The World We Invest In, Go Figure Volatility... And Black Swans

The news this past month:


Report shows consumer borrowing rose more than expected A report from the Federal Reserve shows that U.S. consumer borrowing increased by $7.78 billion in May. Analysts surveyed by Reuters had expected consumer debt to rise by $7 billion. April's figures were revised from an increase of $8.95 billion down to $7.76 billion. CNBC/Reuters (08 Jul.)

Fed hovers between a rock and a hard place Although the U.S. has thus far avoided recession, it is precariously poised to fall at any time. The situation puts the Federal Reserve and its chairman, Ben Bernanke, in a tough position as dismal economic data continue to mount. Even the resilience of the economy in the first half of this year may be more worrisome than previously thought. The Economist (subscription required) (17 Jul.)

Paulson: Months of work ahead to get through crisis Treasury Secretary Henry Paulson expects it to take months to work through the financial crisis. He made his comments as he sought to reassure the public that the banking system is sound. "Our regulators are on top of it. This is a very manageable situation," Paulson said. CNNMoney.com (20 Jul.)

Pimco head sees $1 trillion in U.S. mortgage losses The manager of the world's biggest bond fund said sliding U.S. home prices will wipe about $1 trillion off the balance sheets of the world's financial firms. About 25 million U.S. homes are at risk of negative equity, which could lead to falling home prices and more foreclosures, said Bill Gross of Pacific Investment Management Co. These factors could lead to less lending and a downward economic spiral. Bloomberg (24 Jul.)
Distressed sales more common on housing market: Four out of 10 homes sold in California and Nevada last quarter were foreclosures or some other distressed sale. BusinessWeek.com and Moody's Economy.com ranked 20 states where home sales were most influenced by forced sales. Michigan and Ohio, which did not have the overbuilding of Sun Belt states but continued to suffer big job losses, made the top 10. Affluent Connecticut was in third place. Massachusetts was No. 8. BusinessWeek (25 Jul.)

Mortgage rates up because of trouble at Fannie, Freddie Mortgage rates approached a five-year high as regulators and the White House strive to rescue Fannie Mae and Freddie Mac. Trouble at the mortgage giants could compound problems in the already-struggling housing market. HSH Associates said the average interest rate on a 30-year fixed-rate home loan increased from 6.44% on Friday to 6.71% on Tuesday. The New York Times (registration required) (23 Jul.)

Mortgage losses spur banks to reduce corporate loans Banks are significantly reducing forms of credit vital to American companies in the backlash from the subprime-mortgage crisis, and the slowdown threatens to further hamper the U.S. economy. Even healthy businesses are finding it difficult to borrow money as banks, burned by the fallout from looser lending standards, overcorrect and take a much closer look at repayment ability. The New York Times (28 Jul.)

Inflation presses reluctant retailers to raise prices As major manufacturers prepare to raise prices yet again, retailers that have avoided passing the increases to consumers may soon find themselves left with little choice. Retailers walk a fine line between keeping prices steady and reducing profits or raising prices and risking decreased sales. BusinessWeek/Associated Press (27 Jul.)

Analysis: Despite inflation, Fed likely to hold rates Inflation is at its highest level in 17 years, but the Federal Reserve is unlikely to change interest rates unless it makes a sudden, drastic leap. Oil and commodity prices, which are the underlying causes of the weak economy and high inflation, are directing the Fed's expected decision to keep rates at 2%. Reuters (29 Jul.)

Poll: Economy lost 75,000 jobs in July Economists expect a government report, scheduled for release Friday, to show that the U.S. economy lost jobs for a seventh straight month in July. A median estimate of 80 economists expects the report to show 75,000 lost jobs, which followed a decline of 62,000 in June. Bloomberg (01 Aug.)

Hedge funds suffer worst first half since tracking began Hedge funds have suffered an average year-to-date loss of 0.75%, their worst first-half performance since Hedge Fund Research started tracking returns in 1990. In 2002, the $1.9 trillion industry recorded its only losing year. Antonio Munoz of EIM Management USA in New York said investors have shifted assets to traders who have proven that they can succeed in turbulent markets. "We don't see investors pulling the plug across the board and putting their capital into cash," he said. Bloomberg (09 Jul.)


The World We Invest In, Go Figure Volatility… and Black Swans


It is always nice to check the news, the noise we live with, but what if we could suddenly soar to 10,000 feet and see the whole playing field below, see through the lens of some of this century’s greatest thinkers and then know, that you can’t know.


My grandmother told me that, on her deathbed, she said, “Danny, some things in life are a mystery, and that’s OK!”


Well, trying to make sense of the stock markets is a mystery too. Is that OK, I don't think so, so let’s get into it!


“Black Monday” on the 19th of October in 1987 provides a memorable starting point. On that single day, the Dow Jones Industrial Average dropped an astonishing 25%, nearly twice the drop of the largest previous daily decline of 13% back on the 24th of October 1929, known as “Black Thursday”. On that single day in 1987 the total stock market value lost $1 Trillion dollars, erased.


The point is not only can anything happen in the stock market, but anything does happen. What’s more, changes in the nature and structure of our equity market and a radical shift in its participants are making shocking and unexpected market aberrations ever more probable, ever more predictable.

For example, just recently:
SEC lengthens ban of short sales to mid-AugustThe Securities and Exchange Commission, which plans to implement broader rules to avert stock manipulation, announced that it is extending to Aug. 12 a ban on "naked" short sales of shares in 17 brokerages as well as troubled lenders Fannie Mae and Freddie Mac. The ban intends to protect companies of which collapse might lead to losses for the U.S. government. Bloomberg (30 Jul.)

Congress passes bill to rescue housing marketThe broad housing-rescue legislation passed by the House on Wednesday and the Senate on Saturday offers emergency funding to Fannie Mae and Freddie Mac along with establishing a $300 billion fund to help struggling homeowners. President George W. Bush, after dropping his opposition to the bill last week, is expected to sign the bill quickly. Reuters (26 Jul.)

Paulson unveils rescue plan for Fannie Mae, Freddie Mac After a weekend of discussions with Federal Reserve Chairman Ben Bernanke and New York Fed chief Tim Geithner, U.S. Treasury Secretary Henry Paulson announced a plan for the government to support Fannie Mae and Freddie Mac. The Fed will give the mortgage giants access to emergency funds similar to the access that banks have. Meanwhile, the government will ask Congress for permission to lend money to Fannie and Freddie. Most market participants did not expect such an aggressive plan, which reflects the authorities' fears about the consequences if one or both of the companies should fail. ClipSyndicate/Bloomberg (14 Jul.) , Financial Times (14 Jul.) , The Washington Post (14 Jul.)

Freddie, Fannie draw big bets on bonds Some of the world's biggest bond investors are snapping up debt sold by Fannie Mae and Freddie Mac as the best alternative in troubled times. Not only has the U.S. government agreed to back the beaten-down housing-finance companies but their yields compared with Treasuries also make the bonds a bargain. Bloomberg (28 Jul.)

And during 2007 we witnessed an unprecedented series of amazing market swings. In the 1950s and 60s, the daily changes were in the level of stock prices changing more than only 2%, only three or four times a year. In the second half of 2007 alone, we saw 15 such swings, 9 downward and 6 upward. Based on past experience, the probability of that happening was… zero.

The point is that the application of the laws of probability to our financial markets is badly misaligned. The truth is that an event, although never happening in the past, is not reason for such an event happening in the future.

Black Monday, then, is a rarity, an extreme event. Now, everyone knows that swans are white, right? So, a black swan would be an extremely rare event, like Black Monday.

And just because it has never happened doesn’t necessarily mean that it can’t happen, and conversely, just because an event is expected to happen, doesn’t mean it does. Unlike the 1929 antecedent, Black Monday did not prove to be an omen of dire days ahead, in fact, quite counter-intuitively, a harbinger of the greatest bull market in recorded history, ending when, in 2008?

None the less, despite the recent wild disturbances in both the stock and bond markets, market participants seem confident that future returns will resemble those of the past.

For example, Investors see huge GM losses as temporary The third-worst quarterly loss in General Motors' 100-year history left investors sobered but optimistic about the automaker's prospects. GM announced that its second quarter ended with a $15.5 billion loss, four times more than analysts expected, but that included $9.1 billion in one-time charges and expenses in North America. "That was about as ugly as you can get," said Mirko Mikelic of Fifth Third Asset Management. "But they did throw a lot of junk in there." ClipSyndicate/Bloomberg (04 Aug.) , Detroit Free Press (02 Aug.)

