Calm Before the Storm?

by Puru Saxena

CURRENT SITUATION - Everything seems to be going well in the financial world and the investing public is busy doing what it does best - bidding up stock prices after a big rally. Today, there is no regard for risk with the investors' greed being stoked by the mainstream financial media which claims that the US economy is in a sweet spot due to reasonable growth and low inflation (as measured by the bogus official statistics). In all fairness, the bulls have plenty to cheer about. After all, the long-term bond-yield in the US is still relatively low, the price of oil has taken a tumble and global stock markets are flirting with their record-highs. So, I ask myself whether we should join the herd or is it time for caution?

My observation is that dark clouds are gathering over the horizon and this is the time to be on guard. In fact, we may be experiencing the proverbial calm before the storm. Bearing in mind the recent developments in the Middle-East, I suspect that a geo-political disaster is around the corner. I hope I am wrong but it increasingly looks as though either Israel or the US will attack Iran over its "nuclear program". I had first forecast this in August 2005 and believe my fears will be validated in the near future. Over the past few weeks, Washington has increased its rhetoric over Iran's "nuclear program" and dispatched the USS John C. Stennis and USS Eisenhower aircraft carrier groups to Iran. This is an ominous development and suggests that we may be at the brink of another war.

History has shown that all major bull-markets in commodities have coincided with rising political tensions and war (Figure 1). In other words, whenever shortages in natural resources caused prices to rise, nations did everything in their power to secure their share.

Figure 1: Commodity bull-markets coincide with war

The commencement of the current commodities bull-market coincided with the invention of the "War on Terror" and we have already witnessed attacks on Afghanistan and Iraq. In my opinion, we are currently in the early stages of a new war-cycle as the US desperately tries to secure its future energy supplies. Previously, Iraq was accused of developing weapons of mass destruction and now Iran is being targeted along the same lines. So, if you are in the camp which believes that the US is genuinely worried about Iran's "nuclear program", you have to wonder why then does the US not attack North Korea? The answer to this question lies deep within the earth's crust!

There is no doubt in my mind that the US is extremely interested in Iran's oil and the ongoing "War on Terror" is really about dominating the resources in the Middle-East. You must understand that the US is highly dependent on foreign oil (it imports 13.8 million barrels of oil daily) and with China and India now using up more oil than ever before, the US is using its military prowess to secure its future energy supplies. It is interesting to note that Iran is the 6th biggest oil exporter and ships out 2.39 million barrels of oil per day (Figure 2). Furthermore, Iraq exports 1.82 million barrels of oil per day. So, you can see why the US is so interested in bringing about a regime change!

Figure 2: Oil exporters and importers (2005)

At present, the financial markets have not factored in a military conflict in the Middle-East, making them especially vulnerable to turmoil. Therefore, if there is an attack on Iran, we may get sharp knee-jerk reactions in the capital markets. Under such a scenario, emerging-market assets would be the most affected. In fact, stock markets will probably suffer across the board and the price of oil will appreciate sharply. If Iran's response is muted, the spike in the oil-price may be temporary. However, if Iran decides to stop its exports and disrupt the flow of oil through the Straits of Hormuz, the price of oil could easily reach $100 per barrel. This outcome would be a catastrophe for the energy-dependent global economy.

In addition to this, safe haven assets such as government bonds, gold and oil will thrive. If my assessment is correct, gold and energy stocks may end up appreciating significantly whilst the general stock markets decline. Accordingly, we have reduced our exposure to the emerging-markets and our managed-accounts are now heavily invested in oil and precious metals.

PEAK OIL - Our planet is rapidly approaching its oil-production peak. In fact, some leading geologists argue that we are already past that point.

It is important to understand that oil-production follows a bell-curve (Figure 3). This is true whether we are talking about a particular oil-field, a nation or the planet as a whole. Once more than 50% of the reserves are depleted, the rate of oil production enters a rapid and irreversible decline.

Figure 3: World oil-production peaking?


Today, several oil-provinces around the world are producing significantly less oil when compared to their record-production levels. Despite phenomenal breakthroughs in technology, these regions have failed to sustain their record-high output levels and this is proof of the concept of peak-oil. If we look around today, the US is past its peak, the North Sea is in decline, Indonesia is struggling and even Mexico has announced that its largest oil-field is past its peak-output. Although these regions still have massive reserves, the rate at which they pump oil out of the ground on a daily basis has entered a serious and permanent decline. In the recent past, non-OPEC nations increased their production and managed to compensate for the declining output levels elsewhere in the world. However, when you take into account the fact that these countries are also faced with geological limitations, it becomes clear that unless we discover gigantic oil-fields very quickly, our world will find it extremely hard to keep up with rising demand.

When discussing "peak oil", it is also important to mention that over the past 35 years, we have discovered just one gigantic oil-field anywhere in the world! For sure, there have been some discoveries in different parts of the world but only a single world-class oil-field has been discovered in over 3 decades; Kazakhstan's Kashagan Oil Field in the Caspian Sea. This is despite all the technological achievements over the same period. In other words, unless we have been incredibly unlucky and there is indeed a jackpot waiting to be found, this is not a healthy sign.

To complicate matters further, demand for oil continues to grow rapidly. At present, our world consumes roughly 84 million barrels of oil per day. If current growth rates continue, Asia's demand alone will increase from 22 million barrels per day to approximately 40 million barrels by 2020. According to the US Energy Information Agency, global consumption is projected to increase to 103 million barrels per day in 2015 and 119 million barrels by 2025. In order to meet this explosive demand, global production must increase by 45% - about five times the maximum annual output available from Canada's oil sands.

So, you can see that our world faces an imminent energy crisis which may cause an escalation of resource wars over the coming years. Normally, I do not like to make bold forecasts but I can say with confidence that the era of cheap oil is over. Moreover, I also suspect that things will get a lot worse on the geo-political front before we return to a period of world-peace.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise "Email Updates", which are sent out when an important development in the capital markets warrants immediate attention. Subscribe Today!

Puru Saxena

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication NOW available at www.purusaxena.com. An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC, Bloomberg, NDTV Profit and writes for several newspapers and financial journals.

Copyright © 2005-2007 Puru Saxena Limited. All rights reserved

Hypocrisy in the Middle East

by Dr. Ron Paul ( U.S Congressman )

Hundreds of thousands of American troops already occupy Afghanistan and Iraq, a number that is rising as the military surge moves forward. The justification, given endlessly since September 11th, is that both support terrorism and thus pose a risk to the United States. Yet when we step back and examine the region as a whole, it’s obvious that these two impoverished countries, neither of which has any real military, pose very little threat to American national security when compared to other Middle Eastern nations. The decision to attack them, while treating some of region’s worst regimes as allies, shows the deadly hypocrisy of our foreign policy in the Middle East.

Consider Saudi Arabia, the native home of most of the September 11th hijackers. The Saudis, unlike the Iraqis, have proven connections to al Qaeda. Saudi charities have funneled money to Islamic terrorist groups. Yet the administration insists on calling Saudi Arabia a “good partner in the war on terror.” Why? Because the U.S. has a longstanding relationship with the Saudi royal family, and a long history of commercial interests relating to Saudi oil. So successive administrations continue to treat the Saudis as something they are not: a reliable and honest friend in the Middle East.

The same is true of Pakistan, where General Musharaf seized power by force in a 1999 coup. The Clinton administration quickly accepted his new leadership as legitimate, to the dismay of India and many Muslim Pakistanis. Since 9/11, we have showered Pakistan with millions in foreign aid, ostensibly in exchange for Musharaf’s allegiance against al Qaeda. Yet has our new ally rewarded our support? Hardly. The Pakistanis almost certainly have harbored bin Laden in their remote mountains, and show little interest in pursuing him or allowing anyone else to pursue him. Pakistan has signed peace agreements with Taliban leaders, and by some accounts bin Laden is a folk hero to many Pakistanis.

Furthermore, more members of al Qaeda probably live within Pakistan than any other country today. North Korea developed its nuclear capability with technology sold to them by the Pakistanis. Yet somehow we remain friends with Pakistan, while Saddam Hussein, who had no connection to bin Laden and no friends in the Islamic fundamentalist world, was made a scapegoat.

The tired assertion that America "supports democracy" in the Middle East is increasingly transparent. It was false 50 years ago, when we supported and funded the hated Shah of Iran to prevent nationalization of Iranian oil, and it’s false today when we back an unelected military dictator in Pakistan- just to name two examples. If honest democratic elections were held throughout the Middle East tomorrow, many countries would elect religious fundamentalist leaders hostile to the United States. Cliché or not, the Arab Street really doesn’t like America, so we should stop the charade about democracy and start pursuing a coherent foreign policy that serves America’s long-term interests.

A coherent foreign policy is based on the understanding that America is best served by not interfering in the deadly conflicts that define the Middle East. Yes, we need Middle Eastern oil, but we can reduce our need by exploring domestic sources. We should rid ourselves of the notion that we are at the mercy of the oil-producing countries- as the world’s largest oil consumer, their wealth depends on our business. We should stop the endless game of playing faction against faction, and recognize that buying allies doesn’t work. We should curtail the heavy militarization of the area by ending our disastrous foreign aid payments. We should stop propping up dictators and putting band-aids on festering problems. We should understand that our political and military involvement in the region creates far more problems that it solves. All Americans will benefit, both in terms of their safety and their pocketbooks, if we pursue a coherent, neutral foreign policy of non-interventionism, free trade, and self-determination in the Middle East.

Dollar-Adjusted SP 500

by Adam Hamilton

As a markets junkie, the worst days for me are the market holidays cropping up all over the place lately. Having a big down day and losing money is no big deal, just part of the game. I like upside and downside volatility equally, the action is exciting either way. But when the financial markets are closed for some goofy "holy day", I find myself depressed without my action fix.

Well, this past Monday I woke up in a bad mood because it was Monarchy Day, or some such politician-worshipping nonsense, in the States. As usual, at oh-dark-hundred I trudged through the cold, black morning to the local gym and grumbled to myself about the injustice of shutting down the markets. Vacations are fine, where not everyone disappears. But forced holidays for everyone? Do we live in the Dark Age or the Information Age?

At my gym early every morning CNBC and Bloomberg are always on. The former is totally useless during market holidays, but Bloomberg actually at least makes an effort to air some quasi-normal programming. As I was finishing my workout, Bloomberg ran a fascinating bull/bear debate hour. It proved really interesting and I am glad I had the opportunity to listen to it.

The bull was some random Wall Street minion, no one I have ever heard of before. But the bear was a hardcore contrarian I admire tremendously, Peter Schiff of Euro Pacific Capital. Mr. Schiff not only understands the true state of the financial markets and long cycles like few others on television do, but he has a lionheart. I have seen him interviewed many times on CNBC and Bloomberg and he is always the token bear the networks bring on to spite.

Like a Christian invited to the Coliseum by the Romans to "watch the lions", Mr. Schiff continues to fearlessly expose himself to bullish torment, unacceptable rudeness, and general ridicule in order to spread the contrarian gospel. In the groupthink financial television world in which I continue to see him, he is a bright beacon of clarity and financial truth trying to pierce the perma-bull darkness and deceptions.

As always, on Monday morning Mr. Schiff was articulate and well-spoken despite the lowbrow taunting and juvenile ad-hominem attacks on him by both the bull and the interviewer. He spoke much wisdom, but the thing that really caught my attention was a comment he made on the US stock markets. Paraphrased, he said something like "the bull market in US stocks over the last few years is largely an illusion based on the falling US dollar."

Walking back from the gym with the sun finally peeking above the eastern horizon, I was mulling over this and wondering just how much of the cyclical US stock bull since 2003 was due to the secular US dollar bear. And since there were no markets to watch, Monday was a perfect day to find out. Inspired with a new sense of purpose on a bleak market holiday, after I got home I fired up my computers and went to work.

To examine this provocative thesis, I decided to use the flagship S&P 500 stock index (SPX) as a proxy for the US stock markets as a whole. It is, of course, the metric of choice for tracking general stock-market performance for almost all professional traders and analysts.

In order to see how the stock markets interacted with the dollar, I used the US Dollar Index (USDX) as my measuring rod for the dollar's progress. Several decades old, it measures the dollar against a trade-weighted basket of major world currencies. Today it is dominated by the euro, which has a massive weight in this index of nearly 58%. Its next heaviest component is the Japanese yen near 14%. The British pound, Canadian dollar, Swedish krona, and Swiss franc round out this geometrically-averaged index. It shows where the dollar is trading today relative to its March 1973 indexed base of 100.

Whenever cross-currency analyses are performed, a decision has to be made on the starting point. To see how the SPX has fared adjusted for the USDX's behavior, or in other words how the US stock markets have truly looked to non-American eyes, I chose three extreme starting points. The three charts below start adjusting the S&P 500 for the dollar's behavior at the March 2000 secular SPX top, the July 2001 secular USDX top, and the March 2003 cyclical SPX bottom respectively.

These particular starting points illustrate the best- and worst-case scenarios for foreign investors trading their local currency for dollars and buying into the US stock markets. The best case is buying right at the March 2003 stock-market lows, the point where the dollar's negative influence is minimized. The worst case is buying right at the July 2001 dollar highs, the point where the dollar's negative influence is maximized.

To start though, I just wanted to understand how the S&P 500 has fared through its secular bear market since its secular top in March 2000 in dollar-adjusted terms. If you are not an American but you purchased an S&P 500 proxy at the March 2000 top, how would your investment have fared over the seven-year gulf since? Or from another perspective, how would the S&P 500 look to us Americans if we take into account the dollar's considerable loss in international purchasing power since then?

The blue line below is the USDX-adjusted S&P 500 reckoned from the adjustment point in the chart. Think of it as a dollar-neutral view of the S&P 500, or where this stock index would have traded if the USDX was totally unchanged. The red line is the normal unadjusted headline S&P 500 for comparison purposes. As Mr. Schiff pointed out to the numbskulls who were harassing him on Bloomberg Monday morning, the US stock markets are an entirely different ballgame when the devastating effects of the dollar's bear market are considered.

Even without any dollar adjusting, the S&P 500's performance over the past seven years has been utterly dismal. An investor who bought in early 2000 near the top, the very time when most naïve investors do tend to buy, has lost 4.4% of his capital over the past seven years as of this week's new highs. Can you imagine risking your capital for seven years and having nothing to show for it even before inflation? There is nothing worse for long-term investors than the curse of the trading range in secular bears.

And it is not like there were no other alternatives. Gold stocks, for example, rose nearly 1000% over roughly this same period of time as measured by the HUI gold-stock index. The stocks of companies producing other key commodities like oil and base metals have soared too. General-stock investors who have nothing to show for the last seven years have no one to blame but themselves for their terrible showing.

Even more depressing, the dollar-adjusted reality is far worse than the flat perception. When the S&P 500 is adjusted by the US Dollar Index starting on the very day the S&P 500 topped in March 2000, it shows that the international purchasing power of the US stock markets was still down 28.4% as of this week! Seven long hard years and US stock investors are actually 28% poorer in their international purchasing power than they were in 2000 when they started. Ouch!

Today the dollar-adjusted SPX is still under 1200. All of the fanfare and excitement that have arisen since the nominal S&P 500 finally broke out above 1400 last November are totally misplaced. The cyclical bull since early 2003 that has ostensibly brought the stock markets back near break-even after seven years of struggling is far shallower once the continuing decline in the US dollar is factored in. In true international-purchasing-power terms, the US stock bear is very much alive and well.

With the dollar-neutral S&P 500 under 1200 today as measured from its secular top, the true state of the US stock markets is pretty poor. But believe it or not, this is certainly not the worst-case scenario. The secular dollar bear started back after the dollar topped in July 2001. The dollar then plunged sharply in 2002 and 2003 and has been gradually grinding lower in a long consolidation since. How would the US stock markets look to investors unfortunate enough to have bought US stocks at the dollar's secular top, back when the dollar's prospects looked the brightest?

Considered in its entirety, the dollar bear's impact on the US stock markets has been nothing short of catastrophic. The USDX-adjusted SPX from the dollar's top is barely edging above 1000 today. 1000! This is horrifying, yet it is what US stocks are now worth in international-purchasing-power terms compared to the 1200ish levels the S&P 500 was at back when the dollar topped. If the nominal S&P 500 was near 1000 today, I bet Wall Streeters would be leaping out of skyscrapers to their doom.

Perceptions are everything in the financial-markets game, and we contrarians are not the only ones who pay attention to them. Whenever a stock bull hears that the S&P 500 has languished flat for seven years, it doesn't take a nanosecond for him to attempt to change the subject to what has transpired since early 2003. "True, but the run since 2003 was awesome! It is from the early 2003 lows that this market's progress should be measured."

As is common in the midst of secular bears, there has been a massive cyclical bull since March 2003. The S&P 500 is up nearly 88%. (This is actually from its slightly lower October 2002 lows, although the true sentiment bottom occurred in March 2003.) This is indeed an incredible gain by any reckoning and deserves respect. But it was only gun-slinging speculators, not long-term buy-and-hold investors, who bought and sold at the right times to ride it.

Since early 2003 during that powerful cyclical bull, the dollar-adjusted S&P 500 has climbed nearly 58%. While a 58% gain over four years is certainly nothing to scoff at, it is important to realize that this is only two-thirds of what the nominal S&P 500 managed. Fully one-third of the cyclical bull in general stocks was created by and lost to the falling US dollar. The USDX started 2003 near 103 and is now down 18% to 84ish.

And it is not only the ongoing dollar bear that should be weighing on the hearts of mainstream stock investors, but the huge opportunity costs of being deployed in a poorly performing market. While the nominal S&P 500 rallied nearly 88% since October 2002, other sectors have done far better. The XOI oil-stock index, for example, was up 172% over the exact same time frame to the very day. And the HUI gold-stock index managed a 212% gain. And these comparisons are non-optimized, they don't consider the XOI's or HUI's own rhythms, so this case is understated.

Just as Peter Schiff claimed Monday morning, the falling US dollar has had an enormous impact on the true constant-purchasing-power returns of investors in the US stock markets. Since the dollar has fallen on balance since 2001, a good portion of the stock gains since, up to a third perhaps, are illusory. The S&P 500, even at today's relatively high levels, would only be trading near 1000 now if the full impact of the dollar's bear was properly considered.

Another interesting observation from this chart is that the USDX-adjusted SPX has not broken out to the upside like the nominal SPX has. Technicians have made a big deal over the S&P 500 recently breaking out above its multi-year uptrend last quarter. But unfortunately this breakout did not occur in the adjusted SPX because it was merely a response to a fairly sharp dollar selloff in Q4'06. Considering the dollar's impact once again greatly changes perceptions of how the US stock markets have fared.

While this worst-case scenario is indeed pretty darned ugly, the best case isn't all that good either. This final chart starts adjusting the S&P 500 by the US Dollar Index's fortunes as of the S&P 500's March 2003 low. That was the very day that the powerful four-year-old cyclical stock bull started so it paints the dollar's influence on true stock-market returns in the very best possible light.

Since the brunt of the dollar's secular bear, at least so far, happened before March 2003, the starting point for this adjustment abates the dollar's negative influence considerably. Still though, even with this favorable timing the true constant-international-purchasing-power S&P 500 is lagging the nominal one by 200 points or so. This is a really big deal. If the nominal SPX was near 1250 today, there would be far less exuberance.

I find this final chart the most illuminating of all since it gives the equity bulls all benefits of the doubt. Measured from the very best time for stock investors to buy and encompassing a period of time where the dollar has largely consolidated rather than continue falling, it still shows a serious negative impact on stocks caused by the dollar bear. Roughly 30% of the S&P 500's gains since early 2003 are truly just an adjustment for a lower dollar.

And the big problem here is the secular dollar bear is almost certainly not over yet, it will continue to insidiously erode true gains in US stocks. Not only is the US Federal Reserve continuing to run its printing presses relentlessly to rapidly inflate the global supply of dollars, but Washington continues to meddle worldwide which really irritates foreign investors. These investors are expressing their anger by diversifying out of dollar holdings. The combination of an ever-growing dollar supply at the same time global dollar demand wanes can only result in one thing, a continuing dollar bear.

If the US stock markets were the only financial game in town, these would be dire tidings indeed. But stocks are certainly not the only game. While the US stock markets continue to trade sideways in their seventeen-year secular bear, commodities are in their usual secular-bull mode over this same period of time. We have already won fortunes in commodities and commodities stocks since 2000 and I suspect the best is yet to come.

Elite commodities stocks in particular should experience gains far exceeding those of the general stock markets and far outpacing the dollar bear. When all the dust settles a decade or so from now after the stock bear and commodities bull fully run their courses, odds are the real dollar-adjusted gains in commodities stocks will dwarf every other sector. Commodities are the perfect refuge in which to seek shelter from the dangerous twin dollar and stock bears.

At Zeal we have been actively trading commodities stocks since the very beginning of these bull markets back in 2000. We have already been blessed with realized gains of many hundreds of percent. We are going to continue actively trading these markets and seeking legendary gains. Our latest campaign is in elite gold stocks as it looks like they are in the early stages of a major new upleg. Please subscribe today to learn from our innovative cutting-edge research and profit from our handpicked stock trades in our acclaimed monthly newsletter.

The bottom line is Peter Schiff and the rest of the contrarians are dead right. The gains witnessed in the US stock markets in recent years are considerably smaller when adjusted for the relentlessly declining international purchasing power of the US dollar. Viewing stocks from this perspective helps illuminate their true state which is significantly worse than what the headline nominal stock indexes suggest.

As the dollar bear marches on in the inevitable response to increasing dollar supplies and decreasing global demand, this situation will probably worsen considerably. Prudent American investors will need to increasingly position their capital with the falling dollar in mind in order to weather the dollar calamity. And the accelerating global commodities bull is just the place to park this capital and watch it multiply in the years ahead.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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The Shell Answer Man, Part II

THE PRESIDENT OF Shell Oil Co., John D. Hofmeister, is about midway through a 50-city speaking-and-listening tour, talking about the national energy situation on behalf of Shell. Last week, he brought the tour to Pittsburgh. In Part I of this report, I provided an overview of the energy message that Mr. Hofmeister is delivering on behalf of Shell, embodied in the title of the speech that he has given, in one form or another, in many cities, “How the U.S. Can Ensure Energy Supply for the Future.”

Shell’s Mr. Hofmeister is talking about oil and natural gas, of course, which is what you would expect from the man who runs Shell. But he is also talking about other energy resources such as coal, tar sands, oil shale, heavy oils, biomass, fuel cells, solar power, wind power, and even plain-old energy conservation. It is quite a comprehensive overview, and the theme of the presentation reflects the energy investments and technological pathways that Shell is pursuing. When asked why he is not discussing nuclear power, Mr. Hofmeister states that Shell does not have corporate expertise in that field and thus he is willing to leave that radioactive energy source for others to review. Fair enough.

It Sounds Like the Peak Oil Issue

What is that old expression about, “If it walks like a duck and looks like a duck and quacks like a duck”? Here we have the president of one of the world’s largest publicly traded oil companies, in business for well over a century, traveling back and forth across the land to hold a national energy discussion. The man from Shell states in no uncertain terms that conventional crude oil is getting harder to find and extract. He begins his talks by offering a definition of “energy security” from the perspective of Shell Oil. That is, energy security means ensuring an available, affordable supply of energy for the present, the foreseeable future, and generations to come. The implication is that Shell is on the cutting edge of a strategic vision for delivering energy supply to the nation’s and world’s consumers within a market system, and working to be part of any transition or transformation from where we are now to where we will be many decades from now.

In his speeches across the U.S., Mr. Hofmeister has clearly described how the search for oil and natural gas reserves is moving into distant, dangerous expensive places to operate. Of course, he promotes opening up remote and expensive places for drilling, such as the U.S. Outer Continental Shelf (OCS). This OCS issue is, if you do not know, part of the DNA of every true oilman, certainly including this correspondent. And Mr. Hofmeister is discussing the massive, long-term, and very costly investments that his company is making in alternative energy sources, from tar sands of Canada to oil shale in Colorado. He describes other exotic and expensive energy investments that Shell is making in coal gasification and coal-to-liquid (CTL) technology, as well as in fuel cells, solar cells, and wind power. It all sounds, to the informed listener, like Mr. Hofmeister is discussing the Peak Oil issue.

The Peak Oil Paradigm

All of what Mr. Hofmeister is saying certainly fits in to the standard Peak Oil paradigm, which is that mankind has generally located, if not discovered, most of the conventional crude oil that there is to find in the crust of the Earth, and has produced and consumed something near half of it. That is, out of a conventional, worldwide resource base of conventional oil that is estimated by some knowledgeable commentators at about 2.2 trillion barrels, about 90% has been discovered and about 1 trillion barrels have been extracted and consumed over the past 150 years or so. At the present time the global oil industry is pumping the world’s known oil reserves at a rate of about 1,000 barrels per second, or 85 million barrels per day (mbd), or about 31 billion barrels per year. And the global economy is, as frequent readers of this column know, consuming or otherwise burning up almost every drop of that oil. And not to get too preachy, but watch what happens if just a couple of hundred thousand barrels per day of production (near a rounding error from a production base of 85 mbd) go off line, such as occurred last August when BP closed the Alaska pipeline.

So do the math, dear readers. Follow the facts. Watch the trends. Mankind is at the top (or “peak”) of the conventional oil production curve. The world’s major oil provinces and largest oil fields are barely holding steady in production (Saudi’s Ghawar Field, for example), or are in irreversible decline (U.S. Lower 48 and Alaska, North Sea, Mexico’s Cantarell, Kuwait’s Burgan, China’s Daqing, Russia’s Samotlor and Romashkino, and many others). The world is pumping and burning oil that was discovered decades ago. And despite massive and costly efforts at exploration, overall, the global oil industry is pumping conventional oil reserves out of the ground at a far faster rate than it is discovering new reserves. So in the past few years, “new” oil production has barely kept up with depletion and decline in volumes produced from older areas.

“Call It a Banana”

Yes, do the math. These facts are the heart and soul of the Peak Oil discussion, dear readers. There is a lot of conventional oil in the crust of the Earth, and obviously, there is enough to support current daily global oil production of around 85 mbd, at least for a while. But only for a while. (How long? Good question.) What happens when conventional oil volumes begin to decline in an appreciable manner? This is exactly why big oil companies like Shell, and most government-owned oil companies, and many other large and small firms from around the world, are investing feverishly to develop alternative sources of hydrocarbon production, other energy sources, and advanced energy conservation concepts.

Thus, the future of conventional oil production bodes ill. The most likely forecast is that the rate of oil extraction will hold more or less steady and bounce along, at a maximum production plateau of about 85 mbd for some relatively short-term period of years, and then eventually follow a downward trending and irreversible curve of decline. Call it “Hubbert’s Peak” if you wish, after the title of the fine book by Princeton geology professor Kenneth Deffeyes. But Hubbert’s Peak is only a label. Call it something else, if you wish. You might even want to quote the late, great Groucho Marx and “Call it a “banana.”

Plenty of Uncertainty

So yes, the Peak Oil scenario rests on the assumption that the world’s largest oil provinces, in both area and volume, have been located from Texas and Mexico to Saudi Arabia and Iran, from the North Sea to West Africa, from Western Siberia to Northern China, from many spots here to many other spots there. But no, for all the purists out there, this does not mean that we know where every deposit of conventional oil is located, to a precise grid description on the face of the planet. There is plenty of uncertainty about the future of exploration and production. There are, to be sure, many dry holes yet to be drilled.

Rest assured that the world’s oil industry will be exploring for oil and drilling wells far into the future, to recover the valuable hydrocarbon product from the rock beds of the Earth. And it means that the future of conventional oil exploration will be one in which those geologists and drillers look for smaller and smaller oil fields, in more and more remote locales. There will, of course, in that oil-searching future be plenty of good jobs and good wages for geologists, geophysicists, and engineers of every ilk and stripe, and drillers and logisticians and the myriad of oil service personnel who make it all happen. And again, to his credit, Shell’s Answer Man Mr. Hofmeister has given more than a few speeches addressing the industry-wide chronic shortage of personnel with critical skills that is currently hamstringing many exploration and production efforts.

The Peak Oil Question

As I mentioned in Part I of this article, Mr. Hofmeister takes questions as well as gives speeches. And so I asked him straight up about Peak Oil: “Mr. Hofmeister, does Shell Oil have a corporate policy or position on the concept of Peak Oil, which you know was pioneered by former Shell geologist M. King Hubbert?”

And here is exactly what Mr. Hofmeister said: “Among informed Shell executives, there is a rejection of the Peak Oil theory.” Peak Oil is, he stated, “based on flawed assumptions.”

Mr. Hofmeister listed three reasons why Shell executives reject Peak Oil theory:

Peak Oil deals with conventional oil and does not take into account sources of unconventional oil, such as tar sand, oil shale, and heavy oil.
Peak Oil assumes that technology is static, when, in reality, there have been “huge strides” in the ability to enhance oil recovery from older oil fields.
By diversifying energy resources, “People will switch demand to other energy sources” long before conventional oil runs out.

Amplifying this last point, Mr. Hofmeister mentioned an old saying that has been, I believe, first attributed to former Saudi Oil Minister Sheikh Zaki Yamani, that “The Stone Age did not end for lack of stones, and the Oil Age will not end for lack of oil.”

And finally, Mr. Hofmeister made another comment along these lines: “We will reach Peak Oil, but not for lack of oil.”

Not for Lack of Oil?

Earlier in this article, I mentioned the old expression that “If it walks like a duck and looks like a duck and quacks like a duck…” Well, there are more ducks here than on Old McDonald’s Farm. I honestly admire and commend Shell Oil Co. and Shell’s Mr. Hofmeister for going around to discuss the energy predicament of the U.S. and the world. Mr. Hofmeister is saying many of the right things, in my view, and he is in a position to know what he is talking about. But what is going on? What is with the Peak Oil denial by Shell?

According to the president of Shell, Peak Oil is “based on flawed assumptions”? I just do not get that. Actually, the mathematical support of the Peak Oil argument is based largely upon industry-supplied data sets. That is, Peak Oil is based on historical and current production data for conventional oil, and the only place to get that kind of data is from industrial summaries such as the BP Statistical Review or Oil & Gas Journal or by summarizing collections of government-mandated data. So not to overstate the issue, but it is the camp that diminishes or denies Peak Oil that is using the flawed assumptions.

Conventional Oil

The critics focus on the point that the Peak Oil concept focuses on conventional oil, and does not take into account other hydrocarbon alternatives. Well, yes, after a fashion. Peak Oil is, and always has been, about “conventional oil” recovery. The discovery and recovery of conventional oil has been occurring for about 150 years, since 1859, when Col. Edwin Drake pounded down his famous well at Titusville. When former Shell geologist M. King Hubbert first articulated the Peak Oil concept in the 1950s, conventional oil was the whole ballgame. And the world is now at the point at which conventional oil extraction is a more or less flat, at a production rate of something over 80 million barrels per day (mbd), with the balance in natural gas liquids and other energy fluids.

And this “conventional” oil distinction of the Peak Oil argument is not some sort of “flaw” in the assumption; it is critical to understanding the point. With the exception of just a few million barrels per day of heavy oil, very sour crude, oil from tar, and a few other exotic forms of hydrocarbon, the entire world’s industrial liquid fuel infrastructure is wired and plumbed for conventional crude oil. This is the 150-year legacy of past investment at work. For example, the plastic and rubber gaskets in the engines of almost all of the world’s 500 million or so motorized vehicles are designed for use with oil-based gasoline, and rapidly corrode if ethanol is used for fuel.

Look at it from the other perspective. The world simply does not have the industrial infrastructure to produce 85 mbd of “alternative” forms of hydrocarbon fuel and there is no program in place to construct it, certainly not over the next few decades. After 20-plus more years of investment in the tar sands of Alberta, for example, the government of Canada is forecasting at most about 3 mbd of synthetic crude oil production by 2025. And this will require immense amounts of fresh water and natural gas, the supplies of which are entirely problematic.

And for all intents and purposes, there is simply no oil shale industry (let alone a world-scale oil shale industry), despite over a century of periodic hype to include the research performed by Shell in Colorado. Coal-to-liquid (CTL) efforts are embryonic, and it is a fair statement to say that no one really knows what a large-scale CTL industry will look like, what the technology will entail, what the environmental impact will be, and what the energy return on energy investment (EROEI) will be.

Technology

The critics also often argue that the Peak Oil thesis does not take into account new forms of technology that expands the reach for oil to deeper and more remote locales, or new equipment and processes that improve oil recovery from rock formations.

Actually, the improvement in technology is one of the things that demonstrate the point of Peak Oil. The “easy” oil has been found, and Shell states as much in its corporate advertising, along with Chevron, BP, and most other oil companies that pay good money to advertise their efforts. A deepwater oil well in the Gulf of Mexico, for example, costs in the neighborhood of $125 million, as was the case with Chevron’s 28,000-foot Jack-2 well that drew so much attention in September 2006. Would Chevron, or any other oil company, drill 28,000-foot wells that cost $125 million if there were cheaper alternatives? Deep, remote, expensive exploration and production wells make the case for Peak Oil, not diminish it.

As for enhanced oil recovery (EOR) methods, again these technological advancements make the case for Peak Oil. On the one hand, EOR is a market response to the rising price of conventional oil, so EOR merely illustrates that oil is becoming scarce and worth more investment to recover from the ground.

At the same time, EOR merely allows the oil producer to recover a higher percentage of the oil in place. EOR does not “make” any new oil in the rock formations. What is down there is down there, and EOR is just a way of leveraging your investment in a hole in the ground to get more oil out, and often as not to get it out more quickly. Whether your methodology is to drill horizontal wells or to perform multilateral completions or to inject water or gas to keep up the reservoir pressures or pump surfactants or other chemicals into the oil-bearing formation, what you are doing is mobilizing the oil and accelerating oil extraction from the future into the present.

The Peak Oil problem with EOR comes when the distant future shows up and becomes the present. Then, your extraction drops precipitously and your irreversible decline curve kicks in with a vengeance. Oil-producing regions such as Mexico’s Cantarell, the North Sea, or even parts of Saudi Ghawar illustrate the point. These great oil-producing regions have been the subject of EOR since the 1980s, and now their annual production decline rates are in the range of 12% and more. And compounding the problem, the decline in production leaves a major gap in the supply curve going forward, particularly since no one is “discovering” any other new oil provinces like Ghawar, Cantarell, or the North Sea.

