are a long-term foreign investor, your Dow investment is still a big fat dud. The dollar has given up much ground this decade, making index measurements a rubber yardstick. Hurrah! Celebrate! Champagne for everyone.

I titled this missive “Sucker High” because I think that is what Wall Street is on right now. All these people jumping for joy are in danger of being just that – suckers without a sense of perspective. The classic kind who are ecstatic when they make a little money … only to give it back in the long run. These suckers cheer on the talking heads, and never really seek to understand the game. The global economy is complex. There are many factors constantly at work. Some factors are more important than others, some are trivial, and many cancel each other out. This makes it devilishly hard to figure out what is really happening. But this reality has been abused by Wall Street, in a sort of post-modern fashion, to justify the notion that anything can happen at all. Tortured statistics are used to bolster utterly ludicrous statements. Logic is debased regularly. A world in which the indebted consumer can borrow his way to infinity? A world in which cause and effect decouple, where consequences for actions cease to exist? Sure, why not – if the numbers can justify it here and now. Tomorrow they will just make up something else.

As Jesse Livermore noted, the speculator’s greatest and truest ally is underlying conditions. We are confident because we have underlying conditions on our side. They are like the rock of Gibraltar for us. Unlike the bobble heads, we have been making the same handful of arguments for quite some time now – arguments that still very much apply, and will go on applying for many years to come. Our argument is essentially two fold. There are long-term global growth trends on the one hand, bullish for energy and resources, and the Austrian endgame on the other, in which bloated Western welfare states must eventually open the printing presses.

There are two ways the current downdraft can play out. If we avoid a global meltdown – that is to say, if the developing world is able to stimulate domestic demand and wean itself off the American consumer in time – then demand for energy at the margins will not meaningfully decrease. Demand will in fact increase along with the new middle class in this scenario. Fossil fuel technologies and new alternative technologies will have to go full out to keep up with demand. Alternatively, if the American consumer drags the world down, then Western economies will ultimately cower under a crushing overhang of debt. If things get bad enough, forced liquidation will be required, as Ludwig Von Mises predicted a long time ago. The world then chokes on paper, and turns to hard assets for refuge.

There are a number of moving parts at work here, and they are all connected. The important elements of the big picture do not flip and flop from week to week. They develop slowly over time. My advice? Don’t be cannon fodder. With all thy getting, get thee understanding. Go out there and shore up your mental position with knowledge. Sell down to the sleeping point if necessary, lay hold of your convictions, and then rebuild in a way that makes sense to you. But do not pay too much attention to the talking heads, the arguments du jour, or the sucker highs.

A major Dow Theory nonconfirmation is occurring in the stock market.

This rally has carried stocks much higher than we anticipated two months ago. Well, that is not entirely true – it has carried some stock indexes much higher than we thought they would get. The S&P 500 and Dow industrials have made new rally highs, but the Nasdaq, the small-cap Russell 2000, and the Dow transports have not. Only about 60% of stocks in the S&P 500 are in bull mode – leaving the other 40% behind. But for the S&P 500, the question is why have we gotten it wrong so far?

We did not anticipate the scale of this market top and how long it would take to play out. As we watch all the divergences continue between the blue chips and the high-beta indexes continue for many months now, it is clear that something big is happening. But big trend changes in the market often take time to play out. It is taking more time than we thought. Looking back to the 2000 top, it took more than a year between the time the Dow transports topped in May 1999 and the time the S&P 500 turned down with a vengeance in September 2000. Between May 1999 and September 2000, there was a very significant Dow Theory nonconfirmation, when The DJIA made a new all-time high in January 2000, which was not accompanied by the DJ Transports. But even after that signal, which was followed by the mini-crash of the Nasdaq in March 2000, the broader blue chip indexes like the S&P 500 maintained their composure for another six months before succumbing to gravity.

