"Bo Knows" was a wildly successful ad campaign for Nike cross-training shoes that ran in 1989 and 1990, starring football and baseball sensation Bo Jackson, the only athlete to ever make the All-Star team in two major sports. Wikipedia describes the first ad:

The spot opens with a shot of Jackson playing baseball and fellow ballplayer Kirk Gibson saying, “Bo knows baseball.” The next scene shows Jackson on the gridiron, with quarterback Jim Everett explaining, “Bo knows football.” Jackson then plays basketball, tennis, and ice hockey and goes running, with Michael Jordan, John McEnroe, and Mary Decker vouching for Jackson’s knowledge of their sports (Wayne Gretzky, when confronted with Jackson laying a body check, simply says “No.”) The ad concludes with Jackson trying to play the guitar, whereupon blues legend Bo Diddley exclaims, “Bo, you don’t know diddley!”

Perhaps the "Bo Knows" campaign should be updated to reflect modern day politics:

The spot opens with a shot of Barack Obama teaching a class of 3rd graders.

Dean of Harvard: "Obama knows education."

The next scene shows the president in front of a sea of windmills.

T. Boone Pickens: "Obama knows energy."

Obama flying an Apache helicopter over the mountains of Afghanistan…

Dick Cheney: "Obama knows foreign policy."

The president in surgical mask and gloves performing an operation…

Dr. C. Everett Koop: "Obama knows health care."

The president receiving the Nobel Prize in Economics…

Lew Rockwell: "No."

The president taking a sworn oath to the Constitution…

James Madison: "Obama, you don’t know diddley!"

How can anyone take seriously a president who delivers over 100 speeches during his first seven months in office? The attention to detail and out-of-the-box thinking are truly impressive. The all-knowing president can seamlessly switch from encouraging students to wash their hands during flu season to suggesting doctors share test results by e-mail. The man would have us believe he can rescue a collapsing financial system, make the country self-sufficient in energy, repair centuries-old Middle East animosities, fix classrooms, regulate boardrooms, modernize emergency rooms, raise two children, run faster than a speeding bullet, and jump tall buildings in a single bound.

Setting aside the morality of one man planning the lives of 300 million (more if you include his significant foreign policy aspirations), the futility of it all should be obvious. The central planner always runs into this irritating economic brick wall called "scarcity." As individuals, we all have to deal with this — limitations in our talents, resources, time, energy, and ambition. So we constantly make tradeoffs, based on our own unique preferences and the supply of possibilities. "Should we have cheeseburgers or filet mignon for dinner tonight?" "Should we take the kids to Disneyworld or Niagara Falls?" "Should we tell Johnny to skip plans for college, go up to our eyeballs in debt, or pull the plug on Grandma?" How can the planner know enough to make such decisions for a single person, much less take into account the hopelessly complex interactions of billions?

This plight of the world improver is reminiscent of the movie Bruce Almighty in which Bruce, played by Jim Carrey, gets to play God for a week on the condition he does not interfere with free will. Exhausted by trying to answer millions of prayers by e-mail, he relents by hitting the "reply all" button and granting everyone their wish. Instead of solving the world’s problems, there are consequences, such as a preponderance of lottery winners in his hometown of Buffalo, and all hell breaks loose.

Friedrich Hayek referred to the social engineer’s fatal conceit as "the pretence of knowledge:"

Unlike the position that exists in the physical sciences, in economics and other disciplines that deal with essentially complex phenomena, the aspects of the events to be accounted for about which we can get quantitative data are necessarily limited and may not include the important ones. While in the physical sciences it is generally assumed, probably with good reason, that any important factor which determines the observed events will itself be directly observable and measurable, in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable.

In other words, economic knowledge is highly decentralized and mostly off limits to the planner. But how is this knowledge organized and harnessed? Wouldn’t chaos ensue if individuals were left to their own devices?

In a world of scarcity, people must give up something to get what they want. This necessarily leads to trade with others. Trade creates two challenges. First, if you need bread and only have shoes to offer, you could waste a great deal of time locating a baker who needs shoes. Second, how can you possibly make sense of a system where prices have no common denominator (e.g., one pair of shoes = 8 loaves of bread, 1 loaf of bread = 1 dozen eggs, etc.)? The market provides a solution, out of necessity and without central direction: It naturally and spontaneously adopts one commodity as money, or a medium of exchange.

Let’s say your dream is to own a house on a lake. If there were no scarcity there would be no problem — we’d all own lake houses. Instead, that house has a price based on the supply of similar homes and vacation alternatives (like taking a cruise) and the demand for various leisure activities. You have a plethora of ways to occupy your free time, and the only way to compare the cost of these (what you have to give up in terms of accumulated property and your labor) is with prices. Without a price system there would be no way to allocate resources efficiently, no way to perform economic calculation, no way to plan. Our lives would be chaotic and primitive.

By contrast, the central planner cannot possibly know how prices would be set in a free and constantly changing market. He is essentially ignorant and flying blind, as Ludwig von Mises famously revealed in his 1920 essay, Economic Calculation in the Socialist Commonwealth:

In the socialist commonwealth every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. Socialism is the abolition of rational economy.

Barack Obama may know how to give a speech or win an election, but he doesn’t know economics. Neither did practically every president from William McKinley to George W. Bush. Neither do most of the mainstream media, political pundits, and voting population who expect their government to make a silk purse out of a sow’s ear. As Murray Rothbard wrote, "It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance."

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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"I hope the titans of finance who expect us little people to save them are ashamed of themselves. But at the same time, in painting Main Street solely as a victim of a rapacious Wall Street, we are being hypocritical. We are all to blame."

~ Bethany McLean, "The Borrowers," The New York Times, October 2, 2008

In a sense, the former Fortune investigative reporter of Enron whistleblower fame has a point. It takes two to tango. The borrower was a willing dance partner to the lender’s lead. As the music kept playing, the dance floor became crowded and unruly. Many felt the party would never end. Some, like Citigroup’s Chuck Prince, thought they could quietly sneak out the back door before the cops arrived. Others — soccer moms, retirees, and avid readers of LewRockwell.com — knew better and dropped their invitations in the shredder. A significant portion of the population acted responsibly.

We wrote about this dichotomy in June, 2006, less than a year after the housing boom peaked:

"A long-time friend… points out a distinction in the behavior of the debtor class. Some have clearly acted responsibly: they consolidated their debts into tax deductible mortgages, locked in the lowest long-term rates in 40 years, and tossed the interest savings into their rainy day and investment jars. From a consumption standpoint, little has changed except that these old-school borrowers pocketed a windfall compliments of their friendly neighborhood central banker. Others — to put it mildly — have gotten carried away."

At the time, we reported 29% of the mortgages taken on in 2005 were already underwater. Housing costs consumed over half the income of 16% of those with mortgages, up from just 2% five years earlier. What we failed to mention were that roughly half of all mortgages fell within long-held standard payment limits of 30% of gross income and that 18% of all homes were owned outright.

Scratch the surface and you’ll find plenty of people who resisted temptation during the bubble years and lived within their means. My sister and her husband who live in Harrisburg, Pennsylvania occupy the same home they bought in 1991. In 1998 they refinanced at a lower interest rate and increased their mortgage to pay for a significant extension of their house (my brother-in-law actually did most of the work). After the home improvement loan, their loan-to-value went up to approximately 55%. At the time their mortgage was about 14% of total gross income, 16% with taxes. The bubble from 2001 to 2006 largely passed them by. They failed to get the memo about using their house as an ATM, choosing instead to save before making major purchases (e.g., they began saving two years for a recent trip to Wyoming). They have no credit card debt. Today they have four years remaining on their mortgage. Total payments are 13% of gross income and their current LTV is about 15%.

This is not to say my sister and her family will not suffer from the madness of others the last seven years. Her husband works for a specialty paper company which outsourced two-thirds of the local jobs to South Carolina a few years ago. The current hangover from our housing, credit, and consumption bender does not exactly help his job security. My sister’s family is also being forced to help bear the costs of a $1 trillion 5-year war, some of which shows up at the grocery store and gas pump. Now they’re being asked to pick up the tab for a party they never attended, with the cleanup bill already over $1 trillion. As you might expect, they are not exactly pleased by this prospect.

Government has no resources of its own, no elves working overtime to produce something of value, just promoters who espouse Santa Clause economics. It can only transfer wealth from one group to another (skimming a nominal transaction fee in the process). The current $700 $800 billion bailout (sorry, rescue) package is nothing more than a looting of the responsible and productive by the reckless and profligate. Call it reverse Darwinism, survival of the least fit. As the old economics saw goes, subsidize a certain behavior and you get more of it, tax a certain behavior and get less. Responsible people like my sister and her husband are becoming an endangered species in this country as a result.

Expect such a massive wealth transfer at the hands of the political class to be means tested. Those who were reckless, but friendless in Washington and have already paid a heavy price for their sins will go to the back of the soup line. Paulson’s checkbook will not be used to help Joe Sixpack who got in a little over his head or save Lehman Brothers shareholders who bled to death before the triage unit showed up. It will be closed to smaller banks not privy to high-level discussions about which Fannie Mae creditors the government would bail out and are now stuck with worthless preferred stock. What will Paulson likely tell pension funds holding the very same toxic paper as his "too big to fail" banking cronies? Take a number.

Stripped of its lofty promises, the Emergency Economic Stabilization Act of 2008 will not backstop your 401(k), encourage lenders to crawl out of their bunker, resuscitate an economy on life support, or turn a profit for the hapless taxpayer. Its primary mission in life is to rescue "the Chosen Ones" — Goldman Sachs, Morgan Stanley, Citigroup, Bank of America, and JPMorgan Chase. The early returns are promising. On Thursday, September 18, the financial establishment was coming unhinged. By early afternoon the combined market values of the five companies had shriveled to $360 billion. That night DC’s power brokers — Paulson, Bernanke, Cox, Pelosi, Frank, et al. — concocted their shameless scheme. As of last Friday’s close, the Chosen Ones tacked on $137 billion in market value for a 38% gain while the rest of the market, as measured by the Dow Jones Wilshire 5000 Index, lost $634 billion, or 5.6%.

Market participants are not always rational, but in this case they apparently figure a blank check in the hands of a former CEO of Goldman Sachs will benefit the political economy at the expense of the real economy. Our sense is that both are in trouble; transferring more blood from the productive host to the parasite does not in the long run make either healthier. For the economy and country to begin healing we need capital, credibility, and responsibility to move from the wasteful to the productive. The power elite, predictably, is attempting to achieve the exact opposite.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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In the annals of American-style “capitalism,” this Tuesday resembled an episode from The Twilight Zone.

For starters, the country’s monetary central planner — the Bernanke Fed — dropped rates 1/4%. Investors were miffed, hoping for even more candy. As the kiddies came down from their 1,000 Dow point sugar high of the last 2 weeks, their mood was agitated and whiny. The Dow dropped 300 in less than 2 hours.

Right after the “disappointing” news was released at 2:15 pm, former reporter turned fund-of-funds manager Ron Insana complained,

“This is a decidedly wimpy move by the Fed.”

Perhaps Insana is showing strains from running actual money in the real world. We’d be surprised if he doesn’t return to the more forgiving world of business journalism, that is, if there is anyone left hiring as this bear market firms its grasp.

Next up: American capitalism’s folk hero, Warren Buffet, raising funds for Hillary Clinton. According to the WSJ:

"The fund-raising u2018Conversation with Warren Buffett’ drew over 1,500 people, including a mix of Silicon Valley executives such as John Doerr, a partner at venture-capital firm Kleiner Perkins Caufield & Byers… Tickets ranged from $100 to more than $2,300, drawing in around $1 million, according to the Clinton campaign."

How ludicrous — the country’s prominent venture capitalists and its best known and beloved “capitalist” raising funds for a committed welfare statist and socialist. On CNBC, Hillary agreed with Buffett’s position to maintain the estate tax because, in her words,

"It’s really a tax to prevent us from having inherited wealth generation after generation which would undermine the kind of spirit and meritocracy that the United States stands for."

This is awfully charitable of Hillary and Warren to provide such a vital service to our "free" society. Never mind that Mr. Buffett sells life insurance to these very people attempting to protect their family businesses and family estates from the ravages of the tax man, just so they can keep them intact for their children. Buffett chooses to hand over the vast majority of his $57 billion fortune to charity, so why should he care? Repeal the exemption on charitable giving and you would see him go apoplectic. In 1995, Buffett was quoted on the subject:

I personally think that society is responsible for a very significant percentage of what I’ve earned. If you stick me down in the middle of Bangladesh or Peru or someplace, you find out how much this talent is going to produce in the wrong kind of soil… I work in a market system that happens to reward what I do very well — disproportionately well… I do think that when you’re treated enormously well by this market system, where in effect the market system showers the ability to buy goods and services on you because of some peculiar talent — maybe your adenoids are a certain way, so you can sing and everybody will pay you enormous sums to be on television or whatever — I think society has a big claim on that.

So on the one hand, Buffett realizes the free market maximizes human potential, and on the other supports Big Government, itself the greatest threat to free markets. Some capitalist. Note to Oracle of Omaha: If you feel the need to give back, why not write a few checks to free market think tanks?

