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August 31, 2006

George Soros

The failure of Israel to subdue Hezbollah demonstrates the many weaknesses of the war-on-terror concept. One of those weaknesses is that even if the targets are terrorists, the victims are often innocent civilians, and their suffering reinforces the terrorist cause.

In response to Hezbollah's attacks, Israel was justified in attacking Hezbollah to protect itself against the threat of missiles on its border. However, Israel should have taken greater care to minimize collateral damage. The civilian casualties and material damage inflicted on Lebanon inflamed Muslims and world opinion against Israel and converted Hezbollah from aggressors to heroes of resistance for many. Weakening Lebanon has also made it more difficult to rein in Hezbollah.

Another weakness of the war-on-terror concept is that it relies on military action and rules out political approaches. Israel previously withdrew from Lebanon and then from Gaza unilaterally, rather than negotiating political settlements with the Lebanese government and the Palestinian authority. The strengthening of Hezbollah and Hamas was a direct consequence of that approach. The war-on-terror concept stands in the way of recognizing this fact because it separates "us" from "them" and denies that our actions help shape their behavior.
 
A third weakness is that the war-on-terror concept lumps together different political movements that use terrorist tactics. It fails to distinguish between Hamas, Hezbollah, Al Qaeda or the Sunni insurrection and the Mahdi militia in Iraq. Yet all these terrorist manifestations, being different, require different responses. Neither Hamas nor Hezbollah can be treated merely as targets in the war on terror because they have deep roots in their societies; yet there are profound differences between them.

Looking back, it is easy to see where Israeli policy went wrong. When Mahmoud Abbas was elected president of the Palestinian Authority, Israel should have gone out of its way to strengthen him and his reformist team. When Israel withdrew from Gaza, the former head of the World Bank, James Wolfensohn, negotiated a six-point plan on behalf of the Quartet for the Middle East (Russia, the United States, the European Union and the United Nations). It included opening crossings between Gaza and the West Bank, an airport and seaport in Gaza, opening the border with Egypt, and transferring the greenhouses abandoned by Israeli settlers into Arab hands.

None of the six points was implemented. This contributed to Hamas’s electoral victory. The Bush administration, having pushed Israel to allow the Palestinians to hold elections, then backed Israel’s refusal to deal with a Hamas government. The effect was to impose further hardship on the Palestinians.

Nevertheless, Abbas was able to forge an agreement with the political arm of Hamas for the formation of a unity government. It was to foil this agreement that the military branch of Hamas, run from Damascus, engaged in the provocation that brought a heavy-handed response from Israel - which in turn incited Hezbollah to further provocation, opening a second front. That is how extremists play off against each other to destroy any chance of political progress.

Israel has been a participant in this game, and President Bush bought into this flawed policy, uncritically supporting Israel. Events have shown that this policy leads to the escalation of violence. The process has advanced to the point where Israel's unquestioned military superiority is no longer sufficient to overcome the negative consequences of its policy.

Israel is now more endangered in it existence that it was at the time of the Oslo Agreement on peace. Similarly, The United States has become less safe since President Bush declared war on terror.

The time has come to realize that the present policies are counterproductive. There will be no end to the vicious circle of escalating violence without a political settlement of the Palestine question. In fact, the prospects for engaging in negotiations are better now than they were a few months ago. The Israelis must realize that a military deterrent is not sufficient on its own. And Arabs, having redeemed themselves on the battlefield, may be more willing to entertain a compromise.

There are strong voices arguing that Israel must never negotiate from a position of weakness. They are wrong. Israel’s position is liable to become weaker the longer it persists on its present course. Similarly Hezbollah, having tasted the sense but not the reality of victory (and egged on by Syria and Iran) may prove recalcitrant. But that is where the difference between Hezbollah and Hamas comes into play. The Palestinian people yearn for peace and relief from suffering. The political - as distinct from the military - wing of Hamas must be responsive to their desires. It is not too late for Israel to encourage and deal with an Abbas-led Palestinian unity government as the first step toward a better-balanced approach. Given how strong the U.S.-Israeli relationship is, it would help Israel achieve its own legitimate aims if the U.S. government were not blinded by the war-on-terror concept.