IMF backs U.S. measures, thinks upturn a year away The U.S. economy has been more resilient than expected but probably won't improve until the middle of 2009, as losses in home values depress consumption and worsen credit conditions, according to the International Monetary Fund. The dollar was near its equilibrium, though still overvalued by as much as 10%, the IMF said. Officials said they are in favor of new housing-support legislation. Reuters (30 Jul.)


And so the knowledge that black swans can and do occur, according to the work of Sir Karl Popper (1902 – 1994) holds important lessons for how we should think about risk. Writing about, Sir Karl Popper,in the New Yorker, journalist Adam Gopnik (2002) described Popper’s reasoning in this way:

No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t… Science, Popper proposed… didn’t proceed through observations confirmed by verification; it proceeded through wild, over-arching conjectures, which generalized way “beyond the data”.

Yet most of us, in our investment ideas and in our political ideas do exactly the reverse of this “scientific thought” that Popper pointed out, that is we continue to expect to see, in all probability, a white swan; that is, we remain confident that future returns will resemble the past. We search for facts to confirm our beliefs and hopes, not for facts that would negate them. For example, the news stories I started this article out with, which for most of us, negates what we want.

Thus, in the markets, few theories are advanced with the search for what is wrong with our ideas, because the language of finance uses terms like forecasts and probabilities. We are talking about probability, and probability is a slippery concept when applied to our financial markets. We use the word “risk” all too casually and the word “uncertainty” all too rarely.

The distinction was made first by Frank H. Knight, (1885 – 1972). In Knight’s view, the two things, risk and uncertainty are different. Risk is properly used as a measurable quantity to which probabilities and distributions are known (as with the roll of dice). Uncertainty is immeasurable, and therefore, not subject to probabilities.

According to Peter Bernstein, “Considering the consequences of being wrong is essential in decision-making under uncertainity”. In 2004, Glyn A. Holton pointed out in an article that uncertainty accounts for only one aspect of the idea of risk. The second aspect is exposure. People must have a stake in the outcome; it must matter to them.

Applying abstract theories of Popper and Knight to financial markets is what people do. That’s what Benoit Mandelbrot, the inventor of fractal geometry, did. Fractal geometry, simply defined, is about patterns that repeat themselves continually scaling up or down. This is observed in nature as well as geometry, where growth is not linear, but logarithmic.

Mandelbrot applied this concept to the daily price movements of the Dow. Since 1915, the standard deviation of the Dow has been 0.89 %, that is two-thirds of the fluctuations were within the 0.89 percentage points of the average daily change of 0.74%. None-the-less, the occasions when the standard deviation has been as high as 3 or 4 have been frequent; occasions when it has exceeded 10 have occurred infrequently, only once, and that was on that Black Monday back in 1989. The odds against such a happening are about 10 to the 50th power.

The fact is that the infrequent but extreme daily changes in the stock market can overwhelm the frequent, but usually humdrum fluctuations that take place each day within normal ranges. For example, since 1950, the S & P 500 Index has risen from a level of 17 to a recent level of 1,260. But, if we deduct the returns achieved on only the 40 market days in which the S & P 500 had its highest percentage gains, 40 out 14,588 days, then the level drops to 288. Contrarily, if we eliminate the 40 worst days, the S & P 500 will be sitting at 11,550.

That so much can happen on so few days and so unpredictably, suggests the perils of jumping into and out of the market and the value of simply staying the course. Put another way, investors are more volatile that investments. Economic reality governs the long-term returns earned by our businesses, and black swans in business are unlikely. But emotions and impressions, the tides of hope, greed and fear among the participants in the financial system govern the short-term returns generated in the markets. These emotional factors magnify or minimize the central core of economic reality, and in such an environment, a black swan may appear at any time.

More than 70 years ago, the great British economist John Maynard Keynes (1883 – 1946) recognized the critical distinction between the rational and the irrational in the stock market. And he remarked that in American markets, the influence of speculation is enormous. It is rare for an American to invest for “income” only, rather, he will probably purchase an investment in his hope for capital appreciation. This is another way of saying that the American is attaching his hopes to a favorable change in the conventional basis of valuation based on enterprise, to one based on speculation. This also was Keynes’s great concern.

Corporate earnings in the United States have grown with remarkable consistency at about the rate of the U.S. GDP. There have been no black swans in long-term U.S. investment returns. However, having said that, certainty about the future never exists, nor are probabilities always borne out, so applying reasonable expectations to both investment and speculation returns combined, has proved to be the sensible approach to projecting returns to the stock market over decades. In deed, despite the black swans of the stock market history, ownership of U.S. business of investors who have stayed the course has been a remarkably successful strategy.

Then along comes a U.S. economist Hyman Minsky (1919 – 1996) who observed the fundamental link between finance and economics with these words: “The financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” He noted the symbiotic relationship between finance and industrial development which came to a head in the 1980s when institutional investors became the largest repositories of savings in the country and exerted there influence on financial markets and the conduct of business enterprises. Minsky’s key concept was that the financial economy, focused on speculation, should not be considered separate and distinct form the productive economy, focused on enterprise. This expectation and fear of Minsky, like that of Keynes, was that speculation would come to overwhelm enterprise. Recent history seems to confirm their fears, as rampant speculation in the markets has added a new elements of uncertainty into our economy.

This change in the structure of capitalism has been dramatic. A half-century ago, individuals owned 92 % of US stocks and institutions owned but 8%. Currently, individuals own 26% and institutions own 74%. Critically, in this new environment for money managers, where they are held accountable for the maximization of the value of investments made by their clients as measured in periods as short as years or even quarters. This means that institutional managers have turned increasingly to speculation (versus investment) just as Keynes had predicted and business executives became increasingly attuned to short-term profits and the stock market valuations of their companies.

This brings us up to our current situation, with the growing role of institutional investors to foster continued evolution of the financial system by providing a ready pool of buyers of securitized loans, structured finance products, and a myriad of other exotic innovations whose complex risks are shaking the financial markets of today.

Indeed, over the past two centuries the United States has moved from an agricultural economy to a manufacturing economy, to a service economy, and to what is predominantly a financial economy. The U.S. is becoming a country where no business actually makes anything. Where we merely trade pieces of paper, swap stocks and bonds back and forth with one another, and pay the financial croupiers a veritable fortune. Led by Wall Street’s investment bankers and brokers and mutual funds, followed by hedge funds, pension fund managers, financial advisers and all the other participants in the system. These costs have soared to staggering proportions. Aggregate annual costs incurred by market participants have risen from an estimated $2.5 billion as recently as 1988 to something like $528 billion in 2007, an increase of more than 20 times.

Even more staggering is the increase in financial transactions of all types, a global phenomenon whose implications are far from clear. Although the world’s GDP is about $60trillion, the aggregate nominal value of global financial derivatives is said to be $600 trillion, fully 10 times larger than all the goods and services produced in our entire world. Among the riskiest of these derivatives are credit-default swaps, which alone total $45 trillion, an amazing 9 fold increase in the last three years. These swaps are five times the size of the U.S. national debt and three times the U.S. GDP.

What do they look like? Consider the CDO, collateral debt obligations, which became more and more complex and more and more concealed. The US SEC registered rating agencies placed their imprimatur on hundreds of new issues of CDOs that were created entirely out of subprime mortgages that would likely been considered as rated B, C or even D in quality and then transformed 75% of them into series (traunces) of AAA, 15% into A and 5 percent were rated BBB. Only a remaining 5% carried a rating of B. One might as well call this magical conversion of low quality into high quality akin to turning lead into gold.

We all know, by early 2007, when mortgage defaults started to snowball, that the financial crisis in mortgages was upon us, and at great and growing cost to U.S. citizens and society. This crisis, although not yet a black swan, is a classic example of the impact of the financial economy on the real economy. Issuance of such bonds in the United States in the past five years totaled $2 trillion, of which the investment banks generated an estimated 80 billion. I conclude with Oscar Wilde, that the only thing that the banks could not resist was temptation.

And again, risks in our financial sector are not the only risks investors face. Some huge, seemingly unacknowledged risks also characterize U.S. society. Consider: the Social Security and Medicare payments committed to by our national government; the string of huge deficits in the U.S. federal budget; our enormous expeditions (soon to reach $1 trillion) on the wars in Iraq and Afghanistan; terrorism; the threat of global warming and the cost of dealing with it; unfettered global competition, our trade deficit, and the decline in the value of the US dollar.

