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June 30, 2006

The top is in: Hulbert

ANNANDALE, Va. (MarketWatch) -- The stock market's huge rally Thursday afternoon was a knee-jerk reaction that will get corrected as soon as investors seriously examine the rationales that were used to justify that rally.
That sobering opinion is the majority view among the newsletter editors who had, by Thursday night, commented about the Federal Reserve's decision to raise rates another quarter point and the stock market's extraordinary rally in reaction to that decision. ( Read full story.)
The reason the market rallied was that the Federal Reserve signaled that its rate-hike cycle might soon come to an end. That certainly appears to be a valid rationale, since - other things being equal - the stock market performs better when rates are lower than when they're higher.
But others things are not equal.
The reason the Fed says it may stop raising rates is economic weakness: "Recent indicators suggest that economic growth is moderating from its quite strong pace earlier this year, partly reflecting a gradual cooling of the housing market and the lagged effects of increases in interest rates and energy prices."
It therefore strikes quite a few newsletter editors as odd that, in the wake of the Fed's statement, the stock market would have rallied so strongly - with the Dow Jones Industrial Average ($INDU :
Dow Jones Industrial Average and the COMP2,174.38, +62.54, +3.0% ) tacking on an incredible 62.54 points. As Jeffrey Hirsch of the Almanac Investor Newsletter put it Thursday evening, "When the market rallies because the Fed says the economy is weakening you are in trouble."
tacking on an incredible 62.54 points. As Jeffrey Hirsch of the Almanac Investor Newsletter put it Thursday evening, "When the market rallies because the Fed says the economy is weakening you are in trouble."
Or, as Stephen McKee of the No Load Mutual Fund Selections & Timing Newsletter added, "Something isn't right, though it may take a few months for the markets to figure it all out."
Particularly useful to keep in mind is an analysis conducted several months ago by James Stack, editor of the InvesTech Research Portfolio Strategy newsletter. When ranked according to risk-adjusted performance, Stack's advice is in fourth place over the last 20 years, according to the Hulbert Financial Digest.
Stack examined all instances in the Federal Reserve's history in which it raised interest rates at least two times in succession. He then measured the S&P 500's gain or loss following the final rate hike in each of these series. On average, the S&P 500 index (SPX :
S&P 500 Index
1,272.87, +26.87, +2.2% )
was lower three months later, in six months, and a year later.
This, coupled with the balance of the other indicators that Stack looks at, convinces him that "we have seen the market highs for the time being."
The same conclusion, if not almost the same language, comes from Dan Seiver, editor of the PAD System Report: "The Bull Market. It's done. We think the top is in at Dow 11,650 and S&P 1325." Seiver is editor of the PAD System Report newsletter and an emeritus professor of economics at Miami University of Ohio and currently a visiting professor of economics and finance at San Diego State University and the University of San Diego.
In addition to forecasting a bear market, Seiver argues that we should get used to a lot of market volatility in the wake of Fed decisions. In an interview Thursday afternoon, Seiver pointed out that not only is Fed Chairman Ben Bernanke an unknown quantity, but so also are a number of other new members on the Federal Reserve's Open Market Committee (FOMC). "Wall Street is more confident with guys who have been around for a long time," according to Seiver.
For example, Seiver said, there undoubtedly would have been a lot less uncertainty leading up to the Fed's meeting on Thursday had Alan Greenspan still been Fed chairman. That's because, after nearly two decades at the head of the Fed, Wall Street had gotten to know him and become relatively able to anticipate what he would do.
In contrast to Greenspan, Seiver continues, Bernanke and the other new members of the FOMC are "potentially loose cannons." To compensate for the additional uncertainty this causes, the market in advance of future FOMC meetings will fall further than it would have during the latter years of the Greenspan era. And after those meetings, and provided that there are no surprises, the market will rally more than it would have following meetings headed by Greenspan.
Given that today's FOMC is not as predictable as those in past years, Seiver nevertheless was willing Thursday afternoon to hazard a guess that the FOMC's August meeting will not mark the end of its rate-hike cycle.
Seiver added: "The days of easy money are over." End of Story
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.

June 28, 2006

metals `super cycle' is intact

June 28 (Bloomberg) -- The metals `super cycle' is intact, and mining stocks such as BHP Billiton are likely to recoup their recent losses as continued demand for raw materials offsets rising interest rates globally, according to Merrill Lynch & Co.

Resources stocks including BHP and Rio Tinto Group, the world's biggest and third-biggest mining companies, lost a fifth of their value along with metals prices in May and early June as central banks in the U.S., Europe and China lifted rates.

Sydney-based analysts including Vicky Binns affirmed their `buy' rating for BHP and Rio Tinto in a June 20 note, assigning a 60 percent chance that commodities prices will resume their three- year rally over the next decade.

``We continue to believe the probabilities favor a bull trend case, which indicates that share price dips over the next two to three months is a buying opportunity,'' said Binns, Head of Australian Research at Merrill Lynch. She was ranked fifth among Australian metals and mining analysts in a 2005 survey by Business Review Weekly.

The U.S. Federal Reserve will probably increase rates this week for a 17th straight time. The European Central Bank raised borrowing costs this quarter, while China's government this month ordered banks to hold more money in reserves after lifting rates in April. Japan's central bank is also considering raising its key interest rate, near zero for more than five years.

Demand Vs Supply

Copper, used in wires and pipes, has fallen 21 percent since touching a record on May 11 in London. Aluminum, used in packaging and auto parts, has dropped 22 percent.

Shares of BHP and Rio are likely to be supported as global demand for metals exceeds supply, according to Merrill Lynch.

BHP has climbed 8.2 percent since June 13, after plunging as much as 21 percent from its May 11 record. Rio has rebounded 4.8 percent since June 13 after tumbling 19 percent from a May 12 high.

Demand for aluminum is expected to grow 5.7 percent in 2007, according to Merrill. Demand for copper may grow 4.4 percent, while rates of 3 percent and 4.3 percent are expected for zinc and nickel.

Binns expects BHP and Rio to report record profits for the first half of 2006. She raised her 2007 earnings estimates for BHP by 29 percent to $13.4 billion in a June 9 note, and lifted her 2007 estimate for Rio by 14 percent to $7.6 billion.

Further Weakness?

Still, Binns said there's a 30 percent chance mining shares may drop further in the next three months as concerns escalate that the U.S. will extend its policy of raising borrowing costs and China takes more steps to slow its economy. A 10 percent chance also exists that shares will shrug off the slump and set new highs in the next three months, she said.

Binns said BHP may drop to as low as A$23, 16 percent below today's close, before rallying. Rio Tinto may reach A$65 a share, 13 percent lower than today's close.

She advises existing investors should hold their BHP and Rio shares, and suggests those who don't should wait for further declines before buying.

JPMorgan Chase & Co. Australian-based equity strategists Martin Duncan and Charles Jones on June 15 recommended investors cut holdings in BHP and other mining companies, saying metals prices have tended to peak ahead of U.S. interest rates over the past 25 years.

The brokerage unit of JPMorgan cut its rating on BHP to ``neutral'' from ``overweight'', and reduced allocations to the resources sector.

JPMorgan argued that demand growth for metals from China is slowing. Chinese consumption of base metals grew 15 percent in 2005, down from 23 percent in 2003, the analysts said.

`Still Happy'

``The question of the moment for the Australian resources sector is whether the current sell-off is merely a correction before resumption of boom conditions or the onset of a sustained pullback,'' Duncan and Jones said. ``We believe it is more likely to be the latter.''

Gary Armor at AMP Capital Investors is holding onto his BHP and Rio shares, betting Chinese demand for commodities will keep growing fast enough to fuel more share price gains.

China, the world's fastest-growing major economy, is also the world's biggest user of metals such as copper. The economy grew an annual 10.3 percent in the first quarter, the fastest among the world's 20 biggest economies.

``We're still happy with our investments in BHP,'' said Sydney-based Armor, who helps manage $2.9 billion at AMP. ``The fundamentals that drive demand for metals are still intact, and over the long term we'll look back and see the recent loss as a correction.''

Oxiana Runs Hard

Hegarty runs hard in Oxiana play

Robert Gottliebsen
June 17, 2006

THE latest commodity price and share market fall does not alter the long-term strategy of Owen Hegarty. Like most in the resources industry, he believes there is a long-term underlying shortage of metals such as copper and zinc that will keep prices at very profitable levels for low-cost producers.

The former RTZ executive now has a new goal: double Oxiana's production of base metals and gold to make it a $10 billion company by 2010.

It would then be Australia's second-largest Australian mining house.

Hegarty has already converted Oxiana from a $10 million minnow to a $3.5 billion Australian Stock Exchange top-100 company in less than 10 years.

To achieve the Oxiana long-term goal three events need to take place.

First, because Oxiana does not sell metals forward, he needs to be right that the latest price falls are a short-term correction, multiplied by hedge fund selling, and that the underlying shortages will cause metals to stay firm in the longer term.

Second, Oxiana's expansion programs and new projects have to be completed without a major hitch.

Oxiana needs another small acquisition or an exploration breakthrough to reach its production targets, and this fall in the market will give it the chance to do that, because of the cash bonanza the company has enjoyed over the last year

Third, he must escape the clutches of Xstrata or other raiders who prey on middle-ranking miners when they show any sign of weakness.

The odds are stacked against him.

Nevertheless, Hegarty's success in building an ASX 100 company is an inspiration to all those who aspire to create a big company.

Hegarty succeeded because he made two or three correct calls that put him in a position to take advantage of the good luck that came his way.

He spent the first 25 years of his working life with CRA.

When the Londoners took control after the merger with Rio Tinto, Hegarty saw an opportunity.

The Londoners did not share the CRA executives' belief in the potential of Laos as a major copper-gold province that would extend into neighbouring countries including China.

The Australians at CRA believed that the only way to develop this potential was to start small in Laos and then build.

The merged company was only interested in copper mines that started as a major undertaking.

And so Rio was happy to sell the Sepon gold-copper project in Laos to Hegarty and take a small stake in his new public company, Oxiana.

Hegarty then followed the original CRA plan of first developing a gold mine and then extending it into a 60,000 tonne copper metal plant. And in the next three years it will double to 120,000 tonnes.

