The Closest You'll Get To A Sure Thing

The Closest You'll Ever Get To Betting On A Sure Thing

Since I first moved to New York in 1996 and got my first job as a stock broker, I’ve seen a lot of the ugly underbelly of the Wall Street money machine beast. I’ve also seen a lot of success and wealth created over the years. I’ve fought long and hard and have learned a lot of very important lessons both from keeping my eyes open and observing others and also from my own hard knocks and failures and losses.

Yes, I've had losses and I’ve made a ton of trading and investing mistakes just like everybody who has ever traded or invested has.

I bring all this up because this Easter, at a family function, I got a great question from a niece, a variation of the most common question I get from many new investors: I am going to graduate this year and I've saved a few thousand dollars. How and in what should I invest it in?

Money and life is complex, and so is my answer.

If she was going to buy stocks with that money, I suggested she check out some of  the major brokerage firms' top recommendations and buy a few shares of her favorite two or three from the model portfolio. Otherwise, she could also visit some of the larger financial institutions' websites for their picks. Regardless of what stocks you buy and when you do it the first time, when you first start out investing and trading, you should be prepared for painful times and lessons which will cost you money and profits in your portfolio. You should consider upfront what you would do if you started putting that money to work and immediately saw it blow up.

I remember reading articles in Institutional Investor back in 2007 that quoted “professional” institutional brokers and salespeople explaining how they were selling “risk-free” securities that guaranteed 5% or more income. Within twelve months, those people's employers, the Morgan Stanleys, JPMs, and Goldmans of the world, needed trillions in new taxpayer support and bailouts because those “risk-free” assets weren’t. In Canada, few people remember the ABCP fiasco (Do the words: "Asset-Backed Commercial Paper" ring any bells?)

I also remember the time I was watching television and a speaker gave a presentation about his options trading formula and before he could get to the microphone, he screamed to the audience, “Forget everything else you heard today, if you follow my options trading plan, you’re guaranteed to make money and never lose.”

Don’t think anybody’s immune to huge losses and wipeouts. Even the Warren Buffett’s and other financiers/insiders of the moneyed world, who had hundreds of billions of dollars invested in the same TBTF (Too Big To Fail) banks that would have been wiped out and other assets that too would have been wiped out without all the “emergency measures” and welfare and bailouts and accounting changes that were made back in 2008 too, obviously can’t avoid mistakes too. Buffett’s big money has enabled him to spend the last few decades buying warrants, convertible debt and discounted equity directly from giant corporations in ways that retail investors can’t even fathom, much less get access to.

So think about all that even before buying a single share of any stock in any publicly-traded company. And before you pull any trigger and open up any stock account, I’d suggest asking yourself if that money might be better used in starting a new app company or website business that you have come up with and think could be a big winner. The experience of running a business and more to the point, the upside of betting on your own actions creating value rather than betting on other people at other companies ability to create value for you as a shareholder, is probably the best bet for your money at this age and stage of your life.

"You’re 18. You’ve got a whole career and a whole life ahead of you. Bet on yourself first. Stocks and other people can come later. And either way, understand that it will take a lot of time, perseverance and luck to make that few hundred dollars you’re looking to put to work in the stock market turn into something meaningful to your overall future income and investments."

Defending The Greeks And Their Prime Minister

Prime Minister George Papandreou is correct to put the EU bailout package to a vote.

Without public consent to the tough austerity imposed by the EU aid package, those measures will not be sustained--a future government can balk at its conditions and start spending again.

For their part, the EU, the IMF and leaders in Germany and other wealthy countries are falsely convinced no good solution for the Greek mess exists other than the package now offered Athens. Introduced in 1999, the euro was the last of several sweeping initiatives to more closely bind European economies into a single, integrated unit, as a preface for greater political unity. Others included the elimination of tariffs, a continental antitrust policy, and greater harmonization of tax structures and environmental standards.

However, European leaders never came to terms with the fact that the euro, even if left to float to find a market value against the dollar and other foreign currencies, would be overvalued for some jurisdictions--leaving businesses unable to compete and wages too high to generate adequate exports, as is the case in Spain, Portugal, southern Italy and Greece. Similarly, it would be undervalued for others--creating hypercompetitive enterprises able to offer their workers the very best benefits and short work weeks, as in Germany.

The United States faces similar issues--the dollar is likely undervalued for Manhattan with its robust financial services, advertising and creative arts--and overvalued for mostly rural Mississippi.

Simply, with a single federal tax structure, Washington subsidizes Mississippi with revenues collected in Manhattan, and somewhat equalizes things across the 50 states. Such burden sharing is largely absent in Europe, even though a single market and currency caused voters in Mediterranean jurisdictions to expect the same caliber of health care and other social services enjoyed in Germany and in other northern climes.

Similarly, teachers, doctors and the like, who deliver those services, could demand compensation more comparable to their counterparts in wealthier nations or migrate. Mediterranean governments coped by borrowing too much. Now that string has run out and austerity is not enough to pay off all they owe. The bailout packages simply won't work without draconian consequences.

Government is so intertwined with the private Greek economy, for example, that large cutbacks in government spending are slashing the size of the Greek economy and tax base faster than government obligations can be trimmed and resources freed to pay the interest on outstanding sovereign debt--even with privately held sovereign debt cut in half.

Greeks sense, after successive rounds of austerity, a vicious cycle has emerged, and the EU won't quit in its demands until their economy is reduced to rubble. All to sustain a common currency that is at the center of the problem and really is not necessary for European unity.

Ultimately, Greece must generate a large trade surplus--export considerably more than it imports--to repay its debts, because much so much is held by foreign banks and international agencies like the European Central Bank and IMF. With the euro overvalued for its economy, it can't accomplish that surplus without enduring decades of high unemployment to drive down wages and living standards--likely by 50% or more--to make Greek exports adequately competitive.

If Athens can't pay, private creditors and international agencies can't repossess the Parthenon. In the end, Greek private creditors will be compelled to take additional losses beyond the 50% haircut imposed on them now, and the ECB and IMF will take losses too.

This is simply too draconian compared to the other way out--readopting the drachma, remarking sovereign and private debt to the reinstituted national currency, and letting the value of the drachma fall to levels consistent with a trade surplus that permits Greece to service its debts.

As denominated in euro, foreign creditors would receive payments on Greek debt less than they are currently owed. However, with the Greek economy more fully employed and generating exports, the haircut a reinstituted drachma would impose would be far less than will ultimately occur though the mindless austerity now imposed. In the bargain, Greece would not be pulverized into decades of punishing depression.

2007 Revisited?

THERE was a whiff of August 2007 in the air on Thursday and again today as financial markets tumbled around the world. More than a whiff, in fact. The familiar stench of panic was back as shares fell heavily, bond yields in Spain and Italy rose and the search for a haven sent the price of gold to a record level. Banks took an especially severe pummelling amid fears that they were exposed to the two big concerns of investors: a break-up in the euro zone and a double-dip recession in the global economy.

In a week of anniversaries, Thursday was a day that conjured up all the wrong sort of memories. It was 97 years since Britain declared war on Germany, when the resulting financial turmoil meant the stockmarket, which had closed at the end of July, did not reopen for business until early 1915. Yet even in the month or so after the assassination at Sarajevo, when the great powers gave up on diplomacy and prepared for conflict, the movements in financial markets were less violent than they were on Thursday.

More recently, it is almost four years since an announcement by French bank BNP Paribas that it was temporarily suspending three hedge funds specialising in United States subprime mortgage debt led to financial paralysis. Banks, it was discovered, had lent unwisely, were loaded up with toxic derivatives that were vulnerable to falling American house prices, and had far too little capital set aside for a rainy day. On August 9, 2007, the heavens opened. On the face of it, the banks are in better shape than they were when British bank Northern Rock became the first major UK high-street lender to suffer a bank run since Overend & Gurney in the 1860s. They have been forced to build up capital reserves and to hold a higher proportion of their assets in liquid form - financial instruments such as government bonds that can be quickly turned into cash.

Financial regulators have spent the past four years crawling all over the banks, making up for the not-so-benign neglect in the days leading up to the crisis, when supervision was far too lax. Britain's Financial Services Authority, the European Banking Authority and America's Federal Reserve know where all the bodies are buried in their respective banks. In theory, at least. One of the parallels between August 2007 and August 2011 is the shiftiness of those running the show, a sense that they are not letting on all they know for fear of creating more panic.

The dwindling band of optimists point to differences with four years ago. Many companies, especially the bigger ones, are in rude financial health after cutting costs aggressively. Parts of the emerging world, such as China and Russia, are growing strongly and may act as the locomotive for the rest of the world. In the West, interest rates are low and budget deficits high: policymakers have pressed the pedal to the floor in an attempt to get their economies moving.

But the ultra-loose state of macro-economic policy cuts both ways. Policymakers were the heroes of Meltdown 1, thumbing through their copies of Keynes's General Theory to come up with the measures deemed necessary to prevent the global banking system from imploding. But if the next few weeks see Meltdown 2, the policy options will be limited. Interest rates are already at rock-bottom levels while the flirtation with Keynesian fiscal policies was brief. As one analyst put it yesterday, the monetary and fiscal guns are not obviously full of bullets. Thursday's mayhem will fan speculation that the Federal Reserve will respond with a third dose of electronic money creation through the process known as quantitative easing.

