Fundamental DJI, Value or Water?

Motley Fool
More Manipulation and the Individual Investor
Wednesday June 1, 11:49 am ET
By Stephen D. Simpson, CFA


Yesterday, we began a discussion of the ways in which unscrupulous players can cheat investors out of their money. Unfortunately, it was only the beginning of the story, and today we will discuss still more means of manipulating a stock. Where the first day's discussion focused on activities that are clearly illegal, today's discussion moves toward sneakier means of scamming investors out of their mone


Pump & dump (and short & distort)
Pump & dump scams are also a classic manipulation play. While there are different arrangements from scam to scam, the basic idea is to tout the supposed prospects of a company in an attempt to lure in unsuspecting investors that will push up the price. As the price goes up, the original scammers sell their stock to the new blood and book a nice profit.

Sometimes the company itself engages in the promotion, and other times the insiders hire promoters to pump the stock. In any case, you begin to see streams of press releases and/or "research reports" from companies that you never before heard of. There's a remarkable similarity between them (after all, promoters know the buzzwords that will draw in the rubes) -- new technologies that will revolutionize an industry, imminent cures for dread diseases, and so on.

Of course, none of the garbage is true, and once the insiders have sold out, the hype machine shuts off. Once the hype dries up and there are no new "investors" (and I use that term very loosely), the accumulation pressure evaporates, the stock crashes, volume dries up, and investors go away licking their wounds and wondering how they'll explain a $15,000 loss on Cool Research and Products (symbol: CRAP) to their spouses.

Pump & dump scams are overwhelmingly more common in the penny-stock world, so the first step in avoiding this type of manipulation is to avoid penny stocks in general. What are penny stocks? Although the traditional definition is "any stock trading below $1," a more helpful (though subjective) definition would be that a penny stock is a low-priced stock (say, $5 or below) that is not traded on the major exchanges such as the New York Stock Exchange, AMEX, or Nasdaq. There are plenty of frauds and scams among listed stocks (Enron, anyone?), but there are considerably more critical eyes looking at listed stocks, and the hype isn't usually as blatant.

The nature of the hype is also a good warning. Since these companies are overwhelmingly just junk (usually without products or real sales), the promotional material always talks about the fantastic future -- great new products about to be released, lucrative contracts with major companies just about to be announced, and so on. Ask any of these companies about what's going on today, and you'll get blank stares and quick attempts to turn the conversation to the glorious future.

I realize that nothing I say will dissuade penny-stock players from their favorite little game, but other investors should beware. Industry titans don't often grow from penny-stock seed, so if you're going to play the game, be sure you know what you're doing and what can happen to your darlings.

Rumors and trader tricks
Institutional managers and traders can also manipulate the price of stocks in subtle (and not-so-subtle) ways. Rumor-mongering is one great approach. Everybody loves rumors (anybody can get news, but only the "special" people hear the great rumors), and they spread like wildfire, often without much attempt made at confirming their accuracy.

Money managers can (and do) clearly use this to their advantage. Want to move a block of stock but don't want to get killed on the price? Spread a rumor to move the stock in your favor. If you want to buy some Nokia (NYSE: NOK - News) a little cheaper, start a rumor that its handset volumes are sluggish and it's going to miss the quarter. Want some Delta Airlines (NYSE: DAL - News)? Spread a rumor that it's on the verge of declaring bankruptcy. Want to sell a biotech? Start a rumor saying that clinicians are absolutely raving about a drug they're using in clinical trials.

Traders also get into the game, in most cases using individual investor psychology to their advantage. In simple terms, if you know the books that your opponent is reading from, you can position yourself to manipulate that for your own benefit.

For instance, many individual investors put in stop-loss orders with nice round numbers -- $40, $50, $100, etc. This has been true for so long that traders generally know that if a stock traded as high as $60 and is currently at $51, there's probably a boatload of orders waiting at $50. Spend a little money to shove a block of stock in the right direction, and the cascade of automated trades that follows can reap a tidy profit for the trader.

It's no different with some technical-analysis concepts as well. Everybody knows that a certain element of the investor population pays rapt attention to moving averages, trend lines, and the like. So, if you can find a relatively thinly traded stock trading near an important average line or trend line, you can sometimes goose it over the threshold and profit from technically oriented investors who rush to respond to the "technical breakdown/breakout." Take a look at a chart of Curtiss-Wright (NYSE: CW - News) or Atmel (Nasdaq: ATML - News) and watch what happens to the stock when it does nothing more (or less) than cross a 50-day moving average line.

The bad news here is that these attempts at manipulation are the hardest for investors to spot ahead of time and avoid. Quite frankly, there's not much that can be done if some hedge fund hedgehog wants to spread a rumor to buy your stock on the cheap. Rumors are part of the business, and they're almost impossible to track down. What's more, almost nobody is stupid enough to leave a paper trail that a prosecutor could exploit. (Not too many people keep records like "tried to illegally manipulate ABC Co. today.")

The good news is that most of these manipulation attempts are transitory. A stock might crack a psychologically significant number, trade down a couple of points, and then climb gradually back up. Rumors might buffet a stock, but sooner or later they're either proved or discredited. So as long as investors can maintain their long-term focus of owning quality companies for the long haul, some near-term turbulence caused by greedy and/or unscrupulous traders and managers won't amount to much in the end.

Grand conspiracy
Of course, you can't talk about market manipulation without at least bringing up a fear harbored by a (hopefully) small minority of investors -- that the entire game is rigged. Conspiracy theories abound, and everyone from the Federal Reserve to the Masons to the International Brotherhood of Electrical Workers (just kidding) has been implicated as the "they" that are secretly pulling the strings behind the scenes.

The big run-up in tech stocks in the '90s? It was "they." The nasty crash that wiped out so much money among individual investors? "They" again. Sometimes the conspiracies are even a bit more elaborate -- such as the one I found online that suggests that "they" took their winnings from the late '90s tech run and used it to buy all sorts of mines, refineries, wells, and whatnot before instigating the recent commodity run.

"Balderdash" is the only word I can think of to describe these "theories" -- or at least it's the only word that my editors will let me use. If you really believe that nonsense, you need to do two things right away. First, sell all of your stocks (why play a rigged game?). Second, install heavy-duty padding on your walls and floors because you could really hurt yourself.

Conclusion
Manipulation is one of those nasty facts of life that we all have to deal with as investors. Just like littering and junk mail, it's a scourge that shows no signs of disappearing. Heck, I'd even go so far as to say that about 20 seconds after cavemen invented the first game, another caveman was working on a way to cheat the game.

The good news, though, is that even though manipulation has been part of the U.S. market from its outset, it hasn't prevented millions of people from making money through sound and well-reasoned investments. While this isn't a fail-safe plan to avoid all attempts to illegally separate you from your money, I do believe that most investors who exercise due diligence, due caution, and sound diversification have little to fear from the manipulators and well-dressed pickpockets of Wall Street.

Stephen
 
Jubak's Journal
Why Buffett is buying utilities

The industry is consolidating, and a utility with low-cost financing is going to make a lot of money. Here are three stocks that will benefit and four more worth a look.

By Jim Jubak

On May 24, Warren Buffett bought an electric utility. Should you?

Buffett will pay $5.1 billion to buy PacifiCorp from Scottish Power (SPI, news, msgs). That's about an eighth of the more than $40 billion that Berkshire Hathaway (BRK.A, news, msgs) had in cash at the end of March. And the deal to acquire the provider of electricity to 1.6 million customers in the Pacific Northwest is the biggest for Berkshire Hathaway in the last eight years. When the deal was announced, Buffett said Berkshire Hathaway would be looking for more utility acquisitions.

All in all, it adds up to a pretty hefty endorsement of the electric utility industry from a legendary value investor. Which, of course, takes us back to my first question: If Warren Buffett is buying electric utility stocks, shouldn't you?

At first glance, this seems like an odd time for a value investor such as Buffett to invest in utilities. The Dow Jones Utility Index ($UTIL) has returned 11.5% so far in 2005 (as of June 1) after huge total returns of 25.4% in 2004 and 24% in 2003. Stocks such as AES (AES, news, msgs), up 9.15% in 2005 after returning 44.7% in 2004, American Electric Power (AEP, news, msgs), up 7.8% in 2005 after returning 17.4% in 2004, and Duke Energy (DUK, news, msgs) up 12.94% in 2005 after returning 23.8% in 2004, seem closer to the end of their runs than the beginning.

So why does Buffett think utilities are a good buy now? The answer lies in the long- and short-term potential for electric utilities.

The long-term view: Consolidation builds profits
U.S. utilities are in the early stages of a long-term consolidation. Midsized utilities are buying small utilities, and big utilities are buying midsized players.

Right now, there's a mismatch in how the industry is structured. There are thousands of local companies that deliver electricity to their customers. Then, there are regional wholesale electricity markets dominated by a handful of efficient, large-scale electricity producers. The wholesale markets have emerged because local companies can often buy power from others for far less than the cost of generating it themselves. At the same time, some utilities have developed cost advantages that have turned generating and peddling excess electricity to other utilities into very profitable businesses.




The wholesale markets aren't going away -- in fact, they're gaining in importance. But they are undergoing a subtle transformation. The big low-cost producers aren't content with the profits that come from selling their electricity at wholesale prices. They'd like to capture more of the cash flow by eliminating the local utilities. Why sell bulk power to another utility if you can sell electricity at retail to the company's local customers? Since the electricity business is composed of regulated monopolies, the only way to be able to sell directly to the end users is to buy up the local companies -- lock, stock and customers.

That's exactly what's been going on in recent years. In 2000, American Electric Power bought Central & South West to create the country's biggest utility. Duke Energy plans to merge with Cinergy (CIN, news, msgs), and Exelon (EXC, news, msgs) has proposed the acquisition of Public Service Enterprise Group (PEG, news, msgs).

There's many a slip between projected and real cost savings, as investors know all too well. Even so, when Exelon talks about getting $400 million in cost savings in the first year of the merger by eliminating redundant operations at Public Service Enterprise -- equal to about 4% of PEG's annual revenue -- it's enough to get my attention.

Just one problem, though. There's this inconvenient law left over from the Great Depression when utilities did nasty things like water their stock and play "hide-the-assets" among related shell companies. Called the Public Utility Holding Company Act, the law prohibits nonutility companies, such as Berkshire Hathaway, from directly controlling retail electricity suppliers. The law also requires that utilities (if both are U.S. utilities) must be physically connected in order to merge. It's that latter requirement that led a Securities and Exchange Commission hearing judge to rule in early May that the American Electric Power-Central & South West merger violated the 1935 law. AEP's service area nowhere touched the Texas service area of Central & South West.

For a patient investor like Buffett, though, this is exactly the time to strike. The long-term consolidation trend is gathering speed, and efforts to repeal the 1935 law are making headway in Congress. The energy bill passed by the Senate Energy and Natural Resources Committee on May 26 would allow the large-scale utility mergers now prohibited. Passing a committee, however, isn't the same as getting through the full Senate and the House of Representatives, but the attempts to amend the Public Utility Holding Company Act will bear fruit one of these years.

It's quite possible, however, that Buffett may not have to wait even for that. Technically, Berkshire Hathaway isn't PacifiCorp's buyer. The formal buyer is Berkshire's 80%-owned MidAmerican Energy Holdings.



So, the deal works around the law's ban on nonutility companies owning retail electricity suppliers. (I should add the word "probably" here. This is an exceedingly convoluted area of the law.) Not only does Berkshire Hathaway own 80% of MidAmerican, based in Des Moines, Iowa, but Berkshire can only vote 9.9% of its shares.

The deal may also meet the requirement that the merging utilities be physically connected, since MidAmerican's transmission grid includes South Dakota, which is adjacent to PacifiCorp's grid in Wyoming.

(Of course, exactly what the 1935 act means by "physically connected" is a matter of legal interpretation. The two utilities are located in different regions of the national electricity grid -- what are called interconnects. It is, in fact, quite possible that this means the two aren't connected even if they do business in adjacent states.)