George Soros, a financier and philanthropist, is author of "The Age of Fallibility: Consequences of the War on Terror."

August 28, 2006

The Pause That Depresses: Recession to Begin Within Six Months and Depression Prior to 2008Q2

Clouds are gathering over the US economy and quite a few highly informed people can now see them. What is not understood is that this storm will result in a flashflood and a "the Great Deluge." Americans are lot less prepared for the coming economic storm than the residents of New Orleans were prepared for Katrina exactly a year ago. While Katrina was only a category 3 hurricane, the next economic hurricane that will hit the US, already gathering strength for a while, would have the force of a category 5 storm, with econ-winds of above 175 mph, when it strikes.

The economic forecasters that we do have, to inform the public, give fortunetellers a bad name. A case in point is economist Diane Swank, a pretty face that frequently appears on financial TV, whom I heard saying, answering a question on what the Yield-Curve was forecasting, "this indicator will crash," i.e., totally fail this time. If economists, as a group, had any professional integrity, let alone any shame, they will pay for advertorials to inform the public that they are incapable of forecasting recessions and depressions. The stock market might have predicted, "nine out of the past five recessions," as Nobel economist Samuelson is supposed to have quipped, how many have economists, as a group, predicated? A fat zero. So, please ignore a crank like myself, or any other non-economist prognosticator of the economy, if you must, but don't hold your breath for an economist to forecast a recession until after the economy is already in a recession. And in many cases until it has already come out of a recession. The best ability to forecast recessions and depressions is to be found among those that dwell into investments and among professional speculators. A degree in economics is a very big hindrance in forecasting recessions and depressions; on that history's verdict is clear.

Why can't America have a recession? Because Americans can't afford it! Especially, not now. There is a book titled, When Wish Becomes a Thought, by an American sociologist that encapsulates the truth about most people's forecasts. Add to this the most common psychological disease among Americans - Optimitis Americanitis - and you have all the makings of a grand denial and its consequences (this disease has been carried on by many Indians and Chinese to their native lands). As we saw in the case of New Orleans, catastrophes are more likely to hit those who are least prepared. Or, so it would seem.

The proximate cause of the coming recession would be the bursting of the Housing Bubble, existence of which lot less people deny now than a year ago, and one can list more than a dozen indicators to support the case for a recession within the next 12 months. Here are just a few that quickly come to mind:

1. NAHB (National Association of Homebuilders) Index, at a 15-year low and at levels that precede recessions.

2. LEI - Exhibiting a condition of peaking, since Jan'06, which ALWAYS leads to a recession after average of 11 months (thank you David Rosenberg of Merrill Lynch).

3. Yield-Curve that began to invert in Feb'06 and now is very close to the level (10Y-3M-YD = -0.32%) that ALWAYS leads to a recession within 12 months but mostly in 4-8 months.

4. Consumer Confidence - very low, despite the employment holding OK.

5. Break in the Scam Market in May despite very good earnings and huge buying of their own Scam by corporations.

6. The Pause - the main reason is the expectation of a weaker economy, but how much weaker? (More later).

I have been among the leaders of those who saw the Housing Bubble building and predicted a recession once the Housing Bubble bursts. In fall of 2004, I thought that the Housing Bubble was in the process of deflating. Based on that I forecast the recession to begin before the end of 2006Q2. I was wrong about the deflation of the Housing Bubble to begin in the fall of 2004 (which took place exactly a year later) and, hence, wrong on the dates and probabilities of recession I outlined in the fall of 2004. In the forecasting business making mistakes is not uncommon. The important thing is to learn from the failures. I learned two things - gathering historical data on housing, including supply and demand, and to spend lot more time on understanding various leading indicators and gather data on them. The most important part of this process was to accurately quantify the predictive powers of the Yield-Curve. It is the best predictors of the recessions as well as periods of falling inflation, as presented in my editorials over the past six months:

Feb-27-2006 Why Yield Inversion Foretells Recession? http://www.safehaven.com/showarticle.cfm?id=4681.htm

