Almost all the stories I read in the media pertaining real estate in Miami either miss or gloss over the very important fact that the inventory of homes for sale has declined significantly (over approximately 37%) from November 2008. Even now, after the first-time home buyer tax credit has expired, I still see strong evidence that the inventory levels are continuing to decline. There is also virtually no new construction taking place so we should expect that new housing supply will become more constrained. Nevertheless, there will be more homes put on the resale market via bank owned foreclosures. This is the point which is hammered repeatedly by the media. Banks are stepping up their repossessions of homes that have already been in the foreclosure process for an abnormally long period and will be selling more properties. I agree with this; however, I believe that this is the final clearance sale not the endless abyss. It is important to note that the number of new foreclosure filings (leading indicator) is actually down 34% in South Florida for the first half of 2010 according to a recent report by Bal-Harbor based Condo Vultures. Based on the Case-Shiller home-price index, price levels in Miami began to stabilize over a year ago in April 2009 and have since then been essentially flat. These indicators, as well as the steady decline in overall supply of homes for sale, are concrete signs that we are entering the end game of this down cycle. While the accelerated clearing of backlog in foreclosure homes that has already started will probably last longer than a year and may lead to some more downward price movement, it will likely be remembered as one of the best moments ever to buy properties in Miami.

In the State of Florida, foreclosure sale prices were 28 percent below “regular” sales. In Miami-Dade, foreclosure sale prices averaged $149,236 in May, which was a 33 percent discount in comparison to traditional sales according to RealtyTrac. This current spread between foreclosure prices and traditional sales represents an attractive arbitrage opportunity. Cash buyers can purchase bank owned properties and sell on retail market for a good return with a relatively short turnaround. If someone wants to pursue this or any other purchases, let me know because I can help. I expect the spread may widen further as banks become more aggressive.

Deals are also finally emerging in the commercial market. However, I see the best opportunities in certain submarkets that have a strong future and potential for rent increases, such as Wynwood, the Design District, and areas of Downtown Miami. Bargains are harder to find and negotiate but they are out there. In particular, I like retail properties in these areas because they have had a large influx of luxury high-rise residential buildings and new residents which have been and will continue to increase demand for goods, services, and entertainment.

This will likely be my last commentary for a while. Till next time…

The one area where many in Congress seem to be beginning to try to be more responsible with taxpayer funds is in Federal Reserve transparency. The Fed recently doled out trillions of taxpayer dollars to whomever it chose. Neither the public nor Congress has little to any knowledge of how much money went to whom.  One piece of potential legislation that has not gotten nearly as much media attention as healthcare and executive pay reform is House Resolution 1207, also known as the Federal Reserve Transparency Act of 2009, which would allow for complete audits of the Federal Reserve by the Government Accountability Office (GAO). The bill has two-thirds of the House of Representatives co-sponsoring the bill. This is remarkable, especially considering that the bills creator, Congressman Ron Paul of Texas, is not known to give out political favors nor have any leverage over other members of congress other than pressure from his grass roots supporters. This might suggest that the issue is resonating strongly among the American public in favor of transparency. In fact, a recent poll conducted by Rasmussen Reports determined that 75 percent of Americans support an audit of the Federal Reserve. The Senate version of the bill (S604) sponsored by Senator Bernard Sanders has 25 co-sponsors but that number is likely to increase. This bill, if it becomes law (and potentially before), may be a further catalyst for dollar depreciation. The reason for this is most likely not because the Federal Reserve will become more expansionary due to political pressure, but because possible revelations may harm the credibility of the Federal Reserve as a gatekeeper to the dollar. Officials at the Federal Reserve are not the only ones that are concerned about having their feet to the fire. Despite the fact that HR1207 has had hundreds of co-sponsors for several months, leadership in the Congress have ignored its relevance and prevented it from coming to a vote. This stonewall appears to be finally showing some cracks as Barney Frank, chairman of the House Financial Services Committee, has officially scheduled hearings for HR1207 on September 25th  and has also publicly said the measure will be voted on but has not given a date.  Even though the bill has deep bipartisan support, it will still face steep hurdles from the political establishment including a possible veto from Obama (he has not commented on it but has proposed that the Fed receive more power) if it is not watered down significantly. Nevertheless, we can expect more scrutiny on the Fed and a continued demand for transparency in the coming weeks and months.

How should a retail investor play this expected weakness in the dollar? As I have often outlined in my previous newsletters, this is one of the reasons why I have been bullish on commodities in general and increasingly some areas of real estate. However, investors need to become cautious about how the government will respond to all of this. A recent disturbing trend has been the restrictions placed on Exchange Traded Funds’ (ETF) and other investors’ ability to fully participate in commodities futures exchanges. Even though many commodities have decreased significantly from their all time highs set not too long ago, government regulatory agencies such as the Commodities Futures Trading Commission (CFTC) are stepping in order to preempt what they deem to be destructive speculative behavior. Imagine what will happen to the CFTC’s sense of urgency if these commodities begin the skyrocket. This very unfortunate mindset appears to be the reality that we face. Commodities seem to be the one of the areas where the government feels at most liberty to regulate trading in the “public interest.” Therefore, investors need to be somewhat alert for of potential interference in these markets. It may be better to own the shares certain commodity producers than the commodity ETFs or ETNs. This is a change from my previous perspective that had viewed the commodity ETFs or ETNs as a better vehicle to hedge against inflationary pressures and profit from rising international commodity prices.

Real estate will be another hard asset that will likely benefit from monetary imbalances. The government seems to be more content with people making money on real estate than on commodity speculation. Commercial real estate still has some blood to be spilt as the 2005 vintage of 5-year loans come due this coming year. In most cases, these loans will be very difficult to refinance. Because many of these loans were securitized and owned by unorganized groups of investors, it complicates restructuring efforts that could normally extend maturities. In a way, that is a good thing because we should see more fallout happen sooner, allowing opportunistic investors to take advantage rather than having to wait on the sidelines.

Using data gathered from the multiple listing service focusing on key areas of Miami, I can report that sales have picked up considerably. By my rough estimate, the rate of monthly average rate of sales is up almost 70% from the severely depressed  levels I saw earlier this year. On the supply side nationally, we also see new construction projects falling dramatically in April to to a seasonally adjusted annual rate of 458,000, which is the lowest since record keeping began in 1959 and much lower than the peak rate of 2.27 million in January of 2006. Metrostudy found that housing starts in Miami are almost zero, which is in line with my own cursory observations. While most might see this as a negative, I see it as an essential step in reducing inventory glut. There have been meaningful pieces of legislation passed recently at both the federal and state level (Florida) that have the aim of encouraging buyers and supporting the real estate industry. Even though high inventory levels, impending foreclosures, and increasing unemployment will keep prices at bay in the near future, it seems that the ingredients are in place to slowly start forming a bottom in the residential real estate markets.