He used the knowledge gained to widen Oxiana's exploration net through Laos and into the neighbouring countries, including China.

What nobody could have forecast was that just as Oxiana commissioned its Sepon copper metal production, the copper price exploded.

He also gained control of the Prominent Hill copper-gold prospect in South Australia, which was originally part of the BHP camp but was shed because it was thought to be too small.

And again just before the zinc price trebled, Newmont sold its Golden Grove zinc operation because it was not part of the company's gold strategy.

While the timing of these three events was good luck, Hegarty believed with a passion that base metal prices would boom because the world's mining houses simply didn't have the capacity to produce enough metal to meet demand.

He still believes that while there will be price corrections, shortages will continue for at least another decade, and possibly 20 years. This belief underpins the Oxiana strategy to 2010 and beyond.

For example, Hegarty does not forward sell Oxiana production, which means that when metal prices are rising Oxiana shares soar.

When they fall the shares are punished.

A few years ago the ANZ bank forced him to take out put options on gold so that he had the right to sell at least part of the group's output at what seemed at the time a high price.

The option expired because the gold price rose and it further entrenched the Hegarty view.

Of course, thanks to the recent high copper and zinc prices, Oxiana now has about $270 million in the bank, which goes a long way to cover its $US273 million ($367 million) in borrowing.

Hegarty says ambitious mining companies have to go through three trials before they become major players. Using an Australian Football League analogy he divides those trials into four quarters.

In the first quarter a small company brings together promising assets.

Oxiana has done that and is now playing in the second quarter, where these assets are developed and their range and number are expanded by exploration and small acquisitions. In the third quarter it is all about expanding the base that has been created, usually by large acquisitions or developing big discoveries.

In the fourth quarter the company becomes a major mining house and is usually immune from takeover.

By 2009 Oxiana expects to be at the end of the second quarter with a series of fully developed projects and a production of at least 400,000 tonnes of base metals (mainly copper and zinc) and 400,000 ounces of precious metal (gold and silver). Hegarty's target is to add another 25 per cent to those production levels by 2009, which will require an acquisition or exploration success.

Then Oxiana will be in the third quarter, using its large base for large acquisitions to reach the size required to be a true major company.

In recent times, four Australian miners have reached the end of the second quarter: MIM, WMC, Normandy and North's.

On each occasion the boards succumbed to what are now seen to be very low takeover bids. Only North's put up a real fight.

In the next three years Oxiana plans to spend more than $1 billion on four projects: lift its copper production at Sepon from 60,000 to 120,000 tonnes; increase Sepon gold production from 200,000 to 300,000 ounces; develop Prominent Hill (by 2008) to produce around 120,000 tonnes of copper; and incrementally lift Golden Grove's production to around 150,000 tonnes of zinc and around 100,000 ounces of gold and silver.

The risks of so much construction activity are obvious.

So far Oxiana has commissioned its projects on time and on budget, but if at any stage it stumbles it will be vulnerable to takeover.

A few weeks ago analysts expected Oxiana to earn $400 million in the current year to December 31, or 28c a share.

That will be now downgraded because, as Oxiana sells metal unhedged, profits can move sharply with metal prices.

But whatever way the sums are done Oxiana's price-earnings ratio is well below BHP and other leaders.

Hegarty knows this makes him vulnerable to takeover and with some emotion he says: "What we have to do is keep running as fast as our fat little legs will carry us and keep powering into the second quarter.''

Oxiana is planning to virtually double production, and despite lower metal prices a substantial amount of the investment cash will come from operations because the company has low costs and very little net borrowing.

That will put Oxiana into a very strong financial position to undertake the expansion.

And, with cash in its pocket, it is also looking around for acquisitions.

I put two suggestions to Hegarty and naturally he had little to say on either.

The first was Pan Australian Resources, which is also developing a copper mine in Laos. When I asked the question his quick response was: "I don't think so, not today.''

The "today'' was just before the big share fall which could create an underwriting shortfall in Pan Australia's four-for-five issue.

Pan Aust is backed by ANZ bank, which is also a major supporter of Oxiana.

My second long-term suggestion was a merger with Zinnifex, which is larger than Oxiana.

Hegarty gave the standard no comment.

Lots of companies have looked to takeover or merge with Zinnifex, but are nervous because the company is dominated by zinc and has many old smelters with pollution problems. On the other hand, Zinnifex has lots of cash, which it has begun to return to shareholders.

If Hegarty can complete the projects he is planning, then he will have a base for what he calls "the third quarter'', a period of rapid expansion by acquisition.

Xstrata is just completing this third-quarter process with a takeover bid for Falconbridge.

Once you have hit the final quarter you are of true size and the market will forgive you if you make a mistake, as we saw with BHP.

But if you make a mistake in the second or third quarters then you simply become bait for takeover.

Oxiana has got this far without stumbling, but its belief in the long-term outlook for commodities is now being tested.

If Oxiana can maintain its momentum until 2010 – a big challenge – then the odds will then favour Hegarty creating a second Australian mining house.

But he will need to run very fast.

June 27, 2006

Tomorrow the world

As I predicted last March: "Today Iceland: Tomorrow Turkey, Hungary, Australia, New Zealand, Spain, U.S."... Soon: the Coming US Hard Landing...
Nouriel Roubini | Jun 24, 2006 Last March the current financial markets turmoil had not started yet and investors were still deluding themselves that easy liquidity would allow them to continue their "poor manager's source of alpha" returns (i.e. the easy returns that even mediocre investors can get from simple carry trades when interest rates are low and money is dirt cheap, to use the appropriately sarcastic expression of Raghu Rajan, the chief economist of the IMF).

At that time, I predicted that the then turmoil in Iceland (then the "canary in the mine") would soon transfer to a much wider set of countries with large current account deficits and at risk of a sudden stop. I cited Turkey, Hungary, Australia, New Zealand, Spain and the U.S. 

I then spared from that infamous list - but not in other presentations (see my India paper) - countries such as the U.K., India and South Africa (that also had large current account deficits) only because their overall fundamentals were, at the margin, better and, in the case of South Africa, they were then  benefitting from high commodity prices.

Then, when the market turmoil in emerging market started in May I repeated and fleshed out in more detail my concerns about countries such as Turkey, Hungary, New Zealand, U.S. and other emerging markets with large current account deficits and other vulnerabilities; I argued that that the beginning of that turmoil was not a temporary phenomenon or blip - as investors were still deluding themselves - but the beginning of a more severe and protracted downturn related to a US and global slowdown in an environment of "stagflation lite".

I was not surprised by the virulence of this turmoil because of two reasons: 1) I had been predicting for months now that Three Ugly Bears (higher inflation leading to higher interest rates and draining cheap liquidity, high oil and commodity prices and a housing bubble bust) would hit the US and global Goldilocks and hurt both G7 and emerging market economies; 2) I had written in 2004 a book with Brad Setser on the financial crises in emerging markets in the last decade and we well knew - based on a decade of crises - that large and unsustainable current account deficits may lead to currency and financial crises. Indeed, with the exception of Russia that did not have a current account deficit in 1997-98, every financial crisis in emerging market economies in the last decade (Mexico, Thailand, Indonesia, Malaysia, Korea, Brazil, Argentina, Ecuador, Turkey, Uruguay, Dominican Republic) had been associated - among several other vulnerabilities - with a large current account deficit that led to a sudden stop when a combination of domestic and external shocks hit the economy.

Next, last month when most market commentary was still suggesting that the vulnerabilities of Central and South Europe were inexistent or very modest at best, I wrote a long paper with my co-author Christian Menegatti arguing that many economies in Central and South Europe (a sample of 14 countries from the Baltics all the way to the Balkans and Turkey) were vulnerable to turmoil and a sudden stop as, unlike emerging Asia and emerging Latin America, they were each and all running large current account deficits and had other significant macro and financial vulnerabilities. When I presented a month ago this paper in Istanbul at a conference on Central and South Europe organized by the Turkish Central Bank my concerns were received with skepticism as the conventional wisdom was still that Central and South Europe had both good fundamentals and the protection of EU (and next EMU) membership or soon-to-be membership.

And to elaborate my concerns about Turkey I wrote another paper earlier this month to analyze and highlight in detail the risks and vulnerabilities of this economy. My even larger concerns about the risks of a crisis in Hungary are fleshed out in detail in a new paper co-authored with Christian Menegatti that is available to RGE Premium Content subscribers.

And, indeed, in the last few months the obvious and predictable - if one had the bother to consider and reflect early on on the risks in the US and global economy of a number of serious economic and financial imbalances - did occur. One by one, countries with large current account deficits were hit by financial turmoil in their equity, currency and bond markets. First Iceland, then Australia, then New Zealand, then the US and the US dollar, then Turkey, then Hungary, then this week New Zealand, South Africa and India whose currencies and markets have been rocked this week by news of surging current account deficits. Each one of them has had serious pressure on its currency and its other asset markets, especially equities but now also bonds.

We of course know that current account deficits may be a necessary but not sufficient condition for currency and financial pressure; a whole balance sheet approach to risks and vulnerabiliteis is necessary to assess whether an external imbalance is positive or negative and whether it is sustainable over time. But the predictable response of wishful thinking investors and policy makers in good times is always to down play these current account and other vulnerabilities: every time we are told that this is a good current account deficit driven by high growth, strong investment and high productivity. And every time we are told that a real appreciation of the domestic currency does not represent a fundamental overvaluation or misalignment as the fundamental real exchange rate has appreciated because of a strong and growing economy. This is the kind of non-sense that one hears over and over again until the moment the proverbial "shit hits the fan". And those who warn about such external and financial vulnerabilities are ignored until it is too late.

The knee jerk reaction of many folks at the Istanbul conference on Central and South Europe was to down play my concerns about a region with large current account deficits, fixed exchange rates in most countries, currency mismatches, maturity mismatches given large stocks of short term external debt  relative to forex reserves, large external financing needs, weak banking systems and, in several countries, large fiscal deficits. This was the deadly receipe of vulnerabilities that led to financial crises in Asia and Latin America.