Next in line: Larry Kudlow, so-called supply-side “economist” who talks a good game when it comes to lower taxes and fewer regulations, but supports the very institutions that pump up Big Government most — the military-industrial complex and the Fed. Kudlow is apparently suffering from dementia, extolling heroes such as Joseph Schumpeter and Ludwig von Mises while forgetting they were fierce opponents of central banking. He defended the monetary madness of Greenspan from 2001 to 2004 and now Helicopter-Ben and will be the last to admit their interventions caused an epic credit bubble which is coming unglued. Kudlow’s advice to Bubblevision viewers after the close?

"I wouldn’t panic. Investors should stay in for the long-term. Goldilocks is alive and well."

Thanks, Larry.

Next up to the plate: Jim Cramer, host of CNBC’s aptly named Mad Money, former hedge fund manager, and author of several popular books on navigating the financial markets. Cramer was indignant that the Fed failed to cut rates %:

I am angry because today the Federal Reserve cost this country an enormous sum of money by giving us a dinky 1/4 point rate cut. The Fed has just done its unwitting best to hasten the possibility of recession — or,… to turn the possibility into something closer to a certainty… Today we learned that no matter how bad things get, the good folks running the Fed are going to take a calm, measured approach — even if to be calm at this moment is the height of insanity.

The kiddies love Jim Cramer because he advocates an all-sugar diet, 24/7. In his bizarre world of asymmetric risk, the Fed’s job is to prevent investor losses, no matter the consequences. Quite a free market role model for his adolescent fans.

Earlier in the day, the Maestro himself, Alan Greenspan, wrote an op-ed for the WSJ titled "The Roots of the Mortgage Crisis." We’ll give you a hint: the Greenspan Fed failed to make the short list of culprits:

The root of the current crisis, as I see it, lies back in the aftermath of the Cold War, when the economic ruin of the Soviet Bloc was exposed with the fall of the Berlin Wall. Following these world-shaking events, market capitalism quietly, but rapidly, displaced much of the discredited central planning that was so prevalent in the Third World.

No surprise here — central planners always blame free markets for the messes created by their own intervention. Greenspan sees "the expectation of rising prices" as "the dynamic that fuels most asset-price bubbles." Driving the fed funds rate down to 1% in 2003 and practically handing money to speculators apparently had nothing to do with turning the traffic lights all green and creating a massive pile-up.

And lastly: On Wednesday morning, the Fed apparently caved to the tantrums of investors by announcing a scheme to add liquidity through “alternative measures." On cue, the kiddies salivated, taking the Dow up 250 points on the open only to see nearly all of those gains evaporate by the end of the day.

To paraphrase H.L. Mencken, "Fed intervention in the financial markets is the art and science of running the circus from the monkey cage."

Beam me up, Scotty. There are still no signs of intelligent life.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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"The natural progress of things is for liberty to yield and government to gain ground."

~ Thomas Jefferson

Perhaps the two longest and most intractable trends in this country are the growth of the state and the receding of liberty at least since the days of the Lincoln administration. For over a century and a half, the accumulation and centralization of power have been driven by at least five factors: ignorance, greed, fear, envy, and fantasy.

Ignorance

Sadly, most Americans are ignorant of their own heritage. They confuse freedom with democracy when the Founders knew these were mutually exclusive. "Democracy was the right of the majority to choose its own tyrants," according to Madison. How many references are there to "democracy" in the Declaration of Independence and the Constitution? None. The Founders handed us a foreign policy of free trade and neutrality. Avoid "entangling alliances," advised Washington. Do not go abroad "in search of monsters to destroy," warned John Quincy Adams. "If Tyranny and Oppression come to this land, it will be in the guise of fighting a foreign enemy," predicted Madison, well in advance of the Patriot Act. Where have their words of wisdom gone? Right down the memory hole.

Most people lack a basic understanding of how a market economy functions. They equate a lack of planning on the part of government with chaos, or that some things simply will not get done. For example, if the government does not take care of the poor, most assume they will starve. They fall for the "fatal conceit" that planners possess enough knowledge to actually do their job. They do not stop to think that three hundred million people (or 7 billion for that matter) acting voluntarily to cooperate, compete, and improve their lives possess far greater knowledge than the "Gang of 535" inside the Beltway ever could. Knowledge is decentralized. They overlook the immeasurable contribution of the price system which enables economic calculation — the ability for individuals to weigh trade-offs and make choices in a world of scarcity. They forget that centrally planned economies have been a disaster throughout history, including the early settlements in this country.

Greed

Most fail to differentiate between the public and private sectors. The former is coercive in nature, the latter peaceful and voluntary. They focus instead on the supposed greed of the businessman. The real greed is the businessman who crosses the line and uses the gun of the state to gain special privileges at the expense of everyone else. This is mercantilism (the very system Americans originally fought a War of Independence to overturn), synonymous with “political capitalism” and “crony capitalism.” It is not laissez faire capitalism. Yet the free market gets the blame whenever the government’s meddling in the economy backfires. The response is always more intervention, which ultimately means even less economic freedom and more problems down the road. Meanwhile, the state official is assumed to be selfless and above temptation.

Fear

Any centralizer of power worth his salt knows people are most willing to surrender their liberties during periods of crisis. As John Adams observed, "Fear is the foundation of most governments." Thomas Jefferson famously warned, "A nation that limits freedom in the name of security will have neither." H.L. Mencken was even more emphatic: "The one permanent emotion of the inferior man is fear — fear of the unknown, the complex, the inexplicable. What he wants above everything else is safety." Fear comes in many forms — fear of foreign attack (e.g., the Cold War and War on Terror), fear that the economy will crumble without adult supervision, fear that roads, schools and parks would not exist without government provision, fear that the exhaust from our cars will melt the polar ice caps and flood our coastal cities, and even fear that one of the two political parties poses a greater threat to our livelihoods than the other.

Envy

Some apologists for Big Government are motivated by the resentment of achievement itself. According to the Foundation for Economic Education’s Sheldon Richman, envy can take a large share of the blame for our current welfare apparatus: "It is bad enough that the administrators of the welfare state are moved by a hatred of ability. The greater tragedy is that they poison the minds of the constituency they so desperately need. Instead of the poor learning to admire the productive and aspire to be like them, they are taught by the system that their poverty is caused by others’ affluence. They learn to resent achievement and to prefer seeing the achievers dragged down. That is all the welfare state can bring about." According to Richman, what the poor really need more than a handout is the “invisible hand” of markets: "The welfare statist will cry out that we have responsibility to those less fortunate. We do, but in a sense other than the egalitarian imagines. We have a responsibility to create and maintain a free society so that all may go as far as their abilities and determination will take them."

Fantasy

Finally, we have the dreamer, the idealist. He navely imagines a world of harmony and abundance which, of course, someone must plan and run. The only inconvenience? At the end of the day his Utopia requires brute force. That such fantasy provided the basic foundation of the great atrocities of the 20th century — Stalin’s collectivist famines in the Ukraine, Hitler’s gas chambers, and Pol Pot’s killing fields in Cambodia — always escapes the dreamer. Perhaps this is why Hollywood celebrities routinely fawn all over tyrants like Che Guevara, Fidel Castro and Hugo Chavez, or why Western journalists were enamored of the mass murderer Joe Stalin during the 1920s and 1930s. To the Utopian, it is always the particular implementers at fault, never the system or the theory itself.

As Milton Friedman pointed out three decades ago, it is the knaves and the naïve who primarily drive the inexorable upswing of centralized power and planning. "You almost always, when you have bad programs, have an unholy coalition of the do-gooders on the one hand and the special interests on the other."

When will these trends of expanding government and contracting freedom end? Likely when they exhaust themselves. Trends tend to move through several phases: disbelief, gradualism, acceleration, blow off (accompanied by signs of hubris and rationalization), decline (with denial and desperate acts to keep the game going), and collapse (i.e., a return to sanity). Perhaps the Iraq War was the blow off stage of the foreign policy engine that drove the bull market in state power. And perhaps our recent credit bubble was the blow off phase of the monetary engine. If so, a major change in trend is mercifully upon us.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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According to records obtained under the Freedom of Information Act by Kenneth H. Thomas, lecturer in Finance at The Wharton School, a phone call from none other than Robert Rubin (a.k.a. u201CMr. Bailoutu201D) to Ben Bernanke in early August set in motion a series of public and private sector conversations that culminated in the surprise discount rate cut on August 17th:

The Federal Reserve’s Aug. 7 decision to keep interest rates unchanged set off a chain of high-level discussions with Wall Street executives, money managers and cabinet officials that culminated in Chairman Ben S. Bernanke’s public about-face 10 days later, according to records of his schedule.

Starting with a phone call from former Treasury Secretary Robert Rubin the day after the August rate meeting, Bernanke’s appointments included Lewis Ranieri, founder of Hyperion Capital Management Inc., and Raymond Dalio, president of Bridgewater Associates.

Not surprisingly, Bernanke also consulted with Hank Paulson:

Bernanke was also in frequent contact with Treasury Secretary Henry Paulson, who said in an interview last month that he meets the chairman regularly.

Let’s establish a time line, keeping in mind Rubin and Paulson are ex-Goldman Sachs CEOs in direct communication with the chairman of the Fed…

Aug. 7 — The Fed stands firm, keeping rates unchanged.

Aug. 8 — Rubin calls Bernanke.

Aug. 9 — Bernanke calls some Wall Street bigwigs including Ray Dalio at Bridgewater Associates, the 4th largest U.S. hedge fund firm with $32 billion under management (Dalio is personally worth $4.0 billion according to the latest Forbes 400 issue). The Wall Street Journal reports, “the Fed twice entered the market today to pump a total of about $24 billion of liquidity into the system, more than its typical daily open-market activities.”

Aug. 10 — A Goldman Sachs “quant” hedge fund, Global Equity Opportunities, suffers a brutal week, losing about 28% of its value to $3.6 billion. Its North American Equity Opportunities fund and Goldman’s flagship, Global Alpha, are also taking significant losses.

Aug. 13 — Goldman Sachs injects $2.0 billion into Global Equity Opportunities. The company is joined by a group of big-name investors, including AIG’s Hank Greenberg and Eli Broad, who pony up $1 billion. (Greenberg, 82, is worth $2.8 billion; Broad, 74, is worth $7.0 billion according to Forbes.)

Aug. 16 — In a wild day, the Dow rallies back to unchanged in the final hour after being down nearly 400 points intraday. The Dow closes at 12,846.

Aug. 17 — Before the market opens, the Fed drops the discount rate by 0.50% to 5.75%, timed for maximum bullish effect on an option expiration Friday. The Dow rallies 233 points to 13,079. Global Equity Opportunities rises 12% for the week.

Aug. 31 — Global Alpha loses 22.5% in August, its worst month ever. Year-to-date, the fund has lost a third of its value. According to Bloomberg, “Investors last month notified… Goldman, the most profitable securities firm, that they plan to withdraw $1.6 billion, or almost a fifth of the fund’s assets as of July 31… Global Alpha will have to return 80 percent before the managers can resume collecting 20 percent of investment profits from clients who were in the fund at the beginning of last year.” Global Equity Opportunities finishes the month down 23%.

Sep. 14 — Global Equity Opportunities is reportedly down 1.9% so far for the month. Global Alpha is down 2.8% (and off 46% from its March 2006 peak). “People aren’t going to keep suffering losses,” said Brett Barth, a partner at New York-based BBR Partners, which invests in hedge funds. “These funds are supposed to do well with risk management. Something has gone badly awry.”

Sep. 18 — The Fed surprises the market with 0.50% cuts in both the fed funds and discount rates. The Dow rockets 336 points, its best day in 5 years, to 13,739.

Sep. 20 — Goldman reports much better than expected 3rd quarter results. Trading and principal investments revenue checks in at $7.6 billion, up 21% from the 2nd quarter and up 73% from a year earlier. “The numbers are great,” Glenn Schorr, an analyst at UBS AG in New York, wrote in a note to investors today. The earnings demonstrate Goldman’s “ability to not only navigate choppy waters, but make a ton of money doing so,” he said.

Oct. 1 — The Dow closes at a record 14,088.

Oct. 3 — Goldman Sachs stock hits an intraday high of 230.63, up 46% from its mid-August lows and within 2% of its all-time high.

It is no secret Goldman Sachs has plenty of friends in high places. It is no secret the company, as well as the rest of Wall Street, was on the ropes in August. In mid-August, politically-savvy Hank Greenberg wrote a big check and a week later he was 12% in the black. By the end of August, Goldman reported its second best trading results ever. How much of their good fortune was a result of skill we’ll leave to the reader’s imagination.

Were Goldman, Hyperion, Bridgewater and others privy to what is essentially inside information? A friend and keen observer of the financial scene writes:

Bernanke might defend himself by arguing that he only asked the questions and didn’t answer any. Give me a break! Great traders like Ranieri made their fortunes reading the nuances of comments made by other traders AND policymakers. Tone and emphasis matter as does the types of questions being asked. It is a HUGE advantage having this kind of special access.