Three potential winners from consolidation
To profit from this consolidation over the long haul, I'd look for utilities with the ability to generate and transmit lower-cost bulk electricity. Three I like are Duke Energy, American Electric Power, and FPL Group (FPL, news, msgs).


Duke Energy's merger with Cinergy eventually will create a utility with almost 4 million electricity customers and about 16,000 megawatts of unregulated generating capacity for the wholesale market.


American Electric Power's position in the middle of the country and next to the Appalachian coal fields makes it a natural for expansion as the industry consolidates.


FPL, formerly Florida Power & Light, is the industry's leader in wind-power generation. Wind power is a source of electricity that will gain a cost edge if oil and natural gas prices continue to rise. And it works well in combination with fuel sources with different patterns of peak electricity generation.

Cheaper capital equals bigger profits
Berkshire Hathaway has the one thing that every utility CEO dreams of: piles and piles of low-cost capital. One big reason that Scottish Power sold PacifiCorp was that the company needed to invest a minimum of $1 billion over the next five years to improve reliability in its service area. Some estimates run as high as $5 billion.

The profitability of that kind of investment, when the return that you earn on your investment is set by state regulators in your service area, hinges on what the company pays for the money it invests. Thanks to Berkshire Hathaway's insurance business, the company generates a flood of cash internally and enjoys access to the capital markets at extremely low rates. Also, since Berkshire Hathaway doesn't require units like MidAmerican Energy to pay a dividend to the parent company, MidAmerican will be able to put all of its own internal cash to use. So, in my opinion, MidAmerican should earn a bigger profit on its investment in the PacifiCorp system than Scottish Power could hope for.

And let's not forget the advantage that Buffett gets from taking on $4.3 billion in PacifiCorp debt. Think that it's just possible that MidAmerican Energy will be able to lower the interest cost on that debt thanks to its access to cheaper capital?

4 companies that can win with low-cost capital
So, how to profit from the short-term view of this deal? Look for capital-strapped utilities with lots of customers. A plus would be a credit rating low enough to be easily improved and/or sizeable debt that would let an acquirer quickly reduce interest costs. If the target utility owns assets such as coal mines or fiber-optic networks, so much the better. Utilities to research, in my opinion, include TXU (TXU, news, msgs), TECO Energy (TE, news, msgs), Pepco Holdings (POM, news, msgs), and Sierra Pacific Resources (SRP, news, msgs).

Of course, any decision to invest in utility stocks -- which, because of their high dividend yields, tend to rise and fall with interest rates -- requires that you consider where U.S. interest rates are headed. Utility stocks shine when interest rates are falling or are already low and stuck at low levels.

So, in my next column I'll tell you why the "no" vote on a new constitution for the European Union in France and the Netherlands means that lower U.S. interest rates will be with us for a while.
 
Contrarian Chronicles
Intel keeps rising, but that doesn't make it safe


Intel has been beaten by AMD in chip design, but its stock keeps going up. Why? Blame the human factor that drives markets.

By Bill Fleckenstein

Over the course of my investment career, I have often been asked why such and such happened, or, if A happened, then how come B didn't follow, when it "should" have. To those questions, I often find myself responding: Because these are markets. They're made up of human beings who are governed by human emotions.

In other words, markets can do whatever they want.

That reality is keenly understood by Emanuel Derman, the physicist-turned-quantitative-analyst-turned-author who recently spoke at a conference hosted by my friend Jim Grant. (Jim reprised the quotes that I am about to share in the April 22 issue of his always-interesting Grant's Interest Rate Observer.)

First, though, a word about Derman's fascinating recent book, "My Life As a Quant," which I have read and suggest that others might also. Derman used to run the Quantitative Strategies Group at Goldman Sachs, but he left in 2002. In plain English, he describes his transition from the pursuit of physics to finance, during which he explains lots of concepts that folks might find interesting. (Though I was a math major, there's a vast array of concepts in physics and mathematics that I do not understand. I pass that along so folks won't think a sophisticated knowledge of mathematics is necessary to understand the book.)



An eminently quotable quant
Meanwhile, I encourage everyone to read the following quotes from Derman's speech more than once. I myself read them several times, as I thought they were so insightful and accurate:

"Most trained economists have never really seen a first-class working theory, because economics doesn't have any. ... I don't mean to say that physics is better. I like economics, but I think that it's rather that finance and financial economics are really much harder."

(To quote Derman quoting MIT Professor Andrew Lo: "Physics has three laws that explain 99% of the phenomena, and economics has 99 laws that explain 3% of the phenomena.")




"In physics, you are really playing against God, and He sets the laws once and for all, and you are trying to figure them out, and He doesn't really change them too often. And if you figure out what the laws are, then He kind of gives up and says, 'You're right.' In finance, you are really playing against God's creatures, people like us, who value assets based on their ephemeral feelings. ... They overshoot, they undershoot, and they sometimes don't know when they've lost the game. They keep on trying to play, and they keep trying to change the rules on you."

Living with lawlessness on Wall Street
This is the best description I've seen of the difference between how markets work and the laws of physics. I frequently do my best to try to infer what the markets are concluding, though that effort is complicated by the fact that there's often a high noise-to-signal ratio. (That, by the way, may be higher than normal now.)

The bottom line to take away from Derman's book: There are no hard-and-fast rules in markets (as opposed to science) -- just relationships that are constantly changing.

With Derman's anatomy of market "logic" as a preamble, let's discuss the ongoing no-news rally -- to help illuminate the point that the events you think should matter sometimes do not. Who would have thought that the market could shrug off a downgrading of General Motors' (GM, news, msgs) and Ford's (F, news, msgs) debt to junk, to pick just one recent news item?

On the other hand, certain facets of this tech rally have been somewhat predictable, in that we are once again seeing a no-news period in which dead fish are upgrading their sectors. Recently, one of them upgraded the software sector after virtually all its members blew up last quarter. We've also heard many dead fish saying wonderful things about the chip sector during this period -- as they do in almost every no-news period.

That brings me to Intel (INTC, news, msgs) and the number of e-mails I've received about why it's going up. Thinking back to what Emanuel Derman said, I quite frankly don't know the answer. There are rumors circulating that Intel is doing just fine thus far this quarter, and that its mid-quarter update (due Thursday after the market close) will go swimmingly.

Perhaps that's the case. Perhaps business in Asia is strong enough that everything is hunky-dory thus far in the quarter. Also, with Intel stock having done well, sometimes buying just begets buying. Intel moved higher 19 out of the 21 total trading days in May and the first three days of June. So, folks are unambiguously voting to own it. In any case, I have kept my puts, though I trimmed my short position along with other shorts several weeks ago.

AMD: Spokesman for Intel negativity
I prefer to express my negative view on Intel via a long position in Advanced Micro Devices (AMD, news, msgs). One reason to be long-term negative on Intel, and one of the reasons for my buying longer-dated options in the first place, is the fact that AMD has beaten Intel in the processor-design game. Additionally, with AMD jettisoning the flash-memory business, with insider buying in the stock and given my expectation of a rally, I felt I could better express my Intel negativity in the short run via a long position in AMD.

At some point in the next group of weeks, I plan on adding to my Intel put position and rebuilding my short position. But for the time being, it seems futile to fight the imagination inherent in the no-news period, especially when it comes to the tech tape. Bottom line: I have not changed my opinion on Intel. I have just modified how I express my view, due to the changing set of circumstances that has evolved over the year.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle.
 
Bankrate.com
Why are long-term interest rates declining?
Monday June 6, 6:00 am ET
Greg McBride


Long-term interest rates that serve as the benchmark for fixed-rate mortgages are declining once again, with 10-year Treasury note yields falling through the 4-percent mark. Why is this happening with short-term interest rates rising so consistently and the Fed voicing concern about an overheated housing market? There are several reasons that long-term rates have fallen in the past two months, and some big names think they'll fall even more.





Inflation is a key factor in interest rates, both on the way up and on the way down. The eight increases in short-term interest rates over the past year have brewed confidence that the Fed's efforts are ensuring modest inflation for years to come. The irony is that rising short-term rates have actually contributed to the decline in long-term rates.

Long-term interest rates have also benefited from a steady diet of foreign money flowing into U.S. securities markets. The dollar has suddenly been looked upon more favorably among foreign investors, with the rejection of a European constitution fueling the latest dollar rally and pushing the greenback to an eight-month high against the euro. When dollars are purchased, much of that money is then invested in Treasury securities, which helps to depress yields further.

Another contributor is the prevailing pessimism about the direction of the economy, and not just the U.S. economy. Japan and Germany, the second and third largest economies in the world, both have lower bond yields than the United States and are seeing anemic economic expansion -- if any at all. The high quality of U.S. government bonds, along with yields that are higher than what is available in some other countries, makes Treasury yields appealing on the world stage.

One theory is that if China's economy slows significantly, this would dampen the demand for commodities, smothering the key element of inflation. Lower inflation is music to the ears of bond investors, and they command lower yields as a result.

Bond investors also have a renewed interest in the quality of bonds. Integral to this assessment are the ratings assigned to corporate bonds by agencies such as Moody's, Standard & Poors and Fitch. Recent rating downgrades of both General Motors and Ford sent many money managers scurrying into a safer investment haven, with Treasuries a recipient of some of that money.

Repositioning by traders who were caught flat-footed as bond yields declined has also had an effect. With traders stampeding into Treasuries to cover their losses, this accelerated the decline in yields, particularly as the 10-year Treasury note neared 4 percent.

The declining yields have come despite the Fed's efforts to talk up long-term interest rates, such as Alan Greenspan's remarks about the "conundrum" of low long-term rates in the face of repeated increases in short-term interest rates. Lately, the talk has taken on a more-ominous overtone for homeowners and home buyers, with the Fed sounding repeated alarms about the speculation in the housing market. Greenspan mentioned the "froth" of the housing market and the likelihood of local housing bubbles. On May 27, Fed Governor Roger Ferguson said, "However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently."

But some titans of the bond world think yields could go even lower.

Bill Gross, managing director of Pacific Investment Management Company and the manager of the world's largest bond fund, had forecast in his widely read Investment Outlook that a range of 3 percent to 4.5 percent on 10-year Treasury notes would be seen over much of the next three to five years.

Morgan Stanley's chief economist Stephen Roach wrote, "At some point over the next year, I wouldn't be shocked to see yields on 10-year governments test 3.5 percent."

Declining long-term interest rates are pushing fixed-mortgage rates lower. The average 30-year fixed-rate mortgage has declined by one-half of a percentage point since March 23, from 6.15 percent to 5.65 percent. In turn, the housing boom continues as strong as ever, underscored by low mortgage rates. Until those rates increase in any appreciable fashion, the Fed's concerns about low rates fueling local housing bubbles are falling on deaf ears.
 
AP
Greenspan Can't Explain Rates Divergence
Monday June 6, 10:36 pm ET
By Martin Crutsinger, AP Economics Writer
Greenspan Can't Explain Easily the Unusual Divergence of Short-Term and Long-Term Interest Rates


WASHINGTON (AP) -- Federal Reserve Chairman Alan Greenspan said Monday he does not have a good explanation for why long-term interest rates have been falling at a time when he and his Fed colleagues have been raising short-term rates.



Greenspan called the pronounced decline in long-term interest rates over the past year at the same time the Fed was boosting short-term rates "clearly without recent precedent."

Speaking by satellite to a monetary conference in China, Greenspan rejected the suggestion that U.S. rates have been held down by a massive flow of foreign investment from such countries as China. He said a recent Fed study found that foreign purchases of U.S. Treasury notes have had only a "modest" impact on U.S. interest rates.

Greenspan's comments marked his most extensive remarks on the conflicting movement of interest rates since he called the persistence of low long-term rates in the face of Fed credit tightening a "conundrum" in February.

The Fed has boosted a key short-term rate, the federal funds rate, a total of eight times since last June 30, moving it up in quarter-point increments from a 46-year low of 1 percent to its current level of 3 percent.

But over that same time period, Greenspan noted, the yield on Treasury's benchmark 10-year note has fallen from around 4.8 percent a year ago to around 4 percent currently. The yield on the 10-year Treasury note dipped again Monday to 3.95 percent.

