Wednesday, October 24, 2007

Some bearish thoughts on bearish views

Seems these days, investors can't get enough of gold. Who can blame them, look at any gangbuster chart of gold in terms of the dollar and its hard not to jump on the bandwagon. Especially if there are bearish geniuses spelling out exactly how an impending doom of the global economy might play out--and very convincingly too.

Therefore, it's always nice to read a refreshing piece or two that run counter to the overwhelmingly articulated arguments to own gold. I'm still pretty bullish on Gold myself--and still a believer in very inflationary times ahead, but these days I have been catching a few sneezes here and there curing my conviction hours--not because I don't think America and the American economy is going to be pretty gloomy in the next decade or so, but because of the sheer volume of liquidity that has been piling into gold, commodities, ect... THINKING IT'S AN ATTRACTIVE HEDGE/ALTERNATIVE TO THE MARKETS! The talks of a supercycle that is driven by demand from the likes of BRIC and other emerging markets seems old news, and is actually very accepted now among the investment community, maybe too fast too soon. So while you have the bulls calling for stock markets to be quite alright, you have the bears calling for a rush to safety in precious metals and secular growth commodities (secular only if China keeps up). In other words... everything is up! bulls and bears (shorts excluded) both party! unbelievable! And it's times like these, I get agnostic. There's simply too much money out there still!

Call me a party-pooper, but if (1) liquidity leaves this area--i.e. China slows down or (2) Bernanke grew balls and started targeting excess money supply at the expense of economic growth, then I think there could be a severe correction in not only asset prices, but also the things that are supposed to be "safe" havens for investors--Gold included. Bulks, basic metals, cyclicals, softs (maybe not this one, a story for another time) will do even worse.

The following article tells it well, with a specific focus on Gold. In a nut-shell, it's important to focus again on the Bernanke factor. If, again, he grew balls--ignored politicians and wall streeters like a central banker should in the first place, and raised rates and somehow manage to start a tradition of inflation-fighting, money supply targeting Fed, we will see some serious issues in the Gold call. The market is already pricing in that Bernanke isn't the type of guy that is serious about controlling inflation at the expense of offending wall street and the government (which might be a dangerous assumption since we arguably don't know much about his ultimate policy stance yet, outside the one time liquidity injection he gave that was necessary to prevent a complete banking crisis, and the snippets of being another Alan Greenspan--what investors want to believe). Nobody took Paul Volcker's words seriously at first when he said he's going to focus on fighting inflation (as you'll read about in the following article)... Bernanke said the same things along those same lines once or twice, but nobody is taking that seriously so far--so it's yet to be seen.

Meh... its too late at night. I don't even know sometimes why I focus on these macro things since everything that's ever made me money in my short and humble investing career has mostly been unsystematic, business specific, microeconomic positions. But hey, what can you do, I guess it's too interesting to avoid :D I can't wait until everything is cheap again.

Anyway, without further ado, here is that refreshing look on Gold


Gary D. Halbert
October 23, 2007

Why I’m Taking Profits In Gold Now


1. My History With Precious Metals

2. The Precious Metals Crash Of January 1980

3. Why I’m Selling My Gold Coins Now

4. I’m Not Bearish On Gold

5. Pros And Cons Of Investing In Gold

6. Gold Exchange Traded Funds Revisited


As discussed last week, the response to our recent Reader Survey was much larger than we expected, and we received tons of comments and suggestions. Interestingly, many of you asked me to write about precious metals from time to time. The timing was excellent, since I sold most of my gold coins last week when gold prices topped $760.

The last time I made a sizable investment in gold coins was back in 1998 and 1999 when gold was around $300 per ounce. At that time, I purchased a large number of uncirculated American Gold Eagle coins. I also bought several bags of circulated silver coins, also known as “junk silver.” I have been sitting on them ever since, until now.

Obviously, gold and silver prices have risen substantially since 1998/99, especially in the last two years, and most especially in the last three months as prices spiked higher. Many analysts believe precious metals prices will rise much more in the months and years to come. There are plenty of predictions of $1,000 gold, and maybe they’re right. But in the pages that follow, I will tell you why I sold all but my core holdings of precious metals now. I’ll also tell you a little about my history with precious metals. I think you will find it an interesting discussion.

We will also revisit the subject of exchange traded funds in gold. There are currently two gold ETFs, and they have become a very popular way to participate in the movements in gold prices without having to own the physical metal.

My History With Precious Metals

After getting my Masters degree in 1975, I went to work for Continental Grain Company, one of the largest grain and agribusiness companies in the world. After less than a year, I became a broker in the company’s commodities futures division in their Dallas branch office. Specifically, I was what was called a “hedging broker.”

In a relatively short period of time, I developed a large clientele which consisted mainly of grain elevators, commercial feedlots, cotton gins and many large farmers. Most of my clients were located in Texas, Oklahoma, Louisiana and Arkansas. My clients were not in the futures markets to speculate; rather, they used the futures markets to “hedge” the value of their inventories of whatever commodities they dealt in or produced so as to protect their profit margins.

I actually taught most of them how to do it. In 1977, I wrote a manual entitled “Hedging – Can You Afford Not To?” which explained in layman terms how the complicated process of hedging in the futures markets works. With all of these clients, I quickly became one of the largest producers in the company by the ripe old age of 25 or 26.

What does this have to do with precious metals, you’re probably asking. I’m getting there. It was also in 1977 that I was introduced to The Bank Credit Analyst. At that time, BCA was predicting that inflation was going to get out of control, and that precious metals prices, and tangible assets in general, were going to go through the roof in the next few years.

Of course, I was writing about BCA’s forecasts in my newsletter, even back in those days, and most of my clients agreed that inflation was going to be a big problem in the next few years. They wanted to know how they could make money from this trend. I had always urged my clients not to speculate in futures on the commodities they dealt in or produced. But in this case, we were talking about precious metals futures – gold, silver, platinum, etc.

In 1978, most of my clients loaded up on gold and silver futures at a time when gold was below $200 and silver was below $6. As most of us remember, inflation ran rampant in the last few years of the 1970s, and precious metals prices soared just as BCA had predicted. By late 1979, gold had reached $650, and silver had soared above $30.

My clients were making a killing, and I was a hero. As noted above, I had a lot of clients, and with all the market positions we had on - hedge positions and speculative positions - my daily printout of all accounts and all positions stretched the entire length of our large office suite.

But BCA Killed The Party In Late 1979

You may recall that Paul Volcker became Fed chairman in August of 1979, with a mandate to get inflation under control. Initially, there was a widespread consensus that Volcker was not going to take any significant actions to bring down inflation, what with Jimmy Carter in the White House. However, by late 1979, BCA thought otherwise.

Shortly after Volcker took over at the Fed, he talked about implementing a new monetary policy. Rather than targeting interest rates, as had been done for years, he was going to target the growth in the money supply. Volcker believed that if he squeezed the money supply, interest rates would rise and eventually choke off inflation. And he basically said he didn’t care how high interest rates had to go to get the job done.

As noted above, few believed Mr. Volcker’s words. But BCA did. In their November and December 1979 monthly reports, the BCA editors made it very clear that they believed Volcker was dead serious. They warned in chilling terms (at least for me) how they believed interest rates were going to soar, and how that could lead to a serious recession.

Most importantly they adamantly advised readers to liquidate all positions in precious metals, tangible assets and other inflation hedges immediately.

I was stunned to say the least! My clients and I were having so much fun, after all. And we were all very convinced that inflation would not be brought under control. I anguished for several days about what to do. My clients certainly didn’t want to get out of their inflation hedges. But in the end, I decided to take BCA’s advice, as much as I hated to. By the end of December 1979, I had sold out every single position in gold and silver for every client but one. That one client got so mad at me he transferred his account to another brokerage firm.