Not that the $US2 trillion the US central bank has already pumped into the global economy appears to have had much effect, apart from to provide more casino chips for speculators and to push up food and energy bills around the world. There was a colossal stimulus provided in the northern winter of 2008-09 but the results have been profoundly disappointing. Cheap money and big budget deficits certainly averted a second Great Depression, a very real prospect three years ago when no bank looked safe and factories were lying idle, and that is success of a sort. But it has not produced the normal snap back from recession seen during the post-Second World War era. Indeed, the deepest recession since the 1930s has been followed by the feeblest recovery.

The global downturn of 2008 was a different sort of recession - one caused by banks and individuals borrowing far more than was good for them, rather than one caused by central banks raising interest rates in response to higher inflation. It's a different sort of recovery as well - weak, stuttering and at risk of being aborted at any moment.

In one sense, the mood is different from August 2007. Back then, financiers and politicians spent the first six months after the crisis broke in a state of denial, expecting the return of business as usual. They didn't really get it until the collapse of Lehman Brothers in September 2008. Financial markets were taken unawares by Lehmans, but this is a week that has seen the US taken to the brink of debt default, a deal to safeguard the single currency start to unravel within a fortnight of it being agreed, and a steady drip-feed of downbeat economic news. Only a mug would call Thursday's events a ''Lehmans moment''.

Stockmarkets tend to anticipate change. They rise at the bottom of the cycle in anticipation that economic conditions will improve, and they fall when they assume that things are about to take a turn for the worse, which is what they expect now. It is not just that growth appears to be flagging everywhere, even in China. It is the concern, cruelly exposed in Greece, Portugal, Ireland, Italy, Spain and even the US, about the solvency of nation states.

Back in 2007, the one comfort for markets was that a banking crisis never became a sovereign debt crisis. Now it has, and markets are scared witless as a result.

Why UK Banks Are Not Immune To Eurozone Woes

Will lenders have to accept that they won't get their money back from Greece?

The Bank of England points out that there is an 80% probability that the Greek government won't be able to repay all its debt, based on the current market price for insuring Greek sovereign debt.

For Portugal, investors put the probability of default at some point over the next five years at just under 50% and for Ireland the default probability is a little bit less.

As for the market odds on what eurozone ministers regard as the Armageddon scenario, default by Spain, they're around 40% at any time before 2016 if preceded by Ireland or Portugal going bust, but less than 30% if Greece goes down.

That implies potential contagion from Greece's woes may be less devastating than from Portugal's and Ireland's - which may or may not be a comfort.

Now investors, just like bookies, can be wrong. But a banker or investor who ignores the market odds is probably more foolish than a gambler who bets whatever the price offered in the betting shop.

So if you are a banker or an investor and you have an exposure to these financially overstretched countries, and you don't have a death wish then you would probably be advised to make sure you have sufficient spare capital to absorb 80% of whatever losses would be generated by a Greek default, 50% of Portuguese losses given default, and (perhaps) 45% times 50% of Spain's write-offs from default (keep up!).

Falling dominoes

Here's the thing. It is not at all clear that Europe's banks are making adequate preparation to cope with such potential pain.

In the tests of the stresses they can absorb, being overseen by the newly created European Banking Authority, they have been told - for the first time - to make some provisions for potential losses on the 80% of their sovereign exposure which is held in their so-called banking books.

But it is not at all clear that banks are being asked to protect themselves against either the worst that could happen, in respect of Greece, Ireland, Portugal and Spain - or indeed what may in fact happen.

Which is why Sir Mervyn King, the Governor of the Bank of England, made clear that he doesn't take enormous comfort from big UK banks' relatively limited direct exposure to Greece, Portugal, Ireland and Spain.

According to the Bank of England's analysis, if every single one of those countries went bust and wrote off 50% of their sovereign debt, banking debt and non-bank private-sector debt, that would wipe out around half the capital in the UK banking system - which is another way of saying that, in theory, the majority of our banks would limp on.

What is the probability of all those dominoes falling in that way?

It might be higher than we care to know. But British banks must have done something right that such a catastrophe wouldn't eliminate 100% of their capital.

But it is not only the direct loans to these countries that could do severe damage to our banks.

Sir Mervyn puts it like this: "experience has shown that contagion can spread through financial markets especially when there is uncertainty about the precise location of exposures. A UK bank could have lent to a bank that itself had lent to a bank that in turn was exposed to sovereign risk."

Forgive and forget

So if a British bank has a big exposure to a French bank which is undermined by its exposure to Greece, that could be a problem for said British bank.

And, in the crisis of 2007-8, we learned something else about how modern banks can bring down themselves and the rest of us with them: in an interconnected banking world, it is uncertainty that can be the worst poison.

The point is that those who lend to banks can't be sure where the fatal direct exposures to Greece, or Portugal, or Ireland lie. Which is why in a time of panic they may well stop lending to any bank which may have a direct or indirect exposure.
It is in that way that Greece's solvency crisis can become a liquidity crisis for the banking system - and can even wreak havoc for British banks that have lent relatively little to Greece.

By the way, Sir Mervyn made clear he hasn't got a huge amount of confidence that eurozone ministers have yet come up with a plan to cure the disease that underlies all of this, the excessive amounts that the Greek government has borrowed.

Sir Mervyn said that lending more money to Greece, the eurozone's current strategy, is only useful if it buys time to somehow make those debts affordable.

And there are only two ways that can happen.

Either Greece's relatively weak and small private sector has to be supercharged such that it starts generating current account surpluses that would allow the country to service the enormous debts - which seems unlikely to happen any time soon.

Or lenders to Greece have to accept that they're not going to get all their money back - and Greece's debts would be "forgiven" or reduced to a level it can afford.

Either way, Sir Mervyn noted that Greece has a solvency problem that has not yet been solved.

A Stronger Yuan May Not Help US Workers or the Economy.

Let me get right to the point: A stronger Yuan won't help the US economy and its workers. In fact, it may actually have a disproportionately negative effect on those who are unemployed, underemployed or on the lower scale of incomes.

The US is sqandering precious political capital by pressuring China to strengthen the value of the yuan in order to reduce US imports and help restore output and jobs to the US.

While a weaker currency does make goods produced in China more competitive on the world market, US leaders are mistaken about the effects of this on the US economy and workers.

The weak yuan is diverting jobs and output from Mexico, Thailand and even Japan, not from the U.S. The top 20 products imported into the US from China are in industries that account for less than 5 percent of US gross domestic product. The emerging countries of the world, such as Mexico and Thailand, are China's true competitors on these largely commodity-type products.

The US has high wages associated with the world's highest productivity rates, and so does not have a competitive advantage in the majority of the products imported from China.

The US does produce other goods -- and, notably, services -- that are both competitive and in demand in China. If the US is serious about stimulating sustainable growth in US production and employment, it should implement policies that encourage investment in these high-value-added products and services, rather than attempting to stimulate production of goods that represent America's past. If the US wants China's assistance in reducing the trade deficit, it should pressure Chinese leaders to allow their workers to become consumers, which would lead to increased exports of these US-produced goods and services.

The table above lists the top 20 categories of products that the US imports from China. These account for 75 percent of US imports from China, but less than 5 percent of US GDP. The top three Chinese import categories combined -- computers and peripherals, communications devices, and apparel -- constitute nearly 31 percent of total US imports from China but less than 1 percent of US GDP. Put in plain English: One third of the US imports from China amount to 1 percent of our total production -- little wonder that the Chinese feel unfairly targeted. And don't take my word for it -- the numbers come from the US Department of Commerce and the US Bureau of Economic Analysis. We are literally fighting over pennies on the dollar. The Chinese and the rest of the world know this. That's why we aren't getting any international support on this issue. It's also why other developed nations are focusing on increasing their exports to China, concentrating particularly on the higher-value-added components of the equation.

The 2004 Economic Report of the President made the point that rising Chinese imports were taking markets from Mexico and other developing nations rather than US producers. The reverse is equally true -- foregone imports from China will be replaced by imports from Mexico, Thailand and even Japan, where they are produced more cheaply than in the US, but at a higher cost to the American consumer. This will have the same effect as a regressive tax.

A stronger yuan will not have a meaningful effect on US production because of the disparity between the products imported from China and the capacity to produce those same products in the US. In fact, the trade deficit might worsen if the yuan's appreciation increases the prices of these imports, and would be exacerbated if they came from even higher cost producers, because in the end, they would still be imported!

Additionally, the low level of US production of these goods is not a result of the rising level of imports from China. The majority of the categories in the table have been in structural decline since before the US trade deficit with China surged. The US industry that has experienced the most significant reduction in size relative to the overall economy over the last decade is motor vehicles, an industry in which the Chinese do not yet compete globally.

Trade benefits all parties involved so long as trade patterns are determined by comparative advantage, meaning each country exports products in which it is competitive due to a greater availability of resources or productivity compared to cost.