Feb-28-2006 The Best Way to Interpret Yield-Curve's Ability to Forecast Recessions http://www.safehaven.com/showarticle.cfm?id=4686.htm

Mar-06-2006 Accurate Characterization of Yield-Curve and Recession Probabilities http://www.safehaven.com/showarticle.cfm?id=4720.htm

Jun-17-2006 Yield-Curve, Inflation, and Recessions: Are Recessions Necessary to Control Inflation in the US? http://www.safehaven.com/showarticle.cfm?id=5390.htm

My big break in being on the top of the Housing Bubble Watch came with the historical data on the Fundamental Demand for housing (as in a place to live, including second homes, or for a dwelling, i.e., number of households) and the supply. It is true that the prices were going up so rapidly because of the market demand outstripping the market supply, but what if the market demand were to be Speculative Demand, as I suspected and claimed? The data settled that question as well as repudiated all the arguments by the bulls who claimed that Fundamental Demand for house-dwellings (a term from Adam Smith) was leading to the rapid increase in prices. Just a few days ago, Paul Kasriel, an economist I respect along with David Rosenberg of Merrill Lynch, wrote an article on the Supply-Demand question:

August 25, 2006 New Homes Market: Worst Supply-Demand Situation Since Early 1970s by Paul Kasriel http://www.safehaven.com/showarticle.cfm?id=5766.htm

Well, I foresaw this coming more than a year ago:

07/31/2005 The US Housing Supply-Demand: Countering Lies with the Facts http://www.financialsense.com/fsu/editorials/2005/0731.html

In July of 2005 I became convinced that when this Speculative Demand driven bubble bursts it would be ugly. Thus far, even though the burst has barely begun, it has not disappointed. It will make all the previous bubbles and crashes look mild by comparison.

Connecting the Dots

Few weeks ago, Ron Insana, one of the better commentators on CNBC, said, during a debate on inflation, "Inflation peaks during the first year of a recession (you can see for yourself in Fig 1. of http://www.safehaven.com/showarticle.cfm?id=5390.htm). How many people know this fact even today?

How many of you believe that Bernanke will let inflation keep rising for another six months, let alone a year? If inflation does not start going down, and continues going down, in another six months he will be forced to apply the brakes if for no other reasons than to establish his credibility. Assuming that it takes up to nine months for inflation to start to fall, we will already be in a recession in nine months. I personally think that inflation will start to come down lot sooner than nine months. Why? The Pause!

One risk that Bernanke will not take is that of letting the inflation going out-of-control. Even the current level is way outside the 1-2% declared target zone by Bernanke and various Fed officials who have bought into that. The Pause is a clear signal of expectation by the Fed of weakening economy, led by Housing Bubble bursting, and once the economy starts to weaken due to Asset Deflation, the Fed can't control its slipping into a recession, as we already learned, once again, in 2000-01. The fact is that bursting of an asset bubble is a psychological phenomenon and there isn't much the Fed can do in a short period. By the time the Fed knows that the economy has weakened into a recession, usually it is late by several quarters. The Fed will have to use terms like slowdown, soft landing, orderly retreat, etc., until we are well into a recession.

I have already indicated, earlier, that the Yield-Curve is now at the point where the recession is highly likely to occur in 4-8 months.

Two Most Important Economic Reports

Existing Home Sales reports for the months of August and September. I have been waiting for the August report for some nine months. What is so special about that report? The housing broadly peaked in August 2005 and the YoY comparisons will look plain ugly. Here is what I see between the August and the September reports:

1. The YoY nominal median prices of homes, nationwide, will be negative.

2. The YoY nominal median prices of homes for the state of California will be negative.

3. Sales volume will be down 20-50% across most of the areas in the US.

The first hasn't happened for some 53 years and it will get the attention of all the bulls in denial of how serious the housing problem is going to be for the economy - a hard landing and the beginning of the first depression since the Great Depression.

Why the Depression?

It Is the Debt, Stupid!