When I liquidated all of these large positions, gold was in the area of $650, and silver was around $35. Well, gold went on to soar to near $850 and silver to $50. I didn’t look so smart then, but no one complained that we got out a little early, especially after what happened in January 1980 – but I’m getting ahead of myself.

My branch manager was thrilled because of the huge volume of commissions this unloading of metals positions generated. A couple of days after the liquidation was done, my manager came into my office and asked, “When are you going to buy it all back?” I replied, “We’re not, we’re done.” He was shocked, once he realized I was serious.

In the ensuing days, the manager talked to me on several occasions, trying his best to get me to put all my clients back in these trades. I refused, even though the precious metals were still exploding on the upside. Growing weary of his efforts to get me to put my clients back in the market, I finally responded with something like the following (paraphrasing):

Look, this has been an historic run in the precious metals, which aren’t even my area of specialty; thanks to BCA, we got to ride most of this huge move; we made a lot of money for my clients and for the company, and you and me. We’re done.

When I first got in to the commodities business, I heard an old saying that always made sense to me: ‘There’s some for the bulls, some for the bears, but there’s none for the hogs’. What a great saying! I repeated it to my commission-hungry manager, and he never asked me again. Good thing.

The Precious Metals Crash Of January 1980

After soaring to all-time record highs of $850 in gold and $50 in silver, the precious metals markets collapsed in the last half of January 1980. You may recall that the Hunt brothers of Dallas had driven the price of silver through the roof. But as silver futures prices were exploding to $50 per ounce, the New York Comex Exchange arbitrarily raised the margin requirement to hold futures contracts in silver. That signaled the peak.

Silver futures plunged from $50 to below $17 in less than a month! Silver futures were locked “limit down” for 21 consecutive days, meaning that no one could unload their positions. A move from $50 to $17 was a $33 swing, and on a 5,000-ounce silver futures contract, that move represented a $165,000 loss in value. Margin calls were huge, and several large brokerage firms were rumored to be in trouble.

At the same time, gold collapsed from around $850 to below $500 in less than a month. Gold was also limit down for a couple of weeks. To this day, that was the single most violent move in commodities that I have ever seen. Many speculators were wiped out. Fortunately, I got all of my clients out a month earlier. Talk about dodging a bullet! Perhaps this helps explain why I have valued BCA’s opinions for all these years.

Why I’m Taking Profits On My Gold Coins Now

As you probably know, precious metals prices have been on a tear for the last couple of years, and especially in the last few months. Gold has risen from below $450 in late 2005 to above $760 as this is written. Silver prices have soared from around $7 to above $14 per ounce in the last two years, although prices are slightly below $14 as this is written.

Gold prices

On Wednesday of last week, I decided to take profits on all but my core holdings of gold coins. For better or worse, I called the coin dealer I use (Camino Coin) and locked in the price on my Gold Eagles when spot gold was around $760. Gold prices have dropped back a bit since then, but it will not surprise me if gold prices continue to move higher for a while longer.

So why did I decide to sell last week? To begin with, I have been thinking about selling for a couple of months now, what with the sharp rise in gold prices just since August. Most analysts believe that precious metals prices are soaring due to expectations for a significant rise in inflation. Oil prices are at all-time record highs, and precious metals often track the price of oil to some extent. As noted above, there are analysts who now predict that gold will hit $1,000 per ounce on this move, and maybe they will be correct.

However, as I have discussed in recent E-Letters, the latest inflation numbers have been tame, even as oil prices have soared to record highs near $90 per barrel at one point last week. The Consumer Price Index (including food and energy) rose only 0.3% in September and was down 0.1% in August. For the last 12 months, the CPI is up 2.8%, and the trend is down. The “core” CPI is up only 2.1% over the last 12 months. That is hardly runaway inflation.

Meanwhile, BCA has maintained for several months that US inflation will surprise on the downside over the next year or so. What with the US and global economies slowing down, BCA expects the core rate of inflation to remain tame, or actually decline, in the months ahead. In a Special report issued last week, BCA had the following to say about inflation:

“The cyclical tendency of the world economy is leaning toward disinflation or deflation, not inflation. The reason is simple” The bursting of the U.S. real estate bubble is a deflationary shock whose disinflationary impact will continue to be felt in the global economy… This is because asset price deflation often precedes a period of economic weakness, which in turn restrains the business sector’s pricing power.

In short, BCA expects overall inflation to surprise on the downside over the next year, despite soaring oil prices and the increases in food prices.

The tame inflation rates over the last few months are, in part, what led the Fed to cut interest rates on September 18, and it may do so again on October 31. I don’t think the Fed would be cutting rates if it believed that inflation is going to be a problem in the near-term.

I’m Not Bearish On Gold

For the gold bulls in our E-Letter audience, please note that my selling of my gold coins does not mean that I am bearish on gold, although I do believe it is overbought in the near-term. In fact, the long-term supply/demand fundamentals still look quite encouraging. Demand continues to rise, especially from China, and there have not been any major new discoveries of gold in the last couple of years.

There are a number of other factors that have the potential to impact the price of gold in the future. I have discussed these factors in previous E-Letters, and have updated them below as they are just as relevant to the future price of gold as they were back then:

1. Gold is a good store of value during times of uncertainty, and there is definitely no shortage of uncertainty in the world today. In fact, you could call gold the “currency of global uncertainty,” in that, as a general rule, the greater the geopolitical tensions, the more investors tend to buy gold.

2. Gold is considered by many to be a hedge against inflation. I noted above that BCA does not feel that inflation will be a factor in the short-term. However, that doesn’t mean that inflation will never again be an issue. As Baby Boomers retire and the government is forced to borrow to fund Medicare and Social Security, both interest rates and inflation have the potential to rise in the long-term.

3. Although I do not believe that gold reacts to supply and demand in exactly the same way that many other commodities do (see #4 below for more about this), you cannot discount the fact that exploration was down during the period of low gold prices and gold mining companies have had to play catch-up in the last few years, and this has helped push up the price of gold.

4. As I have written before, another reason why gold does not always react to supply and demand forces the same way that many other commodities do is because gold has a hybrid nature. While it is a commodity used by many industries, it is also a currency maintained in large reserves by many countries, central banks and individual investors. As a result, the price of gold is often dictated more by its relative value to currencies rather than on a strict supply/demand basis.

Accordingly, the slide in the value of the US dollar over the last few years has been bullish for the price of gold. If the US dollar experiences a continued decline, this might provide additional upside potential for gold prices.

Obviously, these are not all of the reasons to be bullish on gold, but they are some of the major factors that I keep on my radar screen in relation to the yellow metal, in addition to the supply/demand fundamentals. The point is that there are several factors that are favorable for a continued increase in the price of gold. But you never know. What is clear is that gold prices are at a 28-year high, despite the fact that the US and global economies are slowing down.

Reasons To Be Cautious

Just as there are reasons to be bullish about the price of gold, there are equally valid reasons to be cautious about running headlong into a major gold investment at this point in time.

1. As noted above, gold prices in the US have tripled since the low around $255 in 1999, including periods of time when prices moved virtually straight up. The spike up in prices since late August has sent gold prices from $650 to $760. That suggests to me that the market is ripe for a pullback at any time. Furthermore, gold has heavy overhead resistance (a technical term for selling pressure) from $750 to the all-time high around $850.