Greenspan said the continued decline in long-term interest rates has not been a development just in the United States but in many other countries around the world.

"Long-term rates have moved lower virtually everywhere," Greenspan said, noting that in many major economies the declines have been more pronounced than in the United States.

He said access to credit has even improved for many developing nations, noting bond sale success stories in Mexico and Colombia.

Greenspan said a number of explanations have been advanced for what he called "this remarkable worldwide environment of low long-term interest rates." But in examining the various explanations, Greenspan said, none of them seemed satisfactory.

He noted that some economists had advanced the idea that the large accumulation of holdings of U.S. Treasuries by foreign governments such as China had "doubtless" helped to lower rates on long-term U.S. Treasury securities. But he said a Fed study estimated that this impact was still "modest" given the overall size of the U.S. Treasury market.

Another explanation -- that the decline in long-term rates is signaling economic weakness ahead -- could not explain why rates continued falling in areas of the world even when other indicators were signaling strength, the Fed chief said.

Greenspan said the need of pension funds for increased investments as baby boomers near retirement or the fact that global financial markets have become more closely linked were not adequate explanations either.

"The economic and financial world is changing in ways that we still do not fully comprehend," Greenspan concluded.

In his comments, Greenspan also included a warning to operators of large hedge funds, investment vehicles for wealthy individuals, saying that most of the "low hanging fruit of readily available profits has already been picked."

He said hedge fund managers who feel driven to continue pursuing above-average returns may encounter risks to their investments that will result in setbacks for the hedge fund industry.

"Consequently, after its recent very rapid advance, the hedge fund industry could temporarily shrink and many wealthy fund managers and investors could become less wealthy," Greenspan warned.

But he said that as long as banks and other lenders to hedge funds manage their own credit risks effectively, "this necessary adjustment should not pose a threat to financial stability."

Greenspan, who in recent comments has said a move on the part of China to a more flexible currency system would benefit China and the global economy, did not specifically address that issue in his prepared remarks.

But he did say, "The recent emergency of protectionism and the continued structural rigidities in many parts of the world are truly worrisome."

That comment could be viewed as criticism of proposed legislation in the United States that would impose across-the-board tariffs on Chinese goods if China does not revalue its currency. The same remark could also be a veiled attack on China's continued refusal to move to a more flexible currency system and the failure of European governments to introduce more flexibility into their labor markets.
 
France and Netherlands' rejection of the new European Union constitution set the U.S. up for a stronger dollar and lower interest rates. Here's why.

By Jim Jubak

Thanks, Europe. The U.S. dollar, U.S. interest rates and the U.S. housing boom needed that.

The recent very loud "No" votes (actually "Non" and "Nee") in France and the Netherlands against the proposed new constitution for the European Union make it likely that, for the next six months at least, the dollar will continue to rally against the euro, interest rates on the U.S. 10-year Treasury bond will stay stuck below 4% and, with interest rates on mortgages so low, the housing boom will keep on booming.

Let me explain why a vote so far away on an issue that so few U.S. investors or homeowners care about will turn out to have such an impact on our lives.

First, the facts
On Sunday, May 29, the French voted 55% to 45% to reject the proposed new constitution for the European Union. The following Wednesday, June 1, Dutch voters rejected the constitution by an even wider 62% to 38%. In order to take effect, the document had to be ratified by all of the European Union's 25 current members. Now those efforts are being shelved.

This doesn't kill the European Union, by any means. The Treaty of Nice, which was the legal basis for decision-making in the union before the vote, remains in force. The euro remains the European Union's joint currency, and the European Central Bank remains in charge of the union's monetary policy and interest rates.



Second, the emotions
To understand the financial shockwaves set off by the vote, you have to look at the emotions that fueled opposition to the constitution. In France, the vote was a protest against an already slow economy. The French economy is projected to grow by just 1.4% this year, according to the Organization for Economic Cooperation and Development, and unemployment is running at 10.2%.

But many of those who voted "No," according to exit polls in France, also feared that closer integration of the French economy into the European Union under the proposed constitution would give bureaucrats in Brussels and bankers in Frankfurt the power to impose what is known in France as the "Anglo-Saxon model."




Many economists favor applying some -- or all -- of that model to France in an effort to increase economic growth and productivity. But most French workers see this "reform" as an excuse to cut vacation hours, lengthen the work week, cut social and unemployment benefits, and open up the French economy to an influx of cheap workers from the new, less-developed Eastern European countries that have just joined the European Union.

Third, the blame
In this atmosphere, the referendums in France and the Netherlands -- where opinion polls show that Dutch voters shared many of the fears of the French -- turned out to be less votes on the proposed constitution than votes on the sitting governments in those countries and on the monetary policies symbolized by the euro.

In France, the government of President Jacques Chirac got blamed for the worst of both worlds. It was the Chirac government's fault, everyone in France agreed, that the economy was growing so slowly and there were so few jobs. And no one gave the government any credit for the few halfhearted steps it had taken toward reforming the economy by trying to cut spending on social services and reducing the number of jobs (and wages) in the public sector. To economic reformers, the steps were too tentative to improve the economy's performance. To most of the French work force, these small steps were too much, since they were just the opening of a campaign to turn French workers into American-style wage slaves.

But not all the blame stuck to domestic politicians. In the Netherlands and France, the European Central Bank and its currency, the euro, drew a good share of the anger. A third of Dutch voters cited opposition to the euro as their reason for voting against the constitution. The Dutch guilder had been undervalued in the currency conversion, and that had led to higher prices for Dutch consumers and an economic slowdown, voters told exit pollsters.

Fourth, the fallout in Europe
The "No" votes in France and the Netherlands seriously weaken the governments of those countries. In the aftermath of the vote, Chirac almost immediately fired his prime minister. But the new prime minister, Dominique de Villepin, has a reputation as a distant aristocrat, and this shuffling of deck chairs isn't likely to reverse the current government's unpopularity. That makes the Chirac team very, very unlikely to propose any measures that would further alienate voters. And this weakened government is extremely unlikely to pay any attention to pressure from the European Central Bank to control spending or cut its deficit.

Which wouldn't be so much of a problem for the European Union and the euro if the French weakness wasn't duplicated in so many of the economies of the countries that made up the core of the pre-expansion union. Germany is growing even more slowly than France. Economic growth in Germany is forecast at 1% for 2005, and its unemployment rate is 12%. The country's ruling party has just lost an important state election that throws its future into doubt. The Italian economy is not only growing slowly, with 2005 growth estimated at just 0.5%, but the government of Silvio Berlusconi doesn't have much room to maneuver. In 2003 and 2004, the country's budget deficit exceeded the European Union's guidelines calling for a deficit of less than 3% of GDP.

It's pretty clear what will give first in Europe. Cutting spending to keep deficits to the European Union guidelines is out the window. Even before the referendum on the constitution, the Chirac government had thrown in the towel on this one by announcing a "special" supplementary increase in wages for government workers. The pressure to spend, even if it means busting the budget, is likely to be irresistible.

So now, the betting is on for when the European Central Bank will cave and abandon its inflation-fighting first take on setting interest rates. The bank has kept its short-term interest rate at 2% for the 12 countries that adopted the euro even as economic growth slowed. At its regular rate-setting meeting June 2, the bank lowered its growth forecasts for the euro-zone economies to 1.4% in 2005 and 2% in 2006, but left short-term interest rates at 2%. Now the financial markets are sensing an interest-rate cut is in the winds.

The justification for that 2% rate has gradually slipped away as the bank's projections for inflation have declined. The June 2 forecast calls for inflation of 2% this year and just 1.5% in 2006. That latter figure is well below the banks' stubbornly defended target of 2% inflation.

Finally, what this means here in the U.S.
Financial uncertainty in the European Union pushes the U.S. dollar higher and U.S interest rates lower. Let me count the ways.
A European interest-rate cut would increase the spread between U.S. short-term rates, now at 3.25%, and European rates at 2%. That would help the dollar and increase demand for U.S. Treasury bonds. That increased demand should drive U.S. bond prices higher and yields on those U.S. bonds lower.


Slower growth in the European Union increases the likelihood of a euro-zone rate cut. (See No. 1 for the effect.)


Budget-busting by European governments pushes more euro-denominated bonds onto the market. More supply usually leads to lower prices. And nobody wants to hold euro bonds if they're about to lose value.


Uncertainty about the euro -- you can even find articles speculating about the death of the euro in the European financial press -- reduces demand for euro-denominated financial assets among the Asian central banks that had been looking to diversify out of U.S. dollars. (By the way, I think the euro is here to stay, and the speculation about its demise is exactly what you'd expect in the first aftershocks of these "No" votes.)
All this leads to a stronger dollar and lower interest rates in the U.S.

Not maybe by a whole lot. With the dollar having retraced seven months of declines against the euro, I'd expect the pace of the euro's decline to gradually slow over the next few weeks. If this move is like most currency moves, history suggests that with the dollar up 11% year to date, the rally is likely to take the U.S. currency up another 4 points against the euro. The huge U.S. trade deficit, which weighs on the dollar in the long term, hasn't gone away. Interest rates on 10-year bonds in Europe are now about 3.5%, in the U.S. they're 3.9%. That's not the kind of huge gap that leads to another big leg down in U.S. interest rates as investors snap up higher U.S. yields.

But the stronger dollar and lower rates could possibly be here for quite a while. While that gap between U.S. and European 10-year yields may not be big enough to trigger a further big decline in U.S. long rates, it is enough to keep U.S. rates down at current levels. Especially if you add in uncertainty's effect on the euro.

Some economists are beginning to argue that the reason U.S. 10-year rates are so low despite eight interest-rate hikes by the U.S. Federal Reserve is because the world's financial markets are awash in savings from Asia. With all that money looking for safety, U.S. Treasurys at 3.9% look pretty good.

Everything that happened last week in Europe just made them look even better. And I think we're looking at a six-month period while Europe recovers its confidence after those "No" votes.

If U.S. interest rates stay below 4%, is it safe to stop worrying about a housing bubble? That’s the topic I’ll explore in my next column.
 
Extra
The overlooked $2.3 trillion deficit



If the government were held to the same standards as public companies, its accounting methods would make Enron's misdeeds pale in comparison. Here's how they obfuscate the truth.

By Scott Burns

Let me be circumspect: Government accounting is vile garbage. It understates the true federal deficit by a staggering $2.3 trillion, an amount equal to the total market value of the 10 largest companies in America – General Electric (GE, news, msgs), Exxon Mobil (XOM, news, msgs), Microsoft (MSFT, news, msgs), Citigroup (C, news, msgs), Wal-Mart (WMT, news, msgs), Johnson & Johnson (JNJ, news, msgs), Pfizer (PFE, news, msgs), Bank of America (BAC, news, msgs), IBM (IBM, news, msgs) and Intel (INTC, news, msgs).

Blessed by historical habits that have no relationship to what our government does today, our legacy of cash accounting now serves to mislead and confuse. The April issue of Economic Indicators, a publication prepared by the Council of Economic Advisers, for instance, projects a unified budget deficit -- the one that lumps the Social Security surplus in with the rest of government -- of $427 billion. (New reports this week that we may be on track for a smaller deficit don't change the fact that the accounting methods are misleading. We'll stick with the $427 billion figure until they make the new estimate official in midsummer.)

The $427 billion deficit, however, is a massive understatement of our true deficit. The real deficit is $2.3 trillion larger. That's more than five times the publicly discussed $427 billion figure -- but it never enters public discussion.

If the executive branch of government were held to the standards of Sarbanes-Oxley, it would be on a fast track to a criminal trial. We would forget about Ken Lay because the crimes at Enron are mere rounding errors compared to what our government does.

A bipartisan problem
Some readers will expect a diatribe against President George W. Bush to follow.

It won't.

This is a bipartisan problem. Both the Democrats and the Republicans, in or out of office, have been using accounting methods that are, at best, quaint and, at worst, criminal. And they have been doing it for decades.

You can understand what's going on by comparing our government to a large corporation like General Motors.