All asset bubbles are "Credit Bubbles." Well, Debt is just the other side of Credit. I think that Americans are running out of bubbles. No? Also, the Fed and its constituency, Bankrupters and Fraudsters of New York City (BFNYC), are running out of "options" to push more Consumption Debt (yes, mortgage is consumption debt) and Scams. And it was the unprecedented push of Consumption Debt, mostly via "reckless mortgage lending," that has kept the US economy out of a recession for the past four years. I think that the "Bush recovery" has been pushed as far as it could be pushed already. Nicht mehr, nicht mehr, nicht mehr. (No more, no more, no more).

Now, about the Deflation case. Most people misjudge the powers of the Fed. Almost all its power, long-term, is a matter of The Confidence Game (title of a book on the Fed). Fed is in no position to inflate as most inflationists think. Deflation will come so suddenly, as a result of the Demand Destruction leading to inflation falling very fast and going from +1.0%, YoY, to below zero within months, that Fed will not be able to pre-empt it. Once Deflation takes root for few months it would be very hard to get rid of. The proverbial Pushing On the String (not being able to Pushing ON More Debt!) will become a reality. It would be good for Americans to learn about the limits of Fed's power in being able to manipulate the economy. Americans will also learn a thing or two about what wealth is and what an investment is.

August 22, 2006

First Nickel, soon Silver?

This past week, the investment world witnessed an event that has only occurred rarely in the past. I am referring to the extraordinary developments in the nickel market on the London Metals Exchange (LME), the largest base metals exchange in the world. Due to an unprecedented scarcity of metal, the LME was forced to revise the delivery terms of its nickel contracts. In return for allowing short sellers to delay delivery of metal, a daily penalty fee of around 1% of the contract value was payable by the shorts to long holders.

Here are some excerpts from the LME’s press release of August 16 –

"Those with short positions in nickel falling prompt on Friday 18 August 2006, and on subsequent prompt dates until further notice, who are unable to effect physical delivery an/or unable to borrow metal at a backwardation of no more than $300.00 per tonne per day, shall be able to defer delivery for a day at a penalty of $300.00 per tonne. Those with long positions for prompt on those days who are subject to deferred delivery shall be entitled to compensation of $300.00 per tonne per day

Commenting on the announcement, Simon Heale, LME Chief Executive said:

"Nickel stocks are at historically low levels and we now have a genuine material shortage. Our first priority is to ensure that trading remains orderly and to prevent the risk of settlement defaults."

Although there has been widespread reporting of this event in all the popular media and news services, I have been thunderstruck by how mostly all of the reports have danced around the key fact at the heart of this matter. That key fact is that the LME just declared that its nickel contract has gone into default.

While Mr. Heale states that the action by the exchange is designed to prevent default, the action taken is nothing but a declaration of default, rendering his statement as absurd. Default is a simple word. Any time you unilaterally violate or negate the terms and conditions of any legal contract, that contract is in default. Period.

Moreover, a simple analysis of the situation reveals that the LME is aligning itself with the interests of the naked shorts in nickel, as common sense should tell you that no long holder asked the exchange to suspend the delivery obligation of the shorts.

I must say that it is troubling that with such widespread reporting of this event, the most important fact, the delivery default, seemed lost as a message. But make no mistake; this default is a most serious matter. In fact, as I have written previously, a contract default is the absolute worst event that could befall any exchange. In an instant, a delivery default renders an exchange suspect as an institution. It makes no difference if that exchange has existed for hundreds of years, a delivery default can immediately destroy the strongest reputation. This is the grave risk that the nickel debacle poses to the LME.

The main concern for the nickel market and the LME is that the abrogation of the shorts’ delivery obligation is not the end of problem, even though it may lead to the end of the LME itself. That is because legitimate long contract holders, particularly industrial consumers, have been left in a lurch by the deferral of delivery of actual metal. What do the industrial nickel users now do?

The legitimacy of any exchange or contract is based upon all conditions and obligations being upheld, and not suspended when it is expedient to certain interests. In the case of a futures or forward contract on a physical commodity, the most important conditions and obligations are those which guarantee and mandate how the contract is converted to actual delivery.