However, there have also been significant pullbacks in the price of gold, such as in 2006, and that’s another negative. Gold prices typically fall off a cliff after a sharp run-up, rather than gently trending downward. This extreme volatility can be disconcerting to many investors.

2. Most analysts believe that the US dollar will continue to fall for at least another year. That may well be true, but keep in mind that the dollar is already down apprx. 20%. If for any reason the dollar stabilizes, or begins to rise, that could take a lot of the wind out of gold’s sails.

3. Another thing to keep in mind is that the run-up in gold prices prior to late 2005 was largely a US phenomenon. If you look at gold prices in Euros, you will see that gold prices in that currency were generally flat during much of the big rise in US gold prices prior to that time because the Euro has strengthened relative to the dollar. So, the relative value of gold as an investment sometimes depends in part on what kind of money you have in your pocket.

More recently, however, it is important to note that gold has experienced a bull market even in other international currencies. Click on this LINK to see a chart of gold prices in various currencies since 2003.

4. Contrary Opinion. More often than not, I am a contrarian, meaning that I don’t like to buy when everyone else is buying (or short when everyone else is shorting). Right now, the bullish consensus on gold is very high, as evidenced by the stampede into the new gold ETFs over the last couple of years (more on this below).

5. As prices have continued to rise, gold producers have begun to ramp-up production. As noted above, they may be playing catch-up at present, but at some point increased supplies may adversely affect gold prices. It is also important to note that most of the gold that has ever been mined continues to exist. As prices rise, some of this gold will find its way to the markets. I’m sure you’ve seen the TV commercials for companies that will buy your gold watches, rings, etc. If enough of this “scrap” gold makes its way to the markets, it could help hold down the price.

6. As I have written in recent weeks, the US economy is clearly slowing down, and the odds of a recession have increased. The global economy is slowing down as well. Historically, weakening economies lead to decreased demand for gold and other metals.

As the above pros and cons illustrate, there are many reasons to invest or not invest in gold. For those of you who do want to include gold as a part of your overall diversified portfolio, the question then becomes how to make the purchase.

Gold Exchange Traded Funds Revisited

As I discussed earlier, there are various obstacles to owning physical metals. Obviously, there is the storage issue – you must have a safe place to hold your precious metals, and this can be expensive. There is also the issue of insurance, which is not cheap. Then there is the shipping issue, unless you trade with a local dealer, which frequently will not have the best prices. Typically, you will need to ship your coins or bullion via registered mail, which I found has gone up substantially in the last 10 years.

I know there are some of you who will prefer to keep your gold in a safe deposit box at the bank. For others, however, there are relatively new gold Exchange Traded Funds (ETFs) that address many of the disadvantages of buying, storing and selling physical gold. If you want to participate in the movements in gold prices, I think ETFs are a good way to do it.

In late 2004, I discussed at length the then new gold exchange traded fund (ETF), StreetTracks Gold Trust (NYSE: GLD). Since then, we have seen the introduction of the iShares Comex Gold Trust (ASE: IAU), which is also an ETF. These funds have become very popular for those who wish to participate in movements in the gold market, either long or short.

There are advantages and disadvantages to trading these ETFs in gold. One of the most obvious advantages of the gold ETFs is that they solve the shipping, insurance and storage problems associated with investments in physical gold bullion or coins. Some of the other advantages of this new way to own gold are as follows:

1. Dealer markup is no longer a problem, in that there is no spread between bid and ask prices. There may be transaction costs associated with purchasing and selling these ETFs, but there is no premium to be paid.

2. The gold ETFs are listed on the New York Stock Exchange and the American Stock Exchange, so they are liquid and can be bought or sold any time the market is open and trading. In addition, the gold ETFs may be “shorted” if an investor believes the price of gold will fall.

3. In the past, many institutional investors were precluded from owning gold because of the costs related to buying, selling, and storing the physical gold. The gold ETFs allow these investors to have an undivided interest in gold, but without all the hassles.

4. Gold mining stocks, a popular way to play the gold market, are often significantly overvalued or undervalued, relative to the price of gold for various reasons, and are typically extremely volatile. Because the gold ETFs closely track the price of gold, they have become a popular alternative to gold mining stocks.

Unfortunately, there are still some disadvantages to investing in these gold ETFs. Perhaps the most obvious is that it is not physical gold. For those investors who want to own gold as a store of value in case of emergency, having an undivided interest in gold sitting in a London or Nova Scotia vault will provide little or no comfort. Those investors who want to run their fingers through their gold hoard will still have to buy physical gold, and deal with the storage, shipping and other hassles involved.

Other disadvantages of the new gold ETFs are:

1. As I have written a number of times, the price of gold is very volatile and can move suddenly and without warning. The gold ETFs do not change this characteristic of gold, but at least they offer a way to quickly trade out of a gold position without the hassles of selling physical coins or bars – on the days the markets are open, of course.

2. The success of the gold ETFs likely contributed to the rise in gold prices over the last few years. As large sums of money have flowed into these gold funds, the ETFs have had to buy more and more physical gold on the open market. This buying almost certainly contributed to the upward pressure on the price of gold, and may continue to do so as long as the demand for these ETFs continues to grow.

Of course, the reverse will also be true whenever gold prices start to decline and investors start to sell their shares in these gold ETFs. In that case, the funds will have to sell physical gold on the open market, and this could exacerbate price declines.

3. While shares in the gold ETFs are considered to be securities, the IRS classifies these shares as “collectibles” for tax purposes. This means that long-term gains will be taxed at a higher 28% rate reserved for collectibles, rather than the 15% rate for other types of investments.

The points above do not represent a complete discussion of the advantages and disadvantages of gold ETFs. Be sure to read the prospectus carefully before you invest. However, the gold ETFs can be a good way to participate in the price movements in gold without having to own physical precious metals.

Other ways to deal in precious metals are and Both of these are electronic Internet currency facilitators backed by gold or other precious metals. E-gold Ltd., a Nevis corporation, states that it is:

“100% backed at all times by gold bullion in allocated storage. Other e-metals are also issued: e-silver is 100% backed by silver, e-platinum is 100% backed by platinum, and e-palladium is 100% backed by palladium. e-gold is integrated into an account based payment system that empowers people to use gold as money. Specifically, the e-gold payment system enables people to Spend specified weights of gold to other e-gold accounts. Only the ownership changes - the gold in the treasury grade vault stays put.”

Apparently, e-gold and e-bullion have become popular as a form of international payment, as well as an investment medium. How popular, I don’t know. I must emphasize that I have never used e-gold or e-bullion, so I cannot recommend these services.


There is an old saying in the commodities markets that “the solution to high prices is high prices.” This probably sounds strange but generally speaking, when commodities prices rise significantly, production increases and demand decreases. This combination usually results in lower prices at some point.

While I don’t profess to know what gold prices will do in either the short-term or the long-term, I simply decided to take some profits on my gold investment, based largely on how much prices have increased over the last two years, and especially in the last few months. So it will not surprise me if we see a pullback in gold prices just ahead.

And finally, while I have sold my speculative position in physical gold, I still maintain my core holdings in precious metals, and I still have exposure to gold via our futures funds and certain of our Absolute Return Portfolios.

Very best regards,

Gary D. Halbert


Monday, October 22, 2007

Stephen Roach Explains It All... Again... For the Last Time... Maybe?

Like all bearish geniuses, Stephen Roach--many bleak reports later--explains it all again in his most articulate/convincing piece yet. So maybe he is finally right this time, not just in theory but also in timing. Just be glad you didn't start shorting everything frothy when he first started this spiel... unless you have been, in which case, hope that this is subprime/credit issue is the final stroke of the matador in the heart of that raging bull... or, at the very least, a blunt to knock some sense into the current economic arrangement of our times.