So EOR is a technological means of pulling more oil out of the same holes, but it is not a contradiction to the argument embodied by the term “Peak Oil.”

Consumer Behavior

As for the argument that people will change demand and consumption habits long before we “run out of oil,” this is actually part and parcel of the basic Peak Oil thesis as well. Peak Oil is real, as are markets and market behaviors. Prices rise, and people react.

And of course, people will change their habits as conventional oil becomes more and more scarce, and expensive, going forward. They will have to, just as the world changed its consumption habits in 1978 and 1979 when the Iranian Revolution took almost the entire petroleum output of that nation offline within a matter of months. When the oil was not there, it was not there. Prices rose. People changed behavior. Economies crashed. And so it will be in the future. We can prepare or not, with a sense of urgency or not.

Moving the Goal Posts

So to my way of seeing things, it is the critics of the Peak Oil concept who keep attempting to redefine the terms. In one intellectual form or another, they keep trying to move the goal posts whenever some new evidence comes along that makes a new point within the discussion.

But this two-part article concerns Shell Oil Co., its president, John Hofmeister, and his traveling speaking tour. Shell and its president are attempting to hold a national energy discussion and to get people at the grass roots thinking about whence will come the nation’s energy supply in the future and the need for a true long-term national energy strategy. The Shell Answer Man is putting quite a bit of valid, accurate information about energy out on the table for all to see, from the depleting oil situation to the need for significant energy conservation efforts. Bravo.

We can disagree about this feature or that of what Mr. Hofmeister is saying, and even differ about the name on the label. Is it “Peak Oil” or no? I happen to believe that it clarifies the thinking process to call things by their correct name. But then again, it all may be of little consequence in the long term. We shall see. As our Arab friends say, “The dogs bark. The caravan moves on.”

Until we meet again…
Byron W. King

for Whiskey and Gunpowder

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.

While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

The Shell Answer Man, Part I

DO YOU REMEMBER the “Shell Answer Man,” dear readers? He was part of a television advertising campaign by Shell Oil Co. back in the 1970s, in reaction to the oil shocks and gasoline shortages of that era. The Shell Answer Man was a nice-looking, pleasant-sounding fellow who would appear on the TV screen to ask and answer basic questions about driving in general and gasoline in particular.

With simple language, and in a disarming and folksy manner, the man from Shell would explain things that related to fuel usage, like how proper tire inflation was good for your gas mileage. Or he would discuss how “jackrabbit starts” wasted gasoline. Over a period of time, there were a variety of topical ads along those lines. If you were somewhat savvy about driving an automobile, there was nothing particularly new or revealing in the message. But if you were what we might characterize, with all due respect, as the “average consumer,” blissfully dwelling in energy La-La Land, then the Shell Answer Man offered some good advice. Well, it was good advice if you followed it.

John D. Hofmeister

And so today we meet John D. Hofmeister. He is a nice-looking, pleasant-sounding fellow who happens to be the president of Shell Oil Co. And he is in the midst of a 50-city lecture tour, on behalf of Shell, giving speeches with a title along the lines of “How the U.S. Can Ensure Energy Supply for the Future?” On Feb. 8, 2007, he brought the show to Pittsburgh.

First of all, Thank you, Shell Oil Co., and thank you, Mr. Hofmeister. No matter what else I say in the following two-part commentary (and frequent readers know that I will have a few things to say), I certainly appreciate that a large company like Shell would make the effort to hold what amounts to a “national energy discussion.” And it says something important that a big, publicly traded company like Shell would send no less than its president out on the road to give the pitch. I suspect that such a senior corporate officer might have a few other things to do, like run Shell Oil. But then again, educating the public about the nation’s energy supply and answering peoples’ questions on the subject might just be more important over the long term than squinting at a few more spreadsheets full of obscure data or buttering up the stock analysts.

A Well-Traveled Road

And what a road Mr. Hofmeister has traveled in the past year or s from Miami to Minneapolis, New Orleans to Irvine, Seattle to Washington, the National Press Club to Harvard Business School. The guy gets around. He calls it a “speaking tour,” of course, because he is giving speeches. But he also calls it a “listening tour,” because he takes questions and offers answers, however well rehearsed. (It’s OK, really. Shell has to be careful not to run afoul of the Securities and Exchange Commission or its many volumes of regulations. So everything has to get scrubbed by the lawyers.)

The typical gig involves a visit to some burgh where Mr. Hofmeister has a lunchtime speech scheduled before a local assembly of worthies, such as the World Affairs Council of this hamlet or that village or town. Also on the schedule, time permitting, is a morning visit to an area high school or college to meet with the young people and hold give-and-take sessions with those inquiring minds. And often as not, the indefatigable Mr. Hofmeister holds a “town meeting” later in the day, at which forum just about anybody can (and ofttimes does) show up to make caustic attacks on the oil industry, if not to bellyache about the price of gas.

In Pittsburgh, for example, one precocious high school student asked one of the most painful of all questions that any oil company executive can hear: “How much do you get paid, Mr. Hofmeister?” Ooooooh! That’s what I compare to a hot welding spark dropping down your shirt. But Mr. Hofmeister gave the nosey kid a good answer: “I get paid more than a rookie player for the Pittsburgh Steelers, but less than [Steelers quarterback] Ben Roethlisberger.” Not bad, Mr. Shell Answer Man, not bad at all.

Just by way of payroll perspective, a rookie player for the Pittsburgh Steelers makes more money than a federal judge, albeit without the lifetime tenure. And although the Steelers’ player No. 7 did steer the team to a Super Bowl championship back in 2006, Ben Roethlisberger has a disturbing habit of riding a motorcycle without wearing a helmet. How smart is that? Yet the Steelers quarterback gets paid more than the guy who runs Shell Oil Co.? Go figure.

And the man from Shell might have added that he gets paid to manage a company that produces real energy and industrial products that people buy and use, and that he makes a heck of a lot less than most of the senior guys at places like Goldman Sachs or the myriad rich guys who run those Greenwich- or London-based hedge funds. Really, dear readers, how much gasoline or engine lubricant have you ever bought from Goldman Sachs, let alone from those Greenwich and London hedge funds? But I digress.

The Edge of Secure Supply

The public speaking coaches will tell you that it is often good to begin your speech with a story to gain the attention of the audience, and Mr. Hofmeister began his lunchtime talk with one heck of a tale. In the aftermath of hurricanes Katrina and Rita in 2005, almost all of the U.S. Gulf Coast refineries were down due to flooding and other storm damage. Shell had 300,000 barrels of refined product in storage at its Baytown, Texas, refinery, which was essentially the only supply available to the entire Southeast region, but there was no electricity with which to run the pumps. Whoops!

Shell employees and contractors were working feverishly to rig up electric generators at the Texas facility, but it was a race against time, over a 48-hour period, until the Plantation and Colonial pipelines -- the major trunk carriers for refined product between Texas and the Southeastern U.S. -- went dry. If word escaped of the predicament, Shell executives believed that many members of the consuming public would have panicked. Then “panic-buying” would have immediately kicked in and rapidly drained whatever fuel was left in the supply system. The entire U.S. Southeast, home to about 60 million souls, could have been caught in a situation in which there would be no fuel available anywhere. It fell to Shell’s Mr. Hofmeister to call the U.S. Secretary of Energy and deliver the bad news.

But like the cavalry arriving near the end of a John Ford Western, Shell’s hardworking people hooked up the Texas facility with electric power, with all of about 12 hours to spare. Shell started pumping gas into the pipeline system. There were, you may recall, spot shortages of fuel in the U.S. Southeast, but no regional lack of product. Still, as Mr. Hofmeister put it, it was a close call and the U.S. was and remains “on the edge of secure supply.”

Shell’s View of the World

In his comments in Pittsburgh, and in his talks to other groups across the U.S., Mr. Hofmeister has noted that he is “president of a company that creates a product that consumers don’t want to see, touch, taste or smell, even though they buy it by the gallon day after day.” At the same time, he notes, the mission of Shell is to “renew the American industrial energy base in order to grow energy supplies in this country -- which are ample.” Mr. Hofmeister continues: “We are deeply, deeply invested in the hydrocarbon economy and there is no short-term exit from the hydrocarbon economy, unless we want to suspend economic growth and development.”

Mr. Hofmeister, in the course of his tour, has on numerous occasions amplified these comments. His talks identify to listeners a key dilemma of our time, that “we are the beneficiaries of an industrial age, having given way to a post-industrial age, having given way to an information age, in which the world is ever more seeing the role of information and the manipulation of information as part of the business model upon which we will build wealth creation.” But the Shell man has noted, “Sustained growth of the post-industrial information era can only occur predicated upon continued development, and in some cases redevelopment, of the industrial infrastructure which many people think we have moved beyond.”

Redeveloping Industrial Infrastructure

In the course of his talk in Pittsburgh, as in his other speeches in many other cities, Mr. Hofmeister addressed the litany of present and future potential energy resources. He spoke at length, as you might expect, about oil and natural gas.

Considering that the focus of the man from Shell was on explaining the need and urgency of developing and redeveloping energy and energy-related industrial infrastructure, it was odd, certainly to this correspondent, that he did not address the concept of depletion. Most people tend not ever to have heard of depletion, let alone to understand it. In fact, I have met many people who think that oil wells just gush away, forever and ever, world without end, amen. They say things like, “If only those damn oil companies would uncap those wells they have shut in down in Texas, we’d have plenty of oil.” Oh please, dear readers, can you feel my pain? But then you explain to these misguided souls how depletion works. Then, unless they are total idiots or utter ideologues (and believe me, dear readers, there are some total idiots and utter ideologues out there), they understand why it is necessary to go out and drill new wells to replace the ones that have declined. So memo from King to Hofmeister: Discuss depletion, even if there are idiots and ideologues who just won’t get it.

Mr. Hofmeister’s emphasis was on the political fact that about 85% of the U.S. Outer Continental Shelf (OCS) is off-limits to oil and gas exploration, as are large areas of federal- and state-owned lands in the U.S. These areas have significant potential to become productive areas for oil and gas, but the environmental opposition is such that the political will is lacking to lease any blocks and spud any wells. And even if, let’s say tomorrow morning, the political will magically appeared for OCS development, it would take much time and investment for any productive potential to come to fruition. Considering that it takes between 10-15 years to begin to develop an offshore province, the decision to open or not to open up the U.S. OCS will impact the energy destiny of the country in 2020 and afterward. In my view, people in the future will look back and think rather unkind thoughts about us for our current inaction, but that is another subject for another time.

To his credit, Mr. Hofmeister acknowledged that drilling the OCS will not “solve” the U.S. energy dilemma. As an oilman, of course, he painted a favorable scenario for future hydrocarbon production from the OCS. But the guy clearly is smart enough to understand (and honest enough to say) that drilling up the OCS is not the answer to the nation’s energy problems going forward. The take-away point was the geologically correct observation that future oil and gas production from the OCS has to be a part of any overall U.S. energy strategy. It will be, of course. It is just a question of time, and how desperate the U.S. becomes for oil and gas as in the future as imports inevitably decline from other parts of the world. It’s that depletion thing.

Mr. Hofmeister spoke about Shell’s efforts in developing other forms of hydrocarbon fuels, as well. These include the “Alberta oil sands” (even though we all know that the correct description is “tar sands”). He discussed the future of liquefied natural gas (LNG) and the importance for the U.S. of having the facilities in place to import LNG from overseas. He discussed the use of domestic coal, noting that “The word ‘coal’ is usually associated with the word ‘dirty.’” The point was not lost on an audience in Pittsburgh, most of whom above a certain age could tell you a few things about dirty old coal. But Shell is focusing quite a bit of investment on a coal-related concept called integrated gasification coal conversion (IGCC), which allows for much cleaner combustion or conversion of the black rock, with the opportunity to capture and sequester the carbon dioxide byproduct. Shell has 15 IGCC projects ongoing in China. And among the other coal-related processes that the company president mentioned were coal-to-liquid (CTL), with which Shell is also well along in China. I have written at length about these energy resources, including Shell’s methanol projects in China.

Other areas of interest and investment by Shell include Colorado oil shale, in which Shell has pursued a 20-year research project. But any major investment in oil shale is, according to Mr. Hofmeister, “still many years away” for Shell. Mr. Hofmeister did not say it in so many words, but the tone of his voice seemed to emphasize the quantity of “many.” So don’t hold your breath. Oil shale has been the “fuel of the future” for a long time, and still is. And Shell is also investing in technology to upgrade heavy oil, of which there are voluminous amounts in the crust of the Earth. Again, this will be a technological stretch that plays out over many years.

According to Mr. Hofmeister, Shell is a major player in what he calls “second-generation biofuels,” meaning ethanol-derived “from nonfood-based cellulose material.” This includes plant stalks, wood chips, and even municipal waste. Why no enthusiasm for corn-based ethanol? Mr. Hofmeister has, on other occasions, explained it thus:

“I got 48 letters from attorneys general (in 2006) accusing us of price gouging
during the course of the last 12 months. It’s not fun to get accused by
attorneys general in 48 states of price gouging when in fact we’re working very
hard on bringing supplies. So the biofuel, we believe, stretches the gas supply,
but the cellulosic avoids the cost of food going up. What I really don’t want to
see is 48 letters from attorneys general accusing us of raising the price of
food in addition to the price of gasoline because of the extensive use of corn
and sugar.”

Shell is also investing in producing energy from solar films and fuel cells, and the company even produces in excess of 300 megawatts per day of electricity from windmill farms in seven states. So Shell has quite an energy aperture.

Energy Conservation

But simply focusing on future energy supplies is not enough, states Mr. Hofmeister on behalf of Shell. Shell believes in promoting a “culture of conservation”:

“We need a culture of conservation. Conservation does not come from turning the thermostat up a bit in the summer and down a bit in the winter. Conservation comes from the minds and the hearts of our engineers and our designers who can rationalize energy efficiency and who can design vehicles, homes, buildings, and appliances in ways in which energy efficiency is increased on an ever-constant-improvement basis. A culture of conservation drives energy efficiency forward for generations to come. We believe that a culture of conservation has to start with education, as does this whole backdrop of energy efficiency and energy education. Shell supports the notion of working with public policy leaders on a rational framework across the whole spectrum of energy development, but, in addition to that, supports the development of a school-based curriculum to educate our young people for generations to come about how important energy is to our life, to our economy, and to our standard of living,”

So in summary, according to its president, Shell Oil Co. is looking at and investing in production of traditional hydrocarbon sources of energy as well as developing novel means of producing energy supplies from alternate forms of carbon. And Shell is working on innovative energy alternatives, and supports conservation efforts. The company’s top executive is out on the road putting a human face on its corporate vision and interests, and giving good speeches about important topics.

In Part II, We Question the Shell Answer Man

So far, so good. And in Part II of this article, we will take things a few steps further and pose some questions to the Shell Answer Man.

Until we meet again….
Byron W. King

for Whiskey and Gunpowder

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.

While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

Worst Single Debris Event Ever

THE HEADLINE says a lot, so let’s start with that: “China ASAT Test Called Worst Single Debris Event Ever.” This is the lead into an article in the Feb. 12, 2007, issue of the authoritative McGraw-Hill publication Aviation Week & Space Technology. The term “ASAT” refers to the Chinese test of an anti-satellite system.

Wind and Cloud and Orbiting Debris

As you may know, China conducted an ASAT test on Jan. 11 of this year, destroying a weather satellite launched in 1999, designated Feng Yun 1C (FY-1C; Feng Yun translates as “wind and cloud”), then orbiting the Earth at an altitude of 537 miles. The January experiment (or the attack, depending on your perspective) was carried out with a kinetic kill vehicle launched by China’s Second Artillery Regiment using a small Chinese ballistic missile. News of the Chinese ASAT test was first revealed to the public by Aviation Week on Jan. 17.

A U.S. Defense official who reviewed the intelligence about China’s ASAT test said that the launch was detected by the United States in the early evening of Jan. 11, which would have been early morning on Jan. 12 in China. American satellites tracked the launch and trajectory of the medium-range Chinese ballistic missile toward the known orbit of the weather satellite, a sun-synchronous circular orbit inclined 98.6 degrees. U.S. space radars later recorded an expanding debris field. In particular, U.S. Air Force radar reports noted what were called “signs of orbital distress” in the days after Jan. 11. By Jan. 18, the radar data showed debris where the FY-1C spacecraft had been orbiting before.

Dr. Jonathan McDowell, an astronomer at Harvard who is a specialist in tracking space debris, said the FY-1C satellite was a cube measuring 4.6 feet on each side (1.5 meters), and that its solar panels extended about 28 feet (9 meters). He added that although the target satellite was launched in 1999, according to Chinese sources it was due for retirement. Still, the satellite appeared to be “electronically alive,” making it an ideal target. “If it stops working,” said McDowell, “you know you have a successful hit.”

Someone Should Tell the Foreign Ministry

If it stops working, you have a hit? Perhaps someone from the Second Artillery Regiment should tell the Chinese Foreign Ministry. Initially, Liu Jianchao, a spokesman for China’s Foreign Ministry, declined to confirm or deny that China had conducted an ASAT test, let alone destroyed one of its satellites. “So far,” he said on Jan. 20, “I have not been informed about it by relevant authorities. China has always stood for the peaceful uses of outer space and against introducing weapons into outer space.” Yes, of course.

Retired Col. Gen. Leonid Ivashov, the former head of the Russian Defense Ministry's International Military Cooperation Department, was more forthcoming. He stated to Moscow News that the Chinese weapon was “modeled on the Soviet IS-1 missile designed to destroy satellites that was developed in the 1970s.” So we have the Russians to thank for this? Pass the vodka.

In the U.S., some commentators (the usual suspects, of course) downplayed the significance of the test, saying China apparently used “simple technology.” A so-called “national security analyst” named Laura Grego, of the Union of Concerned Scientists in Cambridge, Mass., said, “It’s pretty low-tech. It’s essentially like throwing a rock at someone.”

Throwing a Rock? Not Quite

Throwing a rock, huh? Well, it depends whom you ask. “I think that the Chinese ASAT test is very troubling,” stated U.S. Defense Secretary Robert Gates at a Senate Armed Services Committee hearing. “And perhaps what is as troubling as the technical achievement is how one interprets it as a part of...[the Chinese] strategic outlook, and how they would anticipate using that kind of a capability in the event of a conflict, and the consequences for us of that.” So according to one of the key U.S. Defense officials, who happens to be a former director of Central Intelligence, the Chinese ASAT test is a “technical achievement” with “strategic” impact. Maybe it is not “like throwing a rock” at someone. Maybe it is less like a rock and more like rocket science.

All Quiet -- Lately, That Is

Development of ASAT technology began in the 1950s, in both the U.S. and former Soviet Union, not long after ballistic missiles began to fly. The first technical approach to the ASAT issue was to use air-launched missiles, because the basic technology was better understood. The U.S. began tests of an ASAT system in 1959, but initial results were poor and the first test launch missed its target by over three miles. “Throwing a rock” at someone can be hard work. After further failures, the U.S. ASAT project was halted in 1963.

We do not know a lot about the earliest Soviet efforts, due to the secrecy of that former regime. But not to be outdone by the U.S., the Soviets began to pour significant resources into an ASAT program in 1967 and actually built, tested, and deployed ASAT weapons starting in 1976. The Soviet ASAT system eschewed closing with a kill vehicle to a direct hit against the target, and instead was based on moving an explosive device into the vicinity of the target, and then blasting pellets towards the target satellite in a shotgun-like manner. This kind of ASAT device created a significant debris cloud in orbital space. Several Soviet ASAT tests were performed at relatively low orbits, and these tests created several significant debris clouds.

In response to the Soviet effort of the late 1960s and 1970s, the U.S. revived its own ASAT program in 1977. U.S. Defense contractor Vought developed an ASAT to attack satellites in low Earth orbit (LEO), a three-stage missile carrying a miniature homing vehicle designed to make a direct hit against the target. The Vought missile was designed to be fired from an F-15 Eagle in a steep climb. After one successful test to demonstrate the Vought technology on Sept. 13, 1985, in which an aging U.S. satellite was the target, the U.S. ceased further development efforts and never procured or deployed the system. It took about 17 years for the debris from that one U.S. ASAT test to fall from orbit.

In the 1990s, the U.S. invested funds in research and development of a more advanced ASAT device, incorporating more updated sensor and guidance technology, but never tested it. The U.S. currently has no operational or deployed ASAT devices, although the Air Force retains several prototypes of earlier designs in storage.

U.S. Assessments and Concerns

U.S. intelligence services have been following Chinese space developments in recent years. The U.S. Office of the Secretary of Defense went so far as to issue a report on July 19, 2005, that addressed China’s growing space capability. The report -- The Military Power of the People’s Republic of China 2005 -- claimed that China was developing and intends to field ASAT systems. The report stated:

“China is working on, and plans to field, ASAT systems. Beijing has and will continue to enhance its satellite tracking and identification network -- the first step in establishing a credible ASAT capability. China can currently destroy or disable satellites only by launching a ballistic missile or space-launch vehicle armed with a nuclear weapon. However, there are many risks associated with this method, and consequences from use of nuclear weapons.”

The 2005 U.S. report did not predict that the Chinese were developing, or could field, a working version of a kinetic kill device. But in a section of the report concerning what it labeled as China’s “Space and Counterspace” activities, the official U.S. document noted that Beijing has been building infrastructure for space-based command, control, communications, computers, intelligence, surveillance, and reconnaissance (C4ISR) and targeting capabilities. The report stated:

“Building a modern ISR [intelligence, surveillance, and reconnaissance] architecture is likely one of the primary drivers behind Beijing’s space endeavors and a critical component of its overall C4ISR modernization efforts.”

One critic named Jeffrey Lewis, a research fellow at the Center for International and Security Studies at the University of Maryland’s School of Public Policy, was skeptical of the Pentagon’s assertions. At the time, Lewis told the Web site SPACE.com that “Although the 2005 edition does flatly state -- as have previous reports -- that China intends to field ASAT systems, the 2005 edition omits most of the evidence cited in previous reports, including discredited claims about the development of a parasite microsatellite and a ground-based direct ascent ASAT that was supposed to be fielded as early as this year.” Lewis added that, although the U.S. Department of Defense was asserting that China intends to deploy ASATs, “It’s pretty clear they don’t have any evidence to back that up.” Until now, of course. The Chinese have cleared up any confusion, and actually conducted a successful ASAT test complete with hard kill. So much for “discredited claims.”

Chinese Research and Development

While the U.S. assessment may not have included detailed or classified intelligence information, there is a large amount of Chinese research in the field of space control made public every year. Among the titles of significant Chinese publications are the Journal of Astronautics, Aerospace Control, and Modern Defense Technology. All of these learned journals have published original Chinese research in the past two years on kinetic kill vehicles -- for example, an article entitled “Modeling and Simulation of Guidance and Control of Kinetic Kill Vehicle in Terminal Process of Interception” by Gao Da-Yuan et al. in Journal of Astronautics (Yuhang Xuebao) Vol. 26, No. 4 (2005), Pgs. 420-424. Perhaps someone should send a copy to the University of Maryland School of Public Policy.

And according to unclassified U.S. Air Force information, the Chinese apparently conducted three previous intercept missions against the FY-1C satellite, on Oct. 26, 2005, and on April 20 and Nov. 30, 2006. These shots “missed” the target, but that does not mean that they were not experimental or technical successes. It may have been that the Chinese were testing other elements of their ASAT system, such as the launch vehicle, the guidance system, the closing and targeting subsystems, and the general command and control process. Finally, on the fourth shot on Jan. 11, 2007, the Chinese hit the satellite at which they were aiming.

Implications

The U.S. military is especially dependent on satellites for navigation, communications and missile guidance. The U.S. economy, and most other modern economies that rely on space-based communication pathways, could also be broadly damaged by disruptions of communications, weather, and other satellites.

China’s test of an ASAT weapon against its own satellite has increased the quantity of debris able to be tracked by more than 900 objects, or an immediate 10% increase in a figure that has otherwise accumulated in orbit over the past 50 years. This debris is a threat to essentially every spacecraft that orbits below about 1,243 miles.

China’s FY-1C satellite, orbiting at an altitude of 534 miles, shattered, along with the ASAT device, into thousands of pieces large and small, some of which were dispersed into a wide range of orbits ranging in altitude from 2,361 miles on the high end down to about 124 miles at the lowest, according to Nicholas Johnson, NASA's chief scientist for orbital debris and a longtime expert in the field. “This is by far the worst satellite fragmentation in the history of the space age, in the past 50 years,” he stated.

As of mid-February, the U.S. Space Surveillance Network (SSN) in Colorado Springs had cataloged 647 of the more than 900 items its sensors were tracking. On average, these kinds of objects must be at least 3.9 inches in diameter to be tracked from the ground, although smaller objects can be pinpointed using two radars located at the Haystack Observatory in Tyngsboro, Mass., operated by MIT’s Lincoln Laboratory.

NASA’s Mr. Johnson says that the debris models predict an eventual cloud of some 35,000 objects larger than 1 centimeter remaining in orbit. “Many of these debris will be in orbit for 100 years or more because the altitude of the breakup was so high,” he said. “Some will come down earlier, but the majority will be up there for a very long time.”

Space Control and Power Projection

Chinese spokespersons are fond of denying that China has, or can develop, imperial ambitions. The foundation of this argument is that China was an oppressed nation for almost two centuries, and its recent increase in economic and military power is simply a defensive reaction. China, goes the argument, is simply advancing from its past position of weakness, no matter what it does. Yet China, in its effort to demonstrate a capability that the U.S. and former USSR have not tested in over two decades, has fouled the nest of orbital space in a way that could just plain screw it up for everyone.

Michael Krepon, president emeritus of the Henry L. Stimson Center, a Washington, D.C.-based nonprofit organization involved with security issues, called the Chinese ASAT test a response to U.S. space policies. “The Chinese are telling the Pentagon that they don’t own space,” he said. “We can play this game, too,” is the Chinese message, “and we can play it dirtier than you.” Well, that is sure something of which to be proud.

Still, and contrary to the dismissive, if not cavalier, attitudes expressed in some quarters, China’s successful test of an ASAT weapon means that the Middle Kingdom has mastered critical space sensor, tracking, launch, guidance, and other technologies important for advanced military space operations. The implications range from the tactical and operational to the strategic and geostrategic. Based on its demonstrated technical ability, China is now in a position to use “space control” as a foreign and military policy weapon. This will greatly assist China in projecting its growing power, both regionally and globally.

Until we meet again…
Byron W. King

for Whiskey and Gunpowder

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.

While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

Congressman Ron Paul takes on Bernanke

Is Saudi Oil past its peak? Are Saudis really on our side? Are we?

by Stephen Leeb

***** Steady as she goes on the market.

***** Geopolitics is getting funnier all the time … except the joke may be on us.

***** Is Saudi Oil past its peak? Are Saudis really on our side? Are we?

***** More buying opportunities.

***** Alternative energies – even the wrong ones may soon be right.

-------------------------------------


As you may have guessed from last week’s 1-1.5% gain in the overall markets, nothing has altered our generally bullish stance. Our indicators remain so positive we practically need a microscope to find any flaw in the short-term picture, at least from a technical perspective.

Small cap stocks remain in the lead. Specialist shorting remains historically low. Virtually every average has confirmed all-time highs. It’s as though Santa Claus has overstayed his visit by an extra two months just to give investors more presents.

Even oil prices, if we look at the 4-week moving average, are below where they were last year at this time, which is a powerful bullish intermediate-term indicator.

If you’re as used to looking for problems as we are, you’re probably feeling equally frustrated. But so what? We’re making money, and that’s what counts.

Meanwhile, back in the desert …

THE IRONY OF GEOPOLITICS

I was having dinner the other night with some extremely intelligent friends when one of them made a suggestion worth quoting. He said, “Maybe the low price of oil means the world is doing a lot better than we think. After all, if things were really that bad, especially in the Middle East, oil prices would be a lot higher and the market would not be rising.”

It didn’t make sense to him that stocks would be rising and oil prices tame if the world, and especially Iraq and other ME nations, were in such dire straits as the newspaper headlines suggest. I hope he’s right, but I found it difficult to agree. Since my friend is a doctor, here’s how I explained it to him …

Let’s say oil prices are like a thermometer. Just as the temperature shown on a thermometer can indicate a patient’s health, so oil prices both reflect and affect the degree of the world’s geopolitical tensions. The more endangered the world seems, the higher oil prices climb. And the higher oil prices climb, the more investors become afraid.

The trouble is, as every doctor knows, temperature isn’t everything. A patient can have any number of life-threatening illnesses underway that will not be revealed by a thermometer. (It’s also true that some patients will run a thermometer under cold water in order to fool the doctor, but let’s not speculate in that direction for the moment.)

As we’ve mentioned before, the current bull market began last year just as oil prices began to retreat. Trading around $60, oil prices still suggest that geopolitical tensions are under control. However, we must consider the possibility that there could still be threats which are not apparent and have yet to send oil prices skyward, but may do so in the near future.

For example, although we’re not political scientists, when we look at Iraq we can’t help wondering what is going on. Every day it seems, we read reports of Shiites being killed by explosives in Iraq.

Shiites make up the majority in Iraq, while the minority Sunnis are the group that formerly held the most sway in government when Saddam Hussein was in power. However, in the Middle East as a whole Shiites are the minority, except in one important location – Iran. At the risk of oversimplifying the situation, it seems unlikely to us that Shiites would be conducting a campaign of terror against their own people. So we doubt that Iran is financing or otherwise encouraging the killing of Shiites. More likely, it is Sunni groups who are detonating most of these bombs.

So who could be financing these Sunni bombers? If it’s the old guard from Saddam’s government, we’d have to ask ourselves why. With the recent executions, there’s no chance the former regime is returning ever again.

Iran has recently accused both Pakistan and the U.S. of helping Sunni bombers in Iran. Unfortunately, we think the most likely candidate to support such acts is actually Saudi Arabia. That’s the wealthiest Sunni government in the region, and one which has gone on record saying they will protect their Sunni brothers in Iraq. The effect of this campaign is to put American soldiers in the role of fighting Saudi Arabians in order to protect Iranians and their allies – even though Saudi Arabia is our ally and Iran is part of the “Axis of Evil.”

One thing is true about geopolitics … it has a warped sense of humor. How this all will end, we have no idea. We know that Saudi Arabians are of mixed opinion regarding Americans. Some love us; some hate us. The House of Saud that rules the nation is in the “love us” camp, but how long it will stay in power, we cannot say.

We hope there is no hidden anti-American, anti-Shiite virus in Saudi Arabia that will bring further chaos to that part of the world. Because if such a problem were to burst into full view, it would mean the end of moderate oil prices, and the bull market to boot. But apart from the geopolitical considerations, there’s another factor to consider …

PEAKED OIL?

We have a hard time believing supply/demand factors will favor moderate oil prices for much longer. The argument that Saudi oil production reached its peak sometime around 2005/2006 seems increasingly persuasive. At least, production in 2006 was less than in 2005, despite considerably higher prices.

The world’s increasing demand for oil suggests that OPEC may have a very difficult time matching that demand with higher supply.

Although oil prices may remain calm, at least until refiners begin building gasoline supplies for the summer driving season, we think they could easily begin a new uptrend.

The reason we’re going into such detail regarding oil in today’s update is that oil stocks, especially oil service stocks, have been under pressure lately. This can only be a sign of great complacency by investors who cannot conceive of an oil shortfall occurring.

What we have today are investors who are intent on ignoring the real underlying problems in energy. They are like the incompetent doctor who mistakes a normal temperature for good health, while ignoring the patient’s screamingly high cholesterol levels. The day our patient experiences a heart attack, it may be too late for the doctor to do anything.

OUR CHOICE OF ALTERNATIVES

While we’re on the subject of energy … let us draw your attention to a recent article on alternative energy that appeared in Science. The article gives much good information on solar energy, which everyone agrees is not cost effective, except for powering individual houses, particularly in remote areas. Solar energy is unlikely to drive the wheels of industry anytime soon. Wind energy was not well covered in the article, which was unfortunate since wind is economically viable.

We continue to believe that biofuels are a non-starter, so long as they are made from expensive commodities such as corn. With corn headed for $5 a bushel, oil prices would have to truly skyrocket for ethanol to be a cheaper option. Biofuels made from otherwise unusable plant materials might work, but so far that policy has yet to be initiated.

Until we see real efforts being made to develop viable alternative energy supplies, we’re going to stay bullish on oil and oil service stocks. We’re also bullish on alternative energy, even solar, and even though they depend on subsidies to generate profits. The political wind is blowing in their direction, and we expect those subsidies to persist and grow. And even if they don’t, higher oil prices will eventually make them very profitable.

Until next week,

Stephen Leeb, Ph.D
Editor

The Complete Investor

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Bubbles Brewing in Shanghai, Tokyo, and London

by Gary Dorsch

"There is a bubble growing. Investors should be concerned about the risks," said Cheng Siwei, vice-chairman of China's National People's Congress in a January 31st interview with the Financial Times. "But in a bull market, people will invest relatively irrationally. Every investor thinks they can win. But many will end up losing. But that is their risk and their choice," Cheng warned.

In what might develop into the third biggest stock market bubble in history, ranked alongside Japan's Nikkei-225 of 1986-89, and the Nasdaq's 1999-2000 bull run, the Shanghai Composite "A" share Index, restricted mainly to Chinese nationals, has posted a 140% gain over the past 12-months, after soaring 46% in the fourth-quarter of 2006 alone. And without deliberate market intervention, the A-share market could inflate into a Nasdaq-like bubble.

How Beijing decides to deal with the Shanghai bubble, can have a great impact on the outlook for the Chinese economy, global commodity markets, and exporters in the region from Australia, Hong Kong, Japan, and Korea. Will Beijing try to prick the bubble and set-off a steep correction, or carefully calibrate a series of tightening measures to take some steam out of the market and simply flatten it out?

Sometimes, markets can boomerang on central banks and torpedo the most carefully designed strategies. Therefore, jawboning is usually the first act of official intervention in the market place, because it's cost free and doesn't change underlying market conditions. Siwei's remarks did trigger a 15% pullback from January's peak, as traders locked in profits from sky-high valuations, figuring that official warnings might turn into concrete steps to cool down the market.