The US has an advantage in producing capital equipment, robotics, audio and video content, sophisticated services such as insurance, banking, and real estate, and large-scale agricultural products. Accordingly, these industries command large shares of the US economy, led by professional and business services at 12 percent, real estate services at 13 percent, financial and insurance services at 8 percent and health care at 7 percent.

The US $132 billion annual trade surplus on services and $121 billion surplus on income earned abroad are often overlooked in trade discussions, taking a back seat to the $500 billion deficit on goods.

Instead of pressuring China to help move the US economy back to producing products for which it long ago lost its comparative advantage, the US should be working to expand the buying power of Chinese workers who now save close to 40 percent of their income. This, combined with an opening of their financial and other service markets to US providers, would be the best way to reduce the US-China trade imbalance.

Europe And Austerity Don't Mix

Europe has bought itself time with its E 750 billion bail-out for the euro. But the long-term problem remains.

Most of the European Union is living beyond its means. Government deficits are out of control and public-sector debt is rising. If European governments do not use their new breathing space to control spending, financial markets will get dangerously restless again. Unfortunately, European voters and politicians are simply unprepared for the age of austerity that lies ahead.

I used to think Europe had got it right. Let the US be a military superpower; let China be an economic superpower -- Europe would be the lifestyle superpower. The days when European empires dominated the globe had gone. But that was just fine. Europe could still be the place with the most beautiful cities, the best food and wine, the richest cultural history, the longest holidays, the best football and cricket teams. Life for most ordinary Europeans has never been more comfortable.

It was a great strategy. But there was one big flaw in it. Europe cannot afford its comfortable retirement.

Greece's financial crisis is, unfortunately, an extreme example of a broader European problem. Investors have been looking nervously at debt-levels and budget deficits in Spain, Portugal and Ireland for months. But even Europe's big four -- Britain, France, Italy and Germany -- are hardly immune from concern. Italy's public debt is about 115 per cent of gross domestic product. some 20 per cent of this needs to be rolled over during the course of 2010. Britain is currently running a budget-deficit of nearly 12 per cent of GDP, one of the largest in Europe. George Osborne, who is likely to end up as chancellor of the exchequer in the new government, has described Britain's official economic forecasts as a "work of fiction". The French government has not produced a balanced budget for more than 30 years. And one of the reasons for the deep bitterness in Germany at bailing out Greece, is the knowledge that Germany is already struggling to balance its own books.

It is true that the citizens of Latvia and Ireland have already swallowed actual cuts in wages and pensions. But these are both countries that have experienced real poverty in living memory, followed by massive and unsustainable booms. They know that the last few years have been a bit unreal.

As the riots on the streets of Athens illustrate, however, not all Europeans will react so stoically to deep cuts in spending. Many have come to regard early retirement, free public healthcare and generous unemployment benefits, as fundamental rights. They stopped asking, a long time ago, how these things were paid for. it is this sense of entitlement that makes reform so very difficult. As the British election has just amply illustrated, politicians are extremely reluctant to confront voters with the harsh choices that need to be made.

Yet if Europeans do not accept austerity now, they will eventually be faced with something far more shocking -- soverign debt-defaults and collapsing banks. For many Europeans that is the kind of thing that only happens in Latin America. The discovery that Latin Europe -- and maybe northern Europe, too -- can also hit the financial wall will come as a horrible shock.

The growth in the size and power of the EU has fed a dangerous sense of complacency. for the countries of southern and central Europe -- who joinced later than the inner core -- "Brussels" was sold as the ultimate insurance policy. Once they were inside the EU, it was felt that war, dictatorship and poverty were safely consigned to the past. Everybody could aspire to the relatively comfortable, stable lives of the French and the Germans. For many years, it worked beautifully -- as living standards shot up in countries such as Spain, Greece and Poland.

In recent years, European unity has also been marketed as an insurance policy for the founder members of the Union. Both President Sarkozy of France and Angela Merkel, the German chancellor, speak of a Europe that "protects". The idea was that a Union that spanned 27 nations was large enough to protect a unique European social model from the uncertainties of globalisation.

At the most fundamental level, the EU does indeed protect. But while Europeans no longer fear foreign armies, they are starting to fear foreign bondholders. Europe's existence as a "lifestyle superpower" has depended on an ample supply of credit.

This weekend's bail-out essentially extends one last, massive credit-line to those European governments that might need it. But, for all the talk of pan-European solidarity, once cost of this credit-line will be a sharp increase in political tensions with the EU. There is already much bitter talk in Greece about the loss of national sovereignty; matched only by bitter talk in Germany about the costs of bailing out feckless southern Europeans. This crisis has set two peoples against each other as close as it comes to war in modern Europe.

Let us hope so.

But Europeans are discovering that the "European project" provides no protection against the harshness of the outside world. Things can still go badly wrong -- even within the walled garden of the European Union.

Gold -- It's Not Safe, It's Not An Investment, And It's Not The Best Protection Against Inflation

Economic chaos? The dollar crumbling? Central banks printing money like crazy? Probably the only real surprise about the surge in gold prices over the last few months is that it took so long to arrive.

Last week, gold touched an all-time high of $1,277.50. Back in September it was still less than $1000. Chalk that up as a victory for the gold bugs.

This week, the price is heading down, dropping below $1,200. Chalk that up as a victory for the gold skeptics, who regularly point out that the metal's value is just a sentimental memory from a long-buried era.

In reality, while investors are right to be nervous about inflation, maybe they are catching on that it's wrong to see gold as the best hedge against a general rise in prices. There are plenty of alternatives: equities, property, oil, luxuries or private-equity funds should prove just as effective a way of shielding yourself.

It isn't hard to figure out why investors had been getting interested in gold again. Central banks are pumping freshly minted money into the system. A few hundred years of economic history syas that eventualy this will lead to inflation. It might be next year, or the year after. It doesn't make much difference--it will arrive sooner or later, and you'll need to get your portfolio in shape before it does.

Alloyed Record

But gold? Whether it's a hedge against inflation depends on where you want to start drawing the graph. Back in 2002, gold was less than $300. If you bought it then, you'd certainly have protected yourself against rising prices-- and mad a fat profit as well. The 1990's were a different story. Gold started that decade at around $400, and ended it below $300. Not so great. As for the 1980s, forget it: gold lost almost half it's value during that decade.

In reality, gold has a mixed record. Nor should you be surprised about that. A few industrial uses, and jewelry, aside, gold is valuable only insofar as other investors think it is valuable. By itself it isn't necessarily worth anything. Nor does it generate interest or dividends. If the price doesn't rise, you don't get anything.

There isn't much chance, either, of the world's central banks making their currencies convertible into gold once again. They would bankrupt their governments in the process. It may secure itself a greater role as a reserve asset. But the gold standard isn't about to be re-imposed.

In truth, while gold may have a role in protecting against inflation, there are plenty of alternatives. Here are five you should be thinking about--particularly when you bear in mind that gold is already close to an all-time high.

Real-Estate Rebound

One, property. The price of real estate won't always move exactly in line with inflation. And you might want to steer clear of the markets where there has yet to be much of a retreat from the exuberant prices of 2006 and 2007. Even so, if there is more money chasing a static amount of land and buildings, prices are going to rise.

Oil

Two, oil. They used to call it black gold and maybe they should again. It has already stopped being just stuff we put in our cars, and use to heat houses, and has become an investment asset in itself. How else can we explain the fact that oil has ticked up past $70 a barrel even while we're living through the worst global recession since World War II? Oil is already, in effect, an alternative to gold. The one difference is that you can put it in your car and drive somewhere--making it far more useful than stuff good for little more than dental fillings and trinkets to wear around your neck. (Did I just say that?...Oh, that's right....diamonds are a girl's best friend.)

Stock Picking

Three, equities. Moderate, persistent inflation in the 3 percent range is good for the kind of big, blue-chip companies that dominate the major global stock markets. They can edge up rices along with everyone else. And they can usually get away with increasing wages just a bit less than inflation, so cutting labor costs as well--particularly as unions are far less powerful than they used to be. In those circumstances, the shareholders should do fine--and their equities will more than keep up with rising prices.

Luxury Goods

Four, luxury goods and collectibles. Once inflation takes off, it is only real assets that will hold their value--everything else is just paper, and that will be of dwindling use. Assets don't get much more real than historic art, valuable antiques, vintage automobiles or fine wines. They should start to soar in price as the mega-rich realize they are among the few ways to protect wealth. And, if you get it wrong, you can always hang them on the wall, or drink them.

Private Equity Funds

Five, private-equity funds. This one might not be obvious. But a leveraged buyout firm buys well-established companies, in basic industries, and then loads them up with lots of debt, while hanging on to a little bit of equity. Inflation will effectively wipe out all that debt. The result? The equity that is left over will be worth far more. What do you think the Chinese have been doing these last few years?

Rate Squeeze

Of course, none of these will necessarily work in the long-term. The only real way to control inflation once it gets started is to raise interest rates high enough to create a deep recession, and so choke off rising prices. That's what central bankers did in the late 1970s and early 1980s, and may do again sometime around 2015 or 2020. Once that happens, you'll need to think again--you might not want to be in property or equities.