Unfortunately, there are almost no signs of life at all in the commercial market of Miami because most sellers are not budging. There is a trickle of sales activity for smaller multifamily properties with the yields are starting to look attractive in some areas. I expect the sellers and mortgage holders to cave in eventually. Condos will likely have a greater share of foreclosure problems, other supply issues, tougher lending standards, and increased maintenance fees; so one should require a greater discount in price and carefully consider the financial health and other characteristics of the condo association before jumping in. Also, even though property values are declining, one should not infer that tax bills will fall by an equal proportion (or at all) from these levels because the tax rates are likely to be raised in order to offset the lower assessed values and balance city budgets.

Central areas in Miami will likely present the better investment values. These areas the most high-end development in the recent years. These areas stand to continue to benefit from gentrification and the positive agglomeration effects that will likely occur as a result of the newly constructed luxury skyscrapers that are just now reaching high levels of occupancy. Even though the citywide economy might be contracting, there are specific areas that will continue to improve in quality and appearance even in the near term, albeit at a slower pace than otherwise would be the case.

In contrast, I expect more blight to set in the outskirts of the city, in areas that might not look so bad because they have a lot of new construction but still have a lot of vacancies. This is because of the increased congestion and travel time to the central business district, lack of comparable public utilities, prolonged property abandonment, and lack of maintenance. In southern Miami-Dade, the many new housing subdivisions within Homestead are almost ghost towns with low prices that are still not attracting buyers or renters. These areas may suffer from negative reinforcing conditions as more blight creates a less desirable living environment and more crime and, therefore, should be avoided even though pricing and potential income yields might appear to be attractive.

I wouldn’t say we are at a bottom but I would say that we are getting close. Within  a year or less the best opportunities will likely emerge. Individuals will increasingly need to protect their savings and investments with certain types of real estate, in part because it is a hard asset, which cannot be printed at will by a central bank.

At the current rate of government spending (even assuming normal GDP growth) the U.S. government debt will likely be over 100% of GDP in a couple of years. When one factors in the unfunded liabilities of Medicaid and Social Security it becomes clear that foreign central banks will not absorb all of that debt. With so much debt to finance, the situation could spiral out of control. While higher taxes are most probable, another likely event is that the mysterious Federal Reserve will buy up any excess treasuries in the market which will be significant. Isn’t that a neat trick? Not if you are expecting the dollar to retain its purchasing power. As I mentioned in my previous commentary, individuals need to stay away from long-term bonds denominated in U.S. dollars that are not indexed to some measure of inflation. While inflation might not be imminent, the recent steepening of the yield curve indicates that the markets seem to waking up to the fact that Uncle Sam is a drunken sailor that will not sober up before its too late.

Residential real estate prices in many parts of the United States will probably start to bottom out. During this period, which is likely to take some time, investors should be able to find very good deals if they look hard enough. Other areas such as NYC and Chicago will likely have significant downside left. In the case of New York and Chicago, this will be because the financial services industry will be undergoing dramatic consolidation. Most of the rest of the country should show signs of recovery as prices are considerably lower and the federal programs will begin to help set a floor on prices. Some areas that have seen the most dramatic price declines are beginning to present tremendous opportunities. In particular, Miami seems to be one great place to look for good value and upside potential.

There are several reasons why Miami real estate is beginning to be very appealing. Price declines have been much steeper relative to most other U.S. cities which will likely attract more buyers looking for a bargain. Strong buyers have significant leverage over sellers in this market. About six months ago, banks were still not willing to reduce mortgage principals by much in order to close a sale. Now, I am finally seeing huge write-downs on mortgage principals to facilitate short sales. I have observed recent closed sales where the final price is approximately 50% of the original mortgage balance. Over the longer term, another potential upside to Miami is improved relations with Cuba. Obama is much more likely to change US trade policy towards Cuba, which would most likely be initiated by removing travel restrictions. With Fidel Castro’s health being very fragile, it seems more likely now than ever that we will soon see some fundamental changes in U.S.-Cuba trade relations. Some people question whether or not this would be good for Miami. However, I think it would clearly be a strong positive growth factor for both Miami and Cuba.  Miami will benefit by being the natural staging point for trade between the United States and Cuba. Another reason why I am leaning towards Miami is that if dollar declines resume, Miami’s tourism industry should benefit somewhat. Although I see a lot of upside potential, It is still a little too early for me to be bold enough to declare a bottom because selling pressure and lack of buyers will likely cause prices to decline further over the next couple of months.

Commercial real estate may take longer to find a bottom than residential real estate, in large part, due to a lack of financing. Commercial real estate is slightly behind the curve because investors had incorrectly assumed that cash flows would not be significantly impaired by the economic downturn. With high-grade fixed income securities offering enticing yields, commercial real estate will not become attractive until sellers get realistic about the relative value of their properties and market them at higher cap rates. The U.S. government and Federal Reserve are unlikely to offer the same type of direct backstops they have been offering to the residential market through their support of the GSE’s, Fannie Mae and Freddie Mac and purchase of their mortgage backed securities. Many commercial property owners will not be able to refinance loans made over the past three to five years, which will have balloon payments coming due. Those with some equity will be forced to sell which will create more downward pressure on the market. Mortgage lenders will have to accept lower principal payments if we are to reach the bottom more quickly.

The economy is and will continue to be in a deep recession the likes of which the MTV generation has never seen. The most difficult question to answer is how long will the deflationary tendencies of this recession last. If I had to make a call on that, I would say probably less than a year. This is how long I think it would take for many inventories to be cleared and for many bankruptcy liquidations to take their course. Once the excess supply and competition is thinned out considerably the survivors will regain some pricing power. The market seems to be pricing a much longer deflationary period based on the relatively high yields offered by Treasury Inflation Protected Securities (TIPS).  I believe TIPS offer much better capital preservation than any other U.S. Government bonds.

The Obama administration will likely succeed in restarting inflation. Many emerging markets that were at one point trying to support their currencies in face of the downturn are now trying to cheapen their currencies in order to revive exports. The interesting thing now is that so many countries are debasing their currencies at the same time that it will have very little impact on their balance of trade. In the short run this will provide some support to dollar. However, in the end it will only hurt global sentiment for paper currencies as a store of value. Currency debasement will likely encourage speculation in commodities once again as they are relatively cheap. I expect this to happen sooner rather than later. Oil at less than $40 is very cheap will force severe supply contraction if it stays this low for much longer. Even the industrial metals have gotten so low that it seems a depression is already priced in.

The Democratic Party came just short of the 60 senate seats required to block filibusters. However, the terrible shape of the real economy will give the Obama administration the ability to rubber stamp almost any legislation it wants. While I do expect significant stimulus programs, it is unclear to me which promises, if any, will Obama have to sacrifice. It seems that Obama will try to incorporate his promises for green initiatives into various stimulus packages. However, it is likely that in many instances he will have to settle for simply trying to keep the titanic from sinking.