Then on Feb 9th, the People's Bank of China (PBoC) tried to keep the market off balance, by warning that it would use a number of tools to keep flush liquidity conditions in check. "The central bank would use a combination of open market operations and higher required reserves for banks in an effort to stave off a credit-fuelled investment boom, and will make the yuan more flexible," it said.

The Shanghai "A" share index fell 2.5% to an intra-day low of 2,541, within minutes of the PBoC's threats, but then put in a reversal bottom, and closed 2.3% higher on the day. One week later, on February 15th, the "A" share index jumped more than 3% to an all-time closing high of 2,993. A total of 828 stocks rose while only 31 fell, and over 40 stocks in Shanghai rose by their 10% daily limits.

On the smaller Shenzhen market, three new IPO's soared into orbit, suggesting that the Chinese stampede into stocks hasn't run its course. Non-ferrous metals maker Yunnan Luoping Zinc soared to 30.94 yuan, triple its IPO price of 10.08 yuan. Zhejiang Sunwave Communications jumped to 19.65 yuan, double its IPO price of 9.15 yuan. And China Haisun Engineering 002116.SZ surged 178% to 19.16 yuan.

The PBoC put its verbal threats into action on February 16th, when it lifted bank reserve ratios by half-percent to 10%, coming only six weeks after the last hike, and at faster pace of tightening than expected. The hike in bank reserve ratios should drain about 160 billion yuan ($20.7 billion) from the Chinese money markets, and is less expensive to Beijing's budget, that issuing T-bills or raising interest rates.

The reserve ratio hike, the fifth of its kind since last July, was made to deal with "dynamic currency liquidity changes and to consolidate macro-economic controls," said the PBoC in its latest statement. "Imbalanced international payment generated by mounting trade surplus resulted increasing currency liquidity and made another reserve ratio hike necessary," it added.

Shanghai Red-chip Rally fueled by Explosive Money Supply

The PBoC prints yuan in exchange for foreign currency flowing into the country, and until Beijing abandons its crawling peg of the dollar-yuan exchange rate, the M2 money supply growth rate will remain very high. Hot money will continue to flow in Shanghai stocks, feeding the bubble frenzy. The fifth hike in bank reserve ratios since June has only slowed the annual growth rate of China's M2 money supply from an explosive 19.1% to a robust 15.9% rate last month.

So far, the PBoC's open market operations to drain liquidity have only put a floor under Shanghai money market yields rather than pushing them up. The PBoC plays a clever shell game, but is still pegging its 7-day repo rate in a range of 1.50% to 2%, which encourages speculation in stocks. The PBoC bought about $250 billion a year in 2005 and 2006, but only about 75% of such intervention was sterilized.

Until the PBoC lifts interest rates high enough to discourage borrowing, it won't be able to contain the robust growth of the money supply. Official data revealed that yuan-denominated loans jumped 567.6 billion yuan ($74.7 billion) in January, twice as much as last year's monthly average, to 23.1 trillion yuan, up 16% from a year ago. Chinese banks arranged 3.18 trillion yuan in new loans in all of 2006, exceeding the central bank's original target of 2.5 trillion yuan.

Therefore, an interest rate hike seems inevitable, as reserve ratio adjustments and open market operations have failed in curbing liquidity and lending. China's 7-day repo rate has erupted to above 4% on two brief occasions in the past 3-months, linked to strong loan demand for stock market IPO's, but it mostly trades below 2%, due to large to inflows of money from foreign investment and exports.

Is the Shanghai stock market in a Bubble?

It's popular to call a market that triples in value within less than two years, a bubble, but seen from a different angle, the spectacular resurrection of Shanghai "A" share index might have corrected a grossly undervalued position, into closer alignment with the global benchmark MSCI All-World Index, which closed at all-time highs of 1500 last week, up 100% from its low in March 2003.

From 2001 thru 2005, China's economy and the Shanghai "A" share market spent much of time moving in opposite directions. China was emerging as the world's leading manufacturing power, its economy was growing at an frantic 9.5% pace, and exports were tripling, yet the Shanghai A share index, lost half of its value, sliding from a high of 2200 to below 1000 on June 6, 2005.

Daily turnover in Shanghai declined to an average of 8 billion yuan (US$1 billion) at the end of 2005, down more than 25% from the previous year. The overhang of massive blocks of government-owned shares in the listed State-owned enterprises was responsible for much of the decline. Known as "non-tradable shares" (NTS), these share accounted for two-thirds of the $400 billion market value of the companies listed on the Shanghai and Shenzhen stock exchanges.

The threat that Beijing would one day flood the market with NTS shares helped send the mainland share indexes to six-year lows in 2005, although the Chinese economy and exports were booming and other Asian and global markets were posting big gains. On June 6, 2005 the Shanghai stock index dropped to 998.23 points. Two days later, however, the Shanghai and Shenzhen stock exchanges jumped by more than 8 percent. The Shanghai A share index closed at 1,115.58 points.

Beijing announced a new policy to reform the split structure of mainland shares, which took into consideration the rights of holders of exchange traded shares, who bear the risk of decline in share prices when state owned shares are dumped on the market. Compensation is now paid to holders of floating shares when NTS shares are put on the market, and determined at an extraordinary shareholders' meeting, and are subject to prior approval by at least two-thirds of holders of floating shares.

Compensation to floating shareholders was paid with bonus share and supplemented with cash. By July 2006, more than 1,000 listed firms, or 80% of all listed companies had adopted resolutions for the reform of nonnegotiable shares. The ongoing reforms will mean the end of the split share structure, which crippled China's stock markets in recent years, and eventually replaced with one class of shares.

Thus, the black cloud hanging over the Shanghai and Shenzen markets was gradually removed in 2006, and share values were unleashed from artificially low levels, and quickly caught up with other inflated world markets. Gradual yuan appreciation is attracting foreigners to Chinese stocks and encouraging local investors to keep money onshore.

But what disturbs Chinese government officials are signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised a record 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. January turnover was five times early 2006 levels. Beijing is now ordering banks to prevent retail borrowing for stock investments.

China's stock markets are dominated by retail investors, who hold 60% of the total trading shares. By comparison, in Hong Kong, which lists a number of mainland Chinese companies, institutional investors account for 70% of daily transactions.

The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. The high P/E ratio is supported by expectations of 25% earnings growth for 2006 and 2007, from the possible new tax policy and new accounting standards starting from 2007. However, if 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin.

Might Beijing tighten its grip on monetary policy too far in an effort to contain high-flying Shanghai red-chips, even at the risk of triggering a deeper slowdown in the Chinese economy? If history is any guide to the future, the PBoC could control its economy, with a series of small rises instead of infrequent, bigger changes. China should also continue with a gradualist approach to yuan appreciation, and let the currency strengthen by about 5% a year. But would that be fast enough to fend off a protectionist bent US Congress?

Déjà vu in Tokyo, a Stock market Bubble Emerges from Cheap Yen

Is it possible for central banks to devalue their economies to prosperity? Tokyo's financial warlords have the tonic for whatever ails the Japanese economy - a cheap yen. The Japanese yen's real trade-weighted value hit a 21-year low in January energizing its export-driven economy by making Japanese goods cheaper than European and Korean goods, and propelling its exports to a record high in 2006.

Tokyo has pursued a weak yen policy for the past few years by pressuring the Bank of Japan to keep its overnight interest rate near zero percent, and forcing the central bank to monetize about half of its budget deficit. The BoJ buys 1.2 trillion yen of government bonds each month, which if maintained in fiscal 2007, would equal 56% of the projected government budget deficit of 25.5 trillion yen.

Super low interest rates have weakened the yen and helped to boost the local stock indexes. Tokyo's broad equity market, the Topix, touched a 15-year high and the Nikkei-225 is near its highest since May 2000. The two indexes have risen more than 6% and 4% year-to-date, outperforming a number of emerging markets, putting them on a par with high-flying European stock markets.

Foreign investors have pumped 9.1 trillion yen ($76.2 billion) into Japanese stocks and equities over the past three months, and received a timely batch of good news from Tokyo apparatchniks on Feb 16th. Japan's economy grew at a 4.8% annualized clip in the last three months of 2006, the strongest pace in 3-years, and far exceeding July-September's anemic 0.3% annualized growth. Private-sector demand showed a 1.1% gain, rebounding from Q'3 when it dipped 1.1 percent.

It's a big stretch of the imagination to believe that Japan's economy has suddenly vaulted into first place from last place, to become the locomotive for the G-7 industrial nations. But after-all, these are the same government apparatchniks that re-jigged Japan's consumer price index in August, shaving two-thirds off the inflation statistics, to handcuff the BoJ from any further rate hikes since July.

Tokyo boosted its stock market gauges thru manipulation of economic data and abnormally low interest rates that weakened the yen to 21-year lows on a trade weighted basis. But now, Tokyo's schemes are running into opposition from its top trading partners, who are crying foul play, and demand the BoJ lift its interest rates to levels that reflect its $4.7 trillion economy, the world's second largest.

Since the BoJ dropped its overnight loan rate to zero percent in March 2001, the Euro has advanced from around 105-yen to as high as 158.70-yen today. Aided by the Euro's strength against the yen, Japanese exports to the European Union nearly doubled to 1.06-trillion yen in December. But on the flip side, European exports to Japan have waffled between stagnation and deterioration.

Last year, Japan racked up a 18.6 trillion yen ($160 billion) current account surplus, while the Euro zone suffered a 16.8 billion Euro $21.5 billion) deficit. Yet the power of the "yen carry" trade was able to swim against the tide of these trade imbalances, by pushing the Euro 12% higher against the yen last year.

While Japan is a small market for European exporters, Euro zone finance ministers understand that its exporters will suffer in world markets because of cheap competition from Japan in addition to cut-throat competition from China. With the European Central Bank poised to lift its repo rate a quarter-point to 4.00% in the months ahead, the Euro is bound to go higher against the yen, without similar baby-step rate hikes by the BoJ, thus worsening the bi-lateral trade imbalance.

European Central Bank chief Jean "Tricky" Trichet expressed his frustration with Tokyo warlords and their cheap yen scheme on Feb 15th. "I will read again what we just said in Essen, we reaffirm that exchange rates should reflect economic fundamentals. We believe that the Japanese economy is on a sustainable economic path and that exchange rates should reflect these economic fundamentals," Trichet said after Japan released its stellar GDP report.

Central bankers and finance ministers from the Group of Seven industrial powers, that account for 65% of global GDP, warned currency traders on February 10th, that they could get burned by betting in one direction against the yen, with Japan's economy was steaming ahead at a 4.8% clip. "One-way bets in the present circumstances would not be, it seems to us, appropriate. We want the markets to be aware of the risks they contain," ECB chief "Tricky" Trichet warned.

A week earlier, Chicago futures speculators had built-up record short positions against the yen for a third straight week to 173,005 contracts from 164,860 contracts in the prior week, the CFTC said. The large short position left Chicago speculators vulnerable to a minor shake-out from G-7 jawboning. The dollar tumbled 2% to 119-yen, before rebounding to 120.85-yen a few days later. Jawboning ran its course, but the fundamentals of the carry trade haven't changed.

Bank of Japan hikes loan rate to 0.50%, "Too Little, Too Late"

With the yen's trade weighted value against a basket of foreign currencies sinking to a 21-year low, and Tokyo gold climbing to a 21-year high, the Bank of Japan was backed into a corner, and voted 8-1 to hike its overnight loan rate a quarter-point to 0.50%, its highest level in a decade. But the Euro remains resilient, rebounding from a low of 156.25-yen, before climbing to 158.70-yen after the BoJ rate hike.

Japan's interest rates are still be far below the 5.25% fed funds rate in the United States, and next month, the ECB is expected to hike its repo rate to 3.75% while the Bank of England could boost its base rate 5.50%, keeping the yen weak. By dumping the yen after the BoJ rate hike to 0.50%, traders ruled that the central bank's action was "too little, too late" to reverse its long term trend. The BoJ must face a thicket of political wrangling with Tokyo warlords, before it can raise rates again.

Tokyo gold traders track the Euro's performance against the yen for direction, and are not duped by Tokyo's phony claim that consumer prices are only 0.1% higher from a year ago. As long as Tokyo pursues a cheap yen policy, Tokyo gold stays on an uptrend. Would the BoJ continue to hike its interest rates to combat the gold bugs and prevent a bubble from emerging in the Topix index?

"We will continue to adjust interest rate levels slowly," said BoJ chief Toshihiko Fukui on Feb 21st. "If Japan were to achieve real economic growth of around 2%, even amid very low inflation, a policy rate level of 0.50% is, relatively very low. If expectations build up that very low rates will continue for a long time regardless of economic conditions, banks and companies could create excessively tilted positions in the stock, JGB or foreign exchange market," he said.

Meanwhile, Japan's interest rates remain abnormally low and far out of alignment with the rest of the world, and the "yen carry" trade lives on. An estimated $330 billion is invested the yen carry trade worldwide. What can weaken the Euro against the yen, if Tokyo warlords won't allow the BoJ to lift interest rates to normal levels?

"We believe that a weak yen is a reflection of Japanese government policy," said Rep's Charles Rangel, Barney Franks, John Dingell and Sander Levin. "We urge the Japanese government to reverse their weak yen policy through concrete action. Japan should be selling the massive reserves it has accumulated, thereby changing the imbalances with the dollar and the Euro."

Tokyo could quietly sell some of its $874 billion of foreign exchange reserves, mostly held in US dollars and Euros, on the open market to put a lid on the "yen carry" trade. By selling dollars for yen, Tokyo could use the proceeds to pay down some of the 35-trillion yen in short-term debt it acquired in 2003-04, when it intervened on a grand scale, to support the dollar between 104 and 110-yen.

The Bank of England Confesses its Sins

It was the monetary equivalent of "shock and awe". The Bank of England (BoE) delivered a nasty New Year surprise on January 11th, its third quarter-point rise in interest rates in six months. Bank governor Mervyn King and his colleagues had been expected to push up rates in February, but by ambushing the markets with a January move to 5.25%, they may have hoped to make more of an impact.

"The margin of spare capacity in the economy appears limited. It is likely that inflation will rise further above the target in the near term. The risks to inflation now appear more to the upside," the BoE explained. But London's FTSE-100 all but shrugged off the rate hike. It suffered a 30-point fall to as low as 6,140 just after the announcement, but then closed the day 70 points higher. After stabilizing above the 6,200 level, the Footsie-100 tacked on another 5% gain to 6,450 last week.

It wasn't so long ago that even a hint of an interest rate hike sent traders scurrying for the hills. So clearly, like everything else, the markets are putting a positive spin on what would normally have been a nasty surprise. The fact is that interest rates have been too low for too long, and few traders take the BoE seriously. But bringing the UK economy back into balance will unfortunately require a lot more discomfort than the slap delivered by Mervyn King and his chums last month.

For the past four years, the BoE pursued the most radical monetary policy among the Group of Seven central banks, pumping up its money supply to inflate British home prices and the local stock markets. UK home prices rose 10.5% last year, according to Nationwide, a UK home-loan provider, while the UK's Footsie-100 index climbed above the 6400-level last week, to its highest in six years.

But after the UK's M4 money supply expanded by 0.9% in January to stand 13% higher from a year earlier, the Bank of England issued an unusual confession of its past sins. "Investors are likely to take advantage of this ample liquidity and the associated easy credit to purchase other assets, driving risk premiums down and asset prices up," the BoE told parliament's Treasury Committee on Feb 20th.

"In due course, those higher asset prices may be expected to feed through into higher demand for goods and prices, putting upward pressure on the general price level," the BoE concluded. Still, there are plenty of signs of complacency in the Footsie-100 Index, with Sterling Libor futures for June delivery yielding 5.75%, and discounting the possibility of two more BoE rate hikes in the months ahead.

Years of monetary abuse by the BoE are finally coming home to roost. In order to get a handle on the explosive M4 money supply, the BoE would probably have to hike its base rate by at least 75 basis points to 6%, far above the 5.25% US fed funds rate, and the BoJ's 0.50% rate, which could put more upward pressure on the British pound against the Japanese yen and US dollar.

But a stronger British pound could widen the UK's trade deficit with the rest of the world, after it notched its largest annual trade gap on record last year. Britain's goods trade gap grew to 7.1 billion pounds in December,cementing to the largest annual trade deficit in 40-years, with the total trade gap of 55.8 billion pounds in 2006 from 44.6 billion in 2005. The goods balance registered a record deficit of 84.3 billion pounds last year, from 68.8 billion in 2005.

The massive deterioration in the UK trade balance has been accompanied by the British pound's rise to 235-yen, it's highest in 14-years. British manufacturers will find it hard to compete with their Japanese competitors, who enjoy a cheap yen, and super low interest rates at home. Yet if the BoE aims to tackle the explosive M4 money supply by lifting its base rate, without similar rate hikes by the Bank of Japan, it could wreck further damage on Britain's export sector.

How far would the BoE go to contain its money supply and prevent the emergence of asset bubbles? "British interest rates will probably need to rise one more time to keep inflation on track to hit its 2% target," the Bank of England signaled on Feb 14th. Yet one week later, the BoE ratcheted up its hawkish rhetoric by focusing on the explosive growth of M4. Lately, BoE chief King has shown a penchant for the big surprise, outflanking his counterpart Jean "Tricky" Trichet, so stay tuned.

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Accounting Reflects Housing Market Reality

by Dan Amoss

"Subprime" mortgage lending is a disaster unfolding before the eyes of financial market participants. Subprime refers to the practice of providing home mortgages to those with spotty credit histories in return for a few extra basis points of interest.

The Mortgage Lender Implode-O-Meter Web site has gained a wide following as an online obituary for the most aggressive, irresponsible lenders. This site, maintained by concerned citizen Aaron Krowne, has only been up shortly. Yet the site's headline flashes the statement "21 lenders have now gone kaput" since about December 2006. Krowne really cuts to the chase in his description of the unfolding disaster:

"It appears what had to give is now finally giving: the latest subprime loans are going delinquent the quickest, and it seems likely that their prior kin will soon follow (and many of these will likely end up in foreclosure). Further, I expect a large swathe of prime loans to go bad (the prime/subprime distinction is quite fuzzy anyway). Originators cannot handle the buybacks, and so when challenged by them are immediately folding [emphasis added]. The phenomenon is just getting started. What will the banking industry -- often all or part owners in these enterprises -- do? Stay tuned."

Lending in the NEW Century

Most of these companies concentrate on the "origination" side of the lending business, because it's considered the sweet spot. You simply approve your customer's credit application, perhaps buy some sort of "credit enhancement," and sell the mortgage to Wall Street, where it will be bundled together with similar mortgages and sold to some poor sap managing a bond portfolio at an insurance company.

One subprime lender in particular, New Century Financial, has been caught with its pants down and now faces financial restatements, shareholder lawsuits, and an uncertain future.

New Century is a "canary in the coal mine" for the entire mortgage industry. Its recent struggles should not be ignored as company-specific. NEW stock is a good gauge of the credit market's willingness to fund high-risk mortgages:

The availability of subprime credit is drying up as fast as this stock is falling. So what does Implode-O-Meter Web master Aaron Krowne mean when he says, "Originators cannot handle the buybacks?" New Century provides an example. The latest (300-page) 10-K explains:

"We sell whole loans on a nonrecourse basis pursuant to a purchase agreement in which we give customary representations and warranties regarding the loan characteristics and the origination process. We may be required to repurchase or substitute loans in the event of a breach of these representations and warranties. In addition, we generally commit to repurchase or substitute a loan if a payment default occurs within the first month or two following the date the loan is funded, unless we make other arrangements with the purchaser. The majority of our whole loan sales are sold on a servicing-released basis."

Last week, New Century announced that it hasn't been accounting properly for what it calls "early payment defaults." Scores of borrowers are defaulting before the ink on their mortgages even dries. So now New Century is responsible for repurchasing untold numbers of loans backed by homes that are not only illiquid, but probably worth less than the mortgage's face value.

To make matters worse, New Century is facing a liquidity crisis by violating several covenants on its own lines of credit. Creditworthiness is a rather important characteristic for lenders to maintain. The laundry list of Wall Street firms providing these lines probably agrees (we'd hope) and are likely to balk at extending credit at the time New Century needs it the most.

In a final toss of cold water on the widely anticipated housing recovery, New Century management says that these "early payment defaults" had not bottomed, and had in fact reaccelerated in the fourth quarter of 2006.

Many aggressive mortgages are turning sour so fast that, hopefully, regulators and accounting authorities will crack down on the aggressive accounting tactics that have inflated New Century's earnings figures.

Other suspected earnings inflators are Countrywide Financial, Downey Financial, and FirstFed Financial. Negative amortization mortgages have been popular among these institutions' customers because they feature advertisements like "Get a $500,000 mortgage for $250 per month." But the fine print describes how the difference between this payment and a realistic payment is added to principal -- hence "negative" amortization. The principal grows over its life, rather than contracting like a conventional mortgage.

These three players have been booking their customers' payment procrastination as real earnings. Since this behavior is a good indicator of future default, how should such loans be recorded on their balance sheets? They may be "performing" now, but a big chunk of them will stop performing in the near future. The housing market is fresh out of greater fools to bail out overleveraged speculators. At such time, most of the earnings that have been booked from these toxic mortgages will be erased.

Nobody seems to have a clue what the real earnings are in this business, since executives have plenty of leeway to play around with "lost reserves" accounting, making earnings what they want.

HSBC: Oops! Our Accounting Doesn't Reflect Reality

On the same day as New Century's announcement, mortgage giant HSBC Holdings announced a major increase in loan loss reserves, which will directly hit earnings. HSBC's press release explains:

"The impact of slowing house price growth is being reflected in accelerated delinquency trends across the U.S. subprime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options. Slower prepayment speeds are also highlighting the likely impact on delinquency of higher contractual payment obligations as adjustable-rate mortgages reset over the next few years from their original lower rates.

"We have reviewed critically the impact of these factors in determining the appropriate level of provisioning at Dec. 31, 2006, against the Mortgage Services loan book. We have taken account of the most recent trends in delinquency and loss severity and projected the probable effects of resetting interest rates on adjustable-rate mortgages, in particular in respect of second-lien mortgages. It is clear that the level of loan impairment provisions to be accounted for as at the end of 2006 in respect of Mortgage Services operations will be higher than is reflected in current market estimates.

"We now expect that the impact of increased provisioning in this area will be the major factor in bringing the aggregate of loan impairment charges and other credit risk provisions to be reflected in the accounts of the Group for the year ended Dec. 31, 2006, above consensus estimates by some 20%." [Emphasis added.]

HSBC and New Century executives are sending very clear messages about future mortgage default risk, so why are two key purchasers of default risk choosing to merge? And why doesn't their accounting reflect worsening real-world conditions?

MGIC and Radian Increasing Exposure to Defaults

On Tuesday of last week, mortgage insurer MGIC Investment Corp. (MTG) announced that it will be merging with rival Radian Group Inc.. Radian shareholders will receive 0.9658 shares of MGIC in the formation of the new "MGIC Radian." MGIC was the subject of my last Whiskey & Gunpowder article, "Holding the Housing Market Bag, Part II." Wall Street seems to love the deal, sending the stock up sharply:

But the market is "missing the forest for the trees" by celebrating the cost savings of this deal. The "forest" is the risk in the existing book of business and the "trees" are the operational cost savings (i.e., redundant worker layoffs).

On the conference call the day of the announcement, both management teams extolled these cost savings and that popular M&A buzzword "synergies." But I expect that they will regret being distracted by a complex integration when they should have battened down the hatches in preparation for this year's mortgage defaults. So I found it interesting that Radian CEO S.A. Ibrahim, who will become MGIC Radian's CEO in a few years, can't wait to lead the charge into even more exotic credit insurance markets:

"We have an opportunity in the traditional MI [mortgage insurance] area, as well as in offering new kinds of credit enhancement solutions, because the market can no longer really be defined as traditional MI alone. Really, the market for credit enhancement should be viewed as much broader than MI. it's somewhere between the traditional MI which is a $600 billion [market] and the $9 trillion in mortgage debt outstanding, and it is going to be defined by the companies that can define that frontier." [Emphasis added.]

Neither management team mentioned risk on the call -- only opportunities. Would the analysts on the call bring it up? A grand total of two questions out of about a dozen focused on reserve accounting and risk in the existing books of MGIC and Radian. The first came from Goldman Sachs analyst Andrew Brill:

Q: "Do both companies use similar claims factors in their reserves? What have you factored in terms of reserve changes that might be needed as the books get combined?"

A: "We have very similar approaches, but we go about it differently. But ultimately, we get to a reserve base based upon experience on the claims side and severity, and as we looked at the actuarial reports that [MGIC] prepared and [Radian] prepared, [we determined that] the range of the reserve, in theory, is very close. We have different approaches for it, but 'net-net,' the average case basis is very similar when you look at the detail [so we do not believe that there will be any reserve adjustments]."

Management basically reiterated their reserve accounting policy of looking through the rearview mirror at the wonderful boom times in the housing market. This is likely to come back and bite them. Another analyst, probably from the buy side, asked the only other difficult question:

Q: "What is the strategic rationale for this merger outside of the cost reductions, considering the likely management distraction at a time of worsening losses?

A: "We have the issue of running the business. Relative to the business itself, I'm encouraged by what's going on in the business with the return of insurance in force growth as persistency increases with higher rates and the increasing penetration of MI... The loss side of the business is there. I think both [MGIC's and Radian's] portfolios are well managed. We both thought, looking at our books, that [paid losses] would be up about 10%. But we think that's well controlled."

By the end of this conference call, you can tell which analysts are helping management sell MGIC stock to the public with softball questions and which analysts are really trying to properly balance risks and opportunities.

In a presentation a week earlier at Citigroup's 2007 Financial Services Conference, MGIC CEO Curt Culver addressed the issue of default risk. He stated confidently that the trend in future defaults will be highly correlated with the job market. He expects MGIC to emerge from the subprime disaster unscathed because the company did not overly expose shareholder capital to the riskiest mortgages.

But this housing cycle went far beyond any past cycle. Near the peak of the housing bubble, a huge proportion of buyers were investors with no intention of ever moving into the homes they were buying. This inflated purchase prices and lowered the margin of safety for buyers actually intending to move in. Clearly, the higher the mortgage payment required to get into a house, the lower the household's ability to consistently make that mortgage payment.

Merger Accounting Muddies the Water

A great example of how merger accounting can misrepresent reality is the experience of Tyco Intl. investors. Wall Street loved former CEO Dennis Kozlowski's voracious appetite for acquisitions, hailing the company as the "next GE."

That is, until early 2002. Then, the seams fell apart as the Enron scandal and a recession combined to shed light on the real value of the hundreds of businesses Kozlowski had rolled up.

This rollup strategy included an accounting tactic called "bootstrapping earnings." Here's how it worked: Tyco used secondary issuances of its high P/E stock to acquire low P/E companies in stodgy, "old economy" industries. After the books closed on these acquisitions, Tyco would automatically show higher earnings per share. Throughout the 1990s, this conglomerate consistently produced investor-pleasing earnings growth:

How was this wave of acquisitions treated on Tyco's balance sheet? Whenever an acquiring company pays a premium above the target company's book value, the difference usually ends up as "goodwill," an intangible asset on the acquirer's balance sheet. Goodwill and other intangibles cannot fund dividends quite as consistently as capital assets, like plants. Tyco's intangible assets swelled from $6.4 billion in 1998 to $35.3 billion in 2001.

This was a big red flag. How could investors possibly asses the intrinsic value of the underlying businesses? Tyco is not a software company, in which nearly all assets are contained in minds of programmers and lines of code. As such, the explosion of intangible assets was not justified.

It turns out that a good chunk of Tyco's performance in the 1990s was function of a virtuous feedback loop: high investor expectations led right back to even higher expectations as follows:

The past few years have been a period of discovery about the real value of Tyco's conglomeration of businesses. As of early 2007, Tyco management is seeking to speed up the process by splitting up into separate operating units. Apparently, the magic of "synergies" no longer applies.

Tyco is an extreme example of the shenanigans that can occur behind the smoke screen of complex acquisition accounting. While Tyco is a portfolio of manufacturing businesses, New Century is a portfolio of subprime mortgages, and the new MGIC Radian will be a portfolio of insurance policies on $290 billion worth of home mortgages, they all share the common trait of being difficult to value. Now, MGIC Radian's merger accounting will make it even more difficult to value.

MGIC and Radian both trade for 9-10 times earnings, so Tyco-style "bootstrapping" will not be a factor. Changes to loss reserves are the factor that really moves the needle on EPS in the mortgage insurance business

I wouldn't be surprised to see MGIC management slip in an impairment charge or increase loss reserves as the MGIC and Radian financial statements join in holy matrimony. Merger accounting would provide a convenient diversion. I'll be watching closely for management to update their accounting to match reality in the housing market.

Good investing,
Dan Amoss, CFA

Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives, sell-side analysts, and writing proprietary research for the fund’s management team.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst® designation, a professional designation widely recognized within the investment community.

Money, Banking and the Federal Reserve

Thomas Jefferson and Andrew Jackson understood "The Monster". But to most Americans today, Federal Reserve is just a name on the dollar ... all » bill. They have no idea of what the central bank does to the economy, or to their own economic lives; of how and why it was founded and operates; or of the sound money and banking that could end the statism, inflation, and business cycles that the Fed generates.

Dedicated to Murray N. Rothbard, steeped in American history and Austrian economics, and featuring Ron Paul, Joseph Salerno, Hans Hoppe, and Lew Rockwell, this extraordinary new film is the clearest, most compelling explanation ever offered of the Fed, and why curbing it must be our first priority.

From The Mises Institute

Peak Oil Shock

by Byron King

IN A RECENT story in the Fort Worth Star-Telegram, Shell Oil Co. President John Hofmeister was quoted about what he has learned while on his current national 50-city speaking tour. In 2006, Mr. Hofmeister and other Shell executives toured 25 U.S. cities, with visits to another 25 burghs and hamlets on the calendar for 2007. During the visits, Mr. Hofmeister holds town meetings with local residents and public officials and gives speeches about the U.S. energy situation. The results of his tour, said Mr. Hofmeister, were "sobering."

Shocked, Shocked

"I was shocked," said Mr. Hofmeister, "at how many people actually believe in the Peak Oil theory." Was he really shocked? Or perhaps he was, as the inspector of police noted in the movie Casablanca when he learned that people were gambling in a certain saloon, merely "shocked, shocked."

Shell's Mr. Hofmeister cannot be unaware of Peak Oil theory. The Peak Oil theory was, after all, pioneered in the 1950s by a geologist named M. King Hubbert (1903-1989), who worked for none other than Shell. It is not quite like the guy who runs General Electric dismissing the import of Thomas Edison or the development of the light bulb, but it is in the same ballpark.

Shell's geologist Hubbert based his Peak Oil concept on the rather obvious point that you cannot extract oil that you have not discovered from the ground. So Hubbert reviewed mountains of data concerning oil discoveries, and oil extraction and production, dating back as far as the 1860s. Hubbert noted the common trend in oil field development for a new field to come online and oil production to increase as the field was drilled and developed. But then, over time, the inevitable effects of depletion would kick in and cause the overall production of the oil field steadily to decline.

Hubbert's Curve

In the days before sophisticated computers and elaborate spreadsheet programs, Hubbert crunched his own numbers. He cumulated the reserve figures for oil discoveries in the U.S. and the production histories of thousands of U.S. oil fields dating back almost a century. Hubbert observed and demonstrated, through a process called "reserve backdating," that most major oil discoveries in the U.S. had occurred by the 1930s. That is, even though reserves may not have been listed on a company's books until much later, they were, in geological fact, part of the original discovery many years before. And Hubbert focused on the point that after the largest oil fields had been discovered, in terms of both surface area and volume of calculated reserves, the "new" discoveries thereafter tended to be smaller oil deposits, or extensions of previously discovered oil fields and oil-bearing trends:

In a paper that he prepared and delivered in 1956, over the objection of several Shell executives, Hubbert postulated that total U.S. oil production would increase until about 1970 and then reach a "peak," from which it would then steadily decline in volume over time:

Hubbert updated his 1956 predictions in the early 1960s and came up with essentially the same forecast of U.S. oil production peaking by 1970. Hubbert did not anticipate the 1968 discovery of the oil field at Prudhoe Bay, Alaska. But his numbers were prophetic, and eerily accurate, for the lower 48 states. Almost on cue in 1970, overall U.S. oil production peaked and commenced its long trend of irreversible decline, barely changed even by the development of Prudhoe Bay in the 1970s. Thereafter, the U.S. has imported more and more conventional oil to meet its daily needs:

So the discovery side of Peak Oil theory holds that mankind has identified and located, if not actually discovered, most of the conventional crude oil that there is to find in the crust of the Earth. The production side of Peak Oil theory holds that mankind has produced, and, of course, consumed, something near half of it. In terms of really big Peak Oil numbers, out of a worldwide resource base of conventional oil that is estimated by some knowledgeable commentators at about 2.2 trillion barrels, about 90% has been discovered and about 1 trillion barrels have been extracted and consumed over the past 150 years or so.

Bell-Shaped Curve

Mathematically, the history of oil production in any given region is a bell-shaped curve, with "tails" on each side and a relatively rounded top in between. In a very general sense, the initial increase of the first half of the curve is mirrored by the decline phase on the other side. It is like saying that "what goes up must come down," but it is all rooted in the concept that you cannot produce what you have not discovered.

Applying Hubbert's methodology to the global resource base, the world's oil industry currently appears to be at the top of the Hubbert curve. Each day, the world's oil industry is pumping the known oil reserves out of the crust of the Earth at a rate of about 1,000 barrels per second, or 85 million barrels per day, or about 31 billion barrels per year. And the global economy is consuming or otherwise burning up almost every drop of that oil. (Some very small fraction goes into storage, such as for the Strategic Petroleum Reserve of the U.S. or comparable reserves in other nations such as China. This oil, too, will eventually be burned or otherwise consumed.)

The balance between global supply and demand is precarious, such that if just a couple of hundred thousand barrels per day of production (near a rounding error from a production base of 85 mbd) go offline, there can be significant price moves, as occurred last August when BP closed the Alaska pipeline. Or consider what the traders call "political risk," such as the result of hostilities closing a maritime control point such as the Straits of Hormuz. If even one oil tanker were to, say, hit a mine in the Persian Gulf, oil prices would skyrocket within hours.