That, however, is some way off. As we move into the early stages of an inflationary era, those five assets should do at least as well as gold, if not better.

A New Leading Indicator

Economists are wrong to dismiss unemployment as merely a lagging indicator, a sign of where the economy has been.

In fact, I believe that the 26-year high jobless rate is also an omen of things to come.

The climb in the September rate to 9.8 percent, double the level at the start of last year, leaves the U.S. saddled with about 15 million people out of work and with limited prospects. That will further hurt the housing market and weigh on the wages of those still employed, threatening to undercut the economic recovery.

Today’s unemployment rate is much more than a lagging indicator. It is also a signal of future pressures on consumption, housing and the country’s social safety net.

The job market tends to trail the economy in a recovery because companies hesitate to take on more workers until they are convinced the expansion will last. What’s different this time is the large and protracted rise in joblessness and the likelihood that it will stay high for years. That means unemployment will affect the economy going forward, not merely reflect where it has been.

Less Credit, Fewer Jobs

The U.S. is entering a "new normal" -- a sustained period of annual growth of about 2 percent -- as Americans adjust to a world where credit and jobs are less plentiful. In the five years before the recession began at the end of 2007, gross domestic product expanded at an average annual rate of 2.8 percent. The struggle to generate jobs means the Federal Reserve will keep its benchmark interest rate near zero through next year.

Joblessness will be the number one public policy problem for 2010. The Democrats could get hurt by that in the November Congressional elections.

The September numbers were “wall-to-wall ugly,” as payroll cuts accelerated to 263,000 from 201,000 in August.

Dropping Out

Unemployment would have topped 10 percent if not for the more than half million Americans who left the workforce. Long- term joblessness -- the percentage of the unemployed out of work for 27 weeks or more -- rose to a record 35.6 percent, or 5.4 million Americans.

The 62-year-old executive added in an interview that the economy will probably recover more slowly than in past rebounds.

Even before the job figures, Fed Chairman Ben S. Bernanke told lawmakers on Oct. 1 that economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.

Economic Experience

Employment and unemployment, economic experience suggests, is a lagging indicator.

The last recovery started in December 2001; unemployment didn’t fall until five months later. In 1991, the expansion began in April and the jobless rate fell briefly in July, only to resume rising into the next year.

While the unemployment rate this time will again lag behind the recovery, which probably started in the third quarter, the distress in the job market was also saying something about the future.

We have an army of unemployed. That’s telling us a lot, in a leading way, about the picture for the consumer.

Wages And Bankruptcies

U.S. consumer bankruptcies rose past 1 million through the first nine months of the year, the highest since 2005 changes to bankruptcy laws.
Employment expenses in the U.S. -- both wages and benefits -- increased at a record low year-on-year rate of 1.8 percent in the second quarter after a 2.1 percent increase in the first, as the high jobless rate held down worker compensation, according to an index compiled by the Labor Department.

Retailers are pulling back before the holiday sales season.

U.S. retail job losses jumped to 38,500 in September from 8,800 in August as car dealers and other stores cut payrolls.

Mattel Inc. and Hasbro Inc., the world’s two biggest toymakers, are shifting toward lower prices this holiday season as budget-conscious parents seek bargains. Eighty percent of El Segundo, California-based Mattel’s toys will cost less than $30 this year, compared with 75 percent last year.

More Foreclosures

Housing, which has traditionally led the economy out of recession, may also be hurt as the continued rise in unemployment boosts foreclosures. It is possible for home prices to resume their downward slide, after jumping by the most in almost four years in 20 U.S. cities in July, as the jobless rate rises to 10.5 percent in the middle of next year.

Mortgages 60 days or more past due climbed to 5.3 percent of loans through June 30, up from 4.8 percent on March 31 and 3 percent a year earlier, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said on Sept. 30.

First-time foreclosure filings fell 0.4 percent from the first quarter, helped by Obama’s loan-modification program, according to the two government bank regulators in Washington.

U.S. homebuilders will have operating losses of more than $500 million in 2010 as mounting foreclosures and unemployment further erode home prices, Moody’s Investors Service said in a Sept. 30 report. The New York-based bond rating company extended its negative credit outlook for the industry for the next 12 to 18 months, meaning Moody’s may lower the builders’ debt ratings.

Housing Woes

Banks will also be hurt as housing’s woes lead to more loan losses.

The depressed job market may take its toll on politicians. Democratic lawmakers in the House of Representatives are particularly vulnerable if voters blame Obama for a sour economy.

Since 1945, the party that controls the White House has lost an average of 16 House seats in a president’s first midterm election, according to the Cook Political Report. Obama’s Democratic Party currently has 256 seats in the chamber, compared with 178 for the Republicans.

The House approved legislation last month that would extend unemployment benefits by 13 weeks for people in 27 states with jobless rates of at least 8.5 percent in August. The Senate is considering the measure.

It’s very important for policy makers to remain very aggressive. The severe stress in the job market is the most significant threat to the nascent recovery.

The Global Financial Crises' Is Over, If You Believe It Is!

No, Not Really!

Mixed Metaphors

Botanical commentators are finding "green shoots." The astronomically minded have seen "glimmers." The meteorologically minded have spoken about the storms "abating." Strong rallies in equity and debt markets have confirmed the recovery for the "true believers."

The Global Financial Crisis (GFC) crisis is over!

It is useful to remember Winston Churchill's observation after the British expeditionary force's escape from Dunkirk: "[Britain] must be very careful not to assign to this deliverance the attributes of a victory.'' There may be confusion between "stabilization'' and "recovery.''
The green-shoots theory is based on a slowdown in the rate of decline in key economic indicators, improvements in the financial system, unprecedented government support for the banking system, near-zero interest rates and large fiscal stimulus packages. The recovery of emerging markets, especially China, also underpins hopes of a swift return to growth.

Receiving the Messengers

The puzzling thing is that real economy indicators continue to be poor.

GDP forecasts for 2009 have steadily deteriorated, with world growth expected to be negative 2% to 3%, with especially poor prospects for Japan and the euro zone. Industrial output, employment, consumption, investment and global trade continue to be weak. Even China, which expected to grow between 6% and 8% in 2009, experienced a fall in exports of over 20% over the last year.

The wealth effects of the GFC on economic activity are unclear.

In the United States alone, $30 trillion of value has been destroyed. Pension funds have lost anywhere between 20% and 50% of their value. Combined with declines in housing prices and reduced dividends and investment income, the sharp decline in wealth may not be yet to fully flow through into consumption.

The financial system has stabilized but not returned to the "rude good health" that current executive compensation demands within banks would suggest.

Good results for Goldman Sachs and J.P.Morgan are offset by less impressive performances by Bank of America, CitiGroup and Morgan Stanley. Profitability is patchy and reliant on risky trading income and large underwriting revenues from capital raisings by financial institutions and companies who are de-leveraging aggressively. Asset quality remains vulnerable to more bad debts from the normal recessionary credit cycle that is working through the economy.

Bank risk levels have increased to and in some cases beyond pre-crisis levels.

Goldman Sachs second-quarter earnings showed an increase in risk levels as measured by Value-at-Risk (VAR). The increase in risk is probably understated as it takes into account diversification benefits that may be overstated under conditions of market stress. It is probably also understated because of assumption of trading liquidity that may be optimistic given recent experience. The higher levels of risk-taking reflect increasing comfort in central bank support of financial institutions' liquidity and their ability and willingness to intervene to limit price risks. Leverage and lending against risky assets has resumed at a rate not seen since 2007.

Capital remains scarce and bank balance sheets are at best not growing and at worst shrinking. Some estimates suggest that the bank capital shortfall could be in range of $1 trillion to $2 trillion, equivalent to a credit contraction of around 20% to 30% from previous levels. Proposed bank regulations, primarily the increased levels of capital and lower permitted leverage, will also affect the ability of the financial system to extend credit.

The link between debt and economic growth is well established. The global economy probably needs around $4 to $5 of debt to create $1 of GDP growth
.
International Monetary Fund researchers Tamin Bayoumi and Ola Melander, in a study of the economic impacts of an adverse shock to bank capital ("Credit Matters: Empirical Evidence on U.S. Macro-Financial Linkages," IMF Working Paper 08/169) found that in the United States, a one percentage point fall in Tier 1 risk-weighted capital ratios reduces real GDP by 1.5%.

This means that global bank capital shortage may restrain credit creation thereby reducing economic activity and sustainable growth levels.

The impact of fiscal stimulus packages has been variable. In some jurisdictions, the payments have been saved or applied towards debt reduction rather than consumption. Targeted measures, such as the cash-for-clunkers' deals (cleverly packaged as ‘green' environmental initiatives) have boosted immediate demand for cars, but the long-term demand effects are unclear.

The multiplier effect of the fiscal initiatives is likely to be low. Major infrastructure initiatives will take time to implement. Few projects are "shovel ready." The rate of return on government spending programs, some of which are politically motivated, is unclear. Government spending increasing capacity is likely to create problems in a world where many industries are operating with surplus capacity. Government bailout packages for various industries, such as the auto and housing industries, however well intentioned, are delaying much needed capacity adjustments and risk prolonging the problems.