Enjoy, read, and absorb every bit. Hope you guys enjoy, I certainly did :D


A Subprime Outlook for the Global Economy
By Stephen S. Roach

After nearly five fat years, the global economy is headed for trouble. This will come as a surprise to policy makers and investors, alike-most of who were counting on boom times to continue.

At work is yet another post-bubble adjustment in the world's largest economy - this time, the bursting of America's massive property bubble. The subprime fiasco is the tip of a much larger iceberg - an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy. Seven years ago, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the US and global economy into a mild recession. This time, post-bubble adjustments seem likely to hit US consumption, which at 72% of GDP, is more than five times the share the capital spending sector was seven years ago. This is a much bigger problem - one that could have grave consequences for the US and the rest of the world.

There is far more to this story than a potential downturn in the global business cycle. Another post-bubble shakeout poses a serious challenge to the timeworn inflation-targeting approach of central banks. It also presents the body politic with a fundamental challenge to its tolerance and, in many cases, encouragement of a new asset-dependent strain of global economic growth. Subprime spillovers have only just begun to play out - as has the debate this crisis has spawned.

Game Over for the American Consumer

The American consumer has been the dominant engine on the demand side of the global economy for the past 11 years. With real consumption growth averaging nearly 4% over the 1996 to 2006 interval, US consumption expenditures currently total over $9.6 trillion, or 19% of world GDP (at market exchange rates).

Growth in US consumer demand is typically powered by two forces - income and wealth (see Figure 1). Since the mid-1990s, income support has lagged while wealth effects have emerged as increasingly powerful drivers of US consumption. That has been especially the case in the current economic expansion, which has faced the combined headwinds of subpar employment growth and relatively stagnant real wages. As a result, over the past 69 months, private sector compensation - the broadest measure of earned labor income in the US economy - has increased only 17% in real, or inflation adjusted, terms. That falls nearly $480 billion short of the 28% increase that had occurred, on average, over comparable periods of the past four US business cycle expansions.

Lacking in support from labor income, US consumers turned to wealth effects from rapidly appreciating assets - principally residential property - to fuel booming consumption. By Federal Reserve estimates, net equity extraction from residential property surged from 3% of disposable personal income in 2001 to nearly 9% by 2005 - more than sufficient to offset the shortfall in labor income generation and keep consumption on a rapid growth path. There was no stopping the asset-dependent American consumer.

That was then. Both income and wealth effects are now coming under increasingly intense pressure - leaving consumers with little choice other than to rein in excessive demand. The persistently subpar trend in labor income growth is about to be squeezed further by the pressures of a cyclical adjustment in production and employment. In August and September 2007, private sector nonfarm payrolls expanded, on average, by only 52,000 per month - literally one-third the average pace of 157,000 of the preceding 24 months. Moreover, this dramatic slowdown in the organic job creating capacity of the US economy is likely to be exacerbated by a sharp fall off in residential construction sector employment in the months ahead. Jobs in the homebuilding sector are currently down only about 5% from peak levels despite a 40% fall-off in housing starts; it is only a matter of time before jobs and activity move into closer alignment in this highly cyclical - and now very depressed - sector.

Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters. After peaking at 13.6% in mid-2005, nation-wide house price appreciation slowed precipitously to 3.2% in mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall US home prices could actually decline in both 2008 and 2009 - an unprecedented development in the modern-day experience of the US economy. Mirroring this trend, net equity extraction has already tumbled - falling to less than 5.5% of disposable personal income in 2Q07 and retracing more than half the run-up that began in 2001. Subprime contagion can only reinforce this trend - putting pressure on home mortgage refinancing and thereby further inhibiting equity extraction by US homeowners.

[Figure 1]

With both income and wealth effects under pressure, I don't see any way saving-short, overly-indebted American consumers can maintain excessive consumption growth. For a US economy that has drawn disproportionate support from a record 72% share of personal consumption (see Figure 2), a consumer-led capitulation spells high and rising recession risk. Unfortunately, the same prognosis is likely for a still US-centric global economy.

[Figure 2]

Don't Count on Global Decoupling

A capitulation of the American consumer spells considerable difficulty for the global economy. This conclusion is, of course, very much at odds with notion of "global decoupling" - an increasingly popular belief that depicts a world economy that has finally weaned itself from the ups and downs of the US economy.

The global decoupling thesis is premised on a major contradiction: In an increasingly globalized world, cross border linkages have become even more important - making globalization and decoupling inherently inconsistent. True, the recent data flow raises some questions about this contention. After all, the world seems to have held up reasonably well in the face of the slowing of US GDP growth that has unfolded over the past year. But that's because the downshift in US growth has been almost exclusively concentrated in residential building activity - one of the least global sectors of the US economy. If I am right, and consumption now starts to slow, such a downshift will affect one of the most global sectors of the US. And I fully suspect a downshift in America's most global sector will have considerably greater repercussions for the world at large than has been the case so far.

That's an especially likely outcome in Asia - the world's most rapidly growing region and one widely suspected to be a leading candidate for global decoupling. However, as Figure 3 clearly indicates, the macro structure of Developing Asia remains very much skewed toward an export-led growth dynamic. For the region as a whole, the export share has more than doubled over the past 25 years - surging from less than 20% in 1980 to more than 45% today. Similarly, the share going to internal private consumption - the sector that would have to drive Asian decoupling - has fallen from 67% to less than 50% over the same period.

Nor can there be any mistake as to the dominant external market for export-led Asian economies. The United States wins the race hands down - underscored by a 21% share of Chinese exports currently going to America. Yes, there has been a sharp acceleration of intra-regional trade in recent years, adding to the hopes and dreams of Asian decoupling. But a good portion of that integration reflects the development of a China-centric pan-Asian supply chain that continues to be focused on sourcing end-market demand for American consumers. That means if the US consumer now slows, as I suspect, Asia will be hit hard - with cross-border supply chain linkages exposing a long-standing vulnerability that will draw the global decoupling thesis into serious question. A downshift of US consumption growth will affect Asia unevenly. A rapidly growing Chinese economy has an ample cushion to withstand such a blow. Chinese GDP growth might slow from 11% to around 8% - hardly a disaster for any economy and actually consistent with what Beijing has tried to accomplish with its cooling-off campaign of the past several years. Other Asian economies, however, lack the hyper-growth cushion that China enjoys. As such, a US-led slowdown of external demand could hurt them a good deal more. That's especially the case for Japan, whose 2% growth economy could be in serious trouble in the event of a US demand shock that also takes a toll on Japanese exports into the Chinese supply chain. While less vulnerable than Japan, Taiwan and South Korea could also be squeezed by the double whammy of US and China slowdowns. For the rest of Asia - especially India and the ASEAN economies - underlying growth appears strong enough to withstand a shortfall in US consumer demand. But there can be no mistaking the endgame: Contrary to the widespread optimism of investors and policy markers, the Asian growth dynamic is actually quite vulnerable to a meaningful slowdown in US consumption growth.

A Subprime Dollar

This constellation of forces could prove especially vexing for the US dollar. Currencies are, first and foremost, relative prices - in essence, measures of the intrinsic value of one economy versus another. On that basis, the world has had no compunction in writing down the value of the United States over the past several years. A broad dollar index, which measures the US currency relative to those of most of America's trading partners, is off about 20% from its early 2002 peak. Recently, it has hit new lows against the euro and a high-flying Canadian currency, likely a harbinger of more weakness to come.