From my perspective, it seems as if there are finally some signs that the worst of the asset deflation is over. One of these being that there is so much forced liquidation, the type of condition you need to reach a bottom. Volatility and corporate bond spreads over government securities show just how intense the fear is. These spreads have come in a little but are still very wide. I think that it is time to shift gears from extremely defensive to more offensive. I would still focus on companies with quality earnings and strong balance sheets. High-grade corporate bonds also offer very good yields currently and the impending wave of bankruptcies has already been priced in. I would still stick to shorter maturities because of the risk that inflation accelerates rapidly in the coming years. Things remain very unpredictable but I am more optimistic than I was last year. The biggest concern I have going forward is the expansion of the Fed’s balance sheet and what the longer term impact of trying to keep interest rates so low will have on the economy. Considering all of these government bailouts and impending obligations it is a wonder to me that the 30-year treasury currently yields less than 2.9%. As Marc Faber puts it in a recent Barron’s panel discussion, “This was the last bubble the Fed was able to inflate, aside from their egos.”

June 4^th 2007 (Drunk on Liquidity)

-          I warned of a serious recession and the end of the private equity boom. At the time, it was an extremely bold prediction because hardly anyone was arguing this point and the subprime crisis had not yet begun.

-          I recommended defensive stocks such as Proctor & Gamble, Johnson & Johnson, and McDonald’s. Since then, the S&P 500 is down almost 50% while an equally weighted portfolio of just these three companies would have provided a positive total return with a relatively low standard deviation.

-          I warned of potential dollar weakness which we then saw in the proceeding 18 months up until recently where it has retraced much of those losses.

-          I warned that the explosive growth in the unregulated derivatives market had created a very shaky foundation that would become vulnerable in a highly volatile environment.

August 14^th 2007 (Slippery Slope)

-          I cautioned that we were “at the early stages of a very significant credit crunch.”

-          I reiterated my position that the Federal Reserve and the U.S. govt. would not be able to stop the housing market correction because a sharp rise in foreclosures and credit contraction was inevitable.

November 11^th, 2007 (What to Expect from the Fed and the Dollar)

-          I predicted that the Japanese yen and the Chinese RMB would be the best places to store value. Since then, the yen and the RMB been two of the strongest performers against every single asset class (including currencies and commodities).

-          I said Goldman Sachs and Morgan Stanley and many other financial companies “continue to face serious downside risk (even with a bailout).” Since then, Goldman Sachs has lost approximately 80% of its market value and Morgan Stanley has lost approx. 85% and the rest of the investment banks have either declared bankruptcy or been forced to sell themselves.

November 27^th, 2007 (Election 2.0)

-          “Barack Obama seems to be gaining momentum and I expect he could do better than the scientific polls indicate because of a greater percent of younger supporters on the web that are missed in the traditional polls.”

-          I predicted that we would see much greater involvement of young people in this election than in previous years and that it would have a great impact on the election results.

February 16^th 2008 (Power of Denial in the Housing Market)

-          I predicted that we were not close to a bottom in housing and the real estate market.

-          I predicted that Manhattan’s real estate market would finally crack in 2008 and begin price declines, a process which I expect will last longer than most think.

March 4^th 2008 (The Commodities Bull Continues its Charge)

-          I recommended not using leverage if buying commodities because I expected significant pullbacks along the way of a longer-term bull market.

June 10^th 2008 ($135 Oil: Who is the Culprit?)

-          “I would not be surprised to see oil pull back significantly but I would be very surprised if it stayed lower.” Oil was at $135 per barrel then and now it is at less than $50 now.

September 15^th 2008 (Is this the Final Capitulation?)

-          “I could easily envision the federal funds rate eventually getting close zero and other “creative” assistance offered to the likes of Citigroup. I do not see how AIG will survive or even Washington Mutual without intensive government assistance.” Since Sept 15th, Citigroup has lost $80billion in market value going from $15 to $3.77 per share and is on the verge of a bailout. AIG has since received $153 billion in federal loans. Washington Mutual was seized by the FDIC and purchased by JPMorgan Chase but Washington Mutual’s creditors have been left high and dry.

-          I recommended Gold and Agricultural commodities. While both have outperformed the stock market since September 15th, it is too early to make any assessment of those predictions.

I would caution anyone that will be too comforted in the dollar’s recent strength relative to commodities, for the same reasons I have outlined in my previous commentaries. 3 months is not a long time in the world of investing. I don’t know when it will turn around but it is a very likely that the current and future monetary and fiscal policy measures will eventually create an inflationary environment. That said, the dollar rally may continue over the short-term because credit and economic contraction is so pronounced right now.

Everyone is looking to the government for the solution. Although the government let the bears devour Lehman Brothers, I do not expect them to be relatively hands off for much longer. I could easily envision the federal funds rate eventually getting close zero and other “creative” assistance offered to the likes of Citigroup. I do not see how AIG will survive or even Washington Mutual without intensive government assistance but I am not so sure that they will get what they need in time to avoid bankruptcy. Even though Washington Mutual says it has “easy access” to over $50 billion in liquidity, I don’t think it is wise to underestimate how close it is to a classic “run on the bank” or how much they will have to discount their $270 billion in mortgage assets.

Unless there is a concerted international effort to support the dollar, I expect at some point it will resume its decline against most commodities and most Asian currencies. Even though it is not unlikely, currency intervention should not be relied upon because, ultimately, the market forces are much stronger.

The FDIC is going to need a couple hundred billion to make depositors whole as hundreds if not a thousand banks fail. Fannie Mae and Freddie Mac are also going to need a couple hundred billion in cash over the next couple of years to keep up with bond payments. The auto industry is expected to get about $50 billion in new loans. The Fed and the Treasury will have to repossess some of the collateral pledged by financial companies for unpaid loans which will likely result in billions of losses for the government. Neither presidential candidate has outlined concrete proposals that will shrink the size of government or reduce military expenditures, only enlarge it substantially. None of them are addressing the impending tsunami of debt to be incurred from unfunded entitlement obligations Medicare, Medicaid, and Social Security. Considering all of this, why should any sane person NOT have any serious concern over the long-term purchasing power of the dollar? For this reason, I would stay away from any government bonds with maturities longer two years.

Agricultural commodities still have a lot of appeal to me and I view the recent selloff as a technical consolidation as all commodities are being sold to raise cash anyway possible and margin calls put pressure on leveraged positions. At less than $800 per ounce, I even like gold again. Industrial and energy related commodities may continue to face pressure as the outlook for global growth deteriorates. China has signaled it is easing up on monetary policy which could spur more demand for essential commodities.