The phoenix-like recovery in emerging markets is primarily driven by panicked government spending and loose monetary policies increasing available credit. Estimates suggest that around 6% of China's growth of around 8% is attributable to government spending and increased bank lending.

The extraordinary increase in lending in China is fueling unsustainable growth. In the first half of 2009, new loans totaled more than $1 trillion. This compares to total loans for all of 2008 of around $600 billion. Current lending is running at around three times 2008 levels and at a staggering 25% of China's GDP. The combination of government spending and bank loans has resulted in sharp increases in fixed asset investments (up 30% from 2008). Government incentives, in the form of rebates for purchases of high value durables such as cars and white goods, have also increased consumption (up 15% from 2008). Even Chinese government officials have admitted that the recovery is "unbalanced."

The increase in industrial production in the absence of real end demand for products could result in a rapid inventory buildup. The availability of credit is also fueling rampant speculation in stocks, property and commodities. Estimates suggest that around 20% to 30% of new bank lending is finding it way into the stock market, in part driving up values.

The price rise in emerging market shares, debt and currencies also reflects a blind belief that anywhere must be safer and more promising than the U.S., Japan or Europe. This misses the point that these markets have a strong trading and export orientation or are external capital dependent. While some have bright long-term futures, they will need to make difficult and slow adjustments to their growth models to return to trend growth.

The recovery in emerging markets has, in turn, underpinned the recovery in commodity prices and economies dependent on natural resources. A significant part of this is inventory restocking but there is a speculative element. Availability of abundant and low-cost bank financing, combined with a deep-seated fear of the long-term prospects of U.S. Treasury bonds and the dollar, has encouraged speculative stockpiling of certain commodities, artificially boosting demand.

In reality, the global economy has, in all probability, entered a period of stability after a fairly big decline. Market sentiment seems to be shaped less by facts than the Doors' song: "I've been down for so long, it feels like up to me."

Government Largesse

A key risk remains the ability of governments to finance their burgeoning government deficits. A wretched combination of declining tax revenues, increased government spending to cushion the economy from recession and bailout packages for banks and other "worthies" means that many countries face large and continuing budget deficits.

In August, the U.S. Congressional Budget Office released forecast that project the 10-year deficit to reach over $9 trillion, some $2 trillion more than it had estimated as recently as March 2009. Even countries with relatively healthy balance sheets such as Australia do not anticipate balancing their books for many years. If the problems of an aging population and unfunded liabilities such as public sector pensions, health-care and social security arrangements are included, then the budgetary position looks considerably worse.

In 2009, total sovereign debt issues are expected to total more than $5 trillion, of which the United States alone will need to finance around $3 trillion. The increases in sovereign debt issuance are astonishing – U.S. around 300%, U.K. over 400%, euro zone around 50%. Government debt-to-GDP ratios for many developed countries are projected to reach and remain at levels in excess of 100%.

Overall government deficits in major economies through the recession are estimated to total around $10 trillion (around 27% of GDP of these economies). The work of economists Kenneth Rogoff and Carmen Reinhart on previous recessions suggests that the deficit estimates are conservative and the amount that will need to be financed will be between $15 trillion (40% of GDP) and $33 trillion (86% of GDP).

As a comparison, the total amount of global investment assets under management, according to one estimate, is around $120 trillion. This provides some idea of the funding task ahead.
Long-term interest rates have risen sharply, reflecting supply pressures. The 30-year U.S. Treasury yield has increased by around 1.50 percentage points since the start of 2009. Maturities also have shortened, increasing the refinancing challenges ahead. Participation of central banks in the U.S. and U.K. bond markets, under their quantitative-easing mandates, has hold down interest-rate increases, creating a somewhat artificial market.

A key issue over the coming months is the continued demand for increased sovereign debt issues.

China, Japan and Europe historically have been major buyers of U.S. Treasury bonds. As their own fiscal position changes and their current account surplus shrinks, the ability of these investors to absorb the increased supply is unclear. China's foreign exchange reserves are growing more slowly than before. China has continued to purchase U.S. Treasury bonds, but some purchases represent a switch from U.S. agency paper. As the United States has increased its issuance program, China's purchases are now a smaller portion of the total.

In the best case, the government debt issuance is accommodated but squeezes out other borrowers. In the worst case, governments find themselves unable to finance their deficits setting off a new stage of the GFC.

Withdrawal Method

Given the size of the intervention, a key question is the timing of withdrawal of government support for the economy.

The current apparent health of the financial system owes everything to wide-ranging government support. The ability of the banks to raise equity and debt is substantially underwritten by the "too-big-to-fail" doctrine. Profitability is supported by low and, in some cases, zero cost of deposits and a sharply upward sloping yield curve that creates significant earnings from borrowing short and lending long. Withdrawal of support may expose deep-seated and unresolved problems in the financial system.

Substantial quantities of structured securities are now held by central banks either as collateral for funding arrangements or through other innovative market support mechanisms. This has substantially increased the size of central bank balance sheets in the U.S., U.K and Europe.

It is not clear how and when these "temporary" positions will be unwound. Attempts to create structures for repackaging these securities, such as the frequently touted but still to be implemented Public Private Investment Partnership (PPIP) program, have enjoyed limited success. Untimely attempts by governments to liquidate these portfolios may be disruptive to fragile markets.

These securities may have to be held to maturity (sometimes over 10 years in the case of some Asset Backed Securities (ABS) and allowed to self liquidate from the underlying cash flows. The bloated central bank balance sheets may restrict policy flexibility significantly.

Government spending has been substituted for private consumption and investment. The deficits will ultimately necessitate a combination of increased taxation and reduced spending to correct this position.

Assume a country has government debt equal to 100% of its GDP. Assuming an annual interest rate of 5% and a GDP growth rate of 4%, a 1% budget surplus is required to maintain debt at current levels. If the gap between interest rates and growth is greater, then the size of the required surplus is commensurately larger. In effect, it is unlikely that the present expansionary fiscal position can be sustained over a long period. The fiscal position of major economies may restrain growth.

Fundamental Truths

Belief in the recovery story and sharp financial market rallies fail to recognize that little has actually changed since the GFC began. Fundamental failures have not been fully addressed.
The required reduction in debt levels has not been completed. Increases in government debt have substantially offset reductions in private sector debt.

Instead of dealing with the problem of leverage, the debt has also merely been rolled forward through a variety of clever warehousing structures and the manipulation of accounting rules.

In a system that has excessive leverage, there are only two adjustment mechanisms:

The value of assets supporting the debt and income available to service the borrowing can be increased, usually by inflation.

The value of the debt can be reduced through writing it down to the real value of the assets.

Governments and central banks have gambled on inflation despite its social and economic costs. In reality, inflationary pressures in the global economy are not apparent. The rebound in energy and food costs has prevented deflation. The absence of demand, excess capacity, reduced credit creation and low velocity of money circulation may mean that it is disinflation or deflation that is the problem going forward.

There is now faith-based reliance on governments' ability to rescue the economy. Intervention has helped stabilize economic activity and the financial system but it improbable that government actions alone can prevent the necessary adjustment in debt levels and growth rates.
Government's share of most developed economies is around 25% to 40% of GDP. Its role in liberal democracies is limited by the fact that is fundamentally an intermediary, not dissimilar to a bank. It derives its resources through taxation from certain sectors of the economy and redirects it to other sectors. This means that its ability to control an economy has limits in the absence of nationalization of all productive activity.

In the short run, governments can borrow or print money to augment its resources. Like all debt, it borrows from tomorrow to pay for today. Quantitative easing (the now respectable name for printing money) also has limits, unless governments are willing to risk hyper-inflation and the social dissolution of the Weimar Republic or Zimbabwe. While governments can influence an economy, they cannot completely reverse inevitable adjustments dictated by market forces.

Governments may also be impeding necessary adjustments. Rising government investment is increasing capacity in a world with stagnant demand and over-capacity in many sectors.

China's current growth is being driven by government investment that is increasing capacity, which in the absence of sufficient domestic demand may be directed to exports increasing the global supply glut. Politically and socially motivated bailouts of national champions and strategic industries mean the necessary reductions in capacity through bankruptcy and corporate failure have not been allowed to happen.

There are even signs that the financial sector is rediscovering old habits. The government and taxpayer paid for return to profitability of major financial institutions, and the return of remuneration levels to pre-crisis levels raises fundamental questions about whether any change has occurred. After the strong second-quarter earnings report for Goldman Sachs, Chief Financial Officer David Viniar told Bloomberg News that, "Our model really never changed, we've said very consistently that our business model remained the same." Despite the egregious excesses, governments seem collectively to lack the will to reform the financial system to avoid the problems of the past.

In 2007, when the U.S. housing bubble collapsed, the satirical magazine The Onion demanded that the American people be given another bubble to speculate in. Their wish now appears to have granted.

Actions to stabilize the global economy seem only to have created new bubbles – in government debt and emerging markets.

Government actions seem to be primarily designed to ensuring continuation of the Ponzi scheme. The only lesson learned is that no Ponzi scheme can ever be allowed to stop.