But guess, what? The last couple of weeks have been a disaster for Turkey, Hungary and, now increasingly, other countries in that Central and South Europe region as financial "contagion" is now spreading to the region. To cite a couple of reports this week from Goldman Sachs and Citigroup to their clients:

" The global risk reduction began in May with an unwinding of major macro trades held by hedge funds. By early June, many hedge funds appear to have flattened out their risk, and some asset classes showed signs of stabilisation. But over the last two weeks, the contagion has spread to central and eastern Europe, as a new class of investors – real-money convergence funds – has been forced to liquidate positions in the face of redemptions by investors. While differentiation is likely to remain an important theme, even emerging markets with strong fundamentals are likely to continue to suffer portfolio outflows and asset price weakness. " (Goldman Sachs)

"Is the sell-off taking place in emerging market assets driven by technicals or fundamentals? That is the question investors are asking themselves as they once again observe the flicker of red on trading screens as the week draws to a close. The answer to that question has important investment consequences: A “technical” sell-off implies that the brave can probably make money by buying now, while “fundamental” problems may be considerably more complicated. A month ago, many CEEMEA [Central and East Europe, Middle East and Africa] investors would have stridently answered that fundamentals in the region are sound. However, today — with currencies weakening, economists scrambling to raise inflation forecasts, and central banks hiking rates (we count eight hikes in emerging market economies in the past few weeks) — it is becoming more difficult to shrug off concerns over the impact of a changing backdrop.

Although CEEMEA’s [Central and East Europe, Middle East and Africa] economies are clearly in a stronger position than in the past, there is no doubt that financial market volatility has begun to contaminate domestic economic conditions in a number of CEEMEA’s key markets: South Africa, Turkey, and Hungary are all facing higher inflation and interest rates than they were a month ago. Here, however, all markets are not created equal — just as the rand and lira have diverged from the ruble and real, so too do we find differing vulnerabilities of those economies to a prolonged period of capital flight. Above all, markets are punishing current account deficit countries and are likely to continue to do so; in deference to this we downgrade South Africa to Neutral (from Overweight) and upgrade the less-exposed Poland to Overweight (from Neutral).

Just how much farther this vicious process continues is in large part driven by the “technical” side of the equation. How much capital might investors still pull out of these markets and when might buying return? Reviewing funds flows data this week, we find the answer less than reassuring: Although emerging markets funds have seen $15b of outflows since May 10, this represents just under half of the inflows seen in the prior five months, and 25% of the prior three years. With cash levels relatively low, this selling looks like it could well continue." (Citigroup)

Or, as reported by th FT today under the appropriate headline "Emerging Market Deficit Currencies Renew Slide":

"Emerging market currencies dependent on foreign capital flows to balance their books suffered further sharp falls this week. The South African rand, Turkish lira and Hungarian forint, as well as the New Zealand dollar and Icelandic krona, took a fearful beating in a sign that the market is sharpening its focus. Emerging markets have suffered from a wave of sell-offs this year, the most severe biting from May 10. However, while previous episodes hit all emerging currencies fairly uniformly, now there are clear signs of a developing “pecking order”, in the words of Citigroup.

Currencies backed by weak fundamentals are struggling, while those with a sound backdrop are holding steady. “The last six weeks are likely to mark the end of an era in which the markets were ready to overlook unsustainable policies, large external deficits and precarious political outlooks in a global search for higher yield,” said Thomas Stolper, global markets economist at Goldman Sachs.

External deficits were very much to the fore this week, with South Africa revealing that its current account deficit jumped to 6.4 per cent of GDP in the first quarter of the year, while New Zealand – not an emerging market but with many of the same characteristics – saying its deficit had surged to 9.3 per cent of GDP. Both currencies fell sharply, with the rand slumping 7.9 per cent to a 33-month low of R7.415 to the dollar, capping a 16.9 per cent slide so far this year, and the kiwi falling 1.7 per cent to $0.6058, down 11.1 per cent so far this year. The contagion spread to other deficit nations, with the Turkish lira (current account 6.3 per cent of GDP) tumbling 7.2 per cent to a three-year low of TL1.7075 to the dollar, cementing a 26.3 per cent fall this year amid an ongoing inflation scare, despite intervention to prop up the currency.  The Icelandic krona (deficit 16.5 per cent) fell 1.8 per cent to IKr76.19 to the dollar, down 20.5 per cent since January 1, and the Hungarian forint (7.2 per cent) fell 2.7 per cent to an all-time low of Ft280.80 to the euro, with Goldman reporting that Central and Eastern European-focused convergence funds have been forced to liquidate positions in the face of redemptions by investors.

However, in sharp contrast, currencies backed by strong fundamentals, such as the Brazilian real, Mexican peso, South Korean won, Thai baht and Singapore dollar all held firm. Sterling was the weakest major currency, slipping 1.7 per cent to $1.8204 to the dollar, 0.8 per cent to £0.6879 to the euro and 0.7 per cent to Y211.55 against the yen, following the death of David Walton, the sole agitator for higher rates at the Bank of England.

But the dollar continued its rebound, bouncing to two-month highs as it rose 0.9 per cent to Y116.22 against the yen, 0.9 per cent to $1.2525 to the euro and 1.3 per cent to SFr1.2464 against the Swiss franc. The dollar was a beneficiary of the emerging market chaos, as US-based hedge funds continued to repatriate funds. The greenback was also aided by ever-rising US rate expectations. Rumours yesterday that Ben Bernanke, the chairman of the Federal Reserve, has asked bond dealers what the reaction would be to a half-point rate hike this Thursday led the futures market to price in a 12 per cent probability that the Fed will, indeed, hike by 50 rather than 25 basis points. A total of 50 points of tightening to 5.5 per cent by the August meeting is now 80 per cent priced in. However, with the US nursing a current account deficit of 6.4 per cent of GDP, some saw warning signs in this week’s sell-off. “We believe it is somewhat bizarre that whilst the market chooses to sell the rand and kiwi because of their currrent account deficits, it chooses to buy the US dollar,” said David Bloom, currency analyst at HSBC. “What one must realise, longer term, is that these currencies are flags, signals for how the dollar will trade once the economy softens and the market stops looking for ever higher rates.”

So, what about the US dollar? The last quotation from David Bloom from HSBC is exactly on the mark. It is indeed bizarre and weird that the US dollar has been recently strenghtening while investors are dumping the currencies of countries with large current account deficits as the US deficit is much larger both in absolute and relative terms. Indeed, the US dollar started to sharply fall in April when the force of gravity of a larger current account deficit stopped being controlled by anti-gravitational forces such as increasing interest rate and GDP growth differentials between the US and Europe/Japan. Since then, the inevitable fall of the dollar has temporarily stopped and has partly reversed for a few reasons: the Fed has signalled that it is not done with tightening while the BoJ was posponing the moment it will drop its ZIRP; and the turmoil in emerging market economies and increased global risk aversion has led investor to seek the relief of safe haven assets such as US Treasuries. But the US stagflationary slowdown together with a still growing current account deficit will soon sink the US dollar. The US and it currency will be the proverbial "last shoe to drop" for all the usual reasons that give the US the "extraordinary privilege" of sustained external financing and reserve status. But since, the size of the US and its imbalances is not that of a small emerging market "shoe" but rather a massive boulder eventually driven down the mountain by fundamental gravitational forces, once this boulder starts rolling down the avalanche will get real nasty for the US and all the world.

All this while the official Bernanke and Fed and US Treasury and CEA view is that the US current account deficit is not a deficit but "a capital account surplus", that this deficit has little or nothing to do with the US but is caused by a "global savings glut" and that US fiscal deficits have no effects on the US current account deficits. At least some wiser minds at the Fed - such as Tim Geithner and several other sensible Fed governors and Fed presidents - recognize and worry about the unsustainability of the US current account deficit and of the US fiscal deficit and have publicly expressed their concerns about it. And, luckily for the US, Tim Geithner very succesfully managed - both at the US Treasury and next the IMF - all the emerging market financial crises of the last decade. So, the knowledge and wisdom and expertize of this "supremo crisis manager" will come handy when the biggest emerging market of all - the US being the biggest net borrower and net debtor ever - will experience its own nasty financial crisis. The 1998 LTCM mess will then look like a minor ripple in the sea compared to the "perfect storm" that could engulf the US and the global economy once the US policy recklessness and blissful ignorance of the risks we are facing triggers an ugly hard landing.

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Turkey’s Risks and Vulnerabilities in the Current Market Turmoil
Nouriel Roubini | Jun 19, 2006 What explains the recent turmoil in Turkey’s financial markets? How much is it due to changes in global or external conditions as opposed to domestic vulnerabilities? Will Turkey weather the current storm or is it at risk of experiencing another serious financial and real economy crisis? These are complex questions that require a detailed analysis that I have done in a new paper that is available here to RGE’s Premium Content subscribers. I will summarize some of the points of this paper in this blog. See also a recent blog by Brad Setser who discusses the turmoil of Turkey in the context of the turmoil broader pressures on a wide range of economies and emerging markets.

As a starting observation, note that one feature of the recent turmoil in global financial markets is that a wide range of emerging markets – both those with greater vulnerabilities (such as current account deficits and other imbalances) and those with lower vulnerabilities (such as current account surpluses) – have been hit. Indeed, common global factors (the risk of global slowdown, the risk of increased inflation leading to tighter monetary policies in the US and other G7 economies, and an increase in the international investors’ risk aversion) have led to a sell-off in currency, equity and bond markets of most emerging market economies. So, is not just Turkey to have been hit by this financial turmoil; most emerging markets have. However, investors have partly discriminated among these various economies based on their individual vulnerabilities. In fact, the country that has had one of the largest falls in its currency value and in its stock market in recent weeks has been Turkey that also has one of the largest current account deficits among these emerging markets and several other significant vulnerabilities.  (see also my recent paper with Christian Menegatti on vulnerabilities in a large sample of 14 Central and South European emerging market economies) 

Indeed, Turkey is not just at risk because of the current account deficit that makes its economy vulnerable to a sudden stop. It is true that, after the 2001 crisis, Turkey has done a lot to reduce its macro and financial vulnerabilities: a primary surplus of over 6%, a sharp reduction of its fiscal deficit, a fall of inflation to single digit levels and a sharp pick-up in economic growth, a clean-up of its crisis-ridden banking system, privatization and opening to FDI, a build-up of foreign reserves, a flexible exchange rate, a successful IMF program,. But significant vulnerabilities - both at the aggregate and sectoral levels - remain: the short maturity of its public debt; still meaningful, if lower, currency mismatches at the aggregate level; a banking system where credit growth and maturity extension were becoming excessive; an increasingly overvalued currency (before the recent sell-off) that worsened the external balance; and now rising political tensions including a partly botched succession of the central bank governorship, rising conflict between the secular “deep state” plus the military and the islamist government, uncertainty about the timing and outcome of the presidential and parliamentary election, now even the specter of political violence; and the negotiations about EU accession going at a slowing pace and encountering a number of difficulties, including a harder stance by some in the EU on the issue of eventual Turkish accession. Also, the early adoption of a formal low inflation target for 2006 (5 to 7% range) while inflation was inertially above the target and currency overvalued has now created a monetary policy dilemma: with the currency sharply down, given the recent turmoil, the creeping increase in inflation has sharply accelerated in May. Thus, an increase in policy rates – the first in years – became now necessary (with a sharp 175bps increase in the policy rate to a 15% level) but this hike risks to lead to a slowdown in growth at the time when the political system expects continued good economic performance. The central bank is now trying to do the right thing, show its independence and tighten as necessary to stem inflationary expectations; but the costs of such tightening on growth may become painful.