The 2000 top was undoubtedly a major one. And since the Dow industrials have made an intraday all-time high and a new rally high this week, it is time to discuss the state of the most important divergence we are following. We now have a clear Dow Theory nonconfirmation in the works between the industrials and the transports, as clear as it was in 1999-2000, for those that were watching (see DJIA chart and DJT chart). The industrials closed at a new post-2002 rally high this week, but the Transports remain far below their early summer high. The nonconfirmation at the 2000 top (which lasted 9 months) was followed by the 2000-2002 bear market, and the nonconfirmation at the March 2003 bottom (which lasted 6 months) was followed by the 2003-2006 bull market.

The current nonconfirmation started four months ago at the May top, and it could go on longer. We have mentioned in previous weekly updates that while the Transports made a new all-time high over a year ago, the industrials had so far failed to follow, potentially setting up a very large 6-year Dow Theory nonconfirmation. While the industrials have not yet closed above their 2000 high, it seems likely that potential nonconfirmation will be put to rest soon. That is very good news for the long-term technical picture, as a six-year nonconfirmation could have well signaled a bear market of much larger proportions than we have experienced to date.

For now, we are seeing a nonconfirmation of similar scale as the 2003 bear market low and the 2000 bull market high. We are also seeing the same divergences between the blue chip and small caps and tech that we saw at the 2000 high. But as in 2000, what became clear early on to Dow Theorists and others who follow sector divergences is that this market is taking its time to build what looks like a major top. A new all-time high by the Industrials removes the potential long-term nonconfirmation we mentioned, which is a good thing. But we also have to remember the Industrials by themselves have not been a good indicator of new bull or bear market. As an example, the new all-time high in the winter of 1973-1974 (which was made within the 1965-1981 bear market) was followed by an almost 50% decline over the next year to the 1974 low. The industrials are much more reliable as an indicator of the health of the market when compared relative to the Transports.

The Dow: Then and Now

After 6½ painstaking years, the moment Wall Street has been waiting for finally arrived – the Dow Jones Industrial Average looks DOWN on its January 2000 all-time peak. Like any great milestone, the mainstream media is celebrating the event with a slew of The Way We Were articles comparing the stock market THEN to the allegedly new and improved marketplace of NOW. The most obvious distinction is that technology was the darling of stocks in 2000 until the dot.com boom went bust and set off a major recession. That is the day. The night, say the “experts” started when the three tiers of Housing, Hedge Funds, and Energy lifted the U.S. economy up off its bum and boosted it into a whole new dimension.

Here is a brief look back at how it all began. (1) Housing 2000: Healthy and stable with the nationwide inventory of unsold homes at a modest 5-year low BLASTS OFF into a 4-year long boom that sees home values soar to record highs, a “new paradigm” declared where “prices will go indefinitely up,” and a May 2004 news source announcing the revival of “the American Dream. It’s alive and well and should remain strong for the next decade.” (2) Hedge Funds 2000: Exclusive and private industry managing $480 billion in assets SHIFTS into an Egalitarian and public industry managing over $1 trillion. (3) Energy 2000: OPEC officials promise to install a CAP on soaring oil with the statement, “If prices stay above $28 a barrel for a long time, we will take actions to bring the level down to around $25 a barrel,” EXPLODES 300% to a July 2006 record high above $80.

That, of course was THEN. As of October 2006, the first full-year nationwide decline in home prices since the Great Depression is widely expected, Hedge Funds (c/o of Amaranth and others) are making Long Term Capital Management’s debacle look like chump change, AND oil prices have plunged 21% to a 16-month low. Also note that the CRB commodities Index is down 17%, along with 20% plus drops in gold and silver. Natural gas has lost 59% this year, copper 14%, the S&P 600 small cap Index 7%, and the S&P 400 Mid-cap Index 7%.

Which brings us to what many in the mainstream claim to be the most important difference between then (2000) and now: The dot.com crash was the sudden result of burning the “irrationally exuberant” candle at both ends. The downturn in today’s market darlings are “healthy corrections” brought on by a new “caution and skepticism” among participants. As the October 3 Wall Street Journal writes: There will be a “slow and steady flow” of money into stocks “as investors overcome their fears.” The October 2006 Elliott Wave Financial Forecast calls this supposed forethought for what it is. Fatigue.