Lew Rockwell is right: Politics is a rich man’s game.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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On September 12, most of the country’s largest mortgage lenders went hat in hand to DC to chat with Treasury Secretary Hank Paulson. The parade was led by Countrywide Financial CEO Angelo Mozilo, followed by high-level execs from Wells Fargo, Citi Mortgage, JP Morgan Chase, and HSBC. As CNBC’s Diana Olick blogged, there was a bit of turf defending and finger pointing amid the “let’s do what’s right” love-fest…

Unlike periods of financial turbulence I’ve witnessed over many years, this turbulence wasn’t precipitated by problems in the real economy. This came about as a result of some bad lending practices.

~ Hank Paulson

Real estate values have clearly caused most of the problem.

~ Angelo Mozilo

After the meeting, Mozilo did what he does best — shmooze with the press. We parsed the interview and offer our own interpretation…

I don’t think there’s anybody doing more than Countrywide in terms of trying to help these people stay in their homes where that’s possible. So we just continue to work as diligently as we can to make certain every step is taken to preserve the integrity of homeownership. And we’ll continue doing that, and working with the government and any agency we can to make sure that we continue to do the right thing, and we get as much help as we can from the agencies — from Fannie, from Freddie, from FHA… I think everybody wants to do the right thing, and everybody’s on the same page.

Translation: We all just want to save our own bacon, even if it comes at taxpayer expense. Bringing the American dream to the less fortunate is the best way to cover our scam. Most people, especially reporters, fall for this all the time.

Countrywide’s doing fine. And we’re gonna continue to grow…

Translation: We’re in deep doo doo.

It’s always been a prejudicial problem. You know, it’s a risk-based process that we have in this country. But my concern really is that with constraints now being placed on lending, particularly subprime, is the gap is going to widen dramatically between the have and have-nots. That’s my deep concern.

Translation: I have no problem playing the class envy card. Most are too ignorant of economics to realize there’s no free lunch, especially when it comes to buying and maintaining a home.

In terms of increasing the Fannie/Freddie limits, increasing the FHA loan amounts, getting the cap off Fannie and Freddie… I’m for that because we need liquidity in the marketplace… And the government has to play that role right now, in creating liquidity, so I’m in support of it.

Translation: We have a $209 billion “distressed” loan portfolio against a mere $14 billion in equity. We’d love to have the GSEs take some of it off our hands.

I think when you have increasing values as we had — tremendous values similar to the tech boom — everybody wanted to own a piece of real estate to get into the game. And so the rapid increase in values was the problem, and with that came some lending practices that certainly, in retrospect, were not acceptable. And now you have those values receding and… now all the sins of the past are being exposed as a result of receding real estate values. We’ve got to get real estate values at least stabilized in order to keep these people in homes so they can finance themselves out of the problems that they have.

Translation: I’m tossing you a crumb of truth here, so listen up. After the boys at the Fed dropped interest rates through the floor earlier this decade, they inadvertently ignited a housing boom. Everyone and his brother thought real estate always went up and we simply let them place that bet on margin with hardly any money down. Our bad. I’d love to tap our underwater customers on the shoulder and get them to bring their equity up, but it’s too late for that — you can’t get blood from a turnip. So now we’re left holding the bag and our lenders are tapping us on the shoulder. We’re basically screwed, and the only thing that can save us is a new bull market in real estate.

Three weeks ago, Mozilo appeared on CNBC berating a Merrill Lynch analyst (and former employee) for having the nerve to issue a sell rating on his stock, calling it irresponsible and tantamount to yelling fire in a crowded theater.

Yesterday, it was revealed some employees are now suing the company because they held Countrywide stock in their 401(k)s while Mozilo and his lieutenants assured them the riskiest loans were sold off and those remaining on the books were adequately reserved. At the same time, insiders unceremoniously dumped $350 million of their shares over the past year or so.

On the same day, Countrywide issued a press release admitting mortgage loan fundings for August dropped 17% from a year earlier. President and Chief Operating Officer David Sambol, apparently a quick study under the tutelage of Mozilo, was stoic and reassuring:

Looking forward, the Company expects that it will be a long-term beneficiary of the current conditions and corrections in the mortgage industry, and we are confident that the actions which we have taken in response to the current environment will position us for profitable future growth and success.

How does anyone in his right mind believe any of the spin coming out of Countrywide these days?

Perhaps this comment posted to a blog critical of Angelo Mozilo’s antics sums it up best:

Mozilo is the last remaining Oompa-Loompa, thus his beautiful orange glow. Unfortunately he isn’t quite as efficient as Willy Wonka was at running the chocolate factory.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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Critics of paternalist government were hardly surprised last Friday when the Federal Reserve responded to the hopes, tantrums and demands of the investor class (led by the likes of Larry Kudlow, Jim Cramer, and Barton Biggs) by lowering the discount rate from 6.25% to 5.75%. Cramer immediately predicted the largest single day Dow Jones Industrials Average point gain ever (wrong) and Dow 14,500 by the end of the year, up nearly 11% from Friday’s close. He also recounted the tread marks on his back from fighting the Fed’s response in October, 1998 to the Long-Term Capital Management fiasco, professing his allegiance to “don’t fight the Fed” this time.

This is now the third time in 9 years the Fed has acted as “fireman” as many believe is part of its job description:

You can’t just say ‘we told you so’ and turn your back. The Fed is the fireman of our economy, and there’s a fire and they’re gonna put it out. That’s their job. Their job is not to sit around and scold people for making bad loans [and] for other people for buying those bad loans. The Fed’s job is to put out the fire.

~ Peter Yastrow, market strategist, MF Global, August 9, 2007

Fed rescue missions: 1998—2007

Date of Discount Rate Cut

Date of S&P 500 Peak

Trading Days, Peak to Rate Cut

S&P 500, Peak to Rate Cut

S&P 500, Day of Rate Cut

Bank Index, Day of Rate Cut

Trading Days, Ensuing Rally

S&P 500, Ensuing Rally

Oct 15, 1998

Jul 17, 1998

63

—15.3%

+4.2%

+6.6%

364

+51.9%

Jan 3, 2001

Sep 1, 2000

84

—15.6%

+4.7%

+6.3%

19

+7.0%

Aug 17, 2007

Jul 19, 2007

21

—9.1%

+2.5%

+3.5%

?

?

Let’s review all three rescue missions:

October 15, 1998 — In response to Russian default, rising credit spreads, and a banking system on the hook for $1 trillion in notional bets by LTCM, the Fed surprised the markets late on a Thursday afternoon (well-timed right before an option expiration Friday) to catch short-sellers off guard by dropping the discount rate from 5.00% to 4.75%. The market had peaked 63 trading days earlier. The S&P 500 was 15.3% off its highs, with the Banking Index (BKX) down 30.8% and the Broker/Dealer Index (XBD) down 46.0%.

January 3, 2001 — In 84 trading days, the Nasdaq 100 (NDX) lost 48.1% while the S&P lost 15.6% of its value. So the Fed, attempting to contain the fallout from a tech bust and stave off any onset of the “deflation” bogeyman, cut the discount rate from 6.00% to 5.75%. The next day it chopped again, to 5.50%.

August 17, 2007 — Although the S&P 500 was only down 9.1% in just 21 trading days before the Fed broke out its fire hose, the financials had been weak most of the year. The BKX peaked in February and was —12.1% and the XBD peaked in early June and was —20.3% prior to Bailout Friday. The Fed’s rate cut came on the morning of an option expiration in order to inflict maximum pain on the shorts.

As it turns out, the Fed faithful were well rewarded in 1998 as the S&P 500 rallied 51.9% in 364 trading days to its March, 2000 climax. 2001 was entirely different, as the Nasdaq 100 went on a tear, up 19% the first day and up a total of 28% over 14 trading days. Sadly for the dip buyers, the credit drug soon wore off, with the NDX plunging as much as 69% over the next 2 1/2 years. All the Fed’s pumping and all the Fed’s men, could not put the tech bubble back together again. (Though they were wildly successful in fomenting a credit bubble for the ages!)

Which brings us to the current fork in the quagmire: Will Friday’s stimulus work, at least long enough for overleveraged speculators, banks, and Wall Street to save their collective skins? Though self-professed “history buff” Jim Cramer is convinced, we demur.

Our monetary addiction is a progressive disease now in an advanced state.

Yes, there were excesses in 1998, but nothing compared to 2000. In December, 1996 Sir Alan Greenspan fretted about “irrational exuberance” with the Dow at 6500; by July, 1998 the Dow broke 9300. Yahoo! and Amazon.com, though still in diapers from their IPOs in 1996 and 1997 respectively, were each up over 11-fold by mid-1998. Yet Amazon.com was set to quadruple and Yahoo! soar another 8 times before hitting the wall. New Economy poster child Cisco Systems sported a modest $100 billion enterprise value in 1998, or 95 times its annual R&D budget. Two years later, Cisco fetched 185 times R&D — $500 billion — and was expected by many to become the first $1 trillion stock. (Today shares trade for a more pedestrian 37 times R&D.) In mid-1998, technology funds made up just 20% of the total sector fund asset pie; by March, 2000 they accounted for 60%.

Clearly, the same patient who responded to the credit drug in 1998—1999 became overly dependent by 2000. Even the massive dose of easy credit applied from 2001 to 2004 could not reflate the old tech/telecom balloon. The new inflation instead created the 2005 housing bubble and 2007 Wall Street bubble, both now bursting in unison.

Regardless of this lesson in monetary impotence, the asset inflation Kool-Aid drinkers are back in the pool:

“Everything’s changed and it’s looking a whole lot better. Now we don’t have to worry about putting safety first anymore… With the discount rate cut, opportunity has come back to the market.”

~ Jim Cramer, CNBC’s Mad Money, August 17, 2007

Although they use slightly different metaphors than the Fed’s detractors:

"I actually applaud them… This was not a shot of adrenaline to the economy. This was more a shot of penicillin to an otherwise disconcerted economy."

~ Dennis Gartman, The Gartman Letter, August 20, 2007

How does today’s credit bubble compare to its 1998 and 2000 predecessors? Derivative exposure has more than tripled since 1998. And the balance sheets of the top 5 investment banks have nearly tripled since 2000. Structured finance was in its infancy 9 years ago and the collateralized debt obligation (CDO) market was just being invented. LTCM was a liquidity crisis; the current credit meltdown is a solvency crisis.

Cheap and plentiful credit is what caused the current mess. More of the same can only make it worse. It is only a matter of time before this shot of credit heroin wears off. Sometimes the best medicine is none at all.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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The classic 1963 slapstick comedy, It’s a Mad, Mad, Mad, Mad World, begins when the occupants of four vehicles learn about hidden treasure in the fictional town of Santa Rosita, California. According to a dying man’s last words, $350,000 (about $2.3 million in today’s dollars) is buried under a mysterious "big W," less than a day’s drive away. When the strangers can’t agree on how to share the loot, a wild race for riches ensues.

In the 44 years since, the mad dash for wealth without work has been repeated throughout countless bubbles and manias. Witness the Japanese mania and U.S. takeover bubble of ’89, the biotech bubble of ’91, the 2000 tech bubble, and more recently the 2005 housing bubble — all ending in tears. Fittingly, in the movie’s finale the protagonists fall off a fire escape and all end up in the hospital.

Was the film’s director, Stanley Kramer, prescient — metaphorically speaking — or have we evolved to the current state of perfection in which the investing masses are entitled to get rich simply by tuning in to Jim Cramer’s Mad Money?

Fractional reserve madness

The lure of easy money begins with the government printing press. First, the central banker buys an asset — typically a government debt instrument — writes a check on itself and deposits it into the banking system. Since the bank never "redeems" the check, this is equivalent to creating money out of thin air. The banker, happy to receive fresh "reserves," loans out all but a sliver. This new money ends up back with the banks, is counted again as reserves, mostly lent out, and so on and so on. Through this process of fractional reserve banking, credit is expanded at a multiple of the initial central bank deposit. Through such a system, the creation of money and credit (the promise to pay money) looks like an upside-down pyramid — essentially a pyramid scheme on top of a counterfeiting operation.

As James Grant has counseled, the inflation process gives a finite pool of capital the illusion of an endless sea of liquidity, in effect "turning all the traffic lights green."

Such a scheme is a concoction of government privilege (or mercantilism), not laissez faire. The so-called "capitalists" are no longer efficient allocators of capital to its most productive uses, but beneficiaries of and cheerleaders for a monetary fraud in which capital is debased, taken for granted, and abused. As long as they remain chummy with their friendly liquidity provider of last resort, they can act recklessly without fear of igniting an economic forest fire — or if they do, without fear of having to bear the costs. And as long as the value of their collateral is constantly inflated, they never feel the need to worry about default.

Liberated from the gold standard straightjacket, the system has few restraints. For starters, the counterfeiter has an incentive not to draw attention to his racket. But the effectiveness of his ongoing propaganda campaign has weakened this deterrent. The real inflationary action, however, is in credit expansion. For example, in the last 6 years, the Federal Reserve has grown its balance sheet less than $300 billion while the nation’s money supply has expanded by $4.3 trillion, or 14 times as much. In other words, the central banker can bait the hook, but lenders and borrowers still have to take the bait.

This new money is never evenly distributed, but instead gets funneled into whatever narrow area happens to capture the public’s fascination. As prices and valuations soar, greater doses of credit are required to keep the game going. Either more marginal borrowers are drawn in at ever more precarious levels or greater leverage must be applied to existing borrowers. This is what ultimately doomed the housing bubble. In the end, nearly anyone who could fog a mirror was getting an invitation to join the party.