The paper analyzes in detail both the macro and the financial vulnerabilities of Turkey at the aggregate and sectoral levels. Macro imbalances remain significant with a large current account deficit and a fiscal deficit that, while lower, is still significant; while the current account deterioration was partly driven by investment – some of it housing rather than tradeable goods investment fueled by a credit boom – it was also partly due to an overvalued currency. The financing of these imbalances has also some worrisome features, both at the aggregate level and at the sectoral level of public sector, financial institutions and corporate sector: currency mismatches remain significant (at the government and corporate sectors level) in spite of a process of liability de-dollarization; maturity mismatches are important (in the government and financial sector) and external financing needs remain large relative to foreign reserves; there has been greater reliance on debt rather equity for the financing of the current account even if FDI is rising; and while solvency risk is limited both at the aggregate and sectoral levels, debt ratios are still high (if falling) for the country and the public sector.

Hopefully, given its overall good macro and financial fundamentals, Turkey will weather this storm with limited damage. Certainly a flexible exchange rate help to let the financial steam get off the pot via a currency adjustment as opposed to a fixed exchange rate where the pot has a tight lid that entraps the boiling steam inside the pot, only to have the entire pot explode in a currency crisis once the pressure becomes too much to contain. But the financial conditions are most delicate in a worsening global environment with high oil and commodity prices, the risk of a global slowdown, rising global interest rates and rising international investors’ risk aversion. A country like Turkey that has a large current account deficit and even large external financing needs is highly vulnerable to a sudden stop of international capital flows. If the sudden stop is modest, the country may still be able to finance a current account deficit close to the large expected value for 2006. But if the stop were to be more significant, it would force a current account adjustment that would be painful as it would be associated with a significant slowdown of growth. Also, the fall in asset prices – equity, local currency debt, currency value – has been severe and inflicting sharp losses to foreign investors that had only recently ventured in the Turkish market; a mood of near panic was thus setting in recent weeks among such investors that only lately realized the risks of being stuck in a relatively illiquid range of markets.

Thus, sound policy choices are essential in this period of market turmoil. Maintaining a large primary surplus will be essential, especially as concerns about fiscal slippages may increase as elections become closer; and continuing the reforms required to sustain fiscal discipline over the medium term will be important. Monetary policy should be targeted to contain inflationary expectations and actual inflation trends even if this implies a slowdown in economic growth.  However, strict adherence to the inflation target may be counterproductive; given the current currency shock some increase in the inflation rate above the formal target is inevitable and needs to be partly accommodated; overreacting and trying to achieve the strict inflation target would require over-tightening that would hurt more than help the economy. And the recent adoption of a formal inflation target ended up being a tactical mistake; given the risks of financial and currency shocks the country may be better off with a more informal inflation targeting regime rather than adopting a weakly credible formal inflation target. Forex intervention should be used only to smooth excess currency volatility; systematic one sided intervention would be counter-productive and monetary policy – rather than forex intervention – is a better tool to address financial pressures.  In conclusion, very savvy monetary and fiscal policy making – together with less political noise - will be required to stem the growing financial pressures and avoid more severe market developments that would eventually negatively affect the real economy. The central bank is now showing its independence and tightening as necessary to stem inflationary expectations; but the costs of such tightening on growth could become significant in the near future.  Indeed, it is likely that the growth rate in the next few quarters will slow down by at least 1% given the combined effects of rising short term and long term interest rates and falling equity prices.  And further growth slowdown cannot be ruled out if external/global conditions worsen (as it is likely), political noise increases and financial market turmoil continues.


June 12, 2006

Hussman on the Limitations of the Fed

John P. Hussman, Ph.D.

Ivan Pavlov was an accidental psychologist. The Russian scientist was actually interested in stomach ailments and the digestive systems of dogs. In order to study their saliva, he would offer them meat powder. At one point, Pavlov noticed that some of his dogs would start to salivate as soon as he walked into the room, but it only happened with dogs that had been in the laboratory. So he paired a bell with the meat powder, and showed that after a while, the dogs could be made to salivate just by ringing the bell.

Investors who experienced the 1987 market crash might remember that for months after that event, the market would get extreme jitters every time the trade balance was about to be released. The reason is that when the market crashed, investors and journalists looked for the news of that specific day to explain the move, and all they could find was a bad trade number. And just like pairing meat powder with a bell, pairing the market crash with a bad trade number made investors hypersensitive to trade numbers for months.

Investors are now pairing Ben Bernanke with the market's recent weakness as if they are legitimate cause and effect. Don't blame Bernanke. Make no mistake – the recent pullback has little to do with the Federal Reserve except that it creates enough of an excuse for the inevitable to happen. Are we actually to believe that the economy is so precariously perched on pins and needles that one single quarter-point move too-many in the Fed Funds rate means the difference between a continued economic “boom” and an economy driven to its knees? And if the economy is in fact that vulnerable, shouldn't investors be selling stocks anyway based on the prospective risks?

Look. Probable market weakness has been baked into the cake for months – resulting from a combination of unfavorable valuations, weakening internals, and speculation in low quality stocks. Nor does the historically insignificant wiggle that we've seen in the past few weeks do much to resolve those issues. That doesn't mean that stocks should or must decline in the immediate future, but it does mean that the problems for the market (being, as it is, still priced to deliver disappointingly low long-term returns) remain yet be resolved. (There's that “yet” word again).

Personally, I feel a little bad for Bernanke – though as I noted in the October 31, 2005 comment, he more or less invited all of this criticism by focusing on an inflation target which can't, in fact, be controlled by the Fed, and can only be measured effectively with a lag. Remember that the Fed does nothing except determine whether government liabilities will be held by the public in the form of bonds or in the form of cash (currency and bank reserves). The actual quantity of those government liabilities is not under the Fed's control, but is controlled by Congress through its fiscal policies. If fiscal policy makers insist on creating a flood of government liabilities (as they currently are), the Fed's decisions will have extremely little importance or impact in avoiding the resulting inflation. The Fed's policies are important when there is a panic for liquidity, such as bank runs and financial crises, but unless bank liquidity is actually constrained (and it doesn't appear to be presently), the Fed's moves are largely irrelevant.

So it's important to recognize that the economy just isn't that sensitive to little moves in a short-term, Fed controlled interest rate on bank reserves that back an insignificant portion of total lending activity (see Why the Fed is Irrelevant). The economy may very well be in for trouble (credit spreads are just starting to widen, consumer confidence spreads show sudden weakness in future versus present conditions, aggregate weekly hours are stalling, etc.), but though Bernanke may be used as an excuse, he really isn't going to be the cause, regardless of what the Fed does next.

In any event, this sight of nervous investors hammering on Ben Bernanke could be an important signal – maybe the next best thing to actually ringing a bell at the top.

What?!! How can I even mention the notion of stocks being vulnerable when we're so “clearly” oversold and close to a bottom? Well, the S&P 500 is only down about 5.5% from its peak of a few weeks ago, and it's precisely the “fast, furious, prone-to-failure” rallies that keep investors holding on until an enormous amount of damage is done. As I've noted before, bear market psychology typically evolves something like this:

"This is my retirement money. I can't afford to be out of the market anymore!"

"I don't care about the price, just get me in!!"

"It's a healthy correction"

"See, it's already coming back, better buy more before the new highs"

"Alright, a retest. Add to the position - buy the dip"

"What a great move! Am I a genius or what?"

"Uh oh, another selloff. Well, we're probably close to a bottom"

"New low? What's going on?!!"

"Alright, it's too late to sell here, I'll get out on the next rally"

"Hey!! It's coming back. Glad that's over!"

"Another new low. But how much lower can it go?"

"No, really, how much lower can it go?"

"Sweet Mother of Joseph! How much lower can it go?!?"

"There's no way I'll ever make this back!"

"This is my retirement money. I can't afford to be in the market anymore!"

"I don't care about the price, just get me out!!"

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Growth Fund to a fully hedged investment stance.

As usual, our own investment approach doesn't focus much on identifying bull or bear markets (which can only be identified in hindsight), but instead focuses on prevailing, identifiable conditions of valuation and market action. For what it's worth, unfavorable Market Climates have a clear, but far from perfect overlap with periods that turn out to be “bear markets” in hindsight. Unfavorable Market Climates do tend to cover the worst portions of most bear markets, as well as periods within bull markets that were negated by abrupt weakness, which is important.

Given the present constellation of market and economic conditions, if I was to venture a guess, I'd guess that stocks have entered a bear market here. That opinion doesn't drive our actual investment stance, and we'll accept an exposure to market fluctuations on any significant improvement in valuations or market action, but I certainly would not rule out the potential for substantial further market weakness just because stocks are down a little bit from their highs. Nor, however, should we be surprised by a “fast, furious, prone-to-failure” rally to boost short-term hopes to the contrary. We're fully hedged regardless.

Of major significance: Petroruble (and Euro)

The petroruble makes an entry..