As states one familiar but anonymous saying: "Never in the history of the world has there been a situation so bad that the government can't make it worse."

Global Questions

There is broad agreement that a key component of the GFC was the problem of global capital imbalances.

A central feature was debt-funded consumption in the United States that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit.

Japan, China, Germany and the other savers funded the consumption.

At its peak, the United States was absorbing about 85% of total global capital flows to fund its government and private debt.

Any lasting solution to the GFC requires this imbalance to be dealt with.

The glib solution requires the United States to save more and consume less, and the savers to save less and consume more. The problems in implementing the solution are considerable.

Timothy Geithner's recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. government debt to finance its fiscal stimulus and bailouts.

On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings.

All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalize it currency and open its capital account, allowing internationalization of the Renminbi!

A cursory look at the respective economies highlights the magnitude of the task.

Consumption's contribution to U.S. GDP is 71%, while in China, it is 37%. Given that the GDP of China is around $4 trillion to $5 trillion, vs. $15 trillion for the United States, and average income in China is around 10% to 15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

Additionally, over the last 25 years, Chinese consumption has declined from around 50% to current levels of 37%. During that same period, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American buyer, lower U.S. growth and declining consumption creates significant challenges for China.

Dealing with these global imbalances has not been a high priority in the various summits, symposiums and talk-fests that global leaders have shuttled to and from. The focus has been ‘NATO' – no action talk only. Half-hearted and unworkable proposals, such as the use of the synthetic Special Drawing Rights as reserve currency, have emerged.

Globally Unbalanced

Reliance on Chinese foreign currency reserves is probably misplaced.

Chinese reserves, a large proportion denominated in dollars, may have limited value. They cannot be effectively liquidated or mobilized without massive losses. Increasingly strident Chinese rhetoric about the safety of their dollar assets reflects increasing panic.

In reality, China is trying desperately to switch its reserves into real assets – commodity or resource producers where foreign countries will allow. In the meantime, China continues to purchase more dollars and U.S. Treasury bond to preserve the value of existing holdings in a surreal logic.

On the other side, the U.S. continues to seek to preserve the status of the dollar as the sole reserve currency in order to enable itself to finance itself. The intractable nature of this problem is evident in the frequently contradictory statements from various Chinese spokesmen regarding the official position on the dollar.

No sustainable global recovery is likely without addressing the fundamental global imbalances that lie at the heart of the GFC.

Placebo Effects

Wolfgang Münchau, writing in the Financial Times on June 14, 2009, eloquently summed up developments. "Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world."

The placebo effect is a pervasive phenomenon in medicine. A sham medical intervention may cause the patient to believe that the treatment will change his or her condition sometime causing the actual condition to improve. Conditioning, expectations and motivation all can play a role in placebo effect.

In recent times, investors, markets and governments have all come to believe in the recovery, sometimes by selective interpretation of facts to support the conclusion that they need. As T.S. Eliot observed: "Mankind cannot take too much reality."

Given reluctance or inability to deal with the real problems, it is not entirely clear whether the GFC cures are real or inert treatments.

It is also not clear whether current improvements in market and economic conditions are sustainable or merely a short-term placebo effect.

Watch These Indexes This Summer

You might think your summer vacation is nothing more than a week of lazing around, working out how some of those applications on your iPhone actually work, and getting reacquainted with your family.

Not so.

If you are smart, you can tell a lot about how the markets are going to evolve just by keeping a close eye on what is happening around the pool of a luxury five-star resort in Sardinia, Crete or the Algarve.

By the time you get back to your desk after a few weeks off, you will have a pretty good grasp of the world economy and know what to do with your investment portfolio.

Here’s a list of the main indexes you need to be tracking as you lie back on that sun lounger:

The Blackberry Index:
The mergers-and-acquisitions market doesn’t take a rest for the holidays. Blockbuster bids for the European fall are being plotted right now. M&A bankers working on a deal can’t afford to stay out of the loop for more than a few hours. If there are lots of people scrolling furiously on their BlackBerrys and wearing out their fingers composing memos on a tiny keypad, expect plenty of big deals in September. If the BlackBerrys remain silent, assume the markets are dead.

The Private-Jet Index:
After a couple of days, you will have a fair idea of when the scheduled planes land at the closest airport. But private jets operate on their own timetable, and the families traveling on them might show up anytime. The more people flying in privately, the better the markets are looking. This index can mainly be used as a measure of the private-equity industry. Those guys never fly public if they can help it.

The Towel Index:
Take a look at how many towels are left by the time you finally saunter down to the pool in the morning. If there are none to be had, that can only mean one thing: The Germans are back, and talk of the demise of Europe’s export machine will have been exaggerated. Conversely, if there are plenty of towels available, that means the heart of the European economy is still in terrible shape, and there is zero chance of a sustained recovery this year.

The Nanny Index:
Why exactly having a husband who works for a hedge fund means a woman can’t look after her own children is something even the most distinguished biologists have never been able to explain. It is, though, an indisputable fact. If you see a lot of stressed-looking women struggling to figure out how to get sun cream on a 2-year-old, assume redemptions at the hedge funds are still running high. If they are flanked by nannies taking care of everything while the woman of the house works on her tan, you can assume those long-short currency-commodity arbitrage strategies are raking in the cash again.

The Paperback Index:
Take a good look at what your fellow guests are reading around the pool. If they are gripped by some frightening-looking tome explaining why the world is heading for a new Stone Age, you can be sure their company/bank/fund is teetering on the edge of bankruptcy and they are trying to understand why. If they are just relaxing with the latest bestseller, you can deduce that things aren’t so bad.

The Crane Index:
In the last decade, much of southern Europe, and Spain in particular, has been turned into a forest of cranes. New apartment blocks, preferably with views over the sea, were being thrown up every minute and sold just as quickly. From your pool, you may be able to count a dozen or more cranes. But is anyone working on them? If they are, credit must still be flowing through the system. If there are lots of abandoned cranes on building sites, there is only one conclusion: There is still a lot of pain ahead in the property market, more trouble for banks, and you need to scurry back into cash fast.

The Natasha Index:
Anyone visiting a swank Mediterranean resort in the last few years will have noticed the way they have been taken over by Russian oil moguls, usually with a team of gorgeous, if slightly icy-looking, blond women in tow. With the commodity markets in freefall, many oligarchs have been canceling their holidays, or at least cutting back on the number of women they take with them. So take a close look (not too close -- these guys get jealous) at the throng of bikinis. The more Natashas you see, and the more stunning they look, the better the outlook for the oil and commodity markets.

Armed with all that information, you should be able to figure out precisely where the markets are going. You could even Blackberry the data back to the office, along with a few fancy graphs, then reclassify the trip as research, and claim the whole thing back on expenses.

For Whom The Bell Rings

They say a bell never rings in the market. This is not strictly true. Every now and then one does ring - usually two or three times, as in theatre intermissions - to announce a bull or a bear run is nearing its end. Well, U.S. President Barack Obama's recent speech regarding Chrysler was just such a bell.

Before I go any further, I feel that I must make it clear that I am a supporter of Mr. Obama on most issues, but every once in a while, we seem to have irreconcilable differences.

What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.

I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.

Would you buy a U.S. industrial bond in such an environment? No, and neither would I, nor would most other rational bond buyers. Thus in this one act the U.S. President nearly guaranteed that the U.S. stock and bond markets, before year-end, would plunge until the administration realizes that capital cannot be coerced, Soviet-style, into keeping unproductive enterprises going.

It is not yet Hugo Chavez nationalizing foreign oil companies, or Fidel Castro nationalizing United Fruit, or Vladimir Putin robbing BP of its assets, but it is close. From now on, bond investors who up to now could rely on the courts to stand behind their bond indentures could be forced to fight the President of the United States.

To their credit, the bondholders insisted they'd fight for their property rights - but of course they don't have much chance against the President.

When the president of the largest mercantile power on earth effectively says the sanctity of contracts is not for the courts to uphold, and the mesmerized populace (and media) meekly assent, all commercial contracts thereby become devalued, and the market for such contracts - for what are stocks and bonds but that? - must eventually tank.

Are we seeing this happen right before our very eyes? Is this the beginning of a long and painful decline? I sure hope not.

Since early March, the market, just like in 1938, would likely stage a 40- to 50-per-cent rebound from the then-6,600 Dow's fair-value level, before likely going into a two-year funk. The rebound is two-thirds there, and you can forget the "likely": Mr. Obama just ensured the funk would be upon us before year-end.

From here on, the Dow could rise another 1,000 to 1,200 points - say about 15 per cent more. Enjoy it, but don't get taken by Mr. Obama's hypnotizing rhetoric. I'd use the last few hundred Dow points to lighten up. And if you own non-government bonds, be equally wary, because Mr. Obama will have no compunction taking your money and handing it to the unions that helped elect him, forgetting temporarily, if conveniently, that the rest of us, also had something constructive to do with his election.

Can you hear the bell ringing?

Why Hedge Funds Might Shine In 2009

High-Quality Funds Will Emerge Stronger From The War Of Attrition.