“INFLATION” – THEN AND NOW

A couple of weeks ago on this page, I noted that the Federal Reserve was still releasing statements with drivel about how “the prices of energy and other commodities have the potential to sustain inflation pressures.” I have yet to grasp the point of that remark – energy and commodity prices ALWAYS have the potential to sustain inflation. If potential is the word of choice, then I have the “potential” to get hot dates this weekend with Scarlett Johansson and Naomi Watts.

But in the realm we call the “real world”, it is wise to give more weight to probabilities. That is why I had previously asked – if inflation really is a threat – then what is up with the red line on the CRB index chart over the past six months? At that time (September 21) the CRB had fallen some 17% from its May highs. Now it is down even further. So the question about the red line is still relevant, because – all evidence to the contrary – the media continues to blather on about inflation.

Oil prices are DOWN, as are prices across the entire commodities complex. That is the reality. As for the perception – or is it the “potential” – well, now you know that too. Still, a healthy dose of reality was available even back in May. On May 26, in fact, we noted the folly of the notion that commodities were a way to diversify and hedge against inflation: “One of the fatal misconceptions of the post-2000 drive into riskier and riskier financial assets is that they somehow offer shelter against market declines.” That was tomorrow’s news today.

BONDS ARE POPULAR. TOO POPULAR

Bonds are the new “black”. Suddenly, these boring financial assets have become sizzling hot portfolio accessories. Everybody wants to be seen with bonds, especially long-dated Treasury bonds. But we suspect this investment fashion is about to become “so last season.” Please allow us to suggest an avant-garde alternative: The bond-free portfolio. We would not abandon fixed-income entirely, however. In the place of 10- and 20-year Treasuries, we would accessorize a portfolio with baubles like 2- and 3-year Treasuries.

Long-dated Treasuries have enjoyed a delightful rally since late June, causing the 10-year yield to fall from 5.25% to 4.56%. Fueling this rally is the notion that the Fed is finished, and so is housing. In other words, the Federal Reserve has finished raising interest rates for this particular “tightening cycle”. The next move in short-term interest rates therefore, will be down, not up. At the same time, the crashing housing market is raising the prospect of recession – a condition that usually causes bond prices to rise, and yields to fall. All true, perhaps. Even so, the “buy bonds” trade has become so popular and “crowded” that a contrarian-minded investor must consider alternative scenarios – like the scenario that bond prices might not continue rising.

Bond investors have been feeding on these plentiful signs of economic decay like coyotes on a carcass. But the bull case for bonds includes a couple of caveats. First, the inflation rate many not slow as rapidly as bond bulls hope and believe. Second, the U.S. dollar may not resist the gravitational pull of our excessive government debts and trade deficits. If the inflation rate remains stubbornly high and/or the U.S. dollar resumes its downtrend, the Fed could not easily justify cutting interest rates, even if the economy required it.

The third risk to bonds is a touchy-feely one: Bonds are too darn popular. The latest CFTC Commitment of Traders report shows that large speculators – a.k.a., the “dumb money” – hold a record-high long position in Treasury-note futures. Perhaps that is why one of the smartest bond investors, Bill Gross of Pimco Asset Management, favors short-term Treasuries over their long-term counterparts. For the record, Gross does not dislike long-term Treasuries, he simply likes short-term Treasuries much better. “The U.S. bond bull market, which began almost two years ago, remains in its infancy. But the best way to play it … is the front end of the curve,” Gross writes.

One way to express a bullish opinion on short-term Treasurys would be to buy the iShares Lehman 1-3 Year Treasury Bond ETF (NYSE: SHY). At the current quote of $80.26, this ETF yields just under 4%. Alternatively, the 2-year Treasury note itself, yields 4.61%. If the bond bulls are correct, they would probably reap a greater reward than would the buyers of SHY. On the other hand, they might be wrong. In which case, the buyer of SHY would still receive an attractive yield … and many restful nights. We think high-yield slumber is sexy. Be the first one on your block to embrace the new fashion.

CONSUMER CRUNCH: SEPTEMBER UPDATE

A recession may have already started.