Other risks are more subtle in nature: a political system dominated by money and by vested interests; a Congress and an administration seemingly focused entirely on the short term, the vast chasm between the wealthiest among us and those at the bottom of the economic ladder (the top 1% holds more than 33% of our total wealth), our self-centered, “bottom-line” society focused on money over achievement, charisma over character, and finally the paucity of leaders who are willing to lead, to defy the conventional financial wisdom of these times, and to stand up for what is right and noble and true.

Whatever the case, some surprising event out there, far beyond our expectations, will surely come to pass, an event that will carry an extreme impact, and one for which, once it happens, we’ll quickly concoct an explanation as to why it was so predictable after all. That event, if and when it comes, will just be one more black swan, something akin to “Disaster Capitalism” perhaps.

So, be watchful of the news and the noise of the news, and look into it not to support what you want to believe and hope for, but for what is actually happening. And to this end, I return you to the clips from recent news stories as I have come to collect and present in my blog lately.

Keep your powder dry and recognize that these times, they’re a’changing.

Credit crisis far from over, IMF warns Citing "fragile" global financial markets and softening European home prices, the International Monetary Fund warned that further reductions in U.S. credit growth are possible. The July update to the fund's Global Financial Stability Report reiterated the IMF's contention that losses this cycle could reach as much as $945 billion as the subprime-mortgage crisis continues to reverberate. Financial Times (28 Jul.)

Industry insiders expect more bank failures After the seizures of First National Bank of Nevada and First Heritage Bank of California, market professionals said more bank failures are expected before a recovery in the financial markets. "My real concern is that we're not finished," said Kathy Boyle, president of Chapin Hill Advisors. "Wall Street would like to think that the worst is over, but we've been saying that for a while." CNBC (28 Jul.)

And yet, More U.S. banks to issue covered bonds Three more U.S. banks said they would begin issuing covered bonds, a tool common in Europe that could free up mortgage financing. Citigroup, JPMorgan Chase and Wells Fargo said they would begin issuing the debt. The bonds are backed by mortgages but kept on a bank's books and backed by a layer of high-quality mortgages. Bank of America and Washington Mutual previously issued the bonds, but their appeal was limited because of regulatory uncertainty about where investors stand if a bank collapses. The Wall Street Journal (subscription required) (29 Jul.)

Investors worldwide bet big on plummet of stock pricesAround the globe, investors have wagered more than $1 trillion by speculating that the price of stocks will drop. In July, managers made at least $1.4 billion on bets against Fannie Mae and Freddie Mac, Bloomberg data show. Hedge funds and other financial firms have made large sums by short selling. "It's a huge amount of money," said Peter Hahn, a research fellow for Cass Business School. "Shorts have come a long way. They are getting into the mainstream, and long holders need to understand the shorts are not evil." Bloomberg (21 Jul.)

Analysis: Liquidity takes priority in Fannie, Freddie rescueThe U.S. government has made preventing a crisis in liquidity its top priority in rescuing troubled lenders Fannie Mae and Freddie Mac, and rightly so. But policymakers shouldn't overlook the longer-term problems of capital and structure that must be addressed if the two government-sponsored enterprises are to survive. Financial Times (15 Jul.)

Soros warns of more crises to come after Fannie, FreddieBillionaire investor George Soros said the latest financial crisis involving Fannie Mae and Freddie Mac will not be the last. Soros labeled the turmoil in the markets that has marred the last year as "the most serious financial crisis of our lifetime." He also said Federal Reserve Chairman Ben Bernanke might not be able to prevent the U.S. economy from deteriorating even further. "His options are limited -- he is boxed in," Soros said. Reuters (15 Jul.)

G-8 leaders indicate inflation is primary concernLeaders from the Group of Eight said the global economy is being threatened by rising oil and food prices. "We have strong concerns about the sharp rise in oil prices," they said in a statement before their annual summit. "The world economy is now facing uncertainty, and downside risks persist." The leaders proposed holding a discussion between consumers and energy producers with a focus on energy efficiency. "Production and refining capacities should be increased in the short term," the group said. Bloomberg (08 Jul.)

World Bank predicts 8%-plus inflation in Latin AmericaHigher food prices will push Latin America's inflation to an average of more than 8% this year, the World Bank's chief economist for the region said. The rapid rise in commodity costs will especially hurt importers in Central America and the Caribbean, while boosting major oil exporters such as Venezuela and Mexico. Bloomberg (30 Jul.)


Author’s note: This discussion paper is for the dental audience and is largely re-edited content taken from CFA Institute's private wealth resources which include edited portions of a speech delivered to the Risk Management Association on 11 October, 2007 by John C. Bogle. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.

What About Inflation And My Retirement Plans?

Are you reading the news? Take a look at how inflation is raising its ugly head. Then read what this means to your retirement plans.

U.S. trade gap rose 7.8% in April

The U.S. trade deficit jumped in April as a weak dollar pushed the costs of importing foreign oil to record levels. The trade gap rose by 7.8% to $60.9 billion, the largest deficit in 13 months, the Commerce Department reported. U.S. export sales of $155.5 billion were led by commercial aircraft, farm machinery, medical equipment and computers. ClipSyndicate/Bloomberg (10 Jun.) , The Washington Post/Associated Press (11 Jun.)

Paulson to press Chinese for trade changes

With legislation that would punish China for keeping its currency undervalued now unlikely to pass Congress this year, U.S. Treasury Secretary Henry Paulson is vowing to press Beijing for change. Paulson and other members of the George W. Bush administration will meet with Chinese counterparts next week in the latest round of high-level economic talks. U.S. officials say China seems to be using regulation and other barriers to protect Chinese companies from foreign competitors. International Herald Tribune (10 Jun.)

Asian central banks fight dollar climb

Central banks in Thailand and South Korea have sold dollars to support their currencies as recent comments by U.S. leaders drive up the dollar's value. U.S. leaders have geared up for "outright intervention" in world currency markets to break a linkage between a weak dollar and high oil prices, said Stephen Jen, chief currency strategist at Morgan Stanley in London. Bloomberg (11 Jun.)

Canadian central bank swings to inflation-fighting stance

Canada's central bank decided to keep interest rates on hold after months of cuts designed to insulate the country's economy from the spillover of a possible U.S. recession. A statement indicated the Bank of Canada now sees inflation as the main economic threat, putting it in line with the U.S. Federal Reserve and the European Central Bank. The Globe and Mail (Toronto) (10 Jun.)

Fitch says more U.S. LBO debt is troubled

The debt behind U.S. LBOs deteriorated more than other sectors of the debt market, and debt-burdened companies continue to find the lending window closed, Fitch Ratings said in a study released Thursday. Troubles in the economy and credit markets have led to more downgrades and defaults this year for LBO-financed deals. "The vast majority of the downgrades were driven by weak cash flows and weak revenue generation," Fitch Ratings senior director William May said. Financial Times (11 Jun.)

Survey finds confidence in global economy falls

Confidence in the global economy has dropped as central banks prepare to battle inflation, which will likely force down stocks and bonds. The Bloomberg Professional Global Confidence Index declined from 22.7 to 21 in May, with anything below 50 indicating a negative sentiment. Confidence had been rebounding after the index reached a low in March. ClipSyndicate/Bloomberg (11 Jun.) , Bloomberg (12 Jun.)

Analysts see housing slump continuing

U.S. homes may lose a third of their value as a result of the market slump caused by subprime-mortgage defaults, and the slide will probably last another two years until credit loosens again to attract new borrowers, top credit analysts say. "There are a lot more mortgage defaults to come," Fitch Ratings managing director Glenn Costello said. Reuters (11 Jun.)


Lieberman would ban institutional investors from commodities

U.S. Sen. Joseph Lieberman, I-Conn., said he will propose banning institutional investors from the commodities markets. A committee he chairs meets next week to examine whether speculation has driven the prices of crops and fuel to record levels. Another proposal would strengthen regulations limiting the stake that each speculative investor can hold in a given market, Lieberman said. The New York Times (12 Jun.)

BRIC countries raise borrowing costs to cool inflation, economies

The Reserve Bank of India unexpectedly increased borrowing costs on Wednesday to battle inflation. The increase in the repurchase rate, following similar action by Brazil, Russia and China, adds to concerns about a slowdown in the fastest-growing economies in the world. "The BRICs are better placed to withstand a slowdown, but that doesn't mean they won't feel it," said Jay Bryson, global economist at Wachovia. ClipSyndicate/Bloomberg (11 Jun.) , Bloomberg (12 Jun.)