In my last commentary, I laid out the basic arguments for why I thought commodity prices would continue their assent. Most people I hear commenting on the matter complain that speculators are the main culprits behind the recent price trends. That is almost the equivalent of complaining that commuters are responsible for all the traffic during rush hour when there is no access to public transportation and the roads are falling apart. Others point the finger at OPEC saying that they have not done enough to increase supply or find new sources of oil. The truth is that OPEC countries are producing at or near full capacity and if they could find more oil they most certainly would. If anything, it has primarily been the actions of the world’s governments that have been the reason behind the seemingly unstoppable rise in commodity prices. Without a supply and demand imbalance, investors would have no reason to speculate dramatic changes in price over the long run. Government actions have distorted the marketplace, creating significant supply and demand imbalances. For one, energy and food subsidies in many emerging markets have not allowed the higher prices to naturally reduce consumption. Long standing agricultural production subsidies in the US and Europe have prevented many emerging markets from taking advantage of their natural comparative advantages and produce more commodities for the world market. The rapid growth in the world’s money supply caused by the actions of central banks and fiscally irresponsible governments alike have created a lack of confidence in currencies, especially the dollar and those with formal and informal pegs to it. This lack of confidence tends to result in a flight to hard assets such as commodities. Commodities merchants have been complaining that commodity supply levels did not justify the large increase in prices for certain commodities but fail to realize that a large part if not a majority of the increase is due to the depreciating currency and anticipation of further weakness.

These factors have been the main causes of the inflation. How will the brilliant politicians “solve” the problem “caused” by those nefarious speculators? More price controls, export regulations/taxes, consumption subsidies, and more trading restrictions on the futures markets themselves. What will be the impact of all of this? Unfortunately, it will result in higher global prices and more distortions that encourage rational speculators. It is not difficult to see how government intervention in commodities markets has done more harm than good.

Rice became “victim” to politics this year through a series of export bans and restrictions from major producers such as India, Egypt, Vietnam, Brazil, and Indonesia. These restrictions only helped fuel the panic and fears that other major producers may also ban exports. Yet somehow politicians and market commentators manage to place the blame on speculators for the price increases. Argentina has imposed heavy export taxes on its soy products in an effort to keep prices lower at home and force farmers to plant other goods. This has not only dramatically increased the global price for soy products but also put Argentinean farmers, the engine of growth for the country, in a very difficult situation and prompted significant protests and strikes.

Policy makers in India have come to the conclusion that in order to more aggressively combat inflation they need to exclude certain commodities from trading on its exchanges. This kind of backward logic is typical of politicians. By making it more difficult to trade something only increases the transaction cost and, ultimately, the price consumers have to pay. The demand does not go away just because the government decides to make it difficult to trade. If speculators want to buy it, they will find a way, either directly or indirectly. India is not alone, in this new trend.

Even U.S. politicians are proposing measures to limit trading of commodities only to certain individuals and companies. Congress has also put renewed pressure on the Commodities Futures Trading Commission (CFTC) to increase oversight and prevent speculative trading. The CFTC will reclassify major investment banks as speculators which would subject them to certain trading limits. The CFTC also announced a new information sharing agreement with London’s commodities regulator, the Financial Services Authority to gather information about large positions. I guess they will figure out what to do with that information once they obtain it.

China is now the second largest importer of oil behind the United States. Unfortunately for the world, the oil consumption in China, like many rapidly growing emerging economies, is heavily subsidized by the government. Bernard Picchi, a senior managing director at Wall Street Access, believes there is “ample evidence of oil-market manipulation, but not by oil companies or hedge funds, but by governments who subsidize consumption with below-market oil prices. Nine of the ten countries with the highest oil consumption growth have below-market oil prices.” According to Picchi’s estimates, oil price subsidies in China alone now run $125-150 billion a year. Higher world prices will put added strain on the governments’ finances as subsides become more expensive. I do not expect the Chinese oil subsidies to be cut back significantly in the near future considering its strong fiscal position and its enormous currency reserves. There are signs that some governments are having problems sustaining their subsidies and will have to remove or lessen them significantly. India recently lowered its subsidies because they were too costly. What they really should be doing is lower their import taxes. The sharp rise of oil prices has also forced Malaysia to significantly reduce its energy subsidies increasing the price of gas overnight by 40% sending shock-waves to consumers. Eventually, more governments will follow but not soon enough.

$135 oil will certainly curb demand in some areas such as air travel and the U.S. and European economies. However, growth in China, India, and other markets will likely more than offset this. I would not be surprised to see oil pull back significantly but I would be very surprised if it stayed lower. High commodity prices finally have the attention of Mr. Bernanke, who has increased his rhetoric against inflation expectations suggesting that he is done with interest rate cuts and might have to raise them. However, he is rather late to this revelation and any interest rate hikes to support the dollar against commodities will not be as effective due to the weakening U.S. economy, out of control spending, and future government liabilities.

One of the interesting aspects of this debate is that people do not usually complain as much when other asset classes are in the bubble phase. They usually just see it as another quick way to get rich. If we were experiencing another 1999 type stock bubble would people really be complaining about the speculators when their 401ks are going through the roof? I heard very few objections when real estate was being valued at ridiculous levels allowing people to continuously withdraw equity from their homes. Part of the reason is because, in general, the U.S. consumes more commodities than it produces and retail investors typically do not have much investment exposure to commodities. Voters are starting to wave the pitchforks and politicians are sure to see this as an opportunity to play the blame game with anyone but themselves. Prices are trying to adjust to correct the past mistakes of politicians. The real prices must be felt directly by the consumers and producers in order for a balance to be met. Until governments are forced to limit their interference and subsidies in commodities markets, I do not expect world prices to come down and remain down anytime soon.

Is this not old news? Do we really want to get involved in commodities? They have already gone up so much and many of them are at or near all time highs. If you think you can be safe by buying a 10 year U.S. treasury at less than 4%, then your trips to the supermarket will be very painful in the coming years. There are several reasons why I do not think we are close to the end of the commodities bull market.

One reason is that we are still not at the mania that one can expect during the extreme of a major bull (or bear) market. Most of the talk on the major financial networks consists of stocks, real estate, some bonds, and some commodities. When all is said and done, commodities will be front and center of attention. Much like the dotcom boom or the real estate flipping bonanza, we are going to have a commodities frenzy. Don’t get me wrong, some of the mania has taken hold but it is going to be much more pronounced. We may also have some corrections along the way but that is normal in any bull market. Everyone and their mother will be trading commodities. When the cab driver or the shoeshine guy starts giving you advice which commodity to put your money in, then you know the end is probably imminent. We are not close to that point yet and the fundamentals of supply and demand point to higher prices in the years to come.

Let us start with the supply. Bear with me because I am going to have to oversimplify things in order to prevent writing a book. All three categories of commodities (energy, metals, and agriculture) are in very short supply. Oil supplies are stretched thin and most oil producing countries are at full productive capacity. About a month ago, Petrobas discovered a major source of light crude oil off the coast of Brazil but it was extremely deep and will be costly to extract and will take some time before it comes online. We have not discovered any other major sources of oil for some time and those sources that we have not tapped into are in regions where investment capital is not attracted to or gets stolen by politicians. We also do not know the real amount of oil in reserves to begin with and current prices may not reflect the true supply. None of the OPEC countries allow for independent audits of their oil supplies yet each country’s voting influence in OPEC meetings is determined by how much oil the country “has” in reserve. Let’s just trust Hugo Chavez when he tells us how much oil he has. Ironically, while this situation of liar’s poker might strive to improve each country’s political influence, it actually hurts them as a whole because it helps to overstate the total supply of oil and decrease the price and the revenues the cartel receives.