Although only a very small percentage of any futures contract normally results in actual delivery of the physical commodity, it is precisely the delivery mechanism that determines the legitimacy of the contract. Take away that delivery mechanism and you take away the legitimacy. Take away the delivery mechanism and all you have left is paper contract with no connection to the commodity involved. This is what has happened to the LME nickel contract – because the exchange has suspended the shorts’ responsibility to deliver actual metal, that contract has become, essentially, worthless to industrial consumers.

The key point here is not that every contract created between a long and a short will result in actual delivery, but that every contract will result in delivery if either party wants it to. Each party to a contract, the long and the short, entered into that contract voluntarily. No one held a gun to anyone’s head, forcing them to buy or sell any contract. It is unfair and illegal that any authority (the LME) intercedes on behalf of either side to override a contract that was entered into voluntarily.

What the LME has done in nickel is relieve the shorts of having to round up actual metal to deliver against their contractual promise to deliver, and unilaterally transferred the obligation to the longs, the industrial user. These industrial consumer longs (and other longs) entered into their nickel contracts voluntarily and legally, with the option of taking delivery. Now they are told, with no warning, they can’t take delivery and must secure metal elsewhere. The shorts don’t have to scramble for material they promised to deliver, the longs have to scramble for material they were legally promised to receive. Nothing could be more unfair.

Furthermore, as long as the shorts’ obligation to deliver nickel is suspended, there is no good reason for an industrial user to buy an LME contract. This is the greatest threat to the LME. And it’s not just deterrence for those buyers who want to take actual delivery. With the delivery mechanism destroyed in nickel, the linkage between the price of real metal and the LME contract is also destroyed. Without the requirement for delivery, the price of nickel on an LME contract and nickel in the real world loses its connection. In this case, the price of LME nickel is merely a figment of anyone’s imagination. What good does it do an industrial consumer to hedge on the LME, if there is no assurance his contract will converge with the price of actual metal on the delivery due date? Without the delivery mechanism, there is no linkage between paper contract and actual metal.

This is the real meaning of the LME’s delivery default. It is also the same thing with the short-side manipulation in COMEX silver. It is a coincidence that this LME nickel disaster has occurred precisely at the same time others and I have been alleging a manipulation in COMEX silver. However, nothing could prove our case more clearly.

A long-side manipulation, evidenced by a concentrated long position and prices higher than would be without the concentrated position, is something the regulators have vast experience in dealing with. While disruptive and illegal, long-side manipulations are usually short in duration and easy to terminate. The concentrated longs, usually speculators, are forced to sell their positions, causing prices to collapse and end the manipulation.

A short-side manipulation, like those in LME nickel and COMEX silver, is evidenced by a concentrated short position and prices lower than would be without the concentrated short position. (The concentrated short position in nickel has been reported in news stories, while the concentrated short position in COMEX silver is reported by the CFTC). The regulators have little or no experience with short side manipulations, and since the concentrated shorts are industry insiders, rather than outside speculators, there is little incentive for the regulators to move against their own.

The real problem with short-side manipulations is that it is very difficult to terminate without great damage because they have a long duration. When a short-side manipulation is terminated, like in LME nickel, it threatens great and lasting disruption to the actual market because the resultant shortage of material causes real hardship with no easy remedy. This is in addition to the damage caused to an exchange or contract involved in such a short-side manipulation, which ends in a delivery default.

Clearly, the UK regulators and LME officials waited too long to attack and resolve the short-side manipulation in nickel. If they had acted responsibly and forced the concentrated shorts to cease their manipulative activities, the delivery default might have been averted. Now it is too late in nickel, as the damage is done. Is it too late for silver?

I think there may still be time for the US regulators to act in silver and avoid a COMEX silver delivery default. But I also have my doubts. That’s because the CFTC and NYMEX/COMEX officials have been dragging their feet on the issue of the concentrated short position. Instead of promptly responding to allegations of manipulation and a looming delivery default, the regulators are stalling. Stalling didn’t benefit the regulators in LME nickel. It only made matters much worse.