Hedge funds lending to cash-starved companies

As shaken and risk-shy banks cut back on lending to companies, hedge funds are stepping in. More than 100 funds already specialize in lending, usually at interest rates much higher than those charged by banks. Big funds such as Fortress Investment Group and Citadel Investment Group are joining in. The New York Times (13 Jun.)

Lehman Brothers ousts president, demotes finance chief

After posting a $2.8 billion quarterly loss, Lehman Brothers ousted Joe Gregory, president since 2004, and demoted CFO Erin Callan, who was once viewed as a potential CEO. It is the latest management shake-up on Wall Street as banks continue to suffer heavy losses. Lehman's quarterly loss raises speculation about its future, and analysts question whether the changes will relieve pressure on CEO Dick Fuld. Financial Times (12 Jun.)

Fuld said to be actively listening to offers for Lehman: Richard Fuld, CEO of Lehman Brothers, is pondering takeover offers and large investments in the troubled bank, sources say. Lehman's future is in doubt following its disclosure that it may lose $2.8 billion in the second quarter and that it has undergone a management shake-up. CNBC/Reuters (12 Jun.)

SEC may require ratings firms to disclose more

The SEC has proposed new rules that would force agencies that rate bonds to make more information about their work publicly available. The SEC would require ratings firms to make a clear distinction between corporate or government bonds and the structured products at the center of the subprime credit crisis. The three largest ratings agencies welcomed the SEC action. The CFA Institute Centre for Financial Market Integrity and the Council of Institutional Investors said investors would benefit from greater transparency and separate measures for structured-finance bonds. The Wall Street Journal (subscription required) (12 Jun.)

Pressure mounts on oil speculators

The chairman of the House Energy and Commerce Committee added his weight to the legislative push against commodities speculation. U.S. Rep. John Dingell, D-Mich., and the committee's top Republican co-sponsored a bill to allow the Energy Department to gather data on factors influencing oil prices from federal agencies and commissions. The bill is among many proposals to pare the influence of energy speculators on price-setting. But the efforts to rein in bets on oil prices are still too far from reality to affect prices, analysts say. MarketWatch (12 Jun.)

Bernanke warns of growing cost of health care

Increasing government spending on health care threatens to endanger economic stability, Federal Reserve Chairman Ben Bernanke warned Monday. "Soon it will begin to have effects on interest rates, it will have effects on economic growth, and on stability," he said. The cost of health care amounts to more than 15% of the entire U.S. economy and there is scant evidence spending will slow, he said. Reuters (16 Jun.)

Iran pulls $75 billion out of Europe

Iran has pulled about $75 billion in assets from Europe rather than risk seeing the money frozen in retaliation for continuing its uranium-enrichment program. Iran is refusing to kill its nuclear ambitions despite Western governments warning of new punitive steps. "Part of Iran's assets in European banks have been converted to gold and shares and another part has been transferred to Asian banks," deputy foreign minister Mohsen Talaie was quoted as telling a moderate Iranian weekly paper. Reuters (16 Jun.)

Speculators and their role in food, fuel prices

Who are the speculators blamed for boosting global food and energy prices independent of fundamental supply and demand? Speculation is a part of the daily business of farmers, investment bankers, bakery entrepreneurs and hedge fund managers. While farmers and bakers have long hedged against price increases, criticism focuses on financial enterprises. Banks holding the savings of small investors and hedge funds have piled into the business, potentially adding turmoil to food prices and markets. Spiegel Online (13 Jun.)

G-8 leaders warn of growing inflation threat

Finance ministers from the Group of Eight industrialized nations warned at their weekend meeting that inflation presented an increasing risk to their economies. The comments matched inflation warnings by central bankers in the past two weeks. The IMF improved its outlook on the U.S., Europe and Japan, saying all had done better than expected in the first quarter. But IMF Managing Director Dominique Strauss-Kahn said pain remains in the forecast. "Even if the slowdown is not going to be very deep, it is going to be protracted," he said. ClipSyndicate/Bloomberg (16 Jun.) , Financial Times (16 Jun.)

Fed's comments on inflation hinder housing rebound

Anti-inflation rhetoric from U.S. Federal Reserve officials has had a chilling effect on the country's struggling housing market. Hawkish comments by Fed Chairman Ben Bernanke and Vice Chairman Donald Kohn led money markets to see an interest-rate hike in August as a near certainty. That produced a steep rate increase for fixed-rate mortgages, a drop in mortgage applications and a plunge in home-loan refinancing. Reuters (19 Jun.)

Global trade tilts in favor of unprepared U.S.

The cost advantage Chinese manufacturers used to enjoy is disappearing with rising fuel and labor costs and the appreciation of the yuan. This creates an opportunity to rebalance global trade, an opportunity the U.S. hasn't seen in a generation. But U.S. companies can't adapt overnight. Withered factories and supply networks will need abundant time and capital to rebuild before the U.S. can become a major force again. BusinessWeek (19 Jun.)

Factory activity down, jobless claims dip

Factories in the U.S. Mid-Atlantic region have yet to see an expected boost from export demand. Figures from the Philadelphia Federal Reserve showed business activity fell for a seventh month. Meanwhile, the number of U.S. workers filing new claims for jobless benefits totaled 381,000 last week. "This is recession territory, at least if the experience of 2001 is a guide," said economist Ian Shepherdson of High Frequency Economics. FinancialWeek/Reuters (19 Jun.)

Paulson says Fed should have broader emergency powers

The U.S. Federal Reserve might need to make money available to a broader range of financial institutions if there is a market meltdown, and that could mean offering emergency funding to investment banks, Treasury Secretary Henry Paulson said. U.S. lawmakers are considering whether to give the Fed explicit authority to take emergency action in case of a threat to financial stability. Reuters (19 Jun.)

Regulators threaten to get tough on shadow banking

Shadow banking has become a $10 trillion market and a vital source of funds to spur the U.S. economy, but the subprime meltdown exposed major flaws. "The shadow banking system model as practiced in recent years has been discredited," said Ramin Toloui, executive vice president at Pimco. Industry observers say Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and other large brokerage firms may have the most to lose if regulators tighten the reins on shadow banking. MarketWatch (19 Jun.)

Big businesses pass cost of inflation on to customers

Big businesses are passing on higher costs to their customers, increasing concern that this is the beginning of an inflationary spiral. Dow Chemical and South Korean steelmaker Posco announced dramatic price increases Tuesday. Mining giant BHP Billiton said the near-doubling of iron ore prices achieved by rival Rio Tinto on Monday was not enough. Companies faced "tremendous cost pressures" and had the "obligation" to raise their prices in response to higher costs, DuPont chief executive Charles Holliday said. Financial Times (24 Jun.)

Greenspan sees U.S. recession more likely than not

There is a greater than 50% chance that the U.S. will slide into recession as inflation makes further interest-rate cuts unlikely, former Federal Reserve Chairman Alan Greenspan said. "A rebound at this stage is not something I think is in the immediate outlook," he said. Reuters (24 Jun.)
Smaller central banks hesitate in inflation fightCentral bankers in developing nations are reluctant to join a push for higher interest rates that could curb inflation but would also hurt their poor. Their inaction could play a growing role in spiraling global inflation. "If emerging markets don't tighten, then advanced economies import more inflation," said Arvind Subramanian, senior fellow at the Peterson Institute for International Economics in Washington. The Globe and Mail (Toronto) (25 Jun.)

Fed expected to signal anti-inflation bias

The Federal Reserve's rate-setting committee will leave the key U.S. interest rate unchanged at 2% after Wednesday's meeting, all 102 economists surveyed by Bloomberg News said. The Fed instead appears to be laying the groundwork for a shift to an anti-inflation stance and future rate increases. Bloomberg (25 Jun.)

Buffett offers little economic cheer

Billionaire investor Warren Buffett says he can't predict when the U.S. economy will recover from its current slump. "It's not going to be tomorrow, it's not going to be next month, and may not even be next year," he said. The country is in the middle of a period of stagflation, with the economy slowing at the same time inflation worsens. "I think the `flation' part will heat up and I think the `stag' part will get worse," Buffett said. Bloomberg (25 Jun.)
Inflation adds to credit-crisis woesRising worldwide inflation is promising to be a greater worry than the credit crisis. "A lot of companies are ill-positioned to deal with an additional whammy of rising costs," Barclays credit analysis head Mark Howard said. Industries that are able to pass along higher prices are in better shape, including companies in agriculture, biotech, and utilities, he said. FinancialWeek (26 Jun.)