The latest economic statistics show that consumers depended on new debt for 88% of their cash flow during 2005. In 2006, we expect new debt to again account for 88% of cash flow. Historically, consumers have used debt for 40% to 50% of cash flow. Now, any decline in debt flow translates to a decline in cash flow. Our “Real Estate and Money Supply” paper showed that the side effects of a decline in debt flow include a decline in M-2 growth. It is important to realize that annual monthly M-2 growth has never been negative based on monthly M-2 statistics extending back to 1959. If M-2 growth declines toward 0%, it would indicate an extraordinary economy. Since the end of June, M-2 has not increased.

In “Real Estate and Money Supply”, we also developed a 6-step economic process that we expect the economy to follow. In that process, new home construction does not slow until after home resales have entered a continuing and persistent decline. Early indicators of future construction are dropping as July information showed that the permitting process declined over 20% on a year-over-year basis. August information indicates that home starts have also declined over 20% while current homes under construction remain at 2005 levels.

In our June update, we were in Step 4 of the 6-step process: Existing home resales moderate as consumer liquidity remains under pressure. At the time, we indicated that the latest information might mean that we were in transition to Step 5: Existing home resales decline. Current information indicates that we have progressed at least to Step 5 of that process. In our opinion, Step 5 should be the doorstep to a recession. Step 6 is where new home sales and remodeling decline. Current construction remains high as builders rush to finish and clear inventories. The falling sales prices and profit margins are needed to clear inventory.

The falling permit levels and housing starts are consistent with a Step 6 slowdown and the start of an economic recession. Household debt generation and cash flow should decline. Household income growth should decline as employment and profit side effects appear. Economic activity could enter a recession. We have progressed to Step 5 of this consumer cash flow driven process. The most recent data supports the contention that we are in Step 6 of this process. Though we cannot reject that contention, we do not yet accept it.

In our opinion, it is possible that a recession started in July. The consumer cash flow and consumer liquidity data in our full paper provide some support for that interpretation. Our current economic guesstimates show that the fourth quarter of 2006 could be the first quarter of negative real growth. Based on our review of consumer liquidity and of our housing market model, a serious recession starting in the next few months is possible. In the best case, we barely avoid a recession that starts soon.

Consumer liquidity continues to drop dramatically in a process consistent with our previous analyses. Our models point to a small, but real, possibility of a nominal decline in personal consumption expenditures during 2007. The last time a nominal decline in personal consumption expenditures occurred was in 1938. Since we believe that the U.S. government will do everything that it can to maintain inflation, we do not expect a nominal decline in consumption. However, if inflation begins to decline, then we would not be surprised by a nominal decline in consumption and a significant recession.

Growth in U.S. slows to “stall speed”, raising recession risk.

The U.S. economy has slowed more dramatically than most economists expected just a few weeks ago, leaving it more vulnerable to a recession. Forecasters at Goldman Sachs and AllianceBernstein Holding in New York have cut their growth estimates for the just-ended third quarter to an annual rate of 2% or less. They do not foresee much, if any, improvement in the fourth quarter, as auto-production cuts and slumping home sales are likely to overwhelm any boost the economy gets from lower gasoline prices, they say.

Growth is getting closer to what Macroeconomic Advisers LLP President Chris Varvares describes as the “stall speed”, where an unexpected shock such as a terrorist strike or a hurricane might be enough to trigger a recession. A mathematical model of the economy developed by Federal Reserve economist Jonathan Wright puts the chances of a recession over the next year at about 40%. “The one-two punch of a slowing housing market and the large announced auto-production cuts by GM, Ford and Chrysler is really going to slow the economy,” says Mark Vitner, a senior economist at Wachovia Corp in Charlotte, North Carolina. “It’s going to be a bit of a rough landing.”

FALLING DOMINOES

The Sentinel is reporting that in Massachusetts, “State Targeting Abusive Lenders”: “The state Division of Banks is cracking down this month on what it sees as abusive business practices by mortgage lenders and brokers.” The idea that lenders are doing things they may not have done in “normal conditions” may have some merit for some lenders, but when 40% of the loans sold in California before the bust were either stated income loans or pay-option ARMs, I think the idea is more fiction than fact. Anything and everything was done to keep the bubble booming, and that was, as I said, happening well before the bust.