RTS fixes $65.2 price for first oil futures deal
12:43 | 08/ 06/ 2006

MOSCOW, June 8 (RIA Novosti) - The Russian Trading System, Russia's premier stock market, announced Thursday the first futures contract on Urals oil blend had been concluded at $65.2 per barrel and the trade in gold futures had started.

The first oil deal was denominated in rubles (1751 rubles) based on prices calculated by the Platts agency and covered 10 barrels. The settlement period for the contract is one month and the security guarantee on the contract is 10% of its overall value. RTS collects a 1-ruble commission for each concluded contract.

"Crude contracts will safeguard producers and consumers against unfavorable price situations and guarantee business efficiency and stability," an RTS spokesman said. "Market players will also get a new investment derivative."

The derivatives section of the RTS, known by its Russian acronym Forts, has also launched trade in futures on gold in rubles based on the London Stock Exchange evening fixing rate. The first deal for July and September was worth $626.5 per ounce. The settlement period for a contract is one month and the minimum security guarantee on any contract is 5% of its overall value.END

inside Wall Streets Culture of Risk

 On the 31st floor of a skyscraper overlooking Times Square one recent spring day, a dozen or so of Lehman Brothers Inc.'s (LEH ) top executives filed into a conference room to run through risks, relive past financial crises, and worry about new ones. They analyzed how much money the firm might lose if the markets were buffeted like they were after the terrorist attacks of 2001. They pored over complicated risk models showing how tens of thousands of trading positions and financial contracts with clients would fare in the event of an Avian flu epidemic. They tested all conceivable scenarios that might put Lehman in harm's way. "We are in the business of risk management 24/7, 365 days a year," says Chief Administrative Officer David Goldfarb.

Wall Street has always been about taking risk. But never has the "R" word been such an obsession for the men and women who rule the nation's biggest investment banks. Never have they had to reconcile so many bets made on so many fronts. The conditions have been ripe. Historically low interest rates and relatively calm markets in the last few years have allowed a new type of firm to flourish, one that acts primarily as a trader and only secondarily as a traditional investment bank, underwriting securities and advising on mergers.

Goldman Sachs' CEO Henry M. Paulson Jr. has led the charge. Major Wall Street firms have watched with envy as Goldman has repeatedly racked up record earnings on the strength of its trading business. The biggest stunner came in March when Goldman announced that in three months it had tossed off $2.6 billion in profits -- nearly half as much as it earned in all of 2005 -- on $10 billion in revenues. Not coincidentally, Goldman also put a record amount of the firm's capital at risk of evaporating on any given trading day. Its so-called value at risk jumped to $92 million, up 135% from $39 million in 2001. "[Goldman is] a horse of a different color now," says Samuel L. Hayes III, professor emeritus of investment banking at Harvard Business School.

As Paulson prepares to move to Washington to serve as U.S. Treasury Secretary, Goldman shows no sign of easing up. Nor do its followers. This trading boom, fueled by cheap money, is fundamentally different from the ones of the past. When traders last ruled Wall Street, during the mid-'90s, few banks put much of their own balance sheets at risk; most acted mainly as brokers, arranging trades between clients. Now, virtually all banks are making huge bets with their own assets on many more fronts, and using vast sums of borrowed money to jack up the risk even more. They're shouldering risks for their clients to an unprecedented degree. They're dabbling in remote markets from Brasilia to Jakarta, and in arcane products like credit-default swaps and catastrophe bonds. Led by Goldman, many investment banks now do more trading than all but the biggest hedge funds, those lightly regulated investment pools that almost brought down the financial system in 1998 when one of them, Long-Term Capital Management, blew up.

What's more, banks are jumping into the realm of private equity, spending billions to buy struggling businesses as far afield as China that they hope to turn around and sell at a profit. With $25 billion of capital under management, Goldman's private equity arm itself is one of the largest buyout firms in the world, according to Thomson Venture Economics. The moves are not unrelated to trading. In both cases, banks are flocking to exotic and inaccessible markets where there aren't many others to fight for profit. Counterintuitively, they're seeking out the investments that would be the hardest to get rid of in the event of a disaster. They're betting, in other words, that handsome returns when times are good will make up for losses when things turn ugly.

So far, the rewards are justifying the risks: Big investment banks are booking record profits, and their stocks have zoomed, up 64% since 2001. But once-calm global markets are getting rocky as interest rates rise, choking off the easy money. Fears of more rate hikes to come have triggered sell-offs in stocks, bonds, and currencies around the world since early May.

That's raising the stakes for arguably the biggest game of risk ever to play out on Wall Street. If banks succeed, they'll rack up even bigger earnings. But if they borrow too much money for their trades or take on more risk than they can manage, the wreckage could be considerable. "A world where huge amounts of leverage have been brought into the system is a dangerous world," Berkshire Hathaway Inc.'s CEO Warren Buffett observed at his most recent annual meeting. And "as interest rates rise...people will stretch even further and take greater risks," warns John H. Gutfreund, senior adviser at the investment bank C.E. Unterberg, Towbin and former CEO of Salomon Bros. Andy M. Brooks, head of equity trading at investment manager T. Rowe Price Group Inc. (TROW ), puts it more bluntly: "If people step out too much, they're going to get whacked."

Just as investment banks are taking more risks, so are millions of individuals. They've bid up prices and accepted thinner safety cushions in the past few years on commodities, international stocks, and shares of the riskiest U.S. companies. Penny-stock trading has soared, up 640% from three years ago. Gambling and casino stocks have risen sharply in recent years. And home buyers have leveraged up, buying more expensive houses with more complex mortgages. "Investors seem to be displaying signs of pure fearlessness," James Montier, global equity strategist at Dresdner Kleinwort Wasserstein, summed up recently. Says James Grant, editor of Grant's Interest Rate Observer and a financial market historian: "The world is stretching for return." The last time investors stretched so far, during the dot-com boom of the late '90s, the results were disastrous.

But the biggest danger may be on Wall Street. As the banks trade in ever-more-obscure products with ever-more-opaque clients such as hedge funds, observers worry that they might not be able to settle their trades in the event of a market shock, intensifying the damage. "The heartburn," says Robert Fuller, the principal and founder of Hopewell (N.J.)-based financial adviser Capital Markets Management, "could be anywhere from something you can cure with a Tums to death by trauma."

It might not take a major meltdown to send bank profits tumbling: Scandals might get them first. Suspicions are rising that bank traders are acting on nonpublic information gleaned from their clients. So-called front-running is nothing new to Wall Street watchers, but with so many different kinds of financial products being traded today, and so many parties involved, the temptations are unprecedented. The Securities & Exchange Commission has "very active examinations and investigations under way," says Lori A. Richards, an agency director.

Yet for all the risks they're taking on, banks insist they're safer than ever. They've hired many of the greatest mathematical minds in the world to create impossibly complex risk models. They deal in so many markets that the chances of all of them going haywire simultaneously appear minuscule. And traders have been feathering banks' nests for five years. They've produced record earnings and boosted asset bases to unheard of sizes, making even bigger bets possible. Although the scale of trading activity has soared, risk now accounts for about the same percentage of brokers' total equity as it did in the 1990s, notes Tom Foley, financial-services credit analyst at Standard & Poor's, like BusinessWeek a unit of The McGraw-Hill Companies.

The arguments have been good enough for investors, who have been cheering banks on to raise their risk profiles even more. If you thought the recent volatility in the emerging markets would have discouraged them, think again. Even though such jitters have knocked Goldman's stock price down 9% since May 9, wiping out $6.8 billion in market value, analysts from UBS, Merrill Lynch, and Punk Ziegel & Co. have either upgraded or reiterated their support for the stock. They expect that any rise in volatility will create even more trading opportunities. The question is, how far will Goldman and the others go?

From the looks of it, pretty far. All of them are ramping up teams of so-called proprietary traders who play with the banks' own money. Merrill Lynch is expanding a "strategic risk" team for a wide variety of equity securities. More than 100 UBS (UBS ) traders have migrated to a hedge fund the bank has seeded and is marketing to outside investors. The appetite for proprietary traders is growing "exponentially," says Richard Stein of executive recruiting firm Korn Ferry International. Banks are paying up, offering some traders $10 million to $20 million a year, he says.

Banks are building out their infrastructures, too. UBS already boasts the largest trading floor in the world in Stamford, Conn., where more than 1,000 traders inhabit a 103,000-square-foot space that was last updated in 2002. It is no longer big enough. "We're expanding," says Mark E. Bridges, a senior executive. The Swiss bank is so eager to keep its employees focused on the task at hand that it has sprinkled six concession stands that sell Starbucks (SBUX ) coffee around the trading floor. Across the street, the Royal Bank of Scotland expects to start construction of a 95,000-sq.-ft. space this summer. Citigroup (C ), meanwhile, is focusing on squeezing more bodies onto its three main trading floors. Right now there are twice as many technologists crunching analytics and market data as there are traders on the floors. By 2008, the ratio could be 1 to 1. They're needed: Transactions have become so complex that some traders have eight computer screens at their desk.

Wall Street's exuberance is palpable as the pain of big blowups of the past recedes from memory. John Meriwether, the former head of Long-Term Capital Management, is now considered a hero to some. On June 28 the industry newsletter Alternative Investment News will give Meriwether a lifetime achievement award for pioneering alternative investment strategies. (Meriwether, who now runs a fund called JWM Partners, doesn't plan to attend the event.)

To some extent, the jubilation is understandable. Banks in recent years have been remarkably successful in shrugging off crises, from the downgrading of General Motors Corp.'s (GM ) credit to junk status last spring to the destruction of New Orleans, that could have triggered meltdowns. "Right now everything on my screen is flashing red," said Michael Alix, chief risk officer at Bear, Stearns & Co. (BSC ), on May 11, the day after Federal Reserve Chairman Ben S. Bernanke raised interest rates, sending the market gauges he was looking at tumbling. But "that doesn't make me nervous," says Alix. The bank has built such powerful computing systems that Alix can reevaluate every day the risks of thousands of positions across the firm's trading businesses under various stressful scenarios to be sure the firm doesn't hold too much of any risky investment at any one time. That type of analysis used to take a week to complete. "The machine works," he says. The degree to which risk management has evolved in the past few decades is astonishing, say analysts.