The trouble with pyramid schemes is that they’re not designed to go in reverse. Eventually, the number of willing dupes is exhausted. The same people who panicked late to get into the game are just as likely to panic when the music stops. The longer the music plays, the more leveraged and unstable the inverted credit pyramid becomes. As the late economist Hyman Minsky observed, "stability is unstable."

The trouble with stability

The current Federal Reserve experiment with stability began on January 3, 2001. With the Nasdaq Composite down 55% from its March, 2000 peak and a bursting technology bubble threatening to plunge the economy into recession, the Fed began lowering rates. The impact was immediate. The Nasdaq rallied 14% that day and stood 24% higher four weeks later. The guru du jour, Abby Joseph Cohen, echoed the prevailing faith in the Greenspan put: "I am assuming this will be a very short-lived slowdown because policy makers have significant tools at their disposal. The Federal Reserve in adjusting rates last week stood up and said, u2018We are watching and will do more if necessary.’ That serves as a confidence builder."

Lost on the bulls, such misplaced faith in central bankers is commonplace at major tops. In April, 1929 Financial World reassured its readers, "It may be well again to stress the all-important point that the Federal Reserve has it in its power to change interest rates downward any time it sees fit to do so and thus to stimulate business."

Time — June 13, 2005

The first quarter of 2001 saw a spike in corporate bond offerings, including aggressively priced zero coupon convertible bonds by Enron and Tyco International. MCI WorldCom issued $10.8 billion in investment grade bonds — the second largest bond offering on record at the time. Within 18 months the company was bankrupt.

For two years the Fed pounded the funds rate relentlessly from 6.40% to 1.24%. Regardless, the tech balloon continued to deflate, with the Nasdaq collapsing another 61% from its January, 2001 high to its October, 2002 low. The Fed was, however, successful in avoiding the bogeyman of deflation as cheap credit lit a fire under the housing market. From 2000 to 2005, homebuilding stocks leapt nine-fold. Lending standards eroded and, as home prices moved out of reach of the average American, "affordability products" such as interest-only and negative amortization loans became the rage. As it turns out, Time magazine pegged the top of the housing bubble with its June 13, 2005 cover, "Home $weet Home: Why we’re going gaga over real estate." Time captured the zaniness of the times: "If home is where the heart is, it is now where ever more of your cash is. And when love and money collide, things can get a little crazy."

As the new millennium unfolded, the engine of wealth creation shifted from technology to finance. In 2000, technology claimed 99 members of the Forbes 400 who accounted for 40% of the total wealth. By 2006, real estate, investments and finance boasted 140 members and a record 27% share of the billionaire market, while technology slipped to 17%. (This share will certainly go higher when Forbes tallies the numbers this October.)

Another sign of the times (and hubris) is the naming rights on stadiums. From 2000 to 2007, the number of financial sector stadiums doubled from 12 to 24, while tech names slipped from 12 to 9. The Class of 2000 was notable for a number of corporate implosions such as PSINet Stadium, CMGI Field, MCI Center, and Enron Field. In fact, 19% of the sponsors eventually went bankrupt, including several airlines. The Class of 2007 includes Chase Field, Wachovia Center, and Quicken Loans Arena; 14 or 19% of today’s naming rights sponsors are banks.

It appears the Fed experiment in monetary stimulus from 2001 to 2003 didn’t just ignite a housing bubble, but fomented a full-blown credit bubble.

Credit assembly line shifts into high gear

More than in any previous cycle, a sophisticated assembly line has developed to facilitate the creation of credit and expansion of leverage. The days of the neighborhood banker on a first name basis with his customer are long gone. Loans are now originated, packaged into securities by Wall Street, endorsed by insurance companies and ratings agencies, and sold to investors. The assumption is that each of the gatekeepers is unbiased and financially sound. Yet commercial banks such as Citigroup have assets-to-equity of 12 times, investment banks are typically levered 25-to-1, and bond insurers like Ambac and MBIA guarantee 80 to 90 times their capital. If a chain is only as strong as its weakest link, there is plenty that could go wrong with the great intermediation of credit creation.

Investment banks have reveled in an elevated role during this credit cycle. In the past six years, the Fed grew its balance sheet 50%, money supply expanded 60%, and the Top Five investments banks increased total assets by 160%. In the latest quarter, the total assets of Goldman Sachs exceeded total bank credit at the Fed for the first time. Structured finance has become a lucrative business as nearly $500 billion in collateralized debt obligations (CDOs) were issued in 2006 alone, a 60% increase. To at least one cynic, Barron’s editor Thomas G. Donlan, "The work of Wall Street often is to introduce people who should not borrow to people who should not lend."

The credit rating agencies not only sign off on the soundness of the gatekeepers (all investment grade, of course), but on the securitizations themselves. (They also designed the structures with the help of Wall Street.) Without their blessing, institutions such as insurance companies and pension funds would be restricted from investing. Yet the rating companies get paid by the credit issuers — a clear conflict. In fact, structured finance now accounts for over half of Moody’s ratings revenue.

The credit assembly line would not be complete without the end demand of the loan holder. In particular, many public pension funds which got addicted to the strong returns of the late 1990s bull market have been climbing the risk ladder in order to keep employer contribution rates low. Driven by the mantra that diversification into "alternative investments" can deliver the holy grail of higher returns with reduced risk, pensions have moved aggressively since 2000 to place funds with highly compensated managers who have the ability to add leverage and trade more actively.

Condo flipper passes torch to professional speculator

From our perch, it appears the slowly deflating housing bubble has simply morphed into a massive professional speculator bubble, driven by commercial real estate, hedge funds, and private equity.

The number of real estate sector funds has doubled since 2000 and now exceeds the number of technology funds. Commercial mortgage-backed securities (CMBS) issuance is expected to exceed $350 billion this year, credit spreads are widening, and leverage is increasing. According to Moody’s estimates, the average loan-to-value on CMBS was 111.6% in the first quarter, up from 90% in 2003.

Signs of excess are everywhere with regard to hedge funds and private equity. More bells are ringing than at an Austrian downhill. Exhibit A: the highly successful IPO of Fortress Group and the proposed IPO of Blackstone Group. Steve Schwarzman, CEO of Blackstone, recently graced the cover of Fortune as "the new king of Wall Street." U.S. private equity firms raised $160 billion in 2006 and are on pace to double that take this year. During the tech bubble, venture capital inflows went parabolic as well, peaking at $91 billion in the year 2000. The same investment banks who acquired tech underwriters in 2000 and subprime loan originators in 2006 are now busy snapping up hedge funds. According to Bridgewater Associates, hedge fund borrowings were $1.46 trillion last year, up from just $177 billion in 2002.

In addition, investment banks are no longer content to play with other peoples’ money ("OPM"). They are putting record amounts of their own capital at risk. For example over two-thirds of Goldman Sachs’ net revenue now comes from trading and principal investments versus one-third five years ago.

Living on planet leverage

On April 30th, The Wall Street Journal featured a cover article about the copious amounts of leverage employed by the professional speculator community. They quoted a senior credit analyst at Standard & Poor’s: "There’s leverage everywhere — whether at corporations or broker dealers or hedge funds or private equity funds. It sort of feels like something’s got to give." The conclusion of the two WSJ journalists: "We’re living on planet leverage."

The American consumer has been living on planet leverage for quite some time, having taken on another $5.5 trillion in debt just the past six years — an 85% increase. Despite generation-low interest rates and a housing boom for the ages, homeowners’ equity is at all-time lows and the consumer’s balance sheet has never been more stretched.

Cracks are already appearing in the credit façade. Year-to-date, the Bearing Credit Bubble Index (a proprietary composite of 22 credit-related stocks) has underperformed the S&P 500 by over 10%. Sub-indices closest to the mortgage finance bubble are particularly weak, with homebuilders —16.3% and subprime lenders —54.8%.

BusinessWeek — February 19, 2007

The trouble with liquidity

Liquidity remains the rallying cry of the bulls, just as it has at the top of every bubble. But they confuse cash on the sidelines with ready access to credit. As BlackRock CEO Laurence Fink recently warned, "Probably the greatest issue that’s confronting the world’s investors is we are trading liquidity for illiquidity." With mutual fund balances and mutual fund cash levels at record lows, the fuel to power stock prices higher is depleted. The strain of liquidity that has financial markets on steroids is cheap credit, a fair weather friend who will turn tail at the first sign of trouble.

Perhaps the ultimate contrary indicator of this credit cycle will be BusinessWeek’s February 19, 2007 cover story, "It’s a Low, Low, Low, Low-Rate World." BW’s authors gushed, "Borrowers, of course, are deliriously happy. Even the shakiest companies are seeing their debt costs plunge… Most remarkably, the craziness isn’t likely to stop anytime soon." Sound familiar? Simply substitute "home buyers" for "companies" and this quote could have easily appeared two years ago at the top of the housing bubble.

As the actors in this madcap movie continue to chase that illusive pot of gold buried under the "big W," we can’t help but be reminded of the advice of InvesTech Research editor James Stack: "Never confuse an economic miracle with a liquidity bubble."

As the great Austrian economist Ludwig von Mises warned, "There is no means of avoiding the final collapse of a boom brought about by credit expansion."

This article was adapted from a speech given to the Committee for Monetary Research & Education (CMRE) on May 10, 2007 in New York City.

Kevin Duffy [send him mail] is a principal of Bearing Asset Management.

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"I'm
not sure I want popular opinion on my side — I've noticed those
with the most opinions often have the fewest facts."

~
Bethania McKenstry

Opinions are
like noses: everyone has one. But a strange thing happened on the
way to Dow 12,000 — the overwhelming majority of financial pundits
sound like a broken record:

“I think
we should put on another 100 points in the S&P 500 by next
February and another 1000 points on the Dow.”

~
Peter Canelo, Canelo & Associates, 10/13/06

“Our feeling
is that the economy is slowing and this is good news for investors.”

~
Abby Cohen, Goldman Sachs, 10/17/06

"The
upside still outweighs the downside in our view… People forget
— this isn't like the late 1990s. This is like the mid-1990s."

~
Tony Dwyer, FTN Midwest Securities, 10/18/06

“I don’t
think the economy’s ‘landing.’ I think the economy’s doing great…
It’s better than Goldilocks quite honestly. This is the greatest
global boom of all time.”

~
Ed Yardeni, Oak Investments, 10/18/06

“Count
me somewhere between bullish and very bullish. The U.S. stock
market remains undervalued, in my opinion."

~
Bill Miller, Legg Mason, 10/21/06

"It
simply is not remarked upon enough how unbelievably powerful,
how unbelievably bullish this rally is."

~
James Cramer, CNBC's "Mad Money," 10/27/06

Optimism
is pervasive on Wall Street, yet some bulls, well aware of the laws
of contrary opinion, claim too much pessimism as a reason
to own stocks:

“The fact
is we can’t find enough to worry about, and that’s usually a good
time to find value in the stock market… Any red ink between now
and the end of the year is an opportunity and not something for
investors to run from.”

~
Mike Williams, Tocqueville Asset Management, 10/13/06

"…
I think bravado and optimism begets bad times and chronic cautiousness
paints a beautiful picture for the future. [This] is a low-risk,
high-return situation created by cautious players."

~
James Paulsen, Wells Capital Management, 10/20/06

"Could
we have a big bear market? I don't think so. Bear markets come
from a combination of positive sentiment with bad surprises virtually
no one anticipates… Today too many gloomsters and not that many
big-time boomsters (like me) are around for this combination to
occur."

~
Kenneth L. Fisher, Fisher Investments, 10/30/06

The bulls can't
possibly be running confidently and running scared at the same time.
What are the "facts" regarding investor sentiment?

• Guest commentary
  on CNBC (a.k.a. "Bubblevision") is universally upbeat,
  bordering on giddy.
• Over the
  last 420 weeks the Investors Intelligence poll of investment newsletter
  editors has recorded more bears than bulls just 6 times.
• The Hulbert
  Stock Newsletter Sentiment Index shows its sampling of short-term
  market timers with a 67.0% exposure to the stock market. According
  to Mark Hulbert, "the HSNSI’s average reading since the bull
  market began on Oct. 9, 2002, has been just 29.5%, or less than
  half the current sentiment reading. In other words, the wall of
  worry that has on average existed during this more than four-year
  bull market has now evaporated."
• Institutional
  investors have not deviated from their fully invested course.
  Mutual fund cash levels remain at a paltry 4.3%.
• Short sellers
  are nearly extinct. An estimated $4 billion resides in bear fund
  assets against $5.5 trillion in stock fund assets. The
  Strunk Short Index used to follow 25 short bias hedge funds; that
  number has dwindled to 8 or 9 (there were over 9,200 hedge funds
  at last count).
• In a twist
  of irony, many in the bear camp have resigned themselves to owning
  stocks (primarily energy and commodity-related) as a hedge against
  hyperinflation.
• The investing
  public is all in. Equities account for 35.6% of household financial
  assets compared to the long-term average of 26.5% (since 1952).
  Money market fund balances are near an all-time low 21.3% of mutual
  fund assets (see graph).