With every bubble comes fraud. The two go hand in hand, and housing is not unique in this respect. We are only beginning to scratch the surface of the fraud that supported this bubble. Lending standards are going to tighten as a result, and will continue to tighten as more and more of the fraudulent activity is exposed. I consider fraud and tightening of lending standards to be two big dominoes that are now falling.

Consumer spending has been propping up our economy for a very long time, so let’s take a look at the current state of affairs with that oversized domino. The Associated Press is reporting, “Feds Say Consumers Cut Back Spending by 0.1% in August, Largest Amount in Nearly a Year”. Premature reports of the “death of the consumer” have been heard for quite some time now from various people, and I must admit that group includes me. Consumers have been spending more than they have been making for 16 consecutive months. We have seen our first yearly negative savings rate since the Great Depression.

One of the dominoes propping up consumer spending is called mortgage equity withdrawal. In simple terms, people have been treating their houses as ATMs, taking cash out at refinancing and spending it. That source of funding is drying up. Calculated Risk talked about mortgage equity withdrawal in “GDP Growth: With and Without Mortgage Extraction”. Calculated Risk concluded the “declining MEW over the next few years will be a significant drag on GDP growth.” I agree. That falling domino makes it more likely that this downturn in consumer spending is finally the real deal.

Another key domino that is tipping but has not completely fallen over yet is jobs. The reason this domino has not completely fallen over yet is that homebuilders are still building homes at a high rate. Yes, year-over-year rates show huge declines, but homebuilding is remains brisk on a historic basis. Thus, homebuilding is still providing jobs even as it increases inventories and downward price pressure. So while housing-related trade jobs are slowing, they have not yet collapsed. They will. It is just a matter of time.

Is it just Florida, Boston, Phoenix, Las Vegas, and California that are affected by this? Even if it were, that would still be a lot, would it not? One out of every 55 adults in California is a real estate agent. That is a lot of jobs. The question to ask next is how many of them have had any sales lately? Technically, they are still employed, even though many agents in many states have no money coming in. The unemployment numbers produced by the BLS are a joke for many reasons, and this is just one of them. But returning to the initial question, the answer is no. This is not just affecting the coasts and the deserts, but places like Minneapolis and Madison as well. Overbuilding still continues today in spite of sinking demand. It continues in all of the bubble markets as well. Condos and houses are still going up everywhere. Once that building stops, official unemployment rates will soar.

The falling domino from slowing homes sales will soon tip the domino of retail store expansion. Retail expansion, primarily around new subdivisions going up in outer suburbia, supported a multitude of jobs at places like Pizza Hut, Bennigan’s, Outback Steakhouse, Wal-Mart, and Home Depot. With the slowdown in housing activity, the slowdown in strip malls will follow with a lag. Retail store expansion is in its final phase.

There are many dominoes in various stages of tipping. Right now, it seems like we may be headed for a mass collapse all at once, as opposed to a more linear progression of falling dominoes. In the meantime, no one seems to be able to see the recession that is headed our way.

WHY ARE SAUDIS APPROVING CHEAPER OIL?

Unbelievable as it may sound, Saudi Arabia is practically applauding the 22% plunge in global oil prices since July. On Sept. 19, Saudi Oil Minister Ali Naimi called a price of about $60 per barrel “reasonable”. Analysts think the Saudis could even live with a price in the mid-$50s per barrel. “The Saudi price target is probably lower than the rest of OPEC; they are still happy at $50 per barrel,” says David Kirsch, an analyst at PFC Energy in Washington.

The Saudis never felt comfortable with $70 oil, fearing that sky-high prices might kill off the global appetite for their single source of wealth. “There is concern that the volatility in the markets is so beyond anyone’s control that it could cause severe damage to the world economy,” says Sadad Al Husseini, the retired exploration and production chief of Saudi Aramco, the national oil company. The Saudis, he says, “are determined to try and manage better.” That is not to say the Saudis want to see prices continue to drop. In the short term, they are trying to keep them from crashing below $50 per barrel by gradually withdrawing oil from the market. But they are also investing tens of billions of dollars to build spare capacity. At a mid-September OPEC meeting in Vienna, Oil Minister Naimi said Saudi Arabia plans to expand production in seven fields to add 2.4 million barrels per day of capacity, boosting its total to about 12.5 million barrels per day by 2009.