When General Motors (GM, news, msgs) files its annual report, it must report on the condition of its pension fund and other obligations to current and retired workers as well as its profit or loss. If the pension liabilities -- the retirement benefits it has promised workers -- exceed pension-plan assets by more than a certain amount, General Motors must make contributions to the pension fund, reducing its profits. The two, profits and pensions, are deeply linked. General Motors also has substantial health-care obligations to its retired workers.

Sound familiar?

Our government is in a similar position -- but with a lot more zeros on the numbers it uses. It reports its annual profit and loss as a surplus or a deficit. Separately, it reports on its long-term pension, disability and health-care obligations. Unlike General Motors, however, the government doesn't include these figures in the annual statements of surplus or deficit.

The buried details
You can find them only in the trustees' reports for Social Security and Medicare.

The 2005 reports (each over 200 pages) show the programs to be underfunded by a total of $33.7 trillion (in today's dollars) over the next 75 years. That's four times the $8 trillion in formal debt shown in regular government accounting.

You learn still more when you compare the 2005 reports with the reports from 2004. In 2004, the combined unfunded obligations of Social Security and Medicare were $31.4 trillion.

That's an increase of $2.3 trillion in a single year. The trustees' examination of the plans over a longer time period, termed the infinite horizon, shows an even larger change, $7.2 trillion (see table below).

But let's not look so far in the future. Let's stay with the traditional (if inadequate) 75-year measure, that $2.3 trillion. It isn't mentioned in other government documents. It is missing from Economic Indicators. Indeed, it is absent from virtually all discussion of the federal budget -- the one currently estimating a piddling deficit of $427 billion for fiscal 2005.

The overlooked $2.3 trillion deficit*
Program 75 years Infinite horizon Difference
Social Security $4.0 $11.1 $7.1
Hospital Insurance $8.6 $24.1 $15.5
Part B (from general revenues) $12.4 $25.8 $13.4
Part D (from general revenues) $8.7 $18.2 $9.5
Total $33.7 $79.2 $45.5
Comparable total, 2004 $31.4 $72.0 $40.6
Year over year increase $2.3 $7.2 $4.9

*All $ figures in trillions.
Source: 2004, 2005 trustees' reports for Social Security and Medicare.

The unfunded liabilities measure the value, in current dollars, of the amount by which promised benefits exceed expected tax collections. In all three Medicare programs, the financing gap will grow year by year during the 75-year period. It will continue to grow after the 75-year period traditionally used by the trustees of Social Security and Medicare.

Until more accurate figures are presented, neither party knows what it is talking about or where the country is going.
 
Contrarian Chronicles
Straight talk on what the Fed has wrought


Finally, the mainstream press is taking a look at the problems the Fed created with its cheap-money ways. The consequences will be very serious for all of us.

By Bill Fleckenstein

For once, there was a somewhat intelligent (though incomplete) discussion in the mainstream press about how the Federal Reserve bailed out the stock bubble with a real-estate bubble.

I am referring to a page-one story in Thursday's Wall Street Journal headlined "In Treating U.S. After Bubble, Fed Helped Create New Threats." To quote its author, Greg Ip, who is thought to be plugged into the Fed:

"Five years after the stock market's peak, the economy faces other threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed's post-bubble prescription bears some responsibility for all three."

Fed officials acknowledged as much to Ip, but they insisted the alternatives were worse, including a deeper recession and the risk of deflation.

The Fed's response is both true and false. True: The alternatives will be worse, because all the Fed did was to postpone them, guaranteeing that they will be more severe than they would have been then. False: We would have been far better off accepting the harsh medicine from the biggest stock mania in the history of the world, rather than creating gargantuan amounts of debt at the consumer level -- and in the financial system -- in the form of real-estate loans.

A gazette gets it wrong
The article and the Fed argued from a false premise to a false conclusion, by blaming the American bust of the 1930s and the one in Tokyo in the 1990s on monetary tightening: "Faced with an asset bubble, a central bank has two choices: Prick it early or wait for it to burst and try to contain the damage. The Fed in 1929 and the Bank of Japan in 1989 tried the first route, raising interest rates in response to rapidly rising asset prices. The result in the U.S. in the 1930s was depression and deflation. In Japan it was stagnation and deflation that continues today."

That is completely untrue. The aftermaths of both were caused by the preceding asset bubbles, precipitated by reckless monetary policies. It is asset bubbles that create the damage, not the small amount of tightening that comes at the end. In fact, I would argue that the tightening didn't end those bubbles. Exhaustion ended them, and the tightening was coincident with the exhaustion phase.

Policymaking is the perpetrator
The trouble that ensues from a bubble is historical fact, but part of what makes the aftermath better or worse than you might expect are policy decisions. Part of what put "Great" into the phrase "Great Depression" were events that came after the bubble, such as 1930's Hawley-Smoot Tariff Act and the policies of the Hoover administration. I would also note that the inflexibility of the gold standard made "printing" our way out impossible

Similarly, Japan's problems were exacerbated by the failure of its brand of "semisocialist" capitalism to allow markets to clear. Japan tried to prop up zombie companies for far too long, which, in part, has made its recovery process so slow. Bad debt in the banking system, emanating primarily from the Japanese real-estate bust, also exacerbated the country's problems.

We don't know what policy mistakes we're going to make next. I would argue that we've made a policy mistake by bailing one bubble out with another, debt-inspired, bubble. And, when the fallout from these two hit, it will be made better or worse by subsequent government actions. Of course, once you know it's a government action, it's almost certain that it will make matters worse.

Federal Reserve Bank of Frankenstein
The Fed only postponed the pain, ensuring that it will be dramatically worse. Easy Al and the other apparatchiks at the Fed embarked on a grand experiment with the American economy and everyone's lives. Historian Edward Chancellor, author of the terrific history of financial speculation "Devil Take the Hindmost," makes the same point to Ip:

"The Fed is conducting a 'crucial experiment' in post-bubble monetary policy. We don't know what the outcome is yet."

I would say that we can speculate on how ugly it's liable to be.

The Fed chose not to address the stock bubble, choosing instead to bail it out with a real-estate bubble. When the stock bubble was in full bloom, as I have noted many times, rather than even hint that there might be a problem or raise margin requirements, Greenspan got behind the bubble and cheered it on with all his "new era" cooing and "productivity" pompoms. His behavior led many to suggest that the market, in fact, had a Greenspan "put" underneath it.

One of the incorrect points of Ip's article is that, gee, this housing bubble is great because it bailed out the stock bubble. Though he raises the specter of our problems, he doesn't connect the dots as to how catastrophic the consequences are liable to be.

Fed complicity gets publicity
Although I have just criticized Ip and the Journal for not coming to the conclusions I would have liked, I think that getting the discussion into the mainstream press is useful. So is Ip's ability to illuminate the "thinking" behind the Fed's bubble-management practices: "Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges."

You can see that they're still delusional. They think that what they've done has worked; that somehow, job creation and incomes will be able to grow enough to support this tremendous increase in home prices. It isn't going to happen that way.

The housing market is in a bubble. Housing prices have gone up because housing prices have been going up, i.e., rising prices create more demand from speculators. At some point, however, the market will exhaust itself. Time magazine's recent cover, "Home $weet Home: Why We're Going Gaga Over Real Estate," means to me that the moment of exhaustion is circa now. And we should be on red alert for signs of trouble in the housing market.

Incompetence outed
I believe that the more the present situation is understood, the more it's liable to foment angst and panic when, as I noted in "GM's woes one more blow to housing bubble," the next time down eventually unfolds. Lastly, in my personal-pet-peeve department, recognition of where we are will also hasten recognition of the irresponsible, incompetent record of the Greenspan era.
 
Jubak's Journal
Why we were so wrong about 2005


The economic predictions for this year have thus been way off base. But they may end up simply being very, very early.

By Jim Jubak

Remember how 2005 was supposed to turn out?

At the turn of the year, a consensus of economists, prognosticators, market gurus and various experts without a portfolio -- I'm in one or the other of those categories, I think -- predicted that in 2005 the dollar would fall, long-term interest rates would rise, economic growth would slow and the bond market would tumble.

Halfway through 2005, how could we all have been so wrong?

I don't think the year's second half will redeem that record. To me, it now looks like what the consensus predicted for 2005 has been pushed into 2006, and maybe even the second half of 2006 at that.

Wrong, wrong, wrong and wrong, which is an extraordinary record if you remember how clear the long-term trends looked at the year's start. The federal deficit was stuck at high levels and set to go higher, thanks to a future avalanche of costs that included fixing the alternative minimum tax, Social Security and private pension plans. The trade deficit was at historic levels and creeping higher with no end in sight. Commodity costs were rising around the world, with soaring oil prices a key culprit, threatening to slow economic growth. The Federal Reserve was determined to raise short-term interest rates until they reached a neutral position at roughly 3.5%.



The pesky lag problem
I still think the chickens -- big budget deficits, huge trade deficits and crushing consumer debt -- will come home to roost. The dollar will fall, interest rates will rise and the economy will stumble -- just later than everyone predicted. The predictions made at the beginning of 2005 were a victim of lag, one of the worst problems in economic forecasting. Economics is relatively good at telling us what should happen next, but it's downright awful at telling us when next is. For example, if consumers keep borrowing more and more to spend more and more, at some point, economics says, the debt pyramid will come crashing down. But is "some point" the second half of 2005, 2006 or 2010?

If you study that nature of the lags that derailed the predictions of January 2005, that "some point" looks likely to be 2006. Maybe mid-2006.

Consider the mess that has swallowed the euro in the last few months. Slowing economic growth in Europe -- slower than in the United States, for sure -- and lower interest rates had taken a 5% bite out of the euro by the end of March. And then came the dustup as French and Dutch voters said "no" to a new European Union constitution. Knock another 5% off the euro.

And what has been bad for the euro has been good for the dollar.

It's not so much that the dollar looks so much better than it did in January. The United States still faces huge budget and trade deficits. In fact, the April trade deficit climbed to $57 billion after the monthly deficit had dropped to a revised $54 billion in March. But some of the fear that Asian banks would start dumping their dollars to buy euros has dissipated now that so much uncertainty swirls around the euro.

We haven't yet seen a peak in worry about the euro, either. With a good chance that next week's European Union summit will end in bitter fighting between British Prime Minister Tony Blair and French President Jacques Chirac, and that the government of Germany's Gerhard Schroder faces defeat in elections scheduled for the fall, it's hard to see the political turmoil that's now driving the euro's decline ending before the fourth quarter. BNP Paribas now sees the euro falling to $1.16 by the third quarter from the current $1.22, before it begins a recovery to $1.28 by the first quarter of 2006. That seems a reasonable scenario, especially if the Federal Reserve keeps raising short-term interest rates in June and August to 3.5%, and the European Central Bank finally cuts interest rates to revive economic growth. Higher U.S. interest rates compared with those in Europe would support a stronger dollar.

Of course, a strong dollar, which hurts U.S. exports, and higher interest rates at home, which damp domestic spending, do add up to lower economic growth in the United States. Not all at once. And not by a huge amount. But the drop from 4% growth in the third quarter of 2004 to 3.8% in the fourth quarter to 3.5% in the first quarter of 2005 does put the economy on a path that leads to growth nearer 3% by 2006.

The role of globalization
The big wild card in predicting anything about the economy these days is long-term interest rates. When the Federal Reserve raises short-term interest rates, long-term bond rates are supposed to climb. Historically, a two percentage-point climb in short rates, for example, has led to a one-percentage-point climb in long-term rates. This time around, however, the Federal Reserve has raised its target for short-term rates by two percentage points -- to 3% from 1% -- in the last year, but yields on the 10-year Treasury note have tumbled to 3.9% from 4.7% in June 2004.



If you go back to the predictions made at the beginning of 2005, the consensus was that short-term interest would hit 3.5% or so by the end of the year. That looks about right, with Alan Greenspan signaling last week that the Federal Reserve will raise rates at the end of June and in early August.

But predictions that long-term rates would hit 5.5% or even 6% by the end of 2005 stand to be dead wrong.