Ten of our
favorite sentiment indicators are, on average, in the 73rd
percentile of bullishness versus readings over the past ten years
(see table). Overall, 1996 to 2006 was a period of stock market
ebullience, making the current level of enthusiasm all the more
extreme.

Sentiment
Indicator Percentiles (data sample 1996–2006)

Sentiment
Indicator

Current
Reading

Bullish
Extreme

Bearish
Extreme

Bullishness
Percentile

Investors
Intelligence,
Bulls — Bears

+25.3%

+44.1%

–14.8%

66th

Market
Vane,
Bulls

73%

80%

17%

99th

CBOE
Volatility
Index (VIX)

10.80

10.27

43.74

99th

MMF
/ Mutual
Fund + ETF Assets

21.3%

20.6%

35.3%

99th

Equity
Mutual
Fund Cash Levels

4.3%

3.8%

7.4%

74th

Initial
Public Offerings

2.6

16.0

0.1

37th

NYSE
Insider Buys/
Total Transactions

19.5%

12.6%

68.5%

81st

Speculative
OTC
Volume

4.3%

13.0%

0.8%

44th

S&P
500 Speculative Position

96,700
contracts long

118,100
contracts long

37,400
contracts short

63rd

Call
Option
Complacency

44.4%

32.9%

83.8%

66th

Meanwhile,
the Soft Landing crowd continues to turn a blind eye to a credit
bubble about to go into an uncontrolled spin. Median existing home
prices dropped 2.5% year-over-year, their worst showing in nearly
four decades. Foreclosures in California have doubled in the past
year and are up tenfold in Boston since 2004. Default rates on subprime
loans were 7.35% in July from 5.51% a year earlier, according to
Friedman Billings Ramsey. Michael Perry, CEO of Indymac Bank (one
of the nation's largest home lenders), thinks 4% of America’s mortgaged
homeowners might lose their homes to foreclosure in coming months,
four times worse than the historical average. Subprime lender Accredited
Home Lending, Washington Mutual (with a large exposure to subprime)
and mortgage insurer Radian Group all witnessed sharp stock drops
on disappointing 3rd quarter earnings releases. Since
this rally began in mid-July, the Philadelphia Bank Index (BKX)
looks exhausted, capturing just 54% of the gain of the S&P 500.

Never
confuse a stampeding herd with the facts. Only in a bubble can the
majority — utterly intolerant of dissent — delude itself into believing
it is in the dissenting minority. We're not sure whether such behavior
is disingenuous or simply dysfunctional. Perhaps the old saw applies:
"When everyone is thinking alike, no one is really thinking."

November
4, 2006

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

~ Brian Wesbury, as appeared
on CNBC June 20th

Earlier this week economists Gary Shilling and
Brian Wesbury squared off on CNBC to discuss the current state of
the housing market. Wesbury, the younger and far more frequent guest
over the past eight years, was bullish: the market is simply "correcting
back to normal." Shilling, the bear, subscribes to the housing
bubble theory. As evidence, last year 40% of home sales were speculative
in nature — that is, to second home buyers and investors. According
to Shilling, it would take a 35% drop in housing prices to restore
the long-term balance between median home prices and the Consumer
Price Index. What caught our attention was the essence of Wesbury's
assuredness: there never was a bubble because most people are
rational.

In a sense, Brian Wesbury is right. Man tends to
act rationally to pursue his own interests and remove discomfort.
Markets would fail if man always acted randomly and without purpose.
Imagine a household attempting to minimize its income and maximize
prices paid at the grocery store. Its members would quickly perish.
From 2001 to 2004 the Federal Reserve put the price of mortgage
credit on sale as it drove short-term interest rates through the
floor. Can existing and would-be homeowners be faulted for lining
up in droves?

A long-time friend from Scottsdale, Arizona (inventories
up ten-fold the past year) points out a distinction in the behavior
of the debtor class. Some have clearly acted responsibly: they consolidated
their debts into tax deductible mortgages, locked in the lowest
long-term rates in 40 years, and tossed the interest savings into
their rainy day and investment jars. From a consumption standpoint,
little has changed except that these old school borrowers pocketed
a windfall compliments of their friendly neighborhood central banker.

Others — to put it mildly — have gotten carried
away. Mortgage equity withdrawal (a.k.a. going deeper into debt)
was roughly $2.2 trillion over the past three years. Homebuying
on margin (peddled as "the American dream") greatly expanded
in the credit-challenged "subprime" strata. Debt service
costs (household financial obligations at nearly 19% of disposable
personal income) have never been higher, even with generously low
interest rates.

Thanks to the young and reckless, today housing's
vital signs look less than encouraging:

• 29% of mortgages assumed in 2005 are now underwater.
• 16% of those with mortgages pay over half of their income on
  housing, up from 2% five years ago.
• 22% of the $9.3 trillion residential mortgage market is now
  subprime.
• $2.7 trillion of adjustable-rate mortgages are expected to reset
  in the next 18 months with payments increasing on average 45%.
• Total home inventories and the inventory/sales ratio are at
  record highs.

On Main Street, Madison Avenue, and especially
Wall Street, anything worth doing is worth overdoing. A good idea
inevitably wilts under the sunlight of too much attention. So, too,
the mortgage refi bloom is succumbing to over-exposure.

Man tends to act rationally until you place him
in a group and offer him something for nothing. Over a century and
a half ago Charles Mackay, in his classic Extraordinary Popular
Delusions and the Madness of Crowds, observed that "men
go mad in herds." 130 years later historian Barbara Tuchman,
in The March of Folly, chronicled the recurrent "pursuit
of policy contrary to self interest" from the Battle of Troy
to the Vietnam War. More recently Bill Bonner co-authored two highly
readable and entertaining books crash testing his theory on human
progress: in science and technology man tends to learn; in love,
finance, and war he makes the same mistakes over and over. This
play of perpetual blunder has many acts: fear, skepticism, rationalization,
exuberance, denial, resentment, and finally resignation. Only the
actors change.

For some, folly is a participatory sport, while
others choose to watch from the sidelines. Gary Shilling has been
around long enough to see this game before. He recognized the manias
of Japan in the late '80s and tech-land in the late '90s. He
now claims the mortgage market went manic after the Greenspan
Fed opened the credit spigot to fend off a deflating tech balloon
in 2001. We have no knowledge of Brian Wesbury's view on "Japan,
Inc." in 1989, though six
years ago he jumped on the New Economy bandwagon. Today he dismisses
the housing naysayers and assures us that the market is "pulling
back to normal."

We
have little doubt who's crystal ball is more popular with CNBC viewers.

June
24, 2006

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

Four years
ago deflation fears were rampant. The tech bubble was bursting,
the economy slipping into recession, and the Fed seemed impotent
to stem the slide. The Fed responded with a massive dose of ultra-cheap
credit which at first had little effect, but eventually made its
way into the next asset bubble: real estate. Today inflation — particularly
"asset inflation" — is the toast of the town; speculators
are bingeing on stocks, real estate, and commodities; professionals
are reaching for yield with exotic debt instruments; and the Fed
chairmanship has returned to rock star status. Meanwhile, expectations
for consumer price inflation remain guarded; U.S. economists predict
a 2.4% rise in the CPI this year and inflation-indexed bond investors
expect the CPI to average 2.5% over the next 10 years. In the February
2006 issue of The Gloom, Boom & Doom Report, Hong Kong-based
investment adviser Marc Faber discussed this atypical state of affairs:

I regard
the current investment scene as most unusual, in the sense that
everybody is very positive about one or another asset class. Equity
fund managers around the world are positive about equities in
both the developed economies and in emerging markets, while commodity
traders are positive about commodities, gold bugs about precious
metals, property developers about real estate prices, art aficionados
about art prices and collectibles, and bond investors about bond
yields declining further. This universal bullishness about all
asset classes is uncommon… So, as a sceptic and contrarian investor,
I am deeply concerned about this "continuous asset inflation"
consensus amidst a benign "consumer price inflation"
scenario.

The inflationary
side of the boat has clearly gotten crowded. What will cause it
to capsize? Dr. Faber offers two possible scenarios: a crash in
asset prices or an accelerating consumer price inflation in which
asset prices decline in real terms, though not necessarily
in absolute terms.

Before exploring
each of these scenarios, let's take a closer look at the inflationary
process.

What is "inflation?"
Before World War II, the term was defined as an artificial increase
in the supply of money and credit (brought about by a central bank
in cahoots with the banking system). Since then, inflation has been
spun to mean a general increase in prices. As Ludwig von Mises pointed
out, there is a reason for this:

To avoid
being blamed for the nefarious consequences of inflation, the
government and its henchmen resort to a semantic trick. They try
to change the meaning of the terms. They call “inflation” the
inevitable consequence of inflation, namely, the rise in prices.
They are anxious to relegate into oblivion the fact that this
rise is produced by an increase in the amount of money and money
substitutes. They never mention this increase. They put the responsibility
for the rising cost of living on business. This is a classical
case of the thief crying “catch the thief.” The government, which
produced the inflation by multiplying the supply of money, incriminates
the manufacturers and merchants and glories in the role of being
a champion of low prices.

Inflation is
the disease and rising prices are a symptom. Sometimes
the symptom goes undetected due to productivity gains from new technologies,
the dumping of commodities by a splintering empire, or the entry
of billions of capitalists into the global economy. Sometimes the
only rising prices are in assets, which no one ever seems to complain
about. Or if prices do start to rise at the checkout counter or
at the gas pump, economists can simply strip them out, leaving a
less volatile index of "core" prices.

Of course inflation
is an insidious tax, transferring wealth from one group to another,
but the damage to the economy adds insult to injury, as Frank Shostak,
chief economist with Foresight Research Solutions, explains:

We have seen
that increases in the money supply set in motion an exchange of
nothing for something. They divert real funding away from wealth
generators toward the holders of the newly created money. This
is what sets in motion the misallocation of resources, not price
increases as such, which is only the manifestation of this misallocation.

Moreover,
the beneficiaries of the newly created money, i.e., money out
of “thin air”u2014are always the first recipients of money, and so
they can divert a greater portion of wealth to themselves. Obviously,
those who either don't receive any of the newly created money
or get it last will find that what is left for them is a diminished
portion of the pool of real funding.

Additionally,
real incomes fall not because of general rises in prices, but
because of increases in the money supply, which gives rise to
nonproductive consumption. In other words, inflation depletes
the real pool of funding, which undermines the production of real
wealthu2014i.e., a lowering of real incomes. 

How exactly
does our government create inflation? The Federal Reserve does not
literally "drop money out of helicopters" or "run
the printing presses," though these counterfeiting metaphors
are apt. Instead, the Fed engages in a clever two step process:
1) it purchases, or "monetizes," assets with money created
"out of thin air" and 2) it allows the banking system
to pyramid credit on top of this new money. In The Case Against
the Fed (1994), Murray Rothbard explained how this process works:

Suppose that
the "money multiplier" — the multiple that commercial
banks can pyramid on top of reserves, is 10:1. That multiple is
the inverse of the Fed's legally imposed minimum reserve requirement
on different types of banks, a minimum which now approximates
10%. Almost always, if banks can expand 10:1 on top of
their reserves, they will do so, since that is how they make their
money. The counterfeiter, after all, will strongly tend to counterfeit
as much as he can legally get away with. Suppose that the Fed
decides it wishes to expand the nation's total money supply by
$10 billion. If the multiplier is 10, then the Fed will choose
to purchase $1 billion of assets, generally U.S. government securities,
on the open market.

In the first
step, the Fed directs its Open Market Agent in New York City to
purchase $1 billion of U.S. government bonds. To purchase those
securities, the Fed writes out a check for $1 billion on itself,
the Federal Reserve Bank of New York. It then transfers that check
to a government bond dealer, say Goldman, Sachs, in exchange for
$1 billion of U.S. government bonds. Goldman, Sachs goes to its
commercial bank — say Chase Manhattan [editor's note: now a part
of JP Morgan Chase] — deposits the check on the Fed, and in exchange
increases its demand deposits at the Chase by $1 billion.

Where did
the Fed get the money to pay for the bonds? It created the money
out of thin air, by simply writing out a check on itself. Neat
trick if you can get away with it!

Chase Manhattan,
delighted to get a check on the Fed, rushes down to the Fed's
New York branch and deposits it in its account, increasing its
reserves by $1 billion.

But this
is only the first, immediate step. Because we live under a system
of fractional-reserve banking, other consequences quickly ensue.
There are now $1 billion more in reserves in the banking system,
and as a result, the banking system expands its money and credit,
the expansion beginning with Chase and quickly spreading out to
other banks in the financial system. In a brief period of time,
about a couple of weeks, the entire system will have expanded
credit and money supply another $9 billion, up to an increased
money stock of $10 billion.

As Rothbard
pointed out, the Fed is the conductor while the banks play the music.
Over the past five years we can see how they acted in concert to
create the latest inflationary cacophony. Fed holdings of U.S. government
securities increased by $229 billion while money supply (M3) grew
by $2,996 billion, or 42%. Clearly, credit expansion is not only
critical to the inflation process, it does the heavy lifting. (Note:
The expansion of credit does not just take place through the banking
system. The U.S. boasts the most advanced credit distribution system
in the world, aided by government-sponsored mortgage lenders, the
derivatives market, the repo market, and Wall Street's ability to
package and "securitize" loans. Foreign central banks
also assist in providing credit.)