Sadly, this depreciation of the US currency is not surprising. Because Americans haven't been saving in sufficient amounts for a long time, the United States must import surplus savings from abroad in order to grow. And it has to run record balance of payments and trade deficits in order to attract that foreign capital. The United States current account deficit - the broadest gauge of America's imbalance in relation to the rest of the world - hit a record 6.2% of gross domestic product in 2006 before receding slightly in the first half of this year. America must still attract some $3 billion of foreign capital each business day in order to keep its economy growing.

[Figure 3]

Economic theory is very clear on the implications of such huge imbalances: Foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the required compensation. The currency of the deficit nation usually bears the brunt of that compensation. It then follows that as long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping.

The only silver lining so far has been that these adjustments to the US currency have been orderly - declines in the broad dollar index averaging a little less than 4% per year since early 2002. Now, however, the possibility of a disorderly correction is rising - with potentially grave consequences for the American and global economy.

A key reason is the mounting risk of a recession in America. As noted above, the bursting of the subprime mortgage bubble - strikingly reminiscent of the dot-com excesses of the 1990s - could well be a tipping point. In both cases, financial markets and policy makers were steeped in denial over the risks. But the lessons of post-bubble adjustments are clear. Just ask economically stagnant Japan. And of course, the United States lapsed into its own post-bubble recession in 2000 and '01. Sadly, the endgame could be considerably more treacherous for the United States than it was seven years ago. In large part, that's because the American consumer is now at risk. Consumption expenditures currently account for a record 72% of the gross domestic product - a number unmatched in the annals of modern history for any nation.

This buying binge has been increasingly supported by housing and lending bubbles. Yet, as also stressed above, both of these bubbles are now in the process of bursting - an outcome which could put US consumer demand under considerable pressure. That will make it exceedingly difficult for the United States to avoid a recession.

Fearful of that possibility and the additional Fed easing it implies, foreign investors are becoming increasingly skittish over buying dollar-based assets. The spillover effects of the subprime crisis into other asset markets - especially mortgage- backed securities and asset-backed commercial paper - underscore these concerns. As a result, foreign appetite for America's complex and opaque financial instruments is likely to be sharply reduced for years to come. That would choke off an important avenue of capital inflows, putting more downward pressure on the dollar.

The political winds are also blowing against the dollar. In Washington, China-bashing is the bipartisan sport du jour. New legislation is likely that would impose trade sanctions on China unless it makes a major adjustment in its currency. Not only would this be an egregious policy blunder - attempting to fix a multilateral deficit with more than 40 nations by forcing an exchange rate adjustment with one country - but it would also amount to Washington taxing one of America's major foreign lenders.

That would undoubtedly reduce China's desire for United States assets, and unless another foreign buyer stepped up, the dollar would come under even more pressure. Finally, the more the Fed under Ben Bernanke follows the easymoney, market-friendly Alan Greenspan script, the greater the risk to the dollar.

Why worry about a weaker dollar? The United States imported $2.2 trillion of goods and services in 2006. A sharp drop in the dollar makes those items considerably more expensive - the functional equivalent of a tax hike on consumers. It could also stoke fears of inflation - driving up long-term interest rates and putting more pressure on financial markets and the economy, exacerbating recession risks. Optimists may draw comfort from the vision of an export-led renewal arising from a more competitive dollar. Yet history is clear: No nation has ever devalued its way into prosperity.

So far, the dollar's weakness has not been a big deal. That may now be about to change. Relative to the rest of the world, the United States looks painfully subprime. So does its currency.

The Failure of Central Banking

The recent chain of events is not an isolated development. In fact, for the second time in seven years, the bursting of a major asset bubble has inflicted great damage on world financial markets. In both cases - the equity bubble in 2000 and the credit bubble in 2007 - central banks were asleep at the switch. The lack of monetary discipline has become a hallmark of an unfettered globalization. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy.

This sorry state of affairs can be traced to developments that all started a decade ago. Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward.

America's IT-enabled productivity resurgence in the late 1990s was the siren song for the Greenspan-led Federal Reserve - convincing the US central bank that it need not stand in the way of either rapid economic growth or excess liquidity creation. In retrospect, that was the "original sin" of bubble-world - a Fed that condoned the equity bubble of the late 1990s and the asset-dependent US economy it spawned. That set in motion a chain of events that has allowed one bubble to beget another - from equities to housing to credit.

Yet bubbles always burst. And when that happened to the equity bubble in 2000, central banks threw all caution to the wind and injected massive liquidity into world financial markets in order to avoid a dangerous deflation. With globalization restraining inflation and real economies recovering only sluggishly in the early 2000s, that excess liquidity went directly into asset markets.

Aided and abetted by the explosion of new financial instruments - especially what is now over $440 trillion of derivatives worldwide - the world embraced a new culture of debt and leverage. Yield-hungry investors, fixated on the retirement imperatives of aging households, acted as if they had nothing to fear. Risk was not a concern in an era of open-ended monetary accommodation cushioned by a profusion of derivativesbased shock absorbers.

As always, the cycle of risk and greed went to excess. Just as dot-com was the canary in the coalmine seven years ago, subprime was the warning shot this time. Denial in both cases has eerie similarities - as do the spillovers that inevitably occur when major asset bubbles pop. When the dot-com bubble burst in early 2000, the optimists said not to worry - after all, Internet stocks accounted for only about 6% of total US equity market capitalization at the end of 1999. Unfortunately, the broad S&P 500 index tumbled some 49% over the ensuing two and a half years and an over-extended Corporate America led the US and global economy into recession. Similarly, today's optimists are preaching the same gospel: Why worry, they say, if subprime is only about 14% of total US securitized mortgage debt? Yet the unwinding of the far broader credit cycle, to say nothing of the extraordinary freezing up of key short-term financing markets, gives good reason to worry - especially for over-extended American consumers and a still US-centric global economy.

Central banks have now been forced into making emergency liquidity injections - including a rare intra-meeting cut in the Fed's discount rate that was then followed by a 50 basis point reduction in the overnight lending rate. The jury is out on whether these efforts will succeed in stemming the current rout in still overvalued credit markets. While tactically expedient, these actions may be strategically flawed in that they fail to address the moral hazard dilemma that continues to underpin asset-dependent economies. Is this any way to run a modern-day world economy?

The answer is an unequivocal "no." As always, politicians are quick to grandstand and blame financial fiduciaries for problems afflicting uneducated, unqualified borrowers. Yet the markets are being painfully effective in punishing these parties. Instead, the body politic needs to take a look in the mirror - especially at the behavior of its policy-making proxies and regulators, the world's major central banks.

It is high time for monetary authorities to adopt new procedures - namely, taking the state of asset markets into explicit consideration when framing policy options. Like it or not, we now live in an asset-dependent world. As the increasing prevalence of bubbles indicates, a failure to recognize the interplay between the state of asset markets and the real economy is an egregious policy error.

That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one dimensional fixation on CPI-based inflation and also pay careful consideration to the extremes of asset values. This is not that difficult a task. When equity markets go to excess and distort asset-dependent economies as they did in the late 1990s, central banks should run tighter monetary policies than a narrow inflation target would dictate. Similarly, when housing markets go to excess, when subprime borrowers join the fray, or when corporate credit becomes freely available at ridiculously low "spreads," central banks should lean against the wind. The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to keep lurching from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy. It could also spur the imprudent intervention of politicians, undermining the all-important political independence of central banks. The art and science of central banking is in desperate need of a major overhaul.

The Political Economy of Asset Bubbles

There may be a deeper meaning to all this. It is far-fetched to argue that central banks have consciously opted to inflate a series of asset bubbles - and then simply deal with the aftershocks once they burst. At work, instead, are the unintended consequences of a new and powerful asset-led global growth dynamic that is very much an outgrowth of the political economy of growth and prosperity.