In fact, the main, if not only, difference between nickel and silver is that the regulators will never be able to say they were not warned in silver. And if the regulators in silver still do not see how the recent events in LME nickel are directly foretelling what is going to happen in COMEX silver, then they do not deserve to be regulators any longer.

While I will continue to attempt to end the silver manipulation (with your help), it is entirely possible that government regulators and COMEX officials will continue to evade their legal responsibilities and allow the silver manipulation to exist, right up to the inevitable delivery default. That will be tragic, but it will be on their heads.

Fortunately, there is something else that you can do. You can take the debacle in LME nickel as yet another confirmation as what will happen in silver and position yourself accordingly. If there has ever been an exclamation point given to "buy and hold real silver", it has been given to you by the LME actions in nickel. If an exchange that has been in existence for hundreds of years can suddenly terminate delivery obligations in its contracts, how hard do you think it will be for those issuing pool and leveraged accounts in silver to do exactly the same thing? I think anyone holding such accounts needs to have their heads examined.

But the strongest message of the LME default is being sent to the silver industrial consumers of the world, because the biggest potential losers in nickel are the industrial users. If the LME can get away with suspending delivery requirements in nickel, how hard will it be for the COMEX to suspend delivery requirements in silver? Do you think the CFTC will come to your defense? The same CFTC that is stalling on the concentrated short issue in silver? Even more than those investors and speculators dealing in paper contracts, any user who is not stockpiling real silver inventories, in light of what just occurred on the LME, is missing the boat.

I hope the CFTC and the NYMEX does the right thing with this concentrated silver short position and moves against the manipulators. But even if they don’t, there is no good reason for investors and industrial users to not protect themselves and buy real silver. How many wake-up calls are necessary?

August 07, 2006

A Slowdown in a Sensitive Sector


May Bode Ill for Stocks, or Worse
By FLOYD NORRIS

THE most volatile part of the American economy has slowed significantly in the last nine months, providing a warning of both recession and lower stock prices.

The measure looks at growth in three broad areas that are the most sensitive to economic changes and to interest rates — consumer purchases of durable goods, residential construction spending and business investment in equipment and computer software. They can be called the sensitive sector.

In the fourth quarter of 2005, and again in the second quarter of this year, that part of the economy actually shrank, although a strong first-quarter performance meant that even that sector was up a little for the nine months.

As the accompanying charts show, the sensitive sector is more than three times as volatile as the rest of the economy. But it has usually been a better performer. Since the end of 1954, a period of more than half a century, the sensitive sector has grown at an average rate of 4.6 percent a year, compared with 3 percent for the rest of the economy.

Over time, a good indicator of both the economy and the stock market has been the relative performance of the two parts of the economy over nine-month periods. Most of the time, the sensitive sector does better. But when that sector turns in poorer performance after a sustained period of outperformance, it is a warning. And that is what has happened. Over the nine months through June, the sensitive sector grew at an annual rate of 2.1 percent, while the rest grew at a rate of 3.7 percent.

This is only the ninth such reversal since 1954. Each of the previous eight foreshadowed a substantial slowing of the overall economy, although not all were quickly followed by recessions. There was no early recession after reversals in 1955, 1964, 1978 or 1987. But recessions followed quickly after reversals in 1959, 1969, 1973 and 2000.

Moreover, anyone who got out of the stock market when a reversal happened seldom regretted it. There were some gains, but they were generally small. And selling at the time of the reversals would have gotten investors out before the major bear market of 1974-75, the 1987 stock market crash and the worst part of the stock market decline from 2000 to 2002. Over all, the average performance of the Standard & Poor's 500-stock index in the 12 months after a reversal is a negative 5.7 percent.

In some of the cases where no recession came quickly, that was because of abrupt policy reversals. In 1964, tax cuts provided a fiscal stimulus. The 1987 crash was followed by a rapid easing of fiscal policy by the Federal Reserve, which helped to hold off a downturn until 1990.

The fact that the sensitive sector has slowed was pointed out by David Rosenberg, a Merrill Lynch economist. “People have to start thinking about the next cycle,” he said, raising the issue of how the economy will rebound after a downturn. “We don't have a $250 billion surplus to shift into a $400 billion deficit. Mortgage rates are already low. There is no pent-up consumer demand.”