Most supplies of agricultural goods are at or near historical lows. Prices have been so cheap for so long that the proper capital has not been invested to maintain production and prepare for the increase in demand. Whatever limited supply there was has been further compromised by the increase in demand from Asia. We may be on the brink of a starvation epidemic in many parts of the world, especially if we have a case of very bad weather one year. According to the U.S. Department of Agriculture, world grain stockpiles fell to 53 days of supply last year which is the lowest level since record-keeping began in 1960. As government continue to promote alternative energy through corn and sugar based ethanol, this will deplete the supply available for eating and devote more arable land for these commodities and away from other needed to farm other agricultural goods. There is also the possibility that the U.S. and Europe come to some sort of agreement to lessen or remove much of their agricultural subsidies. Should this happen we should see supplies diminish even further.

The demand for agricultural commodities is unlikely to subside. Even in a global slowdown, people are unlikely to eat less and China and India will still have strong growth rates. As China and India consume more grain fed animals due to their rising incomes, we will continue to see rising demand for grain (and substitutes). In this environment and given that agricultural commodities have not risen to the extent that the other commodities have yet, agriculture is my favorite.

Metals should also be in very high demand over the next several years. Again, this is due to the strength in emerging markets, particularly China and India. I am not a huge gold bug. However, I would rather own gold than the U.S. dollar. But, I would also rather own a lot of food than a lot of gold. I also don’t like that everyone seems to be talking an awful lot about gold. Should we reach $1000 soon, we might see a consolidation but that does not mean that this bull market is finished. Commodities related to metals and energy could be more negatively impacted by a global slowdown than agriculture, which is one of the reasons why I favor agriculture.

All of the commodities will have one giant ally on their side: The Federal Reserve. Chairman Ben Bernanke has now publicly admitted that he is more concerned about growth than inflation so he will continue to aggressively increase the money supply. Many central banks around the world will follow his lead. The European Central Bank has been holding out somewhat but they will face a lot of political pressure from export industries as the Euro reaches nose bleed levels. Cash is no longer king in this environment. Commodities are king because they are the only hard assets in limited supply. I am not saying that you buy commodities at high leverage (buying using a lot of borrowed money) because I expect pullbacks along the way and they will wipe out aggressive positions but we need to take the threat of stagflation as very real and in my view probable.

On the supply side we have one positive development. Builders have dramatically cut plans for new construction. However, because many projects take years to build, there is still a last wave of supply coming online in many struggling housing markets. Right now, builders are primarily concerned with getting rid of their bloated inventories and shoring up their balance sheets. This has led to some welcome and significant price reductions and added incentives. Builders are clearly ahead of the curve by adjusting prices more than the average home seller that is still in denial. Some institutional investors have taken advantage of homebuilders’ desperation by buying bulk properties from them at a fraction of their book value. Case in point, Lennar Corp. agreed in December to sell a portfolio of 11,000 properties for $525million at 40% of book value to a joint venture with Morgan Stanley. However, these kinds of fire sales are extremely rare if not impossible for the average home buyer to come across at this point.

And then, there is the hidden supply. I know from experience in Miami that many would be real estate investors bought multiple pre-construction condo units, with as little as 5% to 10% down and never had any intent on renting them out. After they were built (some are still not built yet), many individuals were content to keep them vacant with the logic that they would sell them someday soon so why complicate matters with tenants. Now that these owners are upside-down on their mortgages (owing more than their property is worth), most of them are deciding to find tenants and “wait it out.” This is leading to a dramatic increase in the supply of rental units and decrease rental rates in a lot of markets. As a result, many potential buyers are choosing to sit on the sidelines while they move into their posh new rental unit at cheaper rent. Eventually, many over leveraged condo investors that expect either a quick escalation in rents or a rebound in sales prices will not be able to cope with the bleeding and will have to foreclose.

The declining price of homes normally attracts more buyers to the market. However, one must factor in the total cost of ownership, not just the selling price. Even though average sale prices have gone down, taxes and insurance rates have gone up in many markets. In numerous cases, tax assessors are appraising home values higher than their actual market value and most homeowners are not taking steps to fight these assessments. The cost of home insurance is rising despite the depreciation in home values. While mortgage rates may have gone down for the absolute best borrowers, mediocre to weak borrowers are facing either a higher interest rate or not getting a mortgage at all. Condo maintenance fees for new condo developments will increase. This is because the artificially low introductory association fees guaranteed by developers for a set period will expire and the new rates will have to reflect real costs and added wear to new buildings. Because there was so much new development in recent years, the effect of this adjustment will have a greater impact to the market average than usual. While none of these rising costs by themselves would have significant impact. Added together, they certainly dampen the ability of declining property values to restore balance to the marketplace.

Then there is the rise in foreclosures that will also add to supply and put pressure on prices in the coming years. The federal government and the nation’s largest banks are taking several steps to prevent the tsunami of foreclosures that would happen if interest rates reset as stipulated in many mortgages contracts. However, they will not be able to stem the increased flow completely. Why should someone that already has bad credit and a mortgage that is more than the value of their home continue to make mortgage payments when they do not see prices rising anytime soon to give them positive equity? More and more people will just walk away.

On the demand side we have two major players almost completely out of the marketplace. Most of the speculators are gone. Some speculators are looking for bargains but they are not impacting the market the way they did a couple of years ago. The first time buyers and those with spotty credit are very scarce because mortgages are not readily available. Even many willing buyers with good credit are having a tough time because they now have to come up with a larger down payment.

The lack of mortgage financing will be one of the primary forces driving prices lower in the coming years. Banks and mortgage companies are having a tough time selling portfolios of mortgages to anyone except to Fannie Mae and Freddie Mac. Even though new legislation expected to pass will raise the loan sizes that Fannie Mae and Freddie Mac can purchase, this does not make up for the fact that these agencies already have their hands full and cannot be expected to support the entire mortgage market and bring it close to where it was. Not only are banks having a tough time selling the mortgages they have on their books to free up cash to make new loans but they are having to cope with losses related to bad loans as well as turbulence in the overall financial markets. As a result, mortgage issuance will continue to retreat for some time regardless of how low the Fed lowers rates.

