Vigilant Investor

A report showed that there is a large home backlog building. With sales lagging, the recent warm January increase in building activity left a total of 528,000 new homes still for sale at the end of the month, a nine-year high.

Meanwhile, a survey of business economists says they expect the economy to roar back from the Hurricane related weakness of the fourth quarter of 2005.

And then there is gold, which Bloomberg says may approach a 25 year high after its already hit its highest point since 1981….

What’s this mean? Vigilant investors are monitoring it!

“A democracy cannot exist as a permanent form of government. It can only exist until the voters discover that they can vote themselves money from the public treasure. From that moment on the majority always votes for the candidates promising the most money from the public treasury, with the result that a democracy always collapses over loose fiscal policy followed by a dictatorship. The average age of the world’s great civilizations has been two hundred years. These nations have progressed through the following sequence: from bondage to spiritual faith, from spiritual faith to great courage, from courage to liberty, from liberty to abundance, from abundance to selfishness, from selfishness to complacency, from complacency to apathy, from apathy to dependency, from dependency back to bondage.”

– Attributed to Alexander Fraser Tytler

Perhaps this wisdom is why the U.S. was intended to be a liberty-based republic, and not — by design — an outright democracy. You will not find the word “democracy” in the U.S. Constitution or in its Declaration of Independence, and when it is discussed by the founding fathers, democracy is mentioned only in the most disparaging terms.

Yet, in the past 75 years, the U.S. system is ever more responsive to the direct whims of the body politic, having placed populist idealism far ahead of boring, old liberty. Consequently, politicians now colectivize ever more individual rights and wealth however they see fit; To the highest bidders or most organized voting block go the spoils.

Today, voters clamor for more and more, and the U.S. is a mere shadow of the bastion of liberty it once was.

The results? You be the judge:

We are reminded of Churchill’s comment on democracy: “The best argument against democracy is a five-minute conversation with the average voter.” That may be harsh, but what does the average voter know about economics, or for that matter, history? That said, the reckless indifference reflected in the two previous graphs’ only validates Sir Winston’s point.

In lieu of that dismal reality, its up to you to Remain Vigilant! After all, the body politic does not appear to care!

Note: Some have question this quote’s authenticity, relative to Tytler. But we think that misses the point: The quote stands on its own.

Blue is GDP as reported.

Red is GDP left after you remove the economic growth generated from home-equity withdrawals.

Note the Difference for 2005. While you’re at it, look at the last five years. [ckick image for full sized version]

That difference, readers, is what the super-low interest rate policy of the past few years has done to bail out the economy. Plus, it shows how dependent the U.S. economy is on policies that not only encourage credit expansion (and by inference, bloating the money supply), but also how crucial indebting the U.S. consumer further and further has been to creating just a little economic growth (if you can call it that — perhaps the better word is activity). Do we really believe this sort of thing can continue indefinately?
Your concerns should only increase when you consider that the inflation numbers used to calculate economic growth in the U.S. (Core CPI) is substantially and purposefully underestimating real inflation, which makes GDP seem much better than it really is. How much red would you have left in the post-2000 portions of the graph if GDP was using a CPI figure 2-3% higher than Core CPI?

As for a discussion on the integrity of government CPI figures, we suggest giving a quick gander at ShadowStats‘ graph of CPI, calculated using the old methodology before the most recent adjustment to Core CPI (during Clinton’s first few years).

You should be thinking one thing right now: How to be vigilant as this inevitably shakes out.

“The United States continues to struggle mightily with globalization. China bashing is on the rise in Washington once again, even as the national unemployment rate falls below 5%. There is a political firestorm over a proposed acquisition by Dubai Ports World of a UK operator of five East Coast container terminals in the United States. This backlash and the protectionist debate it has spawned reflect the dangerous mixture of macro and politics. Americas saving shortfall has triggered a classic political blame game. Ever-complacent financial markets could care less.“

The bold emphasis is ours. The rest is Stephen Roach.You can read more of his most recent dose of vigilance here.

Really, you can’t afford not to.

Some news for the vigilant investor….