The Edge of Secure Supply

Shell's Mr. Hofmeister knows all of this. At a recent speech he gave in Pittsburgh, for example, he began his talk with a rather gripping story that dealt with the supply of refined product, as opposed to crude oil. But the story illustrates the point.

According to Mr. Hofmeister, in the aftermath of hurricanes Katrina and Rita in 2005, almost all of the U.S. Gulf Coast refineries were down due to flooding and other storm damage. Shell had 300,000 barrels of refined product in storage at its Baytown, Texas, refinery, which was essentially the only supply available to the entire U.S. Southeast region, but there was no electricity with which to run the pumps. Whoops!

Shell employees and contractors were working feverishly to rig up electric generators at the Texas facility, but it was a race against time, over a 48-hour period, until the Plantation and Colonial pipelines -- - the major trunk carriers for refined product between Texas and the Southeastern U.S. -- went dry. If word escaped of the predicament, Shell executives believed that many members of the consuming public would have panicked. Then panic-buying would have immediately kicked in and rapidly drained whatever fuel was left in the supply system. The entire Southeast, home to about 60 million souls, could have been caught in a situation in which there was be no fuel available anywhere. It fell to Shell's Mr. Hofmeister to call the U.S. secretary of energy and deliver the bad news.

But like the cavalry arriving near the end of a John Ford Western, Shell's hardworking people hooked up the Texas facility with electric power, with all of about 12 hours to spare. Shell started pumping gas into the pipeline system. There were, you may recall, spot shortages of fuel in the Southeast, but no regional lack of product. Still, as Mr. Hofmeister put it, it was a close call and the U.S. was and remains "on the edge of secure supply."

Same Thing With Crude Oil

Mr. Hofmeister's story concerned gasoline, but he could have told the same story with respect to crude oil or natural gas. The Gulf of Mexico hurricanes of 2005 wrecked oil and gas production facilities all along the littoral, to the point of toppling over offshore structures that are the size of World War II aircraft carriers. The hurricanes churned the water column down to the seafloor, and ripped up or displaced underwater pipelines, subsea production equipment, and much else of the Gulf Coast oil infrastructure on which the U.S. relies for energy supply. In addition to the damage to property, tens of thousands of members of the oil industry work force were displaced from their homes and job sites by hurricane damage. The Gulf Coast oil industry still has not recovered, 18 months later.

So yes, "we are on the edge of secure supply" from prospect, to drill bit, to pipeline and refinery, to the gas pump. And a lot of people are starting to figure that out and think about it.

Peak Oil theory is one way of making sense of quite a bit of what goes on in this world, beginning with the supply of conventional crude oil and with implications for the rest of the energy mix of the world's advanced industrial societies. There is a certain geological coherence (even elegance) to the idea of Peak Oil, and a mathematically demonstrable basis to the concept.

So it should not "shock" anyone, let alone the president of Shell Oil Co., that "many people actually believe in the Peak Oil theory." In fact, I think that Peak Oil theory makes Mr. Hofmeister's job easier. Once people understand the key issue behind the nation's energy supply, it is more probable that they will be willing and able to design a solution.

Until we meet again...
Byron W. King

for Whiskey and Gunpowder

Byron W. King is a practicing attorney in Pittsburgh, Pennsylvania, with real clients and real law books on his shelves. After graduating from Harvard University more years ago than he cares to discuss, Byron worked as a geologist in the exploration and production division of a major international oil company. He has followed developments in the oil and gas industry for almost three decades. However, in the process of seeking more excitement than a man can safely obtain from flaring over-pressurized gas whipping out of a 21,000-foot well, Byron also served for many years in both the active and reserve components of the United States Navy.

While in the sea service, Byron logged more flight time in tactical jet aircraft than George W. Bush, as well as 127 more carrier landings than the recently-re-elected commander in chief. Among other assignments, Byron has served as a field historian with the Navy.

Byron looks at current events, economics, and politics through the lens of history. He brings to the table a unique perspective that incorporates many millions of years of the Earth’s geologic history, and blends its significance into the more recent, man-made kind of tale.

Statement for Hearing before the House Financial Services Committee, “Monetary Policy and the State of the Economy”

by U.S. Rep. Ron Paul

Transparency in monetary policy is a goal we should all support. I’ve often wondered why Congress so willingly has given up its prerogative over monetary policy. Astonishingly, Congress in essence has ceded total control over the value of our money to a secretive central bank.

Congress created the Federal Reserve, yet it had no constitutional authority to do so. We forget that those powers not explicitly granted to Congress by the Constitution are inherently denied to Congress-- and thus the authority to establish a central bank never was given. Of course Jefferson and Hamilton had that debate early on, a debate seemingly settled in 1913.

But transparency and oversight are something else, and they’re worth considering. Congress, although not by law, essentially has given up all its oversight responsibility over the Federal Reserve. There are no true audits, and Congress knows nothing of the conversations, plans, and actions taken in concert with other central banks. We get less and less information regarding the money supply each year, especially now that M3 is no longer reported.

The role the Fed plays in the President’s secretive Working Group on Financial Markets goes unnoticed by members of Congress. The Federal Reserve shows no willingness to inform Congress voluntarily about how often the Working Group meets, what actions it takes that affect the financial markets, or why it takes those actions.

But these actions, directed by the Federal Reserve, alter the purchasing power of our money. And that purchasing power is always reduced. The dollar today is worth only four cents compared to the dollar in 1913, when the Federal Reserve started. This has profound consequences for our economy and our political stability. All paper currencies are vulnerable to collapse, and history is replete with examples of great suffering caused by such collapses, especially to a nation’s poor and middle class. This leads to political turmoil.

Even before a currency collapse occurs, the damage done by a fiat system is significant. Our monetary system insidiously transfers wealth from the poor and middle class to the privileged rich. Wages never keep up with the profits of Wall Street and the banks, thus sowing the seeds of class discontent. When economic trouble hits, free markets and free trade often are blamed, while the harmful effects of a fiat monetary system are ignored. We deceive ourselves that all is well with the economy, and ignore the fundamental flaws that are a source of growing discontent among those who have not shared in the abundance of recent years.

Few understand that our consumption and apparent wealth is dependent on a current account deficit of $800 billion per year. This deficit shows that much of our prosperity is based on borrowing rather than a true increase in production. Statistics show year after year that our productive manufacturing jobs continue to go overseas. This phenomenon is not seen as a consequence of the international fiat monetary system, where the United States government benefits as the issuer of the world’s reserve currency.

Government officials consistently claim that inflation is in check at barely 2%, but middle class Americans know that their purchasing power--especially when it comes to housing, energy, medical care, and school tuition-- is shrinking much faster than 2% each year.

Even if prices were held in check, in spite of our monetary inflation, concentrating on CPI distracts from the real issue. We must address the important consequences of Fed manipulation of interest rates. When interests rates are artificially low, below market rates, insidious mal-investment and excessive indebtedness inevitably bring about the economic downturn that everyone dreads.

We look at GDP numbers to reassure ourselves that all is well, yet a growing number of Americans still do not enjoy the higher standard of living that monetary inflation brings to the privileged few. Those few have access to the newly created money first, before its value is diluted.

For example: Before the breakdown of the Bretton Woods system, CEO income was about 30 times the average worker’s pay. Today, it’s closer to 500 times. It’s hard to explain this simply by market forces and increases in productivity. One Wall Street firm last year gave out bonuses totaling $16.5 billion. There’s little evidence that this represents free market capitalism.

In 2006 dollars, the minimum wage was $9.50 before the 1971 breakdown of Bretton Woods. Today that dollar is worth $5.15. Congress congratulates itself for raising the minimum wage by mandate, but in reality it has lowered the minimum wage by allowing the Fed to devalue the dollar. We must consider how the growing inequalities created by our monetary system will lead to social discord.

GDP purportedly is now growing at 3.5%, and everyone seems pleased. What we fail to understand is how much government entitlement spending contributes to the increase in the GDP. Rebuilding infrastructure destroyed by hurricanes, which simply gets us back to even, is considered part of GDP growth. Wall Street profits and salaries, pumped up by the Fed’s increase in money, also contribute to GDP statistical growth. Just buying military weapons that contribute nothing to the well being of our citizens, sending money down a rat hole, contributes to GDP growth! Simple price increases caused by Fed monetary inflation contribute to nominal GDP growth. None of these factors represent any kind of real increases in economic output. So we should not carelessly cite misleading GDP figures which don’t truly reflect what is happening in the economy. Bogus GDP figures explain in part why so many people are feeling squeezed despite our supposedly booming economy.

But since our fiat dollar system is not going away anytime soon, it would benefit Congress and the American people to bring more transparency to how and why Fed monetary policy functions.

For starters, the Federal Reserve should:

Begin publishing the M3 statistics again. Let us see the numbers that most
accurately reveal how much new money the Fed is pumping into the world economy.
Tell us exactly what the President’s Working Group on Financial Markets
does and why.

Explain how interest rates are set. Conservatives profess
to support free markets, without wage and price controls. Yet the most important
price of all, the price of money as determined by interest rates, is set
arbitrarily in secret by the Fed rather than by markets! Why is this policy
written in stone? Why is there no congressional input at least?

Change legal tender laws to allow constitutional legal tender (commodity money) to
compete domestically with the dollar.

How can a policy of steadily debasing our currency be defended morally, knowing what harm it causes to those who still believe in saving money and assuming responsibility for themselves in their retirement years? Is it any wonder we are a nation of debtors rather than savers?

We need more transparency in how the Federal Reserve carries out monetary policy, and we need it soon.

HUI and Stock Selloffs

by Adam Hamilton

Whenever two contrarians meet to discuss the financial markets, odds are three opinions are going to emerge about what is coming next. Yet within this cacophony of ideas there are a couple strategic trends that command nearly unanimous support among the contrarian community today, the gold bull and the stock bear.

Gold is powering higher in a secular bull market because its fundamentals are outstanding. Global gold investment demand is growing relentlessly, particularly out of the rapidly industrializing Asian nations. But gold mined supply, with new-mine lead times running up to a decade, just cannot keep pace. Rising prices are the only economic option when demand is growing while supplies are constrained.

And the general US stock markets almost certainly remain mired in a secular bear despite the cyclical bull we've seen over the last four years. Such secular bears tend to last seventeen years or so in history, but ours only started in 2000 so it is almost certainly not over yet. And it is totally normal and expected for powerful cyclical bulls to erupt in the midst of these long secular bears to keep hope alive and seduce the bulls into complacency ahead of the next brutal downleg.

With these gold-bull and stock-bear theses incredibly well fleshed out and virtually unassailable, holding both of these views together creates plenty of psychological angst for contrarians. The great majority of physical gold investors eventually end up migrating a sizable portion of their investment and speculation portfolios into gold stocks as well. And here lies the problem. When the next major stock selloff hits, will gold stocks get sucked down in the bearish maelstrom?

Interestingly this is not a new concern by any means. I remember contrarians agonizing over this very issue endlessly in 2001 and 2002 during the wicked bear market following the 2000 stock-market tops. But today since the stock markets have now been strong for so long, and because sentiment indicators like the VIX are nearing all-time lows betraying extreme complacency, this issue is becoming particularly poignant again.

I analyzed the hard statistical relationship between the HUI unhedged gold-stock index and the flagship S&P 500 general-stock index a couple years ago. In those studies I found that there is no long-term correlation between gold stocks and general stocks, definitely a good thing for contrarians owning gold stocks but fearing a general-stock selloff.

Yet despite no meaningful mathematical relationship, we have all seen days where gold stocks seem to rise with a strong stock market or fall with a weak stock market. In the charts section of our website exclusively for our subscribers, we have a General Markets Overview webpage. It has real-time intraday charts of the major stock indexes, major commodities-stock indexes, the precious metals, and sentiment proxies all on one page for easy comparison. I keep this webpage open all day every day to deepen my understanding of any interrelationships.

Although I know intellectually from my research that gold stocks will eventually follow gold, their only real long-term driver, I can't count the number of days the stock markets have apparently influenced the HUI. For example, gold can be up and the HUI is rising with it, but then in the middle of the day some event like a Fed comment will hit the wires and the general stock markets will tank. Even when gold remains strong, the HUI can sell off with the S&P 500.

Events like this, while short term in nature, really spark fears among contrarians that gold stocks are going to get the stuffing beaten out of them when the next real general-stock downleg emerges. I certainly share in these fears when I see the HUI temporarily decouple from gold and follow after the stock markets like a lost puppy. And I know from my e-mail inbox that our subscribers are concerned about this as well.

Unfortunately I don't have a definitive answer on whether or not the HUI will follow the stock markets down. Anything can happen in the markets at any time, they are ultimately just a probabilities game. As mere mortals, neither you nor I can see the future. So if you want ironclad assurance that the HUI is not going to plunge when stocks start their next death spiral, you are never going to get it. We contrarians will always face this risk and we will never be able to fully break free from its psychological shackles.

But we can study the past and gain an idea of the probabilities in play. Based on past HUI performance in this bull during stock selloffs, is it likely to get crushed when the next stock selloff inevitably hits? If the HUI has been strong during past major selloffs in the stock markets since 2000, then we should have a good chance it will continue its defiant behavior during the next selloff.

This first chart shows the entire history of this secular gold-stock bull and secular general-stock bear. In cyclical terms, or the shorter multi-year cycles found within bigger nearly-multi-decade trends, the S&P 500 has been in both a wicked cyclical bear and a powerful cyclical bull. So we couldn't ask for a better environment in which to analyze the HUI since we've seen the best (or worst) of both stock worlds since 2000.

In strict technical terms, the S&P 500 cyclical bear that lopped a massive 49% off of this flagship index's value in less than three years ended in early October 2002. But technicals only measure bears' progress, it is sentiment that drives the bears in the first place. From October 2002 to March 2003 general-stock sentiment remained very poor in an environment plagued by concerns over Washington's coming invasion of Iraq.

Stocks nearly eclipsed their October lows in early March 2003 in the week leading up to the war. But once the bombs started flying and armor started rolling and the markets realized their worst fears would not be realized, sentiment turned on a dime. The day the war started the stock markets soared and their cyclical bull we've seen for the past four years launched. So in pure sentiment terms, I believe the March lows are where the cyclical bear ended and the cyclical bull began.

In grand-picture terms, the S&P 500 bled 49% during its cyclical bear and gained 82% in its subsequent cyclical bull. On a sidenote, the S&P 500 has still not recovered to its pre-bear high yet despite this asymmetrical loss and gain. After a big decline it takes far larger gains just to claw back to even, which is probably why the great Warren Buffett says the most important rule for investing is "never lose money".

In light of the S&P 500's gargantuan $13t market capitalization which gives it the inertia of an oil supertanker, it is hard to imagine a wilder ride for the US stock markets than what we've seen since 2000. It would be really hard, and a vanishingly low probability event, for whatever the next downleg looks like to somehow put what we saw in 2001 and 2002 to shame. Thus I could not imagine a more volatile general-stock environment over which to analyze gold stocks.

And you know what, overall the HUI's behavior in the midst of this tremendous general-stock turbulence has been downright awesome. From its November 2000 secular low to its latest May 2006 interim top, the HUI is up a staggering 996%! Meanwhile the S&P 500, from its March 2000 secular top to its latest interim high this week, is actually down nearly 5%. Which would you rather have for risking your hard-earned capital for seven years? A 996% gain or a 5% loss?

And over these seven years, the HUI has had three massive uplegs that are numbered above. The first and largest, an incredible 145% gain in about six months, actually happened during the most brutal downleg in the general stock markets! The second 125% one over eight months happened early on in the stock cyclical bull while the third 137% specimen over twelve months ended last May.

So strategically are the general-stock-market fortunes affecting the gold stocks? Not so you'd notice! The HUI's overall bull-to-date performance has been outstanding as the gold stocks soared higher with gold on balance. This happened during both the cyclical-bear and cyclical-bull phases in general stocks. Thus the general stock markets' performance is obviously not the strategic driver of the gold-stock bull.

If this behavior established over seven wild stock-market years continues, then we contrarians have nothing to fear from the general stock markets. Let them halve or let them double, it makes no difference. All that matters for gold stocks over the long run is the price of gold. And fundamentally gold's bull ought to continue powering higher for another decade or so, which has to be the perfect omen for gold stocks.

Despite this strategic comfort, we've all seen those days when the HUI forsakes its first love of gold and starts chasing after the stock markets like an adulterous lover. When the next major bear downleg in the stock markets erupts, will the HUI have the strength to remain faithful to gold? Will HUI investors hold tough or panic and join the surge for the exits? Our best chance of understanding the odds here lies back in studying the last cyclical bear from 2000 to 2002.

Although the romance of the concept of crashes dominates contrarians' psyches, the truth is outright crashes are exceedingly rare. True crashes, say a 20% decline in the stock markets in no more than a week, virtually always happen only right after major secular tops. Years into a secular bear, as we are today, the threat is not crashes but long prolonged downlegs, selling lasting months on end that gradually decimates the markets. This "slow" approach gradually boils the bulls in water like frogs before they know what ate them for lunch.

The brutal bear market from 2000 to 2002 that lopped-off half the value of the best and biggest American companies took this gradual approach. It was largely steady selling, driving down prices on balance. But several times during this period, steep downlegs emerged where prices started plummeting much faster than usual. These devastated psychology, but they were followed by sharp V-bounces and bear rallies that restored hope to the bulls and kept them in the warming boiling pot.

Note above that during the relentless yet gradual selling between major downlegs the HUI did just fine. It rose on balance in Q4'00 and Q1'01, was flat in mid-2001, and rose in early 2002. Thus during the last cyclical bear the HUI had no problem at all rising when general stocks were selling off day after day. Without panic-type conditions that only fast and aggressive downlegs can spawn, falling stocks aren't a threat to the HUI.

And surprisingly the actual steep downlegs were not as dangerous to gold-stock investor psychology as most people want to believe today. The three most dangerous plunges of the last bear happened in Q1'01, Q3'01, and Q2'02. If you are wondering how the HUI is likely going to weather a steep downleg in the US stock markets today, carefully examine these three quarters. The HUI was typically incredibly resilient until the very end of these plunges.

During the first steep downleg in Q1'01, the HUI actually completed an impressive 113% upleg! From late January to early April, the S&P 500 plunged by 20% in its first truly horrifying downleg of its bear. Over an identical period of time to the day, the HUI actually rose by over 8%! But over the first two-thirds of this plunge, the HUI actually rallied 22%. It wasn't until the latter third when some general selling bled into gold stocks. So the HUI was immune to this particular downleg until its terminal stage. This is certainly not the stuff of nightmares.

After that the HUI did rally along with the V-bounce in general stocks following their April 2001 low. But while stocks soon topped again and started grinding relentlessly lower, the HUI held strong in a high sideways consolidation in the summer of 2001. The next brutal downleg in the S&P 500 started and ended in Q3'01. This one caused much wailing and gnashing of teeth among the stock-market bulls, it really temporarily ripped their bullish sentiment to shreds.

From mid-July to late September, the S&P 500 plummeted 21%. As you can see in this chart, it was an incredibly fast and vicious decline. If ever there was a time when gold-stock investors should have been panicking as wildfires raged in general stocks all around them, this was it. Yet over this identical period of time to the very day, the HUI actually rallied 14%!

This is an interesting example as it illustrates a dynamic that has largely been forgotten today. When general stocks are freefalling, investors seek refuge. Of course gold, the only stable investment throughout all six millennia of human history, comes to mind first. Physical gold is bought but so are gold stocks. So sharp panics don't always scare gold-stock investors into selling like sheep, sometimes they scare general-stock investors into buying gold stocks. Even the sharpest downlegs can have a positive impact on the HUI.

The final exhibit here is the long Q2'02 stock downleg. It was slower, starting in March and ending in July, but devastating in depth with a 32% decline. How did the HUI do overall? From identical start and end points it was up 24% during this 32% stock-market plunge! Yet even this doesn't tell the whole story. During the initial two-thirds or so of this stock downleg, the HUI soared 73% while the S&P 500 fell 11%. Then after topping in early June 2002 at the end of its first massive 145% upleg, the HUI entered correction mode.

No bull market climbs in a straight line. Prices rise then soar to very overbought levels and greed abounds, so a correction down or consolidation sideways is necessary to rebalance sentiment. Initially the HUI largely consolidated, it was only down 5% over the first six weeks after its early June interim high. Over this same period of time, the S&P 500 fell 12%. But the next twelve trading days, from July 10th to July 26th, are probably the most misunderstood of this entire bear for the HUI/SPX relationship.

The HUI essentially crashed in the latter half of July 2002, plunging 32% in just twelve trading days! On the chart above it looks like this HUI crash was sympathetic to the general stock markets, and it was to some extent. But over those same twelve days where the HUI surrendered a third of its value, the S&P 500 only lost another 7%. Yes there was a sharp and terminal move lower in general stocks, but the HUI correction that had been ignored for too long came roaring back with a vengeance far exceeding any stock-market leading.

So the case can be made that the terminal stage of the sharp July 2002 plunge in the stock markets hit the HUI, but I think this link is tenuous at best. And if this argument is advanced, the worst form it can take is that the HUI could succumb to a general panic near the final third of a steep downleg, the terminal stage right before the V-bounce. Ever the speculator, I see this not as a threat but as an opportunity. It means that when general stocks are due to V-bounce and the VIX is super high, it is probably a great time to add gold-stock positions too.

But other than this erratic and not-always-seen terminal-stage influence, steep stock downlegs really don't seem to bother the HUI at all. Over the three massive downlegs discussed here, the S&P 500 lost an average of 24%. Yet over these exact same times to the very day, meaning I am not considering the HUI's own rhythms to its own advantage here, the HUI averaged 15% gains! So it really doesn't seem like steep bear downlegs ought to frighten us, and they are the biggest psychological threat within any bear.

Moreover, during the seventeen-year secular bears that follow seventeen-year secular bulls in stocks, the first cyclical bear of the secular bear is usually the most volatile and violent. While we could certainly see another 50% decline in the S&P 500 by the end of its next cyclical bear just as happened in the midst of the last great bear in 1973 and 1974, odds are it will be a relentless gradual decline over two years or so and not a series of sharp downlegs. History tends to show that downleg volatility abates considerably as a great bear matures, which makes sense because valuation extremes moderate throughout the long bear.

If downlegs get less steep and volatile as cyclical-bear declines become more balanced over time, then we probably won't see anything as bad as 2001 and 2002 again in this secular bear. And the HUI really thrived, generally totally ignoring the stock markets when they were just gradually selling off on balance like they ought to in the future. Once again while I don't know the future, I think the odds definitely favor the HUI doing just fine during the next cyclical stock bear.

And while we are looking at HUI performance relative to general stocks, I figured we may as well take a look at the cyclical bull since 2003 as well. In this chart and the previous one, I drew in little arrowheads to show relevant areas of HUI and SPX movement. The key here is that the HUI can move up, down, or sideways while the S&P 500 independently moves up, down, or sideways. Both gold stocks and general stocks march to the beats of their own drummers and sometimes these beats are synchronized but often not.

The biggest surge in the S&P 500's cyclical bull happened in early 2003 after the Iraq invasion failed to spawn the worst military, economic, political, and environmental disasters feared. The HUI rallied right alongside the general stocks. It is crucial to realize though that gold was rallying to new bull highs over this same period in 2003, so odds are the HUI was just following its primary driver and not the general stocks.

In Q2'04 the HUI corrected sharply while the S&P 500 just meandered sideways in a consolidation. Here we had a relatively sharp selloff in the HUI, again because of a gold correction, that had nothing at all to do with the stock markets. Just as the HUI can rally just fine on its own regardless of stock action, it can also fall just fine on its own too and doesn't need the stock markets' help to push it off a cliff.

We saw another example of this between Q4'04 and Q2'05. The HUI entered a long and difficult correction psychologically and ground lower on balance. Yet during this time the stock markets continued marching higher on balance in their increasingly well-defined cyclical-bull uptrend. The HUI's actual interim low in May 2005 happened about a month after the nearest S&P 500 interim low, there is no correlation at all.

Then from Q2'05 to Q2'06 the HUI commenced an utterly massive upleg, the third of its bull, and soared 137% higher. Over this same period of time, the S&P 500 rallied too but quite modestly. It only managed a 13% gain. Since its May 2006 interim high the HUI corrected sharply and general stocks corrected modestly, the HUI then consolidated sideways while stocks rallied, then the HUI fell while stocks continued rallying, and then the HUI started rising again while stocks still rallied. Stocks aren't driving the HUI!

The moral of the story here from my perspective is yes, the HUI and S&P 500 had more of a correlation since 2003 in a strategic sense but they should have since they were both in bull markets. When two markets are moving up on balance, even when driven by different drivers, they are going to have far more in common than when one is moving up and the other down. But tactically the HUI and S&P 500 relationship was all over the place with no clear predominating condition.

Since 2003 the S&P 500 has rallied 82%, certainly a very impressive move by anyone's standards. Yet this is typical in a cyclical bull in the midst of a secular bear. Meanwhile the HUI rallied 245% since 2003 in its own parallel bull. Once again gold stocks as a sector utterly annihilated the large-caps' performance even when the latter were in their most powerful and persistent bull market in years.

In light of all this, as a gold-stock investor and speculator I am going to spend my time worrying about gold, not general stocks. Yes general stocks are overdue for another cyclical bear, and yes the HUI can sometimes get sucked into terminal-stage downleg panics to some extent. But overall the HUI's performance even through these brief sentiment storms has been stellar. The HUI rallied through all of the steepest downlegs during the last bear market in general stocks.

And there are two other important factors for contrarians to keep in mind when this concern arises. First, as happened in 2001 during the steepest and sharpest downleg of that bear, a general-stock panic not only scares contrarians but it scares mainstreamers into buying gold stocks as a position of refuge. So there is always a pretty good chance that any future sharp downleg in general stocks would actually fuel additional gold-stock demand and lead to a rising HUI on the safe-haven play.

Second, gold stocks are vastly better positioned to rally today than they were in 2001 and 2002. Back then virtually no one knew about gold stocks, gold's own bull was young and unproven, and gold-stock valuations were obscenely high. Today contrarians are telling mainstream friends about our massive gains in gold stocks and spreading the word. Today even the most jaded Wall Streeter is forced to acknowledge gold is in a bull market, and CNBC even talks about gold now which it barely ever did in 2001 and 2002. And today gold-stock valuations are far lower and getting more reasonable all the time.

With more awareness and more investors likely to buy gold itself during trying stock-market times, I suspect our odds are rising that a steep stock-market selloff will end up being bullish for gold stocks. Of course gold is their ultimate driver, but a panic shocking mainstreamers into deploying into gold stocks sure can't hurt temporarily. It will just add to the large gains we contrarians continue to earn in this tiny and neglected sector.

At Zeal we've been aggressively buying elite high-potential gold stocks since gold's latest October lows and we've done quite well. I still believe we are early on in a major upleg and expect a big move in gold stocks soon, which have been lagging gold considerably in 2007. If you want to ride this next upleg to big potential gains in elite hand-picked stocks, please subscribe today to our acclaimed monthly newsletter.

The bottom line is the HUI has thrived on balance since the 2000 stock-market tops regardless of general-stock activity. While the HUI and S&P 500 are not correlated overall, there are times when they do move in parallel. Interestingly the biggest risk to the HUI does not occur until the latter third or so of steep downlegs, and the sometimes resulting minor plunge in the HUI creates great buying opportunities.

Contrarians need to remember that it is gold that drives gold stocks. It is not the stock markets, not interest rates, not real estate, not geopolitics, not the Fed, and not CNBC. As long as gold's secular bull remains intact fundamentally, gold-stock investors have nothing to fear. We have already weathered some utterly brutal stock selloffs and I have no doubt we'll fare just fine on balance through the next one.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at & zelotes@zealllc.com Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

Copyright © 2000-2007 Zeal Research

Understand the Bull!

by Puru Saxena

PRECIOUS METALS - Since the commencement of the bull-market in precious metals, several factors (ranging from rising jewellery demand in Asia to the ongoing war in the Middle-East) have been presented by various analysts as the drivers behind the persistent appreciation in gold and silver.

In my opinion, however, the current bull-market in precious metals is primarily due to the ongoing monetary inflation (money supply and credit growth) and the subsequent debasement of various national currencies. It is important to understand that monetary inflation is the root-cause of increases in asset as well as commodity prices. During times when investors' confidence in governments and central banks is high, monetary inflation spills into financial assets causing the national currencies to lose value against stocks and bonds. On the other hand, when the investing community is suspicious of central banks and confidence in the establishment is running low, national currencies such as the US Dollar, Euro and Yen lose value against gold, silver and other tangible assets.

Since 2001, the purchasing power of the major world currencies has been diminishing against precious metals and this is a sign that at least a part of the investing public does not accept the various national currencies as a genuine store of value. Whilst it is true that the price of gold has risen by over 200% in recent years, I would argue that gold is a constant and it is in fact the US Dollar which has lost considerable value against gold due to its oversupply relative to gold.

Given the level of debt in the US, I expect inflation (money-supply and credit growth) to accelerate in the future and this should result in further US Dollar depreciation when measured in terms of gold and silver. Please note that most of the "developed" nations today are engaged in monetary inflation as they continue to devalue their currencies in order to remain competitive. As long as this insanity remains intact, I expect all the "participating" national currencies to decline further against precious metals, which will assume the role of an alternative currency. Already, we can see this taking place with the price of gold rising in relation to currencies such as the Euro, Yen and British Pound.

Although the price of gold has risen in the recent years, I suspect that we are still only halfway through this bull-market. Once the bull-market gathers steam, both gold and silver will break out to record-highs. However, in the intermediate-term, the first challenge for gold and silver is to better their highs recorded in May 2006. Once this is achieved, I believe the public will finally wake up and accept the presence of a sustainable bull-market in precious metals.

At present, the amount of capital invested in the entire precious metals universe (physical bullion as well as mining stocks) is tiny when compared to stocks and bonds. Furthermore, it is absurd to note that the market capitalization of Microsoft alone is bigger than the entire gold mining industry! So, you can only imagine what will happen to the prices of precious metals' mining stocks when capital starts to flow into this neglected sector.

Figure 1 gives the current bull-market some perspective. The grey line on the chart shows that during its previous bull-market in the 1970's, gold went up several-fold. The current bull-market in gold however is depicted by the blue line on the chart. As you can see, at current levels, the price of gold is still trading at roughly 65% below its all-time inflation-adjusted high of roughly $2,000 per ounce! In a world of inflated asset-prices, it is not very often that you can find assets selling at such depressed levels. Therefore investors are advised to allocate a reasonable portion of their wealth to gold and silver.

Figure 1: Early stages of a gold mania?

Source: BCA Research

So far in this bull-market, mining stocks of precious metals have on average outperformed physical bullion by 300%. In other words, investors who bought the mining shares made three times more money than those who bought the physical bullion. So, my advice is to invest in the un-hedged mining companies, which offer great leverage in the ongoing boom. We have invested our clients' capital in junior exploration companies as well as intermediate level producers who are about to increase their output significantly. Finally, I suggest that you avoid the large-cap mining stocks which hedge their future production as the upside from these will be limited.

The above is an excerpt from Money Matters, a monthly economic publication, which highlights extraordinary investment opportunities in all major markets. In addition to the monthly reports, subscribers also benefit from timely and concise "Email Updates", which are sent out when an important development in the capital markets warrants immediate attention. Subscribe Today!

Puru Saxena

Puru Saxena is the editor and publisher of Money Matters, an economic and financial publication NOW available at www.purusaxena.com.

An investment adviser based in Hong Kong, he is a regular guest on CNBC, BBC, Bloomberg, NDTV Profit and writes for several newspapers and financial journals.

Copyright © 2005-2007 Puru Saxena Limited. All rights reserved

Two commodities we hate to see rise, but will profit from nonetheless.

by Stephen Leeb

In this week’s update …

***** Nothing wrong with this market.

***** Two commodities we hate to see rise, but will profit from nonetheless.

***** The Bipartisan Word of the Year.

***** Head’s up! A sneak peak at our newest TCI stock pick.

-------------------------------------

Despite last week’s tiny pullback (0.71% on the S&P), the market continues to look as positive as it has for many weeks. If anything, the outlook has gotten even better since your last update. Everything we like to see in a market pullback (because it implies it won’t last) occurred last week. Small cap stocks outperformed. Utilities made new highs. And our indicators remain entrenched in bullish territory.

In fact, the only thing we think that could stop us all from getting richer over the next few months would be another unexpected geopolitical trauma – a renewed war in Lebanon, an attack on Iran for failing to meet the U.N. deadline, or maybe the Taliban proving to be stronger than anyone in NATO expects. Ordinarily we would consider such events to be long shots, although we wouldn’t dare guess the odds today. So what is it that makes today’s market so strong? Here’s our theory …

TOO MUCH MONEY? (WE SHOULD ALL HAVE SUCH PROBLEMS…OR NOT.)

When the book is finally written on today’s bull market, we think historians will declare it to have been driven much more by private equity and hedge funds than by central banks. No matter where we look – whether to U.S., European, or even global money measures – we see nothing but extremely high liquidity. It’s like the world economy is living in a vat of whiskey – it can’t help getting high.

While it’s tempting to say the central banks have been remiss in raising interest rates, we disagree. Rather, we think much of the liquidity today is the result of extremely leveraged buyouts in the corporate world. For instance, last week we saw one REIT bought out for some $30 billion. As typical with such buyouts, this was a leveraged transaction. The buyer paid only a fraction of the price. The rest was financed through loans, and the private equity and hedge funds that made the purchase relied on non-traditional sources.

This type of activity puts a great deal of cash into the system, cash which is then reinvested by the sellers of such companies into other investments. The result is support for higher stock prices. Of course, eventually too much cash may contribute to higher inflation, particularly when our favorite commodity becomes more scarce. Oil remains the one factor that can put noose around this bull’s neck. And on that front, we note that recently both Royal Dutch and British Petroleum lowered their production targets substantially for 2008 and beyond.

Their combined projected drop is roughly a million barrels a day, which is a very big deal. For now, oil may fluctuate and generally trade sideways, but sometime this year we expect to see its old highs challenged. So we continue to recommend you hold onto oil service and other energy stocks. Another beneficiary of excess liquidity that we must not forget is gold. Last week gold rose $20.80 an ounce to close at over $666. That makes the third week in a row it has closed over $650, and we expect gold will remain in an uptrend for the foreseeable future. But for the time being, just enjoy the bull market. It’s still going strong. And if you want to look ahead at another opportunity, consider this year’s candidate for “Bipartisan Word of the Year…”

IS YOUR POLITICIAN TURNING GREEN?