Ok so things are bad. We get that part. Isn’t now the time to be a contrarian and jump in while things look the ugliest? The answer is no. The reason lies in one little known fact: Most homeowners are still in denial. A recent survey was conducted by Harris Interactive for Zillow.com, a Web site that gives estimated home values. The survey of 1,619 homeowners found 36% believe their home has increased in value during 2007, and another 41% believe their value has stayed the same. Only 23% believe their home has lost value. This is in direct contrast to the Case-Shiller index that measures home values and the National Association of Realtors that concluded a 2007 average national decline of home prices between 6% and 7%. Home owners will have to come to grips with reality before we can begin to feel that the worst is behind us for both the housing market and the overall economy. The obscure nature of real estate valuation always leads to slower adjustments than other asset classes such as stocks, bonds, or commodities. Housing inventories are increasing while absorption rates are decreasing in many of the once white hot markets. We will also have to see the inventory levels (measured by time) begin to decrease before we can be more confident about a bottom. Even at the point that inventory levels stabilize and begin to decline, the sentiment will probably continue to get worse (because of the irrational behavior usually exhibited at market extremes) causing impatient and fearful sellers to continue to lower prices even though the fundamentals of supply and demand will have begun to improve. That is the time to get in.

There are vast implications to this new development but given that we are in an important election season, I thought it would be appropriate to comment on how this new media fits into the election process and how significant it is. This is the first time these new websites have had any chance to flex their muscle in U.S. presidential elections and mainstream media has repeatedly underplayed and underestimated their significance (aside from CNN’s foray into “YouTube debates”) for several reasons not the least of which is that traditional media may feel threatened. On some fronts, it almost seems as though there is a war between the old media and the new media because of how differently the world is perceived within each realm and how each side tries to defends its credibility by attacking the other.

One of the reasons the traditional media has overlooked or dismissed political support on the Web is that the majority of people that traffic these new websites are of the younger generation, which on average have not been very active in politics in the past. Therefore, it is believed that this support is superficial and will not manifest itself into actual votes or campaign contributions. I would argue that the engaging and empowering nature of the Internet today is drawing a lot more young people into the political arena in a very real way, more so than more passive efforts in the past such as “MTV Rock the Vote.”

National poll statistics have strongly diverged from indicators on the Web on many recent occasions. The traditional media outlets tend to explain this as a result of the unscientific nature of the Web and that it is vulnerable to hackers. However, there are also problems with traditional polling methods which have not been adequately addressed. One rapidly growing problem regarding the accuracy of “scientific” national polls is that they make their “random” calls to registered land-line telephones. According to various sources, the number of households not using a land-line has increased to approximately 15% and for the age group 18-29 that number is closer to 30%. Many of these unaccounted people are exactly the types of tech savvy people that would be frequenting the web the most, and would therefore provide some explanation as to the divergence in the poll statistics; they are measuring the preferences of two groups with distinctly different ideologies. The traditional polls also do not account for the growing number of American citizens and military living abroad.

In addition, using the web as an indication of popularity has been discounted by some because of its unfiltered nature. Extremest from all sides are drawn to the web (in addition to the majority of normal people) which some believe destroys its credibility. I am not so concerned with this, in fact I think its healthy to have a wide range of peaceful debate and allows for all voices to be heard. As people become used to this, they will find that it is not as threatening as it seems.

No other presidential campaign embodies the dramatic conflict between old and new media more than the Congressman of Texas, Ron Paul. Paul gained a lot of online buzz (more than any other candidate) with a deluge of discussion on blog sites, MySpace, Facebook, Meetup and videos on YouTube. Yet, for a while, traditional national polls were only registering at 1-2%. Now his polls are at 5% and rising. In defiance of the natural laws of politics, this candidate has risen from complete obscurity to cult phenomenon to top 4 contender for the Republican Nomination in just a matter of a few months. By my estimates, he will have raised well over $20 million dollars by the end of the year (total). Paul’s supporters have shown considerable organization (made possible by the Internet) and passion and I expect a larger percent of them to show up at the polls compared to the supporters of the other candidates. This should lead to a higher higher voting results for Paul than the current polls indicate, especially in states with low turnout rates. The reason is because pollsters generally determine who are “likely” voters simply by asking the respondents. Approximately 90% of those called say they will be voting in the primaries but, in reality, only a small fraction end up actually going. Therefore, a candidate with a higher percentage of ardent supporters may have national poll statistics that do not accurately reflect the percentage of final votes.

Some people compare the candidacy of Ron Paul to Ross Perot’s but Ross Perot was able to use his own deep pockets to fund his campaign. Howard Dean had a similar grassroots campaign strategy in the 2004 race and also raised impressive cash but there are some important distinctions. Dean had served 10 consecutive years as Governor of Vermont (2nd longest in VT history) and also had many wealthy connections in New York where he was raised. Even though Howard Dean was seen as a relative long-shot in the early stages of the campaign, he eventually gained the front-runner status in the Democratic Party before the Iowa Caucus and the New Hampshire Primary, which further helped fuel financial support. In contrast, Ron Paul was not discussed at all in the mainstream media and is still considered a long-shot late into the campaign for his party’s nomination. Actually, most of the Republican Party leaders despise him, yet the rate of his campaign contributions and support in the polls is accelerating. The fact that Ron Paul is not a governor, senator, mayor, billionaire, or celebrity but is an older humble congressman from Texas (hes not even a great speaker) yet has gained the support of a spontaneous political organization that will most certainly affect how the 2008 presidential race plays out and politics beyond, speaks volumes about how powerful this new type of Internet can be and will become.

While Paul remains a long shot, I think a new political movement and shift in power has begun regardless of the final election results. He will continue to gain support in the coming weeks and months and the mainstream press will continue to be shocked by this, which will increase the coverage and debate on the range of issues which Paul brings to the table, particularly those regarding foreign policy, monetary policy, and fiscal policy. Hopefully, the mainstream media will begin asking the question why they had ignored his online support for so long in the first place and why there was such a discrepancy. In the end, it’s “the economy stupid” and with the dollar in free fall and the economy in recession (based in dollar terms and a more realistic CPI), Paul’s long held Austrian and libertarian philosophies are beginning to resonate strongly with a lot more people, even if they disagree with some of his positions or are turned off by some of the fringe elements that are attracted to his anti-establishment campaign.

On the Democratic side, Barack Obama seems to be gaining momentum and I expect he could do better than the scientific polls indicate because of a greater percent of younger supporters on the web that are missed in the traditional polls. If Paul drops out early, which is highly unlikely, Obama may get some of Paul’s anti-war supporters in open primary states. The Democrats have the clear advantage overall but the primary elections are going to be a very close on many fronts.

How could this possibly relate to the world of business and finance? Is there something in this story that has not already been priced into the market? It is not easy to determine. However, it seems the traditional political establishment is beginning to lose some control. While still extremely powerful, the United States military industrial complex could be facing some headwinds in the somewhat distant future. I would not exactly be selling short military stocks as Hillary is still the front-runner but I do not see the overwhelming value in buying them anymore. It is also difficult to recommend companies that benefit from these new web technologies given their astronomical valuations. I have always believed that the Internet does wonders to fight and expose corruption in politics. We are now seeing Web 2.0 take this fight to the next level, which should have a very positive impact on the global economy and provide more stability to emerging markets. I am not here to say that Web 2.0 is going to save the world but it has been well exceeding the hype so far.