• Warning Signs
• The Short View: Carry trade crumbles at the edges
• Increasingly, the Home Is Paying for Retirement
• Core U.S. consumer inflation rises 0.2%, as expected
• Armed Group Shuts Down Part of Nigeria’s Oil Output
• Balmy weather skewed economic data could lead to market volatility
• Venezuela Will Reduce Flights by American Carriers
• Ten great business games

TD Waterhouse has been using Assistant D.A. Jack McCoy (a.k.a, Sam Waterson from NBC’s “Law and Order”) for pimping its online brokerage for some time. Now there is an advertisement running where the court-faced McCoy explains that busy people can do all that is necessary for building their own quality portfolio in about the time it takes to brew a pot of coffee.

Really.

We think this is a typical example of how overtly systematized the retail investment industry has become. I’m sure Waterhouse is not lying about what they are offering, but what exactly can an investor create in the 10 or 15 minutes it takes to brew a pot of coffee? If its like most of what we see these days, its an out-of-the-box investment guidance program that spits out one of a handful of prefab allocations with systematically selected investments using some quantitative screening process. Push a button after answering some questions, and you’re there!

This, no doubt, is better than using a dartboard for your picks, or investing in last year’s top performers. But such over simplified systems are also universally creating very deeply worn grooves of similarity among the investing masses. With more and more investors doing the same thing – relying on what is mostly buy-and-hold auto-pilot, at what point do the masses resemble a massive herd of sheep relying on safety in numbers, instead of appearing like investors who are taking advantage of real opportunities?

That’s not a knock on do-it-yourself TD Waterhouse any more than it is on the entire brokerage and advisor industry, all of whom largely rely on prepackaged products and systems doing very similar things. Many “sophisticated” advisor-offered portfolio products can churn out portfolios within the same pot of coffee time frame. Generally, they are all built on the fundamental premise that markets are efficient, and therefore you will always be worse off by attempting to do anything proactive. Instead, you are to play the overages and accept the consequent ups and downs associated with being on auto-pilot via long-term buy-and-hold asset allocations.

That may work for many folks on average, as the statistics show. But it is sheer folly to extrapolate that because markets are frequently efficient, they are therefore always efficient. Nor should one assume from averages that all periods are “average times”. Occasionally you have economic and market environments that are on the fringe, and the worst thing you can do is grow brazenly over-confident in the infallibility of a status quo operating as if everything is cruising worry-free along the mean.

Along those lines, Warren Buffet once said, “I’d be a bum on the street with a tin cup if the markets were efficient.” That’s funny. A master of entrepreneurial investing, he also said, “Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.”

Yet, that is more or less what the investment industry is telling investors and retail advisors.

The industry has spent the better part of the last ten years hammering that message, and retail investors are lining up on cue. The grooves from their straight-and-narrow march are growing very deep, especially given the short-term (albeit 18-year-long) validation provided by the bull market from 1982 through 2000. Consequently, entire marketing channels and client implementation systems costing tens of millions of dollars are brining in the clients, while also efficiently delivering an easily serviced product – The very profitability of this model invariably creates a prevailing attitude of complacency within the industry that can be summed up as, if it ain’t broke, don’t fix it.

Still, I believe that the industry is most certain that this is all in the best interest of its clients. Nonetheless, it is also guilty of an alarming amount of overconfidence in the status quo. Rare are those within it who are bothering to contemplate if perhaps the paradigm is shifting or has shifted, and that more proactive methods may be in order.

I think the problem can be best summed with a Daniel Boorstin quote on how attitudes can cloud perception: “The greatest obstacle to discovering the shape of the earth, the continents, and the oceans was not ignorance – it was the illusion of knowledge.” Indeed.

All that said, inevitably the masses will continue to buy into Jack McCoy’s “pot of coffee” portfolios.

The rest of you? Please remain vigilant!

Click for Full Sized Image

The U.S.A. Today is reporting that 43% of first time home buyers put no money down. This figure comes from the National Association of Realtors which adds that the median first-time home buyer only had 2% down on a $150,000 home.

With home prices starting to slide, and with “For Sale” shingles hanging for a lot longer than in a long while, it will be interesting to see how homeowners with no home equity react to owning more than a home is worth. And this applies, too, to the many speculative investors who went far out on a limb for their homes. Traditionally, the banking system relies on homeowners fighting to keep their properties. But with lending standards loosened dramatically in the last ten years, should an individual hit hard times and find they own, for example, $20,000 more than the home is worth, will they even bother to fight to keep the home?