This brings
us back to our original inflation-deflation debate. After throwing
the inflation switch on full throttle, the Fed has backed off somewhat
with 14 "measured" rate increases over the past 20 months.
Why? Perhaps they no longer believe their own sales literature.
As the table below shows, the official inflation measures are grossly
understated. Over the last five years, prices for practically everything
have exceeded the CPI, driven by rapid growth in money and credit.
(The lone exceptions: grains and large-cap equities, which were
held back by the deflating 2000 technology balloon.) Notice that
the inflation aggregates still experienced strong growth in 2005
despite higher rates.

Inflation
in the United States, 2000–2005 (all figures annualized)

Category

Source/
Index

Last
5 Years
(2000–2005)

Last
Year
(2005)

Housing

OFHEO
Index

+9.1%

+11.6%

Large-cap
Equities

S&P
500 Index

-1.1%

+3.0%

Small-cap
Equities

Russell
2000 Index

+6.8%

+3.3%

Credit-related
Equities

Bearing
Credit
Bubble Index

+8.0%

-4.5%

Commodities

CRB
Index

+7.8%

+16.9%

Oil

West
Texas Intermediate

+15.6%

+30.2%

Grains

Dow
Jones-AIG
Grains Index

-6.4%

-4.7%

Gold

London
PM Fix

+13.5%

+17.8%

Luxuries

Forbes
Cost of Living Extremely Well Index

+4.6%

+4.0%

Fed
Holdings of
U.S. Gov't Securities

Federal
Reserve

+7.6%

+3.7%

Money
Supply

M3

+7.2%

+7.3%

Mortgage
Credit

Flow
of Funds

+11.7%

+12.9%

Official
Inflation

Consumer
Price Index

+2.4%

+2.9%

Are investors
overestimating the Fed's ability and will to inflate? For at least
the short- to intermediate-term, we believe that to be the case.
The Fed appears to be in a box. They have allowed the inflation
genie out of the bottle, leaving asset bubbles, a declining dollar,
and rising consumer prices in their wake. An aggressive easing
— at least at this point — would surely exacerbate the situation,
and appears highly unlikely. Further, newly anointed Fed chairman
Ben Bernanke must establish his "inflation fighting" credentials
and paint a picture of continuity with the previous regime.

Meanwhile,
the air is slowly leaving the housing bubble. Its deflation appears
to have plenty of room, perhaps for the next six months, to gain
momentum. By the time the Fed reacts to declining home prices and
rising defaults, it will be too late. Once a bubble starts to burst,
there is no stopping it, as the Bank of Japan proved from 1991–1995
with the Nikkei bubble and the Fed proved from 2001–2003 with the
Nasdaq bubble. In a post-bubble environment, the credit creation
machine becomes crippled, as lenders, borrowers, and speculators
go into post-traumatic shock.

At some point
we would expect the debtor class to beg for inflation, and for the
Fed to give it to them. The Fed will probably be forced to rely
less on banks and other intermediaries and more on monetization
— purchasing various assets and paying for them with money created
out of thin air. Some have suggested that the Fed will branch out
from buying U.S. government securities, purchasing stocks, corporate
bonds, mortgage-backed securities, and even houses, if necessary.
This is certainly among Bernanke's contingency plans (as some of
his academic papers indicate), though it would be a radical departure
from Fed procedure. It will certainly not happen anytime soon and
will come far too late in preventing the housing and consumption
balloon from popping.

Some in the
inflation camp are convinced we are on the road to hyperinflation.
While we don't necessarily disagree, the path may take more twists
and turns than they expect. Mr. Market tends to follow the course
that inflicts the maximum amount of pain. A relative decline in
asset values would bail out the speculator, whereas an absolute
decline would take him and his creditor out to the woodshed. The
investing crowd would then likely react to the new deflationary
reality by selling off assets, paying down debt, and actually saving…
just in time to get smashed by a new wave of inflation.

Under
either scenario — a real or absolute decline in asset values — gold
will almost certainly outperform real estate and the shares of mortgage
lenders.

March
4, 2006

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

~
Texas Governor Rick Perry

It
is not everyday that one gets to witness firsthand the evacuation
of 2.5 million people from an area the size of Rhode Island. Lew
Rockwell asked that I share the experience:

Texans
packing heat

For
the most part, the authorities had enough sense not to enforce mandatory
evacuations. This is Texas. Force someone to vacate their property
and you're likely to get shot. As a politician, you are not likely
to get re-elected. In Galveston, originally thought to be Ground
Zero, roughly 5% of the residents ignored orders to leave and battened
down the hatches. A.R. "Luke" Lucas of Luke's Caterers
vowed to stay open as long as the electricity stayed on, selling
bottled water, beer, soft drinks, hot food, and other goods like
batteries. Lucas couldn't understand all the praise he received
from the 5,000 or so hearty souls who remained. He revealed his
primary motive to the local press: "I'm helping myself."

Texans
cherish the 2nd amendment. Anyone who had stepped foot
in this state longer than a month knew there would be no repeat
of the New Orleans looting spree and that it would be safe to ride
out the storm. A well-armed man (who wishes to remain anonymous)
west of Houston stayed behind, as did most of his gun-toting neighbors.
On Thursday night four men tried to break into one of the few vacant
houses, inadvertently setting off an alarm. One of the armed residents
chased them away.

The
eye of the storm: hysteria

Houstonians
went from complacency Monday and Tuesday to pure panic Wednesday,
the day Rita was upgraded to Category 4 and then 5. With Katrina
fresh on everyone's mind and the press and public officials urging
evacuation 24/7, fear took over. The old bromide "run from
the water, hide from the wind" was forgotten and people as
far as 100 miles from the coast hit the eject button.

Oddly,
gasoline prices remained flat despite the new reality that demand
was increasing and supply limited to the existing gas in underground
tanks as the nearby refineries to the south and southeast were being
shut in. It was as if the laws of supply and demand were suspended.
In fact they were not, just ignored by an energy industry already
under attack before Katrina. By the time Rita approached,
anti-gouging hysteria had gripped Washington: there was talk of
a federal price-gouging law, threats of resuscitating the dreaded
"windfall profits tax," and the unveiling of a new
gas gouging hotline compliments of the Department of Energy.
To make matters worse, Texas is one of over 20 states with an anti-gouging
statute. Predictably, gas lines formed, fights broke out, and by
Thursday the entire city was bone dry, not a drop to be found.

TSA:
MIA

The
airports were a zoo on Thursday. The bottleneck was clearly the
Transportation Security Administration (TSA) screeners who, like
half the New Orleans police force, flew the coop when the going
got tough. Security lines were three hours and longer. Private sector
employees — flight attendants, ticket agents, baggage handlers,
and pilots — all heeded the call. My business partner and I were
scheduled to fly to Phoenix 11:45 AM Friday, well before the brunt
of the storm was expected to hit Houston early Saturday morning.
Our flight was cancelled.

About
1,100 Katrina evacuees (down from a high of nearly 10,000) housed
at Reliant Arena and the George R. Brown Convention Center became
precious political cargo. They
were bused south to Ellington Field and flown out to Fort Chaffee,
Arkansas. Most were frustrated, some were bitter, and one was
even disoriented: "I don't even know where that's at."
(Hint: try just north of Louisiana.)

Declare
success and form a study commission

The
evacuation of coastal areas began immediately and proceeded in an
orderly manner Monday and Tuesday. Residents of Houston (4th
largest city in the country, population 4.7 million) started hitting
the exits Wednesday en masse, creating the mother of all traffic
jams. 100-degree heat and 90% humidity only made a bad situation
worse as people turned off their air conditioners and in some cases
pushed their cars in order to save gas. Contra-flow lanes were not
opened until late Thursday afternoon. A trip to Austin along 290,
normally 2 hours, took 12 to 16 hours. A leisurely 4-hour drive
to Dallas on I-45 turned into a 30-hour ordeal.

The
Houston Chronicle set up an online forum to discuss Hurricane
Rita. There were many reports of small town residents bringing
food and water to the weary and a few cases of police getting in
the way or failing to clear accidents quickly. One evacuee wrote:

"If
I learned anything about this situation it is don't trust the
government and they are the last ones to depend on. If they didn't
block most of the stores and roadways, maybe they could have been
giving people water."

The
death toll from Rita is now up to 107
(nearly all from the exodus), ranging from a 2-year-old Houston
girl crushed by a pickup truck to a 92-year-old La Marque woman
who lost consciousness while stuck in gridlock. The driver of the
truck was a 64-year old man who fell asleep after 20 hours on the
road. This pressure cooker literally exploded just south of Dallas
Friday morning as a bus inferno claimed 23 elderly from a nursing
home in Bellaire. Houston Mayor Bill White conceded, "I don't
think the evacuation should be a disaster in itself."

Government
officials claim the evacuation went as well as can be expected.
(On this point classical liberals and Austro-libertarians would
agree.) A dedicated Republican, who spent 4 hours to cover 11 miles,
then scampered home before she and her husband ran out of gas, gave
the officials a "B" for their efforts. The evacuation
left hundreds of thousands unable to escape, deposited hundreds
of stalled cars alongside the roads, and boasted a fatality rate
of 1 in 25,000. What constitutes a failing grade?

Trials
and simulations

What
could have been done to improve the evacuation process? According
to Alfredo Calzadilla, civil engineer with 50 years experience and
chief architect of the first highway connecting Venezuela and Brazil,
plenty. But it would have required effort and planning, both clearly
lacking. According to Calzadilla, the theoretical capacity of a
highway is 2,000 vehicles per hour for each lane. This assumes no
trucks, no curves, no grade, and ample lane width to facilitate
passing. I-45 to Dallas is flat as a pancake and straight as an
arrow, constituting a high "level of service." Under these
conditions, practical capacity is closer to 1,500 vehicles per hour.

What
would it take to maximize the flow of traffic through the various
arteries and capillaries out of Houston? The immediate use of contra-flow
lanes is a no-brainer. "Ramp metering", in which the traffic
feed into the highway system is regulated, is also important. Bottlenecks
(e.g. curves, on/off ramps) must be looked at and eliminated. This
requires the use of sophisticated traffic simulation software (widely
used SimTraffic
costs all of $500). These programs are able to simulate the effects
of gasoline consumption, auto exhaust, stop-and-go's, and even driver
lethargy (modeling the number of vehicle hours traveled) — all factors
that seemed to take officials by surprise.

How
many people could have been evacuated from Houston with proper planning?
Assuming the contra-flow lanes were open on I-10 west to San Antonio,
1-45 north to Dallas and 290 to Austin, and the average vehicle
carried three people, 1.3 million people per day could have been
evacuated along these routes. This does not include I-10 east to
Louisiana, 59 northeast to east Texas, 59 southwest to Corpus Christi,
the back roads, trains, private planes, and the airlines. There
does not appear to be a shortage of capacity, even for a massive
evacuation of 2.5 to 3.0 million people over roughly a three-day
period. Imagine if highways were privately owned. It is difficult
to fathom profit-maximizing enterprises failing to get the job done.

Greed
is good

In
contrast to the living hell on the freeways, those who remained
in Houston endured much more tolerable circumstances. The greatest
annoyance was power outages. I lost electricity for 21 hours which
was at the high end for Houston (ultimately restored by the aptly
named "Reliant Energy"). When it got dark Saturday night
(still without power), my partner and I drove around looking for
a place to eat. There were very few restaurants open and the waits
were typically two hours. We actually managed to find a place called
"Sushi King", sit at their air-conditioned bar, drink
an ice-cold Kirin on tap, and have a nice sushi dinner. I love capitalism!
It is fascinating to watch the free market respond in a crisis.
Those businesses who stayed behind and got up and running quickly
with skeleton crews and limited wares did phenomenally well… by
providing a valuable service. Good Samaritans? Hardly. More like
little Gordon Gekkos, all exploiting an opportunity.

A
good friend (and fellow investment manager) told me the fresh-made
lasagna dinner his family enjoyed at Azzarelli's Saturday night
"earned that guy a 100% tip just as my voluntary contribution
to a system we both love."

After
rationing gas for the past 6 days, I decided to splurge Sunday and
drive around in my air conditioned car (temperatures were in the
mid-90s), listen to the Eagles, and observe a city that seemed to
be just waking up from a long slumber. There was a Shell station
open near the Galleria, fortunate enough to receive the first shipments
of gas the night before from a terminal in North Houston. People
were waiting 45 minutes, some seemed edgy, and a couple of spats
even broke out. There was a huge TV crew in the adjacent parking
lot. Houston's lifeline was slowly being reattached.

The
grocery stores were beginning to reopen — Rice Saturday night, H.E.B.
Sunday afternoon, Randall's Monday, Kroger on Wednesday. I decided
to go to Rice Epicurean Market around noon Sunday to beat the rush.
Pure joy. I don't think I've ever appreciated the miracle of the
marketplace this much. Some shelves were bare, but the operative
word was "abundance". I was a kid in a candy store. The
process was relaxing and orderly. I took my time, soaked it all
in, and filled up my cart. When the hoards returned Monday it could
be an entirely different experience, like the vultures fighting
over the last scraps on a carcass. (This was, in fact, the case.)