This is in no way meant to single out the United States because it is one of the better monetary systems currently in operation considering that it at least strives for some independence. The question remains: how independent is the central bank really? Whenever you put individuals in charge of monetary policy with very little explicit controls or restrictions, people are bound to hold them responsible for all the economy’s ups and downs. Is it beneficial in the long run to demand that the Fed lower interest rates and bail out reckless companies every time there is a threat of recession? Was it not that very situation which extended the housing bubble? Obviously, the lengthy terms of the Board of Governors may help neutralize potential outcries but to assume that the chairman of the Fed will live in a vacuum and not be influenced by the demands around them (whatever they are) would be a naive perception of human nature. It is also important to investigate where the Board of Governors would most likely hear their complaints from. Considering that the only people that the Federal Reserve actually does business with are wall street bankers which act as its primary dealers, it is not absurd to speculate that monetary policy would become slanted in their favor. Based on its current structure, it is an interesting revelation that the Federal Reserve System itself was conjured up in the early 1900’s by representatives of the largest privately owned financial firms which, in effect, appointed themselves as primary dealers.

One of the Federal Reserve’s main objectives is to maintain price stability. It is important to note that the Fed’s calculation of price stability has changed several times over the past decades, each time having the effect of lowering the stated inflation rate. It does not take a genius to determine that the figures are not indicative of reality when the price of almost every important product or service for the consumer has been rising much faster than the declared rate of inflation. To name a few, health care, education, food, and energy have certainly been rising more quickly than the stated rate. The Fed chooses to focus on the core rate of inflation, which excludes food an energy due to their volatile nature. If these were volatile but with a downward trend, such as computers, I doubt they would have been excluded. What about Housing? Why are rents factored into the index instead of actual sales prices? Should we start using auto leasing costs instead of sales figures as well? Again, I am not singling out the U.S. because it seems that all governments manipulate their figures to make them look better.

There is no question that the Fed has been happy to act as lender of last resort. The minute there is evidence of a problem, the financial community turns to the Federal Reserve for assistance and is almost always given it with very little extra cost or penalty. If you owe the bank $100 thousand, then it is your problem but if you owe the bank $100 million, then it is their problem. If the banks are owed $100 billion dollars, then it is the central bank’s and the government’s problem. The recent ploy by Citigroup Inc., Bank of America Corp., and JPMorgan Chase & Co. to pool many of their now illiquid assets into a $80+ billion structured investment vehicle seems to be nothing other than organizing their political clout so that they can receive one giant bailout package when the time comes to mark these assets down to their market value.

Although we have already seen some write-downs from financial institutions, I expect a lot more to follow. On November 15th, the Financial Accounting Standards Board is implementing a new accounting rule (FAS 157) that will put added pressure to declare the true market value for level 3 assets. Level 3 assets are the most illiquid of all assets on a firm’s balance sheet. Due to a lack of ready comparables, companies were able to value these assets based on in-house models. Marking these assets to their market value will be a long and painful process. Hopefully, we are close to halfway done. All the managers of potentially insolvent funds that have not been fired already are clinging by a thread and doing whatever they can to at least make it through this bonus season. Whether they even make it that long is irrelevant but you can be sure that they have no interest in recording their losses any sooner than they have to.

What does this all mean to the average investor? It probably means that as this financial tightening continues to unfold, the Federal Reserve and the U.S. government are going to concede to our nation’s banks and financial companies by offering assistance and increasing the growth in money supply at a time when almost every foreign central bank and sovereign wealth fund is slowing their accumulation of dollar denominated assets. Despite the recent comments by Ben Bernanke expressing his heightened concern on inflationary pressures, when push comes to shove, he is going give the banks what they ask for. The dollar is headed significantly lower across most currencies and commodities. Unfortunately, this will probably not help to solve the real problem, which is that during this credit bubble, capital was misallocated and now needs to be properly adjusted. The true power of capitalism rests in natural selection and allowing for the survival of only the firms that allocate capital most effectively to the benefit of consumers not politicians. By bailing out financial companies this early in the correction we only promote the same type of reckless speculative activity that caused the problem to begin with. In this case, I think a lesson can be learned from Japan: you do not get out of a recession by simply pouring money into the system, assisting the largest most politically connected companies and devaluing the currency. Unless we can somehow avoid the excessive booms and mal-investment that always occur, we need to get used to the idea that the economy should enter a contraction phase at some point and then we should allow the markets to do most of the work. Once the excesses have been able to work themselves out of the system, we might then think of providing some sort of stimulus but not before then.

Recommendations:
I am still recommending the stocks I did six months ago. Since my recommendation on June 4th, Proctor and Gamble (+11.9%)*, Johnson & Johnson (+4.1%)*, and McDonald’s (+15.9%)* have all significantly outperformed the S&P 500 (-4.5%)* but still have a lot of value and work well as a weak dollar and defensive play. Should the S&P 500 take a huge drop they may be dragged with it but such a situation would only present buying opportunities for these excellent multinationals with strong growth potential in emerging markets. I also like the Chinese yuan and the Japanese yen. For those that do not have access to these currencies through their brokerage account, Everbank.com offers a great service for buying these currencies. I am very positive on China’s currency because their trade surplus keeps going through the roof (27$ billion in October alone) despite high oil prices. They are facing heightened political pressure to allow faster appreciation (now even Europe is rattling its sabers). China’s finance ministers have made recent statements implying that they no longer favor the dollar as a reserve currency. The Yen has a lot of upside potential due to the unwinding of a carry trade (borrowing yen at very low interest to purchase higher yielding assets in other countries) due to risk aversion and a clear change in the directional trend of the currency. This unwinding process can happen very quickly and even at the time of the writing of this it is moving much faster than anticipated. I am negative on most financial stocks due to the large uncertainty regarding their balance sheets. For example, as a percent of equity in level 3 assets, Morgan Stanley has a reported 251% and Goldman Sachs has 185%. Goldman made a large timely bet against the sub-prime markets, which is already priced into the stock now. These and many other financial companies continue to face serious downside risk (even with a bailout) and must be approached with extreme caution.

*Calculated from closing price of June 4th 2007 to the close of November 8th 2007. Calculations exclude dividend payments.

There are several reasons why the problems will not be solved by overly accommodative monetary policy. With regard to the U.S. mortgage market, cutting the federal funds rate might help ease the impact of teaser rate loan resets but the cuts themselves (however dramatic) cannot erase the real problem. Many borrowers never expected to hold on to their existing mortgage long enough for any kind of interest rate reset. Most residential mortgages originated in 2005 and 2006 should never have been made and a Fed bailout would only encourage that type of reckless behavior. Another reason the central bank should exercise caution is that the yen carry trade seems to be on particularly unstable footing. When that begins to unwind, as it appears to be, then lowering of short-term interest rates and increasing the money supply in the U.S. and Europe will only provide fuel to the fire and exacerbate the adjustment. The central bank is often relied upon to avert all financial disasters. That over reliance can sometimes pressure it to do things that will only make the situation worse.