Today, we seem to be witnessing a tipping-point regarding environmentalism. No longer the domain of the Sierra Club and Greenpeace, the environment is now on the lips of every politician in the country. Every candidate and campaigner these days feels obliged to take pro-environmental stance. And that wind change is creating new investment opportunities. Many alternative and renewable energy companies only turn a profit because of small government subsidies.

Their inherent vulnerability has traditionally made their stocks trade at low P/E multiples. Solar power is a prime example of this – wind too, to a lesser extent. Neither of these energies has been able to compete so far with heavily subsidized fossil fuels, such as coal. But thanks to Washington’s newfound green agenda, investors can take heart that subsidies to the renewable energy industry are more secure and likely to enlarge.

Consequently, we think alt. energy stocks will soon trade at much higher multiples. In the past, most alternative energy stocks followed the ups and downs of oil and other fossil fuel prices. That will continue to be true to some extent. The higher oil prices climb, the more people will turn to renewables. However, as people pressure the government to control greenhouse gases and other pollutants, alternative energy stocks may begin to be propelled independently.

In the next issue of TCI, we will cover in depth some of the most exciting environmental companies today.

Until next week,

Stephen Leeb

Editor,

The Complete Investor

http://www.completeinvestor.com/mf/


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Using the Oil Weapon and Sanctions to Avert War With Iran

David J. Jonsson
February 15, 2007

As we drove to work today we observed the beautiful homes and cars, we watched our stock portfolios increase and we also read the disturbing headlines in the newspapers. This brings us to this year's dilemma. The dilemma is the contrast between the world's favorable economics, expanding democracy and free markets and troublesome politics-a new world order which is unknown and certainly a much less prosperous and friendly place. That we face a dilemma is clear enough. But the resolution is not. A range of possible outcomes, from the perverse and catastrophic to the unconformable and even benign, is conceivable. The outcome is inevitable. It took President Bush just seven words to declare on November 6, 2001: "You're either with us or against us." We have a choice. The time to choose is now. Now is not the time to deny there is a "war on terror". Using the oil weapon and sanctions to avert war with Iraq does not mean appeasement.

The risks of failing to act now are presented along with recommendations for actions that include energy independence to make the world a safer and environmentally sustainable place for our children to grow up.

While some U.S. congressional representatives seek to pass a non-binding vote expressing disapproval of President Bush's plan to add more troops in Iraq, and European governments fail to toughen financial sanctions on Iraq over its nuclear program, Iran moves ahead with there nuclear program and the development of ICBMs potentially capable of reaching Western Europe and even Washington DC. While the U.S. Congress and the EU fiddle, Iran plans for their destruction.

To quote U.S. Sen. Lindsey Graham: "We cannot find another occasion in American history … where there were troops on the ground in a war that Congress authorized … when Congress has passed a non-binding resolution opposing the battlefield strategy they were about to implement,"

European governments are using export credits to subsidise exports to Iran. Why, for example, are European governments not taking more measures to discourage investment and financial transactions?” US pressure on the EU has met resistance, with Europe saying it does not have the right mechanisms for taking such action and expressing fears that the extra sanctions would be overturned by courts.

How many of you still notice the stripe at the bottom of screen as you watch CNN or Fox News and even pay any attention anymore to the color of the threat alerts. Today the U.S. Terrorism Alert is yellow for Elevated and U.S. Aviation Alert is orange for High. You should still be interested. I don't think we will see green again in our lifetime.

Most people still think the threats are real. A new FOX News Poll found 64 percent of a sampling of Americans believes that the threats should be taken “very seriously,” while another 24 percent thought they should be taken “seriously.” Only 9 percent said "not very" or "not at all."

Where are you? I hope that you will join the majority and take action. The threat is real!!!

Iran's Push for Nuclear Weapons is Accompanied by It's Development of ICBMs

The threat of a nuclear armed Iran is no longer just a problem for Israel and their Arab neighbors. Iran's development of ICBMs that could reach Washington DC brings the threat home with added urgency. The nuclear Iran is not just a local issue.

Iran has just completed conversion of a powerful ballistic missile into a satellite launch vehicle. But the 25-30-ton rocket could be a wolf in sheep's clothing to test longer-range Iranian missile technologies. The Bush administration will likely view the vehicle as a rogue rocket developed in a cabal of Iran and North Korea. The new launcher has recently been assembled and "will lift off soon," says Alaoddin Boroujerdi, chairman of the Iranian parliament's National Security and Foreign Policy Commission." Said Aviation Week in their article of January 17, 2007, Shia Islamic satellite set for liftoff on ICBM cloaked as space booster,.

An Iranian ICBM with a range of nearly 2,500 miles could reach as far west as Central Europe and well into Russia, China and India. The U.S. Defense Intelligence Agency has told Congress that Iran in fact may be capable of developing 3,000-mi.-range ICBMs by 2015.

It is also troubling that Russia has provided $700 million in surface-to-air missiles to Iran and eight new aerial refueling tankers to China, according to a new Congressional study. Russia is also providing weapons to Venezuela. The sales to improve Iran’s air-defense system are particularly troubling to the United States because they would complicate the task of Pentagon planners should the president order air strikes on Iran’s nuclear weapons facilities. The Russian weapon sales to improve Venezuela's air-defense system are also troubling.

We can talk about ICBMs and all the other weapons being provided by Russia and China around the world. At the bottom line, the involvement of Mahmoud Ahmadinejad and the Iranian's close relations with Chavez in Venezuela, his relations with Cuba and Nicaragua, places the threat just 90 miles from the shores of America. And, this relationship is supported by the Leftists with the likes of Chindy Shaheen and the organizations including Code Pink, Oxfam, Global Exchange and United for Peace and Justice. These groups have intent of destroying America from the inside.

The Zionist and Silicon Valley Dream

More importantly Israel as well as Silicon Valley are centers for technology. Every night the scientists go home and they may leave if the risk is perceived to be high. We must recognize that the economic weapon used by the enemy is equally powerful.

Iran for example does not actually have to use the bomb to cripple Israel. They would be able to destroy the Zionist dream without pressing the button. The era of peace negotiations will come to an end: No Arab partner will be able to make concessions with a nuclear Iran standing over them. Foreign investors will flee the country, and many Israelis will, too. In one recent poll, 27 percent of Israelis said they would consider leaving if Iran went nuclear. "Who will leave? Those with opportunities abroad--the elite. The promise of Zionism to create a Jewish refuge will have failed, and, instead, Jews will see the Diaspora as a more trustworthy option for both personal and collective survival.

“A nuclear Iran means, at the very least, a realignment of power dynamics in the Persian Gulf. It could potentially mean much more: a historic shift in the position of the long-subordinated Shiite minority relative to the power and prestige of the Sunni majority, which traditionally dominated the Muslim world. Many Arab Sunnis fear that the moment is ripe for a Shiite rise. Iraq’s Shiite majority has been asserting the right to govern, and the lesson has not been lost on the Shiite majority in Bahrain and the large minorities in Lebanon and Saudi Arabia. King Abdullah of Jordan has warned of a “Shiite crescent” of power stretching from Iran to Lebanon via Iraq and (by proxy) Syria.”

What Can You Do?

The reducing of the threat of a nuclear Iran cannot be accomplished exclusively through military action, political negotiation, appeasement and sanctions, it requires addressing political, economic, energy, education and even the environment.

The Oil Weapon

Both the United States and Europe along with Israel want to prevent a war with Iran, the question remains as to their commitment. If they had to choose between curtailing trade with the Islamic republic and using the oil weapon, or seeing either America or Israel preventatively strike Iran's nuclear facilities, which would London, Paris and Berlin prefer? These are not unfair questions: at no time since the European Union started the "EU3" negotiations with Iran's clerical regime in 2004 have the Europeans probably had more leverage over Tehran's actions. At no time since 2002, when it became clear that the mullahs were conducting a clandestine nuclear research program, has there been a more critical moment for determining which path - diplomatic or military - the US and Israel will choose to try to stop Iran's pursuit of the bomb. If we close down these options, the odds of a military strike will increase significantly.

Timing is important, as it is is in a poker game. If you do not know when to raise, you always lose. There are signs of serious political and economic turbulence inside the Islamic republic's autocratic, socialist system. Iran's rulers have seen the arrival of additional military presence in the Gulf with the arrival of an additional battle group. They have been hurt by the limited restrictions of financial transactions. There is concern among the Iranian leaders about Mr. Ahmadinejad's competence. The economy of Iran is fragile. Does the West along with their Arab allies still know how to play poker?

According to Daniel Dombey writing in the Financial Times of February 14, 2007, EU paper casts doubt on nuclear talks with Iran, a confidential paper on Iran obtained by FT paints a picture of a country almost within reach of the nuclear bomb, which has increasing regional clout but also suffers from potentially crippling economic weaknesses.

The paper, put together by Mr Solana's staff, says that Iran's economy is vulnerable because of economic mismanagement, with foreign investment all but drying up and a real inflation rate of about 20 per cent a year.

"Without new investment, Iran risks being unable to maintain medium-term oil production, currently 50 per cent of government income," it says. But it concludes that "the problems with Iran will not be resolved through economic sanctions alone".

It notes that: "Iran has shown great resilience to outside pressure in the past".

The paper says: "The government may also exploit the sanctions to benefit nationalism or to explain economic failure. Nevertheless, Iran must understand that the pursuit of policies which the international community rejects is not cost-free."

In an indication of debates deep inside the EU, the paper asks how best to bring Iran to the negotiating table, whether the EU should press for additional sanctions and how to maintain international unity.

EU member states believe that their chances of success would be bolstered if the US offered Tehran comprehensive security guarantees. Skeptics of negotiations will point to the paper's findings to bolster their arguments for a military attack on the country's nuclear facilities. The paper itself does not recommend any such course, commending instead the EU's current "twin track" policy of mixing incentives and disincentives.

The oil weapon has been effectively used previously by Saudi Arabia. In the battle with Russia in Afghanistan, Saudi Arabia used the increase in oil production to bring down the price of oil; the result was the fall of the Soviet Union and ultimately the fall of the Berlin Wall. In 2003, the then Crown Prince Abdullah in meetings with President Putin threatened that Saudi Arabia would increase oil production again if Russia continued its increase and cause economic pain again. Russia curtailed production. Unfortunately, Russia also used this excuse to gain further control of the oil industry in Russia. The lack of availability of oil for Germany and Japan also played a role in WW ll.

Saudi Arabia is again employing quiet but effective diplomacy aimed at curbing Ahmadinejad's inclination for chaos-making in their backyard. Saudi Arabia, like other countries, is concerned both about Iran's nuclear program and about its activities in Iraq in support of the Shia, in Lebanon and in Palestine. While being somewhat silent about Iran's nuclear program, Saudi Arabia's condemnation of Iran's meddling in the Middle East was vocal. Saudi Foreign Minister Saud Al-Faisal could not have been more blunt when he told the French daily Le Figaro, "We repeat what was said to the Iranians: Do not interfere in our affairs." He characterized the Saudi-Iranian dialogue as an effort to explain to the Iranians the Saudi and Arab fears "about the Iranian influence on the Arab world."ⁱ The critical question is whether Saudi Arabia is prepared to translate its warning into action through the use of the "oil weapon." If the Saudis are prepared to apply the oil weapon, the impact on Iran's economic fortunes could be significant.

Saudi Arabia has the financial reserves available to increase oil production and live with a lower oil price. At the same time, Saudi Arabia has announced its intention to expand production capacity to 12 million b/d by 2009 through investment of $80 billion. At this level of production 1.5 to 2 million b/d will be set aside for local consumption, leaving at least 10 million b/d for export which is about 3 million b/d over current level of export.

If Saudi Arabia were to increase its export between one to two million barrels a day, it could bring down the price of oil quite close to the 2007 budget estimate of $37 barrel. If that were to happen, Saudi Arabia could absorb the shock, but Iran's economy could fall into a serious crisis. The oil option of Saudi Arabia, more than anything else, including the U.S.'s second aircraft carrier steaming into the Gulf, could expedite the process of his downfall or, at a minimum, cause him to limp for the remainder of his term of office.

In addition to actions necessary to prevent further investment in Iranian oil infrastructure facilities by European, Chinese and Indian companies, Saudi is also cooperating to influence Russia and China to cooperate in isolating Iran. China has initialed long-term energy deals with Iran, but it has made them conditional on a satisfactory resolution of the nuclear issue.

The Saudi daily Al-Watan February 12, 2007 reported that Saudi King Abdullah bin Abd Al-Aziz told the Russian news agency Itar-Tass in an interview that "the great capabilities of our countries [i.e. Saudi Arabia and Russia] makes the areas of our cooperation extensive." He continued, "During my last visit to Russia, we arrived at a set of agreements and understandings about oil, gas, and cooperation in information, technology, sports, and commerce. About Saudi and Russian oil revenues, King Abdallah said: "The Kingdom and Russia are two big oil states. Likewise, oil is considered one of the main sources of revenues in each of the two countries, and an important and influential element in the world economy in general. This obliges us [i.e. Saudi Arabia and Russia] to cooperate and coordinate in order to assure a safe increase in oil, and to attain security and balance in the global oil market for the benefit of producers and consumers alike.

The London Arabic Daily Al-Sharq Al-Awsat reports, First Russian President to Visit Riyadh that Russian President Vladimir Putin is Russia's first leader to visit Riyadh as he meets with King Abdullah Bin Abdul Aziz.

China is also weighing its relationship with Iran and Saudi Arabia. The most important factor in Chinese thinking will be the strategic considerations of its relationship with Saudi Arabia. King Abdullah bin Abdul Aziz al-Saud and Hu visited each other's capitals within a four-month period early last year, these visits greatly cemented Saudi-Chinese political equations.

The crucial Saudi role in the proposed buildup of China's strategic oil reserves should not be underestimated. China is planning to build four strategic reserve bases at Zhenhai, Daishan, Xingang and Huangdao, which when completed next year will be able to hold the equivalent of one month's national oil imports. Beijing plans to expand the reserves to the equivalent of three months' net oil imports by 2015.

Saudi Arabia's credentials for helping China fulfill its target of building a strategic oil reserve is far more credible than Iran's. Apart from supplying 17% of China's total oil imports currently and making multi-billion-dollar investments in China's petrochemical sector, Saudi Arabia, as a "swing producer", has unique capability to produce oil significantly above its Organization of Petroleum Exporting Countries quota. The expert estimation is that if Saudi Arabia chose to produce for the next three-year period an extra half-million barrels of oil a day for Beijing, that alone would bring China's strategic oil reserve to three months' supply. That is why China has offered extraordinary privileges to Saudi Arabia in the collaboration over the setting-up of the strategic oil reserve.

The criticality of China's "Saudi connection" needs no further elaboration. Besides, China cannot hope to diversify significantly away from the Middle East for its oil supplies. Two-thirds of proven oil reserves are in that region. According to the International Energy Agency, China's dependence on the Middle East will exceed 75% of its total imports by 2015. China's helpful stance at this juncture will considerably strengthen the US strategy to "contain" Iran. Curiously, within the three-way equation involving the US, China and Saudi Arabia, the Bush administration is justified in seeing interesting possibilities.

Against this background of gathering storms, Israeli Prime Minister Ehud Olmert earlier this year was given a red-carpet welcome in Beijing with full military honors at the Great Hall of the People facing Tiananmen Square. During the banquet in Olmert's honor, the band played "Jerusalem of Gold". Aides accompanying Olmert recalled with excitement that there used to be a time when Chinese diplomats wouldn't say the word "Jerusalem" in deference to Palestinian sensitivity.

Curtailing Investment in Terrorist States

Possible examples of individual actions include: not purchasing products made in countries which support goals that are not consistent with good human rights policies, against liberty and freedom and are anti-American. Another is not investing in companies supporting these countries, providing the banking services and building their economies. Economic action is a powerful tool, but the country using this tool must remain economically strong and endure certain hardships.

According to The Center for Security Policy the report The Terrorism Investment of the 50 States, August 12, 2004:

“Terrorism Investments of the 50 States” is the first national security-based statistical analysis of the investment patterns of America’s public pension funds. This report proves empirically that this nation’s largest and most prominent public pension systems tend to be heavily invested in global publicly traded companies that have business activities in terrorist-sponsoring states.ⁱⁱ

Together, these funds invest over $1 trillion in stock aloneⁱⁱⁱ on behalf of this country’s fire fighters, police officers, teachers, state and local officials and other public employees, making this collection of funds one of the most powerful investment blocks in the world. Given this extraordinary financial influence and the important role played by public companies in the economies of terrorist- terrorist sponsoring states sponsoring^iv, the Center for Security Policy has reached a key finding: America’s 100 largest and most prominent pension systems have the power to help defeat terrorism.

From the pension system of this country’s smallest state, Rhode Island, which has close to $400 million invested in 41 companies that are active in terrorist-sponsoring states, to America’s largest public pension system – the California Public Employees Retirement System – which has over $17 billion invested in 201 such companies, the results were remarkably uniform:

On average, America’s Top 100 pension systems invest between 15 and 23 percent of their portfolio in companies that do business in terrorist-sponsoring states.^v

Reduce the Division Among Politicians About the Threat of Iran

There is division among the politicians as to the magnitude of the risk that a nuclear Iran would be to the United States. President Bush said on January 29 the United States "will respond firmly" if Iran escalates military action in Iraq and endangers American forces. But Bush emphasized he has no intention of invading Iran. The U.S. is however increasing its presence in the Gulf with the addition of a second aircraft carrier group and support vessels.

At the same time Iran's calls for the destruction of Israel tend to be dismissed as mere rhetoric by the Western news media [See also: Victory is not an Option by William Odom in the Washington Post-February 11.] and some Congressional leaders. Ex-Israeli Prime Minister "Bibi" Netanyahu has told CNN: "Iran is Germany, and it's 1938. Except that this Nazi regime that is in Iran ... wants to dominate the world, annihilate the Jews, but also annihilate America."

In the Iranian Fars News report of January 28, Kerry Backs Up Iran's N. Rights. "Former US presidential nominee John Kerry voiced full support for the Islamic Republic's right to use civilian nuclear technology on the basis of the rules and regulations of the Non-Proliferation Treaty (NTP)." And according to Associate Press the Massachusetts Sen. John Kerry slammed the foreign policy of the Bush administration yesterday, saying it has caused the United States to become “a sort of international pariah.”

Ghost of " Tokyo Rose"

Anyone who remembers anything about World War II, or has studied anything about World War II, will understand and remember that during World War II, the Japanese developed a way to demoralize the American forces. The Japanese psychological warfare experts developed a message they felt would work.

They gave their psychological warfare script to their famous broadcaster "Tokyo Rose" and every day she would broadcast this same message packaged in different ways, hoping it would have a negative impact on American GI's morale. What was that demoralizing message? It had three main points:

• Your President is lying to you.

• This war is illegal.

• You cannot win the war

The Fantasy Island of a Green Utopian Earth

The vision of the opposition does not merely seek to defeat America, but something much more essential to sustaining the rising tide of freedom across the globe. It seeks the defeat of the American ideal. And it seeks it while perversely claiming that it is here to "rescue" it by facilitating its defeat; an Orwellian apotheosis of stunning assertion, and one that will do more than anything else to advance the level of Global Warming to thermonuclear levels in one brief, shining afternoon than any other philosophy you can recall or imagine. They yearn, from their perches in their perverse cosmopolitan realms, to see their nation defeated and humbled and lowered, because they long ago left that nation and ascended into those ethereal realms of their own private Fantasy Island of a Green Utopian Earth.

Little do the people waging "the war against the war" know that, in exchange for a temporary political advantage, they are gravely endangering America’s security and well-being, ultimately even their own. The Fantasy Island seekers will neither speak nor confront the present existence and inexorable rise of systems of government that do not exactly wish to deliver the higher realms of personal, sexual, and wantless liberty the One Worlders envision. America is the magnet for bright and ambitious people. It also makes America a target. The U.S. is also becoming one of the last holdouts of the traditional Judeo-Christian ideology. America takes it for granted, but it is not as available in other countries of the world. Ultimately, it's an issue of culture. The only people who can hurt America are themselves, by loosing their culture and will to win. If they give up their Judeo-Christian culture, they will become just like the Europeans. If they lose it, there isn't another America to pull us out.

Energy Companies are Supporting a Nuclear Iran Through Investment

The EU, with their companies continuing to seek investment opportunities is resisting the sanctions imposed by the UN on Iran. Iran needs foreign investment and technology to maintain their oil exports to fund their nuclear program and spread their terrorism and ideology.

For example Royal Dutch Shell (NYSE:RDSA) and their partner the Spanish oil company Repsol (NYSE:REP) have signed a $10bn deal with Iran. Other U.S. listed companies from China have done likewise. Iran in the Tehran Times of February 2, 2007 brags about Iran's recent energy agreements having set back the U.S. plans to economically isolate Tehran.

Last December PetroChina (NYSE ADR: PTR) also signed a deal with the National Iranian Gas Exports Company in which Iran agreed to sell China three million tons of gas from the Pars LNG Project over 25 years, beginning in 2011. At the present time the top U.S. shareholders in PetroChina are: Warren Buffett and Berkshire Hathaway, JP Morgan Chase, Fidelity, and Templeton Asset Management. PetroChina is a major gasoline distributor in the Eastern U.S.

China Petrochemical Corp (SINOPEC NYSE:SNP), the nation’s second-largest oil company, is also in negotiations with Iran for an agreement estimated to be worth as much as US$100 billion (HK$780 billion), involving crude oil and LNG.

U.S. legislation permits President George W. Bush to take action against non-US companies investing in Iran’s energy sector. However, because of concerns over an extra-territorial trade dispute and the risk of further alienating allies, no foreign companies have been penalised to date under the Iran Libya Sanctions Act and the subsequent Iran Freedom Support Act.

You can let your congressional representative, brokers and the companies--and even your Credit Card Company know your postion. The real power to punish these companies for being against us in this war for the Free World, should lie with American investors and consumers. Let's show Shell and other foreign owned companies that partner with foes, that Americans take seriously the imparative of countering Iran's nuclear ambitions and support for international terror. They better be with us, or else.

The Defense Should Not Rest

The solutions for dealing with proliferations are not static and no one solution will provide a permanent solution. Each day will present new challenges and each must be met for the protection of civilization. The solution does require the cooperation of countries working together realizing the danger and potential destruction that would issue forth. Today, most of emphasis has been placed of countries developing weapons. The control and security is not one-dimensional. This is not the time to hit the pause button on addressing the total security issue. Security does not stop at the negotiating table. We must address the issue BOTH locally AND globally.

To bolster the efficacy of deterrence in a world of small, closely located nuclear powers, it would be necessary to deploy surveillance systems that could identify and warn against aircraft movement and missile launches. These systems might be operated on a national or a multilateral basis; in fact, a number of states in exposed regions could contribute to collective efforts to detect airborne threats.

Monitoring and Surveillance System

The construction of such a regional surveillance system, moreover, would put in place much of the infrastructure needed to support another useful tool: some form of missile defense. Skeptics of missile defense have often been ridiculed, with some reason, the notion that such systems can be effective against nuclear weapons or large numbers of missiles. What they overlook, however, is that even leaky or somewhat ineffective defenses can play a constructive role in deterring an attack from a nuclear power with a small arsenal or lowering the odds that a full-scale nuclear conflict will erupt from a single use (of whatever origin). Witness Japan moving ahead with their missile defense system.

Disaster Recovery

Other kinds of defense could also help lower the odds of an attack or mitigate its terrible consequences. Government officials whether in the U.S. Asia or Europe should develop the capacity to evacuate those cities at risk of a direct attack or of being in the path of nuclear fallout, as well as stockpile radiation meters, build fallout shelters, and implement other measures first devised in the 1950s. Civil defense came to be seen as a grotesque joke when the Soviet Union acquired tens of thousands of nuclear weapons. But, like missile defense, it could play an important role in a world of smaller nuclear powers.

Should a nuclear bomb get through nevertheless; it would be critical for the government of the targeted state to respond with policies other than doing nothing or ordering indiscriminate retaliation. One option would be to launch a massive non-nuclear military campaign against the responsible party to make sure that such an attack was never repeated. But even with all the will and money in the world, such a response simply could not be summoned up out of the blue; it would require careful planning and preparation.

Eliminate the Funding

Energy independence can be a deterrent to nuclear proliferation. We must pursue at all cost energy self-sufficiency. And, we must do it on a crash basis. Energy independence can become the true liberation movement of our time.

The cost of defending a policy of Energy Interdependence as a cornerstone of foreign policy is huge in terms of potential loss of lives and impact on our economy. The West and particularly America cannot maintain our economy and security without assuming our own energy security. Lack of energy resources will extract the huge price of our security, freedom and liberty. Spreading democracy requires us to take responsibility for our financing and energy needs. A program leading to Energy Independence is both feasible and desirable. The risk of failing to act now for energy independence will make the world a safer and environmentally sustainable place for our children to grow up. See my article: Give Me Energy Security And I Will Give You A Foreign Policy

Many of the countries potentially developing nuclear weapons gain their funding through the sale of oil. Removing the sources of funding would significantly reduce the risk of nuclear weaponization.

Drug trafficking, Internet porn, sex slaves, counterfeiting and other endeavors are also providing funding for the activities.

Close the Open-Borders

Open borders allow the potential transfer of WMD. This requires both the countries that have nuclear materials, such as Kazakhstan and those seeking security such as the EU and the United States to have adequate border control.

Stop Technology Transfer for Weapons Technology

Security is also important with regard to technology transfer, shipment of materials, plans and manufacturing technology. A.Q. Khan and Emil Fuchs transfer of nuclear technology are examples. The technology transfer of missile technology—not components from the U.S. to China allowed their development of intercontinental missiles. With electronic transfer, North Korea may transfer their technology to other countries; inspecting ships will not solve this problem.

Raw Material Security

The U.S. also needs materials and metals, such as rare earths from China and titanium from Russia to maintain our weapons program. Unless we have plans for our security, we are at risk for defense. Shutting down a mining operation for Rare Earth in the U.S. because of an environmental concern can be just as devastating to our security as the transfer of nuclear material to a rogue nation.

International Cooperation

The only thing that would prevent proliferation will be a high degree of cohesiveness and co-operation on the part of the international community. And that has been something that has been lacking.

Conclusion

Peaceful coexistence does not require friendly relations or appeasement, but it does mean exercising mutual restraint while maintaining a will to win. Relinquishing the threat of regime change by force may be necessary and acceptable price for the United States to pay to stop Tehran or Pyongyang from getting the bomb and the delivery systems. But this alone will not prevent the nuclear proliferation and a potential nuclear and/or economic holocaust. The combined forces of the Leftist/Marxist – Islamic Alliance and the Oil Axis have the goal of world domination. If America gives up their Judeo-Christian culture, they will become just like the Europeans. If they lose it to the Leftist/Marxist – Islamic Alliance, there isn't another America to pull us out.

David J. Jonsson is the author of The Clash of Ideologies Xulon Press 2005. His new book: Islamic Economics and the Final Jihad: The Muslim Brotherhood to the Leftist/Marxist - Islamist Alliance (Salem Communications (May 30, 2006). He received his undergraduate and graduate degrees in physics. He worked for major corporations in the United States and Japan and with multilateral agencies that brought him to more that fifteen countries with significant or majority populations who are Muslim. These exposures provided insight into the basic tenants of Islam as a political, economic and religious system. He became proficient in Islamic law (Shariah) through contract negotiation and personal encounter. David can be reached at: djonsson2000@yahoo.co.uk

i ^{Al-Sharq Al-Awsat (London). February 1, 2007}

ii ^{This report sought to analyze America’s “Top 100” largest and most prominent public pension systems, excluding public university endowments. At the time of publication, only 87 of these public pension funds had provided the data required to undertake this analysis.}

iii ^{America’s Top 100 funds invest via a number of other investment vehicles, making their total investments on behalf of the American people closer to $2 trillion.}

iv ^{For the purposes of this report, terrorist-sponsoring states are defined as Iran, Saddam Hussein’s Iraq, Libya, North Korea, Sudan and Syria. Although Cuba is also correctly listed as a state-sponsor of terrorism by the U.S. Department of State, relevant data for Cuba was not available for this study.}

v ^{To perform the analyses of the 100 pension systems’ investment portfolios, the Center forwarded this data to the Conflict Securities Advisory Group (CSAG). Using their Global Security Risk Monitor Monitor, CSAG ran each portfolio to, determine its exposure to companies doing business in terrorist-sponsoring states or to proliferation-related concerns. The Center’s use of this data and the views and policy recommendations expressed in this report do not necessarily reflect those of CSAG or its partner firm, Investor Responsibility Research Center.}

Focus on Currencies (part 2 of 2)

by Mike Shedlock/Mish

This is part 2 of Focus on Currencies. Focus on Currencies (part 1) covered Technical Analysis, Politics, and the Commitment of Traders report (speculation vs. hedging) of futures. Part two covers the carry trade and currency fundamentals.

The Carry Trade

Let's kick this section off with the question: What is the carry trade?
The answer comes from the San Francisco Fed in an article entitled Interest Rates, Carry Trades, and Exchange Rate Movements.

What is the carry trade?
In the most common version of this strategy, an investor borrows a given amount in a low-interest rate currency (the “funding” currency), converts the funds into a high-interest-rate currency (the “target” currency) and lends the resulting amount in the target currency at the higher interest rate.

According to economic theory, an investment strategy based on exploiting differences in interest rates across countries should yield no predictable profits. Consider two countries, one with a high interest rate, and the other with a low interest rate. According to another equilibrium condition of international financial markets called the “uncovered interest parity,” the difference in interest rates between the two countries simply reflects the rate at which investors expect the high-interest-rate currency to depreciate against the low-interest-rate currency. When this depreciation occurs, investors who borrowed a given amount in the low-interest rate currency and then lent it in the high-interest rate currency will find that their return is worth less. The uncovered interest parity condition implies, indeed, that investors should expect to receive no profits, as they should expect the return from lending in the high-interest-rate currency to be worth ultimately as much as the cost of borrowing in the low-interest-rate currency.

In practice, however, investors in international financial markets do seem able to make profits through such strategies.

Empirical evidence shows that currencies that are at a forward premium and that, correspondingly, have a low interest rate, actually tend, on average, to depreciate, not appreciate, as the theory of interest parity conditions predicts. Similarly, currencies that are at a forward discount and that, correspondingly, have a high interest rate, tend, on average, to appreciate, not depreciate.This anomaly, then, implies that an investor who enters a carry trade is quite likely to make predictable profits from two sources: the interest rate differential between two currencies and the appreciation of the high-interest rate currency that was originally bought at a forward discount.

In reference to the COT numbers on the Yen from part 1 ... The numbers might seem huge, after all $13,212,986,904 bet on shorting Yen futures sure looks like a big number, but in all likelihood is peanuts in the grand scheme of things. Expressed as $13.2 billion, it seems much smaller. Please consider Brad Sester's excellent article A trillion dollars gets my attention, whether it comes from the PBoC or the yen carry trade.

Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets.

I suspect Gillian Tett would be far better positioned to guess the actual size of the yen carry trade than most. Her excellent FT article spells out the various ways cheap yen have influenced global markets -- and not just the obvious ones.

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fueling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

There is nothing like borrowing in a depreciating currency to buy the equity tranche of a CDO in a world where there are virtually no defaults. No wonder investment banks have been so profitable.

Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back.
That trade has paid off. Big Time. The MoF borrowed in depreciating yen to buy appreciating dollars -- and got a bit of carry in the process. And the MoF did it on a truly enormous scale.

A private investor might even want to start to take some profits ....

Bottom line: a ton of people -- the Japanese government and Japanese "real money" as well as the leveraged community -- are short yen and long higher carry currencies at a time when the yen is very, very weak by most historical standards.

In September of 2006 MarketThoughts.com had an interesting article called The Yen Carry Trade Revisited.

......The second great Yen carry trade began in the summer of 1995 and it did not end until October 1998 – when the Yen ended its decline by rising 15% in a week!

As for the current Yen carry trade, there is little evidence to believe that much of the borrowed Yen went into commodity speculation – as the decline of commodity prices in the last four months has generally not led to a higher Yen. More likely, the typical profile of the latest Yen carry trade participant is as follows:

1. A speculator who borrows or shorts Yen and use the money to invest in a higher-yielding asset (usually government bonds or CDs) in the U.S., UK, or countries in the Euro Zone. The days of using this money to invest in higher-yielding countries in “peripheral” developed countries like Iceland and New Zealand has definitely ended – given the crash in both of these currencies earlier this year.

2. A Japanese investor (e.g. a pension fund, a life insurer, or an individual investor) who converts his money from Yen to U.S. dollars (or the Euro or the Pound, etc.) in order to invest in Treasuries or overseas real estate. Note that this position is usually unhedged – which again puts further pressure on the Yen.

Quoting the IMF's “Financial Stability Report”:

The evidence that Japanese domestic investors conducted a form of the carry trade by seeking higher returns overseas is quite strong. Domestic institutions, such as life insurers, effectively engaged in the carry trade by purchasing foreign bonds to support yen-denominated liabilities, often on an unhedged basis. Net purchases of foreign bonds by life insurers totaled 848 billion yen ($7.4 billion) in 2005. Individual investors—particularly wealthier retired households — shifted a share of wealth away from bank deposits or other low-yielding yen investments, toward foreign bonds or investment trusts explicitly tied to foreign bonds (see the first figure). At its peak in late 2005, the money flowing into foreign bond funds exceeded 5 trillion yen over the trailing 12-month period, equivalent to about 1 percent of GDP.

Positioning on yen futures contracts also points to the existence of an offshore yen carry trade. Data from the Chicago Mercantile Exchange show noncommercial traders (predominantly financial players) moving from net long to net short yen positions in early 2005, and staying net short until the end of April 2006. (Mish note: Speculators are hugely short Yen futures again as discussed above)

So the $64 trillion question is this: When will the Yen carry trade end? On a purchasing power parity basis, the Yen is undervalued against the U.S. Dollar, but massively undervalued against the Euro. That being said, things can always get more extreme before reversing – especially when it comes to the financial markets. Drawing a tentative up trend line from the previous lows in the Yen in early 1990, October 1998, and early 2002, and one gets a target range of approximately US$0.78 to US$0.82 (for every 100 Yen) before we see the Yen bottoming. But in all likelihood, it will need some kind of trigger. Just what is that trigger? I will discuss more about this as we approach the US$0.78 to US$0.82 range and my preferred timeframe (later this year), but for now, I am guessing lower-than-expected economic growth in Western Europe as the revision of the German VAT comes into play starting January 1, 2007. Historically, a goods & services tax has always meant a stronger-than-expected economic slowdown, and the German economy will be no different – despite the prevalent optimism among the German government at this point.