The globalization of the financial markets has changed the way U.S. interest rates respond to rate moves by the Federal Reserve. Look at one popular trade now: Borrowing in Asia, where interest rates are even lower than they are in the United States, and then investing the proceeds in the U.S. bond market. It's pretty profitable when the overnight U.S. dollar LIBOR rate is at 3.03% and the Japanese LIBOR stands at 0.03%, as it did on June 9. (LIBOR, the London Interbank Offered Rate, is available only to the most creditworthy of international banks. But it's often the base rate used in calculating the yield on other loans, so it gives a good idea of the spread.)

Asia is awash with cash now, thanks to high savings rates and huge cash inflows from international trade surpluses. (That's the other side of the U.S. trade deficit.) This keeps interest rates low in these markets, and the huge movements of cash across international borders works, for now, to push U.S. interest rates lower. Add in global demand for long-dated bonds, as private and public pension funds try to match their investments to their obligations to rapidly aging populations, and you start to get a possible explanation for the puzzle of rising short rates and falling long rates.

The euro is making the dollar look good
What remains especially unclear now is what role expectations for an economic slowdown play in keeping long-term interest rates relatively low around the globe. That's a traditional interpretation of low long-term bond yields: When investors think the economy is about to slump, which will drive down the demand for money and consequently lower the interest rates borrowers are willing to pay, they buy today's bonds with today's higher yields in anticipation of tomorrow's lower interest rates. This has the effect of driving down today's rates, as well. But Greenspan recently told Congress that, this time, lower long-term yields may not be a signal the bond market is anticipating an economic slowdown. May not be. In other words, he doesn't know, either.

The argument at the beginning of 2005 for a weaker dollar and higher U.S. interest rates was based, in good part, on a belief that international investors were becoming gradually unwilling to hold an ever-increasing supply of U.S. dollars. That unwillingness started to show up earlier this year in announcements from Asia central banks that they were thinking about reducing their portfolio concentration of dollars in favor of other currencies.

Haven't heard much talk like that since the euro's political crisis, have you? My best estimate now is that we won't see a significant upward trend in the yield on the U.S. 10-year Treasury until 1) the euro stabilizes and then starts to climb again versus the dollar, and 2) the spread between the yield on the 10-year and two-year Treasury note vanishes. Today the 10-year yields 3.9% and the two-year yields 3.6%, which is an extraordinarily small spread. It's likely explained by the global need by pension funds for long-dated paper.

The key question
But I have to question how willing investors will be to take on eight more years of risk if the spread closes to 0.2 percentage points or vanishes completely. When short-term rates exceed long-term rates, it's called an inverted yield curve. The bond market traditionally gets very nervous when the yield curve inverts because it has often signaled bad times ahead. There are still enough traditionalists in today's bond market to put the brakes on falling long-term yields when we get close to an inverted yield curve.

Where does that leave investors?

The predictions from the beginning of 2005 that look so wrong today are likely to still look wrong for the next six months: The dollar is likely to be strong for a while longer, interest rates don't look headed up at the long end, the bond market is more likely to move up than down and economic growth will remain solid.

But as we move into 2006, those predictions from early 2005 are likely to seem more and more correct. The trends set by the economy, interest rates and currencies so far this year are closer to their end than to their beginning. And many of the strategies that have made money in the first half of 2005 will look increasingly risky as the year's second half plays out.

In other words we market prognosticators weren't wrong in January 2005. We were just very, very early.
 
The greenback's big rally against other currencies has proven Warren Buffett -- and other dollar bears -- wrong. Here's what Buffett missed.

By Jon D. Markman

Six months ago, the value of the U.S. dollar was on the firing line as it plunged to a record low vs. the euro. Amid fears that a united Europe would surmount the spendthrift United States as a safe haven for financial assets in a tumultuous world, investors worldwide -- lead by noted Nebraska sourpuss Warren Buffett -- heaped scorn on our currency and scolded U.S. lawmakers to get the federal deficit under control.

But a funny thing happened to all those dollar bears. Their contempt for U.S. economic freedoms hasn’t amounted to a hill of bill of beans, and their positions have been smoked. The dollar has rallied massively since the start of the year against all other currencies, reflecting a swift, stunning paradigm shift in the way that global political risks are priced.

Buffet, who reportedly lifted his bet against the buck to a position of $22 billion and counting in the first quarter this year, isn’t sounding quite so smug anymore. Normally an equity investor with liberal social views who rarely made forays into the foreign exchange markets, he has had his head handed to him by more experienced currency players. Although his anti-dollar attack worked from 2002 through 2004, since then he has been forced to pay for attempting to mix politics and money.

Berkshire investors suffer
An uncharacteristic earnings growth setback at his Berkshire Hathaway (BRK.A, news, msgs) conglomerate in the first quarter was attributed to this wrong-way wager against the greenback in favor of other currencies -- including the euro, Swiss franc, Australian dollar and British pound. The second quarter is concluding with an even worse tone for the position. It’s not fair to assume that the dollar’s rally will continue, but it has shown typical American scrappiness in its comeback against doomsayers and ill-wishers.



Is Buffett likely to be proven right anytime soon, or will his investors continue to suffer from his bearish posture toward the buck? It all depends on your view of the relative strength of U.S. and European economic policies and political structures.

Buffett has told shareholders that he took his original position based on a belief that Bush policies had led to unsustainable twin deficits in the federal budget and the balance of our trade with the world. But guess what? Due to improved tax collection, higher payroll earnings, a modest decline in overall government spending and better-than-expected corporate earnings, estimates of the U.S. budget deficit are steadily on the decline. The 12-month federal deficit has narrowed to $339 billion, or 2.8% of GDP, according to Ned Davis Research. Receipts have been growing twice as fast as spending over the past 12 months, as both corporate and individual tax contributions have been stronger than estimated.

Although the cutback in spending presents our economy with a fiscal drag, the result has been a positive reassessment of Americans’ focus on getting their house in order.

Good news grows
This week, more uplifting economic news appears to be in store. Economists at ISI Group report that their proprietary weekly survey of corporate results in key sectors are trending much higher than they expected, with particular strength from retailers, restaurants and car dealers. Auto production is much higher on the heels of new incentive programs, and consumer confidence has reversed its decline and is now trending up.




Much of the strength has resulted from the continuing boom in new-home sales. And these sales are themselves a function of the improvement in the bond market that has lowered bond yields, and thus mortgage costs. As for the trade deficit, here’s a shocker: U.S. exports were actually up 13% year over year in April. We may be on the verge, in other words, of a virtuous cycle that could push U.S. GDP growth back up to the 3% level this quarter.

At the same time, Europe and Asia continue to falter. As ISI analysts pointed out, the past week’s news brought word of weaker French industrial production; diminished European corporate finance executives’ confidence; the worst Australian business expectations in 14 years; a setback in Swedish industrial production; and weaker retail sales, home prices and consumer confidence in the United Kingdom. There are also new reports of a cool-down in Chinese imports, exports, home construction, manufacturing growth and leading economic indicators.

For an exclamation point at the end of this scenario, foreign-currency bears point to a 26% decline in scrap-metal prices last week and another 10% plunge in the Baltic Freight Index, which measures demand for ocean shipping.

A country’s currency can be considered in a way to be analogous to a company’s stock. When central banks and trading partners are positive on a country and its ability to be an effective store of value, they simultaneously buy its currency and sell the currency of other countries. When they believe that a country’s ability to pay its debts is eroding, either due to loss of vitality or inflation, then they sell the currency.

The bottom line now is that, according to Bloomberg data, holdings of U.S. government debt by international investors and central banks rose by $93.2 billion, or nearly 5%, to $1.9 trillion last quarter. As the dollar has risen in value, it has helped foreign investors retain the value of their U.S. assets. The dollar’s strength has also kept inflation down -- further preserving the value of bonds’ coupon payments.

Our recent confluence of happy events -- stronger dollar, higher U.S. bond prices, lower bond yields and lower inflation -- has further widened the gap between our economy and that of the disorganized, disrupted and disturbed Europeans. The benchmark 10-year Treasury bond now yields about 90 basis points more than its German equivalent. The average of the spread between the two over the past decade has been 14 basis points, or 0.14 percentage points. To give you some perspective, 10 months ago -- before the recent U.S. presidential election -- there was no difference in yield at all as anti-American paranoia and panic gripped the world’s bond traders.

All of this bodes well for the ability of the U.S. to attract the foreign investors who buy our debt and fund our success. Already, foreign banks and pension funds, most notably in China, Japan and South Korea, own nearly 50% of all the U.S. Treasurys that have been issued, or about $1.9 trillion. And the more they want to buy, the lower the yields will go -- supporting further gains in interest-rate sensitive sectors, such as the U.S. homebuilding industry.

The Euro factor
At the end of the day, all decisions to buy and sell things are made at the expense of some other thing. In the case of the dollar, that other thing is a currency in Europe that may simply not exist five years from now. Influential Italian politicians have begun calling for a return to the lira, a majority of Germans polled say they would like to see a return to the deutschemark, and a leading British editorialist called the euro “a heroic project” whose ultimate failure has become more likely.

What Buffett and his cohorts failed to understand as they thumbed their nose at the dollar was that it’s impossible for Europeans to sustain a single currency without a commitment to a single European political and economic policy. And the liberal immigration laws demanded by such integration have proven to be social anathema, as northern Europeans have freaked out over the prospect of a flood of cheap Eastern European and Turkish labor stealing their good blue-collar jobs.

There will be no credible alternative to the dollar as a store of value until the Europeans decide they can live and work together in peace. While it is a noble and worthwhile goal, there is at least 300 years of recent world history to suggest that was an unlikely prospect.

For the foreseeable future, the greenback will continue to denominate, and dominate, world trade. And it is only a matter of time before Buffett announces he is returning to matters he understands better than world currency flows, like the value of Dairy Queen, See’s Candies and Coke.
 
The Street.com
There's no bond bubble, but beware utilities
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By Richard Suttmeier, RealMoney.com 6/16/2005

Contrary to what some pundits claim, there can't be a bond bubble in the markets now, because the rise in price for a bond is limited by the fact that the yield on a bond cannot go below zero.

A bond bubble did occur between 1981 and 1986, when yields were double-digit, because yields could have continued to go higher, as opined by Dr. Doom and Dr. Gloom (as First Boston's economist at the time and Solomon Brothers' Henry Kaufman were dubbed by the press), two well-known and oft-quoted economists of the day.

While rising yields now are not ending a bubble, I do see the potential for one arising in utilities, as expressed in the Dow Jones Utility Average ($UTIL). There is cause for long-term investors to be wary in both situations, being mindful of bubble lessons learned in both sets of assets.

The bond non-bubble
A bond bubble occurs when yields are extremely high and buyers are difficult to find. To illustrate a bond (or should I say, yield) bubble, consider the auction of $6.25 billion five-year notes in May 1984. The WI (when issued) note trades in the days before the auction rose in yield from 13.35% to 13.86% just as the auction took place. That's correct, the yield increased 50 basis points because buyers were scarce.



Then in the auction, the winning high-yield bid was up an additional 6 basis points to 13.94%. It seems that after this auction, the yield bubble ended and the bull market for bonds began. Back then, there was a boycott of Fannie Mae debt (sound familiar?), and a five-year Fannie Mae debenture was difficult to sell at 2.5% above the Treasury.

Risk/reward for U.S. Treasury yields
I have been warning that yields would fail their declines within what I call risky areas. I have advised that long-term investors fold up their laddered portfolios of fixed-income securities and invest in money-market funds and other short-term alternatives as the Federal Reserve keeps raising yields at a measured pace.

If you listened to Chairman Alan Greenspan last week, the measured pace of hikes in the fed funds rate is likely to continue through the summer, and the Beige Book should reflect that the economy has enough strength and inflationary pressures to merit continuing this posture. By Labor Day, your money-market funds should be returning 3.5%, so why take the risk of longer-term investments? Market Analysis
There's not a bubble in the bond markets now.


The fulcrum of overall volatility in the yield curve is the five-year, so watch its annual and weekly pivots.


The Dow Jones Utility Average signals that a bubble could develop in that group; beware a breakout above 377.47.