The Saudis want to be able to pump more so they can manage prices by adding supply when markets are tight, and removing it when inventories fatten. Of the major OPEC producers, only the Saudis currently have significant spare capacity. But by 2004 they had allowed their buffer to dwindle to around 700,000 barrels per day, not enough to cover a major outage such as a shutdown of Iranian production. Like the rest of the industry, they were caught napping by the big surge in demand beginning in 2004, which triggered a doubling of prices over the following two years.

The cost of expanding production will exceed $24 billion, figures Nawaf Obaid, managing director of the Saudi National Security Project, a Riyadh consultancy. He says the Saudi leadership under King Abdullah wants to “decouple energy and foreign policy” by building up enough spare capacity to offset a cutoff of crude from Iran as well as another major producer such as Venezuela or Nigeria. They also want to tamp down criticism from U.S. politicians.

THE EMPIRE HAS NO CLOTHES

The U.S. is widely adored as the world’s greatest empire. Few realize that the empire has no clothes. As the masses look up to the nation in admiration, they are fooled into believing that it is swimming in wealth. The reality is that it is up to its eyeballs in debt. The U.S. economy is living on borrowed time and judgment day is inevitable. No nation in history has ever managed to escape such economic imbalances, and I suspect the U.S. will not get away with it either. Let us take a look at how this imaginary cloak has been woven.

The economic recovery since the 2001 recession has been manufactured by excessive credit-growth and consumption. For the first time ever, a central bank has purposely engineered a credit bubble with the intention of bringing artificial prosperity via rising asset-prices. The Fed dropped interest-rates and the majority of Americans became the proverbial kids in the candy store, unable to resist the temptation of cheap credit. This is evident from the fact that over the past six years, U.S. household debt soared from $6.99 trillion to almost $12 trillion. Some economists say this record debt-explosion is irrelevant because the net-worth of U.S. households over the same period has surged from $42 trillion, to roughly $54 trillion (largely due to the housing boom). In other words, due to rampant credit and leverage in the economy, asset-prices have risen much more rapidly than debt levels. But the key question is whether this is sustainable – and at what cost?

Asset-prices can continue to rise for a long time if there are willing borrowers, and a central bank armed with an endless supply of credit. However, you have to understand that rising asset-prices only give the illusion of prosperity. Everyone may feel richer as their homes and stock portfolios appreciate in value, but it would be a mistake to confuse rising asset-prices in an economy with real wealth creation. Given the levels of debt in the U.S., I have no doubt that the Fed wants to keep the game going for as long as possible. It will achieve this by continuing to inflate the supply of money and credit. Under this scenario, the U.S. dollar will surely depreciate against other major world currencies, and especially against precious metals whose supply cannot be increased at the same pace.

The recent economic expansion has not been typical. The U.S. wage growth has been extremely poor and the capital spending by American companies has also been dismal. Real disposable income growth is now almost zero, and over the past five years, capital spending has increased by a paltry 12%. The United States looks more and more like a bubble economy, a banana republic of some sorts, which is desperate for ever-rising asset-prices for its very survival. Should American home and stock prices stall, let alone decline, the fate of this great bubble will be sealed. Depreciating asset-prices will act like a dagger in the heart of this artificial recovery, so the Fed must continue to inflate at all costs. The total debt as a percentage of GDP is currently above 300% in the U.S. – an all-time high. The last time the U.S. faced a meaningful contraction in debt relative to the size of its economy, it coincided with the depression years of the 1930’s.

With the U.S. consumer leveraged to the hilt, the fate of the U.S. economy now lies with its corporations and its government. American companies have recently registered great profits and are flush with cash. But so far they have not shown any willingness to spend their money, with capital spending non-existent and wages increasing at less than the inflation-rate. Take U.S. government budget reported in the media claims that the deficit was reduced to $319 billion in 2005. However, the Financial Report issued by the Department of Treasury says it was $760 billion, or over twice as large, when based on the accrual accounting that all businesses with revenues in excess of $5 million are forced to use.