Once
bitten…

Thankfully,
not everyone in Houston and the surrounding area listened to the
authorities. Those who discounted their advice were by far the best
off. Texas Gov. Rick Perry wanted two days to restore order before
allowing people to return to their homes and cause a repeat of the
outbound highway mess. The Texas Dept. of Transportation issued
a three-day "Scheduled
Return Plan." This time nearly everyone ignored the officials
and drove back on their own timetables. Traffic was congested, but
nothing like the evacuation. The police were impotent to do anything
about it.

October
1, 2005

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

1. Panic
   early and drive out before the freeways turned into a parking
   lot.
2. Fly out
   of the storm's path entirely.
3. Panic
   late after the crowd had dissipated and the storm's track became
   more predictable (taking a page out of Walter Block's book).
4. Ride out
   the storm, buying provisions early.

We
eliminated the first option figuring the cost of lost productivity
was too high. Grocery store shelves were noticeably sparser by Tuesday,
especially for bottled water. Gasoline was scarce by Wednesday,
the same day Houstonians started heading for the exits en masse.
Rita was upgraded to Category 5 about 3:00 that afternoon and the
authorities were urging residents to evacuate. By Thursday, the
arteries leaving Houston were clogged, cars running out of gas,
temperatures reaching the high 90s, and tensions running high. It
took one reporter an hour to drive 2 miles on I-45 right through
the heart of Houston. People were passing out from heat stroke and
requiring medical attention. Others were turning around and taking
their chances with the hurricane. A human disaster was building
before the natural disaster had even occurred.

Is
there a lesson here? Are large population centers becoming intractable
and reaching the limits of growth? Is our just-in-time distribution
system like a pool of water a mile wide and an inch deep?

We
see two lessons: crowds are inherently dangerous and the system's
points of greatest vulnerability are where government is in charge.
In New Orleans, the weak link was the levees (the U.S. Army Corp
of Engineer's responsibility); in Houston it was the government-maintained
highways that buckled under the added weight. Both times government
authorities provided assurances that proved hollow.

Can
these lessons be applied to financial disasters? Earlier this week
Treasury John Snow dismissed a housing bust as "improbable
at best." President Bush continues to promote "homeownership,"
now at record levels approaching 70%. Even the Maestro himself,
Fed chairman Greenspan, is more worried about regional bubbles than
a systemic failure.

The
public, assuaged by the authorities, has not exactly prepared for
a rainy day. In the last three years, residential mortgage debt
climbed 45% to $8.2 trillion. Household liabilities grew from 105%
of disposable personal income to 122%. Lending standards collapsed
while speculation in homes and condos soared. In 2002, 6% of mortgage
activity was subprime; today the level is over 20%. 31% of new mortgages
are now interest-only versus 6% three years ago.

Meanwhile,
a parabolic blow-off in homebuilding stocks (more than tripling
in 3 years) has obscured the shutting down of key credit engines
powering the urge to super-size consumption. Fannie Mae is contracting
its balance sheet at double-digit rates and its stock is nearing
an 8-year low; Citigroup, JPMorgan Chase, and Bank of America are
quietly hitting 2-year lows. An estimated $1.4 trillion in adjustable-rate
mortgage debt will be reset in the next two years at considerably
higher rates, adding to already swelling unsold home inventories.
In short, the marginal U.S. consumer and his charitable lender are
facing a financial version of the perfect storm.

We
just got word that our flight out of Houston was cancelled. We're
down to our last two options: panic late or ride out the storm.
As for our nation's mania for credit, our advice? Panic now and
beat the rush.

September
24, 2005

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

~
recovering short seller

There are about
90 references to "housing bubble" on LewRockwell.com and
you've read practically every article and blog. You sold your house,
filled two safe deposit boxes with Krugerrands, and bought put options
on the HGX (Housing Index). You even named your three bloodhounds
Bonner, Corrigan, and North. Let's face it, you're every bit as
obsessed as the condo flippers, twenty-something leveraged landlords,
and Trump seminar faithful. Your wife is questioning your sanity
and you are beginning to wonder if she's on to something.

Sure, bust
follows bubble as predictably as concussion follows a swan dive
into the shallow end of a pool, but when? Can the powers-that-be
keep the party going indefinitely? Can the HGX double, rendering
your option strategy an exercise in futility and grounds for divorce?
Can any mere mortal really know the timing of a bubble?

The honest
answer is that recognizing folly is much easier than knowing its
natural limits. As Sir Isaac Newton lamented in 1721 after losing
his shirt in the South Sea bubble, "I can calculate the motions
of heavenly bodies, but not the madness of people."

Although history
rhymes, the great bubbles of at least the past century have followed
a remarkably similar script right before they popped. As absurdly
high valuations weigh on relentless injections of liquidity, the
advance narrows. Former favorites are treated like lepers while
the remaining beauty queens become the focus of intense adoration
and pursuit. Eventually, even the central bank bubble blowers get
cold feet and begin posting speed limit signs by raising rates.
Initially the crowd runs right through the signs, taking their speculative
vehicles on a reckless, parabolic joyride. As higher rates slow
liquidity, speculators sell their losers in one last desperate attempt
to get their hands on more fuel. The jig is finally, mercifully,
up.

The Roaring
’20s ended with the Dow peaking in August, 1929, well after
the broad market, as represented by the NYSE advance-decline line,
was in full retreat. In 1972, growth stocks like Coke, Polaroid,
Xerox, and IBM were all the rage during a two-tiered "Nifty
Fifty" market that ushered in the 1973–74 collapse — rivaling
its 1929–32 cousin in inflation-adjusted terms. The March,
2000 Nasdaq peak was a similarly bifurcated affair, as the performance-chasing
masses unloaded their Old Economy laggards in order to make room
for more Internet, telecom, and technology stocks. The Nasdaq Composite
proceeded to lose 78% of its value in 2 years.

Before we fast
forward the tape to today's market, a word of clarification is in
order. The bubble du joir is not so much in housing as it is in
credit. We are hard-pressed to know who is crazier, the borrower
swimming without a bathing suit or his Pollyannish lender. Not all
regional housing markets are in bubble territory, but credit availability,
rates, and standards are clearly detached from reality.

Credit-related
stocks, as measured by the Bearing Credit Bubble Index, rose ten-fold
from 1995 through the end of 2004. Its eight sub-indexes (banks,
brokers, subprime lenders, etc.) were all in sync until mid-2003
when the government-sponsored enterprises began to lag. The speculative
darlings of the past 2 years have clearly been the homebuilders
(+170%) and subprime lenders (+107%). This year the subprime lenders
hit the wall, leaving the homebuilders alone to carry the speculative
torch. The remaining credit providers and facilitators (especially
those weighed by heavy market capitalizations) are now either stalled
or joining the GSEs in full retreat:

Industry
Group

Year-to-date
Performance

Average
Market Cap

Homebuilders

+38.8%

$10.7
billion

Brokerage
firms

+2.0%

$41.4
billion

Credit
insurance

-1.9%

$6.2
billion

Non-bank
financials

-4.3%

$365.9
billion (GE)

Money
center banks

-5.3%

$141.6
billion

Credit
cards

-5.9%

$40.7
billion

Subprime
lenders

-6.2%

$8.4
billion

GSEs

-16.8%

$48.8
billion (FNM, FRE)

With
the stocks of the country's largest credit engines – Citigroup,
JPMorgan Chase, and Fannie Mae — shutting down and nearing 2-year
lows, this credit rocket is sputtering on fumes. Mr. Greenspan,
we have a problem.

August
2, 2005

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

~
Thomas Kuntz, CEO, Century 21, February 25, 2005

To
the seasoned investor, four of the most dangerous words in the English
language are "It's different this time." Five years ago,
this country experienced the mania to end all manias for anything
tech-related. Today it seems the public has merely shifted to all
things credit-related.

Manias
share four common characteristics:

• A feeding
  frenzy sends prices parabolic. In March, 2000 the Nasdaq
  Composite briefly touched 5000, up 44% per year over a five-year
  period. Homebuilding stocks today are up 46% annually in five
  years. The median price of a home is up 8.2% per year over the
  same period. Adjusted for 5-to-1 leverage on a typical mortgage,
  the humble abode has appreciated 41% annually.
• The
  public jumps in with both feet. During the late 1990s, stock
  ownership climbed to roughly 50% of households. Today "home
  ownership" has passed 70%, a record.
• Valuations
  detach from economic reality. In 2000 many tech stocks traded
  for over 50 times earnings. Today, in some of the hotter markets
  such as Southern California, home prices command as much as
  50 times their rental incomes.
• Rationalizations
  abound for why valuations are reasonable and the trend will
  continue. Talk of a "New Economy" has been replaced
  by the politically-sanctioned euphemism "Ownership Society."
  Then, as now, favorable demographics and an accommodative Fed
  were expected to keep the party going.

Admittedly,
there are differences. In 2000 Wall Street underwriters raised equity
for marginal businesses; today they raise debt for marginal consumers.
Five years ago the federal government enjoyed a surplus; today deficits
run as far as the eye can see. In 2000, the dollar was strong, inflation
dead, and commodities weak. In the five years since, the U.S. Dollar
Index dropped 22%, money supply (M3) grew 44%, and the CRB Index
gained 40%.

One
question keeps nagging us. Manias are rare occurrences, gracing
us with their presence every 30 or 40 years. How can a crowd delude
itself twice in just five years? Perhaps at least part of the answer
is that there are actually two crowds at work. The tech mania,
it seems, was primarily driven by testosterone — Ferrari driving
CEOs of dot-com and Silicon Valley startups, napkin-scribbling venture
capitalists, master of the universe investment bankers, and hyperactive
day traders. The present day mania appears to have more balance,
with women playing a greater role. Men are more prone to think in
terms of abstractions and do things like chase technology stocks
into the stratosphere, while a house is tangible and appeals to
both sexes.

Tech
Mania, 2000

Credit
Mania, 2005

The severe
Nasdaq bear market of 2000–2002 took the male ego down a few
notches. Wives who were suspicious of the boom, but reluctantly
supported their husbands anyway, knew who to blame when the couple's
finances unraveled. Many refused to adjust their lifestyles to the
new reality. Enter Alan Greenspan offering a cheap and seamless
way to keep up appearances, upgrade the kitchen, and buy that new
home theater system: simply tap into ever-rising home equity. The
wife was able to spruce up her nest, the husband salvaged his marriage,
the finger pointing ended, the house climbed in value, and they
all lived happily ever after.

Predictably,
the residence has become an emotional hot button, making this credit
mania all the more terrifying. Popular mortgage ads feature the
woman in control as lenders line up to provide cheap credit on her
terms. Attention personal bankruptcy specialists, divorce lawyers,
and marriage counselors. Business is about to improve.

March
3, 2005

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

Alone,
most people act rationally. Put them in a crowd and entertain them?
They shave their heads, paint their faces, expose their over-hopped
bellies to sub-freezing temperatures, shout obscenities at well-intended
referees, and generally lose their minds. (In the City of Brotherly
Love, they sometimes toss snowballs at these same officials.)

When
everyone is thinking alike, no one is thinking. Worse, the collective
level of intelligence drops to the lowest common denominator. What
is sure to whip people into a frenzy? Nothing beats an easily discernable
uptrend and a simple explanation for its perpetual continuation,
i.e. all the ingredients for everyone to get rich. The longer the
trend goes on, the smarter, more invincible, and more daring the
mob becomes.

Five
years ago, the crowd thought technology stocks paved the way to
early retirement. Their rationale was simple: the future would be
high-tech, highly productive, and highly profitable for those "New
Economy" companies who "got it." Never mind that
the Nasdaq 100 had vaulted 10 times in just the past five years
or that Cisco Systems' $500 billion market capitalization dwarfed
its sales of $19 billion. They sold their stodgy old-line stocks
(often to insiders) just to buy more.

In
hindsight, the signs of excess were all there. What the consumer
craves, Madison Avenue, Wall Street, and the mass media supply.
Ubiquitous TV ads encouraging day trading reached the sublime, one
showing a successful teenager with his own personal helicopter.
Half of 2000's Super Bowl ads were for dot-coms, many hastily produced.
CNBC (a.k.a. "Bubblevision") told its audience what they
wanted to hear: the future is bright, technology (e.g. the Internet)
is bringing information to the individual investor, and the real
risk is missing the ride. Analysts and strategists were mostly bullish,
and those who didn't give the consumer what he wanted were replaced.
Investment bankers packaged new product and insiders — especially
those fortunate enough to own stock in New Economy companies — generously
sold from existing inventory.

Predictably,
it all ended badly, but did we learn anything? Has human nature
really changed? Has the mob dissipated, kicked its gambling addiction,
and gone back to work?

For
starters, CNBC is still in business, Las Vegas is undergoing a construction
boom, TV shows about casinos are hot, and stock market speculation
is back. A recent headline reads, "Google Heads For the Moon."
With a market cap of $57 billion, sales of $3.2 billion, and its
two founders in their early 30s worth north of $7 billion each,
one could argue Google has already reached its destination.

The
real crowd pleaser these days, however, seems to be cheap credit.
Everywhere one turns there is a billboard, TV ad, or phone solicitation
offering once-in-a-generation low rates to the marginally creditworthy,
as long as the collateral has four walls and a front door. The formula
is simple: interest rates will remain low, credit will stay abundant,
and real estate always goes up. A logical conclusion follows: Buy
as much house as possible and borrow as much as the lenders allow.