This outcome reflects the confluence of three mega-trends - globalization, the IT revolution, and the provision of retirement income for aging workers. Globalization has injected a powerful new impetus to the disinflation of the past quarter century - facilitating a cross-border arbitrage of costs and prices that has put unrelenting pressure on the pricing of goods and many services, alike. At the same time, IT-enabled productivity enhancement - initially in the United States but now increasingly evident in other economies - has convinced central banks that there has been a meaningful increase in the non-inflationary growth potential in their respective economies. Finally, rapidly aging populations in Japan, Europe, and the United States are putting pressure on plan sponsors - public and private, alike - to boost investment yields in order to fund a growing profusion of unfunded pension and retirement schemes.

A key result of the interplay between the first two of these mega-trends - the globalization of disinflation and IT-enabled productivity enhancement - has been a sharp reduction in nominal interest rates on sovereign fixed income instruments for short- and long-term maturities, alike. Lacking in the yield to fund retirement programs from such riskless assets, investors and their fiduciaries have ventured into increasingly riskier assets to square the circle. That, in conjunction with the ample provision of liquidity from inflation- relaxed central banks, has driven down yield spreads in a variety of risky assets - from emerging-market and highyield corporate debt to mortgage-backed securities and a host of other complex structured products. In an era of spread compression and search for yield, the rising tide of ample liquidity covered up a profusion of jagged and dangerous rocks. As the tide now goes out, the rocks now get uncovered. The subprime crisis is a classic example of what can be unmasked at low tide.

The same set of forces has had an equally profound impact on the investment strategies of individual investors. Lacking in traditional yield from saving deposits and government bonds, families have opted, instead, to seek enhanced investment income from equities and, more recently, from residential property. This has created a natural demand for these asset classes that then took on a life of its own - with price increases begetting more price increases and speculative bubbles arising as a result. As long as inflation-targeting central banks remained fixated on their well-behaved narrow CPIs, there was little to stand in the way of a powerful liquidity cycle that has given rise to a multi-bubble syndrome.

In the end, it is up to the body politic to judge the wisdom of this arrangement - essentially, whether the inherent instability of increasingly asset-dependent and bubble-prone economies is worth the risk. Lacking a clear feedback mechanism to render such a verdict, it falls to the world's central banks - the stewards of economic and financial stability - to act as proxies in resolving this problem. This is where the problem gets particularly thorny. It takes a truly independent central bank to take a principled stand against the systemic risks that may arise from the pro-growth mindset of the body politic and act to "take the punchbowl away just when the party is getting good" - to paraphrase the sage advice of one of America's legendary central bankers, William McChesney Martin. Yet as recently retired Fed Chairman Alan Greenspan concedes, "I regret to say that Federal Reserve independence is not set in stone."

Greenspan's confession underscores the important distinction between two models of the central banker - those who are truly politically independent and those who are more politically compliant. The United States has had both types. I would certainly put Paul Volcker in the former category; amid howls of protest, his determined assault against the ravages of double-digit inflation was conducted at great political risk. Yet in the end, he held to a monetary policy that was fiercely independent of political pressures. By contrast, Arthur Burns, who I worked for in the 1970s, was highly politicized in his decisions to avoid the wrenching monetary tightening that a cure for inflation would eventually require. The market-friendly stance of Alan Greenspan - and the asset-dependent US economy it spawned - was more consistent with the model of the complaint central banker who was very much in sync with the pro-growth mindset of the body politic. Greenspan's memoirs are as much about politics as economics - underscoring his much stronger sense of the interplay between these two forces than a more independent central banker might otherwise perceive.

Yet Greenspan's basic point is well taken: It is not easy for any central banker to do unpopular things - especially if he happens to be a political animal operating in a highly charged political climate. But that's where I would draw the line. With all due respect to Alan Greenspan, the truly independent central banker was never supposed to win political popularity contests. I would be the first to concede, however, that it will take great political courage to forge the new approach toward monetary policy that I am advocating. But it can be done - as exemplified by the legacy of Paul Volcker.

In the end, it will undoubtedly take a crisis to provide central banks with the political cover they believe they need to broaden out their mandate from the narrow dictums of CPI-based price stability. Who knows if such a crisis is now in the offing? But with the credit cycle unwinding at the same time that Washington is turning protectionist and the overly-indebted American consumer is in trouble, the wisdom of condoning asset-dependent, bubble-prone economies may finally be drawn into serious question.

A Subprime Prognosis

How all this plays out in the global economy in the years immediately ahead is anyone's guess. I have long framed the tensions shaping the outlook in the context of "global rebalancing" - the need of a lopsided world economy to wean itself from a US-centric growth dynamic. A partial rebalancing now appears to be at hand - likely to be led by the coming consolidation of the American consumer. That is painful but good news for those of us who have long worried about the destabilizing risks of a massive US current account deficit. But a more complete global rebalancing is a shared responsibility - one that must also be accompanied by an increase in domestic demand from surplus-saving economies elsewhere in the world. To the extent that doesn't happen - and, as underscored above, that remains my view - then a asymmetrical rebalancing dominated by slowdown in US consumer demand should take a meaningful toll on global growth.

For a world economy that has been on close to a 5% growth path for nearly five years, that points to nothing but downside over the next 1-2 years. It's always hard to pinpoint the magnitude of such a shortfall with any precision, but I would not be surprised to see world GDP growth slip down into the 3.5% to 4% range at some point in 2008. Interestingly enough, such a downshift would only take global growth back to its post-1970s trend (3.7%). While that's hardly a disaster, it would still represent approximately a 25% slowing from the world's recent heady growth pace. Such an outcome could prove especially troublesome for the earnings optimism still embedded in global equity markets. The silver lining of such a prognosis would be likely cyclical relief on the inflation front - providing support for sovereign bonds.

But, as I have attempted to underscore above, the issues shaping the medium-term prognosis for the global economy go far beyond a standard call on the business cycle. America's asset-dependent growth paradigm is finally at risk. And with those risks comes the potential for collateral damage elsewhere in a still US-centric global economy. Dollar risks are especially problematic but so, too, is the collective wisdom - or lack thereof - of central bankers and politicians who have allowed the world to come to this precarious point. Policymaking and politics remain driven purely by local considerations. Yet the stresses and strains of a globalized world demand a much broader perspective. A new approach is needed - before it's too late.

Friday, October 19, 2007

Inflation is sad for anyone who is not invested in assets

Tell this to the eggheads at the Fed who only focus on "core" CPI and PCE. How convenient it'll be for them to use core numbers as excuse to lower rates again! For a nation who hates China and pokes fun at their 5-6% inflation numbers, it looks like we won't be that far behind soon. Bernanke needs to grow some balls, Volcker style, and let investors and wall street suffer a bit and reign in money supply--by allowing asset prices to deflate and financial markets to deleverage, unlike his intellectually shaky & social climbing predecessor.;_ylt=AsYlhRzO9vVNlgdE9lcciG8E1vAI

Thursday, October 18, 2007

GLA/U CN Equity

Global Alumina... F-yeah!!! gonna get ready for a m-fing bidding war yeah!!! (to the tune of team america)

Tuesday, October 16, 2007

The Russians are Coming

The people at Stratfor writes some of the most mindblowingly detailed analysis of geopolitical matters that I've the fortune of reading. This week's analysis on the consequences of America's royal f-up in the middle east and the coming regional alliances/conflicts that will play out independent of US wants is definitely worth reading and pondering on. Plays out like Final Fantasy XII doesn't it? Guess who the Rozzarians are :D

This made me stop outside my apartment with my blackberry so I could finish reading it. Usually, I just scroll through things very fast as I enter the building but NOT THIS TIME! One day, I swear I am going to get mugged or hit by a bus--but that's a story for another time! HAHA


The Russia Problem

By Peter Zeihan

For the past several days, high-level Russian and American policymakers, including U.S. Secretary of State Condoleezza Rice, Secretary of Defense Robert Gates and Russian President Vladimir Putin's right-hand man, Sergei Ivanov, have been meeting in Moscow to discuss the grand scope of U.S.-Russian relations. These talks would be of critical importance to both countries under any circumstances, as they center on the network of treaties that have governed Europe since the closing days of the Cold War.