Japan's inflation hits 10-year high

Japanese households cut their spending by 3.2% in May, the government said Friday, adding a further drag on the world's second-largest economy. Households account for nearly 55% of the Japanese economy. Their spending pullback is a further recession warning since corporations are already struggling against skyrocketing energy and raw-material costs. Forbes/Thomson Financial News (27 Jun.)

Central bankers agree on inflation threat

Central bankers from around the world seem to share the view that inflation is their biggest economic challenge. Bankers meeting in Switzerland concurred that booming food and energy costs are related to demand and might not be temporary. Once industrial countries have managed the financial turmoil of the past year, "the issue that is remaining and that is becoming more important is containing inflationary pressures," Chile central bank president José de Gregorio said. CNBC (30 Jun.) , The Wall Street Journal (subscription required) (30 Jun.) , Reuters (29 Jun.) , Bloomberg (29 Jun.)

So what does this mean to your retirement plans?

Defined-contribution plans can enable dentists to accumulate tax-deferred savings that far exceed their expectations. On retirement, however, they may be shocked to discover how a seemingly ample savings amount translates into only a modest level of sustainable annual income on an after-tax, after-inflation basis. How shocked, well, let’s see.

Most dentists, even those who are relatively knowledgeable, do not recognize how a large savings accumulation can translate into a relatively modest annual flow of payments. Additionally, this “annuity shock” can actually be exacerbated by the success of tax-deferred accounts, such as 401(k) plans and IRAs. How so?

Consider a postretirement investment having a 6 percent nominal earnings rate subject to 20 percent taxes and 3 percent inflation.

A $300,000 accumulation would be able to fund an after-tax, after-inflation 20-year annuity of only $16,000 from a tax-deferred account and $18,000 from a taxable account.

Many dentists would be shocked to learn that what they might consider a rather significant sum would generate such a modest level of sustainable annual income. Another source of surprise is that it does not matter a great deal, under these conditions, whether the $300,000 is lodged within a tax-deferred account or in a taxable savings account lying outside any tax shelter.

It should be emphasized that, although tax-deferred and taxable savings face roughly similar annuity factors. It is worth trying to understand why these factors are so much lower than many would expect. In the taxable account, the 6 percent interest rate — including the 3 percent inflation component — is first subject to a tax payment of 20 percent that reduces the after-tax earnings rate to 4.8 percent. The insidious “tax” from inflation then strikes a second time to take away another 3 percent each period, reducing the nominal 6 percent to a net rate of 1.8 percent. It is the convergence of effective rates of return due to takes and inflation, under our baseline assumptions, that leads to the taxable and tax-deferred accounts of having virtually the same net annuity factors.

Higher Taxes and Inflation RatesThe preceding discussion focused on an effective tax rate of 20 percent. Higher tax rates erode the net payments and consequently lead to lower annuity factors. Higher tax rates would also lead to a wider differentiation between taxable and the tax-deferred accounts, with higher taxes having the more deleterious impact on the tax-deferred account. So now you know how taxes and inflation can lead to a misperception of what constitutes an ample level of savings.

Although the tone of the preceding comments may have been rather grim, there is some good news in these annuity factors. Suppose an individual also receives a stream of annual nominal or inflation-indexed payments from a corporation or some government entity, e.g. social security. This is in effect a Defined benefit stream of income and it will grow larger in present-value terms. For example, a 30-year stream of fully indexed payments that starts at $15,000 would be equivalent, under the baseline assumptions, to a tax-deferred accumulation of $370,000. The size of this implicit sum might be a pleasant surprise to you. Do you want to know more about this? https://www.cfainstitute.org/memresources/communications/privatewealth/june08/article_1.html


Do you want to make it even better?

Social Security’s handbook contains 2,728 rules. One of these — Rule 1516 — permits Social Security recipients to repay all benefits received in the past on their earnings records and reapply for much higher benefits from scratch.

Social Security charges no interest on the repayment, and the IRS allows the recipient to deduct the repayment or take a tax credit for the extra taxes already paid because of past receipt of Social Security benefits.

Yes, this is hard to believe. But it is true. Repayers need to file Social Security Form 521, and IRS Publication 915 discusses the tax deduction/credit. The gains from taking this option can be sizeable. Take Peter and Kate, who are 70-year-old retirees with $200,000 in regular assets and $200,000 each in retirement accounts. They invest all these regular and retirement account assets in safe assets yielding 3 percent after inflation. Peter and Kate will each receive $13,250 this year in Social Security retirement benefits.

Peter and Kate took Social Security when they were age 62 and have been kicking themselves ever since. Had they waited until now to apply, they would each be eligible for $20,693 per year — their full retirement benefit adjusted by Social Security’s Delayed Retirement Credit; that is, they would be receiving 56.2 percent more in real Social Security benefits this year and every year in the future.

But dreams can come true, and thanks to Rule 1516, Peter and Kate can secure this benefit increase. True, they will each have to repay $94,556 in past benefits received. But it is worth it. Their sustainable consumption expenditure rises, on balance, by 21.7 percent!
How else could Peter and Kate raise their living standard by 21.7 percent? Well, they could find $220,000 lying on the street. With $420,000 in regular assets rather than $200,000, they would be able to sustain the same living standard through age 100 as they would by simply repaying and reapplying for Social Security — something that will take them all of an hour.
What Age Groups Stand to Gain from Repaying and Reapplying?

The results for the other assumed initial ages indicate that households ranging from their mid-60s to mid-70s may gain significantly from this option. Buying inflation-indexed annuities from a reliable, low-cost provider can raise one’s living standard. But buying such annuities from the safest and lowest cost provider, namely, Social Security, can raise one’s living standard in this by a lot more than buying form a commercial annuity broker which would cost you about 40% more than repaying your social security and reapplying.

What is the Gain from Taking Benefits at 62 and Repaying and Reapplying at 70?

If Peter and Kate are age 62, what are their living standard gains from taking their benefits at age 62 and then at age 70, repaying them and reapplying for higher benefits? Taking their benefits at age 62 and never repaying entails a sustainable spending level of $50,410. Taking their benefits starting at age 70 offers an 11.8 percent higher level of sustainable spending. But taking them early, at age 62, and then repaying and reapplying at 70 offers an even better deal — a 15.8 percent higher sustainable spending level than simply taking benefits at age 62. But again, this third option will only be an option if Social Security preserves Rule 1516! Want to learn more about this? https://www.cfainstitute.org/memresources/communications/privatewealth/june08/article_5.html

Author’s note: This discussion paper for the dental audience is largely re-edited content taken from CFA Institute's private wealth resources. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.

Trends? Is US Economy affecting your practice?

Asian shares follow Wall Street down
Asian stock markets dropped broadly on Monday, following heavy losses on Wall Street last week linked to a surge in oil prices. Energy companies rose as crude oil neared $138 a barrel. MarketWatch (09 Jun.)

Wall Street slumps on increase in oil, jobless rate
U.S. stock markets suffered one of their worst days of the year Friday after oil prices skyrocketed by about $11 a barrel and May unemployment surged more than expected. The Standard & Poor's 500 index and the Nasdaq composite each lost about 3%. All 30 companies in the Dow Jones industrial average fell. CNNMoney.com (06 Jun.)

World leaders focus on inflation
Inflation is the main economic threat to the world, corporate executives and government officials concluded during a meeting in Russia. "We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil," German Finance Minister Peer Steinbrueck told the gathering. ClipSyndicate/Bloomberg (09 Jun.) , Bloomberg (09 Jun.)

Medvedev blames U.S. policies for financial crisis: Russian President Dmitry Medvedev said Moscow's growing economic influence could help resolve the global financial crisis, which he blamed on "aggressive" U.S. policies. "Failure by the biggest financial firms in the world to adequately take risk into account, coupled with the aggressive financial policies of the biggest economy in the world, have led not only to corporate losses," Medvedev said. "Most people on the planet have become poorer." Reuters (08 Jun.) , Deutsche Welle (07 Jun.)

Global financial crisis to help BRICs grow
Jim O'Neill, the Goldman Sachs economist who coined the term BRIC, said that the ongoing financial crisis would help Brazil, Russia, India and China take a larger share of the global gross domestic product. "On a relative basis it definitely allows the BRICs to develop faster as they are going to take an even bigger share of GDP sooner," O'Neill said. "This is a financial crisis of the West and we must not forget that of the world's 6 billion people most of them are not affected by this." Reuters (08 Jun.)

Worldwide consumer generation to keep prices high
"Generation A" -- the 400 million people aged 30 to 40 -- may become the world's most important economic force. They earn only about £2,000 a year on average, but they have a refrigerator and want much more, analysts at Macquarie Group say. These consumers represent a looming explosion in demand, suggesting that the soaring prices of food, metals, energy and transport are unlikely to fade. The Times (London) (09 Jun.)