So now we have Japanese life insurers speculating in the carry trade. Isn't that special? One possible answer to the "$64 trillion question: When will the Yen carry trade end?" is that these things always seem to go on much longer and get more insane than any rational person deems likely. Such thinking suggests a possibility that the trendline break in the Yen (as noted in part one and repeated below) is a real one. Those following along carefully will note that is the opposite of what I suggested in part 1 in reference to the COT data (i.e. an unwinding of the futures positions is dollar negative on balance).

Yen / US Dollar (Monthly)



Fundamentals

• All fiat currencies eventually head to zero. The only difference is the length of time it takes to get there.
• Gold has never gone to zero and barring a star trek like replication device, or nanotechnology that can easily combine atoms to make elements, gold is not likely to head to zero either.
• In the meantime the biggest factors that determine relative worth of currencies seem to be interest rate differentials, expansion of money and credit, and Foreign Direct Investment. The much ballyhooed trade deficit is far down the list.
  
• When it comes to the Yen, the interest rate differential between Japan and the US or Japan and Great Britain is substantial.
• Japan is also sitting on a national debt over150% of GDP. What that will eventually do to interest payments when rates rise should be obvious. The implication is Japan may have to raise taxes substantially smack in the face of poor demographics (shrinking population). Japan has lots of reasons to resist hiking rates. That is Yen negative.
  
• Europe has demographic problems of its own. Europe also has a very rapid expansion of M3 but a much lower interest rate than the US. That is Euro negative vs. the US dollar.
  
• Great Britain has a housing bubble of its own and will undoubtedly burst at some point. This should put pressure on the pound as expected rate hikes in the UK may not occur.

Everyone has a tendency to look at problems in the US in isolation. As you can see the issues are both many and complex. There is a lot more to currencies than the one sided view often heard "The US dollar sucks". This post is an attempt to look at things from as many angles as possible.

From a purely technical standpoint I would have to suggest "Trust the trendline breaks on the charts". From the standpoint of things almost always get crazier than anyone thinks, I am inclined to believe the Yen is likely to sink further then whipsaw massively. I suggested this quite some time ago and so far have been correct. From the explosive potential of the unwinding of the carry trade one should be watching those charts carefully.

From a political standpoint I am rather unimpressed with Paulson even as others seem to be going gaga just because he is "watching very, very carefully". From the standpoint of the US dollar in and of itself, things do not seem as bad on many standpoints as most seem to think, especially in relation to the Euro. Ultimately however, the fate of the dollar may depend on the timing, magnitude, and swiftness of the unwinding of the carry trade, and from what level that unwinding occurs. Taking quick action should something go wrong with whatever you are doing (in whatever direction you are doing it) seems like the best advice at this juncture given that the situation is potentially explosive in both directions.

Two Quick Notes:

1. This post originally appeared in Whiskey & Gunpowder.
2. Some of you have had trouble logging in to The Market Traders. If you signed up but could not get logged in, please try one more time. Click here to Email Mish about The Market Traders if you are still having problems getting on.

Mike Shedlock / Mish

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs / Mishedlo and one of the more popular boards on Silicon Investor as well, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis. While he is not writing about stocks or the economy Mish spends a great deal of time on photography, one of his other passions. Mish has over 80 magazine and book cover credits, for magazines such as Country Magazine, Wisconsin Trails, the Chicago Tribune Sunday Supplement, Browntrout Calendars, and numerous other publications. Some of his Wisconsin and gardening images can be seen at www.michaelshedlock.com.

Focus on Currencies (part 1 of 2)

by Mike Shedlock/Mish

What follows is part one of a focus on currencies including the US dollar index, the Yen, the Euro, the British Pound and the Canadian dollar. There is a special emphasis on the Yen.

This analysis covers five factors

1. Technical Analysis
2. Politics
3. Commitment of Traders (speculation vs. hedging) of currency futures
   
4. The Carry Trade
   
5. Fundamentals

Let's kick off with the technicals.
Forex traders will note that charts marked with an "*" are inverse of normal trading pairs. This was done to put all the currency pairs in the same frame of reference (i.e. a weakening chart on a currency pair is bullish for the US dollar and US dollar index).

Click on any chart below for a better view.

Yen / US Dollar (Monthly) *



Euro / US Dollar (Weekly)



Canadian Dollar / US Dollar (Monthly) *



US Dollar Index (Weekly)



US Dollar Index (Monthly)



The charts show that we are at a significant inflection point on the US dollar index, the Yen, and the Euro. Let's look at additional factors to see if we can gather insights as to which way the charts may break. Following is the political perspective.

Congress Takes Aim Over Yen

The Financial Times is reporting US Congress takes aim at Tokyo over yen.

Powerful House Democrats are pressing the Bush administration to persuade Tokyo to strengthen the yen, claiming the currency's weakness is bolstering Japanese imports at the expense of US manufacturers. In a letter to Hank Paulson, US Treasury secretary, the House members alleged that Tokyo was pursuing a cheap currency to subsidize exporters and urged Mr Paulson "to press the Japanese government to reverse their weak yen policy".

The pressure from Democrats sets up a confrontation with the US Treasury secretary, who argues the yen's weakness reflects Japan's economic fundamentals rather than a deliberate policy of manipulation.

Michigan Representative Sander Levin, chairman of the House trade subcommittee, told the Financial Times: "Japan is clearly following policies to maintain a weak yen."

The yen's fall continued on Thursday, down 0.4 per cent to Y121.20 against the dollar and 0.6 per cent to Y157.90 against the euro. Japanese exports as a percentage of gross domestic product have – at 16 per cent – surpassed the levels of 1985 when Japan was forced to revalue under pressure from the US.

Takatoshi Ito, a member of the Japanese cabinet's council on fiscal and economic policy, said: "Japan has not intervened since March 2004 – not even oral intervention – so the ministry of finance is clean as market fundamentals push the yen weaker."

Tensions over the yen are set to be reflected in legislation drafted in the Senate on currency manipulation, analysts said. Representative Barney Frank, chairman of the House Financial Services Committee, said: "This is directly tied to the administration's efforts to get trade promotion authority renewed. It cannot be the case that we will let the status quo go on."

Comments on Taking Aim

• The Democrats in Congress believe that higher prices on goods from Asia (nearly everything but food, energy, planes, and weapons) will be a good thing. It won't.
• The Democrats also must think that higher prices on goods will bring back manufacturing jobs to the US. It won't.
• Michigan Representative Sander Levin, chairman of the House trade subcommittee, says "Japan is clearly following policies to maintain a weak yen." Hmmm. Like we are not doing everything in our power to maintain a weak dollar? Does any country want a strong currency? The answer to that question should be obvious: Competitive currency debasement is everywhere you look.
• Takatoshi Ito, a member of the Japanese cabinet's council on fiscal and economic policy, said: "Japan has not intervened since March 2004". That is the fact. And oddly enough the Yen did not plunge until Japan stopped intervening. That goes to show you two things: 1) A primary trend in currencies or anything else can not be defeated by manipulation, which is something gold bugs need to remember when screaming about these conspiracy theories purported by GATA , and 2) Sentiment was so universally bearish on the US dollar by the Spring of 2005 with numerous magazine covers and the shoeshine boy telling everyone that Gates and Buffett were short the dollar, that the dollar was bound to rally.
• If Congress takes action against either China or Japan as currency manipulators I fully expect a severe market reaction, and that reaction that will generally not be welcome anywhere.
  
• While cautioning against underestimating the shortsightedness of legislative bodies in general, this jawboning is more than likely nothing more than frustration by Congress and this administration that we can no longer bully the world markets into doing what we think is in our best interest (and on that we are not even right) . After all who wants higher prices across the board on all kinds of goods and services when it will not bring a single job back to the US? That is essentially what Congress is begging for.
  

Paulson Sides With Japan

Bloomberg is reporting Paulson, in Congress, Sides With Japan on Yen.

Henry Paulson's defense of Japan's currency policies over the last week is forcing traders to pay more attention to a U.S. Treasury secretary than they have in years.

Paulson caused fluctuations in the yen at least three times in the past week by responding to questions about whether it is undervalued, as alleged by some Democrats and European finance ministers. He sparked an hour-long slide yesterday when he told the House Ways and Means Committee that the currency is set in an open market and that Japan is still struggling with deflation.

Paulson first discussed the yen's slide against the dollar on Jan. 31. Answering a question during testimony at the Senate Banking Committee in Washington, Paulson said he's watching the yen "very, very carefully."

The testimony was only Paulson's second since Bush nominated the 60-year-old for the Treasury post in May. It took Paulson three months to even mention the dollar. When he did, he said he favors a "strong dollar," a script developed by fellow Goldman alumnus Robert Rubin, who was Treasury secretary from 1995 to 1999.

"He has a very hands-off approach to markets and doesn't seem to want to comment very much," said Sophia Drossos, a currency strategist at Morgan Stanley in New York. "He brings a high level of financial savvy. He is viewed as the Republicans' answer to Robert Rubin."

Paulson's remarks may also have had an impact because investors are growing wary about the magnitude of the yen's decline. The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen.

"As soon as he mentioned that he was watching it very closely, that gave traders something to run with," said David Gilmore, a partner at Foreign Exchange Analytics in Essex, Connecticut. "It took literally a couple of days for the market to fully understand," he said.

Paulson "did an admirable job" in cogently laying out his view, Gilmore added. "The interesting thing is that he was so prepared to speak on the yen."

Comments on Paulson

• Supposedly Paulson is watching things "very, very carefully". So what? Is the US going to sell dollars and buy Yen? Wouldn't that be fun? (especially if Japan reacted as they did before by selling Yen to buy dollars)
• Sophia Drossos, a currency strategist at Morgan Stanley, said "He has a very hands-off approach to markets and doesn't seem to want to comment very much," and "He brings a high level of financial savvy. He is viewed as the Republicans' answer to Robert Rubin."
• OK Sophia, if his approach is hands off, exactly why should anyone care what he is watching or for that matter saying? Why does that make him "savvy"? Is he really Robert Rubin?
• David Gilmore, a partner at Foreign Exchange Analytics had to say: 1) "As soon as he mentioned that he was watching it very closely, that gave traders something to run with" 2)The market ran with it even though "It took literally a couple of days for the market to fully understand" and 3) Paulson "did an admirable job" in cogently laying out his view. Sheesh. I will leave this to the reader to sort out the various contradictions in those statements.

Let's now turn our focus on speculation as defined by Commitment of Traders reports (COTs).

Commitment of Traders

For those unfamiliar with this frame of reference, commercial readers and noncommercial traders have to report their open interest in futures (in this case currency futures) once a week. Those results are summarized in COT reports. A quick glance at any of the following charts will show non-commercial, commercial, and non-reportable positions.

Think of commercial traders as either producers or hedgers. In the case of something like gold or corn, the commercials will be the miners or the farmers. But they could also be jewelry makers or cornflake makers like Kellogg's. In short the commercials represent someone wanting to hedge future costs from rising or producers wanting to lock in prices that they can profitably produce at. In the case of currencies, the commercials might be importers or exporters not wanting to take on currency risk. The commercials might also be big trading houses wanting to hedge exposure to various markets for one reason or another. Commercials are thus hedgers.

Think of the non-commercials as the big hedge funds speculating one way or another (long or short) in a commodity or currency. The nonreportable positions would be a small trader speculating one way or another on currencies or commodities. Trading size determines reportability .

Using The COT Report

Investopedia offers advice on Using the COT Report.

In using the COT report, commercial positioning is less relevant than noncommercial positioning because the majority of commercial currency trading is done in the spot currency market, so any commercial futures positions are highly unlikely to give an accurate representation of real market positioning.

Noncommercial data, on the other hand, is more reliable as it captures traders' positions in a specific market.

There are three primary premises on which to base trading with the COT data:

• Flips in market positioning may be accurate trending indicators.
• Extreme positioning in the currency futures market has historically been accurate in identifying important market reversals.
• Changes in open interest can be used to determine strength of trend.

The COT reports come out on Friday as of the previous Tuesday. (This delay is nonsense in the current electronic age, but it is what it is).

If you are still with me, following are a few snapshots from the most recent Currency COT reports.

Yen



The above chart shows that the non-commercials (big speculators) are short 128,526 contracts in the Yen (betting it will fall lower or that if it rises they can make more elsewhere). This is part (but likely only a small part) of the infamous carry trade (shorting the Yen, and investing elsewhere, typically US Treasuries). Each contract represents 12,500,000 Yen (as of this writing $102,804 per contract). The total amount bet on interest rate differentials between the Yen and the US dollar as of the report date is $13,212,986,904.

The article on Paulson above made this statement "The currency is near a 20-year low on a trade-weighted basis, and Commodity Futures Trading Commission figures on Feb. 2 showed a record 173,005 positions betting on a weaker yen."

The COT charts in this blog were reported on Friday February 9th, so we can see some unwinding of positions since then. Or can we? Notice I said reported on February 9th. They reflect positions as of Tuesday February 6th. Just as with stock market short interest (reported only once a month) potentially useful information is kept from the small traders while others potentially know. This is not as bad as short interest in stocks, but there is no real excuse for it. We do not know the current position of the COTs

At any rate the carry trade in the Yen will unwind at some point. It will not be to the benefit of the US dollar when it happens. For more thoughts on this idea please refer to Mr. Practical on the Yen, Carry Trade, and Credit Expansion.

One more point. An unwinding of the Yen position will be Yen supportive and dollar negative. That increases (but certainly does not negate) the likelihood that the trendline break in the Yen as shown on the first chart is a fake one.

British Pound



A quick look at what the non-commercials are doing shows a chart that is about as lopsided as it gets. There seems to be mammoth one sided speculation on the British Pound vs. the US dollar.
62,500 pounds is currently $121,950, and the big specs are long 92,728 contracts thus there is $11,308,179,600 bet on US dollar vs. British Pound currency differentials. This will get unwound at some point and in contrast to the Yen, an unwinding of these contracts should be US dollar supportive when it happens. Timing the reversal is of course the issue.

Canadian Dollar



For whatever reason, hedge funds are short 80,646 contracts on the Canadian dollar.
The unwinding of this trade would be supportive of the Canadian dollar and that similar to the Yen suggests a possibility that this is a potentially false breakdown.

Euro



Speculation on the Euro is not as massive nor is it as one sided as some of the others. However small speculators (nonreportable positions) are substantially long (relative to small spec positions), with commercials net short 65,632 contracts and the big speculators long 45,330 contracts. The unwinding of those contracts would likely be supportive of the US dollar. Each contracts represents 125,000 Euros (as of this writing $162,562 per contract or $7,368,935,460 in total on 45,330 contracts). On the surface, this might not seem like such a big deal (at least as compared to the Yen). But one must also look at the relative weighting of currencies within the US dollar index, and that is where the rubber meets the road.

Relative Weightings

What is the US Dollar Index®?

• A widely recognized benchmark that reflects the value of the US dollar on global markets
• A geometric average that tracks the value of the US dollar against a basket of six currencies
• The USDX® is based upon the original US Dollar Index calculated by the Federal Reserve Bank, base year of 1973

The following pie chart tells the story.



Weightings

Yen 13.6%
British Pound 11.9%
Canadian Dollar 9.1%
Swedish Krona 4.2%
Swiss Frank 3.6%
Euro 57.6%

What the Swedish Krona is doing in the index I haven't a clue. But the key issue is that those expecting a huge rebound in the Yen to sink the US dollar index are likely barking up the wrong tree (at least from the standpoint of an unwinding of futures contracts). The Yen is only 13.6% of the index while Europe (the Euro and Pound) comprise 69.5% of the weighting, with the Euro a whopping 57.6%.

This concludes part one of Focus on Currencies. This is NOT a complete view. The carry trade in the currency markets (as opposed to the futures market) dwarfs the significance of the COT data according to some well respected economists. The message here is that it is easy (too easy) to focus on one or two aspects of a trade while missing the big picture. Tomorrow I will attempt to fill in some of the rest of the picture with a focus on the carry trade as well as a brief discussion on the fundamental factors that drive the relative valuations of currencies.

Mike Shedlock / Mish
for Whiskey and Gunpowder

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs / Mishedlo and one of the more popular boards on Silicon Investor as well, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis. While he is not writing about stocks or the economy Mish spends a great deal of time on photography, one of his other passions. Mish has over 80 magazine and book cover credits, for magazines such as Country Magazine, Wisconsin Trails, the Chicago Tribune Sunday Supplement, Browntrout Calendars, and numerous other publications. Some of his Wisconsin and gardening images can be seen at www.michaelshedlock.com.

Land Ho

by Justice Litle

For some, the weather outside has been frightful. For others it has just been bizarre.

Among other things, January brought us 70 degree temperatures in New York City's Central Park; New England forsythias in joyous springtime bloom; snow in Malibu; more than $700 million worth of freeze damage to California citrus crops; Colorado cattle trapped by 15-foot-high snow drifts; and, last but not least, Midwest ice storms that killed at least 14.

With apologies to Dickens, January was both the warmest of times and the coldest of times. Overall, 2006 was the warmest year in over a century for the continental United States. The mild temperatures enjoyed by the East-even as the West got gob-smacked by Old Man Winter-were enough to send natural gas stockpiles soaring. (No need to heat the house when it's t-shirt weather outside.)

But now it looks like Old Man Winter could be rolling up his sleeves. Joe Bastardi, Chief Forecaster for AccuWeather.com, believes the whole country is going to get walloped. "Those who think that winter 2006-07 is going to remain mild are in for a shock," he says. "Winter is likely to come with a vengeance." Bastardi sees shades of winter 1977-1978, when a warm beginning led to a blizzard-pounding finish.

If Bastardi is right, natural gas storage levels could plummet in short order-reminding Wall Street once again how quickly situations can change. If he is wrong, of course, natural gas will remain mired in negative sentiment for the time being.

Climate change fears suggest a trend of milder winters-a negative for natural gas. But the flip side of that coin is greater temperature volatility and stronger legislative pressure.

Extreme weather patterns (like snow in Malibu, for example) require a larger supply buffer to absorb demand spikes when the outliers hit. Temperature volatility thus lessens the perceived "margin of safety" in existing storage levels. (The more things can swing, the more buffer you need.)

In addition, the more mild and wacky winters we see, the more determined world governments become to "do something" about carbon emissions. This green calculus gives natural gas a leg up on its carbon-spewing rival, coal. While coal is the electricity-generating champ from a financial cost standpoint, natural gas is cleaner and less carbon-intensive, making it the environmentally desirable choice.

Coal will likely remain the electricity king for some time, thanks to its abundance and low cost, but will also cede ground at the margins due to its reputation as a polluter and CO2 spewer. Nuclear power is set to expand its electricity role, but regulatory hurdles and lengthy construction times mean that growth will happen relatively slowly. Solar and wind are ramping up, but starting from a miniscule base. These factors give natural gas a consistent demand edge, in both China and the United States, that will last for quite a while.

All this, too, comes on top of the fact that in terms of depletion rates versus discovery rates, North America is running hard just to stay in place. The new wells are just not keeping up. Elsewhere, industry experts believe the global shortage of liquid natural gas (LNG) could persist until 2011, in part due to the political risk of LNG terminals and the high cost of plant construction. Furthermore Canada's oil sands expansion plans will suck up a larger portion of that country's natural gas production over time.

These natural gas musings are the backdrop for the latest Outstanding Investments recommendation.

This drilling company is a rare find: a small-cap growth stock with a beaten-down value profile.

Normally it's very tough (if not impossible) to find small-cap companies with excellent growth prospects, strong cash flow, and minimal long-term debt trading a mere twenty to thirty percent above book value. (This company is trading just under $16 as of this writing, with a $396 million market cap. Book value is $12.95 per share according to the Wall Street Journal. )

Most of the time, companies trading close to book have an outlook ranging from "blah" to "ugly." If a business sells for a just few dollars more than what the parts are worth, the natural assumption is that something is very wrong with that business.

If that same business is well run, making solid profits, has the means to retire its long-term debt in a short period of time, and could theoretically generate enough cash to buy back all its own stock in the next few years... now you've got a real head scratcher on your hands.

Except in this case, the mystery has already been cracked. We know the problem is the manically gloomy sentiment surrounding natural gas.

This is a small-cap land driller provides contract drilling services-land rigs-to oil and natural gas exploration and production companies, with ongoing contracts in Oklahoma, Texas, Kansas, Colorado, and North Dakota.

Approximately half of their customer base is publicly traded-well-known entities like Devon Energy and Chesapeake Energy. The other half are strong independents. Their customers have at least two things in common: they are committed to the long-term bullish case for natural gas, and they are committed to drilling.

Between December 15, 2006 and January 11, 2007, the shares of this company were pummeled, registering a 30% decline in less than two months. The selloff came during a period of general carnage for the drillers, as oil declined and natural gas fears escalated with the persistence of mild winter weather.

Things were orderly at first, and then Nabors Industries-a large competitor, and one of the biggest land drillers in existence-announced a fourth quarter earnings warning on January 3. Nabors went into freefall at that point, and this company followed.

At the worst point of the decline, the spread between this driller's share price and book value shrank to about sixty-seven cents...less than the company's third quarter diluted earnings of 70 cents per share.

When the implied value of the entire business operation is compressed to less than one quarter's worth of earnings, you know there is some panic in the house.

Legendary value investor Ben Graham liked to talk about "Mr. Market," analogizing the stock market to a human being subject to fits of optimism and depression. Thanks to the dominance of fast money and short-term time horizons, Mr. Market is a bit of a drug addict these days, downing copious quantities of quaaludes and methamphetamines. When Mr. Market gets exceptionally out of whack, opportunities arise like this one.

The real worry for companies like this and Nabors is what's happening in the land rig market. Nabors' cut of fourth-quarter earnings guidance, which it blamed on slowing North American gas markets, led to dire scenarios of collapsing day rates and rigs sitting idle as result of a glut.

In Outstanding Investments' opinion, these fears are overblown. There is fair reason to have concern, but nothing to justify the crush of pessimism that has weighed down the drillers so heavily. That is, if one understands the basic realities of peak oil and the compelling long-term case for natural gas.

In regard to rigs and day rates, this driller also stands out for the quality of its management and farsightedness of its strategy. It keeps close tabs on market conditions, and is careful not to "compete with itself" by putting out more rigs than the going market can support.

When the market is less conducive to putting out refurbished rigs, the company scales back and uses its cash flow to diversify into other complimentary businesses, like workover rigs-the mobile machines that handle cleaning, service and maintenance for wells already in production. Their recent acquisition of Eagle Well Service is an example of expansion in this direction. Not to mention they are also mulling over the possibility of international expansion as conditions and opportunities warrant.

This driller reports good visibility with its clients; the CEO reported on the third quarter earnings call that there seem to be no issues with drill budgets, and "if anything we've seen a push to continue to drill." Because of their high-tier focus on support, service and safety, they also enjoy stronger relationships with clients than many of its smaller independent competitors. This adds a layer of stability to revenues, as the less established fringe players are the ones to see their rigs idle first in adverse market conditions.

The land rig market is not without risk in the coming months, but the potential reward seems well worth it. While this driller has already bounced off its oversold extremes, it is still trading under its $17 initial public offering price as of this writing-and this comes with excellent management and excellent results.

Book value acts as a floor underneath the stock-if worst comes to worst, a vulture investor could break up the pieces and sell them off for $13 a share or so, if not more under the right circumstances. But that isn't likely to happen by any stretch of the imagination. What is far more likely, in our opinion, is that day rates and rig utilization will stabilize and resume their upward trend in due time, and they will continue to grow and thrive.

Of course, if Mr. Bastardi of Accuweather is right in his weather predictions, sentiment for the land drillers could turn extremely quickly. At a current price to earnings ratio of less than eight, they could theoretically see 50% or more upside simply by way of removing the cloud of pessimism overhead.

Even if the weather remains mild and the sentiment adjustment a ways off, the natural gas case is solid-and this driller looks worth holding on to for "multi-bagger" upside potential in the years to come.

Till Next Time,
Justice
for Whiskey and Gunpowder

Justice Litle, co-editor of Outstanding Investments, has a unique background that has served him well in the markets. In college, Justice studied literature and philosophy in places as diverse as Oxford University (Oxford, England), Pulacki University (Olomouc, Czech Republic) and Macquarie University (Sydney, Australia). Originally pursuing a PhD and a life in academia, his career path changed forever after discovering “The Investment Biker,” Jim Rogers’ chronicle of macro investing by way of motorcycle.

Justice Litle has implemented sophisticated trading and hedging strategies for clients on a global scale – a broad cross section including soybean farmers, cattle ranchers, currency hedgers, energy consultants, scrap metal dealers and everything in between. He has worked with hedge funds, traded equities for a private partnership, written multiple articles for Futures Magazine, been quoted in the Wall Street Journal, sought for market commentary by the likes of Reuters and Dow Jones, and made contributions to the book “Trend Following: How Traders Make Millions in Up or Down Markets” (Mike Covel, FT Prentice Hall 2004).

Mr. Litle’s personal interests include philosophy, travel, and chess. He has also been known to hike glaciers, scuba dive with sharks, and jump out of perfectly good airplanes, though only on occasion.

Thieves Target Pollution Rose Colored Glasses

by Stephen Leeb

Thieves Target Pollution

With increasing evidence of solid growth worldwide, commodities have found renewed life. Crude oil is getting most of the coverage now that it’s once again trading in the upper $50s, but other key commodities are also doing well. For instance, despite copper stockpiles having doubled in the past year, the price of the red metal is holding in there around $2.50 a pound, well above its year-ago levels. Other industrial metals, especially those that aren’t subject to speculation in the commodities pits, are also moving higher.

A sure sign that industrial metals are in great demand can be found by reading the local police blotter. According to several reports we’ve seen lately, thieves are no longer content to rip off car stereos and air bags, now they’re scurrying under automobiles to get their hands on catalytic converters. The anti-pollution devices use metals such as platinum, palladium and rhodium to drastically reduce a car engine’s harmful emissions.

But a cash hungry thief can quickly remove the device and score an easy $100 to $150 each for his efforts. Rose-Colored Glasses This week the International Energy Agency (IEA) offered up its latest 5-year energy market forecast. The group raised its projection for global oil demand to a 2 percent annual rate out to 2011, citing rapid growth in Asia (most notably China and India) and in the United States.

The IEA is pegging worldwide supply at 88 million barrels a day by the end of 2008, up from 84.5 million barrels a day presently. That may not sound like a great deal, but this kind of growth isn’t supported by what we’ve seen in recent years. Consider that despite the sharp run-up in oil prices last year, the world’s lone swing producer, Saudi Arabia, was unable to increase its output meaningfully when it had every incentive to do so.

Today, the Saudis output is some 8 percent below its May 2005 peak. The IEA also has U.S. crude oil production rising this year and next. This is a result of the industry recovering from the devastating 2005 hurricanes, and also thanks to expected new deepwater drilling efforts. We want to point out though, since production on the North Slope of Alaska peaked in the 1980s, U.S. oil production has only once increased on a year-over-year basis and even then only marginally. While more domestic oil will likely come from offshore drilling, the added capacity isn’t likely to surpass declining production elsewhere.

The report also contains what we believe to be an overly optimistic assessment of global spare production capacity during the next few years, which fits with the organization’s pattern of offering rosy assessments that must later be adjusted downward. Finally, the IEA’s estimate for OECD days of supply of commercial stockpiles is falling to just 50 by the fourth quarter of this year, which would put supply at its lowest levels relative to demand in five years.

Continued strong global demand that shows no signs of abating, along with Iraq’s devolution, U.S. war drums sounding toward Iran, unrest in Nigeria and production among four of the five largest non-OPEC producers in decline means we can’t afford to be as complacent as the bean counters at the IEA.

Until next time,

Your EI Team

http://www.emerging-investments.com

Disclaimer

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Continuous Commodity CRB

by Adam Hamilton

Commodities investors have faced major psychological trials over the past several quarters or so. Back in early May the flagship CRB commodities index hit an all-time nominal high, but then it started grinding lower into the summer. Not long after it plummeted, crashing through its key support zones like a meteor.

In August and September, the plunging CRB led to a widespread perception that commodities in general were falling off a cliff. Some, like the perpetual commodities bears on Wall Street, rejoiced. To them the utter technical failure in the CRB was prime evidence that this pesky commodities bull that has been competing with their mainstream stocks for capital was finally finished. They were smug in their apparent triumph.

To others including many long-time commodities bulls, the technical devastation in the CRB wrought proportional psychological devastation. For every investor there comes some inflection point when prices have fallen so far technically that they overshadow any bullish fundamentals. Eventually everyone has to cut their losses if a damaging price cascade lower continues unabated. There is simply no other rational choice.

And there is nothing that breeds negative psychology faster than falling prices, so it is not surprising that bearish theories on commodities have flourished in the last six months or so. It is just human nature to want to understand why events are happening around us. We are all the most receptive to theories that explain and justify whatever happens to be transpiring at the moment in our own immediate environments.

A key case-in-point is global warming. Regardless of whether these theories are true or false, they only gain traction among the general populace during unusually warm conditions like this past winter. There is no doubt that if our winter had instead been anomalously cold and bitter, barely anyone would have been talking about global warming. This innate psychological need for explanation intimately affects the markets as well.

When prices are rising fast, bullish theories abound to explain them. Remember all the New Era bullish theories surrounding the NASDAQ in late 1999 and early 2000? And when prices are falling fast, bearish theories gain traction and prominence. If the CRB had been strong rather than weak over the last six months, almost none of the bearish theories so popular today would even exist. Prices drive explanations.

Well, believe it or not, the CRB actually really was strong over the last six months! All the bearish theories based on the cratering CRB are founded on nothing more than an illusion. Every single bearish theory you've heard lately that draws strength and credibility from the falling CRB is simply not valid. An epic misunderstanding, or deception depending on your perspective, has just taken place. The CRB is not as it seems.

If you have been following my research thread on this, you know exactly what I am talking about. I wrote essays about this critical issue in October and January and have discussed it in our newsletters. I believe it is extremely important to properly understand because the crumbling CRB is the foundation of countless bearish theories, and if the CRB is not really falling apart then these theories are instantly rendered void.

In a nutshell if this is new to you, the composition and calculation methodology of the venerable CRB commodities index radically changed in July 2005. The equal weighting of components and geometric averaging of prices that had defined the CRB for its first 48 years of existence were thrown out the window. An entirely new never-before-seen beast was created. A couple weeks ago I wrote an essay with much more detail on this if you need some background. Today's essay assumes you have read this earlier one.

Oil and two of its refined products now account for one-third of the weight of this new CRB revision, the tenth in its storied history. So the index widely known as the CRB today is the radically different tenth revision, or CRBr10. When the anomalously warm winter eroded oil demand across most of the northern hemisphere, oil had no choice but to correct aggressively. Of course the CRBr10, effectively 33% weighted in oil, fell in sympathy.

When the CRBr10 bled with oil, it broke a crucial years-old secular support line as well as the index's 200-day moving average. My controversial contention was that the CRBr10 breakdown was not an indication of a general commodities problem, but merely of a new oil-dominated CRB being led by the nose by a brutal oil correction. The trouble lied in proving this thesis as reconstructing the old ninth-revision CRB, or CRBr9, would be extremely difficult as I explained a couple weeks ago. But if it could be done I wrote...

"So I would love to see what the ninth CRB revision would look like extended to today. I hope someone out there can build it. I know this for sure, the CRB breakdown would either be vastly smaller, a minor dip under its long-term support, or it would not exist at all."

Well, it turns out I was not only right, but I was actually seriously understating the bullish case for the historical CRBr9 extended to today! As a student of the markets I am always seeking new knowledge. One of the great benefits for me of sharing my research in these essays is people far wiser than myself graciously write in and help me better understand issues I am grappling with. Their insightful feedback helps hone my knowledge, just like the famous Proverbs verse says... "As iron sharpens iron, so one man sharpens another."

After my last essay on the CRB two weeks ago, a handful of folks wrote in and set me straight on the CRBr9. I was trying to figure out how to reconstruct it, but they let me know that it still exists as a futures contract! The answer to comparing the CRBr9 to the current CRBr10 was far easier and more elegant than I had dared to hope. If you were one of the people who wrote in to help me with this issue, thank you so much. You have my deep gratitude for your time and wisdom.

So all I needed to do to test my controversial theory that the bears hate and ridicule was to secure some CRBr9 data. This is available in a NYBOT-traded futures contract known as the Continuous Commodity Index, or CCI. The NYBOT describes its neat product as "The Continuous Commodity Index (CCI), represents the ninth revision (as of 1995) of the original Commodity Research Bureau (CRB) Index."

I felt like a kid on Christmas morning when I was told about the CCI and then secured the data. Now all I had to do to compare what has happened in the CRBr10 to what would have happened in the CRBr9 without the tenth revision was to chart both series. After you digest these charts, you will agree that all bearish theories based on a secular CRB breakdown are garbage. The difference is that striking! This commodities bull is very much alive and well.

In these charts, the CRBr9 that made the secular trend in question is charted in blue. The accompanying moving-average and standard-deviation technical lines apply to it alone. Starting just before the actual tenth revision began trading in early July 2005, today's CRB (the CRBr10) is charted in red. This chart is like cool, fresh, pure water to the parched throat of a traveler who has been wandering for months in a scorching desert!

It is best to start at the beginning. The CRB hit its brutal multi-decade bear-market bottom in late 2001 and then started gradually climbing. Over the subsequent five years or so it carved one of the most beautiful and tight secular uptrends that you will ever see. The geometric averaging inherent in the CRB really smoothed it and contributed to a precise uptrend within very-well-defined support and resistance lines.

This uptrend was without a doubt the most important technical foundation underlying the perception of a general commodities bull market. Every time commodities corrected prior to Q3 2006, investors would look at the CRB with hope and trepidation. If the CRB held above its secular support and/or 200-day moving average, then all was well as the commodities bull remained intact technically. A decisive break in this critical support would be devastating for sentiment, and that is indeed just what happened.