Against the backdrop of the Iraq war, however, they have taken on far greater significance. Both Russia and the United States are attempting to rewire the security paradigms of key regions, with Washington taking aim at the Middle East and Russia more concerned about its former imperial territory. The two countries' visions are mutually incompatible, and American preoccupation with Iraq is allowing Moscow to overturn the geopolitics of its backyard.

The Iraqi Preoccupation

After years of organizational chaos, the United States has simplified its plan for Iraq: Prevent Iran from becoming a regional hegemon. Once-lofty thoughts of forging a democracy in general or supporting a particular government were abandoned in Washington well before the congressional testimony of Gen. David Petraeus. Reconstruction is on the back burner and even oil is now an afterthought at best. The entirety of American policy has been stripped down to a single thought: Iran.

That thought is now broadly held throughout not only the Bush administration but also the American intelligence and defense communities. It is not an unreasonable position. An American exodus from Iraq would allow Iran to leverage its allies in Iraq's Shiite South to eventually gain control of most of Iraq. Iran's influence also extends to significant Shiite communities on the Persian Gulf's western oil-rich shore. Without U.S. forces blocking the Iranians, the military incompetence of Saudi Arabia, Kuwait and Qatar could be perceived by the Iranians as an invitation to conquer that shore. That would land roughly 20 million barrels per day of global oil output -- about one-quarter of the global total -- under Tehran's control. Rhetoric aside, an outcome such as this would push any U.S. president into a broad regional war to prevent a hostile power from shutting off the global economic pulse.

So the United States, for better or worse, is in Iraq for the long haul. This requires some strategy for dealing with the other power with the most influence in the country, Iran. This, in turn, leaves the United States with two options: It can simply attempt to run Iraq as a protectorate forever, a singularly unappealing option, or it can attempt to strike a deal with Iran on the issue of Iraq -- and find some way to share influence.

Since the release of the Petraeus report in September, seeking terms with Iran has become the Bush administration's unofficial goal, but the White House does not want substantive negotiations until the stage is appropriately set. This requires that Washington build a diplomatic cordon around Iran -- intensifying Tehran's sense of isolation -- and steadily ratchet up the financial pressure. Increasing bellicose rhetoric from European capitals and the lengthening list of major banks that are refusing to deal with Iran are the nuts and bolts of this strategy.

Not surprisingly, Iran views all this from a starkly different angle. Persia has historically been faced with a threat of invasion from its western border -- with the most recent threat manifesting in a devastating 1980-1988 war that resulted in a million deaths. The primary goal of Persia's foreign policy stretching back a millennium has been far simpler than anything the United States has cooked up: Destroy Mesopotamia. In 2003, the United States was courteous enough to handle that for Iran.

Now, Iran's goals have expanded and it seeks to leverage the destruction of its only meaningful regional foe to become a regional hegemon. This requires leveraging its Iraqi assets to bleed the Americans to the point that they leave. But Iran is not immune to pressure. Tehran realizes that it might have overplayed its hand internationally, and it certainly recognizes that U.S. efforts to put it in a noose are bearing some fruit. What Iran needs is its own sponsor -- and that brings to the Middle East a power that has not been present there for quite some time: Russia.

Option One: Parity

The Russian geography is problematic. It lacks oceans to give Russia strategic distance from its foes and it boasts no geographic barriers separating it from Europe, the Middle East or East Asia. Russian history is a chronicle of Russia's steps to establish buffers -- and of those buffers being overwhelmed. The end of the Cold War marked the transition from Russia's largest-ever buffer to its smallest in centuries. Put simply, Russia is terrified of being overwhelmed -- militarily, economically, politically and culturally -- and its policies are geared toward re-establishing as large a buffer as possible.

As such, Russia needs to do one of two things. The first is to re-establish parity. As long as the United States thinks of Russia as an inferior power, American power will continue to erode Russian security. Maintain parity and that erosion will at least be reduced. Putin does not see this parity coming from a conflict, however. While Russia is far stronger now -- and still rising -- than it was following the 1998 ruble crash, Putin knows full well that the Soviet Union fell in part to an arms race. Attaining parity via the resources of a much weaker Russia simply is not an option.

So parity would need to come via the pen, not the sword. A series of three treaties ended the Cold War and created a status of legal parity between the United States and Russia. The first, the Conventional Armed Forces in Europe Treaty (CFE), restricts how much conventional defense equipment each state in NATO and the former Warsaw Pact, and their successors, can deploy. The second, the Strategic Arms Reduction Treaty (START I), places a ceiling on the number of intercontinental ballistic missiles that the United States and Russia can possess. The third, the Intermediate-Range Nuclear Forces Treaty (INF), eliminates entirely land-based short-, medium- and intermediate-range ballistic missiles with ranges of 300 to 3,400 miles, as well as all ground-launched cruise missiles from NATO and Russian arsenals.

The constellation of forces these treaties allow do not provide what Russia now perceives its security needs to be. The CFE was all fine and dandy in the world in which it was first negotiated, but since then every Warsaw Pact state -- once on the Russian side of the balance sheet -- has joined NATO. The "parity" that was hardwired into the European system in 1990 is now lopsided against the Russians.

START I is by far the Russians' favorite treaty, since it clearly treats the Americans and Russians as bona fide equals. But in the Russian mind, it has a fateful flaw: It expires in 2009, and there is about zero support in the United States for renewing it. The thinking in Washington is that treaties were a conflict management tool of the 20th century, and as American power -- constrained by Iraq as it is -- continues to expand globally, there is no reason to enter into a treaty that limits American options. This philosophical change is reflected on both sides of the American political aisle: Neither the Bush nor Clinton administrations have negotiated a new full disarmament treaty.

Finally, the INF is the worst of all worlds for Russia. Intermediate-range missiles are far cheaper than intercontinental ones. If it does come down to an arms race, Russia will be forced to turn to such systems if it is not to be left far behind an American buildup.

Russia needs all three treaties to be revamped. It wants the CFE altered to reflect an expanded NATO. It wants START I extended (and preferably deepened) to limit long-term American options. It wants the INF explicitly linked to the other two treaties so that Russian options can expand in a pinch -- or simply discarded in favor of a more robust START I.

The problem with the first option is that it assumes the Americans are somewhat sympathetic to Russian concerns. They are not.

Recall that the dominant concern in the post-Cold War Kremlin is that the United States will nibble along the Russian periphery until Moscow itself falls. The fear is as deeply held as it is accurate. Only three states have ever threatened the United States: The first, the United Kingdom, was lashed into U.S. global defense policy; the second, Mexico, was conquered outright; and the third was defeated in the Cold War. The addition of the Warsaw Pact and the Baltic states to NATO, the basing of operations in Central Asia and, most important, the Orange Revolution in Ukraine have made it clear to Moscow that the United States plays for keeps.