Since the end of the recession in November 2001, reported employment growth is up moderately, which makes it the worst performance during any post-war economic recovery. However, closer inspection reveals that even this small reported growth in employment is an absolute joke. The reported official unemployment figures do not include those people who have given up looking for a job, joined a university, or taken a part-time job since they cannot find full-time employment. When you add all these people, the real rate of unemployment is closer to 10%. But the biggest “cover-up” award must go to the officials who determine the Consumer Price and the Producer Price Indices (CPI and PPI). These “inflation-barometers” are a total fraud! By keeping the CPI and PPI artificially suppressed via voodoo accounting and understating the inflation menace, the Federal Reserve maintains the public’s confidence in the U.S. dollar as a great store of value.

In summary, the U.S. economy is not in good health and eventually the monetary stimulus and injections of liquidity will fail to revive this terminally ill patient. Accordingly, I advise you to minimize your exposure to American assets. On other hand, tangible assets (especially precious metals) and mining stocks represent a great opportunity for the medium to long-term investor. Despite the recent pullback, the long-term bull-market is still intact and I anticipate a rally over the coming six to eight months. Accordingly, this is an ideal time to add to your positions in precious metals as well as mining and commodity-producing companies.

BUY SPAM, SELL FRAPPUCCINOS?

Alternatively, buy gold shares, sell financials.

“Buy Hormel, Sell Starbucks,” suggests Stephanie Pomboy, the freethinking mind behind MacroMavens, an elite Wall Street research service. Ms. Pomboy offers up this quirky pair trade as a way to play the housing-induced consumer-spending slump. Now that home prices are falling, she reasons, American consumers will not only feel poorer, they will also lose access to the home-equity lines that have been fueling their consumption. As a result, they will become less inclined to buy $5 espresso drinks, and more inclined to buy low-cost foods of various types. “The deflation of the housing market is sure to wreak far more havoc than its dot-com predecessor,” Pomboy predicts, “shaking the very foundation upon which the U.S. consumer and financial system (with its record real-estate exposure) now rest.”

If, therefore, the free-spending, but overly indebted, American consumer begins to spend a little less freely, which industries would feel the pinch? And which would benefit? Pomboy’s suggestion is to short Starbucks, the purveyor of pricey coffee drinks, while simultaneously buying Hormel, the purveyor of inexpensive forms of “meat and meat by-products.” (Relative stock performance charted here.) But I would not rush to implement this trade. As a hard-core Starbucks consumer, I cannot easily imagine a financial condition so dire that I would abandon his daily cappuccino. (My children would go without shoes first). Nor can I imagine a household budget so stretched that I would purchase a can of Spam … and actually eat it.

That said, I suspect Pomboy is on the right track, which is why I find her second suggestion far more compelling: Sell financials and buy gold shares. The “sell financials” half of the trade is easy enough to understand. Demand for new mortgages is drying up faster than a movie star in rehab. At the same time, delinquencies and defaults are increasing on the trillions of dollars of mortgages that that the lenders still hold on their books. “Contrary to popular perception,” Pomboy writes, “the banks have not shrewdly offloaded all their mortgage risk. They still hold $3 trillion in direct mortgage loans (or 43% of total assets) and have another $1 trillion in mortgage-backed securities, bringing their total real-state exposure to a record-high 55% of assets.”

Therefore, Pomboy would be a seller (or short-seller) of regional banks, credit card companies and sub-prime lenders. Simultaneously, she would be a buyer of gold and gold shares. Her thinking? As inflation fears give way to deflation fears, the Fed may begin slashing rates very soon. But the Fed’s efforts will be for naught, “as over-extended consumers resist the cheap-credit bait.” Even though the Fed’s upcoming easy-money cycle will fail to revive the swooning American consumer, however, it will not fail to undermine the value of the dollar. As a result, gold will rally.