SEC rules may target ratings agencies
The SEC this week may bar ratings agencies from advising investment banks on how to earn top rankings for asset-backed securities. "They basically sold ratings to the highest bidder without any regard to the performance of the rated securities," said Joseph Mason, chairman of the banking department at Louisiana State University's business school. Standard & Poor's, Moody's Investors Service and Fitch Ratings also could be forced to disclose all the data used for a rating so competitors can grade bonds even if they weren't paid. Bloomberg (09 Jun.)

Shanghai, Hong Kong lead decline in Asian markets
On the first day of trading since China's central bank announced that it would increase the reserve ratios of most commercial banks, Shanghai's Composite Index dropped 4.6%. Most other Asian markets were down as well. The Shenzhen stock market's benchmark index plunged 5%, Hong Kong's Hang Seng Index fell 3.3% and the Hang Seng China Enterprises Index declined 4.7%. MarketWatch (09 Jun.)

Paulson refuses to rule out intervening to stabilize dollar
U.S. Treasury Secretary Henry Paulson, who is going to Japan this week to the Group of Seven meeting of financial chiefs, said he would not rule out an intervention in the currency markets to help stabilize the dollar. "I would never take intervention off the table, or any policy tool off the table," Paulson said. "I just can't speculate about what we will or won't do." Paulson said the White House is "focused" on the dollar and soaring oil prices. Reuters (09 Jun.)

Saudis call for global oil summit
Saudi Arabia has called for an oil summit so that oil-producing countries, consuming countries and petroleum companies can grapple with record prices for crude. "Current oil prices are unjustifiable in terms of petroleum facts and market fundamentals," the Saudi cabinet said in a statement. Consuming countries want OPEC to increase its output to drive down oil prices. OPEC blames the weak dollar, speculation and political tension for the price spiral. Arab News (Saudi Arabia) (10 Jun.)

Trends? Is US Economy affecting your practice?

Of course it is…
In my opinion, when there's an economic shift, it's a huge OPPORTUNITY – it just depends upon how you choose to see it.

Times like we're experiencing now are a huge advantage to anyone in a position to assist and leverage change! The real question is, “Where do you want to “go” with your practice?”

We have seen quite a few economic and political gyrations. Remember all the hype about Y2K, and the possibility of the world's power grid coming unglued. In the wake of 9/11 there was unprecedented levels of fear and uncertainty.

The thing to remember is that everything is always changing.

While currently there is a lot of concern in various parts of the world regarding noticeable economic slow down, we still live in huge economies. (The US GDP is over $13 trillion, the EU GDP is now over $16 trillion.) Even in times of slow down or recession, the vast majority of people (over 95% in most developed economies) have jobs and continue to buy what they need. Life and business go on.

It is a very big and ever changing world. With any change there are short-term winners and losers. If you are affected by changes in your market, simply step back, reassess, and find out where the new opportunities are. If you are finding your usual patients a little harder to come by, look at it as an opportunity to go after better markets. Times of change always bring an invitation to step out of your comfort zone, let go of the old ways, grow, become better at marketing yourself, and generally play a much bigger game in the world.

While some fear the great apocalypse with every patient departure, others are out there simply looking to see where the world needs them now. And the world still needs lots of great dentists.

Yet Fear has raised its ugly head and opened its ugly mouth…
“The gods of Greed - they promised economic stability, order and prosperity but instead the world's bankers have delivered chaos, debt and uncertainty - and then blamed the feeble governments that surrendered control of the global economy to them....”

Some say speculation has left the global economy more vulnerable to a financial collapse than at any time since 1929. They said the same, however, about the stock market crash of 1987, the collapse of the hedge fund Long Term Capital Management in 1998 and now the subprime crisis. The obvious conclusion is that these models are flawed. Even so, the International Monetary Fund (IMF) recently described this current crisis that erupted last August as "the largest financial shock since the Great Depression". George Soros, the billionaire speculator who knows a thing or two about financial upsets, says the world is facing the "most serious crisis of our lifetime", hmmm.

At any time, you can look at the world and find many reasons to get very afraid, some reasons are real, most are imagined. Einstein once said that the most important decision you will ever make is deciding whether or not you live in a friendly universe. Don't let fear make you small or avoid social realities. Instead, recognize the need for significant change in society, lobby for social justice and "be the change you want to see in the world". Another one of Einstein's quotes I like is, "problems are never solved at the same level of thinking that gave rise to them."

Well, I don’t know where you live, but my world is far from perfect. I have doubts, fears and disappointments in my life too. I also need sources of inspiration to keep me on the right track, and remind me about what matters most in my life, and that is finding joy. Click Here To Watch a 3 minute movie and remember, “even if you are on the right track, you will get run over if you just sit there” – Will Rogers.

The Crazy Markets You Are Invested In (Part 2)

The Negative trade balance began in the mid-70s, less than 30 years later both the government and consumers were running up debt at an alarming rate. See Chart on the left-hand side of this page.The only way America can continue in its role, is to borrow. How is this borrowing made possible? Let’s first look at gold.

Gold has a past and a present and it has not been a great preserver of wealth during the last 30 years and in this respect it has not been any better than paper money. A bull market in gold or in technology shares or in real estate are all the same, no real wealth is being created, people are just switching their preferences. In the end, trust in gold is the same as trust in paper money until you go back even further in history and then you realize that gold has a much longer history than the paper dollar and because of this, both gold and paper dollars have a future, but gold has much more of it.

Jesus said, “Render unto Caesar that which is Caesar’s” referring to gold and silver coins with Caesar’s head on it. America has dead presidents on its money too but the difference is that a gold denarius is worth today, in terms of buying power, what it was worth 2,000 years ago. And US paper dollars lose 2 to 5 percent of their purchasing power every year. What do you think they will be worth 10 years in the future?

The world’s two largest currencies, the US dollar and the British Pound have both lost 95% of their value in the past century, which is especially remarkable because gold was linked to these currencies for most of this time. For the dollar the final link with gold finished 37 years ago. 70% of the world’s central bankers and Warren Buffet have been increasing their reserves in Euros since 2005.

That is not so surprising given this background of rising debt against the dollar. The dollar is in fact and rational thought, nothing more than electronic information that exists to keep track of it. Relatively few dollars ever make it to paper and many end up in the pockets of drug lords and African politicians. Therefore, most of the US dollars made are not even useful for starting a fire because they do not even tangibly exist.

Gold is the only money that exists in tangible form. Sure it goes up and it goes down just like money say the economists. You can protect yourself from inflation in other ways say the speculators. Gold pays no dividends or interest, gold will not make you happy, but it is better in the long run than anything else. Longevity is not the best recommendation, especially if you do not live as long as the ½ life of gold which is already inert, or nearly immortal. But this feature, gives it staying power, and this is what gives it virtue.

Gold is money that no central bank promotes and none destroys. The world’s improvers will always be with us. They spend more than they have to boss us around, they use civil service jobs and bombs to get their way. Given enough money, the poor can be fed and housed, the middle class can be given free medical, low cost housing loans and social security, and the rich get contracts and favors. Enemies can be created, then bombed, and then reconstructed into seeing the world from our point of view. It is all a circus show and it all costs money.

How do you get more money for these spectacles? Gold refuses to cooperate. US dollars and other paper money barely needs encouragement, the printing presses are already hot. But everything in life has a beginning, a middle, and an end, just as surely as each day passes. Each day that passes in which the present trends don’t come to an end brings us a day closer to when they will end. Stability, leads to instability. The longer things remain stable, the more people are convinced that they will never change.

Today’s house flippers are taking on riskier positions, instead of buying one house, they buy two. Instead of living modestly, they live large, they gush in the direction that the market leads them. What does this really mean? It means that investor’s perceptions of risk are over influenced by recent history. It means that people look for meaning in things where there is none, that they misapprehend the randomness of events. Over the broad sweep of market history, prices have gone up from barely 100 after the crash of 1929 to over 10,000 where it is today. However, adjusted to inflation, the Dow is only about 500, and most of that increase is cyclical.

The Dow, having moved from under 1,000 to over 10,000, from 1982 to 2008 investors would have to believe that the tendency is to go up, that’s its recent history, right? Today’s current investors have made their bets as to whether prices will go up or down, and this is reflected in the stock market or real estate markets currently. Some believe it will go up and some believe it will go down and so the cycle repeats itself as investors eventually come to realize (by a feeling) that they are paying too much for the opportunity to follow the prices going up, and then, some event, and things tend to crash.