As is the development of trading itself. Morgan Stanley's (MS ) John Shapiro, who runs one of the world's most profitable energy and commodities trading operations, joined the firm two decades ago. Back then his group traded mostly metals and crude oil futures. Now it trades a long list of energy products and owns several power plants. Those hard assets have been hugely advantageous, throwing off revenues in their own right and giving Shapiro's traders a much better sense of the overall market than the grinders in the futures pits have. "It's not that I'm looking to take on extra risk," says Shapiro. "But if opportunities we come across require us to do it...I will not hesitate to ask for more."

Some on the Street argue that such confidence is misplaced, and that the relative stability in the global markets since 2003 has lulled traders into a false sense of security. So much speculation has crept into commodities markets, for example, that in April they were trading at prices 50% higher than they would have been based only on fundamentals, estimated Merrill Lynch. A sharp sell-off followed in May. Are bank traders and hedge funds living on borrowed time? One senior bank executive thinks so. He worries that at any moment volatility could spike to levels never seen before.

How the markets will respond to such an event "is up in the air," says Leslie Rahl, president and founder of Capital Market Risk Advisors Inc., a New York-based consultancy. That's because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives. They also use any number of risk models whose predictions vary wildly depending on the assumptions. For example, JPMorgan Chase & Co. (JPM ) estimates on page 76 of its annual report that in 2005 its trading portfolios were at risk of losing $88 million on any given day, a pittance compared with its annual profit of $8.5 billion. The figure it cited is called value at risk, or VAR, which describes the total losses across all positions, from pork bellies to Iraqi bonds, that could be sustained in any single day under normal trading conditions. On average, major investment banks report VAR of $56 million.

But such backward-looking estimates don't capture the extent of the banks' risks. On the very next page of the JPMorgan report, the bank tells investors that losses could have soared to as much as $1.4 billion over, say, a four-week period last year if an abnormal event had occurred. That figure was based on a "stress test" it performed on its books, another kind of risk-modeling technique.

The good news? At least banks are reporting their VAR numbers; they didn't before the late 1990s. The bad news is that JPMorgan is one of only a few banks to divulge results of a stress test or any other measure of unusual risk. Investors, guided mostly by VAR amounts, have no idea what might happen in an abnormal event. "Banks are treating exceptions [to the norm] as adjunct risk," says Nassim N. Taleb, a professor at the University of Massachusetts Amherst and former proprietary trader at UBS and Credit Suisse First Boston (CSR ) who has written extensively about the limits of VAR. "But when you ride a plane, you don't worry about your coffee being cold. What you worry about is the risk that your plane will crash."

Wall Street chiefs are aware of risk models' limitations. During an investor conference last November, Goldman's Paulson was asked to talk about his readiness for a big blow to the financial system. Paulson issued a litany of warnings. The main risk measure Goldman discloses, VAR, "always assumes that the future is going to be like the past," he said. And even though the bank regularly uses many different models to test its resiliency to various disaster scenarios, no one can correctly predict where the next disaster will come from. "The one thing we do know," Paulson explained, "is [that] if and when there is another shock, things you hope wouldn't correlate [or trade in tandem] are going to correlate." Seemingly unrelated assets like, say, silver and options on Japanese commercial mortgages could all go into free fall.

Yet, even if the financial markets don't crash, banks' aggressive moves into trading threaten to scare off clients who wonder where they will rank if a panic triggers a sell-off. Will the bank perform its fiduciary responsibility to its client and execute its trades, or will it cover its own hide?

If banks are seen misusing client information to gain a trading edge, they could find themselves right back in the regulatory quagmire that followed the scandals of the '90s, when they were accused of pushing lousy stocks on unsuspecting investors to win what were then lucrative underwriting deals. Those abuses cost Wall Street more than $1.4 billion in fines. There's no telling what this cycle's price tag could be if the banks mismanage relationships in new ways. The New York Stock Exchange is investigating a major investment bank to see if it's giving a hedge fund it runs preferential treatment. And the SEC is examining whether banks have sufficient controls to prevent information about customer positions from being passed on to traders. Fines aside, the hit to banks resulting from the loss of their reputations could be far bigger this time. It's one thing for them to burn individual investors in order to serve big clients; it's another for the banks to burn big clients to serve themselves.

So why, then, are banks racing ahead to build bigger, more complicated trading operations, risking huge losses and long-term damage to their credibility if things go wrong? For one, the banks think they can handle the risks. For another, their shareholders and clients are demanding it. Consider what happened at Morgan Stanley. Its stock price trailed many of its rivals for four years in large part because the bank wouldn't take on more risk. As it remained cautious, the gap between its bond-, currency-, and commodities-trading revenues and those of Goldman ballooned to $1.7 billion in 2005, up from less than $500 million in 2001. Some say that's one reason why former CEO Philip J. Purcell lost his job. (Purcell did not return calls seeking comment.)

When current CEO John J. Mack accepted the post in July, 2005, he made it his mission to bolster areas Purcell thought risky, including mortgages, equity derivatives, and junk bonds. In April, he created a new group that trades residential loans and other securities. He has also increased the private equity capital pool by $1 billion, to $2.5 billion. The result: Morgan Stanley's VAR is 61% greater than it was in 2003, and the bank is closing the revenue gap with Goldman.

Investors argue that trading is booming now while most traditional banking businesses are languishing. Big firms can no longer subsist on underwriting or stock and bond trading as the combination of more rivals and cheap electronic trading drives down profit margins. "Wall Street doesn't get paid to not take risk anymore," says Merrill Lynch & Co. (MER ) financial-services analyst Guy Moszkowski. The big investment banks add value by "absorbing the risk that their clients are looking to get rid of."

Businesses that once accounted for most of the profits at investment banks are now viewed more as gateways that lead them into the lucrative land of risk. Even mergers and acquisitions, an area that's doing well now, is serving a larger goal. Say a private equity firm acquires a struggling foreign company but worries about currency and electricity price fluctuations. In the past a big bank advising on the deal might have tossed in a currency trade to relieve the firm of some of that risk. Now, it will take on virtually any risk the client wants to hedge, from jumps in electricity prices to hurricanes. And it might also go in on the acquisition itself with its private equity arm, taking on far more risk. Bankers call this a triple play: M&A, trading, and private equity all in one deal. The only sure money is the M&A advisory fee, a pittance compared with the potential private equity gains down the road.

More surprising, banks are also regularly agreeing to buy huge blocks of stock from trading clients even when they know they will likely lose money on the trade. It's a high-risk, low-reward endeavor designed to keep clients coming back to pay for more lucrative business in the future. Some executives estimate the dollar volume of such transactions has doubled in the past few years. Yet banks have barely broken even on about 30% of their big block trades this year, according to Thomson Financial (TOC ). That's because the share prices often fall during the time they hold the securities on their books. Even so, "banks are falling all over themselves to bid on blocks," says T. Rowe Price's Brooks. "It's not for the faint of heart."

In the bond markets, money managers ring up traders routinely and ask them to bid on messy multibillion-dollar portfolios of bonds and other financial products with expiration dates ranging from 2 to 10 years. "You have a trader committing in one or two minutes to a trade that could lose or make tens of millions of dollars," says Thomas G. Maheras, head of capital markets at Citigroup.

Risky though the trading may be, it's the forays into private equity that keep many risk managers awake at night. Fully formed companies are the hardest assets for banks to get off their books if things go wrong; just try selling a pipeline in the middle of a financial panic. Private assets are also difficult to value on a daily basis and don't fit neatly into risk managers' models. Against this backdrop, VAR numbers seem utterly inadequate.

What risk managers particularly fear are "fat tails." The term comes from the shape of a bell curve of probabilities, in which the long, thin tails on both ends represent extremely rare outcomes. Fat tails mean catastrophes are more likely than one would guess given normal day-to-day fluctuations. Risk managers are quick to point out that world events don't always hew to the shape of a bell curve. "The abnormal is really abnormal," says a risk manager who was part of the team that bailed out Long Term Capital Management.

At least one big investor isn't taking many chances on banks. Anton V. Schutz, who manages the $131 million Burnham Financial Services Fund, held almost every investment bank stock last year. Now he holds only Morgan Stanley. Why? "Investment banks are trading like there's no risk in the world," he says.

Wall Street moves in cycles of excess. Before the current cycle turns, the odds are good that at least one bank will take things too far. That's what happened in the '80s, when banks churned out an array of new products like junk bonds and created whole new markets for them, then abused those markets for their own ends. It happened again in the '90s as bankers cashed in on the Internet bubble. "There's always someone who doesn't see that the turning point has been reached," says Frank Fernandez of the Securities Industry Assn. It's possible that all of the banks will show more restraint this time as they chase returns in the red-hot risk market. But don't bet on it.

By Emily Thornton, with David Henry in New York and Adrienne Carter in Chicago

June 08, 2006

McKern's Market Report 8/6/06 (No.1)

Well, I been throwing off “other peoples posts” for months now, like crazy, and writing this and that but its time I bit the bullet. The real purpose of this site was to create a framework that would bring discipline and planning to my investing and trading. Over the next 48 months massive opportunities will unfold and these market reports will record successes and failures, the stories that drove my trading, my big picture view and the trading plans going forward.

Over the last few years I’ve been on the right track but impatience and inexperience cost me dearly. If I had stopped trading in June 2004 my account would now be worth over $250,000. I saw the commodity bull coming back in 2002 and started buying Oxiana, but after losing my job in 2004, I got hot for a big win, lost perspective and blew up shorting the US market that year. A big mistake!

OK, lesson learnt.  My first piece of advice therefore is to remind you all to remember Buffet’s first two rules for making money in the market.

 1) Don’t lose money. 2) Don’t forget rule 1.

Market Action

Well, its looking like a bear market guys. The cyclical bear within the secular bear is back. Clearly, in my view at least, the US Bull market ended in 2000 and the action since then has been a massive topping formation that ended three weeks ago. I think that there is a 80% chance that the Australian market has joined the bear, but there is a small chance that we will see new highs before we experience the really major correction. The odds that new highs for the market indexes are dead ahead, are however getting smaller every day. Japan’s monetary base is shrinking and world liquidity is in decline. As Faber has pointed out, we were in a situation where stocks, commodities, bonds, gold and everything else was going up. When assets that do not normally move together do so, its liquidity driven. That the world’s “money preasure” is falling is clear and the impact showed up in the fingers and toes first, middle eastern markets are down 50%. In fact, Icelandic bonds were the first domino to fall, followed by emerging markets and commodities, followed by problems in Asia the US. What I expect is that the US market will continue down until mid October at least. I’s say 8000 on the DOW is a reasonable target. As for the US gold indexes, near a bottom, I’d say, but of course I might be wrong: in a market driven my margin calls and defensive selling everything is going to get sold off if we get a crash. The odds of a crash to DOW 8000 are about 30% and rising. Stay posted.