Your editor sympathizes will Pompoy’s outlook, and would like to offer a California-inspired variation of Pomboy’s “housing bust” pair trade: Sell Countrywide Financial (NYSE: CFC), and buy California Water Services (NYSE: CWT). (Relative stock performance charted here.) Both companies conduct the bulk of their business in the Golden State. Countrywide is the largest mortgage lender west of the Mississippi. California Water is the largest water utility west of the Mississippi. But the similarities end there.

At 24 times forward earnings, CWT would not likely dazzle any value investors. And yet, we would consider CWT a better value than CFC, a stock that sells for a mere 8 times earnings. As the housing bust continues busting, the “E” component of CFC’s PE ratio will atrophy, if not disappear entirely. The housing boom is over … and we suspect the bust will last a very long time. Coincidentally, “a long time” is also the likely duration of demand for water in California. Over the last four years, the company’s “revenue per customer” has increased more than 20%, producing a 45% jump in net profit. Not surprisingly, therefore, CWT has easily outpaced the S&P 500 over the last several years. Water may not be sexy. But it is very profitable.

WHY FASHION TRUMPS FINANCIAL MEDIA

It takes a strong will to buy stocks when everyone else is selling and, vice versa, to sell when everyone else is buying. The clues about when to buy or sell this way lie in changes in social mood, which are reflected in the world around us, including fashion. Bob Prechter looks at popular culture through the prism of social mood and comes up with some interesting insights. Here is an interview about fashion and bullish and bearish moods taken from the book, Prechter’s Perspective.

“There is little difference in what they reveal about the current mood. When Women’s Wear Daily is showing frisky fashions, The Wall Street Journal is in a frisky mood, too. The problem is that the Journal also gives opinions on the markets and the economy, and people take them at face value rather than for what they are: an expression of the prevailing mood.

“It wasn’t always this way. Back in the 1920s, the Journal was run by a technical analyst – a Dow Theorist, to be exact – named Hamilton. Before the market crashed, he warned readers in a famous article called, “A Turn in the Tide”, which I adapted for the title of my 1995 book, At the Crest of the Tidal Wave. But when I read the Journal today, I am appalled. The current managers of the editorial page publish the most excessive cheerleading for the bull market imaginable, in the face of historically bearish conditions. If these articles had come out in 1974 or 1984, they would have been useful, but not now. William Peter Hamilton must be spinning in his grave like a chicken on a rotisserie. So you’re much safer with Women’s Wear Daily.”

“In bull markets, people focus on progress and production; in bear markets, they focus on limits and conservation. … Bull markets result in increased harmony in every aspect of society, including the moral, religious, racial, national, regional, social, financial, political and otherwise. Bear markets bring polarization. … The bear market will bring back nationalism, racial exclusion, and perhaps even religious conflict. Thinking technically about events, that is, observing what they reveal about social psychology, prepares you for those changes, whereas trying to predict the future from the events themselves leads you to the opposite, and wrong, conclusion. It cannot be stressed enough, because life-or-death decisions can depend upon your assessment. Notice what marks the major bear-market lows of just the last 200 years – the Revolutionary War, the Civil War and World War II. Those were buying opportunities.”

EURO VS. $US: UP AND DOWN, BUT HOW MUCH LONGER?

The whipsaw price action in the EURUSD lately has lots of traders frustrated (including me). Moving seemingly with no clear trend, this market has hardly made any net progress in the past 30 days. And unless you are a skillful enough trader able to ride the recent “rollercoaster”, for an average trend-follower, trading this pair lately has been very, very tough. (Not that it is ever easy.)

The most obvious explanation as to why the EURUSD has been trading sideways for a full month is the “lack of clarity” regarding the Fed’s next interest rate decision. Traders and analysts scrutinize every piece of economic news looking for clues – as if that alone drives the trend in the EURUSD. There is another explanation for all this meandering: correction. A chiefly technical analysis term, corrections can be very drawn-out affairs when the market goes nowhere. In the 1-2-3-4-5 impulse Elliott wave sequence, only waves 2 and 4 are corrective. And as you can see from this chart below, our latest thinking is that the market’s hesitation over the past month has been a sign of the possible corrective wave 2. As you can also see, there is a question mark next to that “wave 2” label. It means that the EURUSD still has to confirm or reject this wave count by breaking above or below certain support and resistance levels.