On June 3, yields reversed after the two-year failed at my quarterly resistance of 3.418%, and the three-year failed at my annual resistance of 3.45%. The 10-year stayed shy of my semiannual resistance at 3.75%, and the 30-year stayed shy of my annual resistance at 4.015%. The five-year ended this week still richer than my annual pivot at 3.878%, keeping yields within their risky area.

This week, the curve straddles weekly pivots at 3.765% on two-years, 3.764% on three-years, 3.791% on five-years, 3.979% on 10-years and 4.266% on 30-years, which is my overall neutral zone. The fulcrum of the overall volatility is thus the five-year, which is between my annual pivot at 3.878% and my weekly pivot at 3.791%. Outside this range is risk to monthly supports at 4.069%/4.09% on the two-year, 4.047%/4.118% on the three-year, 4.012%/4.155% on the five-year, 4.282% on the 10-year and 4.42 on the 30-year.

Bubbling utilities
These days, the Dow Jones Utility Average is flirting with a breakout above 375, a level not seen since 2000-01. This average was the last to peak during the stock bubble period at the beginning of the new millennium, and it appears this group will be the last to peak now.

The last time the DJU was above 375 was between September 2000 and July 2001. Then came the events of Sept. 11 and the Enron scandal, which caused the average to collapse into October 2002.

The utility average has been the best performer so far in 2005, up 11.4%, on energy speculation and the search for dividends. This momentum trade is fine if you are a trader and have a trailing sell stop, and are raising the stop as the utility index moves higher. If you are a long-term investor, beware the risks of five years ago. Don't repeat your mistakes.

Risk/reward for utilities
My model shows an annual pivot at 373.40, which has been tested at the high on May 2 of 374.28, and twice last week. The weekly chart profile is positive, with a rising 12x3 weekly slow stochastic and with last week's close well above its five-week modified moving average at 365.51. With my model indicating weekly resistance at 377.47, a breakout above that must be decisive. That would indicate potential for quarterly resistance at 386.29. Given this move, I would climb down the utility pole and raise even more cash.

Although energy prices can stay high, my model shows that the only two overvalued sectors are energy, at 5.7% overvalued, and utilities, at 3.7% overvalued. These sectors have thus become the latest momentum plays, and, in my judgment, are not for long-term investors.


Richard Suttmeier is president of Global Market Consultants and chief market strategist for Joseph Stevens & Co., a full-service brokerage firm located in lower Manhattan.
 
The price of oil remains at steep levels. The best way to play it is to find companies where sustained high prices will make costly new exploration and production pay off big.

By Jim Jubak

Has there ever been a more irrelevant OPEC meeting than this week's?

Oil ministers from the Organization of Petroleum Exporting Countries would love to increase supply, but they can't since the cartel is already pumping just about all the oil it can and production is well above the official ceiling.

Crude oil production isn't at the heart of the current problem anyway. Instead, the world is faced with a shortage of the kind of sweet grades of crude that oil refiners prefer and OPEC can't pump at the margin, and with a worldwide shortage of oil refining capacity. Globally, refiners are operating at 95% of capacity, compared to run-rates near 75% of capacity in the mid-1980s.

And the numbers that the OPEC meeting is most likely to move, the much-watched benchmark prices for oil, are the least important numbers to watch now anyway. Yes, the benchmark price for light, sweet crude futures for July closed at $55.50 a barrel Tuesday on the New York Mercantile Exchange, just slightly below Monday's close, which had been the highest closing price since April.

The important action is in other numbers now. I'm watching two in particular.

The key figures
First, there's the discount from its own benchmark price that OPEC gives to oil refiners. Back in October 2004, OPEC was offering oil traders and refiners a $14.20 a barrel discount for its benchmark Dubai crude. So even though the quoted market price for a barrel of light sweet crude oil was $51, the real cost to a U.S. oil refiner last October for a barrel of OPEC's heavier oil was $37.

In the months since then, that discount has gotten narrower until it's now just $2. So a U.S. refiner buying OPEC oil isn't paying $37 when the market benchmark is $51 but $50 a barrel when the market benchmark is $52.



That amounts to a huge price increase in the only kind of oil that's available to meet demand at the moment. And it's a sign that despite all its talk about being worried about high oil prices and the possibility that they might slow the global economy (and reduce demand for oil), OPEC is quite comfortable with oil prices above $50 a barrel. In fact, you might conclude that the cartel will do all it can to keep them at these levels until it sees real evidence of falling economic growth and lower demand for oil.

The second number I'm watching comes from the oil companies. The major oil companies are notoriously conservative in their forecasts of the price of oil and they use those projections in setting their exploration and production budgets. In spite of the huge run up in oil prices, oil companies have kept to projections in the upper $20s per barrel. That's one reason that oil exploration and drilling activity have been slow to pick up despite oil prices north of $50 a barrel.

Straying from the pack
On June 8, BP (BP, news, msgs) broke ranks. In comments in the House of Lords, BP CEO John Brown said that world oil prices were likely to remain above $40 a barrel until new supplies come on stream in three to four years. His figure is about two times the benchmark that BP has been using in its own internal planning for capital spending. And it's roughly $10 a barrel above the $30 figure that BP and other big oil companies have fingered as the support level for oil. The important thing here isn't whether Brown is right, but that BP and other oil companies are planning for a world of higher oil prices.

My conclusions for investors after putting these two numbers together: The oil stock rally still has more legs, and the best way to play it is to find companies where sustained high oil prices will make costly new exploration and production pay off big. Oil producers that are developing new supplies in areas where the risk and costs of production might have been daunting in a world of $30 oil are likely to be the big winners in a world where oil stays above $40 a barrel and quite probably above $50 a barrel.

I picked three stocks that fill this bill during my regular appearance on CNBC's "Morning Call."

The Libyan connection

Occidental Petroleum (OXY, news, msgs) was the big winner when Libya reentered the global oil market. Occidental, which had produced oil in the country for decades before sanctions were imposed, won the right to explore and produce oil on five of the 15 blocks let out for bid. Libya has proven resources of 40 billion barrels of oil, which puts it eighth in the list of global oil producers. So it's extremely likely that Occidental's exploration will pay off. Even better, Libya produces light, low-sulfur oil, a precious commodity now because just about all the extra production promised by OPEC will be harder-to-refine heavy oil.

This year Occidental should be able to increase production by about 3% over 2004, and that's before the company sees any oil from Libya. After reducing debt by $665 million in 2004, the company will see a $65 million reduction in interest expenses this year. Analysts call for the company to earn $6.96 a share in 2005. That'll turn out to be low by almost $1 a share. Add that surprise to the growing value of the production coming from Libya and you have a recipe for further stock gains. The shares also carry a 1.6% dividend yield. Our StockScouter rated the stock a 10 out of a possible 10 on June 15.

Bouncing back

Suncor (SU, news, msgs) had a truly terrible first quarter. A fire at its oil sands project cut production and squashed earnings: The company reported 21 cents (Canadian) for the quarter when Wall Street expected 37 cents (Canadian), and the stock plunged almost 15% in April's first two weeks.

But the stock has recovered as the company continues to make progress on its first major production expansion since 2002. The key for Suncor is the company's huge deposits of oil sands: The company estimates that its Athabasca sands hold a potential 11 billion barrels of oil. The price of oil dictates whether it makes sense to turn oil sands into oil. Below $25 the process isn't especially profitable. Above $30 the company really starts to earn money as the price leverage kicks in. And that's even with the rising cost of natural gas, which is used to heat the oil sands so they'll release oil. Even better, Suncor has its own deposits of natural gas, and the company believes it can reach self-sufficiency in natural gas.

Suncor should be back to full production of 225 thousand barrels a day by September, and the company projects that it can increase production to 260 thousand barrels a day by the end of the year. A major expansion, expected to cost $5.9 billion (Canadian) will take production up to 550 thousand barrels a day, better than doubling current production, by 2011 to 2013. Our StockScouter rated the stock a 9 on June 15.

Risk with reward

Imperial Oil (IMO, news, msgs) is for investors who'd like exposure to the high-risk, high-reward potential of Canada's oil sands, but would like it wrapped up in a conservative financial package.

Imperial Oil accounted for almost 20% of Canada's oil from oil sands production in 2004, and the company holds the lease on 460,000 acres of Alberta oil sands. That's a lot of potential oil production, if oil prices stay high, if oil sands processes scale efficiently and if higher natural gas prices don't wipe out profits. Balancing that risk is one of the oil industry's most productive cash flow machines. In 2004, Imperial Oil produced free cash flow of $1.3 billion, and that's after investing $1.1 billion in property, plants and equipment, after spending $700 million on stock buybacks, and after dishing out $264 million in dividends. The stock carries a dividend of 1.2%. About 70% of outstanding shares are owned by Exxon Mobil (XOM, news, msg




Encana (ECA, news, msgs) has been steadily increasing its risk profile by selling its older conventional oil and natural gas holdings and putting the money to work in riskier projects. Well, at least they'd be riskier for another company.

Encana has built a reservoir of expertise in tapping unconventional natural gas deposits that enable it to sell easy-to-access deposits to other energy companies at high prices and then use those funds to buy gas reserves that sell at cheap prices because most companies don't have the technology to tap into them. (In addition, Encana has sold some of its mature holdings in Western Canada at good prices because of the demand for fields with proven cash flows from Canada's energy trusts.) All this repositioning has left the company with a stronger balance sheet and a cash balance at year end of $602 million. It also has a collection of very high-grade fields that Encana has proven it has the technology to tap. Our StockScouter rated the stock a 9 on June 15.


Transocean (RIG, news, msgs) is my favorite play on oil drilling rather than oil production. (I added the stock to my online portfolio Jubak's Picks on April 26.)

With Transocean, investors get a driller leveraged to the deepest of deepwater projects, and that's where the growth is in exploration and production in the Gulf of Mexico these days. With few drillers adding new deepwater rigs, which would take a long time to get to market anyway since they take so long to build, Transocean can look forward to increased day rates well into 2006. In fact, the deepwater rig market is showing shortages in some production areas, such as the North Sea. With deep water rigs just about booked to capacity, oil production companies have started to push up utilization and day rates for mid-water rigs, too.

Wall Street analysts have started to boost their earnings estimates to $1.64 a share for 2005, up from $1.46 90 days ago, and to $3.44 for 2006, up from $2.51. But Wall Street is still underestimating how far oil prices of $50 or better a barrel will push up day rates for drilling rigs and how long that run will last. Our StockScouter rated the stock a 10 on June 15.
 
AP
Goldman Sachs Profit Dips, Estimates Off
Thursday June 16, 4:50 pm ET
Goldman Sachs 2Q Profit Dips, Misses Estimates; Outlook for 3Q Is Improving


NEW YORK (AP) -- Wall Street firm Goldman Sachs Group Inc. on Thursday reported a sharp drop in second-quarter earnings, missing analysts' estimates, but said the outlook for the third quarter was improving. Investors appeared encouraged by the comments about the current quarter and pushed its shares nearly 3.5 percent higher.



Chairman and Chief Executive Officer Henry M. Paulson Jr. blamed tough market conditions for depressing revenues in investment banking and trading in the quarter ended May 27.

But he added: "The economic outlook continues to be favorable, and our client franchise remains broad and deep, and we retain our leadership position in critical businesses."

David A. Viniar, the firm's chief financial officer, told a conference call with analysts that weaker credit and commodities markets as well as the flattening yield curve hurt second-quarter results.

"We remain optimistic that markets will catch up with performance in the economy, rather than the other way around," Viniar said.

Asked to predict third-quarter performance, he said: "It's a bit better. ... It feels like it's trending in the right way."

Goldman Sachs said that net income in the second quarter totaled $865 million, or $1.71 a share, down 27 percent from $1.19 billion, or $2.31 a share, a year earlier.

Net revenue for the quarter totaled $4.81 billion, down 13 percent from $5.51 billion a year earlier.

Analysts surveyed by Thomson Financial had projected second-quarter earnings of $1.87 a share on $4.96 billion in revenue.