The credit issues are spreading. Although the first signs of credit problems were seen in the U.S. residential mortgage market, a significant number of hedge funds located across the globe have imploded. Investors are reading the headlines and wondering who is next. Hedge funds that are not wholly invested in highly liquid assets (a definition that changes daily) are finding themselves in a very bad predicament as loans are called and redemptions flood in. If we see an increasing number of funds halting redemptions, as I expect, confidence in the market will take another severe blow. Many banks claim to have diverted risk by packaging and selling off their loans to other third parties but often the groups they sell the loans to are some of their best customers. The lack of transparency is not helping to ease investor fears. It is a tangled web and very few are immune to the problem.

Most of private equity is entering a deep slumber, which it desperately needed. Many titans of Wall Street will have to accept human status at least for a while. However, as with any great economic shift, some people and companies have shown a keen perception having positioned themselves extremely well in the current market. One such star is the Hedge Fund, Paulson & Co. In 2003 it had a respectable 700 million under management. However, this year alone, assets under management at Paulson & Co. doubled from $10 billion to $20 billion due in large part to investments that benefited from the collapse of the sub-prime mortgage market.

Its time to be defensive if one has not done so already. There are some great opportunities amidst this change and even greater opportunities to follow. It is either a very exciting or frightening time depending on your perspective. As always, I will be keeping a very close eye on the markets and look forward to giving future updates as events warrant.

Buyout firms such as KKR, Blackstone, and Cerberus have seized upon this great opportunity to make mountains of cash. Initially, these private equity groups had a lot of sound long term reasoning behind their acquisitions. Prices were not as high as they are now and by taking companies private they could create added value by decreasing bureaucratic and regulatory inefficiencies as well as creating huge tax savings by being able to write off the company’s debt interest payments. How long can this arbitrage be viable? I do not have the exact answer to that but I don’t think the end is far off. The irony that Blackstone is now taking itself public seems to be a pretty strong signal that things have shifted. While momentum is still on the side of the buyout firms, I believe most of the acquisitions being made now are simply to feed the beast and not for the original sound principles. A lot of speculation has helped move the entire stock market higher because so many companies are now considered potential takeover candidates. That could be one of the reasons why there still seems to be some value in the larger cap stocks that would be the most difficult to acquire.

If the momentum is on the side of buyout firms, what could cause this ride to come to a screeching halt? One answer is interest rates. Higher interest rates will make it harder to finance large acquisitions and stock buyback programs. In addition, it will give the pension fund investors, which have been large contributors to the capital in these deals, a reason to keep their money in bonds.

The US Treasury has been one of the primary benchmarks for the world’s coupons. Foreign central banks, desperately trying to keep their currencies low against the dollar in order to keep exports flowing have gorged themselves of this asset, particularly the US 10 year. Part of the “problem” is that it is the easiest option. To buy certain large US companies foreign entities have jump through hoops and often fail because of the political roadblocks that they face. No one likes to lose money, not even communist countries. The interest rate on the 10 year has finally started trending upward while the dollar has depreciated significantly against major currencies and commodities. You can bet this has a lot of politicians in China (and many other countries) thinking about other ways they could use the money they have in US treasuries, especially since the US congress seems dead set on imposing import restrictions if China doesn’t allow the RMB to appreciate more rapidly. There has been a clear shift already of nations removing or significantly changing their pegs against the dollar and allowing them to float against a wider range of currencies, particularly the Euro. I believe this trend away from the dollar will continue and could accelerate.

Another reason for the historically low global interest rates has been the perception that single-currency interest rate derivatives have eliminated exchange rate and interest rate risk. The explosive growth of this segment in the derivatives market is a testament to how much people believe in it. According to the Bank for International Settlements, in 1995 the notional amount of contracts outstanding in dollars was close to $18trillion. By June 2006, this number had grown to $291trillion (almost 5 times global GDP). While these types of derivatives have withstood some major stress tests such as the 98 Asian currency crisis, the market back then was much smaller also more nimble. Some argue that if something like that were to happen today the major trading houses might not be able to logistically handle the volume of transactions that would take place.

Another more obvious threat to the health of the credit markets is the state of the US housing market. Many investors/traders feel that the risk has already been priced in and that it is old news but I would caution them that things are going to get much worse. Even the sub prime debacle, which a majority feel has hit bottom, has significant future headwinds in the form of many interest rate resets on loans that were made at the peak of the market. Also, many of the bad loans that lenders sold to investors had buyback provisions and if they are forced to exercise them, the cash available in banks coffers for all types of loans will dry up. Downward price pressure of homes in most markets is accelerating. Most investors would say that the problem is “contained” but I do not think they appreciate how long these things take to play out. Housing prices may have been declining for over a year (a short time considering a bull market of about 15 years) but its impact on employment, GDP, and sentiment has only just begun. Could the US enter a recession? Most likely. Does that mean the end of the world? For some people it obviously does because they would never admit something like that. To me it is simply an opportunity if positioned correctly. Timing these things correctly all the time is impossible but an investor needs to maintain independent judgment and not simply run with the herd.

The most common argument I hear against a recession is that there is so much liquidity in the market. I would argue that liquidity would simply make the change more rapid, not prevent it from happening. If there was some catalyzing event or combination of events, liquidity in the form of cash would quickly flee to other parts of the world that are enjoying much stronger growth rates and don’t have severe twin deficits. Liquidity resulting from a generous financing environment could also disappear overnight from a number of scenarios. Was there not a lot of liquidity for sub prime mortgages only a year ago?

Another argument against a recession is that strong global growth will keep the US afloat. This, I believe is a much stronger argument because there are many US companies with a strong presence abroad and will thrive in a strong global economy. Companies such as Procter & Gamble, Johnson & Johnson, and McDonalds should outperform. However, continued expansion in emerging markets could pose some challenges for the US. Faster growth in emerging markets will lead to higher labor costs as well as increased demand for commodities, which will contribute to global inflationary pressures. Should the US Dollar devalue further, the effect of this inflation will be amplified in the US. This will put the US Federal Reserve in between a rock and a hard place not giving it freedom to lower rates and possibly forcing it to raise rates in order to combat inflation.

While some of the things I am predicting may seem dire. It really just depends on your perspective. It might be a good thing should the US stop resting on its laurels as a consumption machine and start producing more. A weaker dollar and higher interest rates probably won’t cure our sins alone but it will certainly sober us up quite a bit. The transition would not be without pain but it would make us better off. After all, we have an obligation to take care of our aging population. We need to start paying off the nation’s giant credit card or we won’t be able to borrow when we need it most. This is certainly not a new argument but freshness has nothing to do with the truth.