Currently I’m long Oxiana, both warrants and shares with the expectation that today represents the floor for the stock. I an also short the DOW via Citi warrants. That trade is looking good. Of course, I’m kickin myself I went short too soon and didn’t sell my OXR at the May top and load the boat with more shorts, but the way I hedged my longs with June 11,000 puts does look like protecting me from losses. But as I was expecting the market to turn, I really messed up a tad. No matter, it won’t happen again.

The only way to play this game is with planning and discipline and by making my positions and thinking public, I’m hoping to shame myself into introducing some. I also hoping for feedback and questions from readers.

The future for all commodities and metals, in particular Gold, Silver and Uranium is very bright and my combining the best that fundamental and technical analysis have to offer a disciplined investor must succeed. The markets, reflecting as they do the nexus of geopolitics, economics, technological change sit at an important juncture.

I look forward to reporting on the ride…

Energy geopolitics

In his recent State of the Union speech, President Putin announced that Russia is planning to make the Ruble convertible into other major currencies, such as the Euro, and to use the Ruble in its oil and gas transactions. The convertible Ruble is due to be introduced according to latest Russian statements, on July 1, 2006, six months before originally planned. Russia also has stated it plans to shift a share of its now considerable dollar reserves away from the dollar and that it will use $40 billion in US dollars to purchase gold reserves.

Russia’s state-owned natural gas transport company, Transneft, has consolidated its pipeline control to become the sole exporter of Russian natural gas. Russia has by far the world’s largest natural gas reserves and Iran the second largest. With Iran, the SCO would control the vast majority of the world's natural gas reserves, as well as a significant portion of its oil reserves, not to mention potential control of the Strait of Hormuz, the narrow corridor for a majority of Gulf oil tanker shipment to Japan and the West.

In late May it was reported that Russia and Algeria, the two largest gas suppliers to Europe, have agreed to increase energy co-operation. Algeria has given Russian companies exclusive access to Algerian oil and gas fields, and Gazprom and Sonatrach will co-operate in delivery of gas to France. Putin has cancelled Algeria’s $4.7 billion debt to Russia, and for its part, Algeria will buy $7.5 billion worth of Russian advanced jet fighters, air defense systems and weapons. Oh oh.

On May 26 Russian Defense Minister Sergei Ivanov also announced Russia will definitely supply Iran with sophisticated Tor-M1 anti-aircraft missiles, reportedly as a prelude to supply far more sophisticated weapons. Ouch.

Then, in one of the more fascinating examples of geopolitical chutzpah by Putin’s Russia in the area of energy, the Kremlin-controlled Gazprom gas monopoly has entered into quiet negotiations with Israeli Prime Minister Ehud Olmert through Olmert’s billionaire friend, Benny Steinmetz, to secure Russian natural gas supplies to Israel via an undersea pipeline from Turkey to Israel.

According to the Israeli paper, Yediot Ahronot, Olmert’s office has said it will support the Gazprom proposal. In several years Israel faces gas shortage from Tethys Sea drilling and soon gas from Egypt. Tethys Sea gas is projected to run dry in a few years. British Gas is in talks to supply gas from Gaza but Israel disputes BG right to drill. But even with Egypt and Gaza gas shortages are expected by 2010 unless Israel is able to find new sources. Enter Gazprom and Putin. The gas would be diverted from the underutilized Russia-Turkey Bluestream pipeline which Russia built for increasing influence over Turkey two years ago. Putin clearly seeks to gain a lever inside Israel over the one-sided US influence on Israel policy. Oyvey!

China energy geopolitics also in high gear

Beijing for its part is also moving to ‘secure energy at the sources.’ China's booming economy, with 9% growth, requires massive natural resources to sustain its growth. China became a net importer of oil in 1993. By 2045, China will depend on imported oil for 45% of its energy needs.

On May 26, Kazakhstan crude oil began to flow into China from a newly-completed oil pipeline from Atasu in Kazakhstan to the Alataw Pass in far western China Xinjiang province, a 1,000 kilometer route announced only last year. It marked the first time oil is being pumped directly into China. Kazkhstan is also a member of the SCO, but had been regarded by Washington since the collapse of the Soviet Union, as its sphere of influence, with ChevronTexaco, Condi Rice’s old oil company, the major oil developer.

By 2011 the pipeline with extend some 3,000 kilometers to Dushanzi where the Chinese are building its largest oil refinery due to complete by 2008. China financed the entire $700 million pipeline and will buy the oil. In 2005 China’s CNPC state oil company bought PetroKazkhstan for $4.2 billion ands will use it to develop oilfields in Kazakhstan.

China is also in negotiations with Russia for a pipeline to deliver Siberian oil to Northeast China a project that could be completed by 2008, and a natural gas pipeline from Russia to Heilongjiang in China’s Northeast. China just passed Japan to rank as world’s second largest oil importer behind the United States.

Beijing and Moscow are also integrating their electricity economies. In late May the China State Grid Corp announced it plans to increase imports of Russian electricity fivefold by 2010.

China everywhere in African oil states

In its relentless quest to secure future oil supplies ‘at the source,’ China has also moved into traditional US, British and French oil domains in Africa. In addition to being the major developer of Sudan’s oil pipeline which ships some 7% of total China oil imports, Beijing has been more than active in West Africa in the states bordering the oil-rich Gulf of Guinea, source of vast fields of highly-prized low-sulphur oil.

Since the creation of the China-Africa Forum in 2000, China has scrapped tariffs on 190 imported goods from 28 of the least developed African countries, and cancelled $1.2 billion in debt.

Indicative of the way China is doing an end-run around the customary IMF-led Western control of African states, China’s export-import bank recently gave a $2 billion soft loan to Angola. In return, the Luanda government gave China a stake in oil exploration in shallow waters off the coast. The loan is to be used for infrastructure projects. In contrast, US interest in war-torn Angola has rarely gone beyond the well-fortified oil enclave of Cabinda, where ExxonMobil along with Shell Oil have dominated until recently. That is apparently about to change with the growing Chinese interest.

Chinese infrastructure projects underway in Angola include railways, roads, a fibre-optic network, schools, hospitals, offices and 5,000 units of housing developments. A new airport with direct flights from Luanda to Beijing is also planned.

Indirectly, through its support of the Sudan government, China is also a contender in a high-stakes game of potential regime change in neighboring, oil-rich Chad. Earlier this year, World Bank ‘tough guy,’ Paul Wofowitz, was forced to back down from plans to cut off World Bank aid, after threat of an oil export cut-off by tiny Chad. ExxonMobil is currently the major oil company active in Chad. But Sudan backs Chad rebels, who were only prevented from toppling the notoriously corrupt and unpopular regime of President Idriss Deby by 1,500 French soldiers propping up the Deby regime. Washington has joined with Paris in backing Deby.

Sudan has involved China, rather than Western corporations, in exploiting its oil fields, largely as a result of misconceived US sanctions imposed in 1997, which blocked American oil companies from doing business in Sudan. A new Sudan-backed regime in Chad would jeopardise the Chad-Cameroon pipeline and Western oil firms. One can imagine China just might be willing to step into such a vacuum and help Chad develop its oil, especially if the lion’s share went to China.

And immediately after his unpleasant diplomatic visit to Washington in April, where the Chinese President was greeted by a White House diplomacy of deliberate insults reminiscent of a University of Texas frat house prank, Hu Jintao went on to Nigeria, long regarded by Washington as its ‘oil sphere of interest.’

In Nigeria, Africa’s largest oil producer, Hu signed a deal with the Nigerian government where Nigeria will give China four oil drilling licenses in exchange for a commitment to invest $ 4 billion in infrastructure. China will buy a controlling stake in Nigeria's 110,000-barrel per day Kaduna oil refinery and build railway and power stations, as well as take a 45% stake in developing Nigeria’s OML-130 offshore oil and gas field, referred to by China CNOOF oil company chairman as, ‘an oil and gas field of huge interest…located in one of the world’s largest oil and gas basins.’

Almost all of Nigeria's current oil production is controlled by Western multinationals. But the situation there will also soon change in China’s favor.

Similar soft infrastructure loans or energy investment offers are being made by China to Gabon, Ivory Coast, Liberia and Equatorial Guinea.

The curious charge against China of ‘not playing by the rules,’ and ‘trying to secure energy at the source,’ begins to assume real dimension when these and Russian recent energy moves are taken as a totality.

Washington’s conclusion? Oops…

It’s little wonder that some Washington hawks are getting alarmed. Suddenly, the world of potential ‘enemies’ is no longer restricted to the Islam-centered War on Terror. Leading neo-conservative ideologue, Robert Kagan wrote a prominent OpEd recently in the Washington Post. Kagan is privy to pretty high-level thinking in Washington, presumably. His wife, Victoria Nuland, worked as Vice President Cheney’s Deputy National Security Advisor until being named US Ambassador to NATO.

Kagan declared, in reference to Russia and China, ‘Until now the liberal West's strategy has been to try to integrate these two powers into the international liberal order, to tame them and make them safe for liberalism.’ Kagan co-founded the hawkish Project for the New American Century (PNAC in the late 1990’s to among other things advocate a major US military buildup and forced regime change in Iraq, the latter a year prior to the September 11, 2001 attack.

Kagan continued, ‘If, instead, China and Russia are going to be sturdy pillars of autocracy over the coming decades, enduring and perhaps even prospering, then they cannot be expected to embrace the West's vision of humanity's inexorable evolution toward democracy and the end of autocratic rule.’

Kagan charged that China and Russia have emerged as the protectors of ‘an informal league of dictators’ – that, according to Kagan, currently includes the leaders of Belarus, Uzbekistan, Burma, Zimbabwe, Sudan, Venezuela, Iran and Angola, among others – around the world, who, like the leaders of Russia and China themselves, resist any efforts by the West to interfere in their domestic affairs, either through sanctions or other means.