The firm's competitors were less affected by the difficult trading environment. On Wednesday, Bear Stearns Cos. Inc. reported a 5 percent increase in second-quarter earnings on the strength of its institutional stock trading business. Lehman Brothers Holdings Inc. reported similarly strong earnings a day earlier.

Goldman Sachs shares rose $3.46 to close at $102.65 on the New York Stock Exchange. Bear Stearns advanced $1.75 to close at $103.09 and Lehman Brothers rose 27 cents to $95.71 also on the Big Board.

"UBS had a tough quarter, which is reflective of the stock's recent underperformance," Glenn Schorr, a banking analyst with UBS Investment Research, said in a note to investors. "But with a healthy backlog and an improving environment, investors will likely look ahead."

Schorr gives Goldman Sachs' stock a "neutral" rating.

Goldman Sachs' second-quarter results reflected drops in revenue in both the investment banking and trading divisions.

Net revenues in investment banking totaled $815 million, a 14 percent drop from the $953 million reported in the year-earlier quarter. Revenues from trading and principal investments were $2.81 billion, down 22 percent from $3.63 billion a year earlier.

Revenues rose in 27 percent in asset management and securities services, totaling $1.18 billion in the second quarter compared with $931 million a year earlier.

The company said it ranked No. 1 in global mergers and acquisitions and in initial public offerings. It said assets under management rose 18 percent from a year earlier to a record $490 billion.

Net income for the first six months of the year was $2.38 billion, or $4.65 a share, a drop of 4 percent from profits of $2.48 billion, or $4.81 a share, in the second quarter of 2004.

Revenue for the six months ending May 27 were $11.21 billion, down 2 percent from $11.44 billion in 2004.
 
AP
Crude Oil Surges to Record $59.18
Monday June 20, 4:11 am ET
By Gillian Wong, Associated Press Writer
Crude Oil Surges to Record $59.18 a Barrel in Asian Trading Over Supply, Demand Concerns


SINGAPORE (AP) -- Crude oil futures hit a record high Monday, reaching $59.18 a barrel in Asian trading on concerns that demand will outpace refineries' ability to produce diesel and gasoline in the second half of the year.



The kidnapping last week of six oil workers, including two Germans, in Nigeria, Africa's largest producer, also contributed to the commodity's rise.

Nymex crude for the July contract reached the mark mid-morning in Singapore, a rise of 71 cents from Friday's close, the second straight day oil has set intra-day records. After reaching the high, it fell back slightly to $58.94 a barrel.

Heating oil, meanwhile, rose more than a cent to $1.666 a gallon while unleaded gas futures were also up a cent to $1.66 a gallon Monday.

On Friday, crude climbed as high as $58.60 per barrel before settling at $58.47, an increase of $1.89 on the New York Mercantile Exchange. That topped the exchange's previous intraday high of $58.28 set on April 4.

While Nymex oil futures are more than 50 percent higher than a year ago, they are still well below the inflation-adjusted high above $90 a barrel set in 1980.

"Bulls believe the only thing that can cool the market is an erosion in demand, but so far there are no signs of this," said Energyintel analyst Matt Piotrowski. "They also focus on OPEC's recent meeting as reinforcing the belief that the organization cannot cool prices."

The Organization of Petroleum Exporting Countries failed to soothe the market last week when it agreed to raise its daily output quota to 28 million barrels a day because its members had already been unofficially exceeding that level.

Including Iraq, which is not bound by the 11-member cartel's quota system, OPEC is pumping close to 30 million barrels a day, or about 35 percent of global demand.

"We saw last week's expectation being built that U.S. refineries would struggle to meet the demand of the driving season. This is likely to provide support for the coming week," said ANZ Bank energy analyst Daniel Hynes from Melbourne, Australia.

Analysts are also concerned that aging U.S. refineries will be unable to cope when demand peaks later in the year for winter production of heating oil, diesel and jet fuel.

Hynes also said crude's rise was partly a reaction to the kidnapping of two German and four Nigerian Shell subcontractors who had been seized by gunmen on Wednesday. They were released Saturday.

The militants, a group called the Iduwuni National Union for Peace and Development, demanded Shell pay local communities $20 million as compensation for pollution and environmental degradation due to oil activities.

"The high crude prices are certainly a reaction to the unrest in Nigeria, and the effects of Western counties removing embassy staff there," said Hynes. "Supply is so tight now that any possibility of supply being halted or constrained has driven up prices over the last couple of days."

Nigeria exports some 2.5 million barrels of oil daily, making it the world's seventh-leading exporter and the fifth-biggest source of U.S. oil imports.
 
Contrarian Chronicles
'Mr. Bubble' should (but won't) tackle the housing ATM


The Times rightly christened Greenspan ‘Mr. Bubble.’ But it missed the fact that he could do a lot more to address the housing bubble.

By Bill Fleckenstein

Picking up where I left off last week: I had to do a double-take when I turned to the June 12 New York Times and found an editorial on Greenspan titled "Mr. Bubble." Unfortunately, because it was rather incoherent, I couldn't tell what the actual complaint was. The editorial had an inkling of insight about Greenspan being a bubblehead, but it didn't quite know why.

What the Times really wanted to do, as usual, was to take a shot at the Bush administration. (That's meant not as a political statement, but as a statement of how the paper feels.)

In any case, here is a comment that shows why the editorial was slightly misguided: "After all, the Federal Reserve chairman has been doing all the things people in his position normally do to push rates up -- warning about 'bubbles' in the housing market, assuring the business community that the economy is basically strong, and tripling the Fed's overnight lending rate, to 3%.



Among other inaccuracies, that statement ignores the fact that short-term rates are still less than the inflation rate, and that Greenspan not too long ago denied that a bubble in housing was even possible.

Rx: Regulation X
Greenspan is certainly not leading a charge to take any action to thwart the housing bubble. If he was serious, he could ask Congress to resuscitate Regulation X (part of the Defense Production Act, passed in September 1950), which empowered the Fed to set minimum downpayments and maximum mortgage-repayment periods for residential properties. (However, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have come out against perceived abuses in mortgage lending, citing interest-only and negative-amortization mortgages.)

Since Greenspan was afraid to change Regulation T during the height of the equity bubble, you can be sure he will pretend not to know about Regulation X now. Therefore, while I'm happy that The New York Times is willing to call Greenspan "Mr. Bubble," I wish the paper could get its facts straight about why he deserves the name it gave him.

Of course, homeowners owe Mr. Bubble a "debt" of gratitude, as their heated refinancing and equity extraction have enabled them to live large. That's something we can surmise from last week's beat-the-number performance by Best Buy (BBY, news, msgs). If folks are going to take money out of their houses, they've got to have a big digital TV. Sales of same were part of what helped Best Buy do as well as it did.

But, even as the housing ATM has been working 24/7 to transform average homeowners into high-end consumers, the folks with no access to this cash machine have been struggling. That can be surmised by Wal-Mart's (WMT, news, msgs) account of lackluster sales. And enterprise and small-to-medium-sized businesses appear soft, based on what we heard recently from CDW Corp. (CDWC, news, msgs).

Handicapping the Achilles’ heels
Therefore, as we head into the preannouncement season, to the extent that we see preannouncements, they will likely come from companies with exposure not to the consumer but the corporate market.

That means we may see another round of puking from software companies, but probably little from chip companies, as many enjoy a good deal of consumer exposure. For this reason, National Semiconductor (NSM, news, msgs) and LSI Logic (LSI, news, msgs) were able to take their guidance up recently, whereas Xilinx (XLNX, news, msgs) (whose parts go into products that are almost exclusively sold to big business) had problems.

Of course, from where Intel (INTC, news, msgs) fits into that mosaic, macro-wise, you would think that the company would be seeing trouble. I still scratch my head when I try to figure out where all the Intel-produced parts are going, because there are no data suggesting that the PC business in the aggregate is all that great. Nor is Asia doing well enough to support what Intel would have us believe.

Oil-pipe dreams
Turning from tech confusion to crude reality, I would like to share the thoughts of a knowledgeable friend who's been quite bullish on copper and oil: As I wrote in my daily column on May 25:

"In his opinion, the fact that oil for delivery three years hence is trading around $50, and given the nature of the buyers who've been, in his words, 'inhaling it,' means it's unlikely that crude will go down in the short run in any meaningful way. He says the front end of the oil curve could get hit from time to time, but with serious demand that far out, he thinks oil is unlikely to witness material weakness from the price levels recently seen."

Just for grins last Wednesday, I checked and saw that as of the day before, oil for December 2011 delivery was approximately equal to oil priced for delivery next month. Historically, whenever oil prices have hit what was deemed to be a temporary peak or an absurdly high price, oil for future delivery has often been $10 or $20 cheaper. The fact that oil trades where it does is indicative of tightness -- meaning that stock bulls who think oil will soon return to the mid-$30s are liable to be disappointed. It will probably take a worldwide recession (and, certainly, a recession in China) to get oil back to those prices, if in fact it ever does.
 
Breakup fever is spreading, and Viacom's planned split into two parts shows why. The move should substantially raise the company's market value.

By Jon D. Markman

Virtually every week lately, Monday morning headlines have been topped by a new industrial, financial, media or retail merger. You have to wonder why. Most of the major mergers of the past few years have not worked out well, particularly among media companies, and they show few signs of improvement except in cases where they are being reversed.

While synergy among disparate corporate assets was the mantra of the past half-decade, the most logical course over the next couple of years is a sort of fundamental disintegration. Much like the coming deconvergence of the socialist dream of a European Union will lead to stronger individual economies, a deconglomeration of U.S. big business will lead to an improvement in focus, capital formation and shareholder wealth.

Bigger mousetraps, but no better
Companies laying merger plans now would do well to study the path of media giant Viacom (VIA, news, msgs) and financial services giant Morgan Stanley (MWD, news, msgs), in particular, to observe the failure of ego-driven attempts to build bigger, but not better, mousetraps. Over the past five years, as the broad market has lost 15% of its value, these two misguided attempts at empire have sunk 50% and 33%, respectively. Burned repeatedly by the difficulty in assessing the value of such outfits, investors have come to refer to a “conglomeration discount” that’s applied to such companies even before their quarterly results are tallied.



Now, at least, there are signs that the boards of both companies are set to do the right thing and try to get small, and breakup fever is spreading. The most recent indication is the spin-out and going-private announcement of troubled cable-media-sports conglomerate Cablevision Systems (CVC, news, msgs) on Monday, and rumors of an across-the-board shake-up at Morgan that could result in the sale of both its retail brokerage and Discover credit card assets.

Viacom and Comcast
Putting aside the Byzantine world of financial services for now, let’s focus in on the prospects of a broken-up Viacom. And along the way, let’s contrast it with its mirror-opposite, the cable services kingdom amassed by Comcast (CMCSA, news, msgs).

The owner of such great brands as CBS, MTV, Infinity Broadcasting and Nickelodeon, Viacom announced that it would split itself into two parts early next year via a tax-free spinoff. Each segment was oriented toward distinct investor types, with all the slow-growing broadcast television, radio and publishing assets going into one new company, called CBS Corp., and all the fast-growing cable networks and film-studio assets going into a “new” Viacom entity. The former will get two-thirds of its revenue and about half of its earnings from TV, with the rest equally split between billboards and radio. The latter will get about 75% of its revenue and 90% of its earnings from cable, and the rest from films, according to estimates from analyst Jeffrey Logsdon of Harris Nesbitt.

Although each will continue to be chaired by billionaire entrepreneur Sumner Redstone, there is little doubt that this will lead to a higher valuation for each new public company, as investment managers who specialize in each group will find it much easier to assess their individual prospects. In its press release, the company said the split would allow it to become “more nimble and focused” -- a clear repudiation of Redstone’s prior strategy -- and would use their already prodigious cash flow both for “significant” share repurchases and acquisitions.


Broadcast television and radio both generate a ton of cash flow via advertising revenue, and they don’t require a lot of capital expenditures except for content. Advertising has certainly been lackluster of late, and high-quality programming is growing more expensive. But Viacom has already proven in the past that it has the ability to compete strongly and smartly for each.