In July 2005 the brand-new red CRBr10 line became known as "the CRB". Almost all technical analysts, including me I am embarrassed to admit, just grafted it on to the old CRBr9 data. Most analysts were not aware of the radical tenth CRB revision so they considered the CRB continuous and comparable out of ignorance. Some, like me, were well aware of it but didn't yet know of a viable CRBr10 alternative. And I suspect a few, probably Wall Streeters, knew about the CCI yet deviously still ignored it in favor of the CRBr10 since it supported their perpetually bearish case for commodities.

So after this tenth revision, the new CRBr10, grafted onto the old CRBr9, continued along higher within the CRBr9's well-established secular uptrend. The CRBr10 was entirely different and not comparable, but due to rising oil prices in 2005 and early 2006 it continued along in its predecessor's path out of pure coincidence. Then in Q3 of last year the CRB suddenly broke down with a vengeance. Its secular support failed, its 200dma failed, and there was great wailing and gnashing of teeth leading to flourishing bearish theories.

The critical problem here was that it was the CRBr10 that had broken down, the new oil-dominated one, not the traditional CRB that had originally made the uptrend in question in the first place. If the same ninth-revision CRB is charted up to today, which is now known as the CCI since July 2005, there was no breakdown! In fact, exceeding my wildest hopes, the CRBr9 actually broke out of its secular uptrend to the upside in early 2006 and has traded above its old trend channel since. This is incredibly bullish, not bearish!

This next chart zooms into the last couple years which set the CRB record straight once and for all. The blue line and the accompanying technicals are from the ninth-rev CRB until July 2005. After July 2005 the CCI, calculated by the identical CRBr9 methodology and component weightings, is grafted on. Meanwhile the red line is the new tenth-rev CRB that is unfortunately known as "the CRB" today. By focusing on it instead of the perfectly comparable CCI, we have all been terribly misled.

The true CRBr9 and the new CRBr10 weren't that different in the first quarter of the latter's introduction. But ever since, they have been increasingly spreading apart and taking their own individual paths. For the second half of 2005 these differences weren't great, but they really started accelerating in impact and importance in 2006. If people considered the CCI today and not the CRBr10, commodities perceptions would be far different from what we've seen over the last six months.

At the dawn of 2006 the CRBr9 was actually breaking out above its secular resistance line while the CRBr10 was merely in the middle of its predecessor's technical uptrend. The strong rally in the metals last spring drove both CRBs up to new bull-to-date highs, but the CRBr9's rally was much more impressive. This true CRB we've all learned to love over the years nearly broke 400. Man I wish I had known about the CCI back then!

In the latter part of Q2 2006 both CRBs corrected, a necessary and healthy reaction after the greedy euphoria that drove them to new highs in the weeks before. Up until Q2, the CRBr10 was not all that different from the CRBr9 performance-wise. Yes it was already understating the bullish technical case for commodities by languishing in a lower range, but at least these two indexes were usually moving in the same direction. But their harmony abruptly ended in Q3.

In the middle of Q3 2006, the headline CRB was already weakening down near the center of its trend channel. But soon it started to really fall with oil. Oil itself retreated from its highs soon after the Prudhoe Bay oilfield problems weren't as bad as feared and traders started growing concerned about the conspicuous absence of any hurricanes approaching the Gulf of Mexico. On top of that, energy traders were spooked after a major hedge fund blew up and decimated the natural-gas market as the fund's trades were unwound at fire-sale prices.

With such a tremendously heavy oil weighting, the CRBr10 started freefalling. It made a valiant attempt to rally at support, but this only lasted a week or so before it started plummeting lower again. Since almost everyone was not aware that the CRBr10 was not comparable to the CRBr9 that had originally carved the breaking uptrend, technically-oriented traders started getting really scared. In light of this erroneous assumption that the current CRB was comparable to the past, their fear was rational.

But in reality, just as the CRBr10 was starting to slide with oil, the CRBr9 was actually making fresh new all-time nominal highs! On May 11th the CCI closed at 398.56, compared to just 365.35 on the CRB. But on August 9th the CCI closed marginally higher at 398.87, a new high. Meanwhile the CRB had already fallen considerably to 353.70 and it was headed a lot lower. So just when people were starting to get worried, the true CRB was near an all-time high!

As oil dragged the new headline CRB lower, the CCI fell too since it also has oil and heating-oil components. But when the CRB initially bounced at dismal deep-sub-trend lows near the end of Q3, the ninth-rev CCI had actually just merely fallen back down to its own upper resistance. Thus in early October when bearish theories really started to germinate in the fertile fields of fear and worry, in reality the CRBr9 was at the very top of its trend channel in a very bullish state. If only the CCI had been widely known then!

In Q4 2006 the spread between the ninth-rev CCI and tenth-rev CRB widened considerably. While the CRBr10 recovered slightly into late November at still very-low levels technically, the CRBr9 was actually making fresh new all-time nominal highs in the midst of the carnage! The CCI closed at 408.79 on November 30th, a whopping 27% higher than the headline CRB's close that day. Instead of listening to the goofy bears, we bulls should have been dancing in the streets.

In reality not only was there no CRB breakdown, but the true historical CRB index was hitting new highs despite the isolated weather-anomaly-driven weakness in oil. And we are still nowhere near a breakdown today. As of this week, the CCI remained a good 12% above its long-term secular support line as well as above its 200dma. And speaking of 200dmas, the CCI's actually rose during the last six months unlike the CRBr10's which nosed over and meandered south.

In all my years of studying the markets and speculating, I have never seen an index change as radically as the CRB did in mid-2005. And on top of that, I have never seen a situation where pretty much everyone, me included, just kept on watching the new index as if it was comparable to the old. The irrational behavior of the masses, even the ones trying to pay attention, never ceases to astound.

At Zeal we strongly suspected that the CRBr10 was not faithfully telling the story of commodities, but we had no way to prove it until I was told about the CCI last week. Despite this, since the October lows we have been aggressively buying elite high-potential commodities stocks in our newsletters to take advantage of the low prices and rotten sentiment. Most of our new trades since then have been gold-stock trades since we feel gold's young upleg has particularly exciting potential.

If you invest in or speculate in commodities stocks, you ought to subscribe to our acclaimed monthly newsletter. In it we are always working hard to try and understand the trends. When the technicals seem wildly in our favor, we recommend great stocks with excellent fundamental prospects to ride the next surge higher. The CRB confusion has created a rare opportunity where perceptions and realities don't match. Please join us today before this great chance to buy vanishes.

The bottom line is the Continuous Commodity Index, an extension of the old ninth-revision CRB's calculation methodology, components, and weighting, decisively shatters the false notion that there has been some catastrophic commodities breakdown. It is a myth. A new never-before-seen "CRB" index was driven lower by oil, but it wasn't the same index that made the secular uptrend in the first place by a long shot.

All bull markets climb an endless wall of worries and this one is no exception. Some worries are valid, others are not. Next time someone tries to get you to buy into a bearish theory based on the CRB breakdown, realize that it is utter nonsense. The true CRB never broke down and instead broke out to achieve new all-time highs recently. There is nothing remotely bearish about the ninth-revision CRB's behavior over the past six months.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at & zelotes@zealllc.com Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

Copyright © 2000-2007 Zeal Research

Counterfeiting Money -- Crime or Good Economics?

by Michael "Mish" Shedlock

Have you ever thought that counterfeiting money could be good for the economy and that the counterfeiter could be considered an economic genius or even a national hero? I received an e-mail from Nic Corsetti, a friend of mine, describing exactly how that might happen. From Nic:

“Let’s say that I invent a printing press that allows me to produce counterfeit
money (let’s say U.S. dollars) by the trillions -- these dollars look EXACTLY
like real ones, so no one can tell the difference, not even the government or
the bank. So I start off the first year by counterfeiting $3 trillion:

I use $1 trillion to buy stocks (jump-starting the bull market)
I use $1 trillion to buy U.S. Treasury bonds (thus driving bond prices higher and interest rates lower)
I use $1 trillion to go around to every neighborhood in every major city of the U.S. and start buying houses for 10% higher than the listed price.
“Obviously, this is a lot of work, so I hire a whole network of employees and consultants to help me achieve those lofty goals in a reasonable time period. The apparent benefits would be huge.

“Benefits:

This will create jobs, since lots of employees and consultants will be needed to spend $3 trillion
The stock market indexes will soar. Everyone's 401(k) and day-trading portfolios will increase in value
Home prices will increase by 10% overnight
Interest rates will fall, which will make it even cheaper for everyone to borrow money to buy new cars, upgrade into bigger homes, and buy new plasma TVs every year, hoping against hope of getting to watch the Cubs someday play in the World Series
The lifeblood of America, vastly underpaid real estate agents, will get a much-needed and well-deserved infusion of cash
The economy will be humming so fine that no one will care about the loss of jobs to India and China
Cheap goods will continue to pour into the U.S., and the CPI will show only a modest 2% rise in the price of goods.

“Additional Printing Presses

“This is such a good plan, I decide to let some of my best friends in on the action. So I pick 12 of my closest cronies and give them identical printing presses and instruct each of them to buy stocks, bonds, and real estate with their counterfeit money. I tell them to loan the money to anyone who asks. Now we are really getting somewhere.

The stock market will rise 30-50% every couple years
By buying massive amounts of Treasuries, interest rates will stay at historic lows
Everyone's net worth will double every few years if they just buy more real estate
There will be no reason to save money, because assets will just keep skyrocketing in value
Wave after wave of immigration proves adequate enough to supply the homebuilding industry with enough manpower to get the job done
So much money is made in the stock market that $50 billion in bonuses can be distributed
Home prices start rising so fast that people start buying 2 or even 3 of them. It's a ‘can't-lose’ venture
There is so much money floating around that credit standards drop and everyone who wants a home gets one
So many homes are being bought that massive numbers of jobs are created for mortgage lenders, homebuilders, architects, real estate agents, title insurers, property insurers, interior designers, lumbermen, copper manufacturers, cement manufacturers, truck manufacturers, granite miners, brick layers, roofers, repairmen, industry analysts, home flippers, Internet bloggers, Internet site maintainers, newspaper ad salespeople, Wall Street specialists (to create RMBS, CDO, CDS, index swaps), hedge fund employees (someone has to trade all these securities), and accountants and lawyers to keep track of all of the above There are additional profits to be made on Wall Street by investing in IPOs, private equity LBOs, M&A, trading, mutual funds, and hedge funds
There is job growth in investment advisers, investment analysts, day traders, media cheerleaders, SEC regulators, state regulators, New York district attorney’s office, and accountants and lawyers to keep track of everything
Government jobs explode. State and local governments get all sorts of funding for projects of all types -- big and small. This creates still more jobs
People need a place to spend their money. Shopping malls, strip malls, big-box stores, specialty stores, boutiques, and nail salons spring up everywhere
People are so busy shopping they do not have time to cook. This creates a need for more restaurants or coffee shops on every corner.
“Even with all of that there is STILL NO INFLATION! Cheap imports keep prices from rising and the best part is that those foreigners keep taking this counterfeit money as if it were real money. No one can tell the difference, anyway.

“This goes on and on -- we have really created a tremendous virtuous cycle where everything just gets better and better.

“Everybody Wins

“After a few years of counterfeiting, I am quite certain that a ‘new era of goodwill and fortune’ would be announced and that I, Nic Corsetti, would rightfully be hailed as the first economic grand wizard to have permanently vanquished recessions.

“But what’s the catch? Where’s the hole in this story? Is there a hole in this story? If counterfeiting is such a great idea, why isn't it legal? Actually, it is legal.

“Legal Counterfeiting

My name is not really Nic Corsetti. It is Ben Bernanke. My 12 friends are the 12 member banks of the Federal Reserve. My employees and consultants are the financial services industry (Wall Street broker dealers, hedge funds, mutual funds, retail banks, and commercial banks). Those printing presses are currently manned by me and my 12 friends. “I, Ben Bernanke, hope these printing presses don't break down and that people keep accepting these counterfeit dollars, or this economy might implode. This is my only fear right now.”

Mish’s Note: Nic Corsetti is a real person. The above idea came from Nic via e-mail and was rewritten and reformatted by me. Still, Nic deserves full credit for the idea. Thanks, Nic.

As proof of the ingeniousness of legal counterfeiting, Alan Greenspan has been hailed as an economic hero and knighted by the queen of England for his “contribution to global economic stability.” Printing presses do work (for a time), and Greenspan's timing was perfect, as discussed in an “Interview With Paul Kasriel”:

“Kasriel: Greenspan is a fascinating study. Someday, I hope to write a book
about him. Right now, I’m willing to say he is the luckiest Fed chairman in
history.

Mish: Greenspan is the luckiest Fed chair in history? How so?

Kasriel: He was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment, the Fed could create large amounts of money and credit without causing inflation other than in asset prices.”

By the way, so many others have acquired the magic printing presses that the Fed is now basically irrelevant when it comes to credit expansion and contraction. Synthetic money is now being created in massive amounts in numerous places. For example, GSEs are now running their own printing presses. Want a $500,000 mortgage? Boom, you got it. No one cares if you can pay it back, either. It is foolproof as long as home prices only go up. Multiply that by the hundreds of thousands and it all adds up, and much of it done with 0% down, and most of it based on the belief that housing prices only go one way: up. The day of reckoning comes when home prices sink. A collapse is now underway, and it has hit the subprime market especially hard. Those credit problems are guaranteed to spread.

Some may object to the term “synthetic money,” perhaps preferring something like creating money by “fiduciary media.” The important thing is not what we label it, but rather the general idea of what is happening. And without a doubt enormous amounts of money (credit/debt) are being borrowed into existence with increasing leverage and risk.

Broker dealers (via junk bond offerings) have figured out how to create their own synthetic money backed by essentially nothing. As yields collapsed, increasing leverage had to be used to generate the same returns. Such offerings have exploded along with mammoth growth in hedge funds all wanting a piece of the pie.

Some 20,000 hedge funds are now doing things with leverage because yields are too low. Various carry traders have created synthetic dollars of sorts by borrowing yen and investing in U.S. dollar-denominated assets such as U.S. Treasuries. This has been building and building and building on itself so that no one even knows how many printing presses are actually running. The day of reckoning on carry trades will come when the Bank of Japan is forced by the market to raise rates rapidly and there is a mad scramble to get out of dollars and back into yen. Rest assured, these events will be anything but orderly when they happen.

Initial sponsorship of “legal counterfeiting” came from the Fed and central bankers in general, but once Wall Street got hold of the magic printing presses, things have gotten more than a little out of hand. This is what happens when you have money backed by nothing and borrowed into existence. This is also what gold lovers see when they recommend gold.

Ponzi schemes can only go so far before they collapse on their own accord, and it's important to recognize what is happening now with stock buybacks, leveraged buyouts, and various carry trades for what it is: one giant Ponzi scheme. This scheme will end the way they all do: when the willingness or ability to take on more debt stops and/or when the willingness to further speculate stops. When either of those happens, there will be a mad rush for the exits and no more buyers for "overpriced tulips" will be found. Be prepared.

Regards,
Mike Shedlock ~ “Mish”

for Whiskey and Gunpowder

Michael Shedlock (Mish) worked in the financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish is currently doing economic and investment research for a number of clients. In addition, Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs / Mishedlo and one of the more popular boards on Silicon Investor as well, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis. While he is not writing about stocks or the economy Mish spends a great deal of time on photography, one of his other passions. Mish has over 80 magazine and book cover credits, for magazines such as Country Magazine, Wisconsin Trails, the Chicago Tribune Sunday Supplement, Browntrout Calendars, and numerous other publications. Some of his Wisconsin and gardening images can be seen at www.michaelshedlock.com.

Standing on the slippery slope

In this week's update

***** Interesting times

*****boring markets.

***** Transports join the party.

***** Standing on the slippery slope.

-------------------------------------

Today's geopolitical turmoil makes us think about Robert F. Kennedy's famous rendition of a supposedly Chinese curse, May you live in interesting times. Certainly there is a lot of interesting political drama in the world today, in places such as the U.S., Mexico, Venezuela, Cuba, the U.K., and many other countries. Even more “interesting” is the appalling violence occurring in Iraq, Afghanistan, and elsewhere, not to mention natural disasters.

We feel sad for the millions of innocent bystanders trying to raise their children in such interesting environments. And speaking of environments, the global environment seems destined to be a lot more interesting in future years too, according to the recent report by the Intergovernmental Panel on Climate Change. It concludes that human activity will make the world a lot hotter and stormier in coming decades. Drier too, unless you live on a seacoast, in which case youd better learn how to swim.

In fact, the only thing in the news which seems boring these days is the stock market. Shares are in an uptrend, which is unlikely to break anytime soon. That's good news for you, as an investor, although it makes our job as commentators more difficult. (Bear markets are so much easier to write about.) But we don't really mind, of course. As long as you're making money, we're happy to work a little harder. So sit back, put your feet up, and bask in the comfort of today's rising prices, while we natter on about other pressing matters

TRANSPORTS HIT NEW HIGHS

The good news last week was that the Dow Transportation Index finally decided to join the party and make new highs. This completes a Buy signal, according to Dow Theory. Before you get too excited, we must remind you that often such buy signals are followed by brief market corrections on the order of 4-6%. We aren't predicting such a correction will occur this time.

And we certainly don't recommend you sell stocks! The indicators are so strong today that we feel any setback if it occurs will be short-lived. We just don't want you to be surprised if it happens. What's particularly positive about the new high in Transports is that it occurred at the same time that oil rallied back above $59 a barrel. This shows that transportation stocks are not as dependent on oil prices as they are on a strong economy. The Transports are important to Dow Theory because they reflect actual goods being shipped, so the recent action is a sign that the U.S. economy is stronger than some of the other indicators suggest.

Of course, we must also keep in mind that the U.S. is not the biggest engine of growth in the world today. Chindia, which is expanding at 10% a year, is becoming more important. India alone is on the verge of overtaking Japan as the world's third-largest economy. Money supply is ample, and stock valuations are not overstretched. All this bodes well for stock prices this year. Longer-term, we see a dark and slippery slope

OIL’S THE THING THAT WILL MAKE OR MAR THE BULL

Ultimately, it all comes down to black gold. We're not surprised that oil has rebounded into the high $50s again, and we won't be surprised if it rises further. In recent months, Saudi Arabia has cut back on oil production and that move was destined to lead to higher prices.

The question we must ask ourselves is whether the Saudi production cut was voluntary, or the result of its oil fields falling into decay, as has long been argued by some analysts. It is undeniable that Saudi production has been declining for the past several years. We can't help noticing that during this decline there have been two oil spikes in 2005 and 2006. On both occasions, oil prices reached over $70. Why didn't OPEC raise its production during these spikes, to take advantage of the higher prices?

Perhaps they really were unable to. And that is an ominous thought. Consider, for example, what has been happening in the world's second largest oil field, the Cantarell field in Mexico. For years now its decline has been the talk of the oil industry. According to a recent article in the Wall Street Journal, The virtual collapse at Cantarell is unfolding much faster than projections.

By 2007, it may be producing 50% less oil than in 2005. That's a serious situation which certainly will help make oil more expensive. However, it's not the worst. The real problem is that most of the world's other giant oil fields, those in Kuwait and Saudi Arabia, may be in equally rough shape. We doubt that the engineers who monitor fields in the Middle East are any better than those in Mexico, they are simply more secretive. But we are seeing some signs that production in the Middle East has also peaked.

If this is true, we are looking at the start of the last great oil bull the one force on earth that can, in time, put a halt to the bull market in stocks. For now, however, please don't panic. The important phrase to remember is in time. The market can withstand oil at $60. At $70, investors might start to have a few doubts. But it would take new highs in oil to put real pressure on the market and create a difficult situation for the Federal Reserve.

We have a little time before that happens, during which we can continue to enjoy the bull market. However, while the economic stats remain favorable, the front page of the newspaper reveals a world that's just too “interesting” for us to ignore. What happens if the world does acknowledge a peak in Saudi oil production?

What happens if something goes terribly wrong with Iran? So as a prudent measure, we continue to recommend you overweight energy stocks. And despite the market's apparent strength, we are sticking with our theme of high quality stocks. Meanwhile, provided nothing too interesting happens, we think the market is likely to be higher six months from now.

Until next week,

Stephen Leeb

Editor,

The Complete Investor

Disclaimer

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Market Mania in Crude Oil, Base Metals, Tokyo Gold, and the Yen

by Gary Dorsch

The name "Einstein" is synonymous with great intelligence and genius. Albert Einstein was named Time magazine's "Man of the Century," because he transformed humankind's understanding of nature on every scale, from the smallest to that of the cosmos. Einstein's theory of relativity is embodied in all motion throughout the universe, and the nature of energy, matter, motion, time, and space.

Unfortunately, Einstein didn't take a fancy to studying the daily motion of commodity and stock markets, where wild and erratic gyrations often seem to have no logical explanation. Why did the zinc market soar nearly 400% due to fast shrinking supplies, only to surrender a third of its gains, over the past two months? How do some copper miners defy the laws of gravity and climb to record highs, even after the price of copper has dropped by almost 50% below its all time highs?

Newtonian physics might explain the 35% slide in crude oil to as low as $50 /barrel since July 2006. But how did oil prices bounce by $10 /barrel towards $60 /barrel over the past two weeks? The DJI hasn't suffered a 2% correction since July, its longest such streak of resiliency since 1965. How does the Dow Jones Industrials (DJI) defy the law of gravity? How did Tokyo gold prices rise by 75% from 18-months ago, if Japan's official CPI is only 0.3% higher from a year ago?

Answers to these questions, that can withstand the test of time, are tough to figure out. Fortunately, Einstein did leave behind a treasure chest of insightful quotes and wisdom that can help traders to cope with the schizophrenia of commodities and the mania of global stock markets. When trying to understand the mood of the markets on any given day, remember some of Einstein's pearls of wisdom!

"Education is what remains after one has forgotten everything he learned in school," said Einstein.

Crude oil has been on a wild rollercoaster ride for the past 18-months. Climbing in an orderly fashion from around $50 per barrel until the spot price of West Texas Sweet peaked at a record high of $78.40 per barrel on July 14th. Then over the next six months, crude oil began a 35% slide, which might have made sense to students of physics, who believe that what goes up, must eventually come down.

But the recent behavior the crude oil market doesn't conform to the classic laws of supply and demand. Crude oil traders focus a lot of their attention each week on the amount of oil held in storage by Big-Oil for clues about the future direction of oil prices. Yet since October 2005, crude oil prices have been acting counter-intuitively, climbing higher when crude oil supplies were rising to 8-year highs of 347 million barrels, then tumbling lower when supplies were shrinking.

Thus, students of Economics 101 should not trade crude oil based on the Law of Supply and Demand taught in college. Instead, in order to trade profitably in the brave new world of the crude oil markets, economists must switch to psycho-analysis to predict future prices. Don't hesitate to make the change-over. "Anyone who has never made a mistake has never tried anything new," Einstein said.

Crude oil prices were falling fast in the second half of 2006, even as OPEC was cutting back on its oil output from a record high of 28.3 million bpd. That's because 1.8 million bpd of new oil supplies from Angola, Brazil, Canada, Kazakhstan, and Russia are expected to come on stream this year. As of Feb 2nd, OPEC-10 had lowered its output to 26.8 million bpd, but is still cheating by one million bpd above the quotas that it agreed upon on in October and December.

When crude oil prices were fast approaching $50 per barrel, Saudi Oil Minister Ali Al-Naimi said on January 16th, there was no need for OPEC to hold an emergency meeting before its next scheduled gathering in March. "The market doesn't need to panic at all, it's in a healthy condition and moving in the right direction. We took measures in October in Doha and measures in Abuja and I believe these measures are working well," he said, sounding indifferent to the plunge in oil prices.

Most of the decline in crude oil prices in the second half of 2006 was due to the evaporation of a $15 pr barrel Iranian ‘war premium" which had been built into prices earlier in the year. The resignation of US Defense secretary Donald Rumsfeld confirmed the market's suspicions that the US would not attack Iran's nuclear installations anytime soon. Instead, President Bush decided to try other tactics first.

US Vice President Dick Cheney visit with King Abdullah on November 25th, was brief, lasting only a few hours before he flew back to Washington.

Cheney might have asked King Abdullah to use his considerable influence in the oil markets to knock prices lower, to put a squeeze Iran's troubled economy, which depends on crude oil sales for 95% of its foreign exchange earnings and 50% of government spending.

Crude oil is the key weapon in the battle between Saudi Arabia, Kuwait, and the UAE, aligned with the United States, against the "Oil Axis" of Iran, Russia, and Venezuela. The Persian Gulf Oil kingdoms fear the emergence of a Tehran-led axis linking Iran, Iraqi Shiites, Syria, Lebanon's Hezbollah, Palestinian Hamas in Gaza, and Islamic militants linked to al Qaeda trying to topple the Saudi royal family.

To counter the Saudi inspired plunge in oil prices, Iranian President Mahmoud Ahmadinejad proposed on Jan 21st, to cut the oil price on which the next Iranian budget is based to $33.70 per barrel for the year starting in March, compared with a price of $44.10 for the existing budget. "It is a signal to Iran's enemies saying we are ready and we will manage the country even if you lower the oil prices more. We assume our enemies want to damage us by decreasing the price of oil. So we must reduce our dependency on oil revenue," Ahmadinejad said.

Iranian crude usually sells for about $7 a barrel less than US crude oil, so West Texas Sweet would have to stay below $51 per barrel for an extended period of time, to wipe out Iran's budget surplus. Tehran spends $20 billion to $30 billion on heating oil and gasoline subsidies per year, costing the government roughly 15% of Iran's GDP. Ahmadinejad was elected promising to bring oil revenues to every family, eradicate poverty and tackle unemployment.

But Ahmadinejad has failed to meet those promises. Instead, inflation in Iran according to various estimates is galloping ahead at 15% to 30%, and the jobless rate among men below 30 years old is at 20 percent. Anticipating a possible US blockade of gasoline imports in the next stage of economic warfare, Tehran has already said it will start rationing gasoline as of March 23rd.

Mohsen Rezai, secretary of Iran's Expediency Council, told the Dubai-based Al-Bayan newspaper on Jan 21st, "America will exploit sanctions against Iran to incite people to rise up against the Islamic revolution, provide aid to movements hostile to Iran, carry out operations inside Iran and promote a sectarian war. The next two months will show the world this strategy. An Iranian-US confrontation is inevitable," he said.

Keeping US oil prices pegged to $51 per barrel or lower looks to be a far fetched strategy however, with US saber rattling with Iran. "We don't believe that Iran's behavior, such as supporting Shiite extremists in Iraq, should go unchallenged," said John Negroponte at his Senate confirmation hearing on January 30th. "If they feel that they can continue with this kind of activity with impunity, that will be harmful to the security of Iraq and to our interests in that country," he added.

Negroponte's stern warning to Iran come at time when two US aircraft carriers are stationed in the Persian Gulf, and Patriot missiles are being delivered to the Arab oil kingdoms. Tough talk from Bush and other US officials has stirred speculation of a possible military strike. That's at odds with Einstein's advice, "Peace cannot be kept by force. It can only be achieved by understanding."

Crude oil prices bottomed out at $50 per barrel, the same day Bush ordered another 21,000 troops to Iraq, and directed the USS John Stennis to the Gulf. US crude oil rallied more than 4% on Jan 23rd, the biggest one-day gain in nine weeks, after US Energy Secretary Sam Bodman announced a plan to expand the nation's Strategic Petroleum Reserves by 11 million barrels (100,000 bpd) starting in April.

Crude Oil Market Jolted by Depletion of Mexico's Cantarell Oilfield

Then on January 29th, crude oil surge by $3 per barrel on news that daily output at Mexico's biggest oil field tumbled by half a million barrels to 1.5 million bpd last year, according to the Mexican government. Mexico's overall oil output fell to just below three million barrels a day in December, down from almost 3.4 million barrels at the start of the year, the lowest rate of oil output since 2000.

Some experts predict that Cantarell's output will drop another 600,000 bpd by the end of this year. Petroleos Mexicanos (PEMEX) might try increase output by 200,000 barrels a day at other fields, leaving the country with a net decline of 400,000 bpd by year's end and daily exports of less than 1.4 million barrels. Mexico's oil reserves are expected to last only nine years and eight months at current rates of production.

Cantarell, the world's second-largest oil complex, in the shallow gulf waters off the shore of Mexico's southern Campeche state, is a prolific giant that is past its prime. Monthly production peaked in late 2004 at just over 2.1 million barrels a day and has fallen more than 28.5% since then. Experts agree it has nowhere to go but down. Its proven reserves have tumbled by more than a third since 2000.

"The only real valuable thing is Intuition" said Einstein

There's not much else that can be said for traders in the once high flying zinc market, which soared by 400% from mid-2004to its peak of $4,500 per ton in November 2006. Zinc is mostly used to galvanize steel which protects the steel against corrosion. Since its peak, zinc has lost a third of its value to $3,100 /ton, amid talk of forced liquidation by a large hedge fund.

Until January, zinc was closely tracking Chinese steel exports, as the good way to gauge Chinese demand for zinc. But the tight relationship has broken down, over the past two months, possibly a signal of global economic slowdown.

On the other hand, the decline in zinc might just be a blow-off of speculative froth from hedge funds, and the market must gauge where industrials users will step in to buy the metal and provide a solid base of support.

China overtook Japan and the EU to become the world's biggest steel exporter last year. Chinese steel production reached 339 million tons in the first nine months of 2006, up 23% from a year earlier. Chinese exports rose 81% in the first nine months of 2006 from a year earlier, to 28.6 million tons. Output is also rebounding in the EU, Russia and Eastern Europe, and global steel shares remain very buoyant.

Booming Chinese steel production also led to a massive shrinkage of zinc stocks at the London Metals Exchange to 98,500 tons today, from 620,000 tons in June 2005, and 787,000 tons in November 2004. Zinc soared to $4,500 per ton in November, on ideas that the supplies at the LME would vanish in 2007, creating the ultimate bear squeeze. But for the first time in 19-months, zinc supplies stopped shrinking from a low of 85,000 tons. Instead, Zinc supply bumped up by just 13,500 tons at the LME over the past two months to 98,500 tons.

Yet zinc supplies at the LME are still 87% lower than two years ago. Zinc supply could continue shrinking, if the global economy is on course to grow by 4.5% this year, as the IMF predicts. Average daily demand for zinc is 29,000 tons, so LME supplies couldn't cover 4-days of global demand. Therefore, the most valuable aid for traders in zinc is intuition, in a market that is gripped by emotional fear.

"Any intelligent fool can make things bigger and more violent. It takes a touch of genius, and a lot of courage, to move in the opposite direction,"

Einstein could have been a Market contrarian. It certainly took a lot of courage to go short on the copper market in May 2006, when prices were surging at a frenzied pace above $4 per pound, up seven-fold from the lows in 2001. Copper consumption has more than doubled since 1970. Demand from China has risen to 23% of world production to become the world's largest consumer.

But with copper soaring over $4 /lb in May 2006, another wise man, the Oracle of Omaha, Warren Buffet said at the time, "You are looking at a market that is responding more to speculative forces than fundamental forces. What the wise man does at the beginning the fool does at the end. Once a price history develops enough for other people to see and get envious that takes over markets. We're seeing that some areas of the commodity markets."

Buffet warned that copper could end badly, likening commodity markets to Cinderella at the ball. "At the start of the party, the punch is flowing and everything's going well, but you know at midnight it's all going to turn into pumpkins and mice. People think they'll be able to get out just before midnight, but everyone else thinks that too. The problem is that, in commodities there are no clocks on the wall," he added.

Copper prices have been undermined by rising supplies of the red metal held in inventory at the London Metals Exchange. A sharp slowdown in demand from the US auto and housing market in the second half of 2006, led to a build-up of copper stockpiles at the LME from 92,000 tons in July to over 215,000 tons last week. However, one should not forget that LME copper stockpiles are still 78% below their record highs of 980,000 tons in May 2002, when copper traded at 65 cents /pound.

Copper supplies in Shanghai have dropped by two-thirds, or 50,000 tons since the start of 2006 as users drew down stockpiles and reduced imports, according to the Shanghai Futures Exchange. Copper processors in China used more than 250,000 tons of the metal that was stockpiled at their plants or warehouses last year. As a result, shipments of refined copper into China declined 36% from January to November last year compared with 2005, according to China's customs office.

China's booming economy could continue to be the driving factor behind copper prices in 2007, because inventories in the Asian giant are low and it would have to buy copper on the world market in coming months. In a few months it possible that China will not have its own inventories to consume. Much will also depend on the extent of monetary tightening by the People's Bank of China, which aims to slow the growth rate of its economy towards 9% from 10.7% to avoid overheating.

"Reality is merely an Illusion, albeit a very persistent one," Einstein

No matter what bearish idea you might have conjured up for the Dow Jones Industrials (DJI) for the past six years, somehow, the faithful die-hard bull managed to defy all the skeptics. The DJI closed higher for the seventh month in a row in January, to a new record high of 12,650. The S&P 500 rose for the eighth straight month, and hasn't been scathed by a 2% correction since mid-July.

On January 31st, the US Commerce department painted the goldilocks scenario that Wall Street has been betting on for the past six months. The US economy rebounded to a 3.5% growth rate in Q'4 from a 2% rate in the previous quarter, while on the inflation front, the PCE price index fell at a 0.8% rate in the quarter, the biggest decline since the third quarter of 1954 when it dropped 1.2 percent.

Adding to Wall Street's jubilation, the Fed kept interest rates on hold at 5.25%, saying US inflationary pressures are easing, and the housing market is stabilizing. The ultimate rosy scenario! All bearish news on the earnings front was ignored, such as disappointing results from DJI heavy-weight 3-M, which caused its stock to tumble 6%, after it warned that the global economy is slowing.

But the DJI's historic surge towards 12,700 is that it's nothing more than a grand illusion. The reality is that the DJI remains within a persistent six-year bear market against gold. In April of 2001, 1 DJI share was worth 40.6 oz's of Gold. Today, 1 DJI share can buy 19.3 oz's of Gold. The sharp drop in crude oil from around $80 per barrel to below $60 /barrel, only provided a small bounce for the DJI/Gold ratio from a low of 16 oz's in April 2006. No wonder central bankers lose sleep over the gold market, which is a direct threat to their money printing schemes.