‘The question is what the United States and Europe decide to do in response,’ wrote Kagan. ‘Unfortunately, al-Qaeda may not be the only challenge liberalism faces today, or even the greatest.’ The question, as Kagan wisely states it, is what the United States or Europe can do in response. The genius of Washington hawk strategy is showing its tattered edges.

The mainstream US foreign policy organization, the New York Council on Foreign Relations has also recently weighed in on the question of especially Chinese energy pursuits. In a recent report, the CFR accuses the Bush Administration of lacking any comprehensive long-term strategy for Africa. They criticize US focus on humanitarian issues such as in Darfur southern Sudan, demanding instead that the US ‘act on its rising national interests on the continent.’ Those interests? The CFR lists oil and gas number one; growing competition with China (closely related to 1) as number two. Oops…

F. William Engdahl is a Global Research Contributing Editor and author of the book, ‘A Century of War: Anglo-American Oil Politics and the New World Order,’ Pluto Press Ltd. He has completed a soon-to-be published book on GMO titled, ‘Seeds of Destruction: The Hidden Political Agenda Behind GMO’. He may be contacted through his website, www.engdahl.oilgeopolitics.net.


June 06, 2006

Investment Implications of Climate Change

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June 03, 2006

Why Gold is going up...

ANNANDALE, Va. (MarketWatch) -- To understand the significance of gold's recent plunge, contrarians argue that we need first to understand the psychology of bull markets.
Their goal is to rise while attracting as few adherents as possible along the way. If the bullish bandwagon gets too crowded, the market must first scare as many as possible of those adherents away from the bullish camp before resuming its upward path.
Bear markets take place when the occupants of that bullish bandwagon stubbornly refuse to jump off. Corrections, in contrast, are characterized by relative eagerness to do so.
From this psychological perspective, we must characterize gold's recent decline as a mere correction rather than the beginning of a new bear market.

In the wake of recent plunge of gold bullion (38099902) - about $100 per ounce since hitting a high of $725 in early May, including $15 on Thursday alone - gold timers have been quick to run for the exits.
Consider the latest readings from the Hulbert Gold Newsletter Sentiment Index (HGNSI), which reflects the average gold market exposure among a subset of short-term gold timing newsletters tracked by the Hulbert Financial Digest. As of Thursday's close, the HGNSI stood at 1.8%.
That means that, on average, these gold timers are almost completely out of the gold market right now.
As recently as late April, in contrast, the HGNSI stood at 73.2%, within shouting distance of its all-time high of 90%.
To place the gold timers' retreat into perspective, consider how they instead reacted in 1980 in the wake of gold's initial drop from the $875 level. That turned out to be the high of the great gold bull market of the 1970s, of course, and remains unbroken yet today, more than 26 years later.
But no one could have known that then. And the reaction of most of the gold-oriented newsletters I followed then was to treat the pullback from the $875 level as a wonderful buying opportunity rather than as a reason to run for the hills.
I remember attending a gold-oriented conference at the time in which the consensus was that the pullback represented the last chance to purchase gold at $750 or $800 before gold resumed its inexorable rise to being priced in the thousands of dollars per ounce.
In an ironic sense, of course, they were right: At least as far as the next 25 years were concerned, that time did represent the last chance to purchase gold at such levels, since bullion has been lower ever since.
But the consensus at the time also represented extraordinarily stubborn bullishness, the hallmark of what contrarians consider to be the preconditions for a bear market.
We're not seeing those preconditions today. Far from stubborn bullishness, advisers are exhibiting a quickness to get out of gold at the early sign of trouble.
To be sure, it's worth reminding ourselves that there are no guarantees. Sentiment is not the only thing that makes the financial world go round.
After all, several weeks ago the HGNSI had already fallen from its late April peak, leading to the contrarian expectation that gold's decline was just a correction - and gold nevertheless has continued to fall.
But if this is the beginning of a gold bear market, it would be one of those rare occasions in which the gold timers in large part anticipated that bear market. End of Story

June 01, 2006



by Dr. Marc Faber

I have great sympathy for the view that over the last 200 or so years investments in commodities performed poorly when compared to cash flow-producing assets such as stocks and bonds. I also agree that, as the team at GaveKal suggests, "every so often, we experience a massive break higher in commodity prices in which commodity indices triple in less than three years," which is then followed by a period of poor performance.

Still, we need to ask ourselves why in the last 200 years, commodities, adjusted for inflation, were in a continuous downtrend and whether it is possible that something might have changed in the last few years, which would suggest that this downtrend is about to give way to a sustained out-performance of commodities compared to the U.S. GDP deflator.

The other question is of a more near-term nature. Should commodities, having approximately trebled in price since 2001, be sold, or should we expect far more substantial price increases? I have to confess that I have little confidence that I can answer these questions satisfactorily. Still, the following should be considered.

In the 19th century, and for most of the 20th, industrialization was concentrated in a few countries, which for simplicity we shall call the Western industrialized world. The world's economy was at the time characterized by an abundance of land, resources, and cheap labor (certainly in the colonies and later in the developing countries) and a relatively limited supply of manufactured goods. At the same time, growth and progress was concentrated among a very small part of the global economy - either in the Western industrialized countries or among a tiny part of the population (the elite) in developing countries. In addition, there were hardly any other sectors in the economy where productivity improvements were as high as in agriculture and mining. These factors - abundance of land, labor, and resources combined with huge productivity improvements and limited demand from the then still small industrialized world - may, at least partially, explain why commodity prices failed to match consumer price increases for much of the last 200 years.

Remember that, in the first half of the 19th century, manufacturing was concentrated in England with a tiny population, while the British Empire could draw on the supply of commodities from an enormous territory. Then, in the second half of the 20th century, we experienced the socialist and communist ideology, and in India policies of self-reliance and isolation.

As a result, about half the world's population remained largely absent as consumers of goods. (How many motorcycles and cars were there in the Soviet Union, China, India, and Vietnam 25 years ago?) But, while largely absent as consumers, people in these countries continued to produce raw materials and agricultural products. Therefore, I suspect that the removal of approximately half the world's population as consumers through socialism and communism may have been an important factor in the poor long-term performance of commodities compared to the US GDP deflator, and other assets such as equities.

Since the breakdown of communism and socialism, the world's economic fundamentals seem to have changed very importantly. Initially, the impact of the end of socialism was muted. Production shifted to China, but as had been the case with production shifting from the West to Japan, South Korea, and Taiwan between 1960 and 1990, rising industrial production in former communist countries largely substituted for production in the West. But over time, in countries such as China, rising investments and industrial production boosted real per capita incomes considerably and made way for a tidal wave of new consumers. In turn, these additional new consumers lifted industrial production further in order to satisfy not only the demand from their export markets but their own needs as well. Thus, industrial production and capital spending increased further. This led to additional income and employment gains, further domestic demand increases and so on (multiplier effects).

In short, the opening of China and of other countries has permanently shifted the demand curve for consumer goods and services (for example,

transportation) to the right and along with it the demand for industrial commodities and, notably, energy. Now, if all goes well in India (a big if, I concede), then the demand for goods, services, and hence commodities will continue to increase very substantially for another 10 to 20 years. Indian oil consumption has just recently started to turn up. Should its demand now accelerate, as we believe it will do, it is very likely that China's and India's oil demand could double in the next eight years.

There are a few more points to consider. For much of the last 200 years, developing countries, where many of the world's natural resources are located, had trade and current account deficits with the industrialized world. These deficits were a constant drag on these countries' ability to accumulate wealth. But now, through its current account deficit, the United States is shifting around $800 billion annually to the economically emerging world.

This represents a huge shift in wealth from the rich United States to the current account surplus countries. That this shift in wealth stimulates their economies and consumption, and along with it their own demand for commodities, should be clear. (Rising domestic energy demand in Indonesia amidst falling production has turned the country into an oil net

importer!) Now, for most countries a current account deficit the size of that of the United States would lead to some sort of crisis (for example, the Asian crisis of 1997) and then to a curbing of consumption. However, in the case of the United States, which is endowed with a reserve currency, trade and current account deficits are simply financed by "money printing."

So, at least for a while (but not forever), the shift in wealth to the emerging world won't have a negative impact on America's economy and consumption. And, at least for now, rising demand and wealth in the rest of the world won't be offset by declining demand and shrinking wealth in the United States. On the contrary, the global imbalances arising from "over-consumption" in the United States have brought about a global economic expansion, which, while unsustainable in the long run, is nevertheless firing on all four cylinders at present. Simply put, the excess liquidity which the Fed has created - and which it is still creating, I might add - has led to a global and synchronized economic boom. (If money were tight, the asset markets wouldn't rise.)

The following point regarding the demand for commodities is frequently overlooked. In the developed countries, commodities account for a very small part of the economy. As a result, price increases for oil and other commodities have a very minor impact on growth rates and on consumption. However, in the commodity-producing countries (Middle East, Africa, Russia, Latin America), commodity production is an important part of the economy.

So, when commodity prices rise, their economies are, as in the case of the Middle East, turbo-charged. GDP per capita then soars and leads to a consumption and investment boom, which then increases these countries' own demand for commodities. This is particularly true for resource-rich countries that have a large population and also explains why, in the 19th century, when agriculture was still the dominant sector in the U.S. economy, rising grain prices led to economic booms, while declining commodity prices were associated with crises. (In recent years, financial markets have begun to have a similar impact on economic activity as agriculture had in the 19th century: rising stock markets = boom; falling stock markets = bust.)

In sum, we could argue that the emergence of a large number of new consumers in the world following the breakdown of communism, expansionary monetary policies in the United States, which have led to a rapidly growing current account deficit, the U.S. dollar's position as a reserve currency, which enables the Fed to create an almost endless supply of dollars, and new demand from the commodity producers themselves, have all led to a significant increase in the demand for raw materials.

I am not predicting here that, from now on, the demand for commodities will always outstrip the supply. In time, new technologies (in particular, in the filed of nanotechnology), which will permit resources to be used more efficiently, and conservation will curtail demand for raw materials. But until the effects of these factors kick in, a tight balance between rising demand and existing supplies could remain in place for quite some time.


Dr. Marc Faber