Over the last 100 years the average price investors tend to pay for $1 of stock market earnings is $12. Today, investors are paying $20 on the S & P 500. They believe it will go up, they are not wrong, they are just paying too much to find out when. What were the odds that Bear Stearns would disappear this year, let alone in 2 weeks? A crash in the stock market would be accompanied by the usual complaints, but a crash in the real estate market would be much worse.

Households that have come to rely on equity build-up to keep themselves solvent will have to cut back on consumption. This would produce job loss, personal bankruptcies, mortgage failures, and falling prices. We know how America was built on debt and an increase in the money supply to feed it. We don’t know how it will end or when it will end. It is rather like thinking about your own death, you would rather not, and generally you tend to avoid the subject. Still, it is the kind of thing you ought to be prepared for! A sensible man may not know the hour, the day of his demise, but he does not doubt that it is coming! He does not want to wake up to a market crash with a portfolio of junk bonds, tech stocks, multiple homes or US dollars. He wants to pour himself a drink of Tequila Gold.

After 20 years of mostly falling interest rates, mostly falling inflation rates, and mostly rising asset prices (stocks and real estate) Americans have come to believe that this is the way the world works. Interest rates mostly go down, real estate prices mostly go up. It’s a beautiful thing. What would happen if real estate prices start to go down as they already are? The answer is, nobody knows. Everyone is scrambling to add more money, re-write the rules, and change the benchmarks.

Go figure, the world richest economy lives off the savings of the world’s poorest. Americans buy what they cannot afford, and the Chinese build factories to produce stuff that we cannot afford, but buy anyway. It is the dandiest thing, the whole global “economy” advances apparently so long as U.S. Housing prices continue to rise, as long as more and more money is made.

Whatever this new “economy” is, it is not a traditional economy. Income that should be helping consumers spend is not there, manufacturing jobs are disappearing or being outsourced overseas. Savings have disappeared. Most of what we read is “noise” – more meaningless stuff. In America the average home went up in value 44% in real terms between 1995 and 2005. People buy property now like they did in the tech stock bubble, there are demographic factors they say, earning don’t matter. It is all a greater fool’s game, betting that someone else will come along and pay you more for it. There is no real economy in that. How the new homeowners are going to pay higher prices on falling incomes is not clear, is it?

Remember when people felt the reason why stocks would continue to go up was because baby boomers must save money and they had to put it somewhere? Then, when stocks went down after 2000, they reasoned for the same reasons, why real estate prices would go up, and so they end up chasing bubbles while the real story of what is happening in America is lost in the “noise”.

Well, after an unprecedented rise in real estate, the biggest boom ever, twice as big as the last one in 1980s according to the FDIC, we are nearing, one day at a time, the edge of the abyss. Perhaps the real story is prices for houses have risen in real terms 66% since 1890, but most of the increases happened in two periods: right after WW II and since 1998. Other than these two periods the real prices for real estate have been either flat or going down. Today lenders have come up with creative means to lend money to people who can’t pay it back. Go Figure, and now maybe you can understand why the Fed has increased our money supply and reduced interest rates, to keep the consumer economy working, to increase our apparent standard of living at the expense of great indebtedness (40trillion) payable ultimately, by the many generations of the non-voting unborn.

Things have changed since the last real estate bubble in the 1940’s, then the U.S. economy was growing and healthy. America had a positive trade balance, the biggest in the world. Wages were going up, families were expanding. Now, families are getting smaller, incomes are stable or declining, and for culture of consumers who spend more than we earn, we desperately need housing prices to go up in value and we need the saving of the poor in China and elsewhere in the 3rd World.

The more things change the more things remain the same. The time is now, the rational man and the prudent man get prepared while the crowds wait anxiously for the next signal.
The probable reality is that the Feds will “fix” the problem by throwing more money at it, continuing to devalue the US dollar knowing it holds a trump card in its military that has a vested interest into convincing the rest of the world from seeing things from the American point of view, and that is to keep using the US dollar.

This means that the dollar continues to be the world’s primary currency, backed by a stable government of laws and order. You see, our US dollar is really the equivalent to Imperial currency. As long as it is the world primary currency and everybody wants it to trade with, then it has intrinsic value to foreigners. This is also why it is in the US military’s strategic interest to advance a net work of trade routes around the world, so the 3rd world will continue to invest their savings in US dollars and so the American consumer will continue to consume, so long as housing prices keep increasing and so the dance goes until it stops and it always will.

Purchasing Power Meltdown
Since the US dollar began falling and emerging markets began booming in 2003:
Corn is up 39.5%
Coffee is up 71.1%
Wheat is up 133.9%
Crude Oil is up 140.8%
Gold is up 149.8%
Soybeans are up 159.2%
Gasoline is up 203.6%
Platinum is up 224.2%
Silver is up 257.7%

And thousand s of products that contain these things cost you more everyday.
Cheers!


Author’s note: This discussion paper for the dental audience is largely re-edited content taken from Empire of Debt: The Rise of an Epic Financial Crisis by Bill Bonner and Addison Wiggin, 2006, John Wiley & Sons. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.

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The Crazy Market You Are Invested In (Part 1 of 2)

Is Your Retirement At Stake?

Have you been reading the news? Just today I heard that Delta Airlines took a 7 billion dollar loss in this first quarter of 2008 and they are not the only ones losing their shirt. General Electric shares fell the most in 2 decades on April 11th after reporting a 12% fall in the first quarter. UBS, the biggest of any bank in the world, took a $37 billion loss from the subprime crisis. Defaults of credit vehicles based on subprime mortgages have risen from $54 billion at the beginning of this year to a current total of $170 billion.
How does that make you feel? Let’s take a step back from the news and see what is really going on, OK? Why, because it is your retirement that is at stake.

Let’s pick up the story with the cost of housing. The cost of housing in many areas has not just inflated, but it has been blown up by speculators buying and selling each others houses. Are you one of the geniuses who is making big money by buying a condo before it is built, then flips it to another investor who keeps it until it is built, then flips it to a professional couple who intends to stay for 2 years and sell at another huge profit to still other buyers… everyone is getting richer – so you believe – as long as prices continue to rise.

But the real story is Americans are getting poorer! With less that 20% of U.S. workers now in employer pension plans and with Social Security typically replacing less than 40% of pre-retirement income, personal savings has never been more important – and yet, few people save any money.

Savings rates have never been lower, we are talking about zero savings for the average American. Are you average? Of course not, but still you are lumped in with the lumpen crowd. The low savings rates, coupled with large deficit financing by Asian banks to the U.S. economy is dangerous for the U.S., but it is even more dangerous for both you, your staff and your patients.

37% of your patients do not have any savings of any kind. 11% of all Americans have retirement savings of $250,000 or more. Yet, people are forever focused elsewhere, there is the crisis in healthcare, in our moral values, in the Middle East or in the media. There is usually little any one of us can do about those things, and if left alone, those things generally take care of themselves in their own way.

Unlike these issues constantly being shown to us by the media, lack of savings is the greatest crisis facing the country that you can do something about, and it is personal. It is your retirement we are talking about!

Or, like so many others, you can just complain and hope things work themselves out. Until now, you weren’t going to put an extra dime into your savings when real estate prices were going up at 10% per year and the Federal Reserve continues to give money away at rates below real inflation. Eventually, however, things that must happen sooner or later will happen. Of course, that is when you will have wished you had saved your money. Now that we are already here, where things that must happen are already happening, let’s take a closer look at how we got here.

Savings, like manufacturing is one of those early American virtues that were once part of the American economy and culture. But now, all this seems to have been exported to China. The Chinese now make our products and do our saving for us. They save more than 25% of their income. And with all that savings, the Chinese are thankful to us for giving them a place to invest it. Go figure!

Let’s figure, OK?

In traditional America, people save. Their savings are borrowed by business interests to build new factories and new consumer items that are sold at a profit which creates new jobs, higher incomes, more purchasing power and savings, etc.

In modern neo-conservative America there is no savings, and hardly any factories have been built in the last 20 years. Mind you, there have been lots of shopping centers built. Go figure; how can this be if the per hour jobs pay little more than they did 30 years ago in real terms, and yet American purchasing power is seemingly increasing more than ever? WRONG!

Have you been noticing that America is borrowing unprecedented trillions of dollars from foreigners, a sum that is reflected in the huge budget and trade deficits.

How then, can American live so well? Some argue that the amount of personal savings is understated because it does not take into account the increase in housing values. True!