Hedge fund managers, once the swashbuckling frontiersmen of international finance and subject of fawning cocktail party banter, have quickly gone from hero to goat. As the global credit bubble burst with a vengeance in 2008, so too did the oft-touted myth that these alternative strategies could deliver positive results in any market.

But those claims painted the universe with too broad a brush. There has always been a difference between arbitrage funds that isolated structural inefficiencies, and speculators that either didn't hedge or used the ability to short stock as a means of leveraging directional bets. Clearly it should never have been expected that a fund that was short financials and long commodities, as many hedge funds were last year, would have a market neutral, "absolute return" profile. The majority of North American offerings fall into that camp, so it's no surprise we've seen stark declines among many of our homegrown funds.

To be sure, even many arbitrage funds have been badly stung, and many, many hedge funds will disappear in the next six months as a war of attrition rages. But the ones that survive may just find that the next two years are very good to them.

The Return Of Mispriced Assets

Arbitrage opportunities are the low hanging fruit of modern investing. In their purest form they represent the chance to make risk-free profits because some inefficiency has caused two identical securities to temporarily diverge in price. These opportunities are the bread and butter of most traditional hedge fund strategies.

In the years preceding the current mess, with the size of the hedge fund world expanding apace, as soon as the price of anything broke out of its normal range there was a wave of capital pushing it back in line. The increased competition had killed, or at least badly maimed, the golden goose. That's one of the reasons equity volatility was so muted between 2002 and 2007, despite major events like the Iraq War, Hurricane Katrina, and the $6 billion implosion of hedge fund Amaranth Advisors. It also explains why hedge funds were strapping on more and more leverage: the size of the mispricings had become so small they needed to magnify them artificially, and credit was abundantly available.

Now some of that low hanging fruit is back. With volatility at record levels and desperate hedge funds reversing their trades to get out of them quickly, mispricings are everywhere and those with the means can take their pick of compelling opportunities.

Indiscriminate Selling

With redemption requests flooding the inboxes of hedge funds and mutual funds alike, good names are being dragged down alongside the bad as investors rush for the nearest exits in equities and corporate bonds. While the direction of markets is unpredictable in the near term, it seems reasonable to assume that quality companies will once again be separated from their weaker counterparts. Hedge funds that can buy an industry's leaders and short its likely casualties are poised to benefit from that differentiation, even if a broad-based rally is slow to materialize.

Food For Vultures

The current crisis had its roots in esoteric derivatives that repackaged subprime mortgages. In fact, anything with an acronym -- CLO, CDS, ABCP -- seemed to draw some blame for the ensuing rout. Complex instruments were uniformly scorned and experienced sell-offs of massive proportion.

Invariably the pendulum swings too far in both directions, and as time passes there will likely be tremendous buying opportunities in areas like convertible bonds and asset-backed securities. This is a realm of the market that most pension and mutual funds don't venture into, either because it's not in their mandate or they don't have the analytical resources. Look for a few well-capitalized hedge funds to swoop in for major bargains in some of these complex securities.

There will also be the potential for strategic acquisitions. In financial markets, disaster breeds opportunism, and as large companies and trading operations teeter on the brink of failure there will be self-interested parties ready to scoop them up on very favourable terms. The winners in this game will be those with flexible mandates and access to cash. When Amaranth collapsed in the fall of 2006, J.P. Morgan Chase and hedge fund Citadel Investment Group bought up the fund's entire trading book at distressed prices. More recently, manager John Paulson, whose hedge funds are among a small group that experienced significant gains in 2008, was one of the acquirers of failed Californian bank IndyMac, along with fellow hedgie George Soros.

As many observers have noted, the global hedge fund industry has begun, and will continue, to go through a well-needed shakeout. Lured by hefty paycheques, traders and rocket scientists began opening hedge funds to the point of saturation, with fewer and fewer market opportunities to justify their existence. From the perspective of unitholders, certain structural aspects of the archetypal hedge fund are undesirable, such as high fees and poor disclosure, and these will need to improve as the asset class matures.

Many funds will soon close their doors forever, but those that survive will emerge with increased market share and a renewed chance to make big profits across the spectrum of tradable securities. As high-volume, fast-acting trading entities, hedge funds are still very important prime brokerage clients for the major banks. Having that VIP status, large hedge funds will be among the first to regain the ability to apply leverage and borrow stock.

As the division sets in between the quick and the dead, monitoring the group's results will be harder than ever. Hedge fund index statistics will be unreliable as survivorship bias takes on more and more significance. Even numbers that incorporate fund failures, such as the returns on funds of funds, will, by averaging out the winners and losers, mask the extremes at either end.

Commodities - The Long And Short Of It.

Commodity price performance has been a wild ride in 2008.

The record of price movement is outlined in the table and chart below. For each commodity, the table details year-to-date (YTD) %-age change, drop from 52-week high, and start of year to the 52-week high.

Oil has had the roughest ride falling 62% YTD, 75% from its 52-week high, and preceded by a rise of 53% to its 52-week high. This was followed by Copper, Platinum, and Natural Gas, which had a meteoric rise to its 52-week high of 83%.

Most of the commodities, save Gold, have behaved in kind, thanks to the long-only commodity indices like GSCI which enabled investors of all kinds to invest naked in long-only baskets of commodities. They all went up together, and they all came down together. Platinum and Silver, the other two precious metals dropped along with other commodities, while Gold resumed its dual status as favoured currency and store of value during periods of turmoil.

Commodities are indeed more volatile than stocks. When, and if, we see the return of expansionary and/or inflationary (or worse, hyper-inflationary) conditions, however, these will be a key asset class to allocate to. With all of the printing presses at the Fed whirring right now, some would say its inevitable.

The facts are that during this period in time, the only asset group to have its fundamentals unimpaired is commodities:

• Farmers can’t even get loans for fertilizer now.
• The supply of things is going to be in even worse shape coming out of this.
• Oil is crushed; it is below the cost of production in many places. It is below the cost of alternate sources of energy, so oil is going to make a huge comeback when it does go through the roof.
• The IEA recently came out with a study showing that the worlds reserves of oil are declining at the rate of 7% per year. You can do the arithmetic, the supply of everything is going down; oil and everything else; we’re going to have serious supply problems before too much longer. In 15 years there isn’t going to be any oil left unless somebody discovers a lot of oil quickly in accessible areas, and the price of energy has to go climb again.
• The fundamentals for General Motors are impaired, the fundamentals for Bank of America are impaired.
• The fundamentals for Zinc are improving, the fundamentals for cotton are improved.

Commodities will be the place to be if and when we come out of this crisis, but even if we don’t come out of it.

• In the 1970’s the economies were bad, but commodities went through the roof.
• In the 1930’s commodities were a much better place to be than stocks, because there was no supply.
• Gold will probably go much higher.

Platinum is more industrial, and certainly tied closely to the Auto industry; hen its time to buy Automobiles again, Platinum will be a spectacular play.

There are shortages, and then demand will suddenly come racing back, and there won’t be any inventories left; this is how economies have always evolved.

Where Do I Put My $200 Million Windfall?

Tomorrow's Europe-wide lottery offers a tax-free, lump-sum jackpot worth about $200 million. When I hand over my winning ticket, though, I will face a dilemma: Where do I stash my luck-gotten gains?

Burning through the first few million won't be a problem. I'll turn up for work on Monday morning with a case of champagne and get roaring drunk at my desk before someone calls security and kicks me out of the office. I'll limousine home, snooze for a few hours to sober up, and then hit the phones. "Hello, NetJets Inc.? I'd like to open an account, please. Oh, and once the funds clear, book me on a Dassault Falcon 7X to Aspen.''

Once I've bought the ski lodge, ordered an Aston Martin DBS sports car and selected my Sunseeker triple-decked yacht, bought the latest fashions from Versace and Chanel though, I have to find a home for my winnings. In these troubled times, there are few, if any, true havens.
I can't put my money in a bank. Deposit insurance programs are underfunded, overstressed and woefully inadequate given the size of my needs. Even with a smaller stash, do I really want to risk finding myself in a line of creditors when the authorities decide to let another institution follow Lehman Brothers Holdings Inc. over the cliff?

Banks still won't lend to each other, which is why the one-month money-market rate for US dollars is at 3.43 percent, its highest level since January. Why would I risk putting my money into an account, rather than under my mattress?

Defensively Dull

I'm sure Goldman Sachs Group Inc. and Morgan Stanley would welcome me with open arms, now that they have seen the error of their racy investment-banking ways and dulled down to become deposit takers. Nevertheless, I'm learning the lesson of recent years. Whatever Wall Street is selling, I'm not buying, no matter what Warren Buffett does.

The regulators, meantime, clearly don't want me to invest in financial markets. They have banned short selling in the stocks of such paragons of economic virtue as credit-rating company Moody's Corp. and hedge fund GLG Partners Inc. They look poised to regulate the credit-derivatives market out of existence.

Pretty soon, it will be illegal to buy anything that is rising in price -- oil and other commodities spring to mind -- and it will be forbidden to sell anything losing value. Why would I walk onto a playing field where the goalposts move arbitrarily and the rules are in flux? The mattress option is looking more and more attractive.