The group will be headed by veteran CBS executive Les Moonves. The company’s Paramount TV production business will remain with CBS, giving it the ability to reduce costs of programming by developing in-house shows.

How should the parts be valued? That’s much more voodoo than science, but Logsdon proposes that if you place a price-to-earnings multiple of 14 to 20 on the new Viacom entity and a 9 to 13 multiple on CBS, you can foresee a blended multiple of 12 to 16. Apply that against expected enterprise value minus debt, and you get a potential new valuation of around $43 to $60 a share, or 28% to 80% more than the current price around $33.50.

The bottom line is that Viacom hasn’t done its shareholders any favors in the past five years by pushing a bunch of great media operations under one roof. It also hasn’t gotten much of a break, either, as poor advertising, lackluster films and poor decision-making at CBS News have all hurt results. And it badly suffers from a lack of recurring revenue, as it must eat what its advertising sales people kill each quarter. But the company appears to have a good plan to restructure intelligently, and should be at least modestly rewarded for the effort.

Viacom and Comcast side by side
Now, it’s interesting to compare the new version of Viacom and CBS with Comcast. On the one hand, you have a more focused, high-margin provider of content; on the other, a more diffuse, low-margin distributor of that content. Which is better?

I recently became a fan of the Philadelphia cable-television goliath after subscribing to its high-definition, video on-demand and digital television service. It provides a tight set of digital media services for a reasonable amount of money, and wraps it with good marketing. Since 1998, its monthly revenue per subscriber has risen to more than $77 from $42, and millions of digital services subscribers are now paying $100-plus per month. And it has recently entered the highly competitive world of voice telephony.

Comcast has grown in a much different manner than Viacom. By buying up minor and major cable operations around the country, it has become bigger without adding a lot of noise to its corporate structure. It is all hardware and carrier services, along with some minor distractions like passive investments on programming and sports marketing. Over the last three years, its shares have risen 27% while Viacom’s have fallen 22%.

Now the two are at an interesting crossroads. To get bigger from here, Comcast needs to continue to invest a lot of its cash flow and debt capital in digital telephony and cable infrastructure. It must keep paying and paying and paying to provide the wires and switches that will make its imperial dream a reality. As a result, its return on invested capital, which has averaged a paltry 1.7% since 1986, according to Rochdale Research, will only worsen. Meanwhile, its cable broadband services, while a strong point today, will remain under siege both by telephone companies’ spending on dragging fiber-optic lines from central offices to homes, as well as by the coming wireless broadband technology known as WiMAX.

Rochdale -- which believes that a strong return on invested capital, in the double-digit area, is the single most important signature of a thriving business with the potential for a lift in shareholder value -- suggests that Comcast is in real danger of becoming an undifferentiated distributor of content provided by others. And commodity products are typically purchased by consumers primarily on the basis of price.

In this context, Viacom’s move to deepen its commitment to content -- which requires an order of magnitude less capital commitment -- through its breakup, and become better valued for that effort, makes a lot of sense. Consider Viacom a buy around here in the $29-$33.50 area over the summer, and look for prices north of $45 in the next 18 months. And be on the lookout for other conglomerates to get this religion, and move in the same direction.

Fine Print
To learn more about Viacom, visit its Web site. Showing that it continues to look for growth opportunities at all demographics, Viacom recently announced the purchase of Neopets.com, a site that my 10-year-old daughter and her friends adore for some reason. … To learn more about Rochdale Research, read here … Thanks for the ton of e-mail received last week on both sides of the Warren Buffett and dollar debate. Despite my view that he might turn out to be wrong on the dollar -- though the verdict is still out, and will be for some time -- I was probably overly harsh in the language that I used for dramatic effect. No disrespect was intended to Buffett, who is clearly one of the greats of his generation. Also, I will humbly note for the record that I have been wrong virtually every time that I have written skeptically on his point of view. … Two weeks ago, I wrote about Google, and now there is word that the company is preparing a PayPal-type service to compete with eBay. One wonders if the search-engine company might not be spreading itself too thin if it tries to leverage its name in the direction of financial services. That is usually how good companies get off track, as they begin to think they can conquer all adjacent business domains at once.
 
The Street.com
Will rallying oil prices burn the bears?
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By Barry Ritholtz 6/23/2005

The underperformance of hedge funds has cemented its place in the center of the myriad forces driving the market today. But in case you've forgotten, the price of oil has not gone away, and may be in the process of setting a very effective bear trap.

After the big run-up in equities from the May lows, the recent consolidation has been far shallower and more contained than many traders expected. I read this as confirming my prior view that there remains a large contingency of underinvested hedge funds (amongst others) that have become dip buyers.

Indeed, many hedgies are lagging this year. Those that got caught leaning the wrong way in the General Motors (GM, news, msgs) trade (long the bonds, short the stock) have unwound that position, so on top of some hefty losses, these funds are also sitting on healthy piles of cash.

At the same time, it is worth noting that mutual funds are running with bearishly low levels of cash on hand. While the latter could lead this sideways consolidation somewhat lower, it is the former that may keep this retracement contained.



While this tension between the "too-much-cash" and the "not-enough-cash" on hand crowds play out, oil has crept back into the market discussion. The easy conclusion is that any increase in the price of crude is automatically bad for stocks. But the reality is far more complex.

A quick look at some charts reveals that, at least for the past three years, there has been a positive correlation between the two assets. Since October 2002, oil has appreciated to $60 from $25 a barrel, a 140% gain. At the same time, the Nasdaq Composite ($COMPX) has rallied to near 2,100 from 1,100, for a 90% gain. As far as stocks are concerned, so far, oil's bark is worse than its bite. To date, it has hardly been the Boogieman so many traders expected it to be.

Of course, reality is less simple: Many of the same forces driving oil over that period -- post-recession recovery, massive federal stimulus, increased economic activity out of China -- have also been driving stocks. At a certain point, we will pass a tipping point where oil price increase will have more bite, but oil tends to be a self-correcting commodity: Once it gets too expensive, it will significantly slow the global economy. In addition, while the "too-expensive" level remains a guessing game amongst economists, the one thing they can all agree upon is the impact of slower growth: It reduces demand for oil, which drives energy prices lower. As oil gets cheaper, the cycle starts all over again.

Some oil bears have been pointing to the fact that the U.S. strategic reserve will be topped off later this year as the basis for oil prices slipping over the longer term. They reason that reduced demand from Uncle Sam removes part of the firm bid below current energy prices. This could (in theory) allow for crude to move back to the $30s.

Unfortunately for this line of thought, China has recently announced the creation of its own strategic petroleum reserve, created just as the U.S. reserve is filled. But don't worry. The Chinese say they will spread out the storage of crude and heating oil over a five-year period. You can assume that the firm bid in crude below present prices will remain pretty firm until a full-blown global slowdown ensues.

Potential bear trap?
From the investor's perspective, the recent surge in prices creates a somewhat counterintuitive opportunity. Crude making new highs has the potential to create a "bear trap."

In March of this year, I wrote about the double-top in oil as creating a possible bull trap. As oil hit my $57 price target, it topped out. The pullback from those lofty levels encouraged bulls to rush headlong into equities. Once oil's brief retracement ended in the high $40s, the trap was set. Oil resumed its trek upward, and the trap door was sprung, dropping out from under the bulls. The Dow Jones Industrial Average ($INDU) slumped to 10,000, the Nasdaq lost 130 points, and the S&P 500 ($INX) declined 5%. All told, the bullish crowd had a rather miserable April.

Market Commentary Bullish
Underperforming hedge funds have loads of cash that they'll use to play catch-up.


But oil's climb has reasserted the commodity's potential threat to the market.


The market chessboard is set to play out a mirror image of April's fall.

At the time, I suspected the lows might be significantly deeper. But after the first four months of the year saw fairly regular selling, the downside was somewhat muted and the deeper targets went unmet. Regardless, "don't fight the tape" is always good advice, and once we crossed my predetermined levels, I flipped to avoid leaning the wrong way for too long. In the markets, being wrong is not a sin, but staying wrong is unforgivable.

What's developed recently looks remarkably like a mirror image of the late March setting: Oil is off its recent lows and is moving toward new highs in the mid-$60s after a sharp run-up. This has emboldened the bears, who may try to press their advantage, buying crude and shorting equities.

As the pullback gets under way -- a move that is long overdue, regardless of oil -- it's easy to see crude getting the blame. I believe this will merely be a backing and filling consolidation, working off some of the recent overbought conditions. But the conventional explanation for the softness may not consider that. Instead, the story line driven financial coverage will paint oil as the villain.

Wall Street's Candides have already been chattering about how increasing oil prices do the Fed's work for it. With crude near $60, energy prices become the Fed's inflation-fighting ally. This reduces the need for more rate hikes. Or so goes the theory.

The reality is that at some point in the future, higher oil will have a significant impact on global growth. But that date may be further away than many analysts had expected. $50 oil has had a far smaller impact than was anticipated by dismal scientists. Even crude in the $60s may turn out to be a minor drag. Be forewarned, however: Once the full brunt of its effects hit the economy, the ensuing consequences will be glaringly nasty.

Turnabout is fair play
The chessboard today looks remarkably symmetrical to the late March period. With crude catching all the blame for market weakness, we could see a very similar trap established -- only this time, to the upside. Imagine the headlines once crude closes over $60. That should scare out some weak holders. On the run to $63, bulls will get nervous and bears will get greedy. Shortly thereafter, the spike fades and I can see a rapid fall below $60 again. This could catch bears leaning the wrong way, and find many bulls underinvested. Short covering fuels the initial move in equities, before technicals and momentum take over.

This is why I have been advising clients to increase their exposure to equities as the market pulls back toward support levels of Dow 10,400, Nasdaq 2,000 and S&P 1,181. Despite my many concerns about an ugly 2006, and the lasting impact of higher crude, a strong second-half rally remains likely. Nimble traders should be able to profit from it.

It is worth recalling that the last rally within a cyclical bull market is often the strongest. If we do see such a move in the second half of the year, my targets are pretty high: Nasdaq 2,400-2,600, S&P 1,350 and Dow 11,800. As we approach those levels, I would not only think about taking profits, but legging into the short side.


Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan
 
USATODAY.com
Investors aren't cranking up the volume
Wednesday June 29, 9:04 pm ET


Q: Why is there so much trading volume every day on the stock market? I don't understand it, because individual investors trade so infrequently.
A: When people think of heavy trading volume, it usually conjures images of traders on the New York Stock Exchange throwing order slips around and making violent hand motions. That's certainly what happens on busy days at the Big Board.




But trading has changed, and much of the action now takes place behind computer screens, not on trading floors. I recently took a tour of one of the busiest trading desks in the world and was stunned at how quiet things were. Even though I'm sure billions of dollars were swirling around before my eyes, to me, it looked like a sleepy insurance office.

I bring this up because it gets to the point of your question: A vast majority of the buying and selling of stocks isn't being done by individual investors logging onto Internet brokers. Hundreds of millions of shares are sloshed around by big investment banks, mutual funds and trading houses. We, as individual investors, are just ants scurrying around these institutions' feet when it comes to generating trading volume.

Why are these institutions are trading so much? Often these mega investors are making big, short-term bets that have little to do with what they think about the direction of the stock market. A great example is Google (NasdaqNM: GOOG - News).

Shares of this search engine giant went into hyper drive in April and May, and trading volume swelled too. Certainly part of that was due to individual investors. And some was due to big investors who were bullish about the company's future. But a big chunk of the trading was likely due to short-term traders piling in on anticipation that the stock will be added to the Standard & Poor's 500 index. They're betting that scores of mutual funds that track the S&P 500 will be forced to buy Google after it's added to the S&P 500.

But with all that said, overall trading volume has been weak in 2005. Back in the heyday of the Nasdaq, it was common for stocks to trade more than 2 billion shares a day. The Nasdaq hit its peak volume of 3.2 billion shares on April 18, 2001. But there hasn't been a top-ten day of trading since June 6, 2003. You can see how volume has been pretty slow at Nasdaq's Web site.

Matt Krantz is a financial markets reporter at USA TODAY. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at [email protected].
 
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