The Americans see it as in their best interest to slowly grind Russia into dust. Those among our readers who can identify with "duck and cover" can probably relate to the logic of that stance. So, for option one to work, Russia needs to have leverage elsewhere. That elsewhere is in Iran.

Via the U.N. Security Council, Russian cooperation can ensure Iran's diplomatic isolation. Russia's past cooperation on Iran's Bushehr nuclear power facility holds the possibility of a Kremlin condemnation of Iran's nuclear ambitions. A denial of Russian weapons transfers to Iran would hugely empower ongoing U.S. efforts to militarily curtail Iranian ambitions. Put simply, Russia has the ability to throw Iran under the American bus -- but it will not do it for free. In exchange, it wants those treaties amended in its favor, and it wants American deference on security questions in the former Soviet Union.

The Moscow talks of the past week were about addressing all of Russian concerns about the European security structure, both within and beyond the context of the treaties, with the offer of cooperation on Iran as the trade-off. After days of talks, the Americans refused to budge on any meaningful point.

Option Two: Imposition

Russia has no horse in the Iraq war. Moscow had feared that its inability to leverage France and Germany to block the war in the first place would allow the United States to springboard to other geopolitical victories. Instead, the Russians are quite pleased to see the American nose bloodied. They also are happy to see Iran engrossed in events to its west. When Iran and Russia strengthen -- as both are currently -- they inevitably begin to clash as their growing spheres of influence overlap in the Caucasus and Central Asia. In many ways, Russia is now enjoying the best of all worlds: Its Cold War archrival is deeply occupied in a conflict with one of Moscow's own regional competitors.

In the long run, however, the Russians have little doubt that the Americans will eventually prevail. Iran lacks the ability to project meaningful power beyond the Persian Gulf, while the Russians know from personal experience how good the Americans are at using political, economic, military and alliance policy to grind down opponents. The only question in the Russian mind pertains to time frame.

If the United States is not willing to rejigger the European-Russian security framework, then Moscow intends to take advantage of a distracted United States to impose a new reality upon NATO. The United States has dedicated all of its military ground strength to Iraq, leaving no wiggle room should a crisis erupt anywhere else in the world. Should Russia create a crisis, there is nothing the United States can do to stop it.

So crisis-making is about to become Russia's newest growth industry. The Kremlin has a very long list of possibilities, which includes:

  • Destabilizing the government of Ukraine: The Sept. 30 elections threaten to result in the re-creation of the Orange Revolution that so terrifies Moscow. With the United States largely out of the picture, the Russians will spare no effort to ensure that Ukraine remains as dysfunctional as possible.
  • Azerbaijan is emerging as a critical energy transit state for Central Asian petroleum, as well as an energy producer in its own right. But those exports are wholly dependent upon Moscow's willingness not to cause problems for Baku.
  • The extremely anti-Russian policies of the former Soviet state of Georgia continue to be a thorn in Russia's side. Russia has the ability to force a territorial breakup or to outright overturn the Georgian government using anything from a hit squad to an armored division.
  • EU states obviously have mixed feelings about Russia's newfound aggression and confidence, but the three Baltic states in league with Poland have successfully hijacked EU foreign policy with regard to Russia, effectively turning a broadly cooperative relationship hostile. A small military crisis with the Balts would not only do much to consolidate popular support for the Kremlin but also would demonstrate U.S. impotence in riding to the aid of American allies.

Such actions not only would push Russian influence back to the former borders of the Soviet Union but also could overturn the belief within the U.S. alliance structure that the Americans are reliable -- that they will rush to their allies' aid at any time and any place. That belief ultimately was the heart of the U.S. containment strategy during the Cold War. Damage that belief and the global security picture changes dramatically. Barring a Russian-American deal on treaties, inflicting that damage is once again a full-fledged goal of the Kremlin. The only question is whether the American preoccupation in Iraq will last long enough for the Russians to do what they think they need to do.

Luckily for the Russians, they can impact the time frame of American preoccupation with Iraq. Just as the Russians have the ability to throw the Iranians under the bus, they also have the ability to empower the Iranians to stand firm.

On Oct. 16, Putin became the first Russian leader since Leonid Brezhnev to visit Iran, and in negotiations with the Iranian leadership he laid out just how his country could help. Formally, the summit was a meeting of the five leaders of the Caspian Sea states, but in reality the meeting was a Russian-Iranian effort to demonstrate to the Americans that Iran does not stand alone.

A good part of the summit involved clearly identifying differences with American policy. The right of states to nuclear energy was affirmed, the existence of energy infrastructure that undermines U.S. geopolitical goals was supported and a joint statement pledged the five states to refuse to allow "third parties" from using their territory to attack "the Caspian Five." The last is a clear bullying of Azerbaijan to maintain distance from American security plans.

But the real meat is in bilateral talks between Putin and his Iranian counterpart, Mahmoud Ahmadinejad, and the two sides are sussing out how Russia's ample military experience can be applied to Iran's U.S. problem. Some of the many, many possibilities include:

  • Kilo-class submarines: The Iranians already have two and the acoustics in the Persian Gulf are notoriously bad for tracking submarines. Any U.S. military effort against Iran would necessitate carrier battle groups in the Persian Gulf.
  • Russia fields the Bal-E, a ground-launched Russian version of the Harpoon anti-ship missile. Such batteries could threaten any U.S. surface ship in the Gulf. A cheaper option could simply involve the installation of Russian coastal artillery systems.
  • Russia and India have developed the BrahMos anti-ship cruise missile, which has the uniquely deadly feature of being able to be launched from land, ship, submarine or air. While primarily designed to target surface vessels, it also can act as a more traditional -- and versatile -- cruise missile and target land targets.
  • Flanker fighters are a Russian design (Su-27/Su-30) that compares very favorably to frontline U.S. fighter jets. Much to the U.S. Defense Department's chagrin, Indian pilots in Flankers have knocked down some U.S. pilots in training scenarios.
  • The S-300 anti-aircraft system is still among the best in the world, and despite eviscerated budgets, the Russians have managed to operationalize several upgrades since the end of the Cold War. It boasts both a far longer range and far more accuracy than the Tor-M1 and Pantsyr systems on which Iran currently depends.

Such options only scratch the surface of what the Russians have on order, and the above only discusses items of use in a direct Iranian-U.S. military conflict. Russia also could provide Iran with an endless supply of less flashy equipment to contribute to intensifying Iranian efforts to destabilize Iraq itself.

For now, the specifics of Russian transfers to Iran are tightly held, but they will not be for long. Russia has as much of an interest in getting free advertising for its weapons systems as Iran has in demonstrating just how high a price it will charge the United States for any attack.

But there is one additional reason this will not be a stealth relationship.

The Kremlin wants Washington to be fully aware of every detail of how Russian sales are making the U.S. Army's job harder, so that the Americans have all the information they need to make appropriate decisions as regards Russia's role. Moscow is not doing this because it is vindictive; this is simply how the Russians do business, and they are open to a new deal.

Russia has neither love for the Iranians nor a preference as to whether Moscow reforges its empire or has that empire handed back. So should the United States change its mind and seek an accommodation, Putin stands perfect ready to betray the Iranians' confidence.

For a price.

"Marking to Model"

Keep this in mind while we frolic in the alchemy of finance :)

Macquarie the Pyramid Scheme?

w0wz0rs, this is some smart/twisted shiznit... it's a skeptic's paradise (to the tune of coolio) :D

Monday, October 08, 2007

Mandelbrot is a genius

1.) Volatility clusters; price movements concentrate and are non-independent
2.) Prices leap, not glide--i.e. are non-continuous
3.) In trading "time" is flexible and non-interval

Yup, I now officially have no faith in modern finance theory.