If a recession does come, he says he thinks the most likely cause will be a downturn in the residential real estate market, which is already starting to suffer. Residential construction spending grew rapidly for most of this decade, but in the most recent quarter it fell at an annual rate of 6.3 percent.

May Bode Ill for Stocks, or Worse
By FLOYD NORRIS

THE most volatile part of the American economy has slowed significantly in the last nine months, providing a warning of both recession and lower stock prices.

The measure looks at growth in three broad areas that are the most sensitive to economic changes and to interest rates — consumer purchases of durable goods, residential construction spending and business investment in equipment and computer software. They can be called the sensitive sector.

In the fourth quarter of 2005, and again in the second quarter of this year, that part of the economy actually shrank, although a strong first-quarter performance meant that even that sector was up a little for the nine months.

As the accompanying charts show, the sensitive sector is more than three times as volatile as the rest of the economy. But it has usually been a better performer. Since the end of 1954, a period of more than half a century, the sensitive sector has grown at an average rate of 4.6 percent a year, compared with 3 percent for the rest of the economy.

Over time, a good indicator of both the economy and the stock market has been the relative performance of the two parts of the economy over nine-month periods. Most of the time, the sensitive sector does better. But when that sector turns in poorer performance after a sustained period of outperformance, it is a warning. And that is what has happened. Over the nine months through June, the sensitive sector grew at an annual rate of 2.1 percent, while the rest grew at a rate of 3.7 percent.

This is only the ninth such reversal since 1954. Each of the previous eight foreshadowed a substantial slowing of the overall economy, although not all were quickly followed by recessions. There was no early recession after reversals in 1955, 1964, 1978 or 1987. But recessions followed quickly after reversals in 1959, 1969, 1973 and 2000.

Moreover, anyone who got out of the stock market when a reversal happened seldom regretted it. There were some gains, but they were generally small. And selling at the time of the reversals would have gotten investors out before the major bear market of 1974-75, the 1987 stock market crash and the worst part of the stock market decline from 2000 to 2002. Over all, the average performance of the Standard & Poor's 500-stock index in the 12 months after a reversal is a negative 5.7 percent.

In some of the cases where no recession came quickly, that was because of abrupt policy reversals. In 1964, tax cuts provided a fiscal stimulus. The 1987 crash was followed by a rapid easing of fiscal policy by the Federal Reserve, which helped to hold off a downturn until 1990.

The fact that the sensitive sector has slowed was pointed out by David Rosenberg, a Merrill Lynch economist. “People have to start thinking about the next cycle,” he said, raising the issue of how the economy will rebound after a downturn. “We don't have a $250 billion surplus to shift into a $400 billion deficit. Mortgage rates are already low. There is no pent-up consumer demand.”

If a recession does come, he says he thinks the most likely cause will be a downturn in the residential real estate market, which is already starting to suffer. Residential construction spending grew rapidly for most of this decade, but in the most recent quarter it fell at an annual rate of 6.3 percent.

August 01, 2006

Small Caps the go..