But, these increasing housing values do not increase America’s wealth; it is simply money flowing into the seller’s pocket from the buyer’s pocket. Elevated home values do not add to the national saving rate unless the seller saves the money – which is generally not the case. They generally go out and buy something with their easy money. In the new economy, people (not Americans) save to get rich, we, consume and get poorer, yet hardly notice.

China, over there, is where people make the things we buy and don’t buy the things we make. American households are rich and buy a lot. Chinese households are poor and buy little. Only 42 percent of the Chinese GDP is for consumption, in America its 71%.

The deception that led to this false sense of security was from our own Federal Reserve who set the key lending rates below inflation and misled everyone beginning back in 2001. The dollar I knew in my childhood is worth 1/10 today. And yet, despite this fraud, the U.S. economy has done no better than Europe. It’s true Americans earn more and spend more…but that is because they work more! Even so, Europe saves more and has less debt. Bully for Europe and the Euro too, as we have seen against the fall of the dollar.

But nationwide homes have grown by 30% since the 1980s, you say. And how did they do this? By the Fed making it possible for lending institutions to extend such a long ropes of credit to the common everyday American, that sooner or later, as all things come and all things go, they will surely hang themselves in debt. And this is what is going on today!

A baby born into America in 1913 came into the world with nothing and he owed nothing. Today, a baby born into America owes approximately $40 Trillion in debt, about $130,000 for having a heartbeat. Such is our democracy, even the unborn get their share of our debt and our politicians are more than happy to stick it to them.

The total value of all assets in America is only about $50 trillion, about $40 Trillion are in current debts, add in future government liabilities and America is broke. When people do not pay their debts, they do not pay them, but the debts do not cease to exist. They are merely paid by the creditor. American debt can be paid in three ways: the currency can be devalued, the currency can be made less valuable through inflation, or the debt can be simply refused. The U.S. doesn’t have to refuse its own currency; after all, it is the worlds reserve currency, that’s like Imperial currency.

Currently, our debts are largely being paid by China who continues to give us credit because even though it is our dollar, it is their problem. Having the world Imperial currency, the dollar, means you can apparently stiff your creditors up to $40 Trillion because everyone wants US Dollars... but not if it is falling in value.

Today, our currency is falling in value because the alternative is to have all those housing loans collapse even more than they already are. It would be very unpopular to put all those millions of Americans out on the street, so, the government is currently re-writing the rules and guess what, it is issuing more currency (inflationary) and more credit to sooth this crisis. That is what it does with everything, it just creates more money to fix the problem for the short-term and then passes the ball off to the next administration, and the next generation!

You and your patients have only the most remote idea, the smallest understanding of what kind of debt obligations are being undertaken on your behalf. The Asians own so many U.S. dollars that any attempt to sell them would cause the very thing they most worry about - a drop in the value of their single biggest asset, the US dollar! Even so, back in 2002 the Euro could be bought for 86 cents, and today it’s worth $1.60.

Something else is happening too, America is getting older. The average American is 45 years old. He no longer is a young man with 60 years ahead. Something odd happens to him, even though he has less years to lose, he becomes careful. He won’t even have a cup of coffee at night before bed for fear it will disturb his sleep. He has a lot to sleep on, he has effectively 10 to 15 years to retire, and he still needs to save $500,000 and you know what, he can’t. Rather than take a chance, he typically shifts his portfolio from capital gains to income.

Over cocktails 1o years ago, all the talk was about stocks. If he got into the stocks in 1997, his portfolio in 2005 was worth about the same when he first entered the market. But in the meantime, his debts increased, his savings went down, and the cost of living rose 12%. Investors took the fall from grace during this period in good form, but now they are 8 years older…

Will 50 something investors panic out of the stock market – yes. Will they panic out of real estate – yes. Will they panic out of the habit of consumption – I don’t know. Who is going to believe he is getting poorer when property prices are still rising, and they are still rising aren’t they, or have things changed? And when he does get his money out of the market without working for it, it is hardly surprising that he spends it. Easy come, easy go. Apparently, the housing bubble has peaked the stock market bubble of 2000 based on P/E and again on irrational exuberance.

The Money Supply

The amount of money, currency in circulation has grown too, faster than in the past 30 years. It rose 20% alone in 2003 –2004. Why was it increasing so rapidly, because the Fed was trying to avoid a deflationary Japan-like slump. It has succeeded so far, through increasing real estate prices, by keeping interest rates artificially low due to the low cost of Chinese made goods, but we creep ever closer to the abyss as more and more money is made available.

So how is it that the increase in money supply happens? It works like this: the U.S. consumers spend more than they can afford buying Asian-made goods. This leaves billions of US dollars with Asian exporters who convert it to local currency through their own central banks which raises there own money supply. Thus, the US is exporting inflation and importing deflation (cheep goods). Back in the 70’s the bond traders would have noticed the rising money supply and sold their bonds causing rates to go up. But now, the rules have changed. No one notices the money supply figures it seems, because the prices for goods don’t go up as they normally would have back in the 70’s because of China. Now the central banks can create what no one thought possible back then, that you can create as much money as you want with out causing consumer price inflation because we are not manufacturing the stuff any more. The good news is that we have delayed the day of reckoning, the bad news is we have reduced American competitiveness by placing all the trade deficit money into Asian hands to invest in new factories, which is deflationary for them as new technology increases production capacity and quality, balancing out the inflationary effect of any increase in local currency. On our side of the pond, lower consumer prices has allowed the Feds to hold down lending rates lower and longer than would otherwise have been possible.

We have already seen what happened to Japan’s currency. Eventually, their domestic real estate and stock prices fell (Nikkei Dow in 1989 at 38,915.87 and today it is at 13,579.13, a 70% loss.) After 1989 Japan’s real estate prices fell for the next 13 years. Imagine if residential real estate prices were to fall in the US? At least in Japan the consumers could stop shopping, but in Japan the consumer shopping was never more than 55% of GDP, unlike in the U.S. where the consumer appetite is responsible for 71% of GDP.

Imagine you are a foreign holder of US dollars and you suspect that the Feds are going to start printing more money, you are not likely to wait till inflation reduces the spending power of your money. This is the situation with US dollars today, if it weren’t the world’s reserve currency and logically going to stay that way with its military dominance, it would signal a mass exodus. But America does have staying power, backed up by its military and the good news is that a 50% fall in the dollar would wipe out half the real value of the US dollar debt overseas. Good for the U.S., bad news for the individual whose savings can’t buy what it used to.

It is note worthy to wonder why corporate profits would continue to go up beyond what they have already experienced, that is, the biggest trillion dollar stimulus jolt in Federal Government’s spending history, and 25 years of falling interest rates, including 3 years of the “prime” rate below CPI levels most recently. Is there any reason to expect any more profits? Yes, they are re-writing the rules as I write this, they have doubled the central bank’s over night lending amount, and proposed new extended credit terms, further out, etc.

What happens to the stocks when corporations like Delta Airlines and GM stop making a profit? What happens when the share price goes up anyway, when investors vote for higher prices? Aren’t they all a little bit richer? Yes, they are richer compared to those non-holders of stock and, no, we as American aren’t any richer. We have merely switched our preferences, from stocks to real estate to stocks, again, and again.

The history of the stock market is one of cycles, in the 1930’s and 40”s you would buy a stock for 5 to 10 times earnings. In the 60’s you would have paid 10 to 25 times earnings followed by the 80’s when it dropped down again to 5 to 10 times earnings and we hit the latest boom in 2000 when guess what, prices were again at 20 to 30 times earnings and guess where we are headed now…

These cycles come and go, and while they may make any given individual richer, if he sells at the right moment, they do not make American society any richer. An investor who follows the crowd cannot expect to make any money towards retirement for he will get what everyone else gets.

Yet somehow, the investor thinks the markets always have to surprise us, or at least half of us or there would be no market at all. People trade their assets because one believes it will go up and the other believes it will go down. Unfortunately, both the pros and the amateurs are overwhelmingly bullish. On the other hand, there is always the man with bearish sentiment who has his reasons too, like me. In the end, the reasons for both pro and con balance themselves out and it is feelings, not a well-reasoned thought, that move the market.

Why is this? I think it relates to warfare ultimately, or being the good soldier. When in battle, everyman must give up his own thoughts – even thoughts for his own survival to lend weight to the collective action, a troop attack, to give it a chance of success. If the soldier lingers or otherwise holds back, he may increase his own chance of survival, but not the troop’s attack mission. In this case too, there is an illusion of security in numbers, even when faced with clear and present danger.

(Continued in Part 2 of 2, next month)