What incentives do they have with little or no “skin” in the game? Especially if the mortgage holder is part of the real estate “day trading” crowd?
This should make for interesting news as the real estate bubble unwinds.

While the government, the Fed, and the sycophant pundocracy made up of mainstream economists and analysts like to tout the low CPI numbers, real inflation appears to be nowhere close. The L.A. Daily News has a nice piece discussing the issue.

Core CPI (the primary figure cited in the U.S. to gauge inflation) has been so badly tweaked and neutered that removes many price increases from being part of the calculation. Since Core CPI goes into many other calculations, figures like GDP are only so reliable as well.

The politicians and Big Ben Bernanke tell us that all is well, and the masses — many of whom should know better — accept it all at face value. And little is discussed about how workers earnings are not keeping up with even the rigged CPI numbers.

Give the L.A. Daily News piece some thought, and while you’re at it, wonder about how it might affect your investment portfolio. If you don’t have any idea, you are hereby mandated to find some answers.

Stay Vigilant!

The National Review’s Jerry Bowyer is pimping Bush’s economy again. This time he’s challenging the gold bugs as being off the mark on gauging if inflation really exists.

Like many who long ago dismissed gold in deference to Federal Reserve politicized stewardship, Bower misses the real structural issues influencing gold prices at the moment. The entire Bowyer piece ends up being a fairly heavy set straw man (supply siders) revealing one of Bowyers primary objectives at the NR: to find any argument to defend Bush’s NeoCon policies.

As it is, the piece misses the real issue: Inflation is hardly tame, never mind gold or the second and third opinions provided by Bowyer. Like many, Bowyer assumes that the markets are efficiently discounting inflation when they may be overlooking more than a few things. Gold is but one indicator. We could also look at commodity prices, industrial metals and energy. Or food. Or housing.

Core CPI is sham through that lens, and is a laughable shadow of the number it was before being neutered by politically motivated statistical adjustments repeatedly over many decades.

To get a broader view of the situation, one has to look at the massive trade imbalance and how the U.S. deficit enabled the Fed to vent massive increases in money supply / credit expansion / currency inflation off to emerging markets, and primarily China. For a while, that comes back to the U.S. as cheaper goods as capacity expands infinitely in those regions given the low overhead issue. That depresses CPI for a while, but eventually this new infrastructure starts competing for finite resources.

This reality also serves to create a bond demand bubble. Foreign central banks (CBs) are providing massive demand for U.S. bond issues in order to recycle the dollars they’ve accumulated via the massive U.S. trade deficit and the recklessly indebted and resilient U.S. consumer. That demand is directly related to massive U.S. credit expansion and the consequent fractional reserve multiplier that inflates the money supply. Hence, the recycled inflation fueled bond-demand depresses bond interest rates, making them a dramatically less reliable indicator of inflation — At least so long as the market fails to fully connect the dots and realize that perhaps the emperor is down to his underwear. So much for Bowyer’s “second opinion” on gold. Continue Reading »

Proponents of institutional investment methodology are always dismissing the benefits of attempting to avoid problems and capture opportunities. They believe markets are efficient, and that little value is to be gained by attempting to do so. As such, the conventional wisdom that has trickled down to permeate most of the U.S. retail investment industry believes in playing the relative return game with buy-and-hold portfolios diversified through conventional long stock and bond allocations, perhaps with a touch of real estate for added diversification. All of this is rooted in what is called modern portfolio theory, which in layman’s terms enables analysts and consultants to extract from historic tendencies of asset classes, risk, volatility and reward potential, from which can be constructed the ideal portfolio allocation for each individual’s personal situation. Results are measured relative to asset class peer groups and pegged indexes.

Yet, as the industry is required to state ad-naseaum on all of its written material, past history is no guarantee of future performance. That’s because things are always changing, and no matter what has happened before, things will always be different in the future.

With that in mind, we note that Geo-Political events can dramatically affect how your portfolio will perform in the future. We also hold that not all such events are pre-discounted by the market, nor are those that surprise the markets as unpredictable as many assert.

For example, take a look at the Iran situation at the moment, related to the Oil Bourse it is starting in March. (A bourse is another word for market-exchange.) This new market for oil will compete with the other major bourses and it will be the first to accept trades in currencies other than the dollar. Additionally, Iran as a major oil producer will be the first to refuse to sell its oil in dollars, favoring instead Euros.