LONDON: For Evy Hambro at Merrill Lynch, who manages the world's biggest mining fund, small is profitable. By increasing investments in small and midsize companies, Hambro steered Merrill Lynch's $6.6 billion World Mining Fund to the best performance this year among 270 peers tracked by Standard & Poor's. Shares of Hambro's top performers, Perilya of Australia and Zijin Mining Group, which runs China's biggest gold mine, have more than doubled. "These companies have a higher sensitivity to commodity prices, compared with the larger miners," said Hambro, who visited mines in Australia, China and South Africa last year. "Our exposure to small and mid-cap companies made a big difference to our performance." Growing demand from China, the largest consumer of metals, combined with underinvestment in production, has spurred the longest rally in commodity markets since the 1950s. Copper, which is used for wiring, coins and pipes, is the best performer this year, surging 74 percent. The Morgan Stanley Capital International world metals and mining index of 67 companies is up 20 percent. World Mining Fund, which is registered in Luxembourg, returned 25 percent through the end of last week. The fund beat its own benchmark, the HSBC world global mining index, which advanced 23.4 percent. Hambro, who is based in London, said shares of small and midsize companies, those with market values of less than $10 billion, accounted for about 20 percent of his fund after he "gradually built up" his holdings last year. His father is Peter Hambro, executive chairman and co-founder of Peter Hambro Mining, a company based in London that digs for gold in eastern Russia. Smaller miners that do not buy financial contracts to lock in prices for future production have benefited more from this year's record metals prices, Hambro said. Phelps Dodge, one of the world's largest copper producers, reported a 31 percent drop in profit last week as a failed hedging strategy meant the company had missed out on the rally. Hambro also held shares of Jiangxi Copper, China's biggest copper producer. The value of those shares has more than doubled this year. Aquarius Platinum, which mines for platinum and palladium in South Africa and Zimbabwe, has gained 98 percent. Both surpassed the 22 percent advance of BHP Billiton, the world's biggest mining company, and the 7.4 percent gain of Rio Tinto Group. Hambro owns shares in both companies. Hambro, whose fund takes positions in as many as 70 companies, also owns Oxiana, which is based in Melbourne and explores in Thailand, China and Australia. The company's shares have risen 72 percent this year. Not everyone agrees that this is the time to put money in commodities. The Reuters/Jefferies CRB index of 19 commodities is down 4.9 percent from its May 11 record on concern that rising global interest rates would slow economic growth, curbing demand for raw materials. India, the world's biggest gold-consuming nation, raised its benchmark interest rate last week to a four-year high. "It's a dangerous time to invest in commodity stocks at the moment, given the uncertainty in the markets," said James Lau, a director at the financial advisers Wightman Fletcher McCabe, based in London. "Shares of smaller companies tend to rise at a fast rate when markets are bullish and fall just as quickly when markets turn the other way." Hambro did not heed analysts who forecast last year that metals prices would fall in 2006. A Bloomberg survey in December estimated that copper would average $3,681 a ton this year and aluminum $1,900. Prices have so far averaged $6,206 a ton and $2,559 a ton, respectively. "Most people thought that commodities would move into a surplus in the second half of 2005," Hambro said. "We expected deficits for this year and 2007 too. The exuberance in the markets was much stronger than we anticipated." Copper reached an all-time high of $8,800 a ton in May in London, while zinc climbed to $3,825 a ton, its highest level ever. Nickel, which is used to make stainless steel rustproof, rose to its highest level in 19 years and gold surged to a 26- year high. Prices for iron ore, the main ingredient in steel, rose 19 percent this year, after a record 72 percent jump in 2005. "There is still room to run in the base-metals markets," said James Gutman, based in London, the senior commodities analyst at Goldman Sachs Group. "Investment still hasn't reached the levels it needs in order to meet future demand. I wouldn't be surprised to see further spikes in the markets." Mining companies are battling for natural resource assets and spending on acquisitions to increase output as demand drives up prices. Mittal Steel agreed in June to buy Arcelor for €26.9 billion, or $33.7 billion, in the steel industry's biggest takeover. Xstrata is poised to buy Falconbridge for 19.2 billion Canadian dollars, or $17 billion, after shareholders of the Canadian nickel miner rejected a takeover offer last week from Inco backed by its partner Phelps Dodge, thwarting the mining industry's largest takeover. Teck Cominco, the world's largest zinc miner, revised its unsolicited offer for Inco on Monday in an attempt to rebuff a competing bid from Phelps Dodge and create North America's biggest mining company. "The problem is that companies are spending their money on buying each other, instead of adding to capacity," Hambro said. China's economy has doubled in size over the past decade, overtaking Britain and France, as it builds bridges, buildings and factories. Its economy expanded 11.3 percent in the second quarter, the fastest pace in more than a decade. Marc Faber, the Hong Kong company that told investors to bail out of U.S. stocks a week before the 1987 Black Monday crash, said earlier this year that commodities were five years into a rally that could last as long as three decades.