Negative Yields

Maybe I should blow my wad on U.S. Treasury bills, even if I end up investing at negative yields that mean I'm paying for the privilege of lending to the government. Do I really want to be in dollars, though, when China and other foreign holders of Treasuries look ready to dump the greenback, and the rating companies should be reviewing the U.S. government's AAA grade?

My lottery win tomorrow, however personally enriching, will be dwarfed by the largess the U.S. government is lavishing on Wall Street. "$700 billion,'' says U.S. Treasury Secretary Henry Paulson "$1 trillion,'' says Barclays Capital. "$2 trillion,'' says Tom Sowanick, the chief investment officer for $22 billion in assets at Clearbrook Financial LLC in Princeton, New Jersey.
Sowanick added together $700 billion for rescuing Fannie Mae and Freddie Mac, the $29 billion Bear Stearns Cos. backstop, the $85 billion loan to American International Group Inc., the $700 billion Paulson plan, $500 billion to the Federal Deposit Insurance Corp., plus sundry other new obligations.

Cover-Up

If Sowanick is correct, the U.S. taxpayer will be on the hook for quadruple the amount that banks around the world have written off so far. That makes the U.S. seem like a place to avoid for a lottery winner seeking security in securities.

Paulson's aptly named Troubled Asset Relief Program, a tarp being the sheet you spread over the junk in the garage to hide it from critical, prying eyes, has a twist. While the Treasury won't buy your damaged collateralized-debt obligations directly, there is a way to offload your toxic CDOs -- provided they have defaulted and you can break them into their constituent parts.

Standard & Poor's reckons about $240 billion of the $450 billion of subprime CDOs it rated has suffered an event of default, according to a research note published this week by Royal Bank of Scotland Group Plc. "When a deal is in EOD, the controlling investor can choose to liquidate,'' the note says. "The Fed plan makes liquidation potentially the best option, as then the Fed bid can be hit for the underlying bonds.''

There's a spoof e-mail doing the rounds, aping those Nigerian banking-scam letters. "I am Ministry of the Treasury of Republic of America,'' it says. "My country has had crisis that causes need for large transfer of funds of $700 billion. If you would assist me in this matter it would be most profitable for you. After you send me bank account details, I will reply with detailed information about safeguards to protect the funds.''

I think I'm going to need a bigger mattress.

Put Away The Shovel

Put away that shovel. Mining stocks are getting hurt as investors anticipate a profit squeeze between rising investment costs and falling commodities prices.

The DJ Basic Resources STOXX index, which includes some of the world's main metals companies, including BHP Billiton and Rio Tinto, is down 26% in the past three months. That has left commodities companies trading at historically low multiples of expected earnings, suggesting either the shares are undervalued or investors believe miners' run of profit growth can't continue.

The latter looks most likely.

Even if commodities prices don't fall further, rising costs could be enough to squeeze profit margins and slow earnings growth -- even if the volumes shipped by the biggest companies continue to rise.

The latest interim results from BHP, run by Marius Kloppers, showed signs of the pressure. Operating margins were two percentage points lower at its Escondida copper mine in Chile compared with last year, and BHP saw deterioration of nine percentage points at its Olympic Dam copper and uranium mine in Australia.

Rival Rio Tinto, facing a takeover bid by BHP, also demonstrates how cost pressures are affecting capital investment. Inflation alone accounted for about half of the increase in its capital spending from 2003 through 2006, according to Lehman Brothers. Since then, Rio Tinto is likely to have found it is getting even less from its capital-expenditure dollars. Its capital spending was $5 billion in 2007, up 25% from 2006.

The rising cost of fuel, transport and equipment as well as hiring and retaining engineers explain the squeeze on miners' margins in some areas.

Miners can't expect higher commodities prices to come to the rescue, either, as consumption slows. Sector consolidation ought to offer safety from a price war or overinvestment. But this strategy, born during the boom, has yet to be tested in a downturn. Forcing more price rises on weakened customers looks unsustainable.

Goldman Sachs reckons half the world economy is in or facing recession. Even China might not spend so heavily on infrastructure in the short term. Some see a post-Olympics slowdown, if not a pause, resulting in the reduction of metal inventories.

With investors able to invest directly in commodities through exchange-traded funds and other vehicles, they don't have to dig into mining companies themselves to retain long-term exposure to metals. Mining stocks now trade on an average of around seven times bullish 2009 earnings estimates, compared with more than 12 times forward earnings at points in the recent past.

The sector looks cheap. But given the potential margin squeeze, only deceptively so.

Those Who Hesitated Have Lost Even More

A year into the credit crunch, banks should have learned a lesson: It pays to be first.

The small number of financial firms that acted early to repair balance sheets must be glad they bit the bullet when they did. It was easier and cheaper to raise equity capital in the early phases of the crisis. In January, when Citigroup raised $12.5 billion from selling convertible preferred shares, its stock was just shy of $25. At Monday's closing price of $17.61, shareholders would potentially face far heavier dilution.

Firms jettisoning troubled mortgage assets today would likely get worse prices than at any time in the crisis. Bonds backed by Alt-A mortgages and jumbo prime mortgages are trading at record lows, according to Credit Suisse, while subprime loans are only slightly above their mid-July trough.

E*Trade Financial looks lucky to have unloaded $3 billion of toxic mortgage assets to hedge fund Citadel in November. Market participants were aghast at the $800 million Citadel paid, because it implied a hefty 75% write-down. But a fire-sale discount today could be even larger.

Admittedly, firms that were quick to take bold steps did so because they had to. Others should have taken the cue from their sicker brethren. In fact, in today's markets, even hitting the wall first could end up being an advantage. Bear Stearns's shareholders should now feel lucky they got $10 a share, as should debt investors who were made whole.

Today, shareholders might get nothing. The Fed is open to the idea of structuring investment-bank bailouts so that shareholders get wiped out completely, according to a speech Friday by Chairman Ben Bernanke. And debt holders might also have to take losses.

It isn't too late to act.

The Greatest Transfer Of Wealth In History

No, this discussion is not about oil.

The credit crisis really puts the free in free market. The freest market is supposed to be the United States, and the evidence in favour of that argument is mounting. It's just not what you think. Free, in this case, means a free ride for a select group of people. Wall Street never looked so good, or bad, depending on your perspective.

From early 2004 until mid-2007, the big Wall Street investment banks made $250-billion (U.S.) in profits. (That's Bank of America, Citigroup, JPMorgan, Morgan Stanley, Goldman Sachs, Lehman Brothers and Merrill Lynch.) During the past year, they've written off $107-billion. Keep in mind as we follow the money that if you include smaller dealers and commercial banks, the profit number swells and the writeoffs are even bigger.

As fate would have it, the writedowns, mostly garbage subprime loans, equal almost perfectly the amount of money Washington will dole out in stimulus cheques to get the economy going again. The House of Representatives Speaker said last year that the stimulus package would create 500,000 jobs. She got the number more or less right, but it was actually a loss of jobs.
Meanwhile, recent figures show that of the money that's been mailed and spent, only a 10th has gone to new spending.

The rest of it has been consumed by inflation (that is, because prices have gone up, even if consumers take their money to the mall, they're not helping the economy much).
Inflation is partly a product of easy money or low interest rates.

Why does the Federal Reserve keep interest rates low? To stimulate the economy, which is being ravaged by the housing recession. The housing recession, meanwhile, was fuelled by Wall Street's greed and recklessness, aided and abetted by the easy money and the fraudulence of builders, appraisers and mortgage brokers.

Back to Wall Street to start connecting the dots. According to the New York State Comptroller's Office, the big banks paid $33.2-billion in bonuses in 2007, down only slightly from 2006, an even more splendid year for subprime origination. During the past four years, bonuses closed in on $100-billion, not far off the writeoffs and the stimulus package.

Back to Washington, whose coffers are bare, meaning that $107-billion is borrowed money. Borrowed from whom? Savers, mostly foreign. Borrowed by whom? The taxpayer of course. So in effect, the stimulus package is simply a matter of the cash-strapped, highly indebted U.S. consumer borrowing to spend (or pay debts) to save the economy. Not good.

It's pretty clear what's happening. Ultimately, the people are borrowing to pay Wall Street bonuses. After all, these handsome rewards are based on the earnings of the banks, but they're not real earnings, since the assets that produced them are subsequently written off. The bubble that created these bogus earnings was inflated with the help of low money costs and lax supervision of financial firms.

The bursting bubble is roughing up the economy so badly that the government has to borrow to stimulate spending, which it fails to do. It might also have to borrow $25-billion to bail out government-sponsored mortgage insurers, including Fannie Mae. And since the government is really just the people who are getting hurt by the slowing economy, with no bonuses to comfort them, is this not the greatest transfer of wealth in history?

And we haven't touched on other largesse the people have extended Wall Street, such as the loan guarantees that helped JPMorgan buy Bear Stearns.

Karl Marx has nothing on these people. But Groucho might.

And you can argue that some of the losses are marked to market and might be reversed and that some of the bonuses were paid to people who had nothing to do with subprime. Probably true, but hair-splitting I say.

As individuals, we can learn a lot from these lessons -- especially what not to do.