Given that the overwhelming majority of oil transactions will still be conducted in dollars, it is unlikely that the dollar will suffer any sudden consequences from such a change. But the long term trend might have more meaning, and that could affect your dollar.

Moreover, Iran was not the first to make such a change. Iraq, months prior to 9/11, made a similar change. Was the U.S. invasion influenced by this? The argument for it is strengthened by the lengths to which Bush’s administration seems to have stretched the truth (WMDs, ties to 9/11, friends with Osama, etc.) to justify an invasion.

Venezuela talked of doing the same in 2001. Perhaps it is coincidence and false accusations, but a failed coup allegedly engineered by the CIA took place against the Venezuelan president who contemplated the change.

When one begins to consider the larger longer term implications of oil no longer being transacted in dollars, there are economic concerns that must be faced. Non of these will arrive from out of the blue, but just the same, few consider it to be something worthy of concern, and the buy and hold mentality ignores it entirely. Yet it could affect your portfolio, and it arguably should play at least some part in what you are monitoring as you go forth investing.

For additional thoughts on the U.S. dollar losing its status as the currency of the World, see our recently published related article.

Were the world to no longer operate with the U.S. dollar as the standard global currency, this shift would result in massive changes to the U.S. economy. The changes would be so seismic that every assumption U.S. citizens have about their financial world, from top to bottom, would be forever shaken and changed.

Perhaps the lone fiscally sober voice in Congress, Texan Dr. Ron Paul, recently explained before the U.S. House of Representatives why this consequence is a very likely reality. Given the predominant governing view of the U.S. government and U.S. economic policy, from the U.S. Treasury to the Federal Reserve, Paul makes a very strong case. His speech is an essential read for anyone wishing to understand how close we may be to the end of dollar hegemony, as well as the dark potential should the brazenly cocky U.S. citizen lose all the perks and pleasures such privilege bestows. (The speech also discusses some of the unspoken currency related reasons for U.S. policy in the Middle East with regard to Iraq and Iran and the oil bourse.)

While this may seem extremely unlikely to folks new to the subject, the world has yet to see any one currency that could withstand destructive political pressures that eventually crush whatever faith believers once had in the predominant currency’s ability to serve as a reliable store of wealth. Inevitably, politicians and kings — in cahoots with whichever era’s version of central bankers — manage to abuse and destroy the original value inherent to said currency. Britain, on whose Pound the sun never set at the start of the 20th century learned this lesson in hubris first hand. We would all do well to study the history of the British Empire, although many in the U.S. might find the story eerily too similar to the last fifty years of ever growing U.S. infatuation with global intervention, and its desires to remodel the rest of the world to fit the dominant U.S. vision of both global democracy and U.S. self interest. And, if you have any doubt, we encourage you to click the graph images below to see (full-sized) how well the Fed has (mis)managed the U.S. dollar.

In the world of asset allocations based on recent historic averages and tendencies of popularly used asset classes, this may seem like a distant concern. After all, in the long run it all works out, right?

Continue on auto-pilot if you’ve bought into the institutional buy-and-hold, efficient-markets theory pimped by the investment industry through the bull-markets of the 1980s and 90s, and into today. In the meantime, entrepreneurial types who take advantage of being cautiously opportunistic will, undoubtedly, consider the real world contingencies and act accordingly. While recent extended bull markets have caused many supposed experts to dismiss such wisdom, we remind our readers of one of the golden rules of some of the best investment minds the world has known: Find the prevailing assumption on which the majority is wrong and bet against it.

Or, as Warren Buffet is quoted as saying, ” Wide diversification is only required when investors do not understand what they are doing.”

We’ve noted previously that the economy in Great Britain seems to be leading the U.S. as an indicator by about a year. Sure enough, as we suggested, the Brit’s real estate boom slackened and started cooling about 18 months ago, and U.S. real estate has followed with its cooling now fully six months in, with homes for sale sitting much longer than a year ago and prices stagnating in all but the most popular, frothy areas.

Well, here’s a new warning signal to keep your eyes on: The London TimesOnline is reporting that the Country’s recovery is in doubt based on a renewed 2006 sales slump, and notes that reality is defying all the central Bank of England talk predicting sustained consumer confidence and economic growth.