Over
the last 5 years household real estate gained $6.3 trillion (62%)
in value, yet homeowners piled on another $2.8 trillion in mortgage
debt, or 44% of this new found "wealth." (Keep in mind,
these are averages which include the 20% or so who own their homes
outright, mostly retirees. Home equity extraction is certainly much
higher for those with mortgages.) At the margin, many are literally
betting the ranch that the easy credit stars stay aligned indefinitely.
Like a compulsive gambler, the home buyer on margin is opting for
higher-octane fuel, moving from fixed mortgages to ARMs, and now
to interest-only mortgages and "piggy back loans" which
cater to the buyer who is challenged to come up with a down payment.
Despite the lowest interest rates in 46 years, the average American
pays over 13% of his disposable personal income just to service
his debts, a record.

It
is not just borrowers who are optimistic. Mortgage lenders are in
a generous mood these days and why wouldn't they be? Borrowing at
2% and lending at 5% is good work if you can get it, especially
if your collateral keeps rising in value. Not only do they want
this virtuous credit cycle to continue, they expect it.

On
conference call after conference call, we find executives with remarkably
similar forecasts: the good times will continue. The CEO of subprime
lender New Century Financial, Robert Cole, admitted, "We're
all competing aggressively for market share," without a thought
that the consensus might be wrong. CFO Patti Dodge projected minimal
loan losses over the next 18 months based on their "historical
experience" of the "last 7 to 8 years." Countrywide
Financial, the nation's #2 subprime lender and prodigious advertiser,
plans to double its assets by 2008. CEO Angelo Mozilo recently boasted,
"Shareholders' total annual return the past 10 years averaged
30% per year and 45% the past 5 years… This is the real Countrywide
story." (We think the real story might be Mozilo "divesting"
himself of $157 million in company stock over the past two years.)

As
the housing beat goes on, who can fault those who, from time to
time, hook up an ATM to their house in order to take the wife to
Paris or the kids to Disneyworld? Or if they happen to be Eagles
fans, why not use some of the proceeds to buy tickets to Super Bowl
XXXIX?

We
understand the Super Bowl's half-time show this year will be sponsored
by Ameriquest Mortgage, this country's #1 supplier of subprime home
loans. Five years ago online broker E*trade secured this dubious
distinction. This time, like the last, we'll let the fanatics have
their fun. We'd rather watch this spectacle unfold in the comforts
of our own home.

February
5, 2005

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management. Special thanks to Bill
Laggner, the other principal, for his considerable contribution
to this article.

~
Ludwig von Mises, Human
Action

For
the typical investor and his adviser, Mises' insight about the origin
of profit must seem out of touch with present day reality. It is
commonly thought that the U.S. economy reaps the benefits of an
entrepreneurial economy and its stock market is merely along for
the ride, providing participants double-digit returns as far as
the eye can see. Stock ownership has in recent years come to the
masses, who fully expect to profit not from their own unique vision,
but because "stocks always go up in the long run," or
so they are told.

Was
Mises wrong? Can the multitudes profit in the investment sweepstakes?
Is capitalism, in fact, democratic? Are we entitled to all get rich
together?

Looking
at the great bull market from 1988–1999, the answers appear
to be "yes". The S&P 500 returned 19.0% per annum
with dividends reinvested. Even if the 2000–2002 bear market
is included, stocks gained 14.2% annually for the 1988–2004
period.

Unfortunately,
the typical investor did not achieve these returns. First, he was
late to the party. In 1989, at the onset of a decade that saw the
Dow Jones Industrials Average quadruple, just 31.6% of households
owned stock. By 2001 stock ownership had swelled to 51.9%. Second,
investors chased momentum to their detriment, in essence navigating
the markets through a rear-view mirror. According to a recent study
by financial research firm Dalbar, from 1984-2002 the S&P 500
returned 12.2% annually, yet the average stock investor earned a
meager 2.6% per year.

How
can Austrian economics in general and Mises' wisdom about entrepreneurial
profit in particular improve an investor's returns? We think in
several ways:

1. Invest
   in market entrepreneurs with a margin of safety (sustainable
   businesses, reasonable valuations, and solid balance sheets).
   A rising tide makes it more difficult to identify true entrepreneurs,
   at the same time lowering investment returns by driving up valuations.
   Better to wait for the tide to ebb, exposing those "swimming
   without a bathing suit," as value investor Warren Buffett
   suggests. Avoid political entrepreneurs (e.g. Enron) who attempt
   to circumvent the whims of the consumer and the vagaries of
   the competitive marketplace by convincing government to grant
   them some sort of privilege or protection.
2. Look
   for investment opportunity in foresight apart from the consensus.
   Stock prices already discount the collective expectations of
   investors. It is the unexpected that moves markets. The
   larger the crowd, the more emotional and irrational, and more
   likely to be wrong in its assessment of the future. An investor
   does not need a crystal ball to succeed, just a more accurate
   glimpse of the future than the rest.
3. Avoid
   the economic errors of the crowd. The typical investor is
   unaware that 1) central bank induced credit expansions create
   artificial booms (bubbles) inevitably followed by painful waste-removing
   busts, 2) increased government spending plus tax cuts equals
   an irresistible temptation to inflate, 3) unrestricted trade
   is a blessing, and 4) economic law ultimately prevails despite
   government attempts to interfere in the process.

Just
as a forest fire provides plenty of sunlight and nutrients for renewed
growth, economic busts create an ideal environment for entrepreneurs
to emerge. During the 1930s and 1940s, great growth stocks like
3M, Eastman Kodak, and IBM performed admirably, though they went
largely overlooked. During the 1983–1989 technology stock bear
market, hundreds of companies disappeared, only to be replaced by
a new breed of saplings. This is when the next wave of growth companies
like Compaq, Cisco Systems, Microsoft, and Dell Computer went public.

During
the dot-com bubble of the late 1990s, Michael Dell commented on
how the landscape for startups had changed since he took his company
public a decade earlier. A true entrepreneurial company must deal
with adversity and scarcity, he reasoned. The problem with Internet
startups was that they were spoiled, showered with venture capital
funds, and highly unlikely to build a corporate culture of thrift
and long-term profitability. Prophetically, the survival rate for
the Class of 1999 turned out to be miniscule compared to that of
1989.

The
interplay of wealth creation (entrepreneurship) and destruction
(government intervention) is constantly at work; it is the focus
and mood swings of investors that change. During the late 1920s
investors turned their attention to the positive — the wonders of
new technology such as autos, electrification, radio, and the telephone.
Meanwhile, the negative — government goosing of the money supply
in the name of maintaining a stable price level — went either largely
unnoticed or celebrated by mainstream economists as a powerful force
to prevent any serious downturn, both for the economy and the growing
crowd of stock investors. The "New Economics" of 1929
was followed over time by similar flights of fancy regarding government's
ability to manage an economy: the U.S. "New Era" (late
1960s), "Japan Inc." (1989), and a global "New Economy"
(2000).

In
contrast, major stock market lows are often set when the failures
of the state are exposed and become engrained in the public psyche.
Depression (1932), world war (1941), expected return to depression
(1949), inflation (late 1970s), and deficits (late 1980s) created
the best buying opportunities for investors of the past 75 years.

How
can an investor profit today? Asked another way, how does the future
— viewed through the lens of an Austrian economist — differ from
the outlook of the typical investor? The greater the disparity,
the greater the potential for profit. (This may sound dangerously
close to forecasting, an exercise Austrians know is impossible with
any degree of precision. Investors must avoid this trap, instead
assigning probabilities to various scenarios in an uncertain future
— what entrepreneurs do all the time.)

From
all appearances, investors today are optimistic. The most recent
Investors Intelligence poll of investment advisers shows 56.3% bullish
and just 17.7% bearish. Equity mutual fund managers hold just 4.7%
of their portfolios in cash, down from 9.4% in 1988. Equities account
for nearly 50% of the assets in pension funds and insurance company
portfolios, up from 28% in 1988.

Goldman
Sachs strategist Abby Cohen sums up the consensus view: "What
matters most is that investors are confident of the sustainability
of economic growth." Few doubt that tax cuts, increased government
spending, and the most aggressive Fed easing in its history will
have the intended effect. There is a palpable belief that Greenspan
& Co. will pull all the right levers. Inflation is thought to
be low and expected to remain so. Interest rates are seen drifting
upward at a "measured pace," though not enough to make
record debt levels unmanageable.

Residential
real estate lending is aggressive and standards increasingly lax.
A local banker told us that five years ago the mortgage payment/pre-tax
income ratio on any home loan could not exceed 28%; today it is
not uncommon to see ratios above 40%. In Orange County, California,
a first-time home buyer recently secured a $360,000 mortgage with
nothing down and a ratio of 50%. Nearly everyone is convinced "real
estate always goes up" and that a worst-case scenario is a
slowing in home price increases.

Are
investors justified in their optimism? From an Austrian perspective,
there appear to be several likely events, in order of their unfolding:

1. The
   economic recovery will derail once the credit drug wears off.
   Since early 2001, thirteen rate cuts by the Fed (with plenty
   of help from the world's central banks and GSEs) stimulated
   little more than the accumulation of debt. From 2000 to 2004,
   total personal debt/GDP climbed from 66% to 83%. Personal debt
   payments/disposable personal income increased from 12.44% to
   13.22% over the same period, despite interest rates (as measured
   by the 10-year Treasury) dropping from 6.28% to 4.44%. By interfering
   with the healthy unwinding of the tech/telecom/Internet bubble
   of 2000, the Fed helped foment the current much larger housing
   and consumption bubble.

Investors
should sell real estate in the most speculative markets: southern
California, Florida, New York, and Washington, DC. They should
avoid stocks of mortgage lenders, mortgage insurers, banks, credit
card companies, homebuilders, consumer discretionary items (autos,
appliances, furniture, and restaurants), and luxury goods purveyors.
There will be few safe havens. Perhaps stocks in consumer staples
(food, tobacco, alcohol, and utilities), oil and gas, discount
retailers, and manufactured housing will hold up relatively well.
For the more daring, short selling or buying put options on the
most egregious extenders of mortgage credit (such as Fannie Mae
and the sub-prime California-based lenders) should provide speculative
profits.

2. Inflation
   will return with a vengeance. The government's deficit is
   expanding and the Fed is on a mission to print money. If the
   stock, bond, and real estate asset balloons break, this new
   money will have nowhere to go but into goods and services. Foreign
   investors (mostly Asian central banks) have soaked up much of
   the new credit creation since 2000. Should they ever slow their
   appetite for dollars or actually begin selling dollars, gasoline
   would be added to the current smoldering inflation fire.

Year-over-year,
money supply (M3) is +7.0%, import prices are +4.6%, gold is +8.8%,
and even the statistically challenged Consumer Price Index is
+3.1%. Investors should sell bonds and dollars, and buy gold,
commodities, and short-term government notes in select foreign
currencies.

3. The
   long march of global capitalism will continue. As billions
   continue to extricate themselves from the abyss of socialism,
   they will greatly expand the global division of labor. Countries
   like China and India will require more commodities, especially
   energy, as living standards improve. They will increasingly
   put global capital to productive use, making it more difficult
   (and more expensive) for Americans to attract capital merely
   for consumption.

Investors
will eventually wake up to the reality that the U.S. is no longer
the center of the universe. With less than 5% of the world's
population and 21% of its GDP, the U.S. commands 45% of its
stock market capitalization (up from roughly 30% in the late
1980s) and 69% of the world's foreign exchange reserves. Though
there will surely be short-term setbacks, investors should keep
an eye on Asian stocks (including those in Japan), commodities,
and stocks in commodity-based countries over the long haul.
They should also diversify their cash and fixed income holdings
away from dollars.

Market
entrepreneurs tend to be optimists, finding solutions where others
see only obstacles. In fact, their optimism often gets them into
trouble, falling for the false signals of an artificial boom that
inevitably lead to a cluster of errors. Entrepreneurial investors
must instead be skeptics and realists, not allowing their judgment
to be clouded by overly rose-colored or opaque glasses.

Can
the concept of entrepreneurial profit be applied to a political
cause, such as the pursuit of a free society? We believe so. If
"profit" is measured in added credibility or new members
enlisted to the cause, opportunity is maximized by dissenting, not
camp following. If the opposition is spreading lies to the gullible,
exposing the truth can hardly be expected to make one popular in
polite conversation, yet the exercise will pay the greatest dividends
once the truth is revealed.

The
greatest chance to advance the cause for freedom is where government
is most powerful, accepted by the masses, arrogant, and thus vulnerable.
These areas are easily identified because they are surrounded by
the most outrageous lies and myths: the imperial presidency (Lincoln,
Wilson, FDR, and recently Reagan to a lesser extent), the war on
terror, and the seemingly omnipotent and omniscient institution
of central banking.

Investing
is an endeavor in which the most succulent fruit is reserved for
the contrarian. As the size of the crowd and level of group-think
increase, so does the opportunity for profit. For both the entrepreneurial
investor and promoter of the free ideal today, this is welcome news
indeed.

July
13, 2004

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.