"Whoever undertakes to set himself up as a judge of Truth and Knowledge is shipwrecked by the laughter of the gods," Einstein

How should one react to Tokyo's fuzzy math, after government apparatchniks added 34 items to the Japanese consumer price index last August, whose prices on balance were falling, and removed 48 goods and services that were becoming more expensive? The fuzzy math produced a stunning two-thirds decline in Japan's core consumer inflation rate to 0.2% in July, from the 0.6% rate reported in June.

Tokyo's new methodology for computing the core rate of consumer inflation, included revisions for all the 2006 data, and the difference is dramatic. In the month of May for instance, the new core CPI base showed zero inflation, compared with a 0.6% annualized rate under the previous rules. Behind Tokyo's sleight of hand, is a power play in which Japan's Ministry of Finance aims to block Bank of Japan chief Toshihiko Fukui from raising the cost of financing Japan's $6.4 trillion national debt.

The ruling LDP party has set itself up as the judge of truth over official Japanese inflation statistics that are accepted as gospel by the mainstream media. The LDP said the CPI was just 0.3% higher last month from a year ago, a remarkable achievement considering the Bank of Japan's 0.25% overnight loan rate is the lowest on the planet, and the yen's real trade-weighted value hit a 21-year low in January. But it's the Tokyo Gold traders who are having the last laugh.

Tokyo gold is trading near an 18-year high, up 74% from two years ago. The BoJ fell prey to heavy political pressure on January 18th, and left its overnight loan rate unchanged at 0.25%, sending the yen lower and gold higher. One of the world's most powerful central banks, which is exporting yen through-out the world, has been hi-jacked by the political establishment, with a radical inflationist bent.

But the LDP's cheap yen policy, which sent Japanese exports to record highs in 2006, is now under attack by European finance officials, who complain that the weak yen against the Chinese yuan, the Euro, and the US dollar, gives Japan an unfair trade advantage over European exporters. With the ECB poised to lift its repo rate to 3.75% next month, the Euro is bound to go higher against the yen, unless Tokyo's Warlords relent to a tiny quarter-point rate hike to 0.50 percent.

On Jan 31st, Bank of France chief Christian Noyer was vocal about the LDP's abuse of power. "I'm concerned about developments in the yen. The yen exchange rate is not in line with an improvement in the Japanese economy and its strength. Japan is one of the engines to drive global growth. A weak yen will cause distortion in the world economy in the medium term," he said. "The yen must reflect the value of the Japanese economy," echoed French Finance Minister Thierry Breton last week.

The yen has fallen more than 60% against the Euro since 2001 giving Japanese exporters, windfall profits and more room to maneuver with prices. For the European car industry, the weak yen subtracted 200 million euros from Germany's Volkswagen's profits in the first nine months of 2006. Meanwhile the operating profit of Japanese rival Toyota in the six months to the end of September 2006 reached record highs, partly thanks to the weak yen.

"Yen Carry" Trade Lifts New Zealand Kiwi to 8-year high

But Tokyo gained a key ally ahead of the expected clash with French, German,and Italian finance officials this weekend. US Treasury chief Henry Paulson said he was not disturbed by the yen's break-out above last year's high of 120-yen. "From my standpoint, the big point is the Japanese have a currency that is traded in an open and competitive marketplace based upon economic fundamentals," he said, signaling no pressure on Tokyo.

The distortions of the LDP's weak yen policy has spawned about $330 billion of "yen carry" trades over the past few years, lifting minor currencies like New Zealand's kiwi to near eight year highs. With the "yen carry" trade, Japanese bank traders can borrow in yen at half-percent, and re-lend the funds in higher yielding NZ kiwis at 7.73%, and pocket a foreign currency profit to boot.

The wide interest rate differential in favor of the NZ kiwi, allows the currency of the $108 billion New Zealand economy, with a current account deficit of 9.7% of GDP, and a population of 4.1 million, to climb sharply against the yen, backed by a $4.7 trillion economy, an external surplus of 4.2% of GDP, and a population of 127 million. Clearly, Japan's super low interest rates are far out of alignment with the reality of the global marketplace, and creating illusions of grandeur for shareholders of Japanese exporters in the Nikkei-225.

Since the BoJ hiked its overnight loan rate to 0.25% on July 14th, the NZ kiwi has climbed from around 70-yen to as high as 85-yen, before traders began to unwind some the "yen carry" trade last week. But regardless of when Japan lifts its overnight loan rate due to european pressure, the kiwi's downside could be limited. On Jan 25th, Bank of NZ chief Alan Bollard warned, "We remain concerned about the upside risks to inflation. In the absence of clear indications of moderation in housing and demand, it is likely that further policy tightening will be required," he said.

The RBNZ has plenty of room to lift rates if it chooses to do so. New Zealand's M3 money supply was 16.5% higher in December than a year earlier, while the index of top-50 NZ blue chip stocks has doubled from four years ago. The RBNZ's 7.25% overnight loan rate might sound high, when compared to Japan's or the Euro zone, but clearly, monetary policy in New Zealand is very easy.

But in a world of competitive currency devaluation, the RBNZ doesn't want to see the kiwi go too much higher, and must wait for Tokyo to raise its rates, before it can start to grapple with run-away money supply growth at home.

"I never think of the future. It comes soon enough," said Einstein. But to read our forecasts for the future of the Japanese yen, the Euro, British pound, Canadian dollar, Gold, crude oil, China's H-share Index, FXI, and what could be the earliest signs of trouble for the high flying European stock markets, plus a lot more, consider a subscription to Global Money Trends. The answers were posted

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Inflation and War Finance

by Dr. Ron Paul

The Pentagon recently reported that it now spends roughly $8.4 billion per month waging the war in Iraq, while the additional cost of our engagement in Afghanistan brings the monthly total to a staggering $10 billion. Since 2001, Congress has spent more than $500 billion on specific appropriations for Iraq. This sum is not reflected in official budget and deficit figures. Congress has funded the war by passing a series of so-called “supplemental” spending bills, which are passed outside of the normal appropriations process and thus deemed off-budget.

This is fundamentally dishonest: if we’re going to have a war, let’s face the costs-- both human and economic-- squarely. Congress has no business hiding the costs of war through accounting tricks.

As the war in Iraq surges forward, and the administration ponders military action against Iran, it’s important to ask ourselves an overlooked question: Can we really afford it? If every American taxpayer had to submit an extra five or ten thousand dollars to the IRS this April to pay for the war, I’m quite certain it would end very quickly. The problem is that government finances war by borrowing and printing money, rather than presenting a bill directly in the form of higher taxes. When the costs are obscured, the question of whether any war is worth it becomes distorted.

Congress and the Federal Reserve Bank have a cozy, unspoken arrangement that makes war easier to finance. Congress has an insatiable appetite for new spending, but raising taxes is politically unpopular. The Federal Reserve, however, is happy to accommodate deficit spending by creating new money through the Treasury Department. In exchange, Congress leaves the Fed alone to operate free of pesky oversight and free of political scrutiny. Monetary policy is utterly ignored in Washington, even though the Federal Reserve system is a creation of Congress.

The result of this arrangement is inflation. And inflation finances war.

Economist Lawrence Parks has explained how the creation of the Federal Reserve Bank in 1913 made possible our involvement in World War I. Without the ability to create new money, the federal government never could have afforded the enormous mobilization of men and material. Prior to that, American wars were financed through taxes and borrowing, both of which have limits. But government printing presses, at least in theory, have no limits. That’s why the money supply has nearly tripled just since 1990.

For perspective, consider our ongoing military commitment in Korea. In Korea alone, U.S. taxpayers have spent $1 trillion in today’s dollars over 55 years. What do we have to show for it? North Korea is a belligerent adversary armed with nuclear weapons, while South Korea is at best ambivalent about our role as their protector. The stalemate stretches on with no end in sight, as the grandchildren and great-grandchildren of the men who fought in Korea give little thought to what was gained or lost. The Korean conflict should serve as a cautionary tale against the open-ended military occupation of any region.

The $500 billion we’ve officially spent in Iraq is an enormous sum, but the real total is much higher, hidden within the Defense Department and foreign aid budgets. As we build permanent military bases and a $1 billion embassy in Iraq, we need to keep asking whether it’s really worth it. Congress should at least fund the war in an honest way so the American people can judge for themselves.

Congressman Ron Paul of Texas enjoys a national reputation as the premier advocate for liberty in politics today. Dr. Paul is the leading spokesman in Washington for limited constitutional government, low taxes, free markets, and a return to sound monetary policies based on commodity-backed currency. He is known among both his colleagues in Congress and his constituents for his consistent voting record in the House of Representatives: Dr. Paul never votes for legislation unless the proposed measure is expressly authorized by the Constitution. In the words of former Treasury Secretary William Simon, Dr. Paul is the "one exception to the Gang of 535" on Capitol Hill.

War of the Nerds

By Fred Sheehan
Braintree, U.S.A.

Financial markets owe much to illusion. Absolute values don't exist. Prices are relative and changing. We create our own references. Gold-topaper currency conversion served that purpose. Yet, the US snookered the world into broad acceptance of the dollar standard after severing its relationship to a tangible object. Until 1971, a foreign bank handed $35 to the US government and received an ounce of gold in return. After that, banks handed 35 dollar bills to the US government and received 35 dollar bills in exchange. That was hardly sporting, but it was honest in one respect. Secretary of the Treasury John Connally was refreshingly blunt: "[T]he dollar is our currency but your problem." That is as true today as then.

Every generation suffers its particular fantasies. So it was a century ago. Investors had grown so immune to the consequences of war that bond markets from London to Vienna didn't flinch after the assassination that provoked World War I. Three weeks later, in that summer of 1914, the fear premium amounted to a total of one basis point. Then, in quick order, European markets ceased to function. A notable feature of this paralysis is that nothing of substance had changed - war had not been declared by any of the parties, but by now, minds were hyperventilating.

Illusions today are such that financial imbalances and debt creation have grown to impossible proportions. Impossible, if the anchor of a gold standard still existed. In 1970, among the US, Japan, and European countries, only two (Italy and Sweden) posted government deficits greater than 0.3% of GDP. By 1994, the governments of France (-5.6%), Japan (-4.8%), Italy (-9.7%), the UK (-7.8%), Canada (-7.3%), Belgium (-7.5%), and Sweden (-12.3%) could thank their lucky stars the gold tether no longer existed. They could make fatuous promises and deliver something for nothing. The world's bond market expanded from US$800 billion in 1970 to over US$62 trillion in 2006. In 1970, most corporate bonds were still backed by a power plant, a large construction project, or oil production. Today, corporate raiders often issue bonds (that is, new debt) to pay themselves a dividend or buy back stock to boost the value of their stock options. Financial derivatives were spawned by the rout of the gold standard. Currency hedging and interest-rate hedging moved from the blackboard to the trading pits. Thirty-five years later, the financial derivative markets top US$350 trillion - when the world's GDP is US$43 trillion.

It is surely an illusion that derivative markets are connected to economic activity - the derivative markets are nearly ten times the volume of the world's annual production. The most unwieldy imbalance of all grows in the US. Not the US$800 billion trade deficit or the US$500 billion federal budget deficit, but the amount of debt created compared to the amount of goods produced. Between 1920 and 1980, every dollar of growth was supported by about $1.40 of new debt. The ratio is $7.00 of borrowing to a dollar of growth today. This is economically unproductive but financially remunerative.

Derivative models are constructed in the mind - elaborate but treacherous probability estimates. The convergence of debt on production is a mathematical fact. As the wise man said: "It is an economic axiom as old as the hills that goods and services can only be paid for in goods and services." This is no less true today, though we have done a good job of evading the consequences and concealing the axiomatic convergence: either the nonproductive debt defaults or the paper inflates to meet our production. The closer we approach this unattractive prospect, the less we seem to care. Europe produced a parallel 35-year illusion that, with the passage of time, was erased from investors' mental probability models, yet was recognised "in a flash".

The historian Niall Ferguson (The Cash Nexus, War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: "Political Risk and the International Bond Market between the 1848 Revolution and the Outbreak of the First World War". Published in the Economic History Review earlier this year (available on www.blackwell-synergy.com), his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary, and Russia) comes to a surprising conclusion - the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

The post-World War II period of fearful consciousness ended in 1971. Armageddon was the intolerable consequence should the US sever its obligation to sovereign states. That obligation was established at Bretton Woods towards the end of World War II. The salient feature of the Bretton Woods system was the United States' promise to pay out one ounce of gold for every 35 US dollars presented by a foreign government. As the budget deficit, interest rates, and inflation spun out of control, Federal Reserve chairman William McChesney Martin offered the public fair warning. The Columbia University commencement speaker on June 1, 1965 instructed the graduates of unnerving similarities to 1929: private domestic debt was soaring, the supply of money and credit increased as gold was depleted, international indebtedness had risen, "and the payments position of the main reserve money center ... the United States ... was shaky in the extreme". The stock market fell 10 points that day and 60 points over the next three weeks to its lowest level in nearly a year. This was known as the "Martin market". Seeming to reserve his worst for college campuses, the Fed chairman's speech at Yale University in 1968 foretold of the doom. In Robert P. Bremner's biography of Martin, the author recounts: "Martin described the economy as 'living on the edge of an abyss' if taxes and spending were not addressed. He then observed that if nothing were done, 'the first trouble would be some basic questions about convertibility of the dollar.... [T]he government will be forced to consider imposing direct control on wages, prices and credit.'"

Martin's fears were too horrible to believe. Bond prices continued their multi-decade swoon, but didn't anticipate catastrophe. Yet, all of Martin's warnings came to fruition. The United States went off gold and would only redeem paper dollars for paper dollars. The currency spent a decade in the doghouse but rehabilitated itself in the world's view to a respectable enough status. We have since weathered any number of financial catastrophes, made possible through the free-floating dollar and unlimited ability to pump credit into the financial system. We have done this so many times - and to no lasting ill effect - that, even the most pessimistic must ask, "Why should this happy circumstance end now?"

Ferguson found that "midnineteenth century investors tended to infer future changes in fiscal and monetary policy from political events, which were regularly reported in private correspondence, the newspapers, and later through telegraph agencies. Among the most influential bases for their inferences were four assumptions: (1) that a political move to the left would tend to loosen fiscal and monetary policy; (2) that a new and radical government would be more likely to pursue an aggressive foreign policy; (3) that any war would disrupt trade and hence lower tax revenues for all governments; and (4) that direct involvement in war would increase a state's expenditure as well as reducing its tax revenues, leading to substantial new borrowings."

Most important, as a parallel to our times, "All these assumptions owed much to the experience of the period between 1793 and 1815." Investors weigh the recent past most heavily in their estimations. The French Revolution and Napoleonic Wars produced, or spawned (in future wars and revolutions), the product of these fears. In this rough estimation, investors between 1848 and 1880 sold sovereign bonds in proportion to how badly bondholders had fared. Ferguson concludes: "Indeed, the experience of the 1790s - when revolution, war, default, and inflation had sent the yields on French securities soaring from 6% to 60% - echoed, like the Marseillaise, for nearly a century. Each time Paris sneezed, to paraphrase Prince Metternich, the European markets caught cold, most obviously in 1830, 1848, and 1871."

Ferguson goes on to describe the "biggest crisis in the European bond market in the nineteenth century". This "occurred during the two months after the outbreak of the 1848 revolution in Paris. Austrian and French bonds were both severely hit, with yields on the London market rising by as much as 662 basis points in the former case, and 505 in the latter."

(For purposes of orientation, a note on 19th-century bond yields: The British consol is the standard by which to judge other sovereign issues. The 3% consol was introduced in 1751 at a par value of £100. It remained the benchmark bond until 1914. Three-percent consols were perpetual issues with covenants that authorised the government to redeem if the price reached par. During the Napoleonic Wars, it traded as low as £50-1/2 to yield 5.98%. Waterloo was distant enough by 1880 that the consol finally traded at £100 and fell below the 3% mark. The perpetuals traded at 2.25% (above £113) by the mid-1890s. The British government didn't redeem the issues, but the possibility prevented yields from dropping further. Eyeing Ferguson's data (painstakingly retrieved from every issue of the Economist between 1848 and 1914), the non-British bonds were generally issued with a 5% coupon until 1880; from 1881 some French rentes (which were also perpetual) and Russian issues paid 3% and 4% (respectively). More importantly, except during crises, yields rarely rose above 5% during the entire 1848-1914 period. The exception was Austria; the imperial credit traded at around 6% or 7% during good times and soared into double-digits during crises. By the 1890s, the four other sovereign issuers traded at yields of 3% or below. The trend for the following 20 years was of higher yields, rising by 0.5% to 1.0%.)

Particularly notable, given the later somnolence, was that after King Louis Philippe gave a "disappointing speech to the Chamber of Deputies" in January 1848, the French market suffered a "depression" ["panic selling", to hazard a guess]. Following the February 1848 revolution in France, the price of British consols fell 7.6%. This was an overreaction in Britain, as was General Motors trading at a price-to-earnings ratio of 5:1 with a dividend yield of 11% in 1949 - American investors who survived the Great Depression could only look back, and British investors schooled in the Napoleonic Wars could only anticipate the long-feared, cross-Channel invasion.

European bond investors suffered similar panic attacks at the outbreak of the Crimean War in 1854, at the impending Franco-Prussian War of 1870-1871, and during the Eastern Crisis of 1876-1878. Russian bond yields rose 5% in March 1878 in fear of a full-scale war between Russia and Britain. This fear, The Economist wrote, was of a "new campaign [that] would lead to a financial disaster. Although the risk of this is very small, this has, nevertheless, depressed Russian stocks." In modern parlance, the risk-pricing models took unlikely events seriously. But, as is true today, the pricing models weigh recent events most heavily. The world knew these splendid little wars could have turned Napoleonic, but none did. The revolutions of 1830, 1848, and 1871 could have spread like wildfire across Europe, but none did.

Then markets turned a deaf ear to bedlam. In Ferguson's summation:

Repeatedly between 1845 and 1880, then, not only war, but even the mere
possibility of war pushed up the risk premia and therefore the yields on great
power bonds. The puzzle is that after around 1880 the threat of war seems to
have counted for much less. Indeed, the magnitude of financial responses to
political crises apparently declined even as 1914 approached - the reverse of
what traditional historical accounts would lead us to expect. That, at any rate,
is one possible inference to be drawn from financial market data. In the decades
before 1914, there was a marked convergence in the longterm interest rates of
most major economies.

Ferguson discusses practical reasons why sovereign bond yields fell and converged after 1880: the widespread adoption of the gold standard, the deepening of markets and liquidity, and the rise of local savings banks lassoed to the (general) requirement that deposits be backed by government bonds. Each explanation has its virtues, but flaws persist. The gold standard, the author explains, was seen as a commitment to fiscal rectitude, but gold "was a contingent rule, or a rule with escape clauses" which could be suspended "in the event of a well-understood, exogenously produced event, such as war".

Ferguson offers an analysis of post- 1880 bond spreads:

Spreads between British consols and approximately equivalent French, German,
Russian, and Italian long-bond yields all tended to fall. For example, Italian
yields, which were close to double British yields in 1894, had fallen to just 54
basis points above them by 1907. Part of this convergence was because of the
rise of consol yields from their all-time nadir of 2.25 in July 1896 to 3.6 per
cent in July 1914. However, the main cause was the decline in yields on the
bonds of the other great powers. Even more strikingly, the magnitude of
short-run fluctuations in yields also diminished. Volatility in the bond markets
has also disappeared today.

We saw compression of sovereign yields in Europe when countries cooked their books in anticipation of the Euro. The wide government deficits of 1993 converged on solvency and even persist, at least in official figures. Sovereign credits of Greece trade at approximately the same yield as German debt. Even such a successful domestic investor as Sophocles would forego the local and buy the foreign bond. This willingness to invest in an illusion may find an analogue in the "contingent rule" of gold "with escape clauses": an inconvenient truth is better dismissed in a bull market.

Let's turn to a mythical, prototypical Serious Investor. A rookie in the late 1960s, he fears rising budget deficits, out-of-control consumption, waning physical production, an economy that survives from financial transactions and the mysterious yet oppressive influence of derivatives on the financial markets. This investor watches credit mushroom; bubbles pop and move on. He sees no-interest, no-downpayment, optional-monthly-payment mortgages hibernate in hedge-fund side pockets, which recycle the central-bank, commercial-bank, prime-broker, credit-inflation pool. Reading Professor Ferguson's study, he won't find the post-1880 atmosphere puzzling.

If the 1878 Russian-British showdown was the climactic event in draining Napoleonic worries from the investing conscience, the 1971 split with gold served the same function for our enlightened financial era. A clear sign of impending financial breakdown lit the trading screens in 1959. (Please forgive the anachronism.) The US balance-of payments deficit had deteriorated throughout the 1950s. In 1959, the London bullion market broke through the official trading ceiling of $35 and surged to $40.60. Gold hadn't risen above $35 for 11 years. Fears abated after government reassurances (and not much more), but anyone with a sense of proportion knew the math didn't work. Unless the US reversed its spendthrift ways, gold at $35 an ounce was doomed.

In 1964, Fed chairman Martin told President Johnson and Secretary of Defense McNamara that US military commitments overseas would cause a devaluation in the dollar. Their reaction reflected both their maturity and sense of responsibility: they shouted and screamed at Martin, then lied about expenditures to Secretary of the Treasury Fowler and the leaders of Congress. This made it all the easier to run the ship of state on to the rocks in a very short time. The vessel splintered so quickly it was difficult to comprehend.

The federal spending deficit was US$1 billion in 1965. By 1967, with nearly half a million US troops in Vietnam, the defence budget was expected to grow to $5.8 billion. In mid-stream, growth was recast at US$13 billion. The 1967 fiscal year deficit widened from a US$4.5 billion forecast to US$11.9 billion in August 1967. The 1968 fiscal year deficit was now expected to be US$19 billion - larger, even on a percentage basis, than during World War II. (Larger, even on a percentage basis, than today.) In October 1967, Secretary of the Treasury Fowler told Johnson the deficit could go to between US$23 and US$28 billion. The First National City Bank projected that net government borrowings could be US$20 billion in the second half of 1967, compared to US$5 billion in 1966. Institutional Investor predicted the "Death of Bonds" on its front cover just before bond traders embarked on their road to fortune.

The question remains whether this collapse of fiscal discipline was made possible by the loosening standards of the leading economists of the day. Reading through the memos and discussions over the course of the decade - particularly the first half, economic advice to the Oval Office grew less authoritarian as political circumstances (that is, elections) dictated lax standards. What alarmed investors and the general population in 1959 (through the press) went unnoticed by 1965. Alarm turns to security with the lapse of time. Yet, the problems were indeed worse. The immediate results, though, if not benign, were certainly not catastrophic - the Martin market passed and new stock market highs weren't long in coming. Parallels to the new millennium are obvious.

Then, too, the question arises how the Bretton Woods arrangement held together as late as 1968. Like today, the arrangement survived through plenty of smoke and mirrors. Government, central bank, and money-centre bank manoeuvres manufactured an illusion. The London Gold Pool (divined in 1960 to halt gold speculation) spawned, in 1968, a parallel London Gold Pool (conjured to subdivide official trading from the market price); Special Drawing Rights introduced finance to the magical derivative world - gold was no longer to be transferred; only the "right" to do so remained. Other Rube-Goldberg measures attempted to fix what could only be fixed by fiscal and financial rectitude on the part of the US government and its citizens. This wasn't going to happen. Yet, there was little awareness on the part of investors that US$35 gold and the purchasing power of the dollar were doomed - unless we permit the supposition that such a possibility was better ignored if you were in the market.

Then, as today, there were plenty of warnings. Martin, who spoke as the transmission of the world's financial engine, warned the world in a well-publicised 1968 speech: "We have been living in a fool's paradise. We face a financial crisis that is not understood by the public." The Fed chairman said he had tried to make himself heard, but "there is no disposition on either side of the aisle in Congress to face up to the problems". Martin apologised several times during the speech for appearing too emotional. He was cracking under the pressure.

How could he have made it clearer to sell the dollar? Yet, the charade went on for another three years before President Nixon officially closed the gold window on August 15, 1971. Gold rose to over US$800 an ounce by the end of the decade, and paper assets were an easy avenue to lose a life's savings. Commodities, rare stamps, and Rembrandts were the assets to hold during the 1970s; Americans abroad found that Italian and Belgian hotels wouldn't accept dollars; wages and prices were frozen by federal decree; likewise, the annual inflation rate of goods (CPI) rose to 18%, short-term Treasury bills traded at 17%, and the 30-year bond rose to a 15.49% yield. (European bond holders of the 19th century never sold off the tottering Austrian Empire to such a level.)

It was a bad decade for America. Nixon was impeached; Vietnam was lost; the Soviet Union was winning; the US federal deficit rose to US$53 billion in 1975. President Carter was elected; he donned his cardigan sweater to enliven the chagrined and the deficit rose to US$73 billion.

Yet, the currency of choice remained the US dollar. As the economy and financial markets turned up, the perfectly human tendency was to kick up one's heels, think the world's financial system had survived - and flourished - after gold convertibility collapsed. Those who still fretted over deficits and the paper monetary system were dismissed as cranks and lumped with the Michigan Militia.

And what was there to fear? As the various financial and economic balances wobbled farther from their gold anchor, financial crises became commonplace. We learned to take them in stride.

This might be similar to the climate after the Eastern Crisis - the rumpus in the Balkans that nearly sucked in most of Europe. Ferguson runs through some flare-ups after 1880 that could have engulfed nations, but did not. Since 1971, we have lived through a series of financial crises that could have turned climactic, but did not. He cites the British occupation of Egypt in 1881 [Citicorp's emerging market loans, circa 1980], the Afghan Crisis of 1885 [Continental Illinois, 1984], the Bulgarian Crisis of 1886 [stock market crash, 1987], the Russian and German standoff between 1888 and 1891 [Savings and Loan crisis, 1989- 1991], the Fashoda Incident in 1898 [money centre bank crisis, early 1990s], the Boer War, 1899-1902 [derivatives meltdown, 1994], the Moroccan Crisis of 1905 [Mexican peso bailout, 1995], the Anglo- German antagonism, 1906-1908 [Asian meltdown, 1997], the Balkan Crisis, 1908-1911 [Russia, 1998], the Balkan Crisis, 1912-1913 [LTCM, 1998], the British and German naval construction buildup, leading up to the War [derivatives compounding and still bursting with innovation today], and another Balkan Crisis in the summer of 1913. To offer a possibility: a fourth Balkan Crisis in the summer of 1914 may have been greeted with the same weariness as notice that Amaranth Advisers, the Greenwich-based hedge fund, lost US$6 billion in the summer of 2006. News of the collapse vanished as quickly as it appeared; other funds absorbed the derivatives positions in a matter of hours. Long-Term Capital Management was only half the size; therefore, we needn't worry about another derivatives crisis. Q.E.D.

The Naval race between Britain and Germany sold newspapers and books in the 1890s. Aside from the prospect of war, shipbuilding programs expanded government spending. British and German bond yields rose, but not significantly. Fears still simmered and haunted in the decade before the War (Norman Angell's The Great Illusion was a bestseller), but the popular imagination had grown accustomed to the debate. Likewise, the US survived the portfolio-insurance meltdown in the stock market crash of 1987. The theorists who devised portfolio-insurance derivatives - a prime cause of the meltdown - discovered this crash was a 20- standard deviation event and concluded: "a day like this wouldn't be expected to happen during the lifetime of the universe." The implosion of Long-Term Capital Management in 1998 was also dismissed as a once-in-the-history-ofthe- universe event. In May 2005, after some hedge funds were caught on the wrong side of the General Motors downgrade, this eightstandard deviation movement in prices was ignored. Considered so remote a probability in the history of human existence, it wasn't worth considering in future derivatives modelling. Alarm turns to security with the lapse of time.

It is 2006. Our Serious Investor (Columbia, B.A. 1965; Yale LL.B., 1968) has grown calloused to once-in-the-history-of-the-universe events. Martin scared him to death. Our Investor understood the dollar was the weak link in the international payments system. Surely, the American Century was at an end. Our Investor survived the dollar crisis, the stock market collapse and deep recession of 1973-1974, the Business Week "Death of Equities" front cover, the US$250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past 20 years (far more prevalent than between 1950 and 1970), the current US$500 billion federal budget deficits, and the (prospective) US$1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the "Greenspan put" (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away, and diligently watches for signs that THIS IS IT.

If convinced THIS IS IT, what would he do? He's not sure. He loses a night's sleep. He goes to the office the next morning and pulls out a faded, 1978 clipping from U.S. News and World Report:

The mountain of debt has grown so high in this country that many economists fear
the United States is unusually vulnerable if a recession occurs.... [S]ome fret
that a load of personal debt will make a recession more severe than it otherwise
would be. In only 3-1/2 years since the end of the last slump, Americans have
added a trillion dollars to their financial obligations. Today, government,
corporations and individuals owe more than 3.5 trillion dollars, equal to nearly
$16,000 for every man, woman and child in the country.... The question now being
raised is whether a day of reckoning is at hand.

Our Serious Investor relaxes. Yes, all of this is still true and now we add a trillion dollars of debt every three months. We have accumulated US$90,000 in debt for every man, woman, and child in the country. A day of reckoning will come. But there's no point worrying about it. The entire credit structure and gutted economy is a shambles, but we inflated our way out of a 1978 reckoning; we may muddle through again. The emperor wears no clothes, but the architects of economic consensus and market wisdom constructed a bunker that excludes the dissidents. Official opinion is like Lenin's tomb. The iconic face demands intensive care as the skin decays. The deception of eternal embalming grows less convincing as the emperor's face erodes. The best minds are diverted from biotechnology labs and mathematical discoveries to design a cosmetic cloak for a dead corpse.

US financial chicanery is similar, with a twist. It bloats and must continue to do so. US engineers and mathematicians (in such demand they are now imported from China and India) must not only disguise blemishes, but perform artistic feats to match the finest trompe-l'æil artists. The asymmetrical cheekbones and mutations of the cranium demand optical illusions. Our Serious Investor knows the suspension of judgment on the part of the viewing public could dissipate in a flash, but trading rooms still watch CNBC, quote Gentle Ben, and are preoccupied with football betting pools. We will be free of thought at least through the Super Bowl.

Investors who held government bonds prior to World War I probably didn't give much thought to the alternative investments. Financial markets had expanded by leaps and bounds over the past generation. This multiplied the ingenuity, nationality, and variety of securities, but railroad bonds issued in Vienna or London carried their own baggage. Gold was the only solution, but a poor one. (Even that was often repatriated in the war effort. US stocks might have seemed an escape hatch, but the British and French governments confiscated their citizens' securities held in New York accounts. Taxes soared on property, and wrought iron fences were nationalised. And this was in Britain - where no battles were fought.)

Our Serious Investor holds one trump card not available to his ancestors. The derivative world offers such an extraordinary range of insurance products - puts on indexes, on stocks, even puts on puts; credit derivative protection against defaults; mutual funds that leverage short positions on bond and stock indexes - and they are extraordinarily cheap. They are cheap because volatility has disappeared from markets, and protecting the downside risk in a portfolio is generally considered a waste of money. It is also a risk to one's career, since clients want every cent of their money chasing higher returns.

Ferguson's narrative of the countdown to war is a splendid chronology of how quickly the world can change:

It was not until 22 July [1914] - more than three weeks after the Sarajevo
assassinations - that the possibility of a European political crisis was first
mentioned as a potential source of financial instability in the financial pages
of The Times. A plausible inference is that continental markets were
anticipating the belligerent tone of the Austrian ultimatum to Serbia, published
on 23 July, which demanded official cooperation with an Austrian inquiry into
the Sarajevo assassinations. This was the signal to investors that war was a
real danger.

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 - a single basis point of fear. If investors now foresaw real danger, they must have believed their portfolios received a personal exemption. Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now consols rose to 3.45%. The St. Petersburg exchange closed on the 29th and The Economist considered the "Berlin and Paris bourses closed in all but name".

It was by no means clear who would fight, or even if there would be a war. Nevertheless, British exchanges suffered a two-fold crisis. In Ferguson's words:

First, foreigners who had drawn bills on London found it much harder to make remittances; those British banks that had accepted foreign bills suddenly faced a general default as bills fell due. At the same time, there were large withdrawals of continental funds on deposit with London banks and sales of foreign-held securities. London became, as The Economist put it, "a dumping ground for liquidation for the whole Continent of Europe".

A wholly unanticipated domino effect now engulfed London. The bond market didn't seem to acknowledge this vaporisation of liquidity:

Even these developments had a remarkably limited impact on great-power bond
yields. Between 22 July and 30 July (the last day when quotations were
published), yields on consols rose by 26 basis points; yields on French rentes
by 22 basis points; and yields on German bonds by 17 basis points. The rises
were twice as large for Austrian and Russian bonds, yields on which rose by
nearly half a percentage point.... The Economist was especially struck by the
widening of the bid-ask spread for consols (the gap between buyers' offers and
sellers' asking prices) to a full percentage point, compared with a historic
average of one-eighth of 1%....

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%. The week before, The Economist was preoccupied with the "continual suspense over Ulster". (Northern Ireland dominated newsprint during the summer of 1914. It made better copy than another Balkan Crisis.) What a difference a week makes - from the August 1, 1914 Economist:

The financial world has been staggering under a series of blows such as the
delicate system of international credit has never before witnessed, or even
imagined.... Nothing so widespread and so world-wide has ever been known before.
Nothing ... could have testified more clearly to the impossibility of running
modern civilisation and war together than this closing of the London Stock
Exchange owing to a collapse of prices, produced not by the actual outbreak of a
small war, but by fear of a war between some of the Great Powers of Europe. [My
italics.]

Did The Economist or the Bank of England consider the international credit system "fragile", under any conceivable circumstances, a year before? Five days before? Ferguson writes:

The key phrase here is "fear of a war". Although Austria had declared war on
Serbia on 28 July, it was still far from certain that the other great powers
would join in; it was not until 31 July that Russia, after three days of
indecision, began general mobilization, prompting the German government to issue
its ultimatums to St Petersburg and Paris. The Germans did not declare war on
Russia until 1 August; their declaration of war on France came two days later.
Britain entered the fray only on 4 August (an event readers of The Economist had
certainly