Notes Kevin Hawkins, the director-general of the British Retail Consortium, “After the pre-Christmas upturn, we are now back to the reality of a tough, discount-driven retail market. The message from every sector of our industry is the same. The squeeze on consumer spending continues unabated. The economy badly needs a cut in interest rates.”

These are much our expectations for the U.S. economy, never mind Ben Bernanke’s talking up of the economy and recent numbers that show some activity is stronger than expected.

In the long run both U.S. and British economies have relied on rates to gin up money supply in order to create activity. But all economic activity is not created equal, and should the Fed follow the BOE in slowing the economy down, we can expect fire-hoses of money supply to be cranked up in order to give us one more wild ride to keep the economy moving without facing the inevitable recession looming on the horizon. What’s left to wonder is what sector this new burst of money will find itself frothing into, creating yet another echo bubble…. And, of course, the big Kahoona of all questions, when will this abuse of the currency finally leave the core stores of capital incapable of sustaining things as we know them?

While we may believe we know some of what is coming, we certainly don’t have a crystal ball on the when’s and how. We can only operate by considering all sides of the story in order to position ourselves appropriately for the various contingencies. And position you should!

While most have seemed to notice that the real estate market has plateued — and in some areas it is appears as if it is teetering on edge — there is still a market for folks looking to turn tidy and quick profits by fixing up properties and flipping them over. Plenty of investors are still willing to shell out to sit through weekend long “fix and flip” workshops to learn the tricks of making a fast buck, even in highly inflated markets like Phoenix, AZ.

What’s there to worry about? Nothing, if you accept the word of newly minted guru’s on the subject like Dolf de Roos, author of 52 Homes in 52 Weeks, an account of his success in another get rich quick market, Las Vegas. Should the market drop by five or ten percent, says de Roos, “If it was the stock market, that would be a minor correction…. So what’s the big brouhaha? In five years, it’ll be way ahead of where it is now. I am not worried about it, not with 100 houses being built and filled every day.” De Roos is also particular about differentiating between speculators and investors.

Maybe de Roos will be right. But we think our readers would do well to review the history of real estate bubble type situations, such as Japan’s. In the most bloated regions, these corrections can be very severe and spiral out of control, having enough gravity to suck the entire nation’s financial markets (stocks, bonds, etc.) and economy into the vortex. While no two situations are ever identical (for example, Japan’s national savings-rate at the time of its real estate bubble pop was pleasant 20% vs. our dismal negative 1%), there is still much to learn by reviewing past situations.

As well, our readers instead ought to ask a few questions:

• What happens if the entire economy slips into recession as more than a few analysts predict? (Reaffirmed by the inverted bond yield curve.)
• What if lenders finally tighten credit standards as the balance sheet of most consumers worsens by the year, with debts piling up and incomes stagnating?
• What if interest rates on mortgages finally reverse and return to a more average rate?

And that’s not all. There is the risk of overextended borrowers who can’t turn a quick profit facing the less than attractive scenario of interest only or adjustable rate mortgages being greeted by higher rate when their investment is under water by de Roos’ 5-10%. We may be surprised by how many investors are actually speculators when push comes to shove.

Meanwhile, CNNMoney.com is reporting that getting rich quick by picking up foreclosed properties is as much myth as reality and that home builders are having to dramatically sweeten their offers to move inventory.

We can’t help but be reminded of the dot-com day trade bubble craze of the late 1990s. Perhaps the floor will not drop out on real estate. But just the same, we can’t imagine the mentality behind ideas

like CondoFlip.com (where the real estate bubble is shamelessly dismissed with the company slogan “Bubbles are for Bathtubs”) will be entitled to any less-severe an encounter with the Gods who punish hubris than were the dot-coms.

Investors ought to at least prepare for such a contingency in order to minimize the collateral damage from such an event.

• Ben Bernanke’s Golden Opportunity
• Bernanke Predicts `Significant’ Economic Rebound
• Bernanke Tells Congress Fed May Need to Raise Rates
• CEOs reserve judgment on Bernanke
• Consumer sentiment weakens in Feb
• January wholesale inflation cements rate outlook
• Housing: Who Gets Blamed If The Roof Caves In?
• China chides U.S. for criticism over trade, yuan
• White House